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as quantity increases. This occurs because a constant is being divided by increasingly large numbers. Average total cost is the summation of the average fixed and average variable cost curves. Because average fixed cost approaches zero, the difference between average variable cost and average total cost also approaches zero (the difference between ATC and AVC is AFC). The marginal cost curve intersects both the average total cost and average variable cost curves at their respective minimums. In other words, as marginal cost is below average total (and average variable) cost the average function is falling to meet marginal cost. As marginal cost is rising above the average function then average 158 total (and average variable) cost are increasing. The following graph relates average and marginal product to average variable and marginal cost. Notice that at the maximum point on the marginal product curve, marginal cost reaches a minimum. Where marginal cost equals average variable cost, the marginal product curve intersects the average product curve. In other words, the cost structure of the firm mirrors the engineering principles giving rise to the firm=s production, hence its costs. This presents some interesting disconnects from how business is presently evolving. The high compensation levels of executives seems to not reflect the actual output of their labors. In other words, the costs of production seemingly fail to account for the history of the 21st century thus far. As it turns out, these issues can be explained by neo-classical economics, and will be in Chapters 10 and 11. The Long Run Average Total Cost Curve In the long-run all costs are variable. In other words, a firm can vary its plant, equipment, technology and any of the factors that were either fixed or variable in the short-run. Therefore, anything that is technologically feasible is available to this firm in the long-run. Further, any short-run average total cost curve (consistent with any size of operation) could be selected for use in the long-run. 159 The long-run average total cost curve (LRATC) is therefore a mapping of all minimum points of all possible short-run average total cost curves (allowing technology and all factors of production (i.e., costs) to vary). The enveloping of these short-run total cost curves map all potential scales of operation in the long-run. Therefore, the LRATC is also called the planning horizon for the firm. The following diagram illustrates a LRATC: The shape of the LRATC is dependent upon the available resources and technology that a firm can
utilize to produce a given commodity. The downward sloping range of the LRATC is due to economies of scale, the upward sloping range of the LRATC is due to diseconomies of scale, and if there is a flat range at the minimum point of the LRATC this is called a range of constant returns to scale. Economies of scale are benefits obtained from a company becoming large and diseconomies of scale are additional costs inflicted because a firm has become too large. The causes of economies of scale are that as a firm becomes larger it may be able to utilize labor and managerial specialization more effectively, capital more effectively, and may be able to profitably use by-products from its operations. Diseconomies of scale result from the organization becoming too large to effectively manage and inefficiencies developing. Constant returns to scale are large ranges of operations where the firm's size matters little. In very capital intensive operations that must cover some peak demand, the size of the firm may matter very little. Several public utilities, such as electric generating companies, telephone company, and water and sewer service have 160 relatively large ranges of constant returns to scale. Where the LRATC curve reaches its minimum, this is called the minimum efficient scale (size of operation). Minimum efficient scale is the smallest size of operations where the firm can minimize its long-run average costs. Minimum efficient scale varies significantly by commodity produced and technology. For example, the minimum efficient scale in agriculture in the Great Lakes area for dairy operations is relatively small (in the $200,000 range). Minimum efficient scale for wheat farmers in the Great Plains may be as large as $1,000,000. There is an interesting implication of the LRATC analysis. There are instances where competition may be an unrealistic waste of resources. A natural monopoly is a market situation where per unit costs are minimized by having only one firm serve the market. Minimum efficient scale is the point on the LRATC where it reaches its minimum. If that happens to be at the beginning of a long range of constant costs, it is the first point (on the left of the range) where costs are at their minimum. Remember, that technical efficiency requires that a firm produce at where it has attained minimum total long-run costs. Where minimum efficient scale is very large for capital intensive operations, it may be more cost effective to permit one company to spread its fixed costs over a very large number of consumers, rather than have several competing firms suffer the fixed costs of a minimum
efficient scale and have to share a customer base. There are several industries that are very capital intensive and require large initial investments to operate. These types of firms are frequently natural monopolies. Railroads, electric generating companies, and air lines requires tens of millions of dollars in fixed costs. KEY CONCEPTS Explicit v. Implicit Costs Opportunity Costs Economic v. Accounting Costs Normal Profit Next Best Alternative Time Periods of Analysis Market Period Short-run 161 Long-run Law of Diminishing Returns Total, average, and marginal product Short-run Costs Total costs Average Total Average Fixed Average Variable Marginal Long-run average total cost Economies of Scale Diseconomies of Scale Minimum efficient scale Planning Horizon Natural Monopoly STUDY GUIDE Food for Thought: Complete the following table then draw the relevant curves from the data (fixed cost is $200). Total Average Average Average Marginal Total Total Product Variable Costs Costs Fixed Cost Variable Cost Total Cost Cost 0 0 1 20 38 2 58 3 64 ___ 4 ___ 76 5 ___ 93 6 ___ 114 7 ___ 139 8 ___ ___ ___ ___ ___ ___ > ___ > ___ ___ ___ ___ > ___ ___ ___ ___ > ___ ___ ___ ___ ___ ___ > ___ > ___ ___ > ___ ___ ___ > ___ ___ ___ ___ 162 Give the algebraic expression of each of the short run average cost curves and explain (in words) what each means and what its relation is to total product. Explain, in detail, why normal profit is included in average total costs? Draw a LRATC demonstrating diseconomies, economies and constant returns to scale. Explain why each range of the LRATC curve is observed. What does this have to do with planning? Explain. Sample Questions: Multiple Choice: Which of the following does the marginal cost curve NOT intersect at its minimum? A. Average variable cost B. Average total cost C. Average fixed cost D. Average fixed cost plus average variable cost Which of the following is not a potential cause of economies of scale? A. Ability to use by-products B. Specialization of labor C. Efficient use of capital D. All of the above are potential causes of economies of scale 163 True - False When marginal cost is below average variable cost, average variable cost must be rising. {FALSE} Long Range Average Total Cost reaches its minimum where short run marginal cost is equal to LRATC. {FALSE} Economic costs include implicit costs, whereas accounting costs do not. {TRUE} Marginal costs are the change in costs associated with the addition of
one more unit of output. {TRUE} 164 CHAPTER 8 Pure Competition Chapter 4 developed the supply and demand diagram. The simple supply and demand diagram is the model of a perfectly competitive industry. That model will be revisited and extended in this chapter. The purpose of this chapter is to introduce models of the firm that are not purely competitive. After a brief introduction to imperfectly competitive models we will turn our attention to the purely competitive industry and firm. In particular, this chapter will develop the model of the perfectly competitive firm, examine its relation to the industry, and then offer some critical evaluation of this important paradigm. Firms and Market Structure There are several models of market structure. In the product market, the two extremes are perfect competition and pure monopoly. This chapter will examine pure competition and the following chapter examines monopoly. However, there are intermediate market structures. These intermediate market structures are oligopoly and monopolistic competition. The assumptions in pure competition are: (1) there is atomized competition (a large number of very small suppliers and buyers relative to the market), (2) there is complete freedom of entry and exit into and from this market, (3) there is no nonprice competition, (4) suppliers offer a standardized product, and (5) firms in this industry must accept the price determined in the industry. Purely competitive firms and industries do not exist in reality. Probably as close as the real world comes to the competitive ideal is agriculture, during the period in which this industry was dominated by the relatively small family farms prior to World War II. 165 The assumptions in pure monopoly are: (1) there is one seller that supplies a large number of independent buyers, (2) entry and exit into this market is completely blocked, (3) the firm offers unique product, (4) there is nonprice competition (mostly public information advertising), and (5) this firm is a constrained price dictator. Pure monopolies abound in reality, including public utilities and manufacturing firms producing products protected from competition by patents or copyrights. A monopolist will produce less than a competitive industry and charge a higher price, ceteris paribus. The assumptions underlying the model of a monopolistically competitive industry are: (1) a relatively small number of sellers compared to pure competition, but this number can still be large, in some cases a few hundred independent sellers, (2) pricing policies exist in these firms, (3) entry into this market is generally somewhat difficult, (4) there is substantial nonprice competition,
mostly designed to create product differentiation, at least some of which is spurious. Numerous industries are properly characterized as monopolistic competition. These industries include computer manufacturers, software manufacturers, most retail industries, and liquor distillers. In general, monopolistic competitors produce less than pure competitors but more that pure monopolists, and charge prices that also fall between competition and monopoly. In general, the graphical analysis of a monopolistic competitive industry is identical to a monopoly, except the demand curve is somewhat more elastic than the monopolists'. 166 The assumptions upon which the model of oligopoly are founded are: (1) that there are few sellers (generally a dozen or less), these firms often collude or implicitly cooperate through such practices as price leadership, (2) entry into this market is generally difficult, (3) there is normally very intensive non price competition in an attempt to create product differentiation, often spurious. Examples of oligopolies abound, the U.S. automobile industry, the soft-drink industry, the brewing industry, segments of the fast-food industry, and airplane manufacturers. Oligopoly will generally produce less than monopolistic competitors and charge higher prices, if price leadership or other collusive arrangements exist an oligopoly may be a close approximation to a pure monopoly. All of these market structures also assume perfect knowledge concerning present and future prices (by both producers and consumers) and all other information relative to the operation of the market, i.e., product availability, quality etc. This perfect knowledge assumption is not realistic, however, it does little violence to the models because people typically learn very quickly in aggregate, and hence there expectations approximate perfect knowledge over large numbers of persons. The Purely Competitive Firm Total, average and marginal product were developed with the various cost curves in Chapter 7. The missing piece of the puzzle is revenue. Because a purely competitive firm sells its output at the one price determined in the industry, price does not change as the quantity sold increases. In other words, the demand curve is horizontal, or perfectly elastic. The result is that average revenue is equal marginal revenue, and both of these are equal to price. Further, total revenue is P x Q which is the total area under the demand curve for the purely competitive firm. A firm is assumed to be rationally managed and therefore it will attempt to maximize its profits. The profit maximizing rule is that a firm will maximize profits where marginal cost (MC) is equal to marginal revenue (MR). The reason for this is relatively simple. There is still a
positive amount of revenue that can be had in excess of costs of the firm produces at a quantity less than where MC = MR. If a firm produces at a quantity in excess of where MC = MR, the firm adds more to its costs than it receives in revenues. Therefore the optimal, or profit maximizing level of output is exactly where MC = MR. 167 The model of the purely competitive industry is the simple supply and demand diagram you mastered in Chapter 4. The simple supply and demand diagram is a representation of the aggregation of a large number of independent firms and consumers. This model is revisited below: Supply Price Pe Demand Qe Quantity The firm in perfect competition is just one of thousands that are summed to arrive at the industry levels of output and price. Because of the atomized competition, it a firm charges a higher price that the industry it will sell nothing because consumers can obtain exactly the same commodity at a lower price elsewhere. If the firm charges a price lower that the price established in the industry it is irrational and will lose revenue it could have otherwise had. Therefore, a firm operating in a perfectly competitive industry has no choice save to sell its output at the industry established price. Because the firm sells at the single price established in the industry it has a perfectly elastic demand curve. (In other words, it is horizontal and not downward sloping). 168 The demand curve for the perfectly competitive firm is illustrated below: Price D = MR = AR = P Quantity Because the firm is a price taker, meaning that it charges the same price across all quantities of output, marginal revenue is always equal to price, and average revenue will always be equal to price. Therefore the demand curve intersects the price axis and is horizontal (perfectly elastic) at the price determined in the industry. Establishing the price in the industry is simply setting the equilibrium in the familiar supply and demand diagram, and that is the price at which the firm is obliged to sell its output. The following diagram illustrates how this is done: Industry Firm in Competition P D=MR=AR Q Pe 169 Q Again, the price is established by the interaction of supply and demand in the industry (Pe) and the quantity exchanged in the industry is the summation of all of the quantities sold by the firms in the industry. However, this yields little information save what price will be charged and what quantity the industry produce. To determine what each firm will produce and what profits each firm will earn, we must add the cost structure (developed in the previous chapter).
Economic profits are total revenues in excess of total costs. Remember from Chapter 7, that profits from the next best alternative allocation of resources is included in the total costs of the firm. In this short-run it plausible that some firms in pure competition can exact an economic profit from consumers, but because of freedom of entry, the economic profit will attract new firms to the industry, hence increasing supply, and thereby lowering price and wiping out the short-run economic profits. The following diagram adds the costs structure to the purely competitive firm’s demand curve and with this information it is possible to determine the profits that this firm makes: Price MC ATC AVC Economic Profits D=MR Qe Quantity The firm produces at where MC = MR, this establishes Qe. At the point where MC = MR the average total cost (ATC) is below the demand curve (AR) and therefore costs are less than revenue, and an economic profit is made. The reason for this is that the opportunity cost of the next best allocation of the firm's productive resources is already added into the firm's ATC. However, the firm cannot continue to operate at an economic profit because those profits are a signal to other firms to enter the market (free entry). As firms enter the market, the industry supply curve shifts to the right reducing price and thereby eliminating economic profits. Because of the atomized competition assumption, the number of firms that must enter the market to increase industry supply must be 170 substantial. The following diagram illustrates the purely competitive firm making a normal profit: Price MC ATC AVC D=MR Qe Quantity The case where a firm is making a normal profit is illustrated above. Where MC = MR is where the firm produces, and at that point ATC is exactly tangent to the demand curve. Because the ATC includes the profits from the next best alternative allocation of resources this firm is making a normal profit. A firm in pure competition can also make an economic loss. The following diagram shows a firm in pure competition that is making an economic loss: Price MC ATC AVC Economic Losses D=MR Qe Quantity The case of an economic loss is illustrated above. The firm produces where MC = MR, however, at that level of production the ATC is above the demand curve, in other words, costs exceed revenues and the firm is making a loss. 171 Even though the firm is making a loss it may still operate. The relation of average total cost with average revenue determines the amount of profit or loss, but
we to know what relation average revenue has with average variable cost to determine whether the firm will continue in business. In the above case, the firm continues to operate because it can cover all of its variable costs and have something left to pay at least a part of its fixed costs. It is shuts down it would lose all of its fixed costs, therefore the rational approach is to continue to operate to minimize losses. Therefore, the profit maximizing rule of producing at where MC = MR is also the rule to determine where a firm can minimize any losses it may suffer. In sum, to determine whether a firm is making a loss or profit we must consider the relation of average total cost with average revenue. To determine whether a firm that is making a loss should continue in business we must consider the relation between average variable cost and average revenue. The following diagram illustrates the shutdown case for the firm making a loss: Price MC ATC AVC AVC SAVED BY SHUT- DOWN D=MR Qe Quantity In the case above you can see that the AVC is above the demand curve at where MC=MR, therefore the firm cannot even cover its variable costs and will shut down to minimize its losses. If the firm continues to operate it cannot cover its variable costs and will accrue losses in excess of the fixed costs. If the firm shuts-down, all that is lost is the fixed costs. Therefore the firm should shut-down in order to minimize its losses. What may not be intuitively obvious is that this analysis determines the industry supply curve. Because firms cannot operate along the marginal cost curve below the average variable cost curve, the firm’s supply curve is its marginal cost curve above average variable cost. To obtain the industry’s supply curve one needs only sum all of the firms’ marginal cost curves about their average variable cost curves. 172 Pure Competition and Efficiency Allocative efficiency criteria are satisfied by the competitive model. Because P = MC, in every market in the economy there is no over- or under- allocation of resources in this economy. This is because the cost of production for the last unit of production is what determines supply, and that cost of production includes only the engineering costs. However, this result is obtained only if all industries in that economic system are purely competitive. This is the contribution of the models of distribution created by economists working in the marginalists traditions. The problem is that this is economic theory that is not necessarily supported by empirical evidence. Additionally, the technical or productive efficiency criteria are also satisfied
by the competitive model because price is equal to the minimum average total cost. In the real world the ideal of technical efficiency is rarely attained. However, this criteria provides a useful benchmark to use in measuring how well a firm is doing with respect to minimizing costs for a specified level of total output. As you may recall from the definition of economic efficiency, allocative and technical efficiency are only two of the three necessary and sufficient conditions for economic efficiency. The third condition necessary for economic efficiency is full employment. If full employment is also in evidence then a purely competitive world is economically efficient. A few economists writing about economic problems through the past three decades have focused their analyses narrowly on the competitive models. Conclusions from the competitive models are straightforward and fairly simple, hence accessible to the population in general. These models suggest that economic utopia is found only by returning to a purely competitive world. However, as Adam Smith himself, notes there was never a point at which competition was observed, let alone, was the general rule. This illustrates a very important point about economics. While it is true that there is a Nobel Prize in Economic Science, economics is not a science in the same vain that physics or chemistry is. Economics relies on assumptions upon which to build models to analyze material goods and their production and distribution. However, the assumptions may reflect value judgments (biases) more than what the analyst believes reflects the state of nature in the real world. Therefore, economics is not value free, as many would posit. 173 Criticism of Pure Competition as a Mode of Analysis for the Real World. In theory, the purely competitive world is utopia. There are several problems that are not excluded by meeting the assumptions behind the competitive models. As wealth increases, predation could easily develop and monopoly power could be gained by the occasional ruthless businessman, especially in cases where government has been significantly limited. Public goods and other commodities may not be available through competitive industries because of the lack of a profit potential. The competitive economic models are motivated by the suppliers seeking to maximize profits, and without the profit motive, there can be no market. Further because of technical efficiency requirements, externalities such as pollution, work environment safety, and other such problems are likely to arise because of the constraint imposed on the firms by the price being determined by the industry. Without strong government and appropriate regulations to protect the environment or workplace, it is unlikely that any private incentive system could impose sufficient discipline upon producers to properly internalize the costs of production that can be allowed to flow to the public
in general. The distribution of income may lack equity or even technical efficiency. In a purely competitive world, workers will be paid the value of what they contribute to the total output of the firm. If the product they produce is not highly valued then some workers could be paid very low wages, even though the human capital and effort requirements are substantial. For example, a mathematician or a physicist may be paid less than a baseball player or musician – even though the value of what the mathematician or physicist is far greater than the athlete’s contribution. This type of result often creates substantial social problems, i.e., alienation, occasionally resulting in alienation, crime, drug abuse, and in the developing world even political instability. If all industries are purely competitive there be consumer dissatisfaction because each firm offers a standardized product. This standardization might very well result in a substantial loss of consumer choice. For example, if the soft drink industry was purely competitive, the product offered might well be a single cola, someplace between CocaCola and Pepsi-Cola, and might very well suite nobody’s tastes and preferences. The present state of technology simply requires the existence of many natural monopolies. The problems with natural monopolies are that under-production occurs at too high of a market price for the product. This misallocation of resources results in an insufficient amount of some commodities, with an excess of resources available to other products, and prices that are not specifically determined by the actual costs of production. Even so, if the natural monopolies are properly regulated at something near a competitive price, then the damage to the economy may be minimized. This issue will be discussed in greater detail in the following chapter (Chapter 9, Monopoly). 174 It is frequently mused that if you teach a parrot to say “supply and demand” you have created a feathered economist. Perhaps the simplicity of this is appealing, however, supply and demand reflects, at best, a very superficial understanding of a modern economic system. One must be very careful in critically evaluating the assumptions that underpin an economic model, and the agenda of those who propose a particular mode of analysis. Economics, is not pure science, and it is not value free as many would lead you to believe. Distributive Acquisition The Place of Science in Modern Civilization and Other Essays, Thorstein Veblen, New York: Memo, 1919, p. 183.... The normal economic community, upon which theoretical interest has converged, is a business community, which
centers about the market, and whose scheme of life is a scheme of profit and loss. Even when some considerable attention is ostensibly devoted to theories of consumption and production, in these systems of doctrine the theories are constructed in terms of ownership, price and acquisition, and so reduce themselves to doctrines of distributive acquisition.... As one can see, Thorstein Veblen was very suspicious of economic theories of the time as being little more that an apology for self-interest of the rich and powerful posing as markets. However, Adam Smith was also suspicious of the real world solutions of his time, to wit: 175 Liberty? An Inquiry into the Nature and Causes of the Wealth of Nations. Adam Smith, New York: Knopf Publishing, 1910, pp. 106-107. Such are the inequalities in the whole of the advantages and disadvantages of the different employments if labour and stock, which the defect of any of the three requisites above mentioned must occasion, even where there is most perfect liberty. But the policy of Europe, by not leaving things at perfect liberty, occasions other inequalities of much greater importance. It does this chiefly in the three following ways. First by restraining the competition in some employments to a smaller number than would otherwise be disposed to enter into them; secondly by increasing it in others beyond what it naturally would be; and, thirdly, by obstructing the free circulation of labour and stock both from employment to employment and from place to place. Adam Smith suspicious of the motivations of businessmen, and craftsmen in the pursuit of their own self-interest. He witnessed the monopolization of many markets in Scotland and in England, and he had also been the Director of the world’s largest monopoly of the time the East India Company. Adam Smith, therefore, had first hand experience with the early beginnings of monopoly and knew their potential for evil. Smith was not only an advocate of competition, but knew that competition is what provided the consumer with alternatives in the marketplace, and hence an ability to choose among various suppliers. It is this consumer ability to choose, that motivated Smith’s view that capitalism would produce socially beneficial results – and monopoly power is a threat to those results. (Hence the invisible hand) KEY CONCEPTS Market Structures Pure Competition Pure Monopoly Oligopoly Monopolistic Competition Industry v. Firm Profit Maximizing Rule MC = MR Economic v. Normal profits 176 Shut down analysis Problems with competition income equity market failures limitations on choice Smith’s Invisible Hand Consumer choice STUD
Y GUIDE Food for Thought: Outline and critically evaluation the assumptions underpinning the purely competitive model. Why is the profit maximizing (loss minimizing) point where Marginal Cost equals Marginal Revenue? Explain, fully. Draw each of the following cases of the firm in pure competition: (1) long-run profit maximizing, (2) short-run, economic profit, (3) short-run, economic loss, and (4) shut down point. 177 Sample Questions: Multiple Choice: A purely competitive firm’s short-run supply curve it its marginal cost curve, for all: A. Quantities of output B. Output where marginal cost exceeds minimum average total cost C. Output where marginal cost exceeds minimum average fixed cost D. Output where marginal cost exceeds minimum average total cost If all of the firms producing a commodity in a purely competitive market are required to adopt antipollution devices that increase their costs of production (even though it cleans up the air), one would expect: A. The demand for the product to decrease B. The market supply curve to shift to the left C. The long-run economic profits of the individual firms to decrease D. The short-run economic profits of the individual firms to decrease True - False If all industries within an economy were pure competitors, the economy would be economically efficient. {TRUE} Oligopoly is an industry with a large number of suppliers, but few buyers. {FALSE} 178 CHAPTER 9 Pure Monopoly The purpose of this chapter is to examine the pure monopoly model in the product market. Because monopolies are price givers, there are significant differences between monopolies and competitive firms, these differences will be examined in details in this chapter. Once the monopoly model is mastered, it will be critically evaluated. Further, the rate regulation of monopolies will be examined and critically evaluated. The Assumptions of Monopoly Revisited The assumptions upon which the monopoly model is based were presented in Chapter 8. However, a quick review of those assumptions is worthwhile here. The assumptions of the monopoly model are: (1) there is a single seller (or a few sellers who collude, hence a cartel), (2) the single seller offers a unique product, (3) entry and generally exit are blocked, (4) there is non-price competition, and (5) the monopolist dictates price in the market. As will become quickly apparent, the differences in the assumptions that underpin the monopoly and purely competitive models make for very different analyses. Further
, the difference in assumptions also creates substantially different results in price and output between the two models. The Monopoly Model In the purely competitive analysis, there were two different models, one model for the industry, in which the interaction of supply and demand established the market price and quantity. The second model was that of the firm, the firm faced a perfectly elastic demand curve, in which demand, price, average revenue and marginal revenue were all the same. However, in the analysis of a monopoly there is but one model. The firm, in monopoly, is the industry (by definition). Because the firm is the industry it therefore 179 faces a downward sloping demand curve, which is also the average revenue curve for the firm (hence the industry). If the firm wants to sell more it must lower its price therefore marginal revenue is also downward sloping, but has twice the slope of the demand curve. Remember when you lower price the average revenue falls, but not as fast as the marginal, and if the average revenue is a linear (as it is here, which is smooth, and continuously differentiable) the there is a necessary relationship between the slope of the average and marginal functions. Consider the following diagram: Price Ela stic R a n g e In ela stic R a n g e Marginal Revenue Demand Quantity The point where the marginal revenue curve intersects the quantity axis is of significance; this point is where total revenue is maximized. Further, the point on the demand curve associated with where MR = Q is the point on the demand curve of unit price elastic demand; to the left along the demand curve is the elastic range, and to the right is the inelastic range (see Chapter 5 for a review of the relation between marginal revenue and price elasticity of demand). Unlike the purely competitive model here is no supply curve in an industry which is a monopoly. The monopolist decides how much to produce using the profit maximizing rule; or where MC = MR. In this sense, the monopolist is a price dictator, in that it is the cost structure, together with the change in total revenue with respect to change in quantity sold that directs the monopolist’s pricing behavior, rather than the interaction of the monopolist’s supply schedule, with the demand schedule of consumers (demand curve). With this information we can discover more about the monopoly model. A monopolist can make an economic profit. An economic profit is that margin above average cost which is in excess of that necessary to cover the
next best alternative allocation of the firm’s assets. As you recall from Chapter 8, in pure 180 competition if there is an economic profit, that profit is a signal to other assets to enter the market. Because there are no barriers to entry into a purely competitive industry, the supply curve increase (shifts right) as these newly attracted resources enter the market – hence driving down the market price in the industry, and eliminating the economic profit. One of the objections to pure monopoly is that there is closed entry. A monopolist making an economic profit can do so as long as the cost and revenue structure permit, perhaps permanently. The self-correcting advantages from pure competition are lost because of these barriers to entry. Price Pe Economic Profit MC ATC D MR Qe Quantity The above diagram shows the economic profits that can be maintained in the long run because of the barriers to entry into this industry. The monopolist produces where MC = MR (where MC intersects MR), but the price charged is all the market will bear, that is, the price on the demand curve that is immediately above the intersection of MC = MR. The rectangle mapped out by the ATC, the indicator over the price index, the origin, and Qm are the total costs, the rectangle mapped out by the demand curve, QM, the origin, and Pm is the total revenue, and the difference between these rectangles is economic profits. On the other hand, there is nothing in the analysis that requires any given monopolist will be profitable. In fact, a monopolist can operate at an economic loss, the same as a competitive firm can. The following diagram shows a monopolist that is unfortunate enough to be operating at an economic loss. 181 Price Pe Economic Loss MC ATC AVC D MR Qe Quantity This monopolist is making an economic loss. The ATC is above the demand curve (AR) at where MC = MR (the loss is the labeled rectangle). However, because AVC is below the demand curve at where MC = MR the firm will not shut down so as to minimize its losses. The firm can pay back a portion of its fixed costs by continuing to operate at this level because the AVC is still below the demand curve. As you will remember from the discussion in Chapter 8, when AVC is above the demand curve the firm should shut down to prevent throwing good money after bad. The Effects of Monopoly There are several implications of the monopoly model; many of which lead to criticisms of monopoly on issues
of both technical and allocative efficiency. The prices and output determined in the monopoly are not consistent with allocative efficiency criteria. In monopoly there are too many resources allocated to production of this product, for which we receive too little output as illustrated by comparison with the competitive solution, the dotted line (discussed below). Consequently, because of the barriers to entry, the price for this product is too high – hence allocatively inefficient. Consider the following diagram of a pure monopoly making an economic profit, in this case: 182 Price Pm Economic Profit Pc MC ATC D MR Qc Qm Quantity The above graph shows the profit maximizing monopolist, Pm is the price the monopoly commands in this market and Qm is the quantity exchanged in this market. However, where MC = D is where a perfectly competitive industry produces and this is associated with Pc and Qc. The monopolist therefore produces less and charges more than a purely competitive industry. A monopolist can also segment a market and engage in price discrimination. Price discrimination is where you charge a different price to different customers depending on their price elasticity of demand. Because the consumer has no alternative source of supply price discrimination can be effective. This practice enhances the allocative inefficiency. When a consumer must pay more for a product, simply because of the monopoly power in the market, less of the consumers’ incomes are available to purchase other commodities. The end result is even more resources flow into the monopolist’s coffers, and out of other industries – hence even more inefficient allocations of productive resources. This does not mean that monopolists are pure evil – in an economic sense. Sometimes a monopolist is in the best interests of society (besides the natural monopoly situation). Often a company must expend substantial resources on research and development (i.e., pharmaceutical firms). If these types of firms were forced to permit free use of their technological developments (hence no monopoly power) then the economic incentive to develop new technology and products would be eliminated – hence economic irrationality would have to prevail for the technological progress we have come to expect in the beginning of the twenty-first century. 183 Regulated Monopoly Because there are natural monopoly market situations it is in the public interest to permit monopolies, but traditionally in the United States they are regulated with respect to price. The purpose of the rate regulation was to ensure that the public would not suffer price gouging as a result of the monopoly position of the firms. Examples of regulated natural monopolies are electric utilities, cable
TV companies, and telephone companies (local). Throughout the 1980s and 1990s, up through 2002, there was substantial deregulation of the power industry, cable TV industry, and telecom. In the 1980s ATT was broken-up into several local telecom companies, i.e., Verizon, Southwestern Bell, Ameritech, and US West, among other, the long lines company (ATT) and Bell Labs (Lucent). The idea was to permit competition in long distance and local service. What happened was far different. The local providers had much invested in microwave towers, switches, and telephone lines – there would be charges permitted for the use of these assets by competitors, and what resulted was poorer service, at higher prices in most areas. In the summer of 2001, California consumers got a taste of what Enron could do in selling power to local public utilities. Consumers were victims of unscrupulous business practices that resulted in billions of dollars in overcharges that cannot be recovered. The problem with regulating the prices that monopolists can charge is that there are several competing goals that can be accomplished through rate regulation. If allocative efficiency is the goal, then the monopolist should be constrained to charge a price where MC = D or the social optimum. If technical efficiency is the goal then some argue that the monopolist’s minimum total cost should be the basis for the rate regulation. If we are concerned about consistently and reliably having the product of the monopolist available, at a reasonable price, then it might be more sensible to regulate the monopolist to charge a price at where ATC = D, or the fair rate of return. So regulatory agencies have alternatives as to where to regulate any monopolists within their jurisdiction. The potential prices at which a monopolist could be regulated, and the potential results of those price levels, is called the dilemma or regulation. This dilemma has presented the opportunity for considerable debate about whether rate regulation is appropriate, and if so, what sorts of regulation should occur. Consider the following diagram, this is a monopolist that is being regulated at the social optimum (MC = D): 184 Price Pr MC ATC D MR Qr Quantity This firm is being regulated at the social optimum, in other words, what the industry would produce if it were a purely competitive industry. The price it is required to charge is also the competitive solution. However, notice the ATC is below the demand curve at the social optimum which means this firm is making an economic profit. It is also possible with this solution that the firm could
be making an economic loss (if ATC is above demand) or even shut down (if AVC is above demand). Consider the following diagram of a monopolist that is being regulated at the fair rate of return: Price Pr MC ATC D MR Qr Quantity The fair rate of return enforces a normal profit because the firm must price its output and produce where ATC is equal to demand. This eliminates economic profits and the risk of loss or of even putting the monopolist out of business. Virtually every 185 state public utility commission relies on this model to regulate their electric companies and other public utilities. Regulation and It’s Problems Regulation is not a panacea. There are problems with rate regulation. In our litigious society, the legal proceedings involved in rate regulation are not inexpensive for any of the parties involved, the state, public interest groups, and the firm. Because of the closeness of the legal advocates, economists, and others involved in the litigation of rate cases, there has been accusations that the public utility commissions have been over-taken by the industries they regulate. The capture theory of regulation is that the retired executives, and economists and lawyers who have made their mark defending utilities have been appointed to public utility commissions, thereby allowing the utilities to regulate themselves. While there have been instances where conflicts of interest have been noted, this “capture theory of regulation” probably overstates the relations between the industries regulated and the public utility commissions in most jurisdictions. Rate regulation using invested capital as the rate base cause an incentive for firms to over-capitalize and not to be sensitive to variable costs of production. This is called the Averch-Johnson Effect. Electric companies, and other utilities are permitted to earn a rate of return only on invested capital. Therefore, given a choice, the utilities will invest in expensive (sometimes overly-expensive) capital to maximize the base upon which they can earn a rate of return. By using too much capital and not enough variable factors, there firms are generally technologically inefficient, and thereby also allocatively inefficient. In the management literature there is come discussion of “organizational slack.” Organization slack is simply excess capacity in the organization, and it is often touted as giving management flexibility. However, economists have observed the same inefficienies, with different conclusions. X-efficiency is where the firm's costs are more than the minimum possible costs for producing the output. Electric companies over-capitalize and use excess capital to avoid labor and fuel expenditures (which
are generally much cheaper than the additional capital) - nuclear generating plants are a good example of this of this type of planned inefficiency. However, there is another issue with public utilities and x-efficiency. Electricity is not something that is easily stored, and therefore the relevant demand for electricity is the peak demand on the system. Because public utilities must plan for peak load demands on the system, most of the time electric companies are operating at some fraction of total capacity. To smooth this peak out and make more consistent use of “slack” electric utilities, particularly in Europe, price their power at different rates taking into consideration the peaks and troughs in demand – higher rates in the peak times, lower rates in the troughs. This is 186 referred to as peak load pricing. Monopoly Essentials of Economic Theory. John Bates Clark, New York: Macmillan Publishing Company, 1907, pp. 375-77.... No description could exaggerate the evil which is in store for a society given hopelessly over to a regime of private monopoly. Under this comprehensive name we shall group the most important of the agencies which not merely resist, but positively vitiate, the action of natural economic law. Monopoly checks progress in production and infuses into distribution an element of robbery. It perverts the forces which tend to secure to individuals all that they produce. It makes prices and wages abnormal and distorts the form of the industrial mechanism... Prices do not conform to the standards of cost, wages do not conform to the standard of final productivity of labor, and interest does not conform to the marginal product of capital. The system of industrial groups and sub-groups is thrown out of balance by putting too much labor and capital at certain points and too little at others. Profits become, not altogether a temporary premium for improvement, – reward for giving to humanity a dynamic impulse, – but partly the spoils of men whose influence is hostile to progress. 187 APPENDIX TO CHAPTER 9 STATUTORY PROVISIONS AND GUIDELINES OF THE ANTITRUST DIVISION1 Sherman Antitrust Act, 15 U.S.C. §§ 1-7 § 1 Sherman Act, 15 U.S.C. § 1 Trusts, etc., in restraint of trade illegal; penalty Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal. Every person who
shall make any contract or engage in any combination or conspiracy hereby declared to be illegal shall be deemed guilty of a felony, and, on conviction thereof, shall be punished by fine not exceeding $10,000,000 if a corporation, or, if any other person, $350,000, or by imprisonment not exceeding three years, or by both said punishments, in the discretion of the court. § 2 Sherman Act, 15 U.S.C. § 2 Monopolizing trade a felony; penalty Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony, and, on conviction thereof, shall be punished by fine not exceeding $10,000,000 if a corporation, or, if any other person, $350,000, or by imprisonment not exceeding three years, or by both said punishments, in the discretion of the court. § 3 Sherman Act, 15 U.S.C. § 3 Trusts in Territories or District of Columbia illegal; combination a felony Every contract, combination in form of trust or otherwise, or conspiracy, in restraint of trade or commerce in any Territory of the United States or of the District of Columbia, or in restraint of trade or commerce between any such Territory and another, or between any such Territory or Territories and any State or States or the District of Columbia, or with foreign nations, or between the District of Columbia and any State or States or foreign nations, is declared illegal. Every person who shall make any such contract or engage in any such combination or conspiracy, shall be deemed guilty of a felony, and, on conviction thereof, shall be punished by fine not exceeding $10,000,000 1 Statutory material is current as of January 1997. 188 if a corporation, or, if any other person, $350,000, or by imprisonment not exceeding three years, or by both said punishments, in the discretion of the court. § 4 Sherman Act, 15 U.S.C. § 4 Jurisdiction of courts; duty of United States attorneys; procedure The several district courts of the United States are invested with jurisdiction to prevent and restrain violations of sections 1 to 7 of this title; and it shall be the duty of the several United States attorneys, in their respective districts, under the direction of the Attorney General, to institute proceedings in equity to prevent and restrain such violations
. Such proceedings may be by way of petition setting forth the case and praying that such violation shall be enjoined or otherwise prohibited. When the parties complained of shall have been duly notified of such petition the court shall proceed, as soon as may be, to the hearing and determination of the case; and pending such petition and before final decree, the court may at any time make such temporary restraining order or prohibition as shall be deemed just in the premises. § 5 Sherman Act, 15 U.S.C. § 5 Bringing in additional parties Whenever it shall appear to the court before which any proceeding under section 4 of this title may be pending, that the ends of justice require that other parties should be brought before the court, the court may cause them to be summoned, whether they reside in the district in which the court is held or not; and subpoenas to that end may be served in any district by the marshal thereof. § 6 Sherman Act, 15 U.S.C. § 6 Forfeiture of property in transit Any property owned under any contract or by any combination, or pursuant to any conspiracy (and being the subject thereof) mentioned in section 1 of this title, and being in the course of transportation from one State to another, or to a foreign country, shall be forfeited to the United States, and may be seized and condemned by like proceedings as those provided by law for the forfeiture, seizure, and condemnation of property imported into the United States contrary to law. § 7 Sherman Act, 15 U.S.C. § 6a (Foreign Trade Antitrust Improvements Act of 1982) Conduct involving trade or commerce with foreign nations Sections 1 to 7 of this title shall not apply to conduct involving trade or commerce (other than import trade or import commerce) with foreign nations unless-- (1) such conduct has a direct, substantial, and reasonably foreseeable effect-- 189 (A) on trade or commerce which is not trade or commerce with foreign nations, or on import trade or import commerce with foreign nations; or (B) on export trade or export commerce with foreign nations, of a person engaged in such trade or commerce in the United States; and (2) such effect gives rise to a claim under the provisions of sections 1 to 7 of this title, other than this section. If sections 1 to 7 of this title apply to such conduct only because of the operation of paragraph (1) (B), then sections 1 to 7 of this title shall apply to such conduct only for injury to export business in the
United States. § 8 Sherman Act, 15 U.S.C. § 7 "Person" or "persons" defined The word "person", or "persons", wherever used in sections 1 to 7 of this title shall be deemed to include corporations and associations existing under or authorized by the laws of either the United States, the laws of any of the Territories, the laws of any State, or the laws of any foreign country. KEY CONCEPTS Monopoly Economic Profits Comparisons with pure competition Economic efficiency induced by monopoly Rate Regulation Social Optimum Fair Rate of Return Proce Discrimination Averch-Johnson Effect Dilemma of Regulation X-efficiency Sherman Antitrust Act 190 Study Guide Food for Thought: Compare and contrast the monopoly model with the purely competitive model. Critically evaluate the social optimum and fair rate of return theories of rate regulation of monopolies. Develop and explain the monopoly model, showing an economic profit, a normal profit, and an economic loss. Can there be maintained in the long-run? Explain. Sample Questions: Multiple Choice: An unregulated monopolist when compared with a purely competitive industry will: A. Produce more, and charge more B. Produce more, and charge less C. Produce less, and charge more D. Produce less, and charge less Which of the following statements is true of an unregulated monopolist? A. Price is less than marginal cost B. Price is more than average revenue C. Price is more than marginal revenue D. Price is set where the monopolist chooses regardless of cost 191 True - False Society would be unambiguously better-off without monopolists. {FALSE} A monopolist can maintain an economic profits in the long-run, because there are substantial barriers to entry into its markets. {TRUE} 192 Chapter 10 Resource Markets To this point the discussion of markets has focused on product markets. The purpose of this chapter is to examine the other set of markets identified in the circular flow diagram – factor markets. The markets to be examined in this chapter are those where firms purchase productive resources (in other words, factors of production). Resource Market Complications Over the course of modern American economic history there have been market failures, serious social problems, and other difficulties that have resulted in certain resource markets becoming heavily regulated. In particular, capital and labor markets have been the focus of substantial regulation. 2001 was the beginning of one series of accounting and brokerage scandals after another. Many of these scandals were from conflicts of interest, resulting in 2003
beginning to witness the regulation of financial markets in the U.S. The late 1990s witnessed the abuse of managerial trust by high ranking executives in awarding themselves very high compensation levels, while laying-off productive employees, and cutting wages and benefits for those who performed the work of the organizations. By 2003 these abuses have not yet been addressed by re-regulation, but as these becoming increasing problematic re-regulation will occur. The United States seems to go through cycles where regulation and de- regulation ebb and flow. Resultant depressions and recessions, give way to more active government involvement in factor markets, and as things seemingly progress political pressure for de-regulation and the results of that political pressure set the stage for another round of economic difficulties. If history is instructive then market ups and downs are the natural order of things in a mixed economy. Because labor (human beings as a factor of production) and private property are involved in resource markets there tends to be more controversy concerning these markets than is true of normal product markets. However, this controversy also serves to make resource market extremely interesting. 193 Resources Head to Head, Lester Thurow, New York: William Morrow and Company, Inc., 1992, p. 40. Historians trace much of America’s economic success to cheap, plentiful, welllocated raw materials and farm land. America did not become rich because it worked harder or saved more than its neighbors. A small population lived in a very large, resource-rich environment. Natural resources were combined with the first compulsory public K-12 education system and the first system of mass higher education in the world. Together they gave America an economic edge. While Americans may not have worked harder, they were better skilled and worked smarter. Once rich, America also found it easy to stay rich. New technologies and new institutions are combining to substantially alter these four traditional sources of competitive advantage. Natural resources essentially drop out of the competitive equation. Being born rich becomes much less of an advantage that it used to be. Technology get turned upside down. New product technologies become secondary; new process technologies become primary. And in the twenty-first century, the education and skills of the work force will end up being the dominant competitive weapon. Derived Demand The demand for all productive resources is a derived demand. By derived demand it is meant that it is the output of the resource and not the resource itself for which there is a demand by its employer. In other words, the demand for any factor of production is the schedule of the value of its
marginal productivity. The marginal product (MP) of a productive resource is the change in total output where ▵TP (▵ means change) attributable to the employment of one more unit of that productive resource ▵L, in this case change in labor. marginal product is MP = ▵TP/▵L where L is units of labor, (or K for capital, etc.) The marginal revenue product of labor (MRP labor) is MRP labor = ▵TR/▵L where ▵TR is the change in total revenue attributable to the employment of one more 193 unit of that resource: MRP = ▵TR/▵L The demand for a productive resource comes from the business sector and the supply of that productive resource comes from the households (see Chapter 3). This is exactly the opposite of what happens in the product market, where consumers are from the households and the suppliers are from the business sector. Because the demand for a productive resource is a derived demand, the demand schedule for that productive resource is simply the MRP schedule for that resource by the firm. The following diagram presents a demand curve (MRP schedule) for a productive resource. Notice, if you will, this demand schedule is downward sloping and is therefore for an industry is pure competition. Resource Price D = MRP Quantity of Resource The determinants of resource demand are: (1) productivity of that specific resource, (2) quality of resource (i.e., education, etc.), and (3) the technology in which the resource will be employed. 194 As with product markets as the price of the resource changes so does the quantity demanded, that is, that causes shifts along the demand curve. If, on the other hand, a change in one of the non-price determinants of demand occurs then the demand curve will shift either left (decrease) or right (increase). If the productivity of a resource increases so too will its demand. Likewise if the quality of the resource declines, so too will its demand. If a change in technology occurs that requires less of a particular resource, the demand for that resource will also decline. The non-price determinants of supply are pretty much factor of production specific. The supply of labor depends are several issues, but is basically the willingness and ability of persons to work, these issues are among the topics of labor economics (E340). The supply of capital depends on several issues, such as investor expectations and the life of plant and equipment, capital supply is
dealt with in greater detail in finance (F301). The determinants of resource price elasticity are: (1) the rate of decline of MRP, (2) the ease of resource substitutability, (3) elasticity of product demand, and (4) capital-labor ratios for the specific firm. The greater the rate of decline of the MRP schedule the more inelastic the demand for the factor production, and the lesser the rate of the decline in MRP the more elastic the demand for the factor. If it is difficult to substitute one factor for another the demand will be relatively inelastic for the factor with few substitutes. The more price elastic the demand for the product, the more elastic will be the demand for the factor of production, and the more inelastic the demand for the product, the more inelastic will be the demand for the factor of production. Capital-labor ratios concern the technology used by the firm. The more intensely a factor is used the more inelastic its demand, all other things equal, and the less intensely the factor is used in a given technology the elastic the demand for the factor. The supply side of the market is the marginal resource cost side of the market. Marginal resource cost (MRC) is the amount that the addition of one more unit of a productive resource (▵L) adds to total resource costs (▵TC), which is: 195 MRC = ▵TRC/▵L The supply curve of a factor production in a purely competitive market is simply the MRC curve for that factor. In general, the industry supply curve for a factor of production is upward sloping just like the supply curve in a purely competitive product market. The profit maximizing employment of resources is where MRP = MRC, where MRC is the supply curve of the resource in a purely competitive resource market and MRP is the demand curve for a purely competitive resource market. Consider the following diagram: Supply = MRC Resource Price P Demand = MRP Q Quantity of Resource The equilibrium resource price and the quantity of the resource employed is determined by the intersection of the supply curve (MRC) and the demand curve (MRP). This equilibrium is similar to that found in the product market. Unless one of the nonprice determinants of demand or supply change neither the supply nor demand curves will shift. Further, if there is a change in price, then all that happens is a movement along the curve, i.e., a
change in the quantity demanded or a change in the quantity supplied of this factor of production. Least Cost Combination of Resources and Technology Marginal analysis also lends insight into the best technology that can be employed. Best, in this case, being judged by the most technologically efficient. The least cost combination of all productive resources is determined by hiring resources to the point where the ratio of MRP to MRC is equal to one for all resources. 196 MRPlabor/MRClabor = MRPcapital/MRCcapital =... = MRPland/MRCland = 1 If the ratio of MRP to MRC for a productive resource is greater than one, then you have hired too little of that productive factor. Hiring more of that factor results in moving down the MRP curve and up the MRC curve until you reach the equilibrium level of employment. If the MRP to MRC ratio is less than one, then you have hired too much of that productive factor. Hiring less of that factor results in moving down the MRP curve and up the MRC curve until you reach the equilibrium level of employment. See the following diagram: The equilibrium level employment is identified as Qe and the equilibrium price level is Pe in the above diagram. The dashed line to the left of the equilibrium identifies the “too little level of employment” and the need to move up the MRP and down the MRC to arrive at an equilibrium price for this factor. The dashed line to the right identifies the “too much level of employment” and the need to move down the MRP and up the MRC to arrive at an equilibrium price for this factor or production. Marginal Productivity Theory of Income Distribution Price MRC=supply Pe Too little Qe Too Much MRP=demand Quantity of Resource Economic freedom (see Chapter 1, economic goals) has both positive and negative implications. During the 1980s and most of the 1990s, the average worker in the United States has experienced a decline in real wages, which results in a lowering 197 of the standard of living. At the same time executive salaries and entertainers’ incomes have enjoyed historically high levels. The distribution of income in this country critically depends on the factor markets and when those factor markets are encumbered by serious market imperfections there is inefficiency that results in people losing what they earn (exploitation in the factor market) and people obtaining income they did not earn (economic rents in the form of stock options, salaries
, etc.) The marginal productivity of resource markets has important implications for economic welfare. In a world of purely competitive markets any observed inequality in income arises simply because of differences in the productivity of different resources and the value of the product that resource produces. However, in a world with both purely competitive markets and monopoly power in some product and factor markets we will observe misallocations of resources as discussed in the monopoly chapter, and in the following chapter. The monopolist charges too much and produces too little, resulting in higher consumer prices and depressed wages in the factor markets for other businesses. Both results have negative implications for allocative efficiency and for workers who may be disadvantaged by such markets. Employers can exercise substantial monopoly power in the factor markets, and often do. Where there is one employer or a small number of employers, especially when they collude to depress wages, this has the effect of giving the employer an exploitable market imperfection that has negative implications for allocative efficiency and any workers caught in such a market. This market power resulting from the described imperfection is called monopsony. Monopsony is one buyer of a resource (or product) and cause factor payments (or prices) to be below the competitive equilibrium. Monopoly power in the product market will also impact the factor markets. Remember that the derived demand for a factor of production arises because the MRP schedule facing an employer is the demand curve for a factor of production. MRP is the change in total revenue due to the employment of one more unit of a resource. If the product is over-priced because it is sold in a monopolized market, then the MRP for that factor is too high. This results in some goods and services being over-valued and the factors that produce them being paid too much. Professional athletes are a prime example of this exercise of monopoly power. Professional sports franchises are exempted from the anti-trust laws in the United States, but they are textbook examples of monopolies. The end result is that their products have become very much 0ver-priced and because their industry is highly labor intensive, the professional athletes are paid a large multiple of their true MRPs. Worse yet, this misallocation of resources results in consumers paying too much for tickets to sporting events, and too much for the products the athletes endorse in advertising. The allocation of resources to this industry also has a depressing effect on wages in other industries (after all there are limited resources). 198 KEY CONCEPTS Derived Demand Marginal Product, Marginal Physical
Product Marginal Revenue Product, Resource Demand Determinants Productivity Quality of Resource Technology Elasticity Determinants Rate of Decline of MRP Ease of Resource Substitutability Elasticity of Product Demand K/L Ratios Marginal Resource Cost, Resource Supply Least Cost Combination of Resources Technology Marginal Productivity Theory of Income Distribution Monopoly power Monopsony in the resource market STUDY GUIDE Food for Thought: Fully explain the profit maximizing rule for employing resources and the least cost combination of resources rule. Using the following data complete the following table and derive a demand curve for labor (price of output is $2 per unit): 199 Marginal Product MRP Workers 1 2 3 4 5 6 7 8 9 Total Product 22 42 60 76 90 102 112 120 126 Fully explain the concept of derived demand. Illustrate a resource market and compare and contrast it with a product market. Sample Questions: Multiple Choice: Which of the following is the decision rule to determine the optimal combination of productive factors? A. MRPlabor = MRPcapital =... = MRPland = 0 B. MRPlabor = MRPcapital =... = MRPland = 1 C. MRPlabor/MRClabor = MRPcapital/MRCcapital =... = MRPland/MRCland = 0 D. MRPlabor/MRClabor = MRPcapital/MRCcapital =... = MRPland/MRCland = 1 An increase in the productivity of a factor of production will typically increase the demand for that factor. Which of the following is associated with an increase in the demand for a factor of production? 200 A. A person's acquisition of human capital B. An increase in the price of a complementary factor C. A decrease in the price of a factor of production that is a substitute for the factor under consideration D. All of the above will cause an increase in the demand for a factor of production True-False: Monopsony is one buyer of a commodity in the market. {TRUE} The MRP slopes downward in an imperfectly competitive (resource) market serving an imperfectly competitive product market because the MP diminishes and the price of the output must be lowered to sell more. {TRUE} 201 CHAPTER 11 Wage Determination This chapter is focused on the labor market. The model of the purely competitive firm's labor market will be developed. Once the competitive model has been completed, the model of a monopsony in the labor market will be developed
. These models will be used to analyze minimum wages and unionization. Wages and Labor Supply Labor cannot be separated from the human being who provides it. The result of the inseparability of labor from the people who provide it, is that the wage for the last hour worked must be equal to the utility lost from the use of that hour for leisure activities (all other activities except work.) Further, because labor is provided by people who are also consumers, the wage variable (the price of labor in a labor market) is somewhat more complicated than prices in product markets. Workers offer their services in the labor market for the standard of living that their wages will provide for them and their households. Therefore, the nominal wage (money wage) unadjusted for the cost of living; or W, means very little in determining the quantity of labor supplied in a factor market. The relevant wage variable is the real wage rate, which is the money wage (W) adjusted for the cost of living or price level (P); or W/P. In theory (in the competitive labor market) an employee should be paid what she earns for the company. What the employee contributes to the revenues of the firm is the marginal revenue product, MRP (the marginal physical product (MPP) times the price of the product produced (P) – MRP = MPP x P). In a perfectly competitive world this is what is supposed to happen. In a competitive labor market the wage is determined in the industry. The firm faces a perfectly elastic supply of labor curve. The equilibrium wage and level of employment is then determined by the intersection of the factor's MRP with the factor's marginal resource cost, MRC. 202 Consider the following diagram: Firm Industry Supply W/P W W/P Supply = MRC W Demand = MRP Q Quantity Q Quantity Demand In this analysis of a firm in a perfectly competitively market, the supply and demand curves for the industry are summations of the individual firms' respective demand and supply curves. Notice that the firm faces a perfectly elastic supply of labor curve, while the supply curve for the industry is upward sloping just like that observed in the product markets. Monopsony in the Labor Market (one buyer of labor) Unfortunately, the real world is not one of perfectly competitive labor markets. Factor markets are generally imperfect, and labor markets are generally monopsonies or contain elements of monopsony power in the hands of employers. A monopsony is one buyer of something. The monopsony model
is based on the assumption that there is one employer, or a group of employers that collude, they purchase standardized labor, and the supply side of the market is competitive. Therefore, the monopsonist is a price giver in this labor market. The result is that the employer has a pricing policy. If the employer wishes to hire more labor he must raise the wage to attract the labor necessary to obtain the labor required. Therefore the monopsonist faces an MRC that is to the left of the supply curve and has twice the slope of the supply curve. 203 Consider the following diagram: MRC Supply W/P Wm Qm Demand = MRP Quantity of Labor Notice, however, that the monopsonist does not have to pay the wage associated with the MRC's intersection with the demand curve. The employer equates MRC with MRP to determine the least cost level of employment and then imposes the lowest wage the market will bear, that being the point on the supply curve associated with the intersection of MRP and MRC. Also notice that the wage and employment levels in the monopsony are much lower than that in a competitive labor market. Control of Monopsony It is clear that monopsony in the labor market is not consistent with allocative efficiency and has the effect of withholding significant amounts the employees' MRP from them, that becomes profits, advertising, charitable expenditures, or payments to other factors that did not earn those payments. It is clear that such reallocations are inconsistent with both equity and efficiency and have been the focus of numerous public policies attempting to thwart such misallocations based purely on market power. One approach to the control of monopsony has been the imposition of minimum 204 wages. This approach is focused on controlling the worst effects of monopsony in the sense of inequitable redistributions from the working poor to the firms. A minimum wage does little to correct monopsony inefficiencies in all by the lowest paying occupations. What is interesting is that some economists argue that the minimum wage is a source of unemployment and inefficiency. To prove their point they argue the minimum wages' effects under the assumptions of a purely competitive labor market. Consider the following diagram. W/P Pe Supply = MRC Minimum Wage Demand = M Qd Qe Qs Quantity of Lab The minimum wage acts the same as an effective price floor in that it creates a surplus of labor -- unemployment. The distance between Qd and Qe is the number of workers who lost jobs
, and the distance between Qe and Qs is the number of workers attracted to this market that cannot find employment. This analysis is exactly correct under these assumptions. However, remember the minimum wage was established to offset market power possessed by employers whose wage policies worked to the detriment of the working poor -- i.e., the monopsonist. To the extent that there may be some labor markets that approximate a competitive labor markets, the minimum wage creates unemployment. However, purely competitive markets, either product or factor, exist only in the pages of textbooks. If minimum wages are analyzed in the context of the monopsony model for which the policy was intended the results obtained are far different than those of the competitive model. This is an example of how an analysis that has been passed-off as positive economics is really a normative model. If we assume competitive labor markets, we are making a normative statement, because only imperfectly competitive markets can be described in the real world. 205 Consider the following diagram: W/P Minimum Wm MRC Supply Demand = MRC Qm Quantity of Labor In a monopsony, the wage increases with the establishment of a minimum wage, but if the employer is rationale so too does the employment level as the employer slide back up the supply curve towards the competitive equilibrium. In the monopsony model there are no negative employment effects of the minimum wage unless it is established above the intersection of MRC with MRP. What the employment effects of the minimum wage are is an empirical question. Most of the research done concerning minimum wage effects have focused on the hospitality industry, in particular fast-food restaurants. This is one of the lowest paying industries in the U.S. economy and most recent research findings suggest either no employment effects or marginal positive gains in employment associated with the minimum wage. However, most of this research suffers from significant data problems. Earlier studies in a broader range of industries have generally found no employment effects, and the few studies where the data were competently gathered tend to confirm the monopsony power that requires market intervention. In most industrialized countries the approach to controlling monopsony power has been to establish collective bargaining or co-determination as a matter of public policy and to provide legislation protecting organizational and collective bargaining rights for workers. Unions have the potential of being an effective response to restore allocative efficiency in the case of monopsony in the labor market. The Harvard Business School studies published recently indicate that unions effects in the U.S. have been to restore much of the efficiency lost
due to monopsony. 206 Unions in a Competitive Market Again, there a group of economists who will rely on the use of the competitive model to illustrate the evils of unionization. The most common analyses are to subdivide unions into two classes, craft and industrial unions and show their effects in an otherwise competitive industry. A craft union is one that was AFL affiliated (before the AFL-CIO merger in 1956), organizes one skill class of employees (i.e., IBEW) and is termed an exclusive union. Consider the following diagram. W/P Union Target Supply Supply = MRC Demand = MRP Quantity of Labor Craft unions could control the supply of labor somewhat because of the fact that they represented primarily skilled employees and had control of the apprentice programs and the standards for achieving journeyman status. Because unions are the ones that train the skilled labor it is presumed that they can restrict the supply of labor within their craft and drive up wages. This is true, if we are willing to assume that unions could organize perfectly competitive industries. An industrial union is one that was a CIO affiliate (before the AFL-CIO merger in 1956), organizes all skill classes within a firm (i.e., UAW), and is called an inclusive union. An industrial union's bargaining power arises from what is called solidarity, its ability to strike and withhold all labor from an employer (bearing in mind that a strike is also a costly venture for a union). Again, consider the following model of an industrial union in an otherwise competitive labor market. 207 Supply W/P Wc Demand = MRP Qu Qc Quantity of Labor The industrial union establishes the minimum acceptable wage to the workers it represents, below which they will strike rather than work. This approach depends upon solidarity among the work force to make the threat of a strike effective. Assuming, that a strike can be effective within the legal and economic environments in which the union and management operate. The serious flaw in this analysis is the market model used to analyze unions makes little sense. Perfectly competitive labor markets are used to illustrate the effects of two different types of unions. If labor markets were competitive and there were not market imperfections unions would likely not be an economic priority for workers. However, unions are necessary in imperfectly competitive labor markets. Further, it is interesting to note that the pure craft and pure industrial unions virtually no longer exist. Originally, the International Brotherhood of Teamsters represented primarily drivers and warehouse workers. Today, the Teamsters represent a wide range of employees working
in most occupations and industries in the U.S. economy. Since the American Federation of Labor (AFL) and Congress of Industrial Organizations (CIO) merged in the mid-1950s, the distinction between the pure craft union has all but disappeared -- the exception are some locals of the traditionally skilled-trades unions in the building trades (i.e., International Brotherhood of Carpenters, International Brotherhood of Electrical Workers, the Bricklayers, the Glaziers, and the Laborers International Union). Most unions today are more consistent with the old model of industrial unions. 208 Unions and Monopsony Unions The Theory of the Labor Movement (Selig Perlman, New York: Augustus M. Kelley, Reprints of Economics Classics, 1970, [original published 1928] pp. 198-99.) In the evolution of the psychology of the American wage earner, the fruition of this "job and wage conscious" unionism and its eventual mastery of the whole field meant a final and complete rupture with the old "producing classes" point of view, which saw the road to economic democracy in a restoration to the individual, or to intimately associated groups of individuals, of access to economic opportunity in land, marketing, and credit; this opportunity once restored, competition alone would suffice to preserve it all around. This philosophy, as already noted, had issued from the typically American premise of an existing abundance of opportunity for every industrious person, -- an abundance, however, which conspiring monopolists have artificially converted into scarcity. The predominance of the "anti-monopoly" point of view in the American labor movement down to this time actually denoted a mental subordination of the wage earner to the farmer, a labor movement in the grip of a rural ideology. In contrast, the ideology of the American Federation of Labor was both an urban and a wage earner's ideology. It was based on a consciousness of limited job opportunities, -- a situation which required that the individual, both in his own interest and in that of a group to which he immediately belonged, should not be permitted to occupy any job opportunity except on the condition of observing the "common rule" laid down by his union. The safest way to assure this group control over opportunity, though also a way so ideal that only a union as favored as the printers' was able to actualize it entirely, -- was for the union, without displacing the employer as the owner of his business and risk taker, to become the virtual owner and administrator of
the jobs. Where such an outright "ownership" of the jobs was impossible, the union would seek, by collective bargaining with the employers, to establish "rights" in the jobs, both for the individual and for the whole group, by incorporating, in the trade agreement, regulations applying to overtime, to "equal turn", to priority seniority in employment, to apprenticeship, and so forth. Thus the industrial democracy envisaged by this unionism descended from Marxism was not a democracy of individualistic producers exchanging products under free competition, with the monopolist banished, but a highly integrated democracy of unionized workers and of associated employer-managers, jointly conducting an industrial government with "laws" mandatory upon the individual. As with the minimum wage, the appropriate analysis is where there is a problem, in the imperfect labor markets. If we assume a monopsony, rather than a perfectly competitive market, we again arrive at a far different set of results. When a monopsony exists, working conditions and compensation levels are allocatively inefficient resulting in an employee's desire for a voice in their working conditions and a method to offset the monopsony power that binds them to wages below the competitive equilibrium. 209 These are the types of conditions that result in employees attempting to form unions for purposes of collective bargaining. Not only in this country, but in Europe and Asia too, where the industrialized nations have higher proportions of union organization. The most common approach to monopsony control is to attempt to offset the monopsony power of the employer by creating a countervailing power on the supply side of the market. To offset monopsony power, unions attempt to approximate a monopoly, which theoretically should neutralize the monopsony. This addition of a monopoly on the supply side to a monopsony is called bilateral monopoly. The MRC W/P Supply Monopsonist Monopolist Pure Competition MRP' Demand = MRP Quantity of Labor following diagram shows a monopsony that has been confronted by a monopoly. The bilateral monopoly model is rather complex. The employer (monopsonist) will equate MRC with demand and attempt to pay a wage associated with that point on the supply curve. The monopolist (union) will equate MRP' (MRP' occurs because now the union also has a pricing policy and must lower price to sell more labor) with supply and attempt extract a wage associated with that point on the demand curve. The situation shown in this graph shows that the competitive wage is just about half-
way between what the union and what the employer would impose. The wage and employment levels established in this type of situation is a function of the relative bargaining power of the employer and union, therefore this model is indeterminant. The theory is that if the union and employer have equal bargaining power, the results of their collective bargaining should approximate the competitive labor market solution and restore allocative efficiency in these markets. The academic significance of the indeterminant nature of this model is the lack of an ability to predict wages and employment levels is why industrial relations developed as a separate field from economics (in large measure). In fact, marginal analysis has 210 not yet evolved to such an extent that it can successfully explain collective bargaining results. Therefore, the mix of social sciences, jurisprudence, and marginal analysis that marks modern industrial relations is because of the need to have greater explanatory power than marginal analysis alone can provide. The following box provides the language of Section 7 of the National Labor Relations Act, which is commonly called the Employee Bill of Rights. This statute applies to preponderance of private sector employees in the United States: Employee Bill of Rights Section 7, National Labor Relations Act – 49 Stat. 449 (1935) as amended Employees shall have the right to self-organization, to form, join or assist labor organizations, to bargain collectively through representatives of their own choosing, and to engage in other concerted activities for the purpose of collective bargaining or other mutual aid or protection, and shall also have the right to refrain from any or all such activities except to the extent that such right may be affected by an agreement requiring membership in a labor organization as a condition of employment as authorized in section 8(a) (3). Labor History The United States has a labor history that is not a particularly bright spot in our democratic traditions. Up to 1932 the U.S. government actively persecuted unions and their members. The first labor law case in the U.S. involved cordwainers, and the application of the criminal conspiracy doctrine to skilled workers Philadelphia Cordwainers (1806). This British common law doctrine was applied to unions until 1842, when three things happened. First, the House of Commons outlawed the use of this doctrine against unions in England. Second, in the United States a judicial decision made it difficult to apply the doctrine to unions. In the Commonwealth v. Hunt (Mass. Sup. Crt.) decision Chief Justice Shaw ruled that unions were not criminal organizations, per se. He reasoned that if unionists were to be convicted
of a criminal conspiracy there would be evidence required to prove that the purposes of the union were to violate some established criminal proscription. Third, employers discovered a preventative, rather than curative measure. The use of an injunction prevented, rather than prosecuted unions after they were already established and operating. Prevention was to the employers advantage because remedies for unionization often occurred long after the fact of a successful organizing campaign. Injunctions are court orders that require someone to do something or to refrain from doing something. An injunction can be issued only in the case where irreparable 211 damage will occur in its absence. The violation of an injunction is punishable as contempt of court. The use of labor injunctions has a long, and sorted history in the United States. Because jurists came from the propertied class they often permitted their biases to interfere in the proper exercise of their obligations. There are literally hundreds of examples of courts issuing injunctions interfering with union activities without evidence in support of the employer's request, or where evidence was clearly not competent, or where the injunction prohibited any and all union activities (blanket injunctions). Frequently, unions and their representatives were not given an opportunity to even be present in court when the petition for the injunction was first heard (a temporary restraining order) and the restraining order was converted to a permanent injunction without a hearing. Perhaps, worse still, workers in the coal fields (and elsewhere) were often required to sign "Yellow-dog" contracts before they were hired. The "Yellow-dog" contract was an instrument where an employee agreed that they would neither join nor associate themselves with unions (and if they did they by so doing resigned their position with the company). Courts, particularly in southern and Midwestern states, enforced these so-called contracts with injunctions. The Congress finally banded the use of labor injunctions and made "Yellow-dog" contracts unenforceable in 1932 with the passage of the Norris-LaGuardia Act. In 1890, the American economy was being overrun by massive monopolies that had become fairly anti-social. The Sherman Act was passed in 1890 to break the power of these giant businesses or trusts. Unfortunately, the anti-trust laws were not brought to bear against monopolies unless their conduct was totally unreasonable (i.e., Standard Oil, Amstar, American Tobacco). However, these anti-trust laws were routinely used against organized labor to prevent or punish labor unions. In 1914, the Congress passed amendment to the Sherman Act (Clayton Act) to
remove judicial interpretations that union could fall under the provisions of the Sherman Act. Again, the courts ignored the law, and finally in 1932 these issues were not made subject to judicial inquiry, unless a product market was effected or there was clear evidence of union misconduct. In 1932, the Congress enacted the first of the federal statutes designed to bring reason to labor-management relations in the United States. The first law passed was the Norris-LaGuardia Act and President Hoover (a conservative Republican) signed it into law. This act outlawed the use of injunctions against unions, the requirement that an employee sign a Yellow-Dog contract, and limited the use of the anti-trust laws 212 (Title I, Section 1, National Labor Relations Act, as amended) Findings and Policies The denial by some employers of the right of employees to organize and the refusal by some employers to accept the procedure of collective bargaining lead to strikes and other forms of industrial strife or unrest, which have the intent or the necessary effect of burdening or obstructing commerce by (a) impairing the efficiency, safety, or operation of the instrumentalities of commerce; (b) occurring in the current of commerce; (c) materially affecting, restraining, or controlling the flow of raw materials or manufactured or processed goods in commerce; or (d) causing diminution of employment and wages in such volume as substantially to impair or disrupt the market for goods flowing from or into the channels of commerce. The inequality of bargaining power between employees who do not possess full freedom of association or actual liberty of contract, and employers who are organized in the corporate or other forms of ownership association substantially burdens and affects the flow of commerce, and tends to aggravate recurrent business depressions, by depressing wage rates and the purchasing power of wage earners in industry and by preventing the stabilization of competitive wage rates and working conditions within and between industries. against unions. 1932-1935 was the only period in U.S. history that the government was neutral towards unions. In 1935, the National Labor Relations Act (N.L.R.A.) was passed making collective bargaining the public policy of the United States. The N.L.R.A. was amended several times. The major amendments occurred in 1947 (Taft-Hartley), 1959 (Landrum-Griffin), and the health care amendments of 1974. Until 1981, the federal government fostered peaceful labor-management relations and enforced the provisions of the N.L.R.A. in a more or less neutral way.
Beginning in 1981 we returned to pre1932 days, without the violence. The purposes of the N.L.R.A. was to foster peaceful labor-management relations and to maintain a reasonable balance between the power of unions and management so that society benefits. Yet, the politics involved in these matters have resulted in a rather unpredictable body of labor law that seems to change with changes in U.S. administrations. This is called the pendulum theory, Democrats seem to support collective bargaining and pro-worker legislation, Republicans seem to support management and government non-involvement (and there are notably exceptions to political party or individual candidate association with one side or the other). To foster peaceful labor-management relations there must be a balance of bargaining power between unions and management. The theory behind the N.L.R.A. 213 was to permit free and equal negotiations to solve the monopsony problem in the nation's labor markets. Because atomized competition could not be enforced without substantial disruption to the economic system, the equalization of bargaining power was thought to approximate the competitive solution in a manner similar to that demonstrated by the bilateral monopoly model's results. Of the world's industrialized nations, the United States has among the most peaceful labor relations. Nations such as England, Italy, and France have far more strikes and lost work time due to strikes than does the United States. Even Germany and Japan generally experience more lost time due to strikes than does the United States. However, compensation levels, and the extent of worker rights in the United States, lags far behind most of the rest of the industrialized world. This situation seems to be worsening over time. As Lester Thurow observes in his book, Head to Head, (pp. 204-06) the standard of living in the United States has steadily fallen since 1980. By 1988 the United States was eighth in the world in per capita purchasing power in the global economy. As of the summer of 1995 the purchasing power of American family's dollars had dropped out of the top ten among the world's industrialized nations (this is strikingly similar to the 1920s). Public sector employees have fared no better than private sector employees. After a series of Federal Executive Orders extending collective bargaining rights to employees and the Postal Reorganization Act extending the N.L.R.A. to postal employees, the Congress passed the Civil Service Reform Act of 1974 which extending bargaining right by statute. However, much of this was negated for several classifications of Federal employees with the passage of the Homeland Security
Act, which once again placed certain Federal Employees in a position where they have no statutory protection to organize and bargain. State and local employee bargaining rights have some piece-meal. Thirty-eight states have collective bargaining laws protecting state employees. Only the old Confederate, and some poor western states, and Indiana do not have such statutes to protect these bargaining rights. Wage Differentials Market structure alone does not account for all of the variations in wages and employment. Market wage differentials arise from several other sources, including, (1) the variations in geographic immobility within segments of the U.S. labor force,. (2) the continuing racial and gender discrimination evident in the U.S. social fabric, and (3) differences in productivity that arise from abilities of workers. The abilities, skills, and characteristics of workers that add to their productivity is called human capital. Abilities, personality, and other personal characteristics are a 214 portion of human capital -- many of these items are genetic, environmental, or a matter of experience. Education, training, and the acquisition of skills are human capital that is either developed or obtained. In general, it is hard to separate the sources of human capital, however, most is probably acquired. There are significant wage differentials to be observed by sector of the economy. While some of this is explainable by human capital, and geographic region of the country, much of this differential has to do with the value of the products the labor is producing. Consider the following table: Weekly Earnings - Bureau of Labor Statistics (in current dollars) Year U.S. Economy Manufacturing Construction Retail Trade 1999 2000 2001 2002 2003(est) 456.78 474.72 489.40 505.13 513.47 579.63 597.79 603.58 625.77 635.66 672.13 702.68 720.76 732.16 751.29 263.61 273.39 282.35 297.26 297.44 The average weekly hours in the U.S. economy for calendar year 2002 was just over 34 hours per week. These data do not include fringe benefits provided such as health insurance, etc. KEY CONCEPTS Nominal v. Real Wages Competitive Labor Market Industry Firm Monopsony Minimum Wages In competition In monopsony Craft Unions Industrial Unions 215 Bilateral Monopoly Wage Differentials Geographic immobility Discrimination Productivity Differences Human Capital Food for Thought: STUDY GUIDE Compare and contrast the real with the
nominal wage. Do these distinctions have any bearing on motivation? Explain. Develop the monopsony model and build in the union response to monopsony. Develop the two models of unions in otherwise competitive labor markets. Critically evaluate these models. Outline and explain the theory of human capital and how it relates to labor earnings. 216 Sample Questions: Multiple Choice: A monopolist in an otherwise competitive labor market will cause (as compared with the competitive labor market): A. Employment to increase, wages to decrease B. Employment to decrease, wages to decrease C. Employment to increase, wages to increase D. Employment to decrease, wages to increase Which of the following best describes a union that organizes only a specific skill group, relies on apprentice programs to influence the supply of labor and is often called an exclusive union? A. An industrial union B. A CIO affiliate C. A craft union D. None of the above True -False: Bilateral monopoly is an indeterminant model, which gave rise to a need for better models to explain labor-management relations. {TRUE} Human capital is concerned with the characteristics of labor that contribute to its productivity. {TRUE} 217 CHAPTER 12 Epilogue to Principles of Microeconomics Changing World Throughout this course, the focus has been on standard microeconomic analysis. However, the subject matter has been primarily focused on ideas that are, in the main, at least vaguely familiar. With the controversies about outsourcing and about corporate corruption, it should be clear that the world is changing rapidly. A stroll through almost any retail establishment will also make clear that the U.S. economy is rapidly becoming very internationalized. Before closing this course, it is necessary to make a few points about this changing economic world. Outsourcing There are several issues involved in the outsourcing of production in the U.S. economy. Outsourcing is an activity designed to cut the costs of production. This has two significant implications. First, the costs of production decline, which normally results in higher profit margins to the firm, with few implications for the pricing of the output. Normally, when something is outsourced it is a method used to cut labor costs. Perhaps one of the best examples of this outsourcing has been the movement to India of much of the computer software industry and a significant part of customer services for computer purveyors. This action was taken to cut costs, but that same cost cutting has implications for consumer incomes. Consumers, for the most part, in this country have the resources to consume because
they are also workers who earn a wage. In the principles of macroeconomics, you will study something called Say=s Law. Say=s Law says that the value of output produced is generally equal to the incomes earned in that production B hence just enough to buy that output in a closed system. When outsourcing results in the loss of income to workers, they consume less, in turn, reducing other people=s income, which has the effect of further depressing incomes, and hence demand. Clearly, and unambiguous, the interdependence (circular flow) that exists in a modern economic system means that consumption and production costs are the opposites sides of the same coin. What may be a good idea in terms of technical efficiency may actually harm allocative efficiency and / or full employment. 218 Economics and Ethics Morality and ethics are strong motivations to behavior. However, economists assume that rationality is a function of demonstrable self-interest. That means, material well-being B greed if you will. The acceleration of corporate scandals through the early part of this century seems to suggest a disregard for issues other than material wellbeing by many people who were in positions of authority in several major companies (Enron, Worldcom, Tyco etc.) Self-interest when measured purely in dollars and cents will often give rise to unethical, immoral, and perhaps even illegal conduct. Ethics and morality are self-imposed (or societal) constraints without the binding authority of law. People may very well do what is right, because it is the proper thing to do. However, the proper thing is too often less binding than what is the most personally profitable. Faced with these decisions, it should come as no surprise that a society will have crises in ethics and morals when faced with decisions concerning their economic well-being. CEOs stealing from the companies they direct are clearly wrong, but there are also many shades of gray. A CEO making tens of millions of dollars, when his contributions to the firm=s productivity are a small fraction is not as clear as stealing directly, but perhaps the difference is in gradient only. Clarence Updegraff (Arbitration and Labor Relations, Washington, D.C.: Bureau of National Affairs, Inc., 1972) describes the relationship of ethics with public opinion and law: In all systems of primitive law, three elements of social control invariably seem to make early appearances. In the Roman law, these social controls were designated as fas, boni mores, and lex. The weakest of these in the beginning
of the historical period was lex, or law. In all legal systems that truly develop to maturity it comes to be the dominate factor, but fas, the ethical or religious teaching, and boni mores, public opinion (or literally good morals) always remain important factors. The judge comes to deal almost entirely with law. At any rate, it dominates his technique of decision.... Notice that economic self-interest is not mentioned. However, look around you and see how economic self-interest is the dominate factor in ruling a person=s conduct. It is the fas, boni mores, and lex that are the constraints on a person=s pursuit of their economic self-interest. Personal embarrassment may restrain greed, but the probability of being caught, and doing jail time is a far greater restrain on unbridled greed for most people. 219 One ought not to become confused. Microeconomics provides decisional tools in making efficient decisions. Microeconomics, however, cannot substitute for what is ethical, moral or legal. As a scientific approach to resource allocation, economics has much to offer, but as a philosophy of what is right, moral, or decent, it falls far short. Internationalization It is clear that the days of the United States remaining safe, secure and isolated by two oceans is long gone. The United States is part of a global economic system, and there is much that can be gained or lost by how we conduct our role on the world economic stage. The United States has a current dominate role, militarily and economically, but as any student of history knows, such dominate roles are never permanent. Egypt, Greece, Rome, Persia, the Mongol Empire, and the British Empire all rose and most had economic sources of their failing. Free trade, tolerance, and a continuing development and reliance on comparative advantage are what provide for economic success. Technological innovation, natural resources, and human capital can provide significant comparative advantages in the production of commodities for trade internationally. It is upon these issues that the fate of the U.S. depends. As cultural barriers to economic activity, tolerance and understanding become evident; Americans will have to learn what values dominate in other cultures, and what constraints exist. Americans will also find that they will need to learn other languages to be able to work and trade in foreign lands. With the advances in communications, transportation, and the increased demands on natural resources, it is clear this economy will become increasingly internationalized. It is how we learn to deal with this internationalization
, and how well we prepare for it that will determine our economic success, as both individuals and as a society. The work-world in the future of most college students today is far different from what confronted their parents. Immigration of workers into the United States, and significant foreign investment assures that greater cultural diversity will be in evidence. Greater understanding of the world=s religion, ethnic diversity, and cultural backgrounds will be absolutely essential if one never leaves the State of Indiana. Much of the conflict in the Middle East today can be traced to failures to understand cultural differences. Because of this country=s inability to be independent and self-sufficient in energy, this critical area of the world will continue to be very important to our economic well-being. American interests abroad generally mean business interests, and generally multi-national firms. The love that most people had for the United States, outside of this 220 country has been seriously mitigated over the past couple decades. Whatever the reason, just as business becomes more focused on the global economy, the global economy is becoming a more challenging place. The great generosity (i.e., Peace Corps, the Marshall Plan etc.) endeared us to a large portion of the world. It will be a challenge to regain this sort of love and respect from countries that are now mistrustful. Finally, the economic environment in the U.S. is uncertain. The de- industrialization of the U.S. economy portends potentially hard economic times. Lower incomes, less economic security, and requirements on the work force to be far more adaptive may result the loss of comparative advantage in many markets, if we don=t rise to the task. Education, investment, and determination will undoubtedly make our future bright, but there is competition, and we must not become complacent. Parting Words The principles of economics provide a rudimentary guide to decision-making on the margin. One of the hallmarks of sound economic reasoning is marginal analysis. While most people find it difficult to ignore Asunk@ costs, it is often these very same sunk costs that lead people astray in deciding what to do next. It is hoped that this course will help make you think more like an economist, and act more rationally in your decision-making. Economics is also the mother-discipline for the academic areas, roughly referred to as business administration. A solid foundation microeconomics is going to make marketing, production management, and finance far easier to master and apply. Price elasticity of demand (and other elasticities) is much
of the subject matter in marketing, marginal analysis will again become central in the methods you use in production management, and finance is concerned primarily with capital markets. Therefore, microeconomics will follow throughout your academic career if you are a business major and throughout your real world career if you make decisions. 221 Sample Examinations 1. 2. Sample Midterm Examination Sample Final Examination 222 Sample Midterm Examination Answers are found at the end of this section. Multiple Choice (4 points each): 1. Which of the following factors of production are NOT properly matched with their factor payments? A. Capital - interest B. Land - profits C. Labor - wages D. All are properly matched 2. Which of the following terms means "all other things equal"? A. Post Hoc, Ergo Propter Hoc B. Fallacy of Composition C. Ceteris Paribus D. None of the above 3. Economic growth can be illustrated with the use of a production possibilities curve: A. By a shift to the left of the curve B. By a shift to the right of the curve C. By a point on the inside of the curve D. By a point on the outside of the curve 4. A small developing country in Central America has an economy that exhibits the following characteristics: (1) exchange occurs through markets, (2) private property is permitted, but there is also a large public sector, (3) what will be produced is decided by the government and the operation of markets, and (4) there is also a strong social desire to maintain the status quo. A. This is definitely a capitalist system B. This is definitely a command system C. The economy is most likely a mixed system D. It is impossible to tell what type of economic system this is from the information given 223 5. If Kansas can produce either 400 tons of wheat or 100 tons of corn and Nebraska can produce 300 tons of corn or 200 tons of wheat then it makes sense for the two states to specialize and trade. Which of the following accurately states the amount of grain that will be produced (assuming corn and wheat can be produced in constant ratios) and the terms of trade? A. Kansas will produce 0 wheat and 100 tons of corn, Nebraska will produce 300 tons of wheat and 0 corn, the terms of trade will be between 1.5 and 4 tons of corn per ton of wheat. B. Kansas and Nebraska will produce the amounts shown in the stem of the question and the terms of trade will 4 tons of corn for 6
tons of wheat. C. Kansas will produce nothing but 400 tons of wheat and Nebraska will produce nothing but 300 tons of corn, the terms of trade, assuming equal bargaining power, will be probably be 4 tons of wheat for 3 tons of corn. D. We cannot tell what the terms of trade will be from the information, but there is no advantage to trade between Nebraska and Kansas. 6. Which of the following is a characteristic of a market economy? A. Limited role for government B. Competition C. Freedom of Choice D. Specialization of Labor 7. If there were a decrease in demand and a decrease in supply, what would we expect to observe in a purely competitive market? A. price will increase, quantity exchanged is indeterminate B. price will decrease, quantity exchanged is indeterminate C. price is indeterminate, and quantity exchanged will increase D. price is indeterminate, and quantity exchanged will decrease 8. The recent flooding in the upper Midwest destroyed a significant proportion of the corn crop. However, it has been discovered that corn oil is far better in keeping cholesterol within acceptable limits than was once believed. What would we expect to observe in the market for corn? A. price is indeterminate, and quantity exchanged will increase B. price is indeterminate, and quantity exchanged will decrease C. price will increase, quantity exchanged is indeterminate D. price will decrease, quantity exchanged is indeterminate 224 9. If the supply curve shifts left and there is also an increase in demand what happens to equilibrium price and quantity? A. Price increases, quantity is indeterminate B. Price decreases, quantity is indeterminate C. Price is indeterminate, quantity increases D. Price is indeterminate, quantity decreases 10. The term "scarcity" in economics refers to the fact that: A. No country can yet produce enough to satisfy completely everybody's wants for everything B. It is impossible to produce to too much of any particular good C. Even in the richest country some people go hungry D. Everything costs money 11. A city government regulates taxi fares. It also limits the number of taxicabs (through licensing), and has not changed the limit on cabs for many years. At one time vacant taxis were scarce and hard to find; but when the city increased the allowable fares 25 percent, vacant taxis suddenly became plentiful. The result is BEST explained by the economic principle of: A. A negatively sloped, downward sloping demand curve B. Specialization
& division of labor C. Increasing marginal cost D. Public goods 12. "The compact disk player has literally revolutionized the recording industry with its state-of-the-art sound, clarity, durability, and the fact that it costs less than cassette tape players." Assuming that compact disks and cassette tapes are substitutes, how will the equilibrium price and equilibrium quantity of cassette tapes be affected? A. Equilibrium price increases, quantity decreases B. Equilibrium price decreases, quantity increases C. Equilibrium price and quantity will both increase D. Equilibrium price and quantity will both decrease 225 13. Which of the following is a function of money? A. Investment B. Store of value C. Bartering for goods D. All of the above are functions of money 14. If the quantity demanded of Pepsi Cola goes up, and its supply increases what will happen in the market for Pepsi? A. Price is indeterminate, quantity increases B. Price goes up, quantity is indeterminate C. Price goes down, quantity goes up D. None of the above 15. Which of the following describes the utility maximization rule? (where MU is marginal utility and P is price) A. MUa/Pa = MUb/Pb =... = Mu z/Pz = 1 B. Total MU = Total P C. MUa = MUb =... = MUz D. None of the above describe the rule 16. A local airline charges $500 to fly (round-trip) to Louisville, Kentucky. Over the past three months, while the $500 fare has been in effect each of the two daily flights have averaged 10 passengers. During last summer, the carrier ran a sale and charged $300 for a round-trip to Louisville; during the six weeks of the sale, the airline averaged 20 passengers per flight. What is the coefficient of price elasticity? A. 0.76 B. 1.00 C. 1.20 D. 1.33 17. Which of the following is a determinant of the price elasticity of demand? A. Whether a luxury or necessity B. Price of complements C. Number of consumers D. All of the above are 226 18. Where is the range of unit elasticity for the following demand curve? Price Quantity. From price 8 to price 6 B. From price 6 to price 5 C. From price 5 to price 3 D. From price 7 to price 5 19. With perfectly inelastic demand, then if supply increases
: A. Price remains the same, quantity increases B. Price remains the same, quantity decreases C. Price increases, quantity remains the same D. Price decreases, quantity remains the same 20. The price of Pepsi decreased from.50 to.40 and the quantity demanded increased from 100 million to 150 million. Which of the following statements are true? A. Quantity demanded decreased B. Demand is elastic C. Demand increased D. None of the above is true True/False (1 point each) 1. A laissez faire economy will always result in economic efficiency. 2. Business sell to households in the resource markets, but households sell to businesses in the product markets. 3. If the prices of Fords decrease, we should expect the demand for Chevrolet to 227 decrease, ceteris paribus. 4. If the price of MacDonald's Cheeseburgers increases, we would expect the demand for Coca-Cola to decrease, ceteris paribus. 5. Correlation can only test whether two variables are statistically associated, it cannot test for causation. 6. The circular flow diagram illustrates that there is interdependence in modern industrialized economic systems. 7. Giffin's paradox states that a demand curve can only be downward sloping if consumers have a limited income. 8. An increase in the quantity demanded of a good can occur because consumers expect the price of that good to increase in the near future. 9. A price ceiling imposed above the competitive equilibrium will result in a shortage. 10. The demand curve slopes downward because of the income and substitution effects. 11. The United States is the example of a laissez faire, capitalist economy. 12. Microeconomics is concerned with decision-making within the firm, household or on the individual level, but macroeconomics is concerned with the behavior of the entire economic system. 13. Economic goals are complementary with one another, but may be conflicting with other social goals. 14. The quantity supplied of a commodity will increase if we increase an ad valorem tax on the commodity. 15. A price floor established above a competitive equilibrium will cause a surplus. 16. The income effect results from consumers having more resources available to purchase everything, if the price of one good decreases. 17. The maximum point (where it is goes flat or from increasing to decreasing) in the total revenue curve is associated with the unitary range in the demand curve. 18. The price elasticity of demand is the slope of the demand curve. 228 19. The law of diminishing marginal
utility states that some consumers experience less utility from the consumption of a commodity than do other consumers. 21. When total revenue and price move in the same direction, demand is price inelastic; when they move in opposite directions demand is price elastic. Answers: Multiple Choice: True/False: 1. B 11. A 2. C 12. D 3. B 13. B 4. C 14. C 5. C 15. A 6. D 16. D 7. D 17. A 8. C 18. B 9. A 19. D 10 A 20. B 1. F 11. F 2. F 12. T 3. T 13. F 4. T 14. F 5. T 15. T 6. T 16. T 7. F 17. T 8. F 18. F 9. F 19. F 10 T 20. T 229 Sample Final Examination Answers are given at the end of the section Multiple Choice (4 points each) 1. In a purely competitive market, the firm will take the price established in the industry. The question that the firm must answer is what quantity it will offer in the market. The firm makes this decision based on which of the following criteria? A. Where average total cost is equal to average revenue B. Where the marginal cost is equal to marginal revenue C. Where the industry supply curve is equal to the demand curve D. The firm cannot "decide" where to produce, this is imposed by the industry equilibrium 2. A perfectly competitive firm's short-run supply curve is its marginal cost curve: A. For all output where marginal cost exceeds minimum average variable cost B. For all output where marginal cost exceeds minimum average total cost C. For all output where marginal cost exceeds minimum average fixed cost D. For all quantities of output 3. A newspaper reports, "COFFEE GROWERS' MONOPOLY BROKEN INTO SEVERAL COMPETING FIRMS." If this is true, we would expect the coffeegrowing industry to: A. decrease output and increase price B. increase output and decrease price C. use more capital goods and hire fewer workers D. use fewer capital goods and hire more workers 4. To regulate a monopolist at the social optimum implies: A. We risk forcing the monopolist to make a loss B. We will approximate a purely competitive market solution C. The point where the social optimum is obtained is where P = D = MC D. All of the above are true 230 5. An unregulated monopolist
when compared with a purely competitive industry will: A. Produce more, and charge more B. Produce more, but charge less C. Produce less, but charge more D. Produce less, and charge less 6. Which of the following is the decision rule to determine the optimal combination of productive factors? A. MRPlabor/MRClabor = MRPcapital/MRCcapital =... = MRPland/MRCland = 0 B. MRPlabor/MRClabor = MRPcapital/MRCcapital =... = MRPland/MRCland = 1 C. MRPlabor = MRPcapital =... = MRPland = 0 D. MRPlabor = MRPcapital =... = MRPland = 1 7. Which of the following is a nonprice determinant of the demand for a factor of production? A. Product Demand B. Resource productivity C. Quality of the Resource D. All of the above are nonprice determinants of the demand for a factor 8. The demand for capital for a firm that can easily automate its production operations (all other things equal) can be characterized as: A. Price elastic B. Price inelastic C. Demand is increasing D. Demand is decreasing 9. Which of the following is true of the minimum wage? A. If we assume a monopsony in the labor market, then there are likely no employment effects of the minimum wage as long as it's imposed below the monopsonist=s desired wage rate. B. If it is imposed above the competitive equilibrium, there will be unemployment as a result of the minimum wage. C. If it is imposed below the competitive equilibrium, it will not be a binding constraint on the market. D. All of the above are true. 231 10. A monopsonist in an otherwise competitive labor market will cause (as compared with the competitive labor market): A. Employment to increase, wages to decrease B. Employment to decrease, wages to decrease C. Employment to increase, wages to increase D. Employment to decrease, wages to increase 11. A craft union is characterized by all but which of the following? A. Changes supply by manipulation of apprentice programs B. Cause a kink in the supply curve at the minimum acceptable wage C. Organizes only one skill group of employees and was associated with the AFL D. All of the above are true 12. In a small Ohio community, we have only five employers who pay wages within a narrow range that is basically acceptable
to each of the employers. The employees believed that the wage they received was below the competitive equilibrium so they unionized. The effects of this unionization in the small community was: A. A higher wage, but with increased employment B. A higher wage, but with decreased employment C. The wage didn't change, but there was increased employment D. We simply do not know because the underlying economic model is indeterminant 13. If we have a monopolist that provides electrical service to a community and it is observed that the monopolist charges, what is viewed by most people as excessive rates, we may wish to regulate the monopolist. If we were to regulate the monopolist at competitive equilibrium we have regulated the monopolist at: A. The social optimum (allocatively optimal) B. At where marginal cost is equal to average revenue C. At a point where there is a greater quantity than would be observed at the monopoly rate D. All of the above are true 14. Which of the following is not an assumption of the pure competition model? A. The is only public relations type non-price competition B. There are no barriers to entry or exit C. There is a standardized product D. All of the above are 232 15. Because of the underlying assumptions of the purely competitive model, all of the following are true, but one, which of the following is not true of competition? A. Economic profits are a signal for new firms to enter the market B. Purely competitive industries are economically efficient C. Competitive firms= are guaranteed a profit at where MC=MR D. All of the above are true 16. Which of the following does the marginal revenue curve intersect at their minimum? A. Short run average total cost B. Total cost in the short run C. Long Run Average Total Cost D. None of the above 17. What are the causes of economies of scale? A. Ability to use by-products B. Ability to use specialized management C. Use of specialized capital goods in production D. All of the above 18. Which of the following is an implicit cost to a business? A. The costs that are associated with factors of production that can be varied in the short-rum B. The forgone opportunity for the business to engage in the current activity C. Any and all costs to the firm that are termed accounting costs D. None of the above 19. Which of the following is true? A. TC - MC = VC B. AVC + TC = FC C. AFC +
AVC = ATC D. MC + MR = profits 20. Fixed costs: A. Exist only in the long run B. Exist only in the market period C. Are the difference between variable cost and total cost D. Are only opportunity costs in the long run, but implicit costs in the short run 233 True/False (1 point each) 1. Other things equal, a monopolist will produce less, at a higher price than a competitive firm will. 2. Oligopoly is an industry with a large number of suppliers, but few buyers. 3. Society would be unequivocally better off without monopolists. 4. X-inefficiency occurs when a firm's actual costs of producing any output are greater than the minimum possible costs. 5. Price discrimination occurs when a firm can segment the market and charge different prices, which do not necessarily reflect the costs of production. 6. The MRP slopes downward in an imperfectly competitive (resource) market serving an imperfectly competitive product market because the MP diminishes and the price of the output must be lowered to sell more. 7. The demand for a factor of production in a competitive factor market is the MRP schedule for that factor, and this is why we refer to the demand as being a derived demand. 8. Human capital is concerned with the characteristics of labor that contribute to its productivity. 9. Labor offers its services for the nominal wage and the determinants of demand for labor are basically utility maximizing decisions within the household. 10. The marginal revenue curve in a monopoly model has exactly half the slope as the demand curve. 11. The supply curve in a monopoly is the marginal cost curve above average fixed costs. 12. The lower the value of the commodity produced, the lower the wage earned by labor, ceteris paribus. 13. In a purely competitive industry, supply is the summation of all the firms= marginal cost curves above average variable cost. 14. The shut down point is where the firm cannot cover its fixed costs of operation. 234 15. A firm in pure competition has a horizontal demand curve, which is also equal to the marginal revenue, and average revenue curves. 16. Long run average total cost curve is also referred to commonly as a planning horizon. 17. An economic profit cannot be maintained in the long run in monopoly, but can be in pure competition. 18. In the market period, all costs are variable, in the short-run there are both fixed and variable costs and in the long run all costs are fixed.
19. The cost structure of the firm is unrelated to the theory of production in pure competition. 20. The average fixed cost increases as the marginal cost curve is above it. 235 Answers: Multiple Choice: True/False: 1. B 2. A 3. B 4. D 5. C 6. B 7. C 8. A 9. D 10 B 11. D 12. D 13. D 14. A 15. C 16. A 17. A 18. B 19. C 20. C 1. T 2. F 3. F 4. F 5. T 6. T 7. T 8. T 9. F 10 F 11. F 12. T 13. T 14. F 15. T 16. T 17. F 18.T 19. F 20. F 236 APPENDIX B SELECTED BIBLIOGRAPHY (BOOK LIST) Becker, Gary, Human Capital: A Theoretical and Empirical Analysis. Chicago: University of Chicago Press, 1993 Friedman, Milton, Essays in Positive Economics. Chicago: University of Chicago Press, 1994.* Friedman, Milton and Rose D. Friedman, Capitalism and Freedom. Chicago: University of Chicago Press, 1972. Galbraith, John Kenneth, The Great Crash of 1929. New York: Houghton - Mifflin, Company, 1997.* Heilbroner, Robert L., The Worldly Philosophers, seventh edition. New York: Simon and Schuster, 1999.* Higham, Charles, Trading with the Enemy: The Nazi-American Money Plot - 1933-1949. New York: Barnes and Nobel Books, 1983. Hilgert, Raymond L. and David A. Dilts, Cases in Collective Bargaining and Industrial Relations, tenth edition. New York: McGraw-Hill / Irwin, 2002. Manchester, William, The Arms of Krupp: 1587-1968. New York: Bantam Books, 1970.* Marx, Karl, Das Kapital, New York: International Publishers, Incorporated, 1982.* McConnell, Campbell R. and Stanley Brue, Principles of Economics, sixteenth edition, New York: McGraw-Hill / Irwin, 2004. North, Douglas C. Economic Growth in the United States: 1790-1860. Seattle: DIANE Publishing Co., 2003. Rahnama-Moghadam, Mashaalah, Hedayeh Samavati and David A. Dilts, Doing Business in Indebted Less Developed Countries. Westport
, Conn: Greenwood Publishing Group, 1995. 237 Schumpeter, Joseph A., Business Cycles. New York: Porcupine Press, Incorporated, 1982. Sloane, Arthur A. and Fred Witney, Labor Relations, eleventh edition. Englewood Cliffs, N.J.: Prentice-Hall, 2003. Smith, Adam, An Inquiry into the Nature and Causes of the Wealth of Nations. New York: Everyman=s Library - Alfred A. Knopf, Inc. 1991 (first published 1776).* Steinbeck, John, Grapes of Wrath. New York, Penguin Books, 2002.* Stiglitz, Joseph E., Globalization and its Discontents. New York: W. W. Norton & Company, 2003.* Thurow, Lester, The Future of Capitalism. New York: Penguin Books, Inc., 1997.* Thurow, Lester, Head to Head New York: Warner Books, Inc., 1993. Terkel, Studs, Working. New York: Ballantine Books, 1974.* Tuchman, Barbara, A Distant Mirror: The Calamitous Fourteenth Century. New York: Random House, 1979.* Veblen, Thorstein, The Theory of the Leisure Class, New York: Penguin Books, 1967 (first published 1899) * denotes classic, must read sometime while you are still in school 238 read. Below you will find several strategies that involve built-in features of Economics: Choices and Concepts. Careful use of these strategies will help you learn and understand economics more effectively. Preview Chapters Before You Read Each chapter begins with a two-page chapter opener. Study these pages to help you get ready to read. 1 Read the chapter title and section titles for clues to what will be covered in the chapter. 2 Read the Concept Review, which reviews previous learning important to understanding chapter content. Then study the Key Concept, which focuses on the main idea explored in the chapter. Finally, read the Why the Concept Matters explanation and question. These help place the chapter’s main idea in a real-world context. 3 Study the chapter-opening photograph and caption. These provide a visual illustration of the chapter’s main idea. Microeconomics U n i t 2 Market Economies at Work CHAPTER 4 SECTION 1 What Is Demand? SECTION 2 What Factors Affect Demand? SECTION 3 What Is Elasticity of Demand? CASE STUDY Fueling Automobile Demand 3 Demand This computer store customer meets the two requirements of demand
—the customer is willing to buy and is able to pay. 1 Demand Microeconomics is the study of the economic behaviors and decisions of small units, such as individuals and businesses Demand is the willingness to buy a good or service and the ability to pay for it AT T E R S The concept of demand is demonstrated every time you buy something. List the last five goods or services that you purchased. Rate each one with a number from 1 (not important to you) to 4 (very important). Which of the goods or services would you stop buying if the price rose sharply? Describe the relationship between your ratings and your willingness to buy at a higher price. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on demand in the automobile industry. (See Case Study, pages 124–125.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. What caused more people to demand hybrid cars? See the Case Study on pages 124–125. 96 Demand 97 S2 Preview Sections Before You Read Each chapter consists of three or four sections. These sections explain and build on the Key Concept. Use the section openers to help you prepare to read. 1 Study the information under Objectives. This bulleted list tells you the key points discussed in the material you are about to read. 2 Preview the Key Terms list. This list identifies the vocabulary you will need to learn in order to understand the material you are about to read. Use the Taking Notes graphic to help you organize information presented in the text. 3 Notice the structure of the section. Blue heads label the major topics; red subheads signal smaller topics within a major topic or illustrative examples of the major topic. Together, these heads provide you with a quick outline of the section. 4 Read the first paragraph under Key Concepts. This links the content of the section to previous chapters or sections. K E Y T E R M S demand, p. 98 law of demand, p. 99 demand schedule, p. market demand sched What Is Demand TA In Section 1, you will demand, p. 98 • define demand and outline law of demand, p. 99 what the law of demand says • explain how to interpret and create demand schedules and describe the role of market research in this process • explain how to interpret and create demand curves demand schedule, p. 100 market demand schedule, p. 100 demand curve, p
. 102 market demand curve, p. 102 As you read Section 1, complete a cluster diagram like this one for each key concept. Use the Graphic Organizer at Interactive Review @ ClassZone.com Demand The Law of Demand 3 4 KE Y CONCEP TS In Chapter 3, you learned that the United States has a free enterprise economy. This type of economic system depends on cooperation between producers and consumers. To make a profit, producers provide products at the highest possible price. Consumers serve their own interests by purchasing the best products at the lowest possible price. The forces of supply and demand establish the price that best serves both producers and consumers. In this chapter, you’ll learn about the demand side of this equation. QUICK REFERENCE Demand is the willingness to buy a good or service and the ability to pay for it. Demand is the desire to have some good or service and the ability to pay for it. You may want to take a round-the-world cruise or to rent a huge apartment that overlooks the ocean. Or you may want to buy a brand-new sports car or a state-of-the-art home entertainment center. However, you may not be able to afford any of these things. Therefore, economists would say that you have no actual demand for them. Even though you want them, you don’t have the money needed to buy them. Conversely, you may want the latest CDs by several of your favorite bands. And, at a price of between $12 and $15 each, you can afford them. Since you have both the desire for them and the ability to pay for them, you do have demand for CDs. Price is one of the major factors that influence demand. The law of demand states that when the price of a good or service falls, consumers buy more of it. As the price of a good or service increases, consumers usually buy less of it. In other words, quantity demanded and price have an inverse, or opposite, relationship. This relationship is graphically illustrated in Figure 4.1 below. NEED HELP? QUICK REFERENCE Law of demand states that when prices go down, quantity demanded increases. When prices go up, quantity demanded decreases. EXAMPLE Price and Demand 3 Let’s take a look at an example of demand in action. Cheryl, a senior at Montclair High School, loves movies and enjoys collecting them on DVD. She and Malik, a friend from school, sometimes meet downtown at Montclair Video Mart to look
through the DVD stacks. Rafael, the owner of the video mart, often jokes that Cheryl and Malik spend so much time at his store that he might have to give them jobs. Actually, Cheryl already has a job—stocking shelves at her neighborhood supermarket. She worked so many hours this summer that she has extra money to spend. Let’s see how DVD prices at Montclair Video Mart affect her spending decisions. Cheryl has been saving to buy the DVD boxed set of the original Star Wars trilogy, one of her favorite series of movies. The set costs $69.95, and Cheryl has the money to buy it this weekend. When Cheryl goes to the Montclair Video Mart, she is disappointed to learn that the Star Wars set is sold out and a new shipment won’t arrive for a week. She decides to buy some other DVDs so that she won’t go home empty-handed, but she also decides to save roughly half of her money toward a future purchase of Star Wars. As she looks through the movie DVDs, she sees that most of those she wants sell for $15. How many will she buy at that price? Let’s say she decides to buy three and keep the rest of her money for the Star Wars trilogy. But what if each of the DVDs she wants costs just $5? Cheryl might decide that the price is such a good deal that she can buy seven. As you can see, the law of demand is more than just an economic concept. It’s also a description of how consumers behave. APPLIC ATION Applying Economic Concepts A. You have $50 and want to buy some CDs. If prices of CDs rose from $5 each to $10, how would your quantity demanded of CDs change? Find an update on the demand for CDs and DVDs at ClassZone.com 98 Chapter 4 Demand 99 S3 STRATEGIES Use Active Reading Strategies As You Read Now you are ready to read the chapter. Read one section at a time, from beginning to end. 1 Read to build your economic vocabulary. Use the marginal Quick Reference notes to reinforce your understanding of key economic terms. 2 Use special features and illustrations to reinforce and extend your understanding of content and to apply your knowledge. Study features such as Your Economic Choices, which applies economic concepts to a real-world situation. Look closely at the figures, which illustrate economic concepts in table, chart, or graph form. Answer the accompanying Analyze questions to test your understanding of the visual
and the concept it illustrates. 3 At natural breaks in the section, ask yourself questions about what you have just read. Look for APPLICATION headings at the bottom of pages and answer the questions or complete the activities. These provide you with opportunities to apply the knowledge you have gained from your reading. QUICK REFERENCE Elasticity of demand is a measure of how responsive consumers are to price changes. 1 Economists use the term elasticity of demand to describe how responsive consumers are to price changes in the marketplace. Economists describe demand as being either elastic or inelastic. Demand is elastic when a change in price, either up or down, leads to a relatively larger change in the quantity demanded. The more responsive to change the market is, the more likely the demand is elastic. On the other hand, demand is inelastic when a change in price leads to a relatively smaller change in the quantity demanded. For this reason, elastic goods and services are often said to be price sensitive. So, in the case of inelastic demand, changes in price have little impact on the quantity demanded. Another way to think about elasticity is to imagine that a rubber band represents quantity demanded. When the quantity demanded increases by a marked amount, the demand is elastic and the rubber band stretches. If the quantity demanded barely changes, demand is inelastic and the rubber band stretches very little. QUICK REFERENCE Elasticity of demand is a measure of how responsive consumers are to price changes. Demand is elastic if quantity demanded changes signiﬁ cantly as price changes. Demand is inelastic if quantity demanded changes little as price changes. 2 EXAMPLE Elasticity of Demand for Goods and Services Let’s look at an example of elastic demand. Suppose that a certain brand of PDAs goes on sale. If the price of that brand goes down 20 percent, and the quantity demanded goes up 30 percent, then demand is elastic. The percentage change in quantity demanded is greater than the percentage change in price. Goods that have a large number of substitutes fall into the elastic category, since if the prices change, consumers can choose other products. Now think about a completely different type of good—the medicine insulin. Many diabetics require daily insulin injections to regulate their blood sugar levels. Even if the price of insulin were to rise sharply, diabetics would still need the same amount of insulin as they did before. If the price were to drop, they would not need any more insulin than their required dosage.
As a result, the demand for insulin is inelastic because the quantity demanded remains relatively constant. YO EC ESSIT Y OR C HOIC E 2 Which of these services could you give up? Most people consider getting a cavity ﬁ lled to be a necessity. Having your teeth whitened is a service that can be postponed or eliminated without harm. As a result, the demand for whitening is more elastic than the demand for ﬁ llings.? Over time the elasticity of demand for a particular product may change. If more substitutes for a product become available, the demand may become more elastic. For example, the cost of cell phones and their service has become more elastic as more providers enter the market. On the other hand, in the case of prescription drugs, if a product is withdrawn from the market and there are fewer choices for the consumer, the demand may become inelastic. The data for elastic demand and the data for inelastic demand produce demand curves that look very different from each other. Compare Figure 4.13 and Figure 4.14 below. Notice that the inelastic demand curve has a steeper slope than the elastic demand curve does. The reason for this difference is that the changes along the vertical axis (the price) are proportionally greater than the changes along the horizontal axis (the quantity demanded). FIGURE 4.13 ELASTIC DEMAND CURVE FIGURE 4.14 INELASTIC DEMAND CURVE ) 12 10 200 160 120 80 40 20 b 4,000 8,000 12,000 16,000 20,000 0 20 40 60 80 100 120 Quantity demanded of movie tickets Quantity demanded of fillings a In Figure 4.13, elastic demand curves have gradual slopes. They are more horizontal than vertical because of the greater changes in quantity demanded. b In Figure 4.14, inelastic demand curves have steep slopes. They are more vertical than horizontal because quantity demanded changes very little. ▲ Cosmetic whitening ANALYZE GRAPHS 1. In Figure 4.13, what happens to the quantity demanded when price drops from $10 to $8? 2. In Figure 4.14, what is the difference in quantity demanded between the most expensive and least expensive filling? Use elastic and inelastic demand curves at ClassZone.com QUICK REFERENCE Demand is unit elastic when the percentage change in price and quantity demanded are the same. Demand is said to be unit elastic when the percentage change in price
and quantity demanded are the same. In other words, a 10 percent increase in price would cause exactly a 10 percent drop in quantity demanded, while the reverse would be true. No good or service is ever really unit elastic. Instead, unit elasticity is simply the dividing point between elastic and inelastic demand. It is a useful concept for figuring out whether demand is elastic or inelastic ▲ Filling a cavity Demand 117 118 Chapter 4 3 APPLICATION Drawing Conclusions A. Decide how elastic demand is for the following item. Explain your reasoning. When a grocery store sells soup at $1.09 per can, it sells 1,500 cans per week. When it dropped the price to $0.75, it sold an additional 1,000 cans. S4 Review and Summarize What You Have Read When you finish reading a section, review and summarize what you’ve read. If necessary, go back and reread information that was not clear the first time through. 1 Look again at the blue heads and red heads for a quick summary of the major points covered in the section. 2 Study any tables, charts, graphs, and photographs in the section. These visual materials often convey economic information in condensed form. 3 Complete all the questions in the Section Assessment. This will help you think critically about the material you have just read. 1 Total Revenue Test S E C T I O N 3 Assessment ClassZone.com AC T I C E 3 QUICK REFERENCE Total revenue is a company’s income from selling its products. Total revenue test is a method of measuring elasticity by comparing total revenues. 1 2 KE Y CONCE PTS Businesses need to know about elasticity of demand because it influences the amount of revenue they will earn. Economists measure elasticity of demand by calculating a seller’s total revenue, the amount of money a company receives for selling its products. Total revenue is calculated using the following formula, in which P is the price and Q is the quantity sold: TOTAL REVENUE = P Q. You can measure elasticity by comparing the total revenue a business would receive when offering its product at various prices. This method is the total revenue test. If total revenue increases after the price of a product drops, then demand for that product is considered elastic. Why? Because even though the seller makes less on each unit sold, the quantity demanded has increased enough to make up for the lower price. For example, if a hot dog stand sells 100 hot dogs for
$2.50 each, the total revenue is $250 for the day. However, if the price of hot dogs drops to $2.00 each and 150 are sold, the total revenue for the day will be $300. The demand is elastic. But if the total revenue decreases after the price is lowered, demand is considered inelastic. If the hot dog stand lowers its price to $1.00 each and sells 200 hot dogs, it makes $200 in total revenue. Clearly, the price reduction has caused only a modest increase in quantities sold, which is not enough to compensate for lower revenues. EX AMP LE Revenue Table Let’s look at an example of demand for movie tickets. In Figure 4.17, you can see how total revenues show whether demand is elastic or inelastic. Price of a Movie Ticket ($) Quantity Demanded per Month Total Revenue ($) a b 12 10 8 6 4 1,000 2,000 6,000 12,000 20,000 12,000 20,000 48,000 72,000 80,000 a At $10 a ticket, the quantity demanded is 2,000. Total revenue is $20,000. b When the price drops to $8, the quantity demanded rises to 6,000. Total revenue rises to $48,000. So, demand is elastic. ANALYZE TABLES When the price range changes from $8 to $6, is demand elastic or inelastic? Explain. APPL ICATION Creating Tables D. Use the information from Figure 4.14 to estimate prices to make a total revenue table. 1. Use each of the terms below in a sentence that gives an example of the term: a. elastic b. inelastic c. total revenue 2. How is total revenue related to elasticity of demand? 3. Why are elastic goods and services said to be price sensitive? 4. What are the factors that affect elasticity of demand and how does each affect elasticity? 5. Analyze the factors that determine elasticity to explain why utilities companies never offer sale prices on their services. 6. Using Your Notes How does the concept of unit elasticity relate to the concepts of elasticity and inelasticity? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com elasticity of demand 7. Analyzing Causes In early 2004, news articles reported that prescription drug prices were rising almost three times faster than the prices of other products. Identify the
factors that explain why the drug companies were able to raise prices so sharply. 8. Analyzing Data In June, Snead’s Snack Bar sold 1,000 fruit smoothies at a price of $2.50 each. In July, they sold 1,300 fruit smoothies at a price of $2.00. Is the demand for fruit smoothies elastic or inelastic? Use the formula on page 121 to decide. Show the math calculations to support your answer. 9. Applying Economic Concepts Suppose the company that runs concession stands at a local sports arena wants to increase revenue on sales of soft drinks. The manager believes the only solution is to charge higher prices. As a business consultant, what advice would you give the manager? Use economic thinking to support your answer. 10. Challenge You learned in this section that no product ever has demand that is unit elastic. What possible reasons can you give for that? Draw on what you know about utility, demand, and elasticity as you formulate your answer. Calculating Elasticity Determine the elasticity of bottled water by calculating elasticity and using the revenue table below. Use the information on pages 121 and 122 to help you. Number of Bottles Sold Price ($) 35 75 100 120 2.00 1.50 1.25 1.00 Write a Summary After you have determined whether bottled water is elastic or inelastic, think about what factors affect the demand for bottled water. Write a summary of your conclusions explaining whether demand is elastic or inelastic and why, and what factors affect the elasticity of water. Challenge What effect might the introduction of a new energy drink have on the demand for bottled water? Use economic thinking to support your answer. 122 Chapter 4 Demand 123 S5 STRATEGIES Part 2: Test-Taking Strategies and Practice You can improve your test-taking skills by practicing the strategies discussed in this section. First, read the tips on the left-hand page. Then apply them to the practice items on the right-hand page. Multiple Choice stem 1 Read the stem carefully and try to answer the question or complete the sentence before looking at the alternatives. 2 Look for key words and facts in a question. They may direct you to the correct answer. 1. The country with the most elements of a command economy is Most is a key word. China has some elements of a command economy but North Korea has more. alternatives A. China B. North Korea C. South Korea D. Japan You can eliminate D if you remember
that Japan has a market economy. 3 Read each alternative 2. Economic models with the stem. Don’t make your final decision on the correct answer until you have read all of the alternatives. 4 Eliminate alternatives that you know are wrong. 5 Look for modifiers to help you rule out incorrect alternatives. 6 Carefully consider questions that include all of the above as an alternative. 7 Take great care with questions that are stated negatively. A. all present statistical information B. represent economic forces C. must be three-dimensional D. always use graphs to convey information Absolute words, such as all, always, never, ever, and only often signal an incorrect alternative. 3. Which of these statements about Adam Smith is correct? A. He is considered to be the founder of modern economics. B. He was an economic advisor at the Versailles peace conference. C. He endorsed the trickle-down theory of economics. D. All of the above. If you select this answer, be sure that all of the alternatives are correct. 4. Which of the following is not a factor of production? A. land B. labor C. services D. capital Eliminate incorrect alternatives by identifying those that are factors of production answers: 1 (B), 2 (B), 3 (D), 4 (C) S6 PRACTICE Directions: Read each question carefully and choose the best answer from the four alternatives. 1. Which of the following is not a type of business consolidation? A. vertical merger B. franchise C. conglomerate D. multinational corporation 2. Wage rates are influenced by A. supply and demand B. discrimination C. government actions D. all of the above 3. As of 2005, the euro had been adopted by A. the United Kingdom B. all the European countries C. some European countries D. every member of the European Union 4. The central bank of the United States A. has no cash reserves B. is the U.S. Treasury C. does not lend money D. was established by the Federal Reserve Act S7 STRATEGIES Charts Charts present information in a visual form. Economics textbooks use several types of charts, including tables, flow charts, Venn diagrams, circular flow charts, and infographics. The chart most commonly found in standardized tests, however, is the table. This organizes information in columns and rows for easy viewing. 1 Read the title and identify the broad subject of the chart. 2 Read the column and row headings and any other labels. These
will provide more details about the subject of the chart. 3 Note how the information in the chart is organized. 4 Compare and contrast the information from column to column and row to row. 5 Try to draw conclusions from the information in the chart. 6 Read the questions and then study the chart again. Gross Domestic Product (GDP)—Percentage Change Over Previous Year—for Selected Countries Country Canada France Germany Italy Japan United Kingdom United States 2002 2003 3.4 1.1 0.1 0.4 -0.3 1.8 1.9 2.0 0.5 -0.1 0.3 2.5 2.2 3.0 Source: Historical Statistics of the United States This chart organizes the countries alphabetically. In some charts, information is organized according to years or the value of the numbers displayed. Notice that the rows contain both positive and negative numbers. Think about what trend or trends the data indicates. 1. The country that had the greatest percentage change in GDP in 2003 was A. the United States B. the United Kingdom C. Japan D. Canada 2. In 2002, which country experienced a decline in GDP? A. France B. Italy C. Germany D. Japan answers: 1 (A), 2 (D) S8 PRACTICE Directions: Use the chart and your knowledge of economics to answer questions 1 through 4. Refined Copper Production for Selected Countries (in thousands of metric tons) North America South America Year Canada Mexico 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 493.4 491.1 528.7 515.2 515.8 538.0 539.3 561.6 527.5 560.0 72.3 128.4 140.9 155.8 157.1 190.1 191.0 197.8 199.5 207.5 United States 1,479.9 1,541.6 1,852.0 1,953.8 2,017.4 2,000.0 2,140.0 2,250.0 2,230.0 2,280.0 Brazil Chile Peru 166.0 201.7 185.9 207.8 201.7 141.4 158.0 161.1 170.0 165.0 783.7 795.0 852.9 1,071.0 990.8 1,012.8 1,242.3 1,093.2 1,080.0 1,288.
8 225.6 224.8 174.7 224.3 181.8 244.1 251.1 261.7 253.0 282.0 Source: 2003 Industrial Commodity Statistics Yearbook, United Nations 1. Which country produced the most refined copper in the years shown? A. Canada B. Mexico C. the United States D. Chile 2. From 1986 to 1988, Mexico’s copper production A. remained fairly constant B. nearly doubled C. decreased slightly D. almost tripled 3. Which North American country showed an increase in copper production each year from 1987 through 1995? A. Canada B. Mexico C. the United States D. all of the above 4. Brazil’s copper production was greatest in A. 1995 B. 1994 C. 1990 D. 1989 S9 STRATEGIES Line Graphs Line graphs display information in a visual form. They are particularly useful for showing changes and trends over time. 1 Read the title of the graph to learn what it is about. 2 Study the labels on the vertical and horizontal axes to see the kinds of information presented in the graph. The vertical axis usually shows what is being graphed, while the horizontal axis indicates the time period covered. 3 Review the information in the graph and note any trends or patterns. Look for explanations for these trends or patterns. 4 Carefully read and answer the questions. Note if questions refer to a specific year or time period, or if they focus on trends or explanations for trends. Nuclear Generation of Electricity in the United States One likely explanation for increase in electricity generated is an increase in demand. 100 90 80 70 60 50 40 30 20 10 Year Source: U.S. Energy Information Administration 1. Nuclear generation of electricity first exceeded 80 percent of maximum capacity in A. 1994 B. 1995 C. 1998 D. 1999 2. During which time period did the percentage of maximum capacity increase the most? A. 1989–1991 B. 1993–1995 C. 1997–1999 D. 1999–2002 answers: 1 (B), 2 (C) S10 PRACTICE Directions: Use the graph and your knowledge of economics to answer questions 1 through 4. Retail Prices for Regular Gasoline 350 300 250 200 150 100 50 ) 2005–06 2004–05 y a M e n Ju July g u A pt e S Oct v o N ec D n Ja b e F ar M pr A Month* *Survey taken last week of month Source: U.S. Energy Information Administration 3. During which period was
the price of gasoline lowest? A. in December 2004 B. in December 2005 C. in May 2004 D. in May 2005 4. In 2005–2006, the price of gasoline per gallon A. nearly reached $3.00 B. dropped from close to $3.00 to less than $2.20 C. fluctuated more than in 2004–2005 D. all of the above 1. During which period did the price of regular gasoline rise toward its peak? A. May–August 2004 B. November 2004–February 2005 C. August–November 2005 D. February–April 2006 2. Which of the following statements most accurately describes the information shown in the graph? A. Gas prices were stable during both 12- month periods. B. There was a severe spike in price during each 12-month period. C. The price of gas was always higher in 2005–2006. D. The price of regular gas fluctuated more during 2004–2005. S11 STRATEGIES Bar and Pie Graphs A bar graph allows for comparisons among numbers or sets of numbers. A pie, or circle, graph shows relationships among the parts of a whole. These parts look like slices of a pie. The size of each slice is proportional to the percentage of the whole that it represents. 1 Read the title of the graph to learn what it is about. 2 For a bar graph, study the labels on the vertical and horizontal axes to see the kinds of information presented in the graph. Note the intervals between amounts or years. 3 Study the legend, if there is one. The legend on a bar graph provides information on what is being graphed. The legend on a pie graph shows what each slice of the pie represents. 4 Look at the source line and evaluate the reliability of the information in the graph. 5 Study the data on the graph. Make comparisons among the slices of a pie graph. Draw conclusions and make inferences based on the data. 6 Read the questions carefully and use any words to reject incorrect alternatives. U.S. Imports of Crude Oil and Petroleum Products by Region Crude oil Petroleum products East C o ast M id w est G ulf C o ast R ockies W est C o ast Region Source: U.S. Energy Information Administration 1. Which region of the United States imported the most crude oil per day during 2004? A. East Coast B. West Coast C. Gulf Coast D. Midwest Components of M1 1% 22% 54% 23% Currency Demand Dep
osits Other Checkable Deposits Traveler’s Checks The graph shows that currency—paper money and coins—makes up more than half of M1. Source: Federal Reserve Statistical Release H.6, July 6, 2006 2. What is the largest component of M1? A. currency B. demand deposits C. other checkable deposits D. traveler’s checks Statistics from government agencies, such as the Federal Reserve, tend to be reliable answers: 1 (C), 2 (A) S12 PRACTICE Directions: Use the graphs and your knowledge of economics to answer questions 1 through 4. New Jobs Added to the U.S. Economy Electricity Generation by Energy Source ) 400 350 300 250 200 150 100 50 0 Ju n–05 Jul–05 A u g–05 Se p–05 O ct–05 N ov–05 D ec–05 Ja n–06 Fe b–06 M ar–06 A pr–06 Ju n–06 M ay–06 3% 3% 7% 19% 49% 19% Coal Nuclear Natural Gas Hydroelectricity Petroleum Other Source: Energy Information Administration, Electric Power Monthly, June 2006 Month and Year Source: U.S. Department of Labor 1. When was the greatest number of jobs added to the economy? 3. Which source of fuel generated nearly half of all electric power? A. July 2005 B. November 2005 C. February 2006 D. March 2006 A. coal B. natural gas C. nuclear D. petroleum 2. Which statement is supported by information in the graph? 4. Which single source generated the least amount of electricity? A. The graph shows that there were greater A. coal B. natural gas C. nuclear D. petroleum fluctuations in job creation in the later months of 2005 than there were in the early months of 2006. B. More jobs were added to the economy in all of 2005 than in all of 2006. C. The graph shows a steady upward trend in the number of jobs added to the economy. D. More jobs were added to the economy between January and June of 2006 than between June and December of 2005. S13 STRATEGIES Extended Response Extended-response questions usually focus on an exhibit of some kind—a chart, graph, or diagram, for example. They are more complex than multiplechoice questions and often require a written response. Some extended-response questions ask you to complete the exhibit. Others require you to present the information in the exhibit in a different form. Still
others ask you to write an essay, a report, or some other extended piece of writing. In most standardized tests, exhibits have only one extendedresponse question. 1 Read the title of the exhibit to get an idea of the subject. 2 Carefully read the extended-response questions. (Question 1 asks you to complete the graph by drawing and labeling a new demand curve. Question 2 asks you to write a brief explanation of what is shown in the completed graph.) 3 Study and analyze the exhibit. 4 If the question requires an extended piece of writing, jot down ideas in outline form to get started. Shifts in Demand e c i r P D1 Quantity demanded 1. The graph above shows the demand for CDs. How would demand for CDs change if the price of CD players rose? Draw a new demand curve to reflect this change. Label the new curve D2. 2. Write a brief explanation of why demand for CDs changed in this way. Sample Response CDs and CD players are used together, so they are complements. If demand for one changes, demand for the other will change in the same way. If the price of CD players rises, then demand for CD players and CDs will decrease and the demand curve shifts to the left S14 PRACTICE Directions: Use the graph and your knowledge of economics to answer questions 1 and 2. Shifts in Aggregate Supply P1 AS1 AD1 Q1 Real GDP 1. The graph above shows an economy at its macroeconomic equilibrium. Copy this graph onto a separate sheet of paper. On the graph, chart how the aggregate supply curve and macroeconomic equilibrium would change if interest rates went up. 2. Write a brief description of these changes and explain why they occurred. S15 Economics and Choice Scarcity and Choices Economics is about making choices. Even such an ordinary task as deciding what to have for lunch involves economic choice. Should you spend $5 on a hot meal, $3 on a sandwich, or should you save your money and bring lunch from home? 2 CHAPTER 1 SECTION 1 Scarcity: The Basic Economic Problem SECTION 2 Economic Choice Today: Opportunity Cost SECTION 3 Analyzing Production Possibilities SECTION 4 The Economist’s Toolbox CASE STUDY The Real Cost of Expanding O’Hare Airport The Economic Way of Thinking Economics is the study of how individuals and societies satisfy their unlimited wants with limited resources Scarcity is the situation that exists because wants are unlimited and resources are limited AT T E R S You confront the issue of scarcity constantly in
everyday life. Look again at the caption on page 2. Suppose you have $20 to cover the cost of lunches for the week. How will you use your limited funds to meet your wants (lunch for Monday through Friday)? What if you stayed late at school twice a week and bought a $1 snack each day? How would this affect your lunch choices? Identify one or two other examples of scarcity in your everyday life. More at ClassZone.com FIGURE 1.9 U. S. COMPUTER AND I N T E R N E T ACC ESS Go to ECONOMICS UPDATE for chapter updates and news on the cost of expansion plans at O’Hare Airport in Chicago. (See Case Study, pages 32–33). Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities 70 60 50 40 30 20 10 0 1998 2003 Year Computers Internet Access Source: National Telecommunications and Information Administration How do economists use graphs? See Section 4 of this chapter. The Economic Way of Thinking 3 S E C T I O N 1 Scarcity: The Basic Economic Problem TA K I N G N O T E S In Section 1, you will • explain how the economic definition of scarcity differs from the common definition • understand why scarcity affects everyone • learn three economic questions that societies face because of scarcity • describe the four factors of production and their uses wants, p. 4 needs, p. 4 scarcity, p. 4 land, p. 8 labor, p. 8 capital, p. 8 economics, p. 4 entrepreneurship, p. 9 goods, p. 5 services, p. 5 consumer, p. 5 producer, p. 5 factors of production, p. 8 As you read Section 1, complete a cluster diagram showing how scarcity is the central concept of economics. Use the Graphic Organizer at Interactive Review @ ClassZone.com Scarcity What Is Scarcity? KEY CONCEPT S Have you ever felt you wanted a new cell phone, a car, a new pair of running shoes, or the latest MP3 play er? You are not alone. Consumers have many economic wants. Wants are desires that can be satisfied by consuming a good or service. When making purchases, people often make a distinction between the things they need and the things they want. Some things that people desire, like a house or an apartment, are more important than other things, like a flat-
screen television. Needs are things, such as food, clothing, and shelter, that are necessary for survival. People always want more, no matter how much they have already. In fact, wants are unlimited, but the resources available to satisfy them are limited. The result of this difference is scarcity, the situation that exists when there are not enough resources to meet human wants. Scarcity is not a temporary shortage of some desired thing. Rather, it is a fundamental and ongoing tension that confronts individuals, businesses, governments, and societies. Indeed, it is so basic to human experience that a social science has developed to understand and explain it. That social science is economics, the study of how people choose to use scarce resources to satisfy their wants. Economics involves 1. examining how individuals, businesses, governments, and societies choose to use scarce resources to satisfy their wants 2. organizing, analyzing, and interpreting data about those economic behaviors 3. developing theories and economic laws that explain how the economy works and to predict what might happen in the future. QUICK REFERENCE Wants are desires that can be satisfied by consuming a good or a service. Needs are things that are necessary for survival. Scarcity exists when there are not enough resources to satisfy human wants. Economics is the study of how individuals and societies satisfy their unlimited wants with limited resources. 4 Chapter 1 Shortages and Scarcity Shortages often are temporary. Movie tickets may be in short supply today, but in a few days’ time they may be easy to come by. Scarcity, however, never ends because wants always exceed the resources available to satisfy them. P RI NCI PLE 1 People Have Wants Choice is central to the use of scarce resources. People make choices about all the things they desire—both needs and wants. You might think of food as a need, because it is necessary for your survival. Nevertheless, you make choices about food. What do you want for dinner tonight? Will you cook a gourmet creation or heat up a frozen dinner? Or will you treat yourself to a meal at your favorite restaurant? You make choices about other needs too. For example, consider the choices you make about the clothes you wear. Wants are not only unlimited, they also are ever changing. Twenty-five years ago, for example, few Americans owned a personal computer. Today, however, few Americans can imagine life without computers and computer-related technology. P RI NCI PLE 2 Scarcity Affects Everyone Because wants are unlimited and resources are scarce,
choices have to be made about how best to use these resources. Scarcity, then, affects which goods are made and which services are provided. Goods are physical objects that can be purchased, such as food, clothing, and furniture. Services are work that one person performs for another for payment. Services include the work of sales clerks, technical support representatives, teachers, nurses, doctors, and lawyers. Scarcity affects the choices of both the consumer, a person who buys goods or services for personal use, and the producer, a person who makes goods or provides services. AP P LI CATION Applying Economic Concepts A. Identify five wants that you have right now. Describe how scarcity affects your efforts to meet these wants. Find an update about computer ownership in the United States at ClassZone.com QUICK REFERENCE Goods are objects, such as food, clothing, and furniture, that can be bought. Services are work that one person does for another. A consumer is a person who buys or uses goods or services. A producer is a maker of goods or a provider of services. The Economic Way of Thinking 5 Scarcity Leads to Three Economic Questions KEY CONCEPT S If you have ever had to decide whether something you want is worth the money, then you have experienced scarcity firsthand. Scarcity in the lives of individual consumers—the gap between their unlimited wants and limited resources—is all too easy to understand. Scarcity, however, also confronts producers and whole societies. Indeed, scarcity requires every society to address three basic economic questions: What will be produced? How will it be produced? For whom will it be produced? QUESTION 1 What Will Be Produced? To answer the first fundamental economic question, a society must decide the mix of goods and services it will produce. Will it produce mainly food, or will it also produce automobiles, televisions, furniture, computers, and shoes? The goods and services a society chooses to produce depend, in part, on the natural resources it possesses. For example, a country that does not possess oil is unlikely to choose to produce petroleum products. Resources, however, do not completely control what a country produces. Japan does not possess large amounts of the iron ore needed to make steel. Yet Japan is a leading producer of automobiles, whose construction requires a great deal of steel. Some Leading Products China South Africa United States Coal Machinery Rice Steel Textiles Chemicals Coal Gold Metal ores Metal products Automobiles Coal Textiles Timber Wheat What to Produce? The availability of natural
resources, such as gold, influences what the country of South Africa produces. Some countries, including the United States, resolve the issue of what goods and services to produce by allowing producers and consumers to decide. For example, if consumers want cars with automatic transmissions, automobile companies would be unwise to make only cars that have manual transmissions. In other countries—Cuba and North Korea, for example—the consumer plays little or no part in answering this question. Rather, the government decides what goods and services will be produced. This first fundamental economic question involves not only what to produce, but also how much to produce. To answer this, societies must review what their wants are at any time. A country at war, for example, will choose to produce more weapons than it would during peacetime. 6 Chapter 1 How to Produce For some societies, using a large amount of human labor is the most efficient way to produce food (left). For other societies, using a lot of machinery is a more efficient method of production (right). QUE S T ION 2 How Will It Be Produced? Once a society has decided what it will produce, it must then decide how these goods and services will be produced. Answering this second question involves using scarce resources in the most efficient way to satisfy society’s wants. Again, decisions on methods of production are influenced, in part, by the natural resources a society possesses. In deciding how to grow crops, for example, societies adopt different approaches. Societies with a large, relatively unskilled labor force might adopt labor-intensive farming methods. For this society, using many workers and few machines is the most efficient way to farm. The United States, however, has a highly skilled work force. So, using labor-intensive methods would be an inefficient use of labor resources. Therefore, the United States takes a capital-intensive approach to farming. In other words, it uses lots of machinery and few workers. QUE S T ION 3 For Whom Will It Be Produced? The third fundamental economic question involves how goods and services are distributed among people in society. This actually involves two questions. Exactly how much should people get and how should their share be delivered to them? Should everyone get an equal share of the goods and services? Or should a person’s share be determined by how much he or she is willing to pay? Once the question of how much has been decided, societies must then decide exactly how they are going to get these goods and services to
people. To do this, societies develop distribution systems, which include road and rail systems, seaports, airports, trucks, trains, ships, airplanes, computer networks—anything that helps move goods and services from producers to consumers in an efficient manner. AP P LI CATION Analyzing Cause and Effect B. Why does the basic problem of scarcity lead societies to ask the three fundamental economic questions? The Economic Way of Thinking 7 QUICK REFERENCE Factors of production are the resources needed to produce goods and services. Land refers to all natural resources used to produce goods and services. Labor is all of the human effort used to produce goods and services. Capital is all of the resources made and used by people to produce goods and services. The Factors of Production KEY CONCEPT S To understand how societies answer the first two basic questions—what to produce and how to produce it—economists have identified the factors of production, or the economic resources needed to produce goods and services. They divide the factors of production into four broad categories: land, labor, capital, and entrepreneurship. All of these factors have one thing in common—their supply is limited. FACTOR 1 Land In everyday terms, the word land usually refers to a stretch of ground on the earth’s surface. In economic terms, however, land includes all the natural resources found on or under the ground that are used to produce goods and services. Water, forests, and all kinds of wildlife belong in the category of land. So, too, do buried deposits of minerals, gas, and oil. FACTOR 2 Labor The word labor usually brings to mind images of hard physical work. In economic terms, however, its meaning is far broader. Labor is all the human time, effort, and talent that go into the making of products. Labor, then, is not only the work done by garbage collectors, factory workers, and construction workers. It also includes the work of architects, teachers, doctors, sales clerks, and government officials. FACTOR 3 Capital When you hear the word capital, you probably think of money. In economic terms, however, capital is all the resources made and used by people to produce and distribute goods and services. Tools, machinery, and factories are all forms of capital. So are offices, warehouses, stores, roads, and airplanes. In other words, capital is all of a producer’s physical resources. For this reason capital is sometimes called physical capital, or real capital. While businesses invest in real capital, workers invest
in human capital—the knowledge and skills gained through experience. Human capital includes such things as a college degree or good job training. When workers possess more human capital, they are more productive. Human Capital Education increases your human capital and makes you more productive in the workplace. 8 Chapter.1 Factors of Production Land All the natural resources found on or under the ground that are used to produce goods and services are considered land. What are the Factors of Production? Labor All the human time, effort, and talent that go into the production of goods and services are considered labor. Entrepreneurship The combination of vision, skill, ingenuity, and willingness to take risks that is needed to create and run new businesses is called entrepreneurship. Capital All the physical resources made and used by people to produce and distribute goods and services are considered capital. So, too, are the knowledge and skills that make workers more productive. ANALYZE CHARTS Two new businesses have opened in your neighborhood—a coffee bar called Lou’s Café and a health club called BodyPower. Construct your own Economics Essentials diagram to show how the four factors of production are used in one of these businesses. FACT OR 4 Entrepreneurship The fourth factor of production, entrepreneurship, brings the other three factors together. Entrepreneurship is the combination of vision, skill, ingenuity, and willingness to take risks that is needed to create and run new businesses. Most entrepreneurs are innovators. They try to anticipate the wants of consumers and then satisfy these wants in new ways. This may involve developing a new product, method of production, or way of marketing or distributing products. Entrepreneurs are also risk takers. They risk their time, energy, creativity, and money in the hope of making a profit. The entrepreneurs who build a massive shopping mall or who open a new health club do so because they think they could profit from these business ventures. The risk they take is that these enterprises might fail. AP P LI CATION Applying Economic Concepts C. Think of a product that you recently purchased. How do you think the four factors of production were used to create this product? QUICK REFERENCE Entrepreneurship involves the vision, skills, and risk-taking needed to create and run businesses. The Economic Way of Thinking For more on cause and effect, see the Skillbuilder Handbook, page R20. Analyzing Cause and Effect Causes are the events that explain why something happens and effects are what happens. An effect can become the cause of other effects, resulting in a chain
of events or conditions. Identifying causes and effects helps economists understand how economic conditions occur. Use the strategies below to help you identify causes and effects using a graphic organizer. Identify causes by using the word why to formulate questions about the topic of the passage. Example: Why did oil become more scarce in 2003? Why did this situation continue? The answers you find will be the causes. Turmoil Reduces Oil Supply Oil is a scarce resource, but events in the Middle East have made it more so. The invasion of Iraq in 2003 by U.S.- and British-led coalition forces led to an almost immediate shutdown of Iraq’s oil exports, thereby reducing the availability of crude oil by some 1.8. million barrels per day. Unrest in Nigeria, Africa’s largest oil producer, further added to global scarcity. More than two years later, in part due to continued unrest in the Middle East, oil production was still sluggish. One result of the continued scarcity was a rise in energy prices. Increased energy prices in turn caused shipping costs to rise. The increased costs of shipping led shippers to seek more economical means of transport. Some shippers have decreased their use of planes and trucks. Instead, they have turned to less fuel-dependent modes of transport. One example is the use of double stacked railroad cars that can carry two shipping containers stacked one on top of the other. Identify effects by looking for results or consequences. These are sometimes indicated by words such as led to, brought about, thereby, and as a result. Look for causeeffect chains, where an effect may be the cause of another event and so on. Diagram the causes and effects in a flowchart like this one. CAUSE: war in Iraq CAUSE: unrest in Nigeria CAUSE: continued Mideast turmoil EFFECT/CAUSE: crude oil availability reduced EFFECT/CAUSE: higher energy prices EFFECT/CAUSE: increased shipping costs EFFECT: decrease in use of planes EFFECT: increased use of doublestacking railroad cars T HINKING ECONOMICALLY Analyzing Causes and Effects Locate and read an economics-related article in a current affairs magazine, such as Time, Newsweek, or U.S. News & World Report. Make a diagram to summarize the causes and effects discussed in the article. 10 Chapter 1 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs:
a. wants scarcity b. consumer producer c. factors of production entrepreneurship 2. What is the difference between needs and wants? Explain how a need may also be a want. 3. How does scarcity affect consumers? Producers? 4. What services that individuals or businesses provide do you use every day? 5. Describe how the owners of a computer repair store might use the four factors of production to run their business. 6. Using Your Notes How does scarcity affect methods of production? Refer to your completed cluster diagram. Scarcity Use the Graphic Organizer at Interactive Review @ ClassZone.com. Drawing Conclusions Many high schools throughout the United States have faced a serious shortage of math and science teachers. Many prospective teachers choose to go into business and industry because of higher salaries. In some communities, businesses are “loaning” employees who want to teach part-time to schools to fill the math and science teacher gap. Does this scenario illustrate scarcity? Why or why not? 8. Applying Economic Concepts Consider the following entrepreneurs: Lucy, who runs an organic farm, and Ron, a sports superstar who owns several restaurants. Describe how they may have used entrepreneurship to establish and run their businesses. 9. Writing About Economics Select a 10-minute period of time in your day-to-day life—when you are in the cafeteria at lunchtime, for example. Analyze how scarcity affects your activities during this time period. Write your analysis in a paragraph. 10. Challenge At one time or another, you have probably made a choice about how to use your scarce resources that you later regretted. For example, you may have purchased a music download instead of going to the movies. What led you to your choice? What did you learn later that might have led you to a different choice? Using Scarce Resources Suppose you are moving into your first apartment like the young woman above. You have saved $1,200 to use for this purpose. When you go shopping, you learn that these are the prices for things you had on your list of furnishings. Item Price ($) Kitchen table and chairs TV set Dishes Silverware Towels Couch Desk & chair Bed Computer Stereo system 200 150 45 25 35 300 175 350 400 300 Make Economic Choices Use these prices to decide how you will spend your budget for furnishings. Make a list of the things you will buy. Challenge What did you have to give up to get the things you chose? Why did you decide to give those things up? The Economic Way of Thinking
11 S E C T I O N 2 Economic Choice Today: Opportunity Cost TA K I N G N O T E S In Section 2, you will incentives, p. 12 • understand why choice is at utility, p. 12 the heart of economics • explain how incentives and utility influence people’s economic choices • consider the role of trade- offs and opportunity costs in making economic choices • demonstrate how to do a cost- benefit analysis economize, p. 12 trade-off, p. 14 opportunity cost, p. 14 cost-benefit analysis, p. 15 marginal cost, p. 16 marginal benefit, p. 16 As you read Section 2, complete a cluster diagram to help you see how the key concepts relate to one another. Use the Graphic Organizer at Interactive Review @ ClassZone.com Economic Choice Incentives The chance of winning a championship trophy serves as an incentive for athletes to train and play hard. Making Choices KEY CONCEPT S involves As you recall from Section 1, scarcity forces everyone to choose. But what shapes the economic choices that people make? One facincentives, or tor benefits offered to encourage people to act in certain ways. Grades in school, wages paid to workers, and praise or recognition earned in personal and public life are all incentives. Choice is also influenced by utility, or the benefit or satisfaction gained from the use of a good or service. When they economize, people consider both incentives and utility. In common usage, the word economize means to “cut costs” or “do something cheaply.” In strict economic terms, however, economize means to “make decisions according to what you believe is the best combination of costs and benefits.” QUICK REFERENCE Incentives are methods used to encourage people to take certain actions. Utility is the benefit or satisfaction received from using a good or service. To economize means to make decisions according to the best combination of costs and benefits. 12 Chapter 1 YO U R EC MAKING C HOIC ES How will you spend time with a friend? You and a friend have the choice of going to dinner or going to a movie. There is an incentive for choosing the movies, since dinner would surely cost more. On the other hand, your friend has offered to help you with college applications. So dining out, which allows time for conversation, has more utility to you than seeing a movie.? Movie FACT OR 1 Motivations for Choice Dinner Choice powers an economy,
but what powers choice? The choices people make are shaped by incentives, by expected utility, and by the desire to economize. For example, look at Your Economic Choices above. How will you decide between the two options? Like other economic decision makers, you weigh the costs against the benefits, and you make your choice purposefully. Perhaps you decide to go out to dinner. Even though you’ll spend more money, you feel that the tips your friend can give you on writing your college application essay are invaluable. You’ve economized by choosing what represents the best mix of costs and benefits. In making this decision, you were guided by self-interest. This does not mean that you behaved selfishly. Rather, it simply means that you looked for ways to maximize the utility you’d get from spending time with your friend. FACT OR 2 No Free Lunch An old saying can sum up the issue of choice in economics: “There is no such thing as a free lunch.” Every choice involves costs. These costs can take the form of money, time, or some other thing you value. Let’s revisit your choices. If you chose to go to dinner rather than to a movie, you gained the benefit of a satisfying, informative, and beneficial conversation with a friend. Even so, you also paid a cost—you didn’t see the movie. On the other hand, if you chose to go to the movie, you gained the benefit of an entertaining evening and having more money to save or spend on something else. Once again, however, your choice involved a cost. You sacrificed the time you could have spent getting advice and guidance on the college application process from your friend. AP P LI CATION Using a Decision-Making Process A. You have enough money to buy either an MP3 player that is on sale or some fitness equipment you want. What incentives and utility would guide your decision? The Economic Way of Thinking 13 Trade-Offs and Opportunity Cost KEY CONCEPT S QUICK REFERENCE A trade-off is the alternative people give up when they make choices. Choices, as you have learned, always involve costs. For every choice you make, you give up something. The alternative that you give up when you make an economic choice is called a trade-off. Usually, trade-offs do not require all-or-nothing choices. Rather, they involve giving up some of one thing to gain more of another. EXAMPLE 1 Making Trade
-Offs To understand how trade-offs work, let’s take a look at decisions made by Shanti, who has just finished her junior year in high school. Shanti wants to go to summer school to earn some credits she can apply to college. She could take a semester-long course at a local university, or she could take an intensive six-week course at her high school. She decides on the six-week course, even though she’ll earn fewer credits. However, she will have several weeks of the summer vacation to have fun and relax. Trade-Offs All the decisions you make, including selecting school or college courses, involve choosing among alternatives. EXAMPLE 2 Counting the Opportunity Cost Shanti’s friend Dan, who has just graduated, has decided to take off a year before going to college. He’s been offered a full-time job for the whole year. However, he decides to take the job for six months and then spend time traveling. Dan’s choice, like all economic choices, involves an opportunity cost. The opportunity cost of a decision is the value of the next-best alternative, or what you give up by choosing one alternative over another. Dan decided to travel around the country and visit friends. The opportunity cost of that decision is the income he could have earned at his job. If, however, Dan had decided to work for the whole year, his opportunity cost would have been the trip around the country that he didn’t take. Note that Dan’s opportunity cost is not the value of all the things he might have done. Rather, it is the value of his next-best alternative, or what he gave up to get what he most wanted. APPLICATION Applying Economic Concepts B. Look again at Shanti’s decision. What was the opportunity cost of her choice? If she had chosen the semester course, what would her opportunity cost have been? QUICK REFERENCE Opportunity cost is the value of something that is given up to get something else that is wanted. 14 Chapter 1 Analyzing Choices KEY C ONCEPT S Shanti and Dan did not make their choices randomly. Rather, they carefully looked at the benefits they would gain and the opportunity costs they would incur from their decisions. This practice of examining the costs and the expected benefits of a choice as an aid to decision making is called cost-benefit analysis. Cost-benefit analysis is one of the most useful tools for individuals,
businesses, and governments when they need to evaluate the relative worth of economic choices. QUICK REFERENCE Cost-benefit analysis is an approach that weighs the benefits of an action against its costs. E XAMPLE Max’s Decision-Making Grid Perhaps the simplest application of cost-benefit analysis is the decision-making grid, which shows what you get and what you give up when you make choices. Look at Max’s decision-making grid in Figure 1.2 below. Max has to decide how to spend his scarce time—studying for his government class or going out with his friends. Max likes nothing better than to spend hours talking with his friends at the local juice bar. However, the F he has in the government class at the moment will not look good on his transcript. So he certainly could benefit from some extra study time. Max knows that he has six hours available for extra study or socializing each week. He begins to build his decision-making grid by listing all the options he has for using these six hours. He then lists the benefits and opportunity costs of each of these options. After reviewing all of this information, he chooses three extra hours of study a week. He feels that the opportunity cost, three hours of time with his friends, is worth the expected benefit, a B grade. F I G U R E 1. 2 Max’s Decision-Making Grid A decision-making grid helps you to see what you gain and what you lose when you make choices. Max’s decision-making grid shows the costs and benefits of hours spent studying versus time spent socializing. Choice Benefit Opportunity Cost One hour of extra study D in government class One hour with friends Two hours of extra study C in government class Two hours with friends Three hours of extra study Four hours of extra study Five hours of extra study B in government class B in government class A in government class Three hours with friends Four hours with friends Five hours with friends Six hours of extra study A in government class Six hours with friends ANALYZE TABLES 1. What is Max’s opportunity cost of three extra hours of study? 2. Read the information about marginal costs on the next page. What is Max’s marginal cost of moving from a grade of B to a grade of A? The Economic Way of Thinking 15 Costs and benefits change over time. So do goals and circumstances. Such changes will influence the decisions people make. For instance, Max learns that Pine Tree State, the college he wants
to attend, only considers applicants with a 3.4 or better grade point average. If he needs to get a B+ or better to raise his GPA to 3.4, he might decide to spend less time with his friends and study four or five hours per week rather than three. EXAMPLE Marginal Costs and Benefits How did Max arrive at his decision? To explain it, economists would look at marginal costs and marginal benefits. Marginal cost is the cost of using one more unit of a good or service, while marginal benefit refers to the benefit or satisfaction received from using one more unit of a good or service. Max’s choice was to study three extra hours, which gave him a B grade at the opportunity cost of three hours with his friends. Look again at Max’s decision-making grid in Figure 1.2. What would be the marginal cost of one more hour of study? As you can see, it is the loss of one more hour with his friends. The marginal benefit of that extra hour would be an improvement in grade from B to B+. Max decided that the benefit of a slight improvement in his grade was not worth the cost of one less hour with his friends. The analysis of marginal costs and marginal benefits is central to the study of economics. It helps to explain the decisions consumers, producers, and governments make as they try to meet their unlimited wants with limited resources. QUICK REFERENCE Marginal cost is the additional cost of using one more unit of a product. Marginal benefit is the additional satisfaction from using one more unit of a product. YO U R EC MARGINAL B EN E FIT S AND COST S Which will you do—basketball practice or after-school job? For every hour you practice basketball, you gain in skill and increase your chances of making the team. However, each hour you practice is an hour you could have spent working at an after-school job to save for a car or college or something else you want.? Basketball practice Part-time job APPLICATION Using a Decision-Making Process C. Look at Your Economic Choices above. Construct a decision-making grid that analyzes the potential choices of attending basketball practice and working at an after-school job. Which option would you choose? 16 Chapter 1 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs: a. incentive utility b. trade-off c. marginal cost
opportunity cost marginal benefit 2. Two action movies are playing at your movie-theater complex. You have a half-price coupon for one. However, you choose to see the other. How might this still be an example of economizing? 3. Think of some of the options you have for spending time after school—sports practice, hobby clubs, work, or extra study, for example. Which option would you choose? What is the opportunity cost of your choice? 4. How is a decision-making grid an example of cost-benefit analysis? 5. Use the concepts of marginal costs and marginal benefits to explain why some people might see the same movie ten times while others will watch it only once or twice. 6. Using Your Notes How do marginal costs and benefits relate to trade-offs? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Economic Choice. Applying Economic Concepts A Web site reviewing new CDs offers you a free subscription. All you have to do is complete a brief online application. What is the opportunity cost of this “free” offer? Why do you think the offer is being made? 8. Evaluating Economic Decisions Explain how self-interest is part of each economic choice. Use an example from your own experience that shows how you purposely served your own selfinterest in a choice you made. 9. Conducting Marginal Cost–Marginal Benefit Analysis You are on a limited budget and planning a four-day camping trip to a national park. Bus fare is $75 each way and the ride takes 12 hours. Plane fare is $150 each way and the ride takes an hour and a half. Conduct a cost-benefit analysis to help you choose your method of travel. 10. Challenge Why are all choices economic choices? Illustrate your answer with examples. Making Choices Some of the incentives that spur people to action are money, recognition, self-esteem, good grades, immediate benefit, future benefit, and altruism (doing good for others, such as working for Habitat for Humanity). Consider Economic Choices Copy and complete the chart by noting the incentives that might motivate people to take the listed actions. (Several incentives might apply in some cases.) Action Incentive Donate to charity. Get a promotion. Buy a friend a present. Attend a good college. Buy organic foods. Buy inexpensive imported goods. Challenge Have you ever had two or more conflicting incentives for a certain behavior? If so, how would you choose among them? If
not, which of the incentives above motivates you most often? The Economic Way of Thinking 17 S E C T I O N 3 Analyzing Production Possibilities TA K I N G N O T E S In Section 3, you will economic model, p. 18 • describe what a production production possibilities curve possibilities curve is and how it is constructed (PPC), p. 18 efficiency, p. 20 • explain what economists learn from using production possibilities curves • analyze how production possibilities curves show economic growth underutilization, p. 20 law of increasing opportunity costs, p. 21 As you read Section 4, complete a summary chart to identify the most important points on production possibilities. Use the Graphic Organizer at Interactive Review @ ClassZone.com Analyzing Production Possibilities PPC shows impact of scarcity Graphing the Possibilities KEY CONCEPT S In Section 2 you learned that all economic choices involve trade-offs. Economists have created economic models—simplified representations of complex economic activities, systems, or problems—to clarify trade-offs. One such model is a production possibilities curve (PPC), a graph used to illustrate the impact of scarcity on an economy by showing the maximum number of goods or services that can be produced using limited resources. Like all other economic models, the PPC is based on assumptions that simplify the economic interactions. For the PPC these assumptions are: 1. Resources are fixed. There is no way to increase the availability of land, labor, capital, and entrepreneurship. 2. All resources are fully employed. There is no waste of any of the factors of pro- duction. In other words, the economy is running at full production. 3. Only two things can be produced. This assumption simplifies the situation and suits the graphic format, with one variable on each axis. 4. Technology is fixed. There are no technological breakthroughs to improve methods of production. Since the curve on a PPC represents the border—or frontier—between what it is possible to produce and what it is not possible to produce, this model is sometimes called a production possibilities frontier. It is a useful tool for businesses and even governments, but it works just as well with individual, small-scale economic decisions. For example, suppose you are preparing food for a soup kitchen and have the ingredients to make 12 loaves of whole wheat bread or 100 bran muffins or some combination of the two. A PPC can help you decide what to make. QUICK REFERENCE An economic model is a
simplified representation of economic forces. The production possibilities curve (PPC) is a graph used by economists to show the impact of scarcity on an economy. 18 Chapter 1 Production Possibilities Curve The production possibilities table in Figure 1.3 below shows five production possibilities for loaves of bread and bran muffins. These production possibilities run from the two extremes of all bread or all muffins through several combinations of the two products. The data in the table also can be plotted on a graph, as in Figure 1.4. The line joining the plotted points is the production possibilities curve. Each point on the curve represents the maximum number of loaves of bread that can be produced relative to the number of bran muffins that are produced. Further, the PPC shows the opportunity cost of each choice in a visual way. Trace the curve from left to right with your finger. Notice that as you move along the curve you make fewer loaves of bread and more muffins. The opportunity cost of making more muffins is the bread that cannot be made. Production Possibilities A production possibilities curve can show all the possible combinations for producing muffins and bread. FIGURE 1.3 PRODUCTION POSSIBILITIES TABLE: BREAD VS. MUFFINS FIGURE 1.4 PRODUCTION POSSIBILITIES CURVE: BREAD VS. MUFFINS Loaves of Bread Bran Muffins a b c 12 10 7 4 0 0 35 63 84 100 a b 12 10 10 20 30 40 50 60 70 80 90 100 Bran muffins a Here you are using all the ingredients to make only bread. b This point shows a combination of 7 loaves of bread and 63 muffins. The opportunity cost of making the 7 loaves is 37 muffins (100 – 63). c At this point, you are making all muffins and no bread. ANALYZE GRAPHS 1. If you decided to make ten loaves of bread, how many bran muffins could you make? 2. What is the opportunity cost of making the ten loaves of bread? Use an interactive production possibilities curve at ClassZone.com AP P LI CATION Interpreting Graphs A. Look at the production possibilities curve in Figure 1.4. What is the opportunity cost of increasing bread production from four loaves to seven loaves? The Economic Way of Thinking 19 What We Learn from PPCs KEY CONCEPT S QUICK REFERENCE Efficiency involves producing the maximum amount of goods and services possible. Underutilization means producing
fewer goods and services than possible. No economy actually operates according to the simplified assumptions underlying the PPC. However, economists use the simplified model because it spotlights concepts that work in the real world of scarce resources. One important concept revealed in a PPC is efficiency, the condition in which economic resources are being used to produce the maximum amount of goods and services. Another is underutilization, the condition in which economic resources are not being used to their full potential. As a result, fewer goods and services are being produced than the economy is capable of making. Both of these conditions are easy to see in the PPC. EXAMPLE Efficiency and Underutilization Figure 1.5 shows the classic production possibilities model of guns vs. butter. In this model, “guns” is shorthand for military spending and “butter” represents consumer products. Every point along this PPC shows a different combination of military and consumer production. Regardless of the combination, each point represents efficiency, the most that can be produced with the available resources. Any point inside the curve represents underutilization, or the inefficient use of available resources. Look again at Figure 1.5 and notice that point 3 indicates that all resources are not fully employed. The PPC shows that the economy is capable of producing either 47 million more guns (point 1 on the curve) or 30 million more pounds of butter (point FIGURE 1.5 PPC: GUNS VS. BUTTER 300 250 200 150 100 50 ) 50 100 150 200 250 300 350 Butter (in millions of pounds) a Any point along the curve—1, 2, or 5—represents efficiency. b Point 3 inside the curve represents underutilization. Some or all of the factors are not being used efficiently. c Point 4, outside the curve, represents a production impossibility. Regardless of how the available factors of production are used, this level of production cannot be reached. ANALYZE GRAPHS 1. What is the opportunity cost of moving butter production from 1 to 2? 2. At 3, factors of production are not being used efficiently. Identify a situation where this might occur. Use an interactive production possibilities curve at ClassZone.com 20 Chapter 1 2 on the curve). Any point outside the curve is impossible to meet because resources are fixed. To produce the number of guns indicated at point 4, fewer pounds of butter would have to be made (point 1 on the curve). Similarly, to produce the amount of butter indicated at point 4, fewer
guns would have to be made (point 2 on the curve). The shape of the PPC shows a third important economic concept. This is the law of increasing opportunity costs, which states that as production switches from one product to another, increasingly more resources are needed to increase the production of the second product, which causes opportunity costs to rise. E XAMPLE Increasing Opportunity Costs Return again to Figure 1.5. A nation makes 250 million pounds of butter (point 1 on the curve), but wants to make 280 million pounds (point 2 on the curve). The opportunity cost of making the extra 30 million pounds of butter is 37 million guns. That works out to a cost of about 1.2 guns for every pound of butter. If the nation increases its output of butter to 312 million pounds (point 5 on the curve), the opportunity cost of the change would be 63 millions guns, nearly 2 guns for every pound of butter. This increase in the opportunity cost—each additional unit costs more to make than the last—explains why the curve is bow-shaped. ______________ ______________ _____________________________________________________________________________________________________________________________________________________________ _______________ QUICK REFERENCE The law of increasing opportunity costs states that as production switches from one product to another, increasing amounts of resources are needed to increase the production of the second product. Opportunity Cost In the guns vs. butter equation, if more resources are used to make military products, such as stealth bombers, there are fewer resources available for other things, such as butter and other consumer goods. The opportunity cost of making more military products is the other products that cannot be made. The reason for the increasing costs is fairly straightforward. Making butter involves different resources than making guns. Converting from gun production to butter production is not a simple procedure. New machinery must be produced, new factories must be built, and workers must be retrained. The cost of all these actions will be fewer and fewer guns. AP P LI CATION Writing about Economics B. Write a brief paragraph explaining the concepts a PPC shows graphically. The Economic Way of Thinking 21 Changing Production Possibilities The PPC illustrates a country’s present production possibilities as if all resources are fixed. However, a country’s supply of resources is likely to change over time. When additional resources become available, new production possibilities beyond the original frontier become attainable, and the PPC moves outward. EXAMPLE A Shift in the PPC In the late 1700s, the United States occupied a relatively narrow strip of land along the
Atlantic Coast. Yet in less than a hundred years, it had expanded to the Pacific Ocean. This additional land provided the United States with an abundance of natural resources. Similarly, successive waves of immigration have added huge numbers of workers to the labor pool. Also, new technology has made the use of land, labor, and capital more efficient. The addition of new resources or the more efficient use of resources already available meant that the United States could produce more goods and services. This is shown on the PPC as a shift of the curve outward, or to the right, as Figure 1.6 illustrates. Economists refer to this increase in the economy’s total output as economic growth. You’ll learn more about this concept in Chapter 12. FIGURE 1.6 SHIFT IN THE PPC 300 250 200 150 100 50 ) More resources or increased productivity shifts the PPC outward, or to the right, from PPC1 to PPC2. This means that the economy can produce more of both guns and butter and point 4, which was a production impossibility in Figure 1.5 on page 20, now is located on the curve. 1 4 PPC2 PPC1 0 50 100 150 200 250 300 350 Butter (in millions of pounds) ANALYZE GRAPHS 1. If the curve PPC2 represents current production possibilities, what does point 1 represent? 2. What might cause the PPC to shift inward? Use an interactive production possibilities curve at ClassZone.com APPLICATION Applying Economic Concepts C. Identify three developments that would cause the PPC to move outward. 22 Chapter 1 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain how each of these terms is illustrated by the production possibilities curve. a. underutilization b. efficiency 2. On what assumptions is the PPC based? Explain how these conditions do not correspond to the real world. 3. What economic data does a PPC bring together? 4. Why do opportunity costs increase as you make more and more butter and fewer guns? 5. Based on what we learn from PPCs, what does an economy need to be able to produce more of both products on the graph? 6. Using Your Notes Write a one- paragraph summary of this section. Refer to your completed summary chart for the ideas to use in your summary. Analyzing Production Possibilities PPC shows impact of scarcity Use the Graphic Organizer at Interactive Review @ ClassZone.com.
Applying Economic Concepts Explain why, in an economy that produces only fish and computers and is working at efficiency, the 500th computer made will cost more in terms of fish than the 450th computer made. 8. Applying Economic Concepts Suppose the owners of a car- manufacturing company are thinking of entering the motorcycle production business. How would a PPC model help them make a decision? 9. Analyzing Cause and Effect If new technology was introduced but there were not enough skilled workers to use it, where would the nation’s production be plotted on the PPC—inside or outside the curve? Explain your answer. 10. Challenge During a war, a country suffers massive devastation of its industry. How would the country’s PPC change from before the war to after the war? Sketch a PPC to illustrate your answer. Creating a PPC The following information reflects the production possibilities of an economy that makes only corn and television sets. Use the data to create a production possibilities curve. Bushels of Corn (in thousands) Television Sets (in thousands) 10 9 7 4 0 0 1 2 3 4 Label Points on a PPC Use the letters to locate the following points on your PPC: A The point at which the economy makes all TVs and no corn B A point representing efficiency C A point representing underutilization D A point representing an impossible level of production Challenge Use information from your PPC to explain the law of increasing opportunity costs. Use to complete this activity. @ClassZone.com The Economic Way of Thinking 23 S E C T I O N 4 The Economist’s Toolbox TA K I N G N O T E S In Section 4, you will statistics, p. 24 microeconomics, p. 27 macroeconomics, p. 27 positive economics, p. 29 normative economics, p. 29 • demonstrate how and why economists use economic models • understand how and why economists use statistics, charts, tables, and graphs • compare macroeconomics to microeconomics • contrast positive economics with normative economics As you read Section 4, complete a chart to see similarities and differences between key concepts. Use the Graphic Organizer at Interactive Review @ ClassZone.com Concepts Similarities Differences Charts & Tables vs. Graphs Micro vs. Macro Positive vs. Normative Working with Data KEY CONCEPT S An old joke notes that economics is everything we already know expressed in a language we don’t understand. While many economists might disagree with the second part of this joke, they probably would
have little argument with the first part. Economics is something that everybody engages in every day, and in that way everyone has knowledge of it. Individuals, business owners, and government officials make economic decisions all the time. Economists study these decisions and look for logical ways to explain why some nations are rich while others are poor, or why some consumers want one kind of product while others want another. Since economists can’t interview every person in every nation about economic choices, they rely on statistics—numerical data or information—to see patterns of behavior. To help organize and interpret the data they collect, they develop economic models. As you recall from Section 3, an economic model is a simplified representation of complex economic forces. The language of economists—these statistics and models—may sometimes be a little hard to understand. However, it is a more efficient way of explaining economic relationships and interactions than everyday language. Using Economic Models In science class, you may have seen a model of a lunar eclipse, which shows how, with the sun behind it, the earth casts a shadow on the moon. The model assumes certain laws of planetary orbit and simplifies the relationships among the objects in the solar system. However, these assumptions and simplifications make the process of the eclipse quite clear. QUICK REFERENCE Statistics are information in numerical form. 24 Chapter 1 Economic models work in the same way. They are based on assumptions and are simplified because they focus on a limited number of variables. Economists can express their models in words, graphs, or equations. Models help economists explain why things are as they are. In some cases, models can help economists to predict future economic activity. You’ve already learned how economists construct and use one important economic model—the production possibilities curve—in Section 3. You’ll learn about another, the circular flow model, in Chapter 2. FIGURE 1.7 DE VELOPMENT A SSISTANCE Using Charts and Tables Country Economists study statistics in a particular way, looking for trends, connections, and other interesting relationships. They have several tools to help them with this task. Among the most common tools are charts and tables, in which data are arranged and displayed in rows and columns. (See Figure 1.7 above.) By showing numbers in relation to other numbers, charts and tables can reveal patterns in the data. Luxembourg Canada 2,599 236 Aid (in millions of U.S. Dollars) Percentage of Total Economy 0.83 0.27 Source: Organization for
Economic Co-operation and Development, 2004 Figures Suppose, for example, you were curious about how much money various developed countries give to help developing countries. In Figure 1.7, if you looked at one set of numbers, you would see that Luxembourg contributed $236 million, while Canada gave more than ten times that, offering nearly $2.6 billion. Your immediate interpretation of these data might be that Canada gives far more in foreign aid than Luxembourg does. But looking at other sets of numbers might suggest a different interpretation. Luxembourg may have contributed far less than Canada in actual dollar amounts. However, the foreign aid Luxembourg gave represented close to 1 percent of the value of all the goods and services the nation produced. Canada’s contribution, in contrast, was about 0.3 percent of its total economy. After studying these numbers, you might conclude that in relative terms Luxembourg gives more than Canada in foreign aid. Using Graphs When economists are interested in identifying trends in statistics, they often use graphs, or visual representations of numerical relationships. The most common type is the line graph. Line graphs are particularly useful for showing changes over time. Find an update on foreign aid at ClassZone.com Statistics During a debate in the U.S. Senate on the future of Social Security, Senator Charles Grassley of Iowa illustrates a point using statistics in graph form. The Economic Way of Thinking 25 T YPES OF GR APHS FIGURE 1. 8 P C S PER 10 0 PEOPLE I N DE VELOPING COUNTRIES FIGURE 1.9 U. S. COMPUTER AND I N T E R N E T ACC ESS.0 2.5 2.0 1.5 1.0 0.5 0.0 1995 1996 1997 1998 1999 2000 2001 70 6 0 50 40 30 20 10 0 1998 Year 2003 Source: United Nations Source: National Telecommunications and Information Administration Year Computers Internet Access FIGURE 1.10 INTERNE T USERS BY REG ION 3% 1% 5% 21% 70% Developing Countries: Asia and Oceania Developing Countries: Americas Developing Countries: Central and Eastern Europe Developing Countries: Africa Developed Countries Source: United Nations, 2001 figures ANALYZE GRAPHS Graphs show statistics in a visual form. Line graphs (Figure 1.8) are particularly useful for showing changes over time. Bar graphs (Figure 1.9) make it easy to compare numbers or sets of numbers. Pie, or circle, graphs (Figure 1.10
) show relationships among the parts of a whole. Use a variety of interactive graphs at ClassZone.com All line graphs use at least two sets of numbers, or variables: one plotted along the horizontal axis, running from left to right, the other plotted along the vertical axis, running from bottom to top. On the line graph in Figure 1.8 above, the range of time from 1995 to 2001 is shown on the horizontal axis. The number of PCs (personal computers) per 100 people in developing countries is shown on the vertical axis. The number of PCs for each year is plotted on the graph and then these points are joined to form a line. The line may slope upward, showing an upward trend, or downward, showing a downward trend. The line may be straight, keeping the same slope throughout, or it may be curved, having a varied slope. (In later chapters you’ll see that where graphs are used to illustrate economic concepts, lines are referred to as curves whether they are straight or curved.) How would you describe the trend shown in Figure 1.8? A bar graph is especially useful for comparisons. The bar graph in Figure 1.9 above shows information on the percentage of households in the United States that have access to computers and the Internet. The bars vividly illustrate that access to information technology increased dramatically in the United States between 1998 and 2003. A pie graph, often called a pie chart or circle graph, is especially good for representing numbers in relation to a whole. Take a look at the pie graph in Figure 1.10 above. The whole circle represents all the Internet users in the world. The slices of the pie, which represent regions of the world, are drawn in proportion to the percentage of the whole they constitute. APPLICATION Interpreting Graphs A. Look at the pie graph in Figure 1.10 above. Write a generalization based on information in the graph. NEED HELP? Throughout this book, you will be asked to interpret and analyze information in graphs. If you need help with these tasks, see “Interpreting Graphs.” Skillbuilder Handbook, page R29 26 Chapter 1 Microeconomics and Macroeconomics KEY C ONCEPT S For scientists, everything in the earth, air, and water—and beyond—is a source of data to be observed and studied. Yet the data often make little sense until they are seen through the lens of a microscope or telescope. Economic information, as with scientific data, takes on meaning when it is viewed through the most
useful lens. Two of the lenses through which economists observe economic behavior are microeconomics and macroeconomics. Microeconomics is the study of the behavior of individual players in an economy, such as individuals, families, and businesses. Macroeconomics is the study of the behavior of the economy as a whole and involves topics such as inflation, unemployment, aggregate demand, and aggregate supply. QUICK REFERENCE Microeconomics is the study of individuals, families, and businesses in an economy. Macroeconomics is the study of the economy as a whole and is concerned with large-scale economic activity. Microeconomics As the prefix micro-, meaning small, would suggest, microeconomics examines specific, individual elements in an economy. The elements include prices, costs, profits, competition, and the behavior of consumers and producers. Microeconomics can help you understand how the sandwich shop owner arrived at the price of the lunch you bought today, why the neighborhood has several sandwich shops offering the same kinds of food, and why some of these shops flourish while others fail. Microeconomics also can offer explanations for why students decide to work only on the weekends and not on school nights, why some families buy a used car rather than a new car, and why the mom-and-pop grocery store in your neighborhood closed after the superstore opened nearby. Within the field of microeconomics there are areas of specialized concentration. Business organization, labor markets, agricultural economics, and the economics of environmental issues are among the topics that microeconomists might study. You will study the issues of microeconomics in more depth starting in Chapter 4. Macroeconomics Macroeconomics, as its prefix macro-, meaning large, would suggest, examines the economic “big picture.” In other words, macroeconomics is the study of the economy as a whole. While the limited spending power of an unemployed person would be in the realm of microeconomics, the effect of widespread unemployment on the whole nation would be a macroeconomic issue. In a similar way, the rising price of coffee would interest a microeconomist, but a general rise in prices, a sign that the whole economy is experiencing inflation, would be a matter for a macroeconomist. Microeconomics vs. Macroeconomics Changes in coffee prices might interest a microeconomist. A macroeconomist might study general changes in prices. The Economic Way of Thinking 27.11 The Two Branches of Economics Economists Study Macroeconomics The study of the whole economy
Microeconomics The study of the individual consumer Units of Study Units of Study • Economic growth • Economic stability • International trade • Consumer markets • Business markets • Labor markets Topics of Interest Topics of Interest • Money, banking, finance • Government taxing and spending policies • Employment and unemployment • Inflation • Markets, prices, costs, profits, competition, government regulation • Consumer behavior • Business behavior ANALYZE CHARTS The division between microeconomics and macroeconomics is not a fixed one. Some topics fall under both areas of study. For example, a microeconomist might be interested in employment levels in the hotel industry, while a macroeconomist looks at employment levels in the economy as a whole. Identify another topic area that might be of interest to both microeconomists and macroeconomists. While microeconomics considers the individual consumer, macroeconomics studies the consumer sector, also called the household sector. A sector is a combination of all the individual units into one larger whole. Macroeconomics also examines the business sector, and the public, or government, sector—that part of the economy that provides public goods and services. Macroeconomists bring a national or global perspective to their work. They study the monetary system, the ups and downs of business cycles, and the impact of national tax policies on the economy. In addition, they look at such global issues as international trade and its effect on rich and poor nations. You will study macroeconomics in depth beginning in Chapter 10. APPLICATION Categorizing Economic Information B. Which does each of the news headlines relate to—microeconomics or macroeconomics? 1. National Unemployment Figures Rise 4. Cab Drivers on Strike! 2. World Trade Organization Meets 5. Gasoline Prices Jump 25 Cents 3. Shipbuilder Wins Navy Contract 28 Chapter 1 Positive Economics and Normative Economics KEY C ONCEPT S Economics also can be viewed through another pair of lenses. One of those lenses is positive economics, a way of describing and explaining economics as it is, not as it should be. Positive economics involves verifiable facts, not value judgments. The other is normative economics, a way of describing and explaining what economic behavior ought to be, not what it actually is. Normative economics does involve value judgments because it seeks to make recommendations for actions. Positive Economics QUICK REFERENCE Positive economics studies economic behavior as it is. Normative economics involves judgments of what economic behavior ought to be. Positive economics uses the scientific method to observe data, hypothesize, test,
refine, and continue testing. Statements made within positive economics can be tested against real-world data and either proved (or at least strongly supported) or disproved (or at least strongly questioned). Suppose, for example, your state is debating the pros and cons of a lottery to raise money for education. In the framework of positive economics, researchers would study data from states with lotteries to see if educational spending increased after the lotteries were begun. Normative Economics Why is this statement about the North American Free Trade Agreement (NAFTA) an example of normative economics? Normative Economics Normative economics, in contrast, is based on value judgments. It goes beyond the facts to ask if actions are good. Since the values of people differ, so do the recommendations based on normative economics. Consider the issue of using lottery money to fund education. Two economists might agree that the data show that state-run lotteries result in more money for schools, and that many lottery tickets are purchased by people who are poor. Their recommendations, however, might differ because they have different values. One economist might support a lottery because it increases funding for schools. The other might oppose a lottery because it places a burden on the poor. AP P LI CATION Applying Economic Concepts C. Are the following statements examples of positive economics or normative economics? 1. Because of scarcity, everyone must make choices. 2. Americans buy too many cars and do not use mass transit enough. 29 ECO N O M I C S PAC ES E T T E R Adam Smith: Founder of Modern Economics Some 250 years ago, economics as an academic discipline did not even exist. Any discussion of economic issues usually took place in the fields of politics and philosophy. In 1776, however, Adam Smith completely changed this. Seeing the Invisible No other economist has had as much influence as Adam Smith, yet he would not have even considered himself an economist. Smith was born in Kirkcaldy, Scotland, in 1723 and studied, and later taught, literature, logic, and moral philosophy. In 1764 he traveled to France and met many European Enlightenment writers and thinkers. His discussions with them encouraged him to look at the world anew. The result was his groundbreaking work, An Inquiry into the Nature and Causes of the Wealth of Nations, which he published in 1776. In The Wealth of Nations, Smith challenged the idea that mercantilism—a system by which the government of the homeland controlled trade with its colonies— was economically sound. Instead, he
argued, a nation would be wealthier if it engaged in free trade. It was in this market where goods could be exchanged freely that Adam Smith saw a new economic relationship. Founder of Economics The Wealth of Nations is considered the founding work of the subject of economics—even though Smith never used the word economics in the book. He reasoned that people behave in ways that satisfy their economic self-interest. A tailor will make clothes as long as people will buy them at a price that satisfies him. If he makes more clothes than customers wish to buy, he will cut back and make fewer until he finds the balance again. In this way, according to Smith, an “invisible hand” guides the marketplace. In such a free market, both the buyer and the seller benefit from each transaction. Smith’s idea of the “invisible hand,” as well as many other principles he explained in The Wealth of Nations, became the foundation of modern economic theory. APPLICATION Analyzing Effects D. What impact do you think individual self-interest has on the economy as a whole? Illustrate your answer with examples. FAST FACTS Adam Smith Scottish political economist and moral philosopher Born: June, 1723 Died: July 17, 1790 Accomplishment: Laying the foundation for modern economics Other Major Work: The Theory of Moral Sentiments (1759) Famous Quotation: “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.” Influenced: Alexander Hamilton Thomas Malthus Karl Marx Defenders of capitalism Critics of capitalism Learn more about Adam Smith at ClassZone.com 30 Chapter 1 S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. statistics economic model b. macroeconomics microeconomics c. positive economics normative economics 2. Why do economists often choose to present statistics in charts, tables, or graphs? 3. Create a simple model to explain how you decide how much time to study and how much time to unwind each evening. You may use words, charts or graphs, or equations. 4. Think of an example of a macroeconomic issue that affects an individual person, family, or business and explain its effect. 5. Explain the value of statistics and other data to positive economics Ford Motor Company assembly line, 1913 and to normative economics. 6
. Using Your Notes In what ways was Adam Smith a microeconomist? In what ways a macroeconomist? Refer to your completed comparison and contrast chart. Concepts Similarities Differences Charts & Tables vs. Graphs Micro vs. Macro Positive vs. Normative Use the Graphic Organizer at Interactive Review @ ClassZone.com. Making Inferences How do you think politicians might use normative economics statements? 8. Applying Economic Concepts In which category does each item below belong—microeconomics or macroeconomics? Why? a. Studying statistics to see how well the economy is doing at creating jobs or increasing exports; b. Studying statistics on gasoline sales and hotel bookings to explore the impact of higher gas prices on vacation plans. 9. Distinguishing Fact from Opinion Consider the example of the state lottery to raise money for education. How might it be possible for two economists to see the same information and arrive at different opinions about what to do? 10. Challenge When you go out shopping, do you often worry that there will be a shortage of something you really want? If so, explain why you think there might be a shortage. If not, explain why there seems to be enough of everything you would want to buy. Using Graphs Graphs are among the most important tools used by economists. Create Graphs Use the following information about Model T Fords (shown above) to create two line or bar graphs. Average price per car 1909 — $904 1911 — $811 1913 — $638 1915 — $626 Number of cars sold 1909 — 12,176 1911 — 40,400 1913 — 179,199 1915 — 355,249 Source: Model T Ford Club of America Challenge As Henry Ford lowered the price of the Model Ts, he potentially reduced his profit—the amount of money he made—on the sale of each car. Why was that a good economic choice? Use to complete this activity. @ ClassZone.com The Economic Way of Thinking 31 Case Study Find an update on this Case Study at ClassZone.com The Real Cost of Expanding O’Hare Airport Background Chicago’s O’Hare airport is one of the busiest airports in the United States. It is a major hub for both domestic and international airlines, and its smooth running is essential if the many airlines that fly in and out of O’Hare are to remain on schedule. However, delays at O’Hare are commonplace, and this sometimes disrupts air travel throughout the United States
and abroad. Two main factors are responsible for delays at O’Hare: turbulent Midwestern weather and the layout of O’Hare’s runways. Because all but one of the runways are interconnected, bad weather results in the shutting down of most of the runway system. A modernization plan to improve efficiency at O’Hare was adopted in 2005. This plan generated considerable, and often heated, discussion and debate. What’s the issue? What are the real costs involved in airport expansion? Study these sources to determine the costs tied to the expansion of O’Hare airport. Chicago O’Hare Airport Expansion The modernization plan is estimated to cost $6.6 billion (in 2001 dollars), which will probably be more like $8 billion by completion.... Supporters of the expansion plan say delays could be cut by 79% and that 195,000 jobs and $18 billion would be put into the local economy. In 2004 the airport played host to 69.5 million arriving, departing and connecting passengers and had total aircraft operations at nearly 929,000, an average of one landing or takeoff every 56 seconds.... The airport has 178 gates on eight connected concourses and one freestanding terminal. The realignment [of the runways] and modernization program could make a great deal of difference to the efficiency of the airport. Overall, delays are expected to drop by 79%. The future airfield will be able to accommodate approximately 1.6 million aircraft operations and 76 million [passengers] per year. Source: Airport-technology.com/projects/chicago Thinking Economically What factors led to the development of the plan to expand O’Hare? What are the projected costs and benefits? A. Online Report This report describes the anticipated benefits of the O’Hare Modernization Plan to redesign the runway system and expand the airport. 32 Chapter 1 B. Political Cartoon Cartoonist Grizelda drew this cartoon about people protesting noise pollution at an airport. Thinking Economically Which opportunity cost does this cartoon address? Explain your answer. Source: www.CartoonStock.com C. Organization Website The Alliance of Residents Concerning O’Hare (AReCo) addresses problems related to the aviation industry. AReCo’s website presents the group’s findings and views regarding the expansion of O’Hare. Area Residents Challenge Wisdom of O’Hare Expansion AReCo cites health hazards, seeks
alternatives to enlarging O’Hare. The [aviation] industry and airport expansionists consistently try to minimize the impacts of airports and aircraft. One example of the harm that has been... understated by the federal government... [is the] underreporting [of] the amounts of deadly pollution coming from airports/aircraft. For example, combined aircraft-related amounts of benzene [a known cause of cancer in humans] totaled 20 tons at Logan, Bradley, and Manchester airports in 1999!... Mega airports, such as Chicago’s O’Hare, operate more aircraft annually than all of the three above-mentioned airports combined, thus emitting even more harmful and even deadly pollution in heavily urban-populated areas.... In the meantime, there are intelligent steps that Chicago (and others) can take that will really modernize the metropolitan air transportation system and retain Chicago’s title of “our nation’s transportation hub.” Such steps include placing a much stronger emphasis on [more than one type of] transportation, such as medium and high-speed rail, that would link O’Hare airport to other airports (becoming a “virtual hub”) and building a new airport in a less populated peripheral area. Source: Areco.org Thinking Economically What alternatives does AReCo cite to O’Hare’s expansion? THINKING ECONOMICALLY Synthesizing 1. Explain the real cost of expanding O’Hare airport. Use information presented in the documents to support your answer. 2. Who are the most likely winners and losers as a result of the O’Hare expansion? Explain your answer. 3. How might supporters of expansion use a production possibilities model to strengthen their case? The Economic Way of Thinking 33 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com CHAPTER 1 Assessment Scarcity: The Basic Economic Problem (pp. 4–11) 1. In what ways does scarcity affect both consumers and producers? 2. What are the four factors of production and how do they relate to scarcity? Economic Choice Today: Opportunity Cost (pp. 12–17) Choose the key concept that best completes the sentence. Not all key concepts will be used. 3. What does
the phrase “there’s no such thing as a free lunch” mean in economic terms? consumer economic model economics efficiency factors of production incentive macroeconomics microeconomics opportunity cost producer production possibilities curve scarcity statistics trade-off underutilization utility wants 1 is the fundamental economic problem. It arises because human 2 are limitless, while resources are limited. It affects what a 3 buys and what a 4 makes. It affects what is produced, how it is produced, and who gets what is produced. It affects how the four 5 are put to use. Since people cannot have everything they want, they have to make choices. Every choice, however, involves a 6, something you have to give up to get what you want. When making an economic decision, you need to consider the 7, the value of the thing you gave up. Economists often use an 8, a simplified representation of reality, to clarify concepts. Economists use such tools in 9, the study of the economic behavior of individual persons, families, and businesses, and in 10, the study of the economy as a whole. One useful model, the 11, shows the maximum amount of goods that an economy can produce. It also shows 12, when not all resources are put to full use. 4. Why is it important to consider marginal benefits and costs when you do a cost-benefit analysis? Analyzing Production Possibilities (pp. 18–23) 5. What are three things a PPC shows? 6. What factors could lead to economic growth? The Economist’s Toolbox (pp. 24–33) 7. What are some tools that economists use to draw meaning from large amounts of data? 8. What are the differences between microeconomics and macroeconomics? A P P LY Look at the bar graph below showing the relationship between educational level and weekly wages. 9. Describe the relationship between education and earnings for males in 1979. 10. Explain why the earnings gap between college and high school graduates might have changed between 1979 and 2004. FIGURE 1.12 EDUCATION AND EARNINGS,200 1,000 800 600 400 200 0 1979 2004 Year Male high school graduates, no college Male college graduates 34 Chapter 1 Source: U.S Bureau of Labor Statistics 11. Creating Graphs Use the following information to create a bar graph showing the weekly wages for females with a high school education and those with a college education in 1979 and 2004. 1979 High school graduates, no college, $424 College graduates
, $605 2004 High school graduates, no college, $488 College graduates, $860 Source: U.S. Bureau of Labor Statistics Use to complete this activity. @ ClassZone.com 12. Interpreting Graphs Compare the graph you created with the one on page 34. Identify three differences between the changes over time for women and for men. 13. Evaluating Economic Decisions You plan to open a restaurant that specializes in meals cooked with organic products. You realize that location is very important for this kind of business. You have two options: you can rent an expensive site downtown or you can buy an inexpensive building in a quiet neighborhood. What are the benefits and the opportunity cost for each option? 14. Conducting Cost-Benefit Analysis You are considering taking a part-time job after school at a local veterinary surgery. Create a decision-making grid to analyze your potential choices. Include alternative jobs you might take and the costs and benefits of each. Similarly, list activities other than working that you might pursue after school. Indicate which alternative you would choose and explain your choice. 15. Challenge You own a small factory that makes widgets and you want to increase production, so you hire new workers. Each new worker increases productivity, but each also must be paid. When will you stop hiring new workers Start a Business Step 1 Team up with a partner or small group of classmates. Step 2 With your partner or group, decide on a business you want to start. This could be anything that has a realistic chance of succeeding: computer technician, T-shirt printer, caramel-corn producer, dog walker, or anything you think may fulfill a want. Step 3 On a chart like the one below, list the factors of production you will need to use to start and run your business. Step 4 Develop a business plan—a way that you can use the factors of production so efficiently that you will be able to make money. Describe your business plan in a paragraph. Step 5 Present your plan to the rest of the class. When all pairs or groups have made their presentations, hold a class vote to select the best plan. Factors of Production Land Labor 1. 2. 3. 1. 2. 3. Capital 1. 2. 3. 1. 2. 3. Entrepreneurship The Economic Way of Thinking 35 Traditional Economy Some economic activities have changed little over time. This farmer in Guizhou Province, China, employs rice-farming methods that the Chinese have used for centuries. 36 CHAPTER 2
SECTION 1 Introduction to Economic Systems SECTION 2 Command Economies SECTION 3 Market Economies SECTION 4 Modern Economies in a Global Age CASE STUDY Contrasting Economies: North Korea and South Korea Economic Systems Scarcity is the situation that exists when there are not enough resources to meet human wants An economic system is the way in which a society uses its scarce resources to satisfy its people’s unlimited wants AT T E R S How does a society decide the ways to use scarce resources to meet unlimited wants? Its economic system determines what to produce, how to produce, and for whom to produce. Although every country today uses a mixture of economic systems, some mixed systems provide more economic and political freedom and create more wealth than others. More at ClassZone.com FIGURE 2.7 PER C A P I TA GD P Go to ECONOMICS UPDATE for chapter updates and current news on the economies of North Korea and South Korea. (See Case Study, pp. 64–65.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 SOUTH KOREA NORTH KOREA 1994 1996 1998 2000 2002 2004 Year Source: United Nations Statistics Division Go to INTERACTIVE REVIEW for concept review and activities. How do the economies of North Korea and South Korea compare? See the Case Study on pages 64–65. Economic Systems 37 S E C T I O N 1 Introduction to Economic Systems TA K I N G N O T E S In Section 1, you will economic system, p. 38 • identify the three main types traditional economy, p. 38 command economy, p. 39 market economy, p. 39 of economic systems • understand how a traditional economy operates, including its advantages and disadvantages • analyze how modern forces are changing traditional economies As you read Section 1, complete a cluster diagram that provides information on the different kinds of economic systems. Use the Graphic Organizer at Interactive Review @ ClassZone.com traditional economy Economic System Types of Economic Systems QUICK REFERENCE An economic system is the way a society uses resources to satisfy its people’s wants. A traditional economy is an economic system in which people produce and distribute goods according to customs handed down from generation to generation. 38 Chapter 2 KEY CONCEPT S In his book Utopia, 16th-century writer Thomas More describes a society without scarcity, where wants are limited and easily fulfilled
. It is no accident, however, that the word utopia means “no place” in Greek. In the real world, scarcity is a fact of life. To address scarcity, societies must answer three questions: • What should be produced? • How should it be produced? • For whom will it be produced? The answers to these questions shape the economic system a society has. An economic system is the way a society uses its scarce resources to satisfy its people’s unlimited wants. There are three basic types of economic systems: traditional economies, command economies, and market economies. In this chapter you will learn about these economic systems, as well as “mixed” economies that have features of more than one type. TYPE 1 Traditional Economy A traditional economy is an economic system in which families, clans, or tribes make economic decisions based on customs and beliefs that have been handed down from generation to generation. The one goal of these societies is survival. Everyone has a set role in this task. Men often are hunters and herders. Women tend the crops and raise children. The youngest help with everyday chores while learning the skills they will need for their adult roles. There is no chance of deviating from this pattern. The good of the group always takes precedence over individual desires. Traditional The Kavango people of Namibia use fishing techniques passed down from generation to generation. Command Food was scarce and expensive in this store in the former Soviet Union, a command economy. Market Advertisements, like these billboards in New York City, are a common sight in a market economy. T YPE 2 Command Economy In the second type of economic system, a command economy, the government decides what goods and services will be produced, how they will be produced, and how they will be distributed. In a command economy, government officials consider the resources and needs of the country and allocate those resources according to their judgment. The wants of individual consumers are rarely considered. The government also usually owns the means of production—all the resources and factories. North Korea and Cuba are current examples of command economies. Before the collapse of communism in Europe, countries such as the Soviet Union, Poland, and East Germany also were command economies. T YPE 3 Market Economy The third type of economic system, a market economy, is based on individual choice, not government directives. In other words, in this system consumers and producers drive the economy. Consumers are free to spend their money as they wish, to enter into business, or to sell their labor to

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