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market provides a production and sale of a larger quantity of the commodity compared to a monopoly firm. Further the price of the commodity under perfect competition is lower compared to monopoly. The profit earned by the perfectly competitive firm is also smaller. In the Long Run We saw in Chapter 5 that with free entry and exit, perfectly competitive firms obtain zero profits. That was due to the fact that if profits earned by firms were positive, more firms would enter the market and the increase in output would bring the price down, thereby decreasing the earnings of the existing firms. Similarly, if firms were facing losses, some firms would close down and the reduction in output would raise prices and increase the earnings of the remaining firms. The same is not the case with monopoly firms. Since other firms are prevented from entering the market, the profits earned by monopoly firms do not go away in the long run. Some Critical Views We have seen how a monopoly will typically charge higher prices than a competitive firm. In this sense, monopolies are often considered exploitative. However, varying views have been expressed by economists concerning the question of monopoly. First, it can be argued that monopoly of the kind described above cannot exist in the real world. This is because all commodities are, in a sense, substitutes for each other. This in turn is because of the fact that all the firms producing commodities, in the final analysis, compete to obtain the income in the hands of consumers. Another argument is that even a firm in a pure monopoly situation is never without competition. This is because the economy is never stationary. New commodities using new technologies are always coming up, which are close substitutes for the commodity produced by the monopoly firm. Hence, the monopoly firm always has competition in the long run. Even in the short run, the threat of competition is always present and the monopoly firm is unable to behave in the manner we have described above. 97 2019-20 Still another view argues that the existence of monopolies may be beneficial to society. Since monopoly firms earn large profits, they possess sufficient funds to take up research and development work, something which the small perfectly competitive firm is unable to do. By doing such research, monopoly firms are able to produce better quality goods, or goods at lower cost, or both. While it is true that monopolies make supernormal profits, they may benefit consumers by lowering costs. 6.2 OTHER NON-PERFECTLY COMPETITIVE MARKETS 6.2.1 Monopolistic Competition We now consider a market structure where the number of firms is large, there is free entry and exit of firms, but the goods produced by them are not homogeneous. Such a market structure is called monopolistic competition. This kind of a structure is more commonly visible. There is a very large number of biscuit producing firms, for example. But many of the biscuits being produced are associated with some brand name and are distinguishable from one another by these brand names and packaging and are slightly different in taste. The consumer develops a taste for a particular brand of biscuit over time, or becomes loyal to a particular brand for some reason, and is, therefore, not immediately willing to substitute it for another biscuit. However, if the price difference becomes large, the consumer would be willing to choose a biscuit of another brand. A consumers’ preference for a brand will often vary in depth, so the change in price required for the consumer to change her brand may vary. Therefore, if price of a particular brand is lowered, some consumers will shift to consuming that brand. Lowering of the price further will lead to more consumers shifting to the brand with the lower price. Hence, the demand curve faced by the firm is not horizontal (perfectly elastic) as is the case with perfect competition. The demand curve faced by the firm is also not the market demand curve, as in the case with monopoly. In the case of monopolistic competition, the firm expects increases in demand if it lowers the price. Recall that the demand curve of a firm is also its AR curve. This firm, therefore has downward sloping AR curve. The marginal revenue is less than the average revenue, and also downward sloping. The firm increases its output whenever the marginal revenue is greater than the marginal cost. What does this firm’s equilibrium look like? The monopolistic competitive firm is also a profit maximizer. So it will increase production as long as the addition to its total revenue is greater than the addition to its total costs. In other words, this firm (like the perfectly competitive firm as well as the monopoly) will choose to produce the quantity that equates its marginal revenue to its marginal cost. How does this quantity compare with that of the perfectly competitive firm? Recall that the MR for a perfectly competitive firm is equal to its AR. So the perfectly competitive firm, in an identical situation, would equate its AR to MC. So a firm under monopolistic competition will produce less than the perfectly competitive firm. Given lower output, the price of the commodity becomes higher than the price under perfect competition. The situation described above is one that exists in the short run. But the market structure of monopolistic competition allows for new firms to enter the market. If the firms in the industry are receiving supernormal profit in the short run, this will attract new firms. As new firms enter, some customers shift from existing firms to these new firms. So existing firms find that their demand curve 98 2019-20 has shifted leftward, and the price that they receive falls. This causes profits to fall. The process continues till super-normal profits are wiped out, and firms are making only normal profits. Conversely, if firms in the industry are facing losses in the short run, some firms would stop producing (exit from the market). The demand curve for existing firms would shift rightward. This would lead to a higher price, and profit. Entry or exit would halt once supernormal profits become zero and this would serve as the long run equilibrium. 6.2.2 How do Firms behave in Oligopoly? If the market of a particular commodity consists of more than one seller but the number of sellers is few, the market structure is termed oligopoly. The special case of oligopoly where there are exactly two sellers is termed duopoly. In analysing this market structure, we assume that the product sold by the two firms is homogeneous and there is no substitute for the product, produced by any other firm. Given that there are a few firms, each firm is relatively large when compared to the size of the market. As a result each firm is in a position to affect the total supply in the market, and thus influence the market price. For example, if the two firms in a duopoly are equal in size, and one of them decides to double its output, the total supply in the market will increase substantially, causing the price to fall. This fall in price affects the profits of all firms in the industry. Other firms will respond to such a move in order to protect their own profits, by taking fresh decisions regarding how much to produce. Therefore the level of output in the industry, the level of prices, as well as the profits, are outcomes of how firms are interacting with each other. At one extreme, firms could decide to ‘collude’ with each other to maximize collective profits. In this case, the firms form a ‘cartel’ that acts as a monopoly. The quantity supplied collectively by the industry and the price charged are the same as a single monopolist would have done. At the other extreme, firms could decide to compete with each other. For example, a firm may lower its price a little below the other firms, in order to attract away their customers. Obviously, the other firms would retaliate by doing the same. So the market price keeps falling as long as firms keep undercutting each others’ prices. If the process continues to its logical conclusion, the price will have fallen till the marginal cost. (No firm will supply at a lower price than the marginal cost). Recall that this is the same as the perfectly competitive price. In practice, cooperation of the kind that is needed to ensure a monopoly outcome is often difficult to achieve in the real world. On the other hand, firms are likely to realize that competing fiercely by continuously under-cutting prices is harmful to their own profits. So, the oligopolistic equilibrium is likely to lie somewhere between the two extremes of monopoly and perfect competition • The market structure called monopoly exists where there is exactly one seller in any market. • A commodity market has a monopoly structure, if there is one seller of the commodity, the commodity has no substitute, and entry into the industry by another firm is prevented. The market price of the commodity depends on the amount supplied by the monopoly firm. The market demand curve is the average revenue curve for the monopoly firm. • 99 2019-20 • The shape of the total revenue curve depends on the shape of the average revenue curve. In the case of a negatively sloping straight line demand curve, the total revenue curve is an inverted vertical parabola. • Average revenue for any quantity level can be measured by the slope of the line from the origin to the relevant point on the total revenue curve. • Marginal revenue for any quantity level can be measured by the slope of the • • • • tangent at the relevant point on the total revenue curve. The average revenue is a declining curve if and only if the value of the marginal revenue is lesser than the average revenue. The steeper is the negatively sloped demand curve, the further below is the marginal revenue curve. The demand curve is elastic when marginal revenue has a positive value, and inelastic when the marginal revenue has a negati
ve value. If the monopoly firm has zero costs or only has fixed cost, the quantity supplied in equilibrium is given by the point where marginal revenue is zero. In contrast, perfect competition would supply an equilibrium quantity given by the point where average revenue is zero. • Equilibrium of a monopoly firm is defined as the point where MR = MC and MC is rising. This point provides the equilibrium quantity produced. The equilibrium price is provided by the demand curve given the equilibrium quantity. Positive short run profit to a monopoly firm continue in the long run. • • Monopolistic competition in a commodity market arises due to the commodity • being non-homogenous. In monopolistic competition, the short run equilibrium results in quantity produced being lesser and prices being higher compared to perfect competition. This situation persists in the long run, but long run profits are zero. • Oligopoly in a commodity market occurs when there are a small number of firms producing a homogenous commodity. s Monopoly Monopolistic Competition Oligopoly KKKKK . What would be the shape of the demand curve so that the total revenue curve is (a) a positively sloped straight line passing through the origin? (b) a horizontal line? 2. From the schedule provided below calculate the total revenue, demand curve and the price elasticity of demand: Quantity Marginal Revenue 1 10 5 3. What is the value of the MR when the demand curve is elastic? 100 2019-20 4. A monopoly firm has a total fixed cost of Rs 100 and has the following demand schedule: Quantity Price 1 100 2 90 3 80 4 70 5 60 6 50 7 40 8 30 9 20 10 10 Find the short run equilibrium quantity, price and total profit. What would be the equilibrium in the long run? In case the total cost was Rs 1000, describe the equilibrium in the short run and in the long run. 5. If the monopolist firm of Exercise 3, was a public sector firm. The government set a rule for its manager to accept the goverment fixed price as given (i.e. to be a price taker and therefore behave as a firm in a perfectly competitive market), and the government decide to set the price so that demand and supply in the market are equal. What would be the equilibrium price, quantity and profit in this case? 6. Comment on the shape of the MR curve in case the TR curve is a (i) positively sloped straight line, (ii) horizontal straight line. 7. The market demand curve for a commodity and the total cost for a monopoly firm producing the commodity is given by the schedules below. Use the information to calculate the following: Quantity Price Quantity Total Cost 0 52 0 10 1 44 1 60 2 37 2 90 3 31 4 26 5 22 6 19 7 16 8 13 3 4 5 6 7 8 100 102 105 109 115 125 (a) The MR and MC schedules (b) The quantites for which the MR and MC are equal (c) The equilibrium quantity of output and the equilibrium price of the commodity (d) The total revenue, total cost and total profit in equilibrium. 8. Will the monopolist firm continue to produce in the short run if a loss is incurred at the best short run level of output? 9. Explain why the demand curve facing a firm under monopolistic competition is negatively sloped. 10. What is the reason for the long run equilibrium of a firm in monopolistic competition to be associated with zero profit? 11. List the three different ways in which oligopoly firms may behave. 12. If duopoly behaviour is one that is described by Cournot, the market demand curve is given by the equation q = 200 – 4p, and both the firms have zero costs, find the quantity supplied by each firm in equilibrium and the equilibrium market price. 13. What is meant by prices being rigid? How can oligopoly behaviour lead to such an outcome? 101 2019-20                             Average cost Total cost per unit of output. Average fixed cost Total fixed cost per unit of output. Average product Output per unit of the variable input. Average revenue Total revenue per unit of output. Average variable cost Total variable cost per unit of output. Break-even point is the point on the supply curve at which a firm earns normal profit. Budget line consists of all bundles which cost exactly equal to the consumer’s income. Budget set is the collection of all bundles that the consumer can buy with her income at the prevailing market prices. Constant returns to scale is a property of production function that holds when a proportional increase in all inputs results in an increase in output by the same proportion. Cost function For every level of output, it shows the minimum cost for the firm. Decreasing returns to scale is a property of production function that holds when a proportional increase in all inputs results in an increase in output by less than the proportion. Demand curve is a graphical representation of the demand function. It gives the quantity demanded by the consumer at each price. Demand function A consumer’s demand function for a good gives the amount of the good that the consumer chooses at different levels of its price when the other things remain unchanged. Duopoly is a market with just two firms. Equilibrium is a situation where the plans of all consumers and firms in the market match. Excess demand If at a price market, demand exceeds market supply, it is said that excess demand exists in the market at that price. Excess supply If at a price market, supply is greater than market demand, it is said that there is excess supply in the market at that price. Firm’s supply curve shows the levels of output that a profitmaximising firm will choose to produce at different values of the market price. Fixed input An input which cannot be varied in the short run is called a fixed input. 2019-20 Income effect The change in the optimal quantity of a good when the purchasing power changes consequent upon a change in the price of the good is called the income effect. Increasing returns to scale is a property of production function that holds when a proportional increase in all inputs results in an increase in output by more than the proportion. Indifference curve is the locus of all points among which the consumer is indifferent. Inferior good A good for which the demand decreases with increase in the income of the consumer is called an inferior good. Isoquant is the set of all possible combinations of the two inputs that yield the same maximum possible level of output. Law of demand If a consumer’s demand for a good moves in the same direction as the consumer’s income, the consumer’s demand for that good must be inversely related to the price of the good. Law of diminishing marginal product If we keep increasing the employment of an input with other inputs fixed then eventually a point will be reached after which the marginal product of that input will start falling. Law of variable proportions The marginal product of a factor input initially rises with its employment level when the level of employment of the input is low. But after reaching a certain level of employment, it starts falling. Long run refers to a time period in which all factors of production can be varied. Marginal cost Change in total cost per unit of change in output. Marginal product Change in output per unit of change in the input when all other inputs are held constant. Marginal revenue Change in total revenue per unit change in sale of output. Marginal revenue product(MRP) of a factor Marginal Revenue times Marginal Product of the factor. Market supply curve shows the output levels that firms in the market produce in aggregate corresponding to different values of the market price. Monopolistic competition is a market structure where there exit a very large number of sellers selling differentiated but substitutable products. Monopoly A market structure in which there is a single seller and there are sufficient restrictions to prevent any other seller from entering the market. Monotonic preferences A consumer’s preferences are monotonic if and only if between any two bundles, the consumer prefers the bundle which has more of at least one of the goods and no less of the other good as compared to the other bundle. Normal good A good for which the demand increases with increase in the income of the consumer is called a normal good. Normal profit The profit level that is just enough to cover the explicit costs and opportunity costs of the firm is called the normal profit. Oligopoly A market consisting of more than one (but few) sellers is called a oligopoly. Opportunity cost of some activity is the gain foregone from the second best activity. Perfect competition A market environment wherein (i) all firms in the market produce the same good and (ii) buyers and sellers are price-takers. Price ceiling The government-imposed upper limit on the price of a good or service is called price ceiling. Price elasticity of demand for a good is defined as the percentage change in demand for the good divided by the percentage change in its price. 2019-20          Price elasticity of supply is the percentage change in quantity supplied due to a one per cent change in the market price of the good. Price floor The government-imposed lower limit on the price that may be charged for a particular good or service is called price floor. Price line is a horizontal straight line that shows the relationship between market price and a firm’s output level. Production function shows the maximum quantity of output that can be produced by using different combinations of the inputs. Profit is the difference between a firm’s total revenue and its total cost of production. Short run refers to a time period in which some factors of production cannot be varied. Shut down point In the short run, it is the minimum point of AVC curve and in the long run, it is the minimum point of LRAC curve. Substitution effect The change in the optimal quantity of a good when its price changes and the consumer’s income is adjusted so that she can just buy the bundle that sh
e was buying before the price change is called the substitution effect. Super-normal profit Profit that a firm earns over and above the normal profit is called the super-normal profit. Total cost is the sum of total fixed cost and total variable cost. Total fixed cost The cost that a firm incurs to employ fixed inputs is called the total fixed cost. Total physical product Same as the total product. Total product If we vary a single input keeping all other inputs constant, then for different levels of employment of that input we get different levels of output from the production function. This relationship between the variable input and output is referred to as total product. Total return Same as the total product. Total revenue is equal to the market price of the good multiplied by the quantity of the good sold by a firm. Total revenue curve shows the relationship between firm’s total revenue and firm’s output level. Total variable cost The cost that a firm incurs to employ variable inputs is called the total variable cost. Value of marginal product (VMP) of a factor Price times Marginal Product of the factor. Variable input An input the amount of which can be varied. 2019-20                            
the change in total revenue (marginal revenue) is positive then demand is price elastic, if the change in total revenue is negative the demand is price inelastic. If the marginal revenue is exactly zero then demand is unit elastic. 5. The following determinants of the price elasticity of demand will determine how responsive the quantity demanded is to changes in price. These determinants are: a. substitutability 31 b. proportion of income c. luxuries versus necessities d. time 6. Price Elasticity of Supply is determined by the following time frames. The more time a producer has to adjust output the more elastic is supply. a. market period b. short run c. long run 7. Cross elasticity of demand measures the responsiveness of the quantity demanded of one product to changes in the price of another product. For example, the quantity demanded of Coca-Cola to changes in the price of Pepsi. 8. Income elasticity of demand measures the responsiveness of the quantity demanded of a commodity to changes in consumers' incomes. 9. Interest rate sensitivity. 32 6. Consumer Behavior Lecture Notes 1. Individual demand curves can be constructed from observing consumer purchasing behaviors as we change price. a. This is called REVEALED PREFERENCE b. Market demand curves are constructed by aggregating individual demand curves for specific commodities. 2. Individual preferences can be modeled using a model called indifference curve - budget constraint and from this model we can derive an individual demand curve. a. The budget constraint shows the consumer's ability to purchase goods. The consumer is assumed to spend their resources on only beer and pizza. If all resources are spent on beer then the intercept on the beer axis is the amount of beer the consumer can purchase; on the other hand, if all resources are spent on pizza then the intercept on that axis is the amount of pizza that can be had. 33 If the price of pizza doubles then the new budget constraint becomes the dashed line. The slope of the budget constraint is the negative of the relative prices of beer and pizza. b. The indifference curve shows the consumer's preferences: 1. There are three assumptions that underpin the indifference curve, these are: 1) Indifference curves are everyplace thick 2) Indifference curves do not intersect one another 3) Indifference curves are strictly convex to the origin The dashed line (2) shows a higher level of total satisfaction than does the solid line (1). Along each indifference curve is the mix of beer and pizza that gives the consumer equal total utility. Consumer equilibrium is where the highest indifference curve they can reach is exactly tangent to their budget constraint. Therefore if the price of pizza increases we can identify the price from the slope of the budget constraint and the quantities purchased from the values along the pizza axis and derive and individual demand curve for pizza: 34 When the price of pizza doubled the budget constraint rotated from the solid line to the dotted line and instead of the highest indifference curve being curve 1, the best the consumer can do is the indifference curve labeled 2. Deriving the individual demand curve is relatively simple. The price of pizza (with respect to beer) is given by the (-1) times slope of the budget constraint. The lower price with the solid line budget constraint results in the level the higher level of pizza being purchased (labeled 1for the indifference curve - not the units of pizza). When the price increased the quantity demanded of pizza fell to the levels associated with budget constraint 2. Notice that Q2 and P2 are associated with indifference curve 2 and budget constraint 2, and that Q1 and P1 result from indifference curve 1 and budget constraint 1. The above model shows this individual consumer's demand for pizza. 35 3. Income and substitution effects combine to cause the demand curve to slope downwards. a. the income effect results from the price of a commodity going down permitting consumers to spend less on that commodity, hence the same as having more resources. b. As a price increases, the consumer will purchase less of that commodity and buy more of a substitute, this is the substitution effect. c. The combination of the income and substitution effects is that an individual (hence a market) demand curve will generally slope downward. d. Giffin's Paradox is the fact that some commodities may have an upward sloping demand curve. This happens because the income effect results in less of a quantity demanded for a product the lower the price. 1. There is also the snob appeal possibility where the higher the price the more desired the commodity is - Joy Perfume advertised itself as the world's most expensive. 3. Utility maximizing rule - consumers will balance the utility they receive against the cost of each commodity to arrive at the level of each commodity they should consume to maximize their total utility. a. algebraic restatement - MUa/Pa = MUb/Pb = . . . = Mu z / P z = 1 36 7. Costs of Production Lecture Notes 1. Explicit are accounting costs, however, Implicit Costs are the opportunity costs of business decisions. a. normal profit includes an opportunity cost - the profit that could have been made in the next best alternative allocation of productive resources. 3. In other words, there is a difference between economic and accounting cost; accountants are unconcerned with opportunity costs. 2. Time Periods are defined by the types of costs observed. These time periods differ from industry to industry. a. market period - everything is fixed b. short run - there are both fixed and variable costs c. long run - everything is variable 3. Prelude to Production Costs in Short Run - include both fixed and variable costs: a. the law of diminishing returns is the fact that as you add variable factors of production to a fixed factor at some point, the increases in total output become smaller. b. total product is the total units of production obtained from the productive resources employed. 37 c. average product is total product divided by the number of units of the variable factor employed d. marginal product is the change in total product associated with a change in units of a variable factor 1. graphical presentation: The top graph shows total product (total output). As total product reaches its maximum marginal product becomes zero and then negative as total product declines. When marginal product reaches its maximum, the total product curve becomes flatter. As marginal product is above average product in the bottom diagram, average product is increasing. When marginal product is below average product, then average product is decreasing. The ranges of marginal returns are identified on the above graphs. 38 4. Short-run costs: a. total costs = VC + FC b. variable costs are those items that can be varied in the short-run, i.e., labor c. fixed costs are those items that cannot be varied in the short-run, i.e., plant and equipment The fixed cost curve is a horizontal line because they do not vary with quantity of output. Variable cost has a positive slope because it vary with output. Notice that the total cost curve has the same shape as the variable cost curve, but is above the variable cost curve by a distance equal to the amount of the fixed cost. d. average total costs = TC/Q e. average variable cost = VC/Q f. average fixed cost = FC/Q g. marginal cost = ÎTC/ÎQ; where Î stands for change in. 39 1. The following diagram presents the average costs and marginal cost curve in graphical form. Notice that the average fixed cost approaches zero as quantity increases. Average total cost is the summation of the average fixed and average variable cost curves. The marginal cost curve intersects both the average total cost and average variable cost curves at their respective minimums. The following graph relates average and marginal product to average variable and marginal cost. Notice that at the maximum point on the average product curve, marginal cost reaches a minimum. Where marginal cost equals average variable cost, the marginal product curve intersects the average product curve. 40 5. Long Run Average Total Cost Curve a. Is often called an envelope curve because it is the minimum points of all possible short-run average total cost curves (allowing technology and fixed cost to vary). 6. 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. a. The causes of economies of scale are: 1. labor specialization 2. managerial specialization 3. more efficient capital 4. ability to profitably use by-products b. Diseconomies of scale are due to the fact that management loses control of the firm beyond some size. 41 c. Constant returns to scale are large ranges of operations where the firm's size matters little. d. Minimum efficient scale is the smallest size of operations where the firm can minimize its long-run average costs. e. Natural monopoly is a market situation where per unit costs are minimized by having only one firm serve the market -- i.e., electric companies. 42 8. Pure Competition Lecture Notes 1. There are several models of market structure, these include: a. pure competition (atomized competition, price taker, freedom of entry & exit, no nonprice competition, standardized product) b. pure monopoly (one seller, price giver, entry & exit blocked, unique product, nonprice competition) c. monopolistic competition (large number of independent sellers, pricing policies, entry difficult, nonprice competition, product differentiation) d. oligopoly (very few number of sellers, often collude, often price leadership, entry difficult, nonprice competition, product differentiation) 1. all assume perfect knowledge 2. Assumptions of Pure Competition: a. large number of agents b. standardized product c. no non-price competition d. freedom of entry & exit 43 e.
price taker 3. Revenue with a price taking firm: a. average revenue and marginal revenue are equal for the purely competitive firm because price does not change with quantity. b. total revenue is P x Q which is the total area under the demand curve (up to where MR = MC) for the purely competitive firm. 4. The profit-maximizing rule is that a firm will maximize profits where Marginal Cost is equal to Marginal Revenue. a. MC = MR b. Where MC = MR; revenue is at its maximum and costs are at their minimum. 5. Model of the purely competitive industry: The purely competitive industry is the supply and demand diagram presented in chapter 4. 44 6. Firm in Perfect Competition a. perfectly elastic demand curve b. 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). c. Establishing price in the industry and the firm: 45 d. 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. e. Economic profit for the competitive firm is shown by the rectangle labeled AEconomic Profit@ in the following diagram: f. 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. 1. 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 substantial. g. A normal profit for the competitive firm is shown in the following diagram: 46 1. 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. h. economic loss for a firm in pure competition: i. 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. 47 j. shut-down case 1. The firm will continue to operate in the case presented in (d.) above because the firm can cover all of its variable costs and have something left to pay on its fixed costs - this is loss minimization. However, 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. 7. Pure Competition and Efficiency a. 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. b. Technical or Productive efficiency criteria are also satisfied by the competitive model because price is equal to the minimum Average Total Cost. c. This, however, does not mean a purely competitive world is utopia. There are several problems including which are typically associated with a purely competitive market: 1. Market failures and externalities. 48 2. Income distribution may lack fairness. 3. There may be a limited range of consumer choice. 4. Many natural monopolies are in evidence in the real world. 49 9. Pure Monopoly Lecture Notes 1. Assumptions of Monopoly Model a. single seller b. no close substitutes c. price giver d. blocked entry e. non-price competition 2. The Firm is the Industry and therefore faces a downward sloping demand curve, which is also the average revenue curve.. a. 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. 50 1. 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 unit price elastic demand; to the left along the demand curve is the elastic range, and to the right is the inelastic range. 3. There is no supply curve in an industry which is a monopoly. a. The monopoly decides how much to produce using the profit maximizing rule; or where MC= MR 4. Monopolized Market a. Economic Profit: b. Because entry is blocked into this industry the economic profits shown above can be maintained in the long run. The monopolist produces where MC = MR, but the price charged is all the market will bear, that is, where the demand curve is above the intersection of MC = MR. 51 c. Economic losses 1. 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. 5. Economic Effects of Monopoly: a. prices, output & resource allocations are not consistent with allocative and maybe not technical efficiency criteria. With allocative efficiency consider the following graph: 52 1. The above graph shows the profit maximizing monopolist, Pm is the price in the monopoly 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. b. 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. c. 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. If these types of firms where forced to permit free use of their technological developments (hence no monopoly power) then the incentive to develop new technology and products would be eliminated. 6. Regulated Monopoly - Because there are natural monopoly market situations it is in the public interest to permit monopolies, but they are generally regulated. Examples of regulated monopolies are electric utilities, cable TV companies, and telephone companies (local). a. A monopoly regulated at social optimum P = D = MC 53 1. 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). b. A monopolist regulated at the fair return P = D = AC 1. 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. c. The dilemma of regulation is knowing where to regulate, at the social optimal or at the fair return. In reality regulated monopolies are permitted to earn a rate of return only on invested capital and all other costs are simply passed on to the consumer. 1. Rate regulation using, invested capital as the rate base, causes an incentive for firms to over-capitalize and not be sensitive to variable costs. This is called the Averch-Johnson Effect. d. 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 54 much cheaper than the additional capital) - nuclear generating plants are a good example of this. 9. Sherman Antitrust Act B monopolize or restraint trade or conspire to monopolize a market. a. Interstate Commerce b. Criminal Provisions 1. Felony c. Civil Provisions 1. Private civil suit, not criminal 2. Treble damages 55 10. Resource Markets Lecture Notes 1. Resource Market Complications: a. Resource markets are often heavily regulated, particularly capital and labor markets. b. 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. 2. 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. a. marginal product is MP = ÎTP/ÎL where L is units of labor, (or K for capital, etc. b. marginal revenue product is MRP = ÎTR/ÎL 3. Demand Curve: 56 a. Because the demand for a productive resource is a derived demand, the demand schedule for that productive resource is simply the MRP schedule of that resource. 4. Determinants of Resource Demand: a. productivity b. quality of resource c. technology 5. Determinants of Resource Price Elasticity: a. rate of decline of MRP b. ease of resource substitutability c. elasticity of product demand d. K/L ratios
6. Marginal resource cost is the amount that the addition of one more unit of a productive resource adds to total resource costs. a. MRC = ÎTRC/ÎL 7. 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. 57 a. resource market equilibrium 8. Least Cost Combination of all productive resources is determined by hiring resources where the ratio of MRP to MRC is equal to one for all resources. a. MRPlabor/MRClabor = MRPcapital/MRCcapital = ... = MRPland/MRCland = 1 b. The quantities of the resource to the left (right) of the equilibrium point is under-utilization (over-utilization) where MRP / MRC > 1 (MRP / MRC < 1) 9. Marginal Productivity Theory of Income Distribution a. inequality under this theory arises because of differences in the productivity of different resources and the value of the product it produces. b. One serious flaw in the theory is that of imperfect competition in the product and resource markets. 58 1. monopsony is one buyer of a resource (or product) and causes factor payments below the competitive equilibrium. 2. monopoly power can also cause some goods and services to be over-valued. 59 11. Wage Determination Lecture Notes 1. Nominal versus Real Wages: a. Nominal wages (W) are money wages, unadjusted for the cost of living. b. Real wages (W/P) are money wages adjusted for the cost of living (P) in other words, what you can buy. 2. Earnings and Productivity a. In theory an employee should be paid what she earns for the company, MRP, however, this theory has serious flaws in practice. b. Market imperfections, i.e., monopsony results in the earnings of workers being paid to other factors of production. c. Problems with measuring MRP, because of engineering complications of technology. 3. Supply and Demand for Labor: a. competitive labor market 60 1. 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 we observed in the product markets. b. monopsony labor market (one buyer of labor) 61 1. Notice that MRC breaks out to the right of the supply curve and is much steeper; this is due to the pricing policy the monopolist can employ. Also the wage and employment levels in the monopsony are much lower than in a competitive labor market. 4. Control of Monopsony: a. minimum wages has been one approach to the control of monopsony. 1. minimum wages under competition 2. 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. 3. Minimum wage opponents argue that the minimum wage does two things that are bad for the economy (and these arguments are based on the competitive model) b. The working poor can very easily become the unemployed poor if the competitive model's predictions are correct. c. Again, the government interferes with the freedom of management to operate its firm -- thereby reducing economic freedom and increasing costs of doing business. 62 1. minimum wages in a monopsony 2. 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. 3. If the monopsony model is accurate then the conservative argument does not hold water. Recent research results seem to suggest the monopsony predictions are correct. 5. Unions have also be an effective response to monopsony: a. craft union (exclusive union): 1. AFL Affiliated, organizes one skill class of employees (i.e., IBEW) 63 2. Craft unions can control the supply of labor somewhat because of the fact that they represent primarily skilled employees and have control of the apprentice programs and the standards for achieving journeyman status. b. industrial union 1. CIO affiliate, organizes all skill classes within a firm (i.e., UAW) 2. The industrial union establishes the minimum acceptable wage, below which they will strike rather than work. This approach depends upon solidarity among the work force to make the threat 64 of a strike effective. c. There is a flaw in this analysis. 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. 1. The pure craft and pure industrial union virtually no longer exist. The AFL and CIO merged in the mid-1950s and the distinction between the two types of unions had all but disappeared by this time -- the exception is some of the building trades unions. 6. Bilateral Monopoly is where there is a monopsonist that is organized by a union that attempts to offset the monopsony power with monopoly power. a. 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' 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 halfway between what the union and 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. 65 b. The indeterminant nature of this model is why industrial relations developed as a separate field from economics (in large measure). c. Industrial relations in the United States has been a function of the legal environment as much as market forces. 7. Private sector labor history is a sorted affair, with distinct periods. a. The first years (until 1932) the law in the U.S. was extremely anti-worker and anti-union, Injunctions, anti-trust prosecution etc. b. 1932-1935 was the Norris-LaGuardia Act and Railway Labor Act period, and the government was neutral towards workers and unions. c. 1935-47 Government was pro-union, pro-worker B the Wagner Act period. d. 1947-1982 The Taft-Hartley Act period less pro-union, more balanced. e. The post-PATCO; post-Requinst activitist court 1982 on, anti-union, anti- worker B almost back to the pre-1932 period 8. Public Sector industrial relations more problematic. a. Civil Service Reform Act of 1974 governs Federal Employees 1. Homeland Security Act contains negation of bargaining rights for tens of thousands of Federal Employees b. State employees covered by state statutes; most states have protective legislation 1. States without protective legislation are typically southern and 66 rather poor B Indiana has no protective legislation 9. Market Wage Differentials arise from several sources: a. Geographic immobility b. Discrimination c. Differences in productivity 1. Ability 2. Difference in price of final product 10. Human Capital refers to the various aspects of a person that makes them productive. Gary Becker=s book in the 1950s Human Capital earned him the Nobel Prize, but also brought greater attention to skills and knowledge as a determinant of income. a. Abilities, personality, and other personal characteristics are a portion of human capital -- many of these items are genetic, environmental, or a matter of experience. b. Education, training, and the acquisition of skills are human capital that is either developed or obtained. 1. In general it is hard to separate the sources of human capital; however, most is probably acquired. 2. In general, the higher the levels of human capital, the more productive an employee. 67 12. Epilogue to Principles of Economics Lecture Notes 1. Changing World - Economically a. Outsourcing B sending work out of the firm for cost cutting reasons B generally to save labor costs. 1. Consumer incomes and production costs 2. Say=s Law B accounting identity B cost of product is factor incomes b. Economics and Ethics 1. Fas – ethics 2. Boni Mores - public opinion or morals 3. Lex - law a. Law becomes dominate, but law is a constraint on the pursuit of self-interest (same as ethics and morals) b. Self-interest - rationality c. Internationalization 1. Comparative advantage is the basis for trade among nations as well as people. 68 a. Natural resources b. Technological innovation c. Human capital 2. Language and cultural diversity important to individual and societal success a. The middle east and different value systems and perceptions 2. American interests and foreign policy a. Anti-American perspectives abroad b. Reliance on foreign sources of energy c. Perception of imperialism versus American generosity 1. Peace Corps 2. Marshall Plan 3. Globalization and domestic changes a. Increasingly the U.S. is a service economy 1. Goods producing comparative advantage being lost 2. Multi-national corporations b. De-industrialization 69 1. Lower incomes 2. More rapid changes 4. Parting words a. Principles of microeconomics is a scientific framework for decision- making. 1. Mother discipline of the business disciplines a. Marketing, finance, production management b. Useful in career, brings rational standards to decision-making. 70 READING ASSIGNMENTS INTRODUCTION TO MICROECONOMICS E201 71 CHAPTER 1 Introduction to Economics This is an introductory course in economics. As with most introductory courses there are certain foundations that must be laid before the structure of the discipline may be meaningfully examined. This chapter and the following two chapters will lay those foundations -- the rudimentary definitions, and basic concepts upon which the following ideas will be built are di
scussed. Further, there is a general discussion of the methods used by economists in their analyses. Specifically, this chapter will focus on specific definitions, policy, and objective thinking. A discussion of the role of assumptions in model building will also be offered as a basis for understanding the economic models that will be built in the following chapters. Definitions Economics is a social science. In other words, it is a systematic examination of human behavior, based on the scientific method, and reliant upon rigorous analysis of that behavior. Economics is the mother discipline from which most of the business disciplines arose. Most people have a vague idea of what the word economics means, but precise definitions generally require some academic exposure to the subject. Economics is the study of the ALLOCATION of SCARCE resources to meet UNLIMITED human wants. In other words, economics is the study of human behavior as it pertains to material well-being. The key words in this definition are in all capital letters. Because there are a finite number of resources available, the fact that human want exceed that (are unlimited) then the resources are scare relative to the want for them. Because there are fewer resources than wants there must be allocation mechanism of some sort – markets, government, law of the jungle, etc. Robert Heilbroner describes economics as the "Worldly Philosophy." A "Worldly Philosophy" is concerned with matters of how our material or worldly well-being is best served. In fact, economics is the organized examination of how, why and for what purposes people conduct their day-to-day activities, particularly as it relates to the accumulation of wealth, earning an income, spending their resources, and other matters concerning material well-being. This worldly philosophy has been used to explain most rational human behavior. (Irrational behavior being the domain of specialties in sociology, psychology, history, and anthropology.) Underlying all of economics is the 72 base assumption that people act in their own perceived best interest (at least most of the time and in the aggregate). Without the assumption of rational behavior, economics would be incapable of explaining the preponderance of observed economic activity. As limiting as this assumption may seem, it appears to be an accurate description of reality. In 1776 Adam Smith penned An Inquiry into the Nature and Causes of the Wealth of Nations. With its publication, capitalism was born, from the ashes of the mercantilist system that preceded it. Smith described an economic system of cottage industries and relatively unfettered pursuit of self-interest, and how that unfettered pursuit of self-interest could result in a system that distributed its limited resources in an efficient fashion. Adam Smith’s view of self-interest and exchange An Inquiry in the Nature and Cause of the Wealth of Nations, Adam Smith, New York: Knopf Publishing, 1910, p. 14. . . . In almost every other race of animals each individual, when it is grown to maturity, is entirely independent, and in its natural state has occasion for the assistance of no other living creature. But man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and show then that it is for their own advantage to do for him what he requires of them. Whoever offer to another a bargain of any kind, proposes to do this. Give which I want, and you shall have this, which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good office which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages. . . . Adam Smith, Wealth of Nations. New York: Alfred A. Knopf, 1991, p. 13. Experimental economics, using rats in mazes, suggests that rats will act in their own best interest (incidentally, Kahneman won a Noble Prize for this sort of research – it is serious business, not just fun and games like it sounds). Rats, it was discovered, prefer root beer to water. The result is that rats will pay a greater price (longer mazes and electric shocks) to obtain root beer than they will to obtain water. Therefore it appears to be a reasonable assumption that humans are no less rational – as Adam Smith postulates in his view of how we might best obtain our dinner. Most academic disciplines have evolved over the years to become collections of 73 closely associated scholarly endeavors of a specialized nature. Economics is no exception. An examination of one of the scholarly journals published by the American Economics Association, The Journal of Economic Literature, reveals a classification scheme for the professional literature in economics. Several dozen specialties are identified in that classification scheme, everything from national income accounting, to labor economics, to international economics. In other words, the realm of economics has expanded over the centuries that it is nearly impossible for anyone to be an expert in all aspects of the discipline, so each economist generally specializes in some narrow portion of the discipline. The decline of the generalist is a function of the explosion of knowledge in most disciplines. In general, economics is bifurcated by the focus of the analysis – that is, there are two bundles of issues that are examined by economists. These bundles of issues are considered together, by the level of the activity upon which the analysis is focused. Economics is generally classified into two general categories of inquiry, these two categories are: (1) microeconomics and (2) macroeconomics. Microeconomics is concerned with decision-making by individual economic agents such as firms and consumers. In other words, microeconomics is concerned with the behavior of individuals or groups organized into firms, industries, unions, and other identifiable agents. The focus of microeconomics is on decisionmaking, and hence markets. Microeconomics is the subject matter of this course (E201). Macroeconomics is concerned with the aggregate performance of the entire economic system. That is, the performance of the U.S. economy or, in a more modern sense, the global economy. The issues of unemployment, inflation, economic development and growth, the balance of trade, and business cycles are the topics that occupy most of the attention of students of macroeconomics. These matters are the topics to be examined the course that follows this one (E202). Methods in Economics Economists seek to understand the behavior of people and economic systems using scientific methods. These scientific endeavors can be classified into two categories of activities, these are: (1) economic theory and (2) empirical economics. Theoretical and empirical economics are very much related activities, even though distinguished here for simplicity of presentation. Economic theory relies upon principles to analyze behavior of economic agents. These theories are typically rigorous, mathematical representations of human behavior with respect to the production or distribution of goods and services in 74 microeconomics – and the aggregate economy in macroeconomics. A good theory is one that accurately predicts future human behavior and can be supported with evidence. Nobel Prize Winners in Economic Science 1969 J. Tinbergen (Netherlands); R. Frisch (Norway) 1970 P.A. Samuelson (USA - Indiana) 1971 S. Kuznets (USA, Soviet Union) 1972 J. R. Hicks (United Kingdom); K. J. Arrow (USA) 1973 W. Leontief (USA) 1974 F. A. Hayek (Austria, USA); K. G. Myrdal (Sweden) 1975 T. Koopmans (USA); L. Kantorovich (Soviet Union) 1976 M. Friedman (USA) 1977 B. Ohlin (Sweden); J. Meade (United Kingdom) 1978 H. A. Simon (USA) 1979 T. W. Schultz (USA); A. Lewis (United Kingdom) 1980 L. R. Klein (USA) 1981 J. Tobin (USA) 1982 G. J. Stigler (USA) 1983 G. Debreu (USA) 1984 R. Stone (United Kingdom) 1985 F. Modigliani (Italy, USA) 1986 J. Buchanan (USA) 1987 R. M. Solow (USA) 1988 M. Allais (France) 1989 T. Haavelmo (Norway) 1990 H. Markowitz (USA); M. Miller (USA); W. Sharpe (USA 1991 R. H. Coase (United Kingdom, USA) 1992 G. S. Becker (USA) 1993 R. W. Fogel (USA); D. C. North (USA) 1994 R. Selten (Germany); J. C. Harsanyi (USA); J. F. Nash (USA) 1995 R. E. Lucas (USA) 1996 J. A. Mirrlees (United Kingdom); William Vickery (Canada, USA) 1997 R. C. Merton (USA); M. S. Scholes (USA) 1998 A. Sen (India, United Kingdom) 1999 R. A. Mundell (USA) 2000 J. J. Heckman (USA); D. L. McFadden (USA) 2001 G. A. Akerlof (USA); A. M. Spence (USA); J. E. Stiglitz (USA - Indiana) 2002 D. Kahneman (USA, Isreal); V. L. Smith (USA) Economic theory tends to be a very abstract area of the discipline. Mathematical modeling was introduced into the discipline early in the eighteenth century by such scholars as Mill and Ricardo. In the middle of the twentieth century, an economist, Paul 75 Samuelson, from M.I.T., published his book, Mathematical Foundations of Economic Analysis, and from the that point forward, economic theory was to become heavily mathematical – gone were the days of the institutionalists from the mainstream of economic theory. (Incidentally Paul Samuelson won the Nobel Prize for Foundations, and he is a Hoosier, Stiglitz is also from Indiana, and both are from Gary, Indiana). The above table presents a list of those who have won Nobel Prizes in Economic Science. Notice that the overwhelming majority of these persons are Americans – two of whom are from Indiana, and several are from the University of Chicago. It is also interesting to note that one must be living to receive the Nobel Prize
; so many famous economists who met their end before receiving the prize will not be listed. Further, it is also interesting to note that the Nobel Prize in Economic Sciences is the newest of the prizes, beginning with Tinbergen’s award in 1969. Empirical economics relies upon facts to present a description of economic activity. Empirical economics is used to test and refine theoretical economics, based on tests of economic theory. The area referred to as econometrics is the arena in economics in which empirical tests of economic theory occurs. The area is founded in mathematical statistics and is critical to our ability to test the veracity of economic theories. Theory concerning human behavior is generally constructed using one of two forms of logic – inductive logic or deductive logic. Most of the social studies, i.e., sociology, psychology and anthropology typically rely on inductive logic to create theory. Inductive logic creates principles from observation. In other words, the scientist will observe evidence and attempt to create a principle or a theory based on any consistencies that may be observed in the evidence. Economics relies primarily on deductive logic to create theory. Deductive logic involves formulating and testing hypotheses. In other words, the theory is created, and then data is applied in a statistical test to see if the theory can be rejected. Often the theory that will be tested comes form inductive logic or sometimes informed guess-work. The development of rigorous models expressed as equations typically lend themselves to rigorous statistical methods to determine whether the models are consistent with evidence from reality. The tests of hypotheses can only serve to reject or fail to reject a hypothesis. Therefore, empirical methods are focused on rejecting hypotheses and those that fail to be rejected over large numbers of tests generally attain the status of principle. However, examples of both types of logic can be found in each of the social sciences and in most of the business disciplines. In each of the social sciences it is common to find that the basic theory is developed using inductive logic. With increasing 76 regularity standard statistical methods are being employed across all of the social sciences and business disciplines to test the validity and the predictability of theories developed using these logical constructs. The usefulness of economics depends on how accurate economic theory predicts human behavior. In other words, a good theory is one that is an accurate description of reality. Economics provides an objective mode of analysis, with rigorous models that permit the discounting of the substantial bias that is usually present with discussions of economic issues. The internal consistency brought to economic theory by mathematical models of economic behavior provides for this consistency. However, no model is any better than the assumptions that underpin that model. If the assumptions are unrealistic, so too will be the models' predictions. The objective mode of analysis is an attempt to make a social study more scientific. That is, a systematic analysis of rational human behavior. “Rational” is a necessary component of this attempt. It is the rationality that makes behavior predictable, and what most economists don’t like to admit is without this underlying premise, economics quickly falls into a quagmire of irreproducible results and disjointed theories. The purpose of economic theory is to describe behavior, but behavior is described using models. Models are abstractions from reality - the best model is the one that best describes reality and is the simplest (the simplest requirement is called Occam's Razor). Economic models of human behavior are built upon assumptions; or simplifications that allow rigorous analysis of real world events, without irrelevant complications. Often (as will be pointed-out in this course) the assumptions underlying a model are not accurate descriptions of reality. When the model's assumptions are inaccurate then the model will provide results that are consistently wrong (known as bias). One assumption frequently used in economics is ceteris paribus which means all other things equal (notice that economists, like lawyers and doctors will use Latin for simple ideas). This assumption is used to eliminate all sources of variation in the model except those sources under examination (not very realistic!). 77 Economic Goals, Policy, and Reality Most people and organizations do, at least, rudimentary planning, the purpose of planning is the establishment of an organized effort to accomplish some economic goals. Planning to finish your education is an economic goal. Goals are, in a sense, an idea of what should be (what we would like to accomplish). However, goals must be realistic and within our means to accomplish, if they are to be effective guides to action. This brings another classification scheme to bear on economic thought. Economics can be again classified into positive and normative economics. Positive economics is concerned with what is; and normative economics is concerned with what should be. Economic goals are examples of normative economics. Evidence concerning economic performance or achievement of goals falls within the domain of positive economics. The normative versus positive economics arguments begs the question of whether economics is truly a value free science. In fact, economics contains numerous value judgments. Rational behavior assumes that people will always behave in their own self-interest. Self-interest is therefore presented as a positive element of behavior. In fact, it is a value judgment. Self-interest is probably descriptive of the majority of Americans’ behaviors over the majority of time, however, each of us can think of instances where self-less behavior is observed, and is frequently encouraged. Efficiency is a measurable concept, and is taken as a desirable outcome. However, efficiency is not always desirable. Equity or fairness is also something prized by most people. The efficiency criterion in economics is not always consistent with equity; in fact, these two ideas are often in conflict. Economics also generally assumes that more is preferred to less by all consumers and firms. However, there are disposal problems, distributional effects, and other problems where more may not be such a good thing. Obesity is a result of more, but a bad result. Pollution, poverty, and crime may also be examined as more begetting problems. Most nations have established broad social goals that involve economic issues. The types of goals a society adopts depends very much on the stage of economic development, system of government, and societal norms. Most societies will adopt one or more of the following goals: (1) economic efficiency, (2) economic growth, (3) economic freedom, 78 (4) economic security, (5) an equitable distribution of income, (6) full employment, (7) price level stability, and (8) a reasonable balance of trade. Each goal (listed above) has obvious merit. However, goals are little more than value statements in this broad context. For example, it is easy for the very wealthy to cite as their primary goal, economic freedom, but it is doubtful that anybody living in poverty is going to get very excited about economic freedom; but equitable distributions of income, full employment and economic security will probably find rather wide support among the poor. Notice, if you will, goals will also differ within a society, based on socio-political views of the individuals that comprise that society. Economics can hardly be separated from politics because the establishment of national goals occurs through the political arena. Government policies, regulations, law, and public opinion will all effect goals and how goals are interpreted and whether they have been achieved. A word of warning, eCONomics can be, and has often been used, to further particular political agendas. The assumptions underlying a model used to analyze a particular set of circumstances will often reflect the political agenda of the economist doing the analysis. An example liberals are fond of is, Ronald Reagan argued that government deficits were inexcusable, and that the way to reduce the deficit was to lower peoples' taxes -- thereby spurring economic growth, therefore more income that could be taxed at a lower rate and yet produce more revenue. Mr. Reagan is often accused, by his detractors, of having a specific political agenda that was well-hidden in this analysis. His alleged goal was to cut taxes for the very wealthy and the rest was just rhetoric to make his tax cuts for rich acceptable to most of the voters. (Who really knows?) Conservatives are fonder of criticizing the Clinton administration’s assertions that the way to reduce the deficit was to spend money where it was likely to be respent, and hence grow the economy and the result was more tax revenues, hence eliminate the deficit. Most political commentators, both left and right, have mastered the use of assumptions and high sounding goals to advance a specific agenda. This adds to the lack of objectivity that seems to increasingly dominate discourse on economic problems. On the other hand, goals can be public spirited and accomplish a substantial amount of good. President Lincoln was convinced that the working classes should have access to higher education. The Morrell Act was passed 1861 and created Land Grant institutions for educating the working masses (Purdue, Michigan State, Iowa State, and 79 Kansas State (the first land grant school) are all examples of these types of schools). By educating the working class, it was believed that several economic goals could be achieved, including growth, a more equitable distribution of income, economic security and freedom. In other words, economic goals that are complementary are consistent and can often be accomplished together. There
fore, conflict need not be the centerpiece of establishing economic goals. Because any society's resources are limited there must be decisions about which goals should be most actively pursued. The process by which such decisions are made is called prioritizing. Prioritizing is the rank ordering of goals, from the most important to the least important. Prioritizing of goals also involve value judgments, concerning which goals are the most important. In the public policy arena prioritizing of economic goals is the subject of politics. Policy Policy can be generally classified into two categories, public and private policy. The formulation of public and private policy is the creation of guidelines, regulations, or law designed to effect the accomplishment of specific economic (or other) goals. Public policy is how economic goals are pursued. Therefore, to understand goals one needs to understand something of the process of formulating policy. Business students will have an in depth treatment of policy making in Administrative Policy (J401) and the School of Public and Environmental Affairs requires a similar course in some of its degree programs. For students in other programs the brief treatment here will suffice for present purposes. The steps in formulating policy are: 1. stating goals - must be measurable with specific stated objective to be accomplished. 2. options - identify the various actions that will accomplish the stated goals & select one, and 3. evaluation - gather and analyze evidence to determine whether policy was effective in accomplishing goal, if not reexamine options and select option most likely to be effective. 80 Both the public and private policy formulation process is a dynamic one. Economic goals change with public opinion and with achievement. Step 1 involves the value statement of setting goals. Step 2 involves selecting the appropriate model and the options associated with that model to accomplish the specified goal. The final step involves gathering evidence and the appropriate analysis to determine whether the policy needs revision. The process of formulating policy is therefore a loop, and requires continuous monitoring and revising. The major difference between public policy and private policy is that private policy is not subject to democratic processes. The Board of Directors or management of a company will decide what goals are to be accomplished and what policy options are best used to do so. Often private policy is made behind closed-doors without public accountability, even though there are often public costs imposed. The strength of public policy is created in the open, with public debate, and often has the force of law (and not just company rules and regulations). Objective Thinking Most people bring many misconceptions and biases to economics. After all, economics deals with people's material well-being – a very serious matter to most. Because of political beliefs and other value system components rational, objective thinking concerning various economic issues fail. Rational and objective thought requires approaching a subject with an open-mind and a willingness to accept what ever answer the evidence suggests is correct. In turn, such objectivity requires the shedding of the most basic preconceptions and biases -- not an easy assignment. What conclusions an individual draws from an objective analysis using economic principles, are not necessarily cast in stone. The appropriate decision based on economic principles may be inconsistent with other values. The respective evaluation of the economic and "other values" (i.e., ethics) may result in a conflict. If an inconsistency between economics and ethics is discovered in a particular application, a rational person will normally select the option that is the least costly (i.e., the majority view their integrity as priceless). An individual with a low value for ethics or morals may find that a criminal act, such as theft, as involving minimal costs. In other words, economics does not provide all of the answers; it provides only those answers capable of being analyzed within the framework of the discipline. There are several common pitfalls to objective thinking in economics. Among the most common of these pitfalls, which affect economic thought, are: (1) the fallacy of composition, and (2) post hoc, ergo prompter hoc. Each of these will be reviewed, in turn in the following paragraphs. The fallacy of composition is the mistaken belief that what is true for the 81 individual must be true for the group. An individual or small group of individuals may exhibit behavior that is not common to an entire population. For example, if one individual in this class is a I.U. fan then everyone in this class must be an I.U. fan is an obvious fallacy of composition. Statistical inference can be drawn from a sample of individuals, but only within confidence intervals that provide information concerning the likelihood of making an erroneous conclusion (E270, Introduction to Statistics provides a more in depth discussion of confidence intervals and inference). Post hoc, ergo prompter hoc means after this, hence because of this, and is a fallacy in reasoning. Simply because one event follows another does not necessarily imply there is a causal relation. One event can follow another and be completely unrelated, this is simple coincidence. One event can follow another, but there may be something other than direct causal relation that accounts for the timing of the two events. For example, during the thirteenth century people noticed that the black plague occurred in a location when the population of cats increased. Unfortunately, some concluded that the plague was caused by cats so they killed the cats. In fact, the plague was carried by fleas on rats. When the rat population increased, cats were attracted to the area because of the food supply. The rat populations increased, and so did the population of fleas that carried the disease. This increase in the rat population also happened to attract cats, but cats did not cause the plague, if left alone they may have gotten rid of the real carriers (the rats, therefore the fleas). Perhaps it is interesting to note that in any scientific endeavor there is a basic truth. Simple answers to complex problems are appealing, abundant, and often wrong. This twist on Occam’s razor is true. Too often the desire to have a simple solution will blind individuals, and public opinion to the more complex and often more harsh realities. One must take great care to assure that this simple trap does not befall one in their search for truth, because not all truth is simple. Policy is fraught with danger. Failure to anticipated the consequences of certain aspects of policy may cause results that were neither intended nor anticipated by the policy-makers; this is referred to as the law of unintended consequences. The following box presents an excellent historical example of the law of unintended consequences. 82 Law of Unitended Consequences “The Legend of Pig Iron” (David A. Dilts, Indiana Policy Review, Vol. 1, No. 5, pp. 28-29.) Many a cliché seems to center on pork. The head of the household is supposed to " put bacon on the table," "pork barrels," and politicians are frequently accused of being in too close a proximity. It only seems fitting that one more story concerning pork should be brought to your attention. During World War II, farmers in the corn belt argued that regulation of the price of pork had no effect on the war effort, and that they should be permitted to sell their commodities without government interference. The farmers brought political pressure to bear on the Congress and our representatives to deregulate the price of pork. The end result was to shut down the steel mills in Gary. Shut down our steel mills? How could this be? Since it is not intuitively obvious how this happened, I'll explain. In 1942, there had been a change in management in the Philippines. And, as luck would have it, we didn't have good trade relations with the new management -- the Japanese. Therefore we did not have access to Manila fibre, necessary in making everything from rope to battleships. We had not yet developed synthetic fibre and therefore has to rely on the fibre previously available. That fibre was hemp. Now hemp grows in the same places, under the same climatic conditions as does corn. Corn is what hogs eat. And because corn was not being grown in the Midwest, the farmers sought alternative feed for the increased number of hogs they were raising. (Remember, increased price results in a larger quantity supplied.) Oats, wheat and barley were available from the Great Plains region. The problem was shipping it to where the hogs were raised in the Corn Belt of the Lower Midwest. In their search for transportation, the farmers found that railroads were regulated and reserved for military and heavy industry; trucks needed gasoline and rubber, both in short-supply; and airplanes were being built almost exclusively for military purposes. This left the farmers without a ready source of domestic transportation for the needed grain. But they eventually found a source of shipping that was neither regulated nor controlled, because it was international in nature -- the iron-ore barges on the Great Lakes. They bid up the price and the barges started hauling oats to the pigs and stopped hauling ore to the Gary steel mills. And there you have it: Without the requisite iron ore the steel mills could not produce; they were actually shut down for a period as a direct result of deregulating the price of pork. 83 Statistical Methods in Economics The use of statistical methods in empirical economics can result in errors in inference. Most of the statistical methods used in econometrics (statistical examination of economic data) rely on correlation. Correlation is the statistical association of two or more variables. This statistical assoc
iation means that the two variables move predictably with or against each other. To infer that there is a causal relation between two variables that are correlated is an error. For example, a graduate student once found that Pete Rose's batting average was highly correlated with movement in GNP during several baseball seasons. This spurious correlation cannot reasonably be considered path-breaking economic research. On the other hand, we can test for causation (where one variable actually causes another). Granger causality states that the thing that causes another must occur first, that the explainer must add to the correlation, and must be sensible. As with most statistical methods Granger causality models permit testing for the purpose of rejecting that a causal relation does not exist, it cannot be used to prove causality exists. These types of statistical methods are rather sophisticated and are generally examined in upper division or graduate courses in statistics. As is true with economics, statistics are simply a tool for analyzing evidence. Statistical models are also based on assumptions, and too often, statistical methods are used for purposes for which they were not intended. Caution is required in accepting statistical evidence. One must be satisfied that the data is properly gathered, and appropriate methods were applied before accepting statistical evidence. Statistics do not lie, but sometimes statisticians do! Objectivity and Rationality Objective thinking in economics also includes rational behavior. The underlying assumptions with each of the concepts examined in this course assumes that people will act in their perceived best interest. Acting in one's best interests is how rationality is defined. The only way this can be done, logically and rigorously, is with the use of marginal analysis. This economic perspective involves weighing the costs against the benefits of each additional action. In other words, if benefits of an additional action will be greater than the costs, it is rational to do that thing, otherwise it is not. Too often people permit the costs already paid to influence their decision-making, and hence they are lead astray by not focusing on the margin. The problem with rationality is perception. Often what people believe is in their own self-interest may not be. (Remember the Pig Iron example). Education and the gathering of information helps to make perceptions more accurate views of reality. In 84 other words, the more we can eliminate our biases and faulty perceptions, the more likely we are to act in our own interest. However, there are costs associated with information gathering and with education, therefore rationality may be costly. KEY CONCEPTS Economics Microeconomics Macroeconomics Economic Theory v. Empirical Economics Inductive v. Deductive Logic Usefulness of Economics Occam’s Razor Rationality Assumptions in Economics Ceteris Paribus Simplification for rigor’s sake Positive v. Normative Economics Economic Goals Policy Formulation Objective Thinking Fallacy of Composition Post hoc, ergo propter hoc fallacy Causation v. Correlation Granger Causality Tests Cost-Benefit Perspective 85 Food for Thought: STUDY GUIDE Most people have their own opinions about things. How might opinions be of value? Explain. Compare and contrast deductive logic with inductive logic. What evidence can statistical analysis provide? Critically evaluate this evidence and explain the role of empirical economics in developing economic theory. Sample Questions: Multiple Choice: Which of the following is not an economic goal? A. Price Stability B. Full Employment C. Economic Security D. All of the above are economic goals If we provide school lunches for children from households with incomes below the poverty level, and finance the school lunch program with an increase in taxes on incomes in excess of $100,000, these actions are likely to: A. Promote stability but reduce growth B. Promote equality but reduce freedom C. Promote efficiency but reduce equality D. Promote efficiency but reduce security True/ False: Non-economists are no less or more likely to be biased about economics than they are about physics or chemistry. {FALSE} Assumptions are used to simplify the real world so that it may be rigorously analyzed. {TRUE} 86 CHAPTER 2 Economic Problems The purpose of this chapter is to introduce you to several basic economic principles that will be useful in understanding the costs, markets, and the materials to follow in subsequent chapters. This chapter will examine scarcity, factors of production, economic efficiency, opportunity costs, and economic systems. In this chapter the first economic model will also be developed, the production possibilities frontier (or curve). The Economizing Problem Economics is concerned with decision-making. An economic decision is one that allocates resources, time, money, or something else of use or value. The fundamental question in economics is called the economizing problem. The economizing problem follows directly from the definition of economics offered in Chapter 1. The economizing problem involves the allocation of resources among competing wants. The economizing problem exists because there is scarcity. Scarcity arises because of two facts; (1) there are unlimited human wants, but (2) there are limited resources available to meet those wants. In other words, scarcity exists because we do not have sufficient resources to produce everything we want. Perhaps at some date in the future, a utopian world may be obtained where everyone's desires can be fully satisfied -- most economists probably hope that will not happen in their lifetimes because of their own self-interest. Economists do not differentiate between wants and needs in examining scarcity. Unfortunately, the want of a millionaire for a new Porsche is not differentiated from the need of a starving child for food in the aggregate. However, in a realistic sense, social welfare and the implications of needs versus wants are partially addressed later in this chapter in the discussions offered for allocative efficiency and economic systems. The concept of scarcity is embedded in virtually every analysis found in economics. Because there is scarcity there is always the question of how resources are allocated and the effects of allocations on various economic agents. Each decision allocating resources to one use or economic agent is also, by necessity, a decision not to allocate resources to an alternative use. To fully understand the idea of scarcity, each of its components must be mastered. The following section of this chapter examines resources. The next sections will examine economic efficiency, opportunity costs and allocations, before proceeding 87 to the production possibilities model and economic systems. Productivity is the key Head to Head (Lester Thurow, New York: William Morrow and Company, Inc., 1992, p. 273.) If the "British disease" is adversarial labor-management relations, the "American disease" is the belief that low wages solve all problems. When under competitive pressure, American firms first go the low-wage nonunion parts of America and then on to succession of countries with ever-lower wages. But the strategy seldom works. For a brief time lower wages lead to higher profits, but eventually other with even lower wages enter the business (low wages are easy to copy), prices fall, and the higher profits generated by lower wages vanish. The search for the holy grail of high profitability lies elsewhere -- in a relentless upscale drive in technology to ever-higher levels of productivity -- and wages. Since rapid productivity growth is a moving target and therefore hard to copy, high long-run profits can be sustained. But to get the necessary human talent to employ new technologies, large skill investments have to be made. High wages have to be paid, but paradoxically high wages also leave firms with no choice but to go upscale in technology. High wages and high profits are not antithetical -- they go together. Resources and factor payments The resources used to produce economic goods and services (also called commodities) are called factors of production. These resources are the physical assets needed to produce commodities. The way that these resources are combined to produce is called technology. For example, a man with a shovel digging a ditch is one technology from which ditches can be obtained. Another technology that can produce the same commodity as a man with a shovel is a backhoe and an operator -- the former is more labor intensive, and the latter is more capital intensive. Land is a factor of production. Land includes space, natural resources, and what is commonly thought of as land. A building lot, farm land, or a parking space is what people normally think of when they think of land. However, iron ore, water resources, oil, and other natural resources obtained from land are also one dimension of this factor of production. Another, perhaps equally important dimension, is space. The location of a building site for a business is an important consideration. For example, a retail establishment may succeed or fail because of location, therefore location is another important aspect of the resource called land. The factor payment that accrues to land for producing is rent. 88 Capital includes the physical assets (i.e., plant and equipment) used in the production of commodities. Often accountants refer to capital as money balances that are earmarked for the purchase of plant or equipment. The accounting view of capital is not the physical asset envisioned by economists (in reality the difference is one of a future claim (the accountant's view) and a present stock of capital (the economist's view) and is not trivial). Capital receives interest for its contributions to production. There is one important variation on capital. Economists also called the skills, abilities, and knowledge
of human beings as human capital. Human capital is a characteristic of labor. Human capital can be acquired (i.e., education) or may be something inherent in a specific individual (i.e., size, beauty, etc.). This subject will be examined in more depth in Chapters 10 and 11. Labor includes the broad range of services (and their characteristics) exerted in the production process. Labor is a rather unique factor of production because it cannot be separated from the human being who provides it. Human beings also play other roles in the economic system, such as consumer that complicates the analysis of labor as a productive factor. The amount of human capital possessed by labor varies widely from the totally unskilled to highly trained professionals and highly skilled journeymen. Labor also includes hired management, and the lowest paid janitor. Labor is paid wages for its contribution to the production of commodities. Entrepreneur (risk taker) is the economic agent who creates the enterprise. Entrepreneurial talent not only assumes the risk of starting a business, but is generally responsible for innovations in products and production processes. The vibrancy of the U.S. economy is, in large measure, due to a wealth of entrepreneurial talent. This factor of production receives profits for its contribution to output. To obtain the maximum amount of output from the available productive resources an economic system should have full employment. Full employment is the utilization of all resources that is consistent with normal job search and maintenance of productive capacity. Full employment includes the natural rate of unemployment, which economists estimate to be between four and six percent (unemployment due to job search and normal structural changes in the economy). Empirical evidence suggests that about 80% capacity utilization is consistent with the natural rate of unemployment. When the economy is operating at rates consistent with the natural rate of unemployment it is producing the potential total output. However, full production, 100% capacity utilization involves greater than full employment and cannot be maintained for a prolonged period without labor and capital breaking-down. Underemployment has been a persistent problem in most developed economies. Underemployment results from the utilization of a resource that is less than what is consistent with full employment. There are two ways that underemployment manifests itself. First, individuals can be employed full time, but not making use of the human 89 capital they possess. For example, in many European countries it is not uncommon for an M.D. to be employed as a practical nurse. The second way that underemployment is typically observed is when someone is involuntarily a part-time employee rather than employed full-time in an appropriate position. Economic Efficiency Economic efficiency consists of three components; these are: (1) allocative efficiency, (2) technical or productive efficiency, and (3) full employment. For an economy to be economically efficient all three conditions must be fulfilled. Allocative efficiency is concerned with how resources are allocated. In a perfectly competitive economy, without institutional impediments, monopoly power, or cartels the markets will allocate resources in an allocatively efficient manner. Allocative efficiency is measured using a concept known as Pareto Optimality (or Superiority in an imperfect world). Pareto Optimality is that allocation where no person could be made betteroff without inflicting harm on another. A Pareto Optimal allocation of resources can exist, theoretically, only in the case of a purely competitive economy (which has never existed in reality). What is of practical significance is a Pareto Superior allocation of resources. A Pareto Superior allocation is that allocation where the benefit received by one person is more than the harm inflicted on another. [cost - benefit approach] Technical or productive efficiency is a somewhat easier concept. Technical efficiency is defined as the minimization of cost for a given level of output or (alternatively) for a given level of cost you maximize output. In other words, for an economic system to be efficient, each firm in each industry must be technically efficient. Again, a technically efficient operation is difficult to find in the real world. However, most profit-maximizing firms (as well as government agencies and non-profit organizations) will at least have technical efficiency as one of its operational goals. For an economic system to be economically efficient then full employment is also required. Due primarily to the business cycles, no economic system can consistently achieve full employment. The U.S. economy typically has one (during recoveries) to four percent (during recessions) unemployment above that associated with the natural rate of unemployment. We will return to this topic in the discussions of market structures in Chapters 8 and 9. 90 Allocative Efficiency The Economics of Welfare, fourth edition (A. C. Pigou, London: Macmillan Publishing Company, 1932, p. 89.) . . . Any transference of income from a relatively rich man to a relatively poor man of similar temperament, since it enables more intense wants to be satisfied at the expense of less intense wants must increase the aggregate sum of satisfaction. The old "law of diminishing utility" thus leads securely to the proposition: Any cause which increases the absolute share of real income in the hands of the poor, provided that it does not lead to a contraction in the size of the national dividend from any point of view, will, in general, increase economic welfare. Pigou states the basic proposition of Pareto Superiority in the real world; an application of income re-distribution. The “transference of income from a relatively rich man to a relatively poor man of similar temperament” making one less poor, and the other less rich, results in an application of the principle of diminishing marginal utility and, hence, allocative efficiency. In other words, the cost-benefit approach on the margin. We take the last dollar from those with less value for that dollar and add that to those more desperate for an additional dollar of income. Not only is this allocatively efficient, but there are those who would argue that this is also fair. Economic Cost Economic cost consists of two distinct types of costs: (1) explicit (accounting) costs, and (2) opportunity (implicit) costs. Explicit costs are direct expenditures in the production process. These are the items of cost with which accountants are concerned. An opportunity cost is the next best alternative that must be foregone as a result of a particular decision. Rather than a direct expenditure, an opportunity cost is the implicit loss of an alternative because of a decision. For example, reading this chapter is costly, you have implicitly decided not to watch T.V. or spend time doing something else by deciding to read this chapter. Every choice is costly; that is, there is an opportunity cost. Economic costs are dealt with in greater detail in Chapter 7. 91 Production Possibilities The production possibilities frontier (or curve) is a simple model that can be used to illustrate what a very simple economic system can produce under some restrictive assumptions. The production possibilities model is used to illustrate the concepts of opportunity cost, productive factors and their scarcity, economic efficiency (unemployment etc.) and the economic choices an economy must make with respect to what will be produced. There are four assumptions necessary to represent the production possibilities in a simple economic system. The assumption which underpin the production possibilities curve model are: (1) the economy is economically efficient, (2) there are a fixed number of productive resources, (3) the technology available to this economy is fixed, and (4) in this economy we are going to produce only two commodities. With these four assumption we can represent all the combinations of two commodities that can be produced given the technology and resources available are efficiently used. Consider the following diagram: Beer Pizza Along the vertical axis we measure the number of units of beer we can produce and along the horizontal axis we measure the number of units of pizza we can produce. Where the solid line intersects the beer axis shows the amount of beer we can produce 92 if all of our resources are allocated to beer production. Where the solid line intersects the pizza axis indicates the amount of pizza we can produce if all of our resources are allocated to pizza production. Along the solid line between the beer axis and the pizza axis are the intermediate solutions where we have both beer and pizza being produced. The reason the line is curved, rather than straight, is that the resources used to produce beer are not perfectly useful in producing pizza and vice versa. The dashed line represents a second production possibilities curve that is possible with additional resources or an advancement in available technology. Increasing Opportunity Costs is illustrated in the above production possibilities curve. Notice as we obtain more pizza (move to the right along the pizza axis) we have to give up large amounts of beer (downward move along beer axis). In other words, the slope of the production possibilities curve is the marginal opportunity cost of the production of one additional unit of one commodity, in terms of the other commodity. Inefficiency, unemployment, and underemployment are illustrated by a point inside the production possibilities curve, as shown above. A point consistent with inefficiency, unemployment, or underemployment is identified by the symbol to the inside of the curve. Economic growth can also be illustrated with a production possibilities curve. The dashed line in the above model shows a shift to the right of the curve.
The only way this can happen is for there to be more resources or better technology and this is called economic growth. It is also possible that the curve could shift to the left (back toward the origin -- the intersection of the beer axis with the pizza axis), this could result from being forced to use less efficient technology (pollution controls) or the loss of resources (racism or sexism). Economic Systems Production and the allocation of resources occur within economic systems. Economic systems rarely exist in a pure form and the pure forms are assumed simply for ease of illustration. The following classification of systems is based on the dominant characteristics of those systems. Pure capitalism is characterized by private ownership of productive capacity, very limited government, and motivated by self-interest. Laissez faire means that government keeps their hands-off and markets perform the allocative functions within the economy. This type of system has the benefit of producing allocative efficiency if there is no monopoly power, but this type of system tends towards heavy market concentration left unregulated. There are substantial costs associated with pure capitalism. These costs include significant loses of freedom, poverty, income inequity 93 and several social ills associated with the lack of protections afforded by stronger government. What is perhaps the saving grace, is that pure capitalism does not exist in the course of economic history. Pure capitalism exists only in the tortured minds of economists, and pages of the Wealth of Nations. In the following box, Thorstein Veblen discusses his view of capitalism and the “struggle” associated with the pursuit of self-interest in a system marked with private interests. The Struggle The Theory of the Leisure Class, Thorstein Veblen, New York: Penguin Books, 1899, pp. 24-25. Wherever the institution of private property is found, even in a slightly developed form, the economic process bears the character of a struggle between men for the possession of goods. It has been customary in economic theory, and especially among those economists who adhere with least faltering to the body of modernised classical doctrines, to construe this struggle for wealth as being substantially a struggle for subsistence. Such is, no doubt, its character in large part during the earlier and less efficient phases of industry. Such is also its character in all cases where the “niggardliness of nature” is so strict as to afford but a scanty livelihood to the community in return for strenuous and unremitting application to the business of getting the means of subsistence. But in all progressing communities an advance is presently made beyond this early stage of technological development. Industrial efficiency is presently carried to such a pitch as to afford something appreciably more than a bare livelihood to those engaged in the industrial process. It has not been unusual for economic theory to speak of the further struggle for wealth on this new industrial basis as a competition for an increase in the physical comforts of life, – primarily for an increase of the physical comforts which the consumption of goods affords. In command economies the government makes the allocative decisions. These decisions are backed with the force of law (and sometimes martial force). Political freedom is the antitheses of a command economy. Even though political and economic freedom could result in a reasonable allocation, but rarely will command economies be associated with democratic forms of government. Examples, of these types of systems abound, Nazi Germany, Chile, the former Soviet Union are but a few examples. Traditional economies base allocations on social mores or ethics or other non- market, non-legislative bases. For example, Iran is an Islamic Republic and the allocation of resources is heavily influenced by religious precepts. The purest forms of traditional economies are typically observed in tribal societies. In the South Pacific and certain South American Indian tribes, the allocation of resources is determined by 94 traditions, only some of which are based in their religion. Many of these traditions developed because of economic constraints. For example, the tradition that some native tribes in the Arctic had of putting their elderly out of the community to starve or freeze may seem barbaric, but because of the difficulty in obtaining the basic requirements of life, those that could not contribute, could not be supported. Hence a tradition that arose from economic constraints. Socialism generally focuses on maximizing individual welfare for all persons based on perceived needs, not necessarily on contributions. Socialist systems are generally concerned more with perceived equity rather than efficiency. The basic idea here is that when there is assurance of economic security then society in general is better-off. Sweden, Denmark, Norway and Iceland have systems that have large elements of socialism. Each of these three countries have been reasonably successful in maintaining relatively high levels of productivity and standards of living. Communism is a system where everyone shares equally in the output of society (according to their needs), at least theoretically. Generally, there is no private holdings of productive resources, and government is a trustee until such time as what is called "Socialist Man" fully develops (where the individual is more concerned with aggregate welfare than individual gain). The former Soviet Union was not a communist society as perceived by Karl Marx in Das Kapital. However, examples of communist societies exist on small community levels. Both New Harmony, Indiana and Amana, Iowa were utopian communist systems that were probably more in keeping with Marxist ideals, but without the political implications and in very limited scope. Division of Labor – and possibly society Class Warfare, Noam Chomsky, Monroe, Maine: Common Courage Press, 1996, pp.19-20. . . . People read snippets of Adam Smith, the few phrases they teach in school. Everyone reads the first paragraph of The Wealth of Nations where he talks about how wonderful the division of labor is. But not many people get to the point hundreds of pages later, where he says that division of labor will destroy human beings and turn them into creatures as stupid and ignorant as it is possible for a human being to be. And therefore in any civilized society the government is going to have to take some measures to prevent division of labor from proceeding to its limits. 95 Virtually all economic systems are mixed systems. A mixed system is one that contains elements of more than one of the above pure systems. The U.S. economy is a mixed system, with significant amounts of capitalism, command, and socialism. The U.S. economy also has some very limited amounts of communism and tradition that have helped shape our system. Much of the political controversies concerning the budget deficit, social security, and the environment focuses on the what the appropriate mix of systems should exist in our economic system. Most developed economies are mixed systems. As a society grows and becomes more complex, simple pure examples of economic systems are incapable of handling the demands placed on them. Complexity generally requires elements of command, socialism and capitalism to properly allocate resources and produce commodities. This is no more evident in the troubles being experienced in the former Soviet Union and in China. As these economies attempt to modernize and develop, the policy makers have discovered the utility of market systems for many economic decisions. Estranged Worker The Economic & Philosophic Manuscripts of 1844, Karl Marx, New York: International Publishers, 1964, p. 107-8. The worker become all the poorer the more wealth he produces, the more his production increases in power and size. The worker becomes an even cheaper commodity the more commodities he creates. With the increasing value of the world of things proceeds in direct proportion the devaluation of the world of men. Labor produces not only commodities: it produces itself and the worker as a commodity – and this in the same general proportion in which it produces commodities. This fact expresses merely that the object which labor produces – labor’s product – confronts it as something alien, as a power independent of the producer. The product of labor is labor which has been embodied in an object, which has become material: it is the objectification of labor. Labor’s realization is its objectification. In the sphere of political economy this realization of labor appears as loss of realization for the workers; objectification as loss of the object and bondage to it; appropriation as estrangement, as alienation. Developed economies are generally high income economies, because the production processes tend be capital intensive, and focused on high value-added products. An economy that has a per capita GDP of $8000 or more is a high income economy. Less developed economies fall into two categories, middle income $8000 to $800, and low income economies or those below $800. Low income economies are concentrated in South Asia, and Africa South of the Sahara. Middle income economies are in the Middle East, Eastern Europe and Latin America. The majority of the world’s 96 population, over half, live in low income economies. Perhaps the greatest economic issue facing the current generation is what can be done to bring the low income economies into meaningful participation in the global economy. The poverty of the low income economies is a serious matter without any other issue. AIDS, malaria, and a host of other health problems are associated with the poverty in these nations. Perhaps more importantly, with rising incomes in these parts of the world come several benefits globally. As income rise in low income countries, cheap labor is no longe
r a cause for outsourcing from the high income, industrialized parts of the world. Further, as income rise, so too does the demand for goods and services. The often used cliché “a rise tide makes all boats float higher” is exactly the case in these nations emergence into full participation in the global economy. More concerning these issues will be offered later in this book. KEY CONCEPTS Economizing problem Scarce Resources Unlimited Wants Resources and Factors Payments Land - rent Labor - wages Capital - interest Entrepreneurial Talent - profits Full Employment Underemployment Economic Efficiency Allocative Efficiency Technological Efficiency Full Employment Opportunity Cost Implicit vs. Explicit Costs Production Possibilities Frontier (or Curve) Growth Inefficiency Law of Increasing Opportunity Costs 97 Economic Systems Pure capitalism Command Tradition Socialism Communism Mixed Systems Developed vs. Less Developed Economies High Income Middle Income Low Income Globalization Food for Thought: STUDY GUIDE What is the economizing problem? What, precisely does scarcity have to do with this? Explain. Draw a production possibilities curve that illustrates a one-to-one trade-off between the two goods, what would cause such a production possibilities curve? Explain. Compare and contrast the various economic systems? Is a mixed system best? Explain. Differentiate between explicit and implicit costs. Is this differentiation important in economic decisions? Explain. 98 Sample Questions: Multiple Choice: Which of the following factors of production are not properly matched with their factor payments? A. Land - profits B. Labor - wages C. Capital - interest D. All are properly matched Unemployment can be illustrated with a production possibilities curve. Which of the following illustrates unemployment? A. A shift to the left of the curve B. A shift to the right of the curve C. A point on the inside of the curve D. A point on the outside of the curve Which of the following is an implicit cost of your obtaining a college education if you go to school exclusively? A. Tuition B. Books and supplies C. Income lost from a job you didn’t take D. All of the above The U.S. economy is closest to which of the following economic systems? A. Mixed B. Pure Capitalism C. Pure Command D. None of the above TRUE-FALSE A laissez faire, purely capitalistic economy will always result in economically efficient distributions of resources. {FALSE} 99 If the assumption of a fixed technology is relaxed in the production possibilities curve model, then the exact position and shape of the curve will be impossible to show using a single line. {TRUE} The former Soviet Union was an example of pure Communism and the Swedish economy an example of pure socialism. {FALSE} Opportunity cost is an example of an implicit cost. {TRUE} 100 CHAPTER 3 Interdependence and the Global Economy This chapter begins with a discussion of the interdependence of nations in the modern global economy before proceeding to a discussion of capitalist ideology. The characteristics of a market based economic system, and the motivation for international trade will then presented before offering a discussion of the role of money in a global economic system. The final section of this chapter develops the circular flow diagram that illustrates interdependence within a global economy. Open Economic System The modern economy of most nations is no longer a closed-localized system. Virtually every nation on earth has some sort of relations with other nations. The extent to which an economic system is involved in economic relations with other countries is the degree to which that economy is open. Foreign economic relations involves the importation and exportation of goods and services. When you buy a Toyota you are having economic relations with Japan. When you work for Philips (Aero-Quip etc.) you are having economic relations with Holland (Philips is a Dutch company). Over the past three decades our reliance on foreign produced goods has become increasingly important to our standard of living. On the other hand, foreigners have become increasingly reliant on American goods. Without trade among nations then everyone would suffer the loss of goods they desire that must be imported. Foreign investment in the United States has been and continues to be an important component of our economic development. From the very beginnings of the United States European countries, i.e., France, Britain and Germany have heavily invested in the United States. In the Nineteenth Century the motivation was that the U.S. was far from the turmoil of the repeated European wars (Napoleon etc.) and investment here was protected by the expanse of the two Oceans on our east and west. As our institutions developed and became more secure, investment was attracted by the safety offered by our financial institutions and government regulations. At the same time, American industry sought to move into markets they presently served only by exportation. Controversy abounds concerning international economic relations. The outsourcing of jobs abroad has real costs for the affected households and is a source of discontent among workers who have lost their jobs to foreign competition (more concerning this will discussed in chapter 12). In many cases these job loses are simply 101 employers taking advantage of very low income populations in poor countries – with all of the social and political ills associated with economic exploitation. Over the next several decades these issues will take a more central place in political debate, and concerns over the social responsibility of business. Technology transfers are also controversial. There are currently bands on the transfer of certain technologies that have implications for national defense. However, in general, technology transfers is the exportation of ideas, knowledge and equipment that may permit less fortunate nations to more adequately participate in the global economic system. The United States is presently experiencing large deficits in our balance of payments. The balance of payments is the net investment abroad (capital accounts) plus the net exports (current accounts) of the United States. If the balance of payments is positive, ignoring investment (capital accounts) for the moment, that means we are exporting more than we are importing. With the capital accounts that means we invest more abroad, than foreigners invest in the U.S. Together, if the balance of payment is negative, that means the net of the capital and current accounts is a negative number (i.e., we invest less abroad than foreigners invest here, and we import more than we export). Capitalist Ideology Ideology is defined by Webster’s Dictionary as: that system of mental philosophy which exclusively derives our knowledge from sensation. Webster’s also appropriately defines capitalism as: An economic system characterized by private ownership of natural resources and means of production. However, what our system is, and what ideology has grown up around the system are two different things. We have a mixed system, which includes a significant amount of market allocation mechanisms, but it is not a pure capitalist system. Further, what Adam Smith envisioned for capitalism is in many respects very much different from the more radical proponents of capitalism would have us believe is the ideal system. One should remember that a mixed system evolved for a reason, and that the ideology ought not taint the wonders of that system and the standard of living it provides. The following box is an excerpt from Adam Smith’s Wealth of Nations which clearly and unambiguously examines the idea of social welfare, with respect to the pursuit of individual welfare. Bear in mind Adam Smith was the father of capitalism as you read this excerpt. 102 Individual Self-Interest and Social Welfare An Inquiry into the Nature and Causes of the Wealth of Nations (Adam Smith, New York: Random House, Modern Library editions, 1937 [original published 1776] Book IV, Ch. 2) Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it. Capitalist ideology is therefore what we wish to perceive it to be, rather a dispassionate observation of some characteristics of a our economic system. The characteristics of a market system are dispassionate observations about markets and their operation. Therefore capitalist ideology is different than the characteristics of a market system. The characteristics of a capitalist economy are familiar to anyone who has grown up in western industrialized countries. The elements of a capitalist ideology are: (1) freedom of enterprise, (2) self-interest, (3) competition, (4) markets and prices, and (5) a limited role for government. Freedom of enterprise, self-interest and a limited role for government are related characteristics of capitalist ideology. By limiting government participation in the economy it is thought that economic freedom to pursue one's self-interest increases – hence government participation is often called “int
erference.” To the extent that government limits the freedom of enterprise, there is merit to this argument. However, there are often problems associated with the pursuit of self-interest. One of the primary problems with this aspect of the ideology is it is based on the assumption that the power to limit people's self-interest comes only from government. There is also a significant amount of potential to limit economic freedom by predatory behaviors from the private sector. For example, large businesses running small ones out of business to obtain a monopoly to permit prices to increase. Again, assuming that monopoly power is not exerted over otherwise competitive markets, the competition among producers in a market economy will approximate a 103 Pareto Optimal (see Chapter 2) allocation of resources. Competition does provide for alternate sources of supply that generally increases quality and keeps prices in check. The market system is largely responsible for our high standard of living and the ability to effectively respond to changes in the global economy. Maybe the best example of the benefits that arise from a capitalist economy is the U.S. automobile industry. In the 1970s the U.S. car producers did not have effective competition, and their prices increased as the quality of U.S. built cars declined. The Japanese entered the U.S. markets and successfully competed with the U.S. manufacturers. This caused the U.S. manufacturers to significantly increase the quality of their products and keep their prices in check. By 2004 many of the top ten vehicles in quality according to consumer reports are U.S. automobiles. Consumer Guide’s Recommended List for 2004: (http://auto.consumerguide.com/auto/new/index.cfm) lists fifteen foreign built vehicles (14 of which are Japanese name plates) and eighteen American vehicles as best buys for 2003. This is a significant benefit from competition that is fundamental to capitalism. However, capitalism has its drawbacks. Poverty, high rates of litigation, pollution, crime and several other social problems are associated with freedom and limiting government's role. There is a broad range of legitimate roles for government in a capitalist economy. As social responsibility by producers and consumers declines, the legitimate roles of government generally expand. Worse still, over the past three or four years, businesses in the U.S. have been rocked by scandals. The accounting and analyst frauds at Enron, WorldCom, Health South, and an array of brokerage firms and investment banks, have illustrated that the ethic of self-interest is hardly a reasonable basis for an economic system – without some countervailing forces. Self-interest, without government, or at least effective government regulation, may produce results that are extremely harsh for those without the resources to defend themselves. Therefore there is a strong need not only for a strong ethic of honest and forthright dealings, but also governmental regulation to proscribe the worst abuses. For the tendency of capitalism toward monopoly and market power to be held in proper balance government must have a significant role. The exact magnitude of the role of government in a free economy has always been controversial, but there is little doubt of its potential for positive outcomes. President Bush, during his first election campaign argued that he envisioned American society becoming "kinder and gentler" society. This reference was for the need for certain elements of socialism to provide limited assurance for the disabled, the elderly, and children freedom from poverty. In the years since George Bush, it seems that neither Democrats nor Republicans shared the first President Bush’s vision. Mixed economic systems are the response to the 104 drawbacks of capitalism. Not all people accept our view of the proportions of market activity that should be in evidence in a mixed economy. The Europeans and major Asian economies have far more socialism than we do. On the other hand, many of the Less Developed Countries permit far more free enterprise than we do. Whatever the proportions, two things are certain. First, no two societies are alike in their mix of allocative mechanisms, and second the mix evolves and changes over time with the societies the system serves. Market System Characteristics The characteristics of the market system is both practically and intellectually different than capitalist ideology. The characteristics of the market system are those things upon which the operationalization of markets depend to decide what is produced and how it will be allocated. The characteristics of a typical of market system are: (1) the division of labor & specialization, (2) significant reliance on capital goods, and (3) reliance on comparative advantage. These characteristics have significant interactions and together are responsible for the competitive well-being of most market system economies. In market economies the competition among producers requires high levels of technical efficiency, which, in turn, requires labor to become specialized and focused on narrow aspects of a particular production process. By dividing tasks into small components people become better at repetitive movements and therefore their efficiency increases. As efficiency increases, cost per unit declines. 105 Division of Labor and Production An Inquiry into the Nature and Causes of the Wealth of Nations (Adam Smith, New York: G. P. Putnam and Sons, 1877 (original published 1776) Book II, Chapter V.) To take an example . . . from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour had rendered a distinct trade), nor acquainted with the use of machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. I have seen a small manufactory of this kind where ten men only were employed, and where some them consequently performed two or three distinct operations. But though they were poor, and therefore indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousands pins of middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each them have made twenty, perhaps not one pin in a day. Because of the need to compete, capital is typical used where it is less costly. Capital can be substituted for labor in many production processes and significantly reduce per unit costs of production. Comparative Advantage and Trade However, comparative advantage is somewhat more complicated. Comparative advantage is the motivation for trade among people (and nations). Terms of trade are 106 those upon which the parties may agree and depends on the relative cost advantages of trading partners and their respective bargaining power. Interdependence and Comparative Advantage An Inquiry into the Nature and Causes of the Wealth of Nations (Adam Smith, New York: Random House, Modern Library editions, 1937 [original published 1776] Book IV, Ch. 2) . . . It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost more to make than to buy. The taylor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a taylor. The farmer attempts to maler neither the one nor the other, but employs those different artificers. All of them find it for their interest to employ their whole industry in a way in which they have some advantage over their neighbors, and to purchase with a part of its produce, or what is the same thing, with the price of a part of it, whatever else they have occasion for. What is prudence to the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage. Consider the following illustration: Texas Cows Oranges 1000 100 Florida 100 1000 The data above show what each state could produce if all of their resources were put into each commodity. For example, if Texas put all their resources in cattle production they could produce 1000 cows but no oranges. Assuming the data give the rate at which the commodities can be substituted, if both states equally divided their resources between the two commodities, Texas can produce 500 cows and 50 oranges and Florida can produce 50 cow
s and 500 oranges (for a total of 550 units of each commodity produced by the two states together). If Texas produced nothing but cows it would produce 1000, and if Florida produced nothing but oranges it would produce 1000). If the countries traded on terms where one orange was worth one cow then both states would have 500 units of each commodity and obviously benefit from specialization and trade. In this example notice that oranges are relatively expensive. Trade between industries and individuals also arises from comparative 107 advantage. However, barter (direct trading of commodities) becomes increasingly difficult as an economic system becomes more complex. Barter requires a coincidence of wants, it does no good to have apples if you want oranges and the only people who have oranges hate apples. No transaction will occur under this scenario unless a third-party can be found that has a commodity that both original trading parties value and who accept both apples and oranges. Therefore, as complexity rises, so does the need for the ability to conduct business without reliance on barter, therefore the need for money. TRADE SUMMARY - U.S. Department of Commerce, International Trade Administration (billions of dollars) Year Total Exports Total Imports Balance of Trade –$378.7 $1064.2 2000 2001 998.0 1356.3 – 358.3 2002 971.7 1407.3 – 435.7 1489.2 – 501.4 2003 (est) 988.8 $1442.9 Money in an Economic System Money facilitates market activities and is necessary in complex market systems. With money people can avoid the problems associated with coincidence of wants. Among, these problems is the pricing of commodities. Prices stated in the terms of all possible trading goods makes it difficult to determine what anything costs. In barter economies hours are spent in negotiating for even simple transactions, these hours are resources that could have been spent on other activities (therefore the hours of negotiations are the opportunity cost of a money economy). The functions of money include; (1) medium of exchange, (2) store of value, and (3) a measure of worth. Because money is acceptable as a form of payment for all commodities, barter is no longer needed. Money can be easily stored in a tin can or bank account, so commodities need not be stored and can be purchased when needed. Because money is acceptable in virtually all transactions, prices can be stated in terms of dollars or yen thereby simplifying transactions substantially. In other words, money is the grease that lubricates any complex economic system. 108 Fiat money is what is common in modern economic systems. Fiat money is money that is defined as legal tender by either a government or some organization with the authority to define legal tender. In the United States the Federal Reserve System issues Federal Reserve Notes, which serve as the legal tender for the United States. The currency used here is backed by nothing except the faith of the general public that this money will be acceptable by everyone else with whom you could have an economic transaction. President Nixon in 1971 took the United States off of the gold standard. Up to that point of time the value of the dollar was expressed in some fixed ratio to the commodity – gold. The end result was the dollar had become seriously over-valued, and something had to be done so that American exports could resume to our trading partners. When the U.S. abandoned the gold standard gold went from less than forty dollars an ounce, to over $1000 an ounce in a matter of weeks. Thus illustrating the folly of pegging one’s currency to the value of some commodity. Fiat money is not a new idea. Some European historians identify the first use of fiat money in Europe resulting from gold and silver smiths issuing their customers receipts for gold or silver left in their care. The receipts were commands over that gold and silver, and began to trade as easily as the commodity itself, to the extent that the parties to the transaction knew of the smith and the note bearer. This trade in receipts dates back to the mid-fifteenth century. Hence, in this case the value of money is based on some mutual trust between the principles to these transactions. The first recorded use of fiat money, however, dates to three hundred years earlier in Asia. Because of the shortage of gold and silver to run the Mongol Empire, Genghis Kahn began to issue orders, in writing, that the written order was to be given deference as a specific amount of gold or silver. Genghis was known to a be nononsense sort of guy, and the violation of his decrees were clearly unhealthy acts, therefore these orders were the first fiat money recorded in history, and not backed by anything save the martial might of the Mongol Army. Perhaps, in retrospect, it is better that currency be acceptable on economic grounds, than under threat of violence from a government. Foreign Exchange International economic relations also depend, in large measure, on monetary issues. You are unlikely to accept the Turkish Lire in payment for your wages in this country, simply because you can’t easily use that money to buy anything. You want U.S. dollars in payment for your services, because you can easily spend the dollar. Countries act the same way you do. There are currencies that virtually everyone accepts as payment, and those widely accepted currencies are called hard currency. 109 The currency of the big, developed, high income economies are the hard currencies – U.S. dollar, Japanese Yen, Canadian dollar, British pound and the E.E.U.s’ Euro. Prior to the Euro, there were seven countries whose currencies were considered hard currencies. In addition to the U.S., Japan, Canada, and the United Kingdom, the French Franc, German Mark, and Italian Lire were also considered hard currencies. These seven nations are called the G-7 countries because the size and strength of their economies made them the leading economic forces on the planet, and their currencies the most accepted. The relative value of currency is called the exchange rate. For example, one U.S. dollar may buy 109 Japanese Yen but only .85 Euros. It is these currency exchange rates that, in large measure, determine net exports and foreign investment in the U.S. As the dollar gains strength, i.e., goes from 109 Yen to the dollar to 120 Yen to the dollar, then imports are cheaper. If at 110 Yen to the dollar a particular Japanese car costs $20,000 that is also 2.2 million Yen. If the dollar gains strength, and it can now purchase 125 Yen per dollar, then that 2.2 million Yen car is only $17,600. As can be readily seen the strong dollar give the American consumer an advantage in buying imports. If the dollar becomes weak then that advantage turns to disadvantage. Going back to the example above, if the 2.2 million Yen vehicle was available at $17,600 at 125 Yen per dollar, the additional cost of $2400 would be observed if the dollar could only purchase 110 Yen. The same sort of analysis applies to American exports. With an expensive dollar it is hard to sell American goods abroad. If the Mexican Peso will buy 10 cents we may be able to sell some goods in Mexico, however if the dollar becomes stronger and Mexicans can only get 5 cents per peso, we will observe a marked decline in exports to Mexico. Currency also impacts foreign investment. If our Mexican friends invest 2 million pesos in the U.S. when the peso buys 10 cents ($200,000), and then suddenly the peso becomes worth 25 cents ($500,000) the foreign investor just made 250% on his investment simply because the U.S. dollar weakened with respect to the Mexican peso. On the other hand, if the Mexican investor bought dollars at 25 cents per peso and over a year the dollar fell to 10 cents per peso, his investment went from $500,000 to only 40% of his original investment. In other words, foreign investment becomes more attractive with strength in the host countries’ currency. A strong dollar policy means that the government will undertake policies that will increase the value of the dollar with respect to other currencies. Contractionary fiscal and monetary policies are typically associated with strong dollar policy and is properly the subject of the next course (macroeconomics). Strength a nation’s currency is typically a reflection of its strong economy and institutions. The relative supply and 110 demand for a currency will also impact the currency exchange rates. Strong dollar policies promote the importation of goods and services from abroad, and foreign investment in our domestic enterprises. On the other hand, a weak dollar policy promotes the exportation of goods and services abroad, and U.S. investment overseas. Often, the international aspects of domestic monetary and fiscal policies are less important than political consideration in the U.S. or policy consideration concerning unemployment or inflation. However, one must always remember that lobbyists and special interest groups are quick to point-out to policy makers the advantages and disadvantage of either policy for their constituents back home. The Circular Flow Diagram The circular flow diagram is used to show the interdependence that exists among sectors of the economy. The diagram illustrates that there are several collections of similar economic agents, called sectors. Households provide resources to government and business and consume the outputs of these other sectors. The markets in which land, labor, capital, and entrepreneurial talent are sold are called resource markets. The markets in which the output of business and in some cases government is sold are called product markets. To this point, the circular flow diagram is relatively simple. However, when a foreign sector or substantial governmental sector is added it becomes more complicated. It is not unusual for a modern economy to have substantial participation in both the product and resource markets from both foreigners and governments (somet
imes even foreign governments). Consider a relatively simple open-economy, trade and foreign investment occurs. The following diagram illustrates this relatively simple economic system. The interdependence in the sectors is represented by the flows in both the resource and factor markets. Resources flow from household to both the government and businesses. Private goods and services flow from the businesses to households and government, and public goods and services flow from the government to both households and businesses. The triangle representing these domestic sectors rests on a foundation called the foreign sector. Foreign households, business, and even governments (in limited ways) participate in the flows that would otherwise have been purely domestic if the economy was a closed economy. 111 _____________________________________________________________________ _____________________________________________________________________ FOREIGN SECTOR As can be easily observed the government provides public goods and services to both businesses and households and receives resources and private goods and services in return; the business sector sells commodities to households and households provide resources to businesses. This is the nature of interdependence. 112 KEY CONCEPTS Capitalist Ideology Freedom of Enterprise Self-Interest Competition Markets and Prices Limited Role for Government Market System Characteristics Division and Specialization of Labor Capital Goods Comparative Advantage Barter Coincidence of Wants Functions of Money Medium of exchange Store of Value Measure of Worth Foreign Exchange Balance of Payment Current Account Capital Account Exchange Rates Imports and Exports Foreign Investment Circular Flow Diagram Interdependence Sectors Foreign Sector 113 STUDY GUIDE Critically evaluate capitalist ideology? How does this differ from market characteristics? Explain. Explain the role of money in a modern economic system. Does this simplify or complicate matters? Explain. Develop the traditional circular flow diagram and illustrate the interdependence between the sectors. Add the government and the foreign sectors, how does this complicate matters? Explain. The following two commodities are produced by Tennessee and Kentucky: Sour Mash Whiskey Bourbon Tennessee 5,000 Kentucky 500 500 10,000 Assuming free trade and that each state wishes to consume as much of each commodity as possible, what will each state produce? What will the terms of trade be? Explain the role of currency exchange rates in international trade. What cause these exchange rates to change? Sample Questions: Multiple Choice: 114 Which of the following is not a function of money? A. Store of value B. Measure of worth C. Medium of exchange D. All of the above are functions of money Barter is a system that historically existed since the beginnings of time. Why has barter been displaced by more modern systems? A. Coincidence of wants makes exchange complicated B. Coincidence of wants no longer exists in the world’s economy C. Gold and silver are now in plentiful supply so that money can be used D. None of the above If the dollar gains value with respect to the Euro what would we expect to observe? A. U.S. imports increase, foreign investment in the U.S. increases B. U.S. exports decrease, foreign investment in the U.S. decreases C. U.S. imports decrease, U.S. investment abroad increases D. None of the above True - False The circular flow model demonstrates that there is interdependence between the sectors but does not identify how the sectors are interdependent. {FALSE} Comparative advantage derives from having an ability to produce some commodity at a lower cost than a potential trading partner. {TRUE} The majority of the countries in the world are high income, developed countries. {FALSE} 115 CHAPTER 4 The Basics of Supply and Demand The purpose of this chapter is to develop one of the most powerful methods of analysis in the economist's tool kit. In this chapter we will develop the model of a simple market – supply and demand (the industry in pure competition – discussed further in Chapter 8). The demand schedule and supply schedule will be developed and put together to form the analysis of a market. The market presented here is the starting point for the analysis of all market structures. Markets A market is nothing more or less than the locus of exchange, it is not necessarily a place, but simply buyers and sellers coming together for transactions. Transactions occur because consumers and suppliers are able to purchase and sell at a price that is determined through the free interaction of demand and supply. Adam Smith, in the Wealth of Nations, described markets as almost mystical things. He wrote that the interaction of supply and demand "as though moved by an invisible hand" would determine the price and the quantity of a good exchanged. In fact, there is nothing mystical about markets. If competitive, a market will always satisfy those consumers willing and able to pay the market price and provide suppliers with the opportunity to sell their wares at the market price. To understand the market, one need only understand the ideas of supply and demand and how they interact. Demand The law of demand is a principle of economics because it has been consistently observed and predicts consumers’ behavior accurately. The law of demand states that as price increases (decreases) consumers will purchase less (more) of the specific commodity, ceteris paribus. In other words, there is an inverse relationship between the quantity demanded and the price of a particular commodity. This law of demand is a general rule. Most people behave this way, they buy more the lower the price. However, everyone knows of a specific individual who may not behave as predicted by the law of demand, but remember the fallacy of composition -- because an individual or small group behaves contrary to the law of demand does not negate it. 116 The demand schedule (demand curve) reflects the law of demand. The demand curve is a downward sloping function (reflecting the inverse relationship of price to quantity demanded) and is a schedule of the quantity demanded at each and every price. Price P1 P2 Demand Q1 Q2 Quantity As price falls from P1 to P2 the quantity demanded increases from Q1 to Q2. This is a negative relation between price and quantity, hence the negative slope of the demand schedule; as predicted by the law of demand. Consumers obtain utility (use, pleasure, jollies) from the consumption of commodities. Economists have long recognized that past some point, the consumption of additional units of a commodity bring consumers less and less utility. The change in utility derived from the consumption of one more unit of a commodity is called marginal utility. The idea that utility with the amount added to total utility will decline when additional units are consumed past some point has also the status of principle. This principle is called diminishing marginal utility. Because consumers make rational choices, that is they act in their own self interest, there are two effects that follow from their attempts to maximize their well-being when the price of a commodity changes. These two effects are called the; (1) income effect, and (2) the substitution effect. Together these effects guarantee a downward sloping demand curve. The income effect is the fact that as a person's income increases (or the price of item goes down [which effectively increases command over goods] more of everything will be demanded. The income effect suggest that as income goes down (price increases) then less of the commodity will be purchased. 117 The substitution effect is the fact that as the price of a commodity increases, consumers will buy less of it and more of other commodities. In other words, a consumer will attempt to substitute other goods for the commodity that became more expensive. The substitution effect simply reinforces the idea of a downward sloping demand curve. The demand schedule can be expressed as a table of price and quantity data, a series of equations, or in a downward sloping graph. To this point, our discussion has focused on individuals and their behavior. Assuming that at least a significant majority of consumers are rational, it is a simple matter to obtain a market demand curve. One needs only to sum all of the quantities demanded by individuals at each price to obtain the market demand curve. Changes in the price of a commodity causes movements along the demand curve; such movements are called changes in the quantity demanded. If price decreases, then we move down and to the right along the demand curve; this is an increase in the quantity demanded. If price increases, then we move upward and to left along the demand curve, this is a decrease in the quantity demanded. Remember, (it is important) such changes are called changes in the quantity demanded because the demand curve is a schedule of the quantities demanded at each price. Movements of the demand curve itself, either to the left or right are called changes in demand. A change in demand is caused by a change in one or more of the nonprice determinants of demand. A shift to the right of the demand curve is called an increase in demand; and a shift to the left of the demand curve is called a decrease in demand. The nonprice determinants of demand are; (1) tastes and preferences of consumers, (2) the number of consumers, (3) the money incomes of consumers, (4) the prices of related goods, and (5) consumers' expectations concerning future availability or prices of the commodity. If the tastes and preferences of consumers change they will shift the demand curve. If consumers find a commodity more desirable, ceteris paribus, then an increase in demand will be observed. If consumer tastes wane for a particular product then there will be a shift to the left of the demand (a decrease in demand). An increase i
n the number of consumers or their money income will result in a shift to the right of the demand curve (an increase in demand). A decrease in the number of consumers or their income will result in a shift of the demand curve toward the origin (a decrease in demand). Consumers will also react to expectations concerning future prices and availability. If consumers expect future prices to increase, their present demand curve will shift to the right; if consumers expect prices to fall then we will observe a decrease in current demand. 118 The prices of related commodities also effect the demand curve. There are two classes of related commodities of importance in determining the position of the demand curve, these are (1) substitutes, and (2) complements. A substitute is something that is alternative commodity, i.e., Pepsi is a substitute for Coca-Cola. A complement is something that is required to enjoy the commodity, i.e., gasoline and automobiles. If the price of a substitute increases, then the demand for our commodity will increase. If the price of a substitute decreases, so too will the demand for our commodity. In other words, the price of a substitute and the demand for our commodity move in the same direction. For complements, the price of the complement and the demand for our commodity move in opposite directions. If the price of a complement increases, the demand for our commodity will decrease. If the price of a complement decreases, the demand for our commodity will increase. Increase in Demand Decrease in Demand Price Price D2 D1 Quantity D2 D1 Quantity An increase in demand is shown in the first panel, notice that at each price there is a greater quantity demanded along D2 (the dotted line) than was demanded with D1 (the solid line). The second panel shows a decrease in demand, notice that there is a lower quantity demanded at each price along D2 (the dotted line) than was demanded with D1 (the solid line). 119 Changes in Quantity Demanded Price P1 P2 Demand Q1 Q2 Quantity Movement along a demand curve is called a change in the quantity demanded. Changes in quantities demanded are caused by changes in price. When price decreases from P1 to P2 the quantity demanded increases from Q1 to Q2; when price increases from P2 to P1 the quantity demanded decreases from Q2 to Q1. Supply The law of supply is that producers will supply more the higher the price of the commodity. The supply curve is an upward sloping function showing a direct relationship between prices and the quantity supplied. In other words, the supply curve has a positive slope that shows that as price increase (decreases) so too does quantity supplied. As with the demand curve a change in the price will result in a change in the quantity supplied. An increase in price will result in an increase in the quantity supplied, and a decrease in price will result in a decrease in the quantity supplied. Again, this is because the supply curve is a schedule of the quantities supplied at each price. Changes in one or more of the nonprice determinants of supply cause the supply curve to shift. A shift to the left of the supply curve is called a decrease in supply; a shift to the right is called an increase in supply. The nonprice determinants of supply are; (1) resource prices, (2) technology, (3) taxes and subsidies, (4) prices of other goods, (5) expectations concerning future prices, and (6) the number of sellers. When resource prices increase, supply decreases (shifts left); and when 120 resource prices decrease, supply increases (shifts right). If a more cost effective technology is discovered then supply increases, increases in taxes cause the supply curve to shift left (decrease). An increase in a subsidy effects the supply curve in the same way as a cut in taxes, an increase in supply. If the price of other goods a producer can supply increases, the producer will reallocate resources away from current production (decrease in supply) and to the goods with a higher market price. For example, if the price of corn drops, a farmer will supply more beans. If producers expect future prices to increase, current supply will decline in favor of selling inventories at higher prices later. In other words, supply will decrease (a shift to the left, and exactly the opposite response will occur if producer expect future prices to be lower. If the number of suppliers increases, so too will supply, but if the number of producers declines, so too will supply. Decrease in Supply Increase in Supply Price Price S2 S1 S1 S2 Quantity Quantity A decrease in supply is shown in the first panel, notice that there is a lower quantity supplied at each price with S2 (dotted line) than with S1 (solid line). The second panel shows an increase in supply, notice that there is a larger quantity supplied at each price with S2 (dotted line) than with S1 (solid line). 121 Changes in Quantity Supplied Price Supply P1 P2 Q2 Q1 Quantity Changes in price cause changes in quantity supplied, an increase in price from P2 to P1 causes an increase in the quantity supplied from Q2 to Q1; a decrease in price from P1 to P2 causes a decrease in the quantity supplied from Q1 to Q2. Market Equilibrium Market equilibrium occurs where supply equals demand (supply curve intersects demand curve). An equilibrium implies that there is no force that will cause further changes in price, hence quantity exchanged in the market. This is analogous to a cherry rolling down the side of a glass; the cherry falls due to gravity and rolls past the bottom because of momentum, and continues rolling back and forth past the bottom until all of its' energy is expended and it comes to rest at the bottom - this is equilibrium [a rotten cherry in the bottom of a glass]. 122 Price and Value Principles of Economics, 8th edition (Alfred Marshall, London: Macmillan Publishing Company, 1920, p. 348.) . . . We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production. It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens. The following graphical analysis portrays a market in equilibrium. Where the supply and demand curves intersect, equilibrium price is determined (Pe) and equilibrium quantity is determined (Qe) Price Pe Supply Demand Qe Quantity The graph of a market in equilibrium can also be expressed using a series of equations. Both the demand and supply curve can be expressed as equations. Demand Curve is Qd = 22 - P (Notice the negative sign in front the price variable, indicating a downward sloping function) 123 Supply Curve is Qs = 10 + P (Notice the positive sign in front of the price variable, indicating an upward sloping function) The equilibrium condition is Qd = Qs (For this market to obtain equilibrium, the quantity demanded must equal the quantity supplied in this market) Therefore: 22 - P = 10 + P adding P to both sides of the equation yields: 22 = 10 + 2P subtracting 10 from both sides of the equation yields: 12 = 2P or P = 6 To find the equilibrium quantity, we plug 6 (for P) into either the supply or demand curve and get: 22 - 6 = 16 (Demand side) & 10 + 6 = 16 (Supply side) The system of equations approach to solving for equilibrium gives a specific number for price and for quantity. Unless the numbers are specified along the price axis and the quantity axis, the graph does not yield a specific number for price and quantity. However, the graph provides a visual demonstration of equilibrium which may aid learning. Changes in supply and demand in a market result in new equilibria. The following graphs demonstrate what happens in a market when there are changes in nonprice determinants of supply and demand. 124 Change in Demand Supply Price P1 P2 D2 D1 Q2 Q1 Quantity Movement of the demand curve from D1 (solid line) to D2 (dashed line) is a decrease in demand (as demonstrated in the above graph). Such decreases are caused by a change in a nonprice determinant of demand (for example, the number of consumers in the market declined or the price of a substitute declined). With a decrease in demand there is a shift of the demand curve to the left along the supply curve, therefore both equilibrium price and quantity decline. If we move from D2 to D1 that is called an increase in demand, possibly due to an increase in the price of a substitute good or an increase in the number of consumers in the market. When demand increases both equilibrium price and quantity increase as a result. Considering the following graph, movement of the supply curve from S1 (solid line) to S2 (dashed line) is an increase in supply. Such increases are caused by a change in a nonprice determinant (for example, the number of suppliers in the market increased or the cost of capital decreased). With an increase in supply there is a shift of the supply curve to the right along the demand curve, therefore equilibrium price and quantity move in opposite directions (price decreases, quantity increases). If we move from S2 to S1 that is called an decrease in supply, possibly due to an increase in the price of a productive resource (capital) or the number of suppliers decreased. When supply decreases, equilibrium price increases and the quantity decreases as a result. That is the result of the supply curve moving up along the negatively sloped demand curve (which remains unchanged). 125 Changes in Supply S1 S2 Price P1 P2 Demand Q1 Q2 Quantity If both the demand curve and supply curve change at the same time the analysis becomes more complicated. Consider the following graphs: Increase in Demand Decrease in Supply Decrease in Demand Increase in Supp
ly Price D1 D2 S2 Price S1 P2 P1 P1 P2 S1 S2 D1 D2 Q Quantity Q Quantit Notice that the quantity remains the same in both graphs. Therefore, the change in the equilibrium quantity is indeterminant and its direction and size depends on the relative strength of the changes between supply and demand. In both cases, the equilibrium price changes. In the first case where demand increases, but supply decreases the equilibrium price increases. In the second panel where demand decreases and supply increases, the equilibrium price decreases. In the event that demand and supply both increase then price remains the same 126 (is indeterminant) and quantity increases, and if both decrease then price is indeterminant and quantity decreases. These results are illustrated in the following Price P Increase in Supply and in Demand Decrease in Supply and in Demand diagram s. Price P D1 D2 S2 S1 D2 D1 S2 S1 Q1 Q2 Quantity Q2 Q1 Quantity The graphs show that price remains the same (is indeterminant) but when supply and demand both increase quantity increases to Q2. When both supply and demand decrease quantity decreases to Q2. Shortages and Surpluses There is some rationale for limited government intervention in a free market economy. Perhaps the most powerful rationale for limited government arises from the effects of price controls in competitive markets. Shortages and surpluses can only result because by having some sort of price controls in the market. For example, the Former Soviet Union had a centrally planned economy and the government decided what would be produced and for what price that production would be sold. The government also was the sole employer and paid very low wages, therefore prices were also controlled at below market equilibrium levels. The result was that whenever any commodity was available in the market, there were long lines observed at any store with anything to sell, prices were low but there was nothing to buy (shortages). The popular Russian immigrant comedian, Yakov Simirnov, summed-up the plight of the working class consumer in Russia prior to break-up of the Soviet Union. He said, "In Russia we used to pretend to work, but that was alright, the government only used to pretend to pay us!" 127 Shortage is caused by an effective price ceiling (the maximum price you can charge for the product). Effective, in this sense, means that the government can and does actively enforce the price ceiling. With the exception of the Second World War, there is little evidence that the government can effectively enforce price ceilings. Consider the following diagram that demonstrates the effect of a price ceiling in an otherwise purely competitive industry. SHORTAGE Supply Price Pe Price Ceiling Demand Qs Qe Qd Quantity For a price ceiling to be effective it must be imposed below the competitive equilibrium price. Note that the Qs is below the Qd, which means that there is an excess demand for this commodity that is not being satisfied by suppliers at this artificially low price. The distance between Qs and Qd is called a shortage. It is interesting to consider the last time that wage and price controls were attempted during the Carter administration. These short-lived price ceilings resulted in producers technically complying with the price restrictions, but they frequently changed the product. For example, warranties were no longer included in the sales price, service was extra, delivery was extra, and where possible, the product was reduced in size. For example, in the previous administration’s failed wage and price controls (Nixon) candy bars were made smaller and they put fewer M & Ms in the package and the price for these treats was not changed – effectively cutting costs, but not price, hence increasing the profit margin without raising the price of the candy. The lesson is simple, if government is going to control prices, they must be prepared to control virtually all other aspects of doing business. Surplus is caused by an effective price floor (minimum you can charge): 128 SURPLUS Price Floor Supply Price Pe Demand Qd Qe Qs Quantity For a price floor to be effective it must be above the competitive equilibrium price. Notice that at the floor price Qd is less than Qs, the distance between Qd and Qs is the amount of the surplus. Minimum wages are the best known examples of price floors and will be discussed in greater detail in Chapter 11. Implicit in these analyses is the fact that without government we could have neither shortage or surplus. In large measure, the suspicion of government is because it has the power to create these sorts of peculiar market situations. Even with the power of government to enforce law, the only way that a shortage or surplus could occur is if the price ceiling or the price floor were effective. Markets and Reality As intuitively pleasing as these analyses are, they are only models, and these models are based on assumptions that are not very good approximations of reality. In Chapter 8 the analysis of a purely competitive market is offered. What this chapter presents is the industry in pure competition, which is based on assumptions that do not exist in reality. The assumptions are (1) perfect information about all past, and future prices, (2) no barriers to entry or exit from the market, (3) no non-price competition (advertising etc.), (4) atomized competition (so many suppliers and consumers that none can appreciably affect price or quantity), and (5) there is a standardized product (corn is corn is corn). If all of these assumptions accurately represent reality, then the firm must sell at whatever price is established in the industry. To sell at a lower price denies the firm revenue it could have otherwise earned, and to sell at a higher price would mean the firm could sell nothing. In other words, the competitive industry impose price discipline on all of the firms that together comprise that competitive industry. 129 Part of the controversy in almost any discussion of microeconomic activity is whether the results of policy can be predicted by the simple supply and demand model. Often the results of the simple supply and demand diagram are not bad rough approximations of reality – but remember that it is only a rough approximation – based on assumptions that are not very accurate depictions of reality. However, more often imperfect market models are more accurate approximations of reality – because one or more the assumptions underpinning those models more accurately reflects reality. One must be careful in applying these models, and in policy debates concerning these models. To the extent that the assumptions are not fulfilled, then the results may not be accurate. The real value of the simple supply and demand model is to provide a beginning point for coming to understand how markets really work. In most respects the simple supply and demand model is little more than the beginning point for constructing one of the more realistic market models. Pure monopoly, monopolistic competition and oligopoly are, in some important respects, refinements from the purely competitive market model. KEY CONCEPTS Market Equilibrium Law of Demand Demand schedule Utility Marginal Utility Diminishing Marginal Utility Income Effect Substitution Effect Demand Curve Determinants of Demand Tastes & Preferences Number of Consumers Money Income of Consumers Prices of Related Goods Substitutes Complements Expectations 130 Change in Demand v. Change in Quantity Demanded Price changes v. Non-price determinant changes Law of Supply Supply Schedule Supply Curve Determinants Resource prices Technology Taxes & Subsidies Prices of other goods Number of Sellers Expectations Change in Supply v. Change in Quantity Supplied Price changes v. Non-price determinant changes Shortage and Surplus Price Floor and Price Ceiling STUDY GUIDE Food for Thought: Demonstrate what happens to a market equilibrium when: (1) demand increases, supply increases, (2) demand decreases, supply decreases, (3) demand increases, supply decreases, and (4) demand decreases, and supply increases. Do the same exercise showing only the demand curve increasing and decreasing and only the supply curve increasing or decreasing. Demonstrate the effects of a price floor: (1) above the competitive equilibrium, and (2) below the competitive equilibrium. 131 Repeat exercise 2, using a price ceiling. Using the system: Qd = Qs, where Qd = 124 - 4P and Qs = -16 + 3P What is the equilibrium price and quantity exchanged in this market? What would happen if there were a price floor of 6 imposed in this market? If 6 was a price ceiling would that change your answer? If so, how and why? Sample Questions: Multiple Choice: If a minimum wage were imposed below the competitive equilibrium what would we expect to observe in the effected labor markets? A. An excess demand for labor B. People being attracted by the higher wage cannot find jobs and some who were employed will lose their jobs, but those remaining employed will have a higher wage C. There will be unemployment created by people losing jobs, but there will be no new employees attracted to this labor market. D. Nothing will be caused by the introduction of this minimum wage If there is an increase in demand and an increase in the quantity supplied in a product market what should be observed? A. Price increases, quantity exchanged is indeterminant B. Price decreases, quantity exchanged is indeterminant C. Price decreases, quantity exchanged decreases D. Price increases, quantity exchanged increases 132 True - False If the price of Pepsi-Cola increases we should expect the demand for Coca-Cola increase, ceteris paribus. {TRUE} If consumers expect the price of computers to increase in the near future there should be an increase in the quantity demanded observed. {FALSE} 133 CHAPTER 5 Supply & Demand: Elasticities The purpose of this chapter is to extend the supply and demand analysis presented in the prev
ious chapter. Specifically, this chapter will develop the methods employed by economists to measure consumer responsiveness to price changes -- the price elasticity of demand. Other topics examined in this chapter are the price elasticity of supply, cross-elasticities, the income elasticity of demand and the interest elasticity of demand. Price Elasticity of Demand The price elasticity of demand is how economists measure the responsiveness of consumers to changes in prices for a commodity. In other words, as price increases (decreases), the quantity demanded by consumers will decrease (increase). The relative proportions of the changes in price and the respective quantities demanded are the responses of consumers and are referred to as the price elasticity of demand. It is this consumer responsiveness that is the subject of this chapter. Business decisions concerning prices are not always a simple matter of adding some margin to the cost of production of the commodity (cost-plus pricing). Suppliers will wish to obtain the most revenue the market will bear from the sales of their products – in other words, maximize their profits. It is therefore necessary for business to have some idea of what the market will bear, and that is where the price elasticity of demand enters the picture in business decision-making. There are three methods that are used to measure the price elasticity of demand, these are; (1) the price elasticity coefficient (midpoints formula), (2) the total revenue test, and (3) a simple examination of the demand curve. Each of these will be examined in turn, in the following paragraphs. Elasticity Coefficient The elasticity coefficient is a number calculated using price and quantity data to determine how responsive consumers are to changes in the price of a commodity. The elasticity coefficient may be calculated in two distinct ways. Point elasticity is 134 measuring responsiveness at a specific point along a demand curve. The other method is using the mid-point of the difference in the price and the mid-point in the difference of the quantity numbers. Because the midpoints formula cuts down on the confusion of which prices and quantities are to be used, it is the only coefficient we will use in this course. The price elasticity coefficient (midpoints) is calculated using the midpoints formula: Ed = Change in Qty ÷ Change in price (Q1 + Q2)/2 (P1 + P2)/2 Calculating the elasticity coefficient will yield a specific number. The value of that number provides the answer as to whether demand is price elastic or price inelastic. Elastic demand means that the consumers' quantities demanded respond (more than proportionately) to changes in price; with elastic demand the coefficient is more than one. Inelastic demand means that the consumers' quantities demanded do not respond very much to changes in price; with inelastic demand the coefficient is less than one. Unit elastic demand means that the consumers' quantity demanded respond proportionately to change in price; with unit elastic demand the coefficient is exactly one. What this equation states is illustrated in the graph below. The midpoint between price one (P1) and price two (P2) is labeled Midpoint along the price axis and M on the quantity axis. Price P1 Midpoint P2 Demand Quantity Q1 M Q2 135 On the graph this number is the difference between Q1 and Q2 divided by the distance between the origin and the point labeled M on the quantity axis for the numerator and the difference between P1 and P2 divided the distance between the origin and the point labeled midpoint on the price axis for denominator. The ratio of the numerator to the denominator on this graph is the same number yielded by the equation. Examining the demand curve can also provide clues concerning the price elasticity of demand. A perfectly vertical demand curve indicates that the quantity demanded will be exactly the same, regardless of price. This type of demand curve is called a perfectly inelastic demand curve. A perfectly horizontal demand curve indicates that consumers will have almost any quantity demanded, but only at that price. This is called a perfectly elastic demand curve. Perfectly unit elastic demand curves are not linear, they have slopes that vary across ranges. Perfectly elastic demand Perfectly inelastic demand Price Price Demand Demand Quantity Quantity Perfectly Elastic and Perfectly Inelastic Demand Curves There is a trick to remembering inelastic and elastic demand. Notice in the above graphs that the perfectly elastic demand curve is horizontal, (add one more horizontal line at the top of the price axis and it will look like an E). The perfectly inelastic demand curve is vertical (looks like an I). If you have problems remembering the concept of inelastic or elastic demand you need only draw the curves above and observe what happens to the quantity demanded when the price changes. In the case of perfectly inelastic demand consumers will buy exactly the same quantity of a product without regard for its price. In the case of a perfectly elastic demand curve, if producers raise the price of the product, then they will sell nothing. Slope and elasticity are two different concepts. With linear demand curves, elasticity changes along the demand curve, however its slope does not. Elasticity is 136 concerned with responses in one variable to changes in the other variable. The slope of the curve is concerned with values of the respective variables at each position along the curve (i.e., its' shape and direction). Demand Curve and Total Revenue (total revenue = P x Q) Curve Price Elastic Total Revenue t i n U Inelastic Demand Quantity Total Revenue Quantity The total revenue curve in the bottom graph is plotted by multiplying price and quantity to obtain total revenue and then plotting total revenue against quantity. In examining the above graphs, notice that as total revenue is increasing, demand is elastic. When the total revenue curve flattens-out at the top then demand becomes unit elastic, and when total revenue falls demand is inelastic. In other words, moving from left to right on the demand curve, as price and total revenue move in the opposite direction demand is price elastic, and when price and total revenue move in the same direction demand is price inelastic. The total revenue test uses the relation between the total revenue curve and the demand curve to determine the price elasticity of demand. In general, price and total revenue will move in the same direction of the demand is price inelastic (hence consumers are unresponsive in quantity purchased when price changes) and move in opposite directions if price elastic (consumers’ quantities being responsive to price changes). 137 Consider the following numerical example: _____________________________________________________________________ _____________________________________________________________________ Table 1: Total Revenue Test _____________________________________________________________________ Total Quantity _____________________________________________________________________ Price per unit Total Revenue Elasticity 12 15 16 15 12 7 >+5 >+3 >+ Elastic Elastic Elastic Inelastic Inelastic Inelastic _____________________________________________________________________ _____________________________________________________________________ Marginal revenue is the change in total revenue due to the a change in quantity demanded. The total revenue test relies on changes in total revenue (marginal revenue) to determine elasticity. If the change in total revenue (marginal revenue) is positive the demand is price elastic, if the change in total revenue is negative the demand is price inelastic. If the marginal revenue is exactly zero then demand is unit elastic. The following determinants of the price elasticity of demand will determine how responsive the quantity demanded by consumers is to changes in price. The determinants of the price elasticity of demand are; (1) substitutability of other commodities, (2) the proportion of income spent on the commodity, (3) whether the commodity is a luxury or a necessity, and (4) the amount of time that a consumer can postpone the purchase. If there are no close substitutes then the demand for the commodity will be price inelastic, ceteris paribus. If there are substitutes then consumers can switch their purchasing habits in the case of a price increase, but if there are no substitutes then 138 consumers are more likely to buy even if price goes up. For example, if the price of Pepsi goes up, then certain consumers will buy Coke, if the price of Coke has not increased, hence the demand for Pepsi is likely to be elastic. All other things equal, the higher the proportion of income spent for the commodity more price elastic will be the demand. Most home owners are familiar with how this determinant works. The demand for single family dwellings is likely to be more elastic than the demand for apartments, because a higher proportion of your income will be spent on housing when you own your home. Commodities that are viewed as luxuries typically have price elastic demand, and commodities that are necessities have price inelastic demand. There is simply no substitute for a insulin, if you are an insulin dependent diabetic. Because insulin is a necessity for which there is no substitute, the demand will be price inelastic. Time is an important determinant of price elasticity. If a price changes, it may take consumers a certain amount of time to discover alternative lifestyles or commodities to account for the price change. For example, if the price of cars increases, a family that planned to buy a car may wait for their income or wealth to increase to make buying a new car viable alternative to continuing to drive an older vehicle. In other words, the longer the time frame for the decision to purchase the more price elastic the demand for the commodity. Price Elasticity of Su
pply The price elasticity of supply measures the responsiveness of suppliers to changes in price. The price elasticity of supply is determined by the following time frames; (1) market period, (2) short-run, and (3) long-run. The more time a producer has to adjust output the more elastic is supply. The time frames for producers will be discussed in more detail in Chapter 7 as they pertain to a firm's cost structure. However, it is important to understand the basic idea behind this classification of time as it relates to price elasticity. The market period is defined to be that period in which the producer can vary nothing, therefore the supply is perfectly inelastic. The long-run is the period in which the producer can vary everything, therefore the supply is perfectly elastic. The short-run is the period in which plant and equipment cannot be varied, but most other factors' usage can be varied, therefore it depends on a producers capital - intensity as to how elastic supply is at any particular point. 139 Other Elasticities There are three other standard applications of the elasticity of demand. The cross elasticity of demand, the income elasticity of demand, and the interest rate elasticity of demand. Each of these will be examined, in turn, in the remaining paragraphs of this chapter. The cross elasticity of demand measures the responsiveness of the quantity demanded of one product to changes in the price of another product. For example, the quantity demanded of Coca-Cola to changes in the price of Pepsi. Cross elasticity of demand gives an indication of how close a substitute or complement one commodity is for another. This concept has substantial practical value in formulating marketing strategies for most products. For example, as the price of coke increases, then consumers may purchase proportionately more Pepsi products. In such a case, the cross elasticity of demand of Pepsi to the price of coke would be termed elastic. The equation for the cross elasticity of demand described here is presented below. Ed = Change in Qty pepsi ÷ Change in price coke (Q1 Pepsi + Q2 Pepsi)/2 (P1 coke + P2 coke)/2 The income elasticity of demand measures the responsiveness of the quantity demanded of a commodity to changes in consumers' incomes. This is typically measured by replacing the price variable with income (economists use the letter Y to denote income) in the midpoints formula. Again, in business planning the responsiveness of consumers to changes in their income may be very important. Housing and automobiles, as well as, several big ticket luxury items have demand that is sensitive to changes in income. The income elasticity formula is presented below. Ed = Change in Qty ÷ Change in income (Q1 + Q2)/2 (Y1 + Y2)/2 Often interest rates will also present a limitation on a consumer’s quantity of demand for a particular commodity. As with income, often big ticket items are very sensitive to interest rates on the loans necessary to make those purchases. With the record low mortgage rates in the Spring of 2003 the quantity demanded for housing, both new and existing homes, witnessed dramatic increases. 140 The automobile companies rarely reduce prices for their vehicles, but rather, GM, Ford and Chrysler will offer incentives. Rebates, which are temporary reductions in price, and attractive financing rates are the hooks offered to get the consumer in the showroom and into the new car. In May of 2003 all of the American producers were offering zero percent financing on all but a very few of their vehicles, and even some of the European and Japanese producers were following suite with either very low rates, or zero percent financing. The interest rate elasticity formula is (where interest rate is “r”): Ed = Change in Qty ÷ Change in interest rate (Q1 + Q2)/2 (r1 + r2)/2 These analyses are important to businesses in determining what issues are important to the successful sales of their products. There are industries that have not been particularly good at understanding the notions of cross elasticity or price elasticity – the airlines in particular, and many of these firms have suffered as a result. The bankruptcies of United Airlines and US Air being excellent examples. The automobile companies have been, in some measure, forced into the financing business because of the interest rate sensitivity of consumers. By offering financing the car companies are, essentially, maintaining some modicum of control over one important aspect of their business. Interest rate sensitivity can also be understood from another perspective. The total cost of a commodity is not just its price, but also what must be paid to borrow money to purchase that item. With modern views of instant gratification, it is rare for someone to save to purchase a house, or any other big ticket item, what is more common is to borrow the money, buy the item, and make installment payments. Therefore the interest charges are a part of the total cost of acquiring that big ticket item – hence consumer sensitivity to interest rates when buying a house or a car. It is also noteworthy, that purely competitive firms are price takers, and it is the imperfectly competitive firm that has a pricing policy. What is often referred to as “pricing power” in the business press, means the ability to take advantage of the price elasticity of demand or one of the other elasticities examined here – hence implying some market structure, hence market power not otherwise identified in the model of pure competition. 141 KEY CONCEPTS Price Elasticity of Demand Elasticity coefficient Elastic Demand Perfectly Elastic Demand Inelastic Demand Perfectly Inelastic Demand Unitary Elasticity Total Revenue Test Price and Total Revenue Marginal Revenue Determinants of Price Elasticity Substitutability Proportion of Income Luxuries v. Necessities Time Elasticity of Supply Time periods Market period Short-run Long-run Cross Elasticity of Demand Income Elasticity Interest Rate Sensitivity Pricing Power 142 STUDY GUIDE Food for Thought: List and explain the determinants of the price elasticity of demand and of supply. What are the income and cross elasticities of demand? Why might they be useful? Explain. 3. Consider the following data: Price Quantity Total Revenue Marginal Revenue 1 2 3 4 5 6 7 8 2000 1900 1750 1550 1250 900 400 100 2000 3800 5250 6200 6250 5400 2800 800 Calculate the marginal revenue for each change in price. Perform a total revenue test and determine the ranges of price elastic and price inelastic demand. Draw the demand curve and the total revenue curve and show these ranges thereon. Using the data in question 3 above calculate the price elasticity coefficient moving from price of 3 to a price of 4; from a price of 5 to a price of 6. 143 Explain what the price elasticity of demand is and why it is of interest in examining markets. Might it be useful in the airline industry? Why? Sample Questions: Multiple Choice: Which of the following is a determinant of the price elasticity of demand? A. Proportion of income spent on commodity B. Price of complements C. Number of consumers D. None of the above Where is the range of unit price elasticity of demand 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 4 Calculate the elasticity coefficient from the data above for the interval where price changes from 8 to 7. That coefficient is: A. 0.47 B. 1.00 C. 2.14 D. None of the above 144 True - False: The longer the period the more suppliers can adjust to price changes, hence the greater the price elasticity of supply. {TRUE} The income elasticity of demand shows whether a product has a close substitute or complement. {FALSE} The maximum point on the total revenue curve correlates with the elastic range of the demand curve. {FALSE} 145 CHAPTER 6 Consumer Behavior The purpose of this chapter is to refine the income and substitution effects introduced in Chapter 4. This chapter will also introduce the idea of Giffin’s Paradox, consumer equilibrium, and the utility maximization rule. The appendix to this chapter also introduces you to indifference curves and budget constraints to analyze consumer behavior. Income and Substitution Effects Revisited The income and substitution effects combine to cause the demand curve to slope downwards as was discussed earlier in Chapter 4. In fact, an individual consumer's demand curve can be rigorously derived using concepts from intermediate microeconomics (E321) called indifference curves which illustrate, graphically, the income and substitution effects. For students who are interested, it is recommended that you take E321, Intermediate Microeconomics; or at a minimum go through the appendix to this chapter. The results of the indifference curve analysis (presented in the appendix to this chapter) can be described in words. The income effect results from the price of a commodity going down having the effect of a consumer having to spend less on that commodity, hence the same as having more resources. However, as price increases, the consumer will purchase less of that commodity and buy more of a substitute, this is the substitution effect. It is the combination of the income and substitution effects, and their relative strength, that causes an individual (hence generally a market) demand curve to slope downward. However, there is an interesting exception to this general rule -- Giffin's Paradox. Giffin's Paradox is the fact that some commodities may have an upward sloping demand curve. Such commodities are called inferior products. (Not necessarily because of quality problems with the product, but because the analysis is inferior -- not generalizable to all commodities). This happens because the income effect results in a lesser demand for a product. (In other words, the income effect overwhelms the substitution effect). There are at least two types of goods th
at often exhibit an upward sloping demand curve. One is necessity for very poor people and the other is one for which a high price creates a snob effect. Each case will be reviewed, in turn, in the following paragraphs. 146 Price P1 P2 Demand with Giffin’s Paradox Quantity In the diagram above notice that as price is decreased from P1 to P2 the quantity demanded decreases, hence snob appeal may go down from the loss of a prestigiously high price – consumers who value the product simply because it is high priced leave the market as the price falls. As price increases from P2 to P1 poor people can’t afford other more luxurious items therefore they have to buy more of the very commodity whose price wrecked their budgets. In the case of poor people who experienced the price of necessity increasing, their limited resources may result in their buying more of the commodity when its price increases. For example, if the price of rice increases in a less developed country, people may buy more of it because of the pressure placed on their budget prevents them from buying beans or fish to go with their rice. To maintain their caloric intake rice will be substituted for the still more expensive beans and fish. The other situation is where a luxury is involved. There is the snob appeal possibility where the higher the price, the more desired the commodity it. Often people will drive expensive cars, simply because of the image it creates. If the car is extremely expensive, i.e., Rolls Royce, the snob effect may be the primary motivation for the purchase. This also works with less expensive commodities. For example, Joy Perfume advertised itself as the world's most expensive to attract consumers that their marketing surveys indicated would respond to the snob effect. 147 Consumer Equilibrium Incentive and Economic Welfare Principles of Economics, 8th ed. (Alfred Marshall, London: Macmillan Publishing Company, 1920, pp. 15-16.) . . . If then we wish to compare even physical gratifications, we must do it not directly, but indirectly by the incentives which they afford to action. If the desires to secure with of two pleasures will induce people in similar circumstances each to do just an hour's extra work, or will induce men in the same rank of life and with the same means each to pay a shilling for it; we they may say that those pleasures are equal for our purposes, because the desires for them are equally strong incentives to action for persons under similar conditions. Rational behavior was defined as economic agents acting in their self interest. It is the idea of rational behavior that permits the rigorous examination of economic activity. Without rationality, our analyses fail to conform with the basic underlying assumption upon which most of economics is based. Consumers (when acting in their own self interest) will generally attempt to maximize their utility, given some fixed level of available resources and income with which to purchase goods and services. The utility maximizing rule is that consumers will balance the utility they receive from the consumption of each good or service against the cost of each commodity they purchase, to arrive at how much of each good they need to maximize their total utility. The algebraic restatement of the rule: MUa/Pa = MUb/Pb = . . . = MUz/Pz When the consumer reaches equilibrium each of the ratios of marginal utility to price will be equal to one. If any single ratio is greater than one, the marginal utility received from the consumption of the good is greater than the price, and this means the consumer has not purchased enough of that good. Therefore the consumer must purchase more of that good (causing price to increase and marginal utility to go down to the point they are equal), where MU > P. If the ratio is less than one, where MU< P, then the consumer has purchased too much of the commodity (price is larger than the marginal utility received from the commodity) and needs to cut back. Whether consciously or not, rationality requires each individual consumer to allocate their resources in such a manner as to meet the restrictions of the above 148 equation that is when the consumer is said to be in equilibrium. In reality, a consumer is always seeking those levels, but because of changing prices and changing preferences, it is understood that the consumer is always seeking, but never quite at equilibrium. APPENDIX TO CHAPTER 6 Utility and Demand Curves The material in this appendix is not subject to testing and will not be included on any of the examinations or quizzes. It is provided simply to demonstrate how an individual demand can be derived. The demand curve is dependent on the individual consumer's tastes and preferences, as was shown in Chapter 5. Therefore we can derive an individual demand curve using what we have learned about utility in this chapter. Individual preferences can be modeled using a model called indifference curve - budget constraint and from this model we can derive an individual demand curve. A consumer's budget constraint is a mapping of the ability to purchase goods and services. We assume that there are two goods and that the budget constraint is linear. The following budget constraint shows the consumer's ability to purchase goods, beer and pizza. Budget Constraint Beer Pizza The consumer is assumed to spend their resources on only beer and pizza. If all resources are spent on beer then the intercept on the beer axis is the amount of beer the consumer can purchase; on the other hand, if all resources are spent on pizza then the intercept on that axis is the amount of pizza that can be had. 149 If the price of pizza doubles then the new budget constraint becomes the dashed line. The slope of the budget constraint is the negative of the relative prices of beer and pizza. An indifference curve is a mapping of a consumer's utility derived from the consumption of two goods, in this case beer and pizza. There are three assumptions necessary to show a consumer's utility with an indifference mapping. These three assumptions are: (1) every point in the positive/positive quadrant is associated with exactly one indifference curve (every place thick), (2) indifference curves do not intersect (an indifference above another shows greater utility unequivocally), and (3) indifference curves are strictly convex toward the origin (bow toward the origin). The following indifference curve shows the consumer's preferences: Beer 2 1 Pizza The dashed line (2) shows a higher level of total satisfaction than does the solid line (1). Along each indifference curve is the mix of beer and pizza that gives the consumer equal total utility. Consumer equilibrium is where the highest indifference curve they can reach is exactly tangent to their budget constraint. Therefore if the price of pizza increases we can identify the price from the slope of the budget constraint and the quantities purchased from the values along the pizza axis and derive and individual demand curve for pizza: 150 Beer 2 1 2 1 Pizza When the price of pizza doubled the budget constraint rotated from the solid line to the dotted line and instead of the highest indifference curve being curve 1, the best the consumer can do is the indifference curve labeled 2. Deriving the individual demand curve is relatively simple. The price of pizza (with respect to beer) is given by the (-1) times slope of the budget constraint. The lower price with the solid line budget constraint results in the level the higher level of pizza being purchased (labeled 1for the indifference curve - not the units of pizza). When the price increased the quantity demanded of pizza fell to the levels associated with budget constraint 2. Price P2 P1 Quantity Q2 Q1 Notice that Q2 and P2 are associated with indifference curve 2 and budget constraint 2, and that Q1 and P1 result from indifference curve 1 and budget constraint 1. The above model shows this individual consumer's demand for pizza. 151 KEY CONCEPTS Revealed preference Utility Budget Constraint Indifference Curves Income Effect Substitution Effect Giffin’s Paradox, Inferior goods Consumer Equilibrium STUDY GUIDE Food for Thought: What is utility and diminishing marginal utility? Explain. In detail, explain the utility maximization rule? Critically evaluate this concept. How is a market demand curve derived? What does this have to do with indifference curves and budget constraints? 152 Sample Questions: Multiple Choice: Which of the following describes the utility maximization rule? (where MU is marginal utility and P is price) A. MUa/Pa = MUb/Pb = . . . = MUz/Pz B. Total MU = Total P C. MUa = MUb = . . . = MUz D. None of the above describe the rule True - False: The law of diminishing marginal utility states that total utility will become negative as more units of a commodity are consumed. {FALSE} Typically, the income and substitution effects combine to cause a downward sloping demand curve. {TRUE} 153 CHAPTER 7 Costs of Production The purpose of this chapter is to examine the production costs of a firm. The first section develops the economic concepts of production necessary for understanding the cost structure of a firm. The second section presents the models of short-run costs. The final section develops the long-run average total cost curve and discusses its implications for the strategic management of a business. Production and Costs The reason that an entrepreneur assumes the risk of starting a business is to earn profits. The fundamental assumption in the theory of production is that a rational owner of a business will seek to maximize the profits (or minimize the losses) from the operation of his business. However, before anything can be said about profits we must first understand costs and revenues. This chapter will develop the basic concepts of production costs. An economist's view of costs includes both explicit and implicit costs. Explicit costs are accounting costs, and im
plicit costs are the opportunity costs of an allocation of resources (i.e., business decisions). Accountants subtract total cost from total revenue and arrive a total accounting profits. An economist, however, would include in the total costs of the firm the profits that could have been made in the next best business opportunity (e.g., the opportunity cost). Therefore, there is a significant difference in how accountants' and economists' view profits B economic profits versus accounting profits. For the purposes of economic analysis, a normal profit includes the cost of the lost opportunity of the next best alternative allocation of the firm=s resources. In a purely competitive world, a business should be able to cover their costs of production and the opportunity cost of the next best alternative (and nothing more in the long-run). In an accounting sense there is no benchmark to determine whether the resource allocation was wise. Instead various financial ratios are used to determine how the firm has done with respect to similarly situated companies. 154 Time Periods Revisited As was discussed briefly in the section of elasticity of supply in Chapter 5, time periods for economic analysis are defined by the types of costs observed. These time periods differ from industry to industry, and will differ by the technology employed between firms. Again, these time periods are; (1) the market period, (2) the short-run, and (3) the long-run. In the market period, all costs are fixed costs (nothing can be varied). In the short-run, there are both fixed and variable costs observed. Generally, plant, equipment, and technology are fixed, and things like labor, electricity, and materials can still be varied. In the long-run everything is variable. That is, the plant, equipment, and even the business into which you put productive assets can all be changed. In the long-run, even the country in which the business is located can be changed. Because everything is fixed in the market period, this period is of little interest in economic analysis. Therefore, economists typically begin their analysis of costs with the short-run and proceed to examine the operation of the firm and the industry. The long-run is of interest because it is also the planning horizon for the business. Production Another view of the short-run cost structure is that fixed costs are those that must be paid whether the firm produces anything or not. Variable costs are called variable because they increase or decrease with the level of production. Therefore to understand short-run costs, you must first understand production. Total product or total output is the total number of units of production obtained from the productive resources employed. Average product is total product divided by the number of units of the variable factor employed. Marginal product is the change in total product associated with a change in units of a variable factor of production. As a firm increases its output it normally makes more efficient use of its available capital. However, with a fixed level of available capital as variable factors are added to the production process, there is a point where the increases in total output begin to diminish. The law of diminishing returns is the fact that as you add variable factors of production to a fixed factor, at some point, the increases in total output begin to become smaller. In fact, it is possible, at some point, that further additions in the units variable factors to a fixed level of capital could actually reduce the total output of the firm. This is called the uneconomic range of production. In reality, most firms come to realize that their total additions to total output diminish, long before they begin to experience negative returns to additions to their workforce or other variable factors. 155 The following diagram provides a graphical presentation of total, average, and marginal products for a hypothetical firm. The top graph shows total product. After total product reaches its maximum marginal product where marginal product changes from positive to negative (first derivative is zero, second derivative is negative). When the total product curve reaches its maximum, increased output results in negative marginal product. The maximum on the marginal product curve is also associated with the first inflection point (the acceleration or where the curve becomes steeper) on the total product curve. The ranges of marginal returns are identified on the above graphs. The beginning point in developing the cost structure of a firm is to examine total costs in the short run. Total costs (TC) are equal to variable costs (VC) plus fixed costs (FC). TC = VC + FC Variable costs are those costs that can be varied in the short-run, i.e., the cost of hiring labor. Fixed costs are those costs that cannot be varied in the short-run, i.e., plant (interest). Therefore, total costs consist of a fixed component and a variable component. These relations are presented in a graphical form in the following diagram: 156 The fixed cost curve is a horizontal line. These costs are illustrated with a horizontal line because they do not vary with quantity of output. The variable cost curve has a positive slope because it varies with output. Notice that the total cost curve has the same shape as the variable cost curve, but is above the variable cost curve by a distance equal to the amount of the fixed cost. This is because we added fixed cost (the horizontal line) to variable cost (the positively sloped line). From the total, variable and fixed cost curves we can obtain other relations. These are the marginal cost, and the total, variable, and fixed costs relation to various levels of output (averages). Average total cost (ATC) is total cost (TC) divided by quantity of output (Q), average variable cost (AVC) is variable cost (VC) divided by quantity of output (Q), and average fixed cost (AFC) is fixed cost (FC) divided by quantity of output (Q). Marginal cost (MC) is the change (denoted by the Greek symbol delta), in total cost (TC) divided by the change in the quantity of output (Q). 157 These relations are presented in equation form below: ATC = TC/Q AVC = VC/Q AFC = FC/Q MC = ÎTC/ÎQ; where Î stands for change in. The following diagram presents the average costs and marginal cost curve in graphical form. Please notice that the average fixed cost approaches zero 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 pea
k 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 ind
ustry 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 STUDY 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 de
mand). 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 b
een 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 co
st 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 equil
ibrium 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 eff
iciency 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 Affai
rs, 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 communi
ty 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 ele
ments 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 Deposits 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 el
ectricity? 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 so
up 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 sho
ws 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 whi
ch 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 iss
ue 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 whomever they want. Producers decide what goods or services they will offer. They make choices about how to use their limited resources to earn the most money possible. In a market economy, then, individuals act in their own self-interest when they make economic choices. However, as they seek to serve their own interests, they benefit others. As a consumer, you choose to buy the products that best meet your wants. However, this benefits the producers who make those products, because they earn money from your purchases. As Adam Smith noted in The Wealth of Nations (1776), when you make economic decisions you act in your self-interest, but you are “led by an invisible hand” to promote the interests of others. AP P LI CATION Applying Economic Concepts A. How might economic activities within a family with adults, teenagers, and young children represent aspects of traditional, command, and market economies? QUICK REFERENCE A command economy is an economic system in which the government makes all economic decisions. A market economy is an economic system in which individual choice and voluntary exchange direct economic decisions. Find an update on issues in a market economy at ClassZone.com Economic Systems 39 Characteristics of Traditional Economies KEY CONCEPT S In the earliest times, all societies had traditional economies. Such systems serve the main purpose of traditional societies—survival—very well. The traditional economic system, however, tends to be inefficient and does not adapt to change. TRAIT 1 Advantages and Disadvantages The one great advantage of a traditional economy is that it so clearly answers the three economic questions. A traditional society produces what best ensures its survival. The methods of production are the same as they have always been. Systems of distribution are also determined by custom and tradition. In a traditional economy, then, there is little disagreement over economic goals and roles. Traditional economies have several major disadvantages, too. Because they are based on ritual and custom, traditional economies resist change. Therefore, they are less productive than they might be if they adopted new approaches. Further, while traditionally defined roles eliminate conflict, they also prevent people from doing the jobs they want to do or are best suited to do. People who are in the “wrong” jobs are less productive. The lower productivity in traditional economies means that people do not acquire the material wealth that people in other societies do. As a result, people in traditional economies have a much lower standard of living. Forces of Change The use of the cell phone has brought changes to many traditional African societies. TRAIT 2 Under Pressure to Change Around the world, traditional economies are under pressure
from the forces of change. The Kavango people of Namibia in southern Africa, for example, have lived as subsistence farmers for centuries. (Subsistence farmers grow just enough to feed their own families.) Modern telecommunications, however, have bombarded the Kavango with images of the world beyond their homeland. As a result, many young Kavango want something more than the life of subsistence farming. Thousands have left their homeland for the cities. Even the old ways of farming are beginning to change. The vast majority of the Kavango people still make a living from subsistence farming. However, a few have turned to commercial farming, where they grow crops not for their own use, but for sale. APPLICATION Making Inferences B. There are no pure traditional economies today. Why do you think this is so? 40 Chapter 2 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Demonstrate your understanding of the following terms by using each one in a sentence. a. traditional economy b. command economy c. market economy 2. Which is more important in a traditional economy, accumulating individual wealth or honoring tradition? Explain your answer. 3. How are economic decisions made in a command economy? 4. What drives the choices of consumers and producers in a market economy? 5. Does Adam Smith’s “invisible hand” also function in traditional and command economies? Explain your answer. 6. Using Your Notes What do the three kinds of economic systems have in common? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com traditional economy economic system . Drawing Conclusions How might strongly defined economic roles and goals be both a strength and a weakness of traditional economies? 8. Analyzing Cause and Effect What effect might mass media have on the erosion of traditional economies in today’s world? 9. Generalizing from Economic Information You have the following information about an economy: 1) People have little choice in the kinds of jobs they do. 2) Producers are not free to use resources as they wish. 3) People have little, if any, say in how the basic economic questions are answered. What kind of economy might this be? Explain your answer. 10. Challenge Most modern economies are a mixture of the three economic systems described in Section 1. Identify elements of traditional, command, and market economic systems in the American economy. (You will learn more about mixed economies in Section 4.) Market economy in action in Mexico Identifying Economic Systems The three economic systems may be identified by the way they answer the basic economic questions: What to produce? How to produce? For whom to produce? Complete a Table Copy the table below. Complete it by noting how each of the three economic systems answers the basic economic questions. Economic System Answers to the Basic Economic Questions Traditional economy Command economy Market economy Challenge Identify modern countries that have economies that closely resemble each of the three economic systems. Explain each of your choices. Economic Systems 41 S E C T I O N 2 Command Economies TA K I N G N O T E S In Section 2, you will centrally planned economy, p. 42 • describe the main features of a socialism, p. 43 communism, p. 43 authoritarian, p. 43 command economy • note how socialism and communism differ • identify modern examples of command economies • explain the advantages and disadvantages of a command economy As you read Section 2, complete a hierarchy chart to categorize information about command economic systems. Use the Graphic Organizer at Interactive Review @ ClassZone.com Command Economies government controls command economies today Government Controls KEY CONCEPT S QUICK REFERENCE A centrally planned economy is a system in which central government officials make all economic decisions. In command economies, leaders decide what should be produced and how it should be produced. They also decide for whom it should be produced, in part by setting wages. By determining who earns the highest wages and who the lowest, these leaders decide who has the money to buy available products. A system in which the society’s leaders, usually members of the central government, make all economic decisions is called a centrally planned economy. EXAMPLE Government Planning Think for a moment about how the federal government affects you. If you work, you have to pay taxes. If you’re 18 years old and male, you have to register with the Selective Service System. State and local governments exert somewhat more control over your day-to-day life. State laws set both speed limits and the age at which people can drive. Local laws set standards for cleanliness in food stores and restaurants and for honest business practices. And state and local taxes are collected to support such services as police and fire departments and public education. However, what if the government went further? Suppose that bureaucrats in a government office in Washington, D.C., had the power to decide which businesses could operate in your city. Further, these bureaucrats decided not only what these businesses should produce, but also how much each business should produce each month. Finally, they also decided who could have jobs and set work hours and pay scales for workers. Government controls of this type are a feature of a command, or centrally planned, economy. 42 Chapter 2 E XAMPLE Socialism and Communism Modern societies that have adopted command economies have done so largely because of the influence of Karl Marx, a 19th-century German philosopher, historian, and economist. According to Marx’s analysis, all of history is a struggle between classes. In his own time, the struggle was between the owners of the great industrial factories and the workers who exchanged their labor for wages. While the industrialists grew rich, the workers remained relatively poor. Marx predicted that in time the workers would overthrow this system and transfer ownership of the factories to public hands. With the means of production owned by the government, the class struggle would be resolved and all citizens would share in the wealth. F I G U R E 2 .1 Comparing Economic Systems Communism Socialism Market System Who owns resources? Government Government owns basic resources; the rest are privately owned All resources privately owned How are resources allocated? Government planners decide how resources are used What role does government play? Government makes all economic decisions Government planners allocate basic resources; market forces allocate privately-owned resources Market forces allocate resources Government makes decisions in the basic industries Government’s role limited—mostly to ensure market forces are free to work ANALYZE TABLES Government involvement varies among economic systems. How do communist systems answer the three basic economic questions? Socialism, an economic system in which the government owns some or all of the factors of production, developed from the ideas of Marx. Communism, a more extreme form of socialism in which there is no private ownership of property and little or no political freedom, also grew out of Marx’s thinking. Essentially, it is authoritarian socialism. An authoritarian system requires absolute obedience to authority. Figure 2.1 lists the major characteristics of socialism and communism. Democratic socialism is established through the democratic political process rather than through the violent overthrow of the government. In this form of socialism, the government owns the basic industries, but other industries are privately owned. Central planners make decisions for government-owned industries. Central planners might also control other sectors—health care, for example—to ensure that everyone has access to these important services. AP P LI CATION Comparing and Contrasting A. How are socialism and communism similar yet different? QUICK REFERENCE Socialism is an economic system in which the government owns some or all of the factors of production. Communism is an economic system in which the government owns all the factors of production and there is little or no political freedom. Authoritarian systems require absolute obedience to those in power. Economic Systems 43 ECO N O M I C S PAC ES E T T E R Karl Marx: Economic Revolutionary Millions of lives were affected by the work of Karl Marx. Governments were toppled and new political alliances were forged on the strength of his arguments. What was it in the thousands of difficult-to-read pages he wrote that fueled revolutions? FAST FACTS A New View of Economics Marx was born in what is now Germany in 1818 and grew up in middle-class comfort. In college, however, he became involved in radical politics. In time, his political activism led to his exile from his homeland. He moved from country to country, eventually settling in London. During his travels, he met Friedrich Engels, the son of a factory owner. Through Engels, Marx became aware of the struggles of the working class and he undertook a deep study of economics. He concluded that the Industrial Revolution had created a system of wage slavery. Factory owners, Marx said, looked upon labor as just another commodity that could be bought. They then used this labor to convert other productive resources into products. The factory owners made a profit by selling products at a higher price than the cost of labor and other resources. By keeping wages low, they could make ever greater profits. The whole industrial system, Marx reasoned, was based on this exploitation of workers. Communism Marx’s writings influenced revolutionary leaders such as V. I. Lenin in Russia and Mao Zedong in China. To Marx, rising tension between worker and owner was an inevitable development in economic history. Over time, more and more wealth would be concentrated in fewer and fewer hands, and dissatisfied workers would revolt and create a new
society without economic classes. Marx, assisted by Engels, laid out these ideas in The Communist Manifesto (1848). Marx discussed his economic ideas more fully in his enormous study Das Kapital, which was published in three volumes between 1867 and 1894. Because of the way that communist economies worked in practice and the eventual collapse of communism in the early 1990s, Marx’s theories have fallen into disfavor. Even so, few people had more impact on 20th-century economic and political thinking than Karl Marx. APPLICATION Drawing Conclusions B. What did Marx think was the logical outcome of the struggle between owners and workers? Karl Marx German philosopher, historian, and economist Born: May 5, 1818 Died: March 14, 1883 Major Accomplishment: Detailed analysis of capitalism and foundation for socialist economic theory Famous Quotation: Workers of the world unite; you have nothing to lose but your chains. Influenced: Russian Revolution, 1917 Chinese Revolution, 1949 Learn more about Karl Marx at ClassZone.com 44 Chapter 2 Command Economies Today KEY C ONCEPT S There are no examples of pure command economies today. The forces that have brought changes to traditional economies are also transforming command economies. However, some countries—North Korea, for example—still have economies with mostly command elements. North Korea Once under the control of China and later Japan, Korea was split into North Korea and South Korea following World War II. North Korea came under communist control. The government controlled every economic decision. For example, it diverted many of the country’s resources to the military, building up an army of more than 1 million soldiers—out of a population of about 22 million. It also developed a nuclear weapons program. However, this military buildup came at the expense of necessities. During the late 1990s and early 2000s, food was so scarce that millions of North Koreans died from hunger and malnutrition. Many North Koreans survived only because of food aid from other countries, most notably South Korea. The failure to provide food and other important products was just one result of a flawed economic plan. For much of the 1990s, North Korea produced less and less each year, and its economy actually shrank. (See Figure 2.2 below.) In 2003, however, central planners relaxed some restrictions on private ownership and market activity. North Koreans hoped that this experiment with free markets would revive the country’s ailing economy. (For more information on North Korea’s economy, see the Case Study on pages 64–65.) FIGURE 2.2 NORTH KOREA: ECONOMIC GROWTH 8 6 4 2 0 -2 -4 -6 - North Korea had a negative growth rate for much of the 1990s. (The red line on the graph marks 0 percent, or no growth.) The average yearly growth rate for all economies during this time period was about 3 percent. 1990 1995 2000 2005 Source: United Nations Year ANALYZE GRAPHS 1. The North Korean economy began to show positive growth after 1999. To what might this development be attributed? 2. During the 1990s, some newspaper reports noted that the North Korean economy was “shrinking.” How is this shown in the graph? Economic Systems 45 Meeting Demand (Left) In communist East Germany, government planners’ decisions left this butcher with just one goose to sell. (Right) In West Germany, a market economy, store shelves were laden with consumer goods. Impact of Command Economies In theory, command economies have some advantages. For example, they seek to provide for everyone, even the sick and the old who are no longer productive economically. Also, leaders in a command economy can use the nation’s resources to produce items that may not make money in a market economy—certain medicines, for example. In practice, however, the disadvantages of command economies are abundantly clear. To begin with, central planners often have little understanding of local conditions. Because of this, their economic decisions are frequently misguided or wrong. Also, workers often have little motive to improve their productivity, since they know they will be paid the same wages regardless of their output. And because there is no private property, there is no motivation for workers to use resources wisely. Centrally planned economies often set prices well below those that would be established in a market system. As a result, command economies face shortages. One scene repeated in many command economies is people standing in long lines waiting to buy goods. Such shortages often lead to creative behavior. In the former Soviet Union, for example, light bulbs were almost impossible to buy for home use. However, burned-out bulbs in factories were regularly replaced. Some people took and sold these burned-out bulbs. Why? Other people would buy them and use them to switch out with working bulbs in their factories. They then took the working bulbs to light their homes. Perhaps the greatest failing of strict command systems is the great suffering that people living under them endured. Carrying out centrally planned economic policies requires that individual rights—even the right to life—be subordinate to the needs of the state. Millions of people died in the efforts to build huge collective farms in China and the Soviet Union. Millions more were imprisoned for exercising their political or economic rights. Estimates suggest that the deeply flawed policies of command economies are responsible for more deaths than two world wars. APPLICATION Applying Economic Concepts C. Why are consumer goods often in short supply in a command economy? 46 Chapter 2 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Write a brief paragraph explaining the links between the following three terms. a. centrally planned b. socialism c. communism economy 2. Why do communist countries use authoritarian methods to maintain their economic and political system? 3. List and describe some advantages of centrally planned economies. 4. What are some disadvantages of centrally planned economies? 5. What is the relationship between the individual and the state in a communist nation? 6. Using Your Notes Write a sentence that makes a generalization about the nature of command economies. Refer to your completed hierarchy chart to complete this question. command economies government controls command economies today Use the Graphic Organizer at Interactive Review @ ClassZone.com . Making Inferences Look again at the sentences about Thomas More’s Utopia on page 38. Do you think that Karl Marx, like Thomas More, was trying to imagine a utopia in his writings? Give reasons for your answer. 8. Explaining an Economic Concept How do command societies address the problem of scarcity? Illustrate your answer with examples. 9. Analyzing Cause and Effect Read again the information about the North Korean economy on page 45. What factors caused North Korea’s serious economic problems? What steps has the North Korean government taken to improve the dire economic situation? 10. Challenge Adam Smith used the “invisible hand” as a metaphor for the forces that balance a free market. What might be a good metaphor for the forces at work in a command economy? Explain your answer. Celebration of communism in the Soviet Union Using Graphs Presenting information in a graph shows economic changes more clearly. Create a Graph Use the following data to create a line graph. Household Expenditures in the Soviet Union ($) 1979 1981 1983 1985 1987 1989 825.2 million 934.7 million 966.7 million 1,017.1 million 1,064.7 million 1,152.3 million Source: United Nations Challenge During the 1980s, Soviet leaders introduced market elements into the economy. How might this explain the increase in household expenditures? Use to complete this activity. @ ClassZone.com Economic Systems 47 S E C T I O N 3 Market Economies TA K I N G N O T E S In Section 3, you will • describe what a market is and how it works • identify the main features of a market economy • analyze how the circular flow model represents economic activity in a market economy • explain the advantages and disadvantages of a market economy private property rights, p. 48 market, p. 48 laissez faire, p. 49 capitalism, p. 49 voluntary exchange, p. 49 profit, p. 49 competition, p. 49 consumer sovereignty, p. 50 specialization, p. 50 circular flow model, p. 52 product market, p. 52 factor market, p. 52 As you read Section 3, complete a chart to identify and describe the features of a market economy. Use the Graphic Organizer at Interactive Review @ ClassZone.com Market Economy private property rights Fundamentals of a Market Economy KEY CONCEPT S QUICK REFERENCE Private property rights are the rights of individuals and groups to own businesses and resources. A market is any place where people buy and sell goods and services. Market economies have several distinct characteristics. Earlier in this chapter you read about the fundamental feature of a market economy—the fact that people’s economic behavior is motivated by self-interest. Self-interested behavior is behind two other features of a market economy. One is private property rights, the rights of individuals and groups to own property. In economic terms, property means everything that an individual owns. This includes factories, offices, clothes, furniture, house, car, and other belongings; money; and even intellectual property, such as songs or ideas developed for inventions. It also includes the labor individuals provide to earn money to buy what they own. The other feature that stems from self-interest is the market, any place or situation in which people buy and sell resources and goods and services. It may be the farmers’ market on Saturdays in the town square, or it may be an enormous cybermarket on the Internet, such as eBay. Large or small, real or virtual, the market is where people can exchange their private property for someone else’s. Private Property Rights In a market economy, people are free t
o own and use private property— houses, for example. 48 Chapter 2 FEATUR E 1 Private Property and Markets For markets to operate efficiently, private property rights need to be well defined and actively enforced by law. If you have ever bought a car, you know that an essential part of the transaction is getting possession of the title. You need proof that the person you are buying it from actually owns it and has the right to sell it. Since clear ownership is vital to any sale or exchange, private property rights are necessary to make markets work properly. If buyers could not trust that the sellers actually had the right to offer their products on the market, trade would break down. Further, suppose you are a musician but know that your songs can be downloaded for free, depriving you of your right to exchange what you own for money. In such a situation, it is doubtful that you would be motivated to record music. In protecting private property rights so that producers have motivation and consumers have trust, the government performs an important role in a market economy. FEATUR E 2 Limited Government Involvement Sometimes the government’s economic role is to stay out of the marketplace. The principle that the government should not interfere in the economy is called laissez faire, a French phrase meaning “leave things alone.” The concept of laissez faire is often paired with capitalism, an economic system that is based on private ownership of the factors of production. Capitalism, the foundation of market economies, operates on the belief that, on their own, producers will create the goods and services that consumers demand. Therefore, according to laissez faire capitalism, there is no need for government involvement in the marketplace. Laissez faire capitalism is a market economy in its pure form. However, there are no pure market economies—all real-world market economies have some degree of government involvement. FEATUR E 3 Voluntary Exchange in Markets When a buyer and seller agree to do business together, they engage in a voluntary exchange, a trade in which the parties involved anticipate that the benefits will outweigh the cost. Both sides in a voluntary exchange believe that what they are getting is worth more than what they are giving up. In a market economy, most trade is based on an exchange of a product for money rather than for another product. Self-interest guides voluntary exchanges. Suppose you buy a new guitar. Even though you spend a good part of your savings, your self-interest is served because you’ve wanted this particular model of guitar. The seller’s self-interest is likely served by profit, a financial gain from a business transaction. If you pay more for the guitar than the seller did, the seller earns money. In voluntary exchange, then, both sides must believe that they are gaining by trading. FEATUR E 4 Competition and Consumer Sovereignty Market economies are also characterized by competition, the effort of two or more people, acting independently, to get the business of others by offering the best deal. You are able to choose today between a Macintosh and a Windows PC operating system because of the competition in the computer market. In the case of these competing systems, each has somewhat different features but mainly performs the same QUICK REFERENCE Laissez faire is the principle that the government should not interfere in the marketplace. Capitalism is an economic system that is based on private ownership of the factors of production. Voluntary exchange is a trade in which both traders believe that what they are getting is worth more than what they are giving up. Profit is a financial gain that a seller makes from a business transaction. Competition involves all the actions sellers, acting independently, do to get buyers to purchase their products. Economic Systems 49 YO U R EC CO M PETITION Where will you buy your computer? You want to buy a new computer. You could buy a “standard package” from the electronics discount store. The price will be very reasonable, but you won’t be able to customize the software package or the service program. Alternately, you could buy from a computer specialty store. You’ll pay more, but you can choose the extras that you want and the customer support program is excellent. ? Electronics discount store Computer specialty store functions as the other. You are free to decide which you prefer based on whatever combination of price and value appeals to you more. When you buy over-the-counter medications, you can also clearly see the competitive aspect of the market. Often next to a well-known brand-name product you will see a product with the same ingredients, similar packaging, but a different name and lower price. The producers of the lower priced item are competing for the business established by the brandname product. If the producers of the brand-name product want to keep your business, they must lower their prices or find a way to add some other value. That’s because you, the consumer, hold the real power in the market place. Consumer sovereignty is the idea that because consumers are free to purchase what they want and to refuse products they do not want, they have the ultimate control over what is produced. Sovereignty means supreme authority, which is what consumers exercise as key economic decision-makers. Let’s look at the over-the-counter medications again. If there were no competition, the brand-name producers could charge higher prices. It would be in their self-interest to charge as much as they possibly could. Competition, however, acts as a control on self-interested behavior, guiding the market toward a balance between higher value and lower prices. Rather than lose your business, the brand-name producers will either lower their prices or raise the value of their product. Because producers must compete for the consumer’s dollar, they have to work at pleasing you, the consumer, while pleasing themselves. FEATURE 5 Specialization and Markets A market economy encourages efficient use of resources by allowing people and businesses to specialize in what they do best. Specialization is a situation in which people concentrate their efforts in the areas in which they have an advantage. This allows people to trade what they can most efficiently produce for goods and services QUICK REFERENCE Consumer sovereignty is the idea that consumers have the ultimate control over what is produced because they are free to buy what they want and to reject what they don’t want. Specialization is a situation in which people concentrate their efforts in the activities that they do best. 50 Chapter Fundamentals of a Market Economy Private Property Buyers and sellers are free to own and use private property. Specialization Buyers and sellers are able to concentrate their efforts in areas where they have an advantage. Consumer Sovereignty Buyers can exercise their dominance over what is produced by freely deciding whether to buy or not to buy. ANALYZE CHARTS Competition Sellers are free to attempt to get the business of others by offering the best deal. Government Involvement Buyers and sellers must be free to operate with minimal government intervention. Voluntary Exchange When a buyer and seller agree to do business together, each believes that the benefits outweigh the costs. Profit Sellers are free to attempt to maximize their profits. Identify a business in your community. Consider how the fundamentals of a market economy noted in the diagram are illustrated by the operations of that business. Record your ideas in a two-column table. produced more efficiently by others. Specialization removes the need for households to be self-sufficient, and markets allow households to trade for what they need. Suppose one adult in your house is a bank teller and another is a welder. Neither banking nor welding needs to happen within your household, but your household does need groceries. By specializing in what they do best—earning money in their jobs—in a market economy these adults are able to trade the dollars they earn for items and services others specialize in. If, however, they had to grow all the family’s food themselves, they’d be less efficient than those who specialized in farming. Also, with each hour spent on growing food they would lose an hour’s worth of wages from their jobs. Specialization, then, leads to higher-quality yet lower-priced products. AP P LI CATION Applying Economic Concepts A. Which is more important in determining the format in which recordings are offered by the music industry, new technology or consumer sovereignty? Explain. Economic Systems 51 QUICK REFERENCE The circular flow model is a tool that economists use to understand how market economies operate. The product market is the market where goods and services are bought and sold. The factor market is the market for the factors of production—land, labor, capital, and entrepreneurship. Circular Flow in Market Economies KEY CONCEPT S How do all these fundamental characteristics combine to allow a market economy to function? Economists have developed a model to help them answer this question. Called the circular flow model, it visualizes how all interactions occur in a market economy. The model represents the two key economic decision makers in a market economy—households, which are made up of individuals like you, and businesses. It also shows the two markets where households and businesses meet—that for goods and services, and that for resources. (See Figure 2.4 on the next page.) Product Markets The market for goods and services is called the product market. This is the market you probably know best. The product market isn’t a place as much as it is a set of activities. Whenever or wherever individuals purchase goods or services—at a local mall, a dentist’s office, the phone company, or an online service selling concert tickets—they are doing so in the product market. The suppliers o
f the product market are businesses, which offer their goods or services for sale and use the money they earn from the sales to keep their businesses going. Factor Markets To run a business, firms must, in turn, purchase what they need from the factor market, the market for the factors of production—land, labor, capital, and entrepreneurship. Individuals own all the factors of production. They own some factors of production outright, such as their own labor and entrepreneurship. Others they own indirectly as stockholders in businesses. In the factor market, businesses are the customers and individuals are the producers. A restaurant buys your labor as a server, for example, to serve meals prepared by chefs whose labor they have also bought. The chefs make the meals from products bought from farmers who own the fields and farm equipment. Circular Flow This set of interactions between businesses and individuals is illustrated in Figure 2.4 on the next page. On the left and right of the model, you can see the two main economic decision makers, businesses and households. At the top and bottom are the two main markets, product and factor. The green arrows represent the flow of money. The blue arrows represent the flow of resources and products. 52 Chapter 2 Circular Flow Individuals, such as restaurant servers, sell their labor to businesses in the factor market The Circular Flow Model Business revenue Product Market Consumer spending Sell goods and services Buy goods and services Businesses Buy productive resources Households (Individuals) Sell land, labor, capital, entrepreneurship Payments for resources Factor Market Income from resources ANALYZE CHARTS The circular flow model is a tool for understanding the relationships among economic decision makers and various markets. Why do you think that money always flows in one direction, while resources and products always flow in the opposite direction? Use an interactive circular ﬂ ow model at ClassZone.com Find the “Households” box at the right side of the chart. If you follow the green arrow, you see that individuals spend money in the product market to buy goods and services. From the product market, the money goes to businesses as revenue. The businesses spend this in the factor market, paying for the land, labor, capital, and entrepreneurship needed to produce goods and services. The receivers of that money are individuals who own all the factors of production. With the money they receive, individuals can make more purchases in the product market, and so the cycle continues. If you look at the blue arrows, you can follow the route of the resources and products in the circular flow model. Once again, start with individuals. They sell their land, capital, labor, and entrepreneurship in the factor market. Follow the arrows to see that these factors of production are bought by businesses. The businesses then use these productive resources to make goods and services. The goods and services are then sold in the product market and flow to individuals who purchase them. AP P LI CATION Interpreting Economic Models B. Think of a good or a service you have recently bought. Using the circular flow model as a guide, write an explanation of the impact of your purchase on the economy. Economic Systems 53 Impact of Market Economies KEY CONCEPT S Between the late 1940s and the early 1990s, between one-quarter and one-third of the world’s population lived under command economic systems. The Soviet Union and its Eastern European neighbors, China and much of Southeast Asia, Cuba, and North Korea all had centrally planned economies. However, with the collapse of communism in the early 1990s, most of these countries have adopted some form of market economy. Also, as you read in Section 2, even those that have clung to communism and central planning have introduced market-economy measures. Why were these countries so ready to embrace the market system? Advantages On November 9, 1989, the Berlin Wall, a symbol of the division between the communist and democratic worlds, was finally opened. Over the next few days, hundreds of thousands of East Germans began pouring into West Germany through gates and improvised breaches in the wall. What drew these jubilant East Germans to the west? For most of them, the answer was freedom. Economic and Political Freedom Freedom is one of the chief advantages of a market economy. A market economy requires that individuals be free to make their own economic choices, since it depends on the consumer’s right to buy or refuse products to determine what will be produced. Individuals are also free to develop their interests and talents in work they find satisfying, rather than being assigned to jobs. Also, since the government does not use a heavy hand to control the economy, the political process can be much freer, with a diversity of viewpoints and open elections. Government bureaucracy is generally less cumbersome and costly in a market economy than in a command economy, since there are fewer areas of government involvement. A market economy also can be responsive to changes in conditions and accommodate those changes quickly. Freedom New shopping malls, like this one in Bucharest, Romania, are a common site in many formerly communist countries. Further, individuals in local communities are free to make their own economic choices without the interference of the government. These individuals’ better knowledge of the resources and potential of their area leads to better economic decisions and greater productivity. Profit The profit motive, a key feature of a market economy, insures that resources will be allocated efficiently, since inefficiencies would result in lower profits. It also serves as a reward for hard work and innovation. Knowing you can earn money Find an update about developing market economies in Eastern Europe at ClassZone.com 54 Chapter 2 Competition Competition among dairy companies ensures that there is a wide variety of milk and other dairy products. if you come up with a good idea is an incentive to do so, and the more good ideas people have, the more the economy grows. The incentive to come up with good ideas is related to another advantage of a market economy: it encourages competition, letting consumers have the final say. Competition leads to higher-quality products at lower prices. It also helps to create a diverse product market. Disadvantages Market economies, however, have disadvantages as well. In a pure market economy, the economic good of the individual is the primary focus. A pure market economy has no mechanism for providing public goods and services, such as national defense, because it would not be profitable from a strictly economic viewpoint to do so. Another disadvantage is that a pure market economy cannot provide security to those who, because of sickness or age, cannot be economically productive. Nor can it prevent the unequal distribution of wealth, even though that gap may be the result of unequal opportunities. The industrial boom in the United States in the late 1800s and early 1900s illustrates the problems that can develop in a market economy with little government regulation. During this time, a few business leaders became very rich. At the same time, most of those who worked for these leaders were paid low—but increasing— wages. Further, most business leaders did little at the time to address the negative consequences of industrialization such as pollution. Issues like these led most industrialized societies to adopt some level of government involvement in the economy. The result was economic systems that mix elements of market and command economies. In Section 4, you’ll learn more about such mixed economies. AP P LI CATION Analyzing Causes C. Why did many societies feel it necessary to adopt some level of government involvement in market economies? Economic Systems 55 For more information on comparing and contrasting information, see the Skillbuilder Handbook, page R19. Comparing and Contrasting Economic Systems Comparing means looking at the similarities and differences between two or more things. Contrasting means examining only the differences between them. To understand economic systems, economists compare and contrast the ways in which societies use their limited resources to meet unlimited wants. TIPS FOR COMPARING AND CONTRASTING Look for subjects that can be compared and contrasted. Economic Systems An economic system is the way in which a society uses its resources to satisfy its people’s needs and wants. Two common economic systems are the market system and the command system. Both systems provide answers to three basic economic questions: What to produce? How to produce? For whom to produce? In a command economy, government economic planners decide what goods and services will be produced, how they will be produced, and for whom they will be produced. Individuals, then, have little or no influence on how economic decisions are made. In contrast, in a market economy the individual plays the major role in answering the basic economic questions. Consumers spend their money on the goods and services that satisfy them the most. In response, producers supply the goods and services that consumers want. Few, if any, “pure” economic systems exist today. Most economic systems are “mixed.” For example, market economies generally have some limited form of government control—a characteristic of command economies. Most command economic systems are likewise mixed in that they have some elements of market economies. Comparison This passage compares two economic systems that have both similarities and differences. Contrast To contrast, look for clue words that show how two things differ. Clue words include however, in contrast, on the other hand, and unlike. Similarities To find similarities, look for clue words indicating that two things are alike. Clue words include both, similarly, and likewise. T HINKING ECON
OMICALLY Comparing and Contrasting 1. How are market and command economic systems similar? 2. In what ways do these two economic systems differ? 3. Read the paragraphs about North Korea under the heading “Command Economies Today” on page 45. Construct a Venn diagram showing similarities and differences between the economy of North Korea and a typical market economy. 56 Chapter 2 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. private property rights c. specialization market b. laissez-faire capitalism profit d. factor market product market 2. What are the essential elements of market economies? 3. What are some advantages of market economies? 4. What are some disadvantages of market economies? 5. How does the profit motive help lead to efficient use of productive resources? 6. Using Your Notes Make charts for a traditional economy and a command economy and compare and contrast them with your completed market economy chart. Market Economy private property rights Use the Graphic Organizer at Interactive Review @ ClassZone.com . Analyzing Cause and Effect Review the circular flow model on page 53. Based on the model, how do businesses benefit from the wages they pay? 8. Creating and Interpreting Economic Models Return to the answer you gave for Application B on page 53. Create a circular flow model to illustrate your answer. 9. Solving Economic Problems How do you think the disadvantages of a market economy can be minimized while its advantages continue to operate? 10. Challenge On August 29, 2005, Hurricane Katrina devastated regions of the Gulf Coast states of Louisiana, Mississippi, and Alabama. Most of New Orleans, for example, was flooded after the levees protecting the city broke. How would a pure market economy respond to the devastation and loss? Employers and employee discuss salary Understanding the Market Economy Market economies can be identified by certain fundamental characteristics. These include self-interested behavior, private property rights, voluntary exchange, profit, competition, consumer sovereignty, specialization, and a limited role for government. Identify Features Each sentence in the chart illustrates one fundamental feature of a market economy. Complete the chart by identifying these features. Feature Description An author secures a copyright for her latest novel. Declining sales signal the end of production for a model of car. A prospective employee and a business reach an agreement on salary and benefits. Taking advantage of their beautiful natural environment, local planners approve development of new hotels and resorts. Challenge Write sentences illustrating two fundamental features of market economies not illustrated in the sentences above. Economic Systems 57 S E C T I O N 4 Modern Economies in a Global Age TA K I N G N O T E S In Section 4, you will mixed economy, p. 58 • identify the main characteristics nationalize, p. 61 privatize, p. 61 global economy, p. 61 of a mixed economy • understand why most modern economies are mixed economies • explain why modern economies are becoming increasingly global As you read Section 4, complete a cluster diagram to record what you learn about modern economies in a global age. Use the Graphic Organizer at Interactive Review @ ClassZone.com Today’s Mixed Economies Trends in Modern Economies Modern Economies Today’s Mixed Economies KEY CONCEPT S QUICK REFERENCE A mixed economy is an economy that has elements of traditional, command, and market systems. Today, the mixed economy—an economic system that has elements of traditional, command, and market economies—is the most common type of economic system. Even the most strongly market-based modern economies have some elements of central planning. Similarly, market influences have penetrated all of today’s command economies to some extent. Traditional production methods are still followed in some areas of both market and command systems. And traditional economies everywhere are experiencing greater government involvement and growing pressure from market influences. Life in a Mixed Economy Let’s look at a farming family in the rural Midwest of the United States to see how elements of all three economic systems may be present in a mixed economy. The family has owned and operated the farm for many generations. While they use the most modern farming methods, family members still cling to some old customs. At harvest time, for example, everybody works to get in the crops. Even the youngest children have their own special tasks to do. The family’s crops are sold on the market along with those of their neighbors and of farmers throughout the region. Wellmaintained highways connect the farm to the various locations where the crops are sold. Two teenagers in the family attend the public high school. The oldest one works in town at a part-time job during the week, earning the minimum wage. Two grandparents who no longer work full time on the farm each receive a Social Security check every month. 58 Chapter 2 In this scenario, all three types of economic system are blended. The harvest-time customs the family follows represent the influence of a traditional economy. The command aspects of the economy are reflected in the ways that government has become involved. The well-maintained roads, the public high school, the minimum wage, and the Social Security checks are all examples of government benefits and regulations at the local, state, or national level. (You’ll learn more about government involvement in the economy, including the minimum wage and Social Security, in later chapters.) The market aspects of the economy are represented in the private property rights and entrepreneurship of the family members. They own their land and have figured out the best ways to use it to make a living. Other aspects of a market economy include the competitive market in which their goods are sold, and the voluntary exchange that takes place when the family sells its crops and when one of the teenagers exchanges labor for wages. Elements of Command One way the U.S. government intervenes in the economy is to set safety standards for automobiles and other products. Types of Mixed Economies Although all modern economies are mixed, they often emphasize one type of system or another. In the scenario you just read, which is based on the economy of the United States, the market economy dominates. Even though there are traditional and command elements, the driving forces of the U.S. economy are such features as private ownership and markets. So, the United States essentially has a market economic system. Many European countries have a more even mix of market and command economies. France, for example, tried to find a “middle way” between socialism and capitalism. In the years following World War II, its economy emphasized the command system with government ownership of core industries. In the 1980s, however, many people expressed dissatisfaction with the performance of government-owned industry. As a result, the French government pulled back from its ownership role in the economy, privatizing several industries, most notably banking and insurance. Even so, it still has a controlling share of ownership in a number of industries, including energy, automobiles, transportation, communications, and defense. In addition, it provides an array of social services, including health care and education, to the French people. Sweden, while also a mixed economy, has much greater government involvement. The Swedish government and government-related organizations own about one third of all Swedish companies. In addition, Swedish citizens receive “cradle to grave” social benefits. These include childcare for children ages 1 through 5, schooling for Economic Systems 59 M AT Calculating Percentages Economists often use percentages to express the level of government involvement in a country’s economy. Step 1: Read the table, which contains data on the total economy and government consumption—the value of all the goods and services government buys—for three countries. Step 2: Using Canada as an example, calculate government consumption as a share of the total economy. Country Canada Nigeria Sweden Total Economy Government Consumption (in billions of U.S. dollars) (in billions of U.S. dollars) 789.8 48.8 259.2 152.4 11.4 72.2 Source: Heritage Foundation Share of economy consumed by government = Government consumption Total economy $152.4 $789.8 = 0.192960243 Step 3: Convert the answer to a percentage by multiplying by 100. 0.192960243 x 100 = 19.2960243% Step 4: Round your answer to a whole number. 19.2960243 rounded to a whole number 19% Comparing Economies To compare government consumption in the economies of two different countries, economists can calculate percentages for each country and compare the percents. NEED HELP? Math Handbook, “Calculating and Using Percents,” page R4 children ages 6 through 16, additional years of school and college for those who choose them, health care, dental care, paid time off for raising families, and generous old-age pensions. In return, however, the Swedish pay very high tax rates, in some cases as high as 60 percent of income. Each country has its own distinct balance of economic types. Namibia, as you read in Section 1, has a large number of people engaged in subsistence farming, following traditional production methods. Since the early 1990s, however, the Namibian government has been encouraging a more market-driven approach, including foreign investment in farming and other businesses. The country’s leaders hope that these efforts will help the economy to grow and provide more economic opportunities for all Namibians. APPLICATION Synthesizing Economic Data A. Look at the Math Challenge above. What level of government involvement in the economy does each country shown have? 60 Chapter 2 Trends in Modern Economies KEY C ONCEPT S Economie
s have changed, and are always changing, in response to changes in natural, social, and political conditions. In the early 1990s, for example, some Eastern European economies experienced abrupt change when their command systems broke down after the collapse of communism in the Soviet Union. Many of these economies have been making reforms to introduce more market elements. (You’ll learn more about these economies in Chapter 18.) T RE ND 1 Changes in Ownership Economies in transition often go through predictable processes. Some of the most important relate to changes in ownership. After World War II, some European economies became more centrally planned. For example, the British government, to help the country more effectively recover from the war, nationalized several important industries, including coal, steel, and the railroads. To nationalize means to change from private ownership to government or public ownership. More recently, many economies have moved away from command systems to market systems. In this process, government-owned industries have been privatized. To privatize means to change from government or public ownership to private ownership. Poland, for example, is undergoing a transition from a command to a market economy with an extensive privatization program. Since 1990, Poland has privatized a number of manufacturing, construction, trade, and service industries. The Polish government hoped that private ownership of economic resources would provide incentives for greater efficiency, which, in turn, would help the economy to grow. QUICK REFERENCE To nationalize means to change from private ownership to government or public ownership. To privatize means to change from government or public ownership to private ownership. The global economy refers to all the economic interactions that cross international boundaries. T RE ND 2 Increasing Global Ties One way to help privatize an industry is to open it up to foreign investors. This kind of economic tie between nations is only one example of the global economy. The global economy is all the economic interactions that cross international boundaries. Today, American consumers and businesses are actors in a world economy. Businesses now engage in more foreign trade than ever before, and they depend not only on the products they buy from foreign nations, but also on the foreign markets in which they sell their products. There are several reasons for this surge in economic globalization. One reason is the opening up of the world’s markets to trade. Nations have been discussing ways to open trade for many years. The outcome of these talks has been the signing of agreements that ensure that trade among nations flows as Globalization Some people are opposed to globalization, charging that it results in the loss of national identity. Economic Systems 61 F I G U R E 2 . 6 The World Student Backpack Made in Mexico Backpack Contents Mechanical Pencil Made in South Korea Textbooks Printed and made in the United States MP3 Player Made in China Calculator Designed in the United States, made in Taiwan, powered by batteries made in the United States Cell Phone Designed and made in the United States by a subsidiary of a Finnish company. Shirt Assembled in Honduras from fabric pieces made in the United States Watch Designed in the United States, made in Hong Kong Belt Made in China Jeans Made in Costa Rica Shoes Made in Indonesia ANALYZE CHARTS List all the things that you use in a normal day—the clothes you wear, the foods you eat, the appliances you use, and so on. Identify where each item was made— in the United States or in another country. smoothly and freely as possible. Another reason for the growth of the global economy is the development of faster, safer, and cheaper transportation. Distribution methods have become so efficient that resources and products can be moved around the world relatively inexpensively. In addition, telephone and computer linkages have made global financial transactions quick, inexpensive, and easy. Globalization also has been enhanced by cross-border business partnerships. For example, Ford Motor Company of the United States and Mazda Motor Corporation of Japan have long worked as partners. They design and engineer cars together, use each other’s distribution systems, and share manufacturing plants. Recently, Ford and Mazda have joined with China’s Changan Automotive Group to produce engines for Ford and Mazda cars. Such shared efforts lead to greater efficiency, which results in lower production costs and greater profits. Other global partnerships have grown out of the need to share the enormous costs of researching and developing new technology. For example, Hitachi of Japan has joined with two American companies, Texas Instruments Incorporated and Integrated Device Technology, to develop smaller and more powerful computer memory chips. Such joint efforts are an illustration of today’s economic reality—businesses can cooperate and learn from one another even while pursuing their own interests. Find an update on global partnerships at ClassZone.com APPLICATION Analyzing Effects B. How do global business alliances benefit the U.S. economy? 62 Chapter 2 S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. For each of the following key terms, write a sentence that illustrates its meaning. a. mixed economy c. privatize b. nationalize d. global economy 2. What is a market-driven mixed economy? Illustrate your answer with examples. 3. In the transition from command to market economies, most economic resources are privatized. What is the expected impact of this action? 4. What forces have contributed to the growth of the global economy? Shopping for shoes 5. How are you, as an individual, affected by the global economy? 6. Using Your Notes Write a foursentence summary of this section, using your completed cluster diagram as a reference. Use the Graphic Organizer at Interactive Review @ ClassZone.com Today’s Mixed Economies Trends in Modern Economies Modern Economies 7. Explaining an Economic Concept Explain, with examples, how the American economy includes elements of traditional, command, and market economic systems. 8. Analyzing Cause and Effect Since the fall of communism in the 1990s, countries in Eastern Europe and the former Soviet Union have abandoned command economies in favor of market economies. How do you think economic life in these countries has changed? 9. Applying Economic Concepts Many nations import U.S. capital and technology by purchasing equipment that U.S. businesses manufacture. Explain how this development can benefit the American people. 10. Challenge How do market forces operate in the global economy? Illustrate your answer with examples. Illustrating the Global Economy How do you participate in the global economy? Study Figure 2.6 opposite and then complete this exercise. Conduct a Survey Make a survey of class members to identify the “Made in” labels in their clothes, shoes, and other items they use every day. Use a chart similar to the one below to list the items and the countries in which they were produced. Product Where Made Sweaters Shirts Pants or dresses Shoes Jackets Backpacks Challenge Write a short explanation of how this list illustrates the global economy. Economic Systems 63 Case Study Find an update on this Case Study at ClassZone.com Contrasting Economies: North Korea and South Korea Background Korea was an independent kingdom for nearly 1,000 years. After World War II, the country was divided into two nations, North Korea and South Korea. Since then, the two countries have developed in vastly different ways. After the Korean War ended in 1953, North Korea’s communist government followed an economic, political, and military policy of isolation. North Korea has a command economy, though elements of a market system are taking root. South Korea, in contrast, is a democracy with a market economy. South Korea has achieved incredible economic growth, in part because of its chaebols (jeh BOLZ), huge technology conglomerates like Samsung and Hyundai that originated from a single family. Strong government support for businesses has aided the country’s economic success. What’s the issue? How effective are command and market economies? Use these sources to discover how well the economies of North and South Korea function. North Korea South Korea A. Online Article In this article, the United States Institute of Peace (USIP) summarizes the findings of Andrew P. Natsios about the great famine in North Korea. Natsios is the author of The Great North Korean Famine: Famine, Politics, and Foreign Policy (2001). North Korea Suffers Famine Workers in “unproductive” industries die from lack of food According to some estimates, . . . three million people died in the North Korean famine of the mid-1990s. . . . Faced with a massive food shortage, the North Korean government “made a choice,” Natsios said. Making the regime’s survival its top priority, the government decided that food would go to the country’s elite and its military forces. Most citizens, especially those who lived in regions or worked in industries that the government deemed “unproductive,” were considered expendable. As many as three million people may have died. Before the famine, North Korea relied on food and oil subsidies, mostly from the former Soviet Union. When that aid declined and a series of natural disasters occurred, the North Korean government cut food rations to farmers. Many people started hoarding and stealing. The system collapsed. In Natsios’ view, North Koreans lost faith in the state. Source: “The North Korean Famine.” Peace Watch Online, June 2002 North Koreans receive contributions of rice from an international humanitarian agency. Thinking Economically What decision described in this document is characteristic of a command economy? Explain your answer. 64 Chapter 2 FIGURE 2 .7 PER C A P I TA GD 16,000 14,000 12,000 10,000 8,000 6,000
4,000 2,000 0 B. Graph This graph compares North Korea’s and South Korea’s per capita GDP— each person’s share of everything produced in the economy—from 1994 to 2004. SOUTH KOREA NORTH KOREA 1994 1996 1998 2000 2002 2004 Year Source: United Nations Statistics Division Thinking Economically What does this graph suggest about productivity in the two nations? C. Magazine Article This article reflects the contributions of corporations like Samsung to South Korea’s growing economy. Samsung and the “Next Great Tech Revolution” Heading Towards a Digitized Life Lee Jong Jin, 51, is no couch potato. But lounging in his apartment overlooking the mountains of Seoul, the international trader has little reason to leave his sofa. As he watches an interactive game show, he uses the remote to send in answers. In a corner of the 50inch plasma screen, he can link to his online bank or control his air conditioner. Lee is one of thousands of Koreans involved in trials of Samsung Electronics’ Home Network, which allows digital products to talk to each other. If Samsung has its way, millions around the world will be running their homes from the comfort of their couch within a few years. . . . Over the last decade, [Samsung] has . . . become the most diverse and profitable consumer-electronics company on the planet. Samsung leads the global market for color televisions, VCRs, liquid crystal displays for electronic devices and digital memory devices. . . . Since 1999, revenues have doubled, and profits have risen 20 times. . . . In the digital world all these products will finally be networked to each other . . . creating the sort of “smart” living space imagined only in science fiction. That’s the idea, anyway. The change, says analyst Keith Woolcock of Westhall Capital in London, will be “the biggest event in technology for the next 10 years.” Source: “Digital Masters,” Newsweek (International Edition), October 18, 2004 Thinking Economically What aspects of a market economy are illustrated by Samsung’s financial success? THINKING ECONOMICALLY Synthesizing 1. Based on documents A and C, in which country does the government appear to be more involved in controlling business and the economy? 2. Based on documents A and C, what can you infer about the effects of government activities on productivity in the two nations? 3. In today’s global economy, is a command economy or a market economy more likely to succeed? Support your answer with information presented in the three documents. Economic Systems 65 CHAPTER 2 Assessment Introduction to Economic Systems (pp. 38–41) 1. What are the three types of economic systems? 2. What are features of a traditional economy? Command Economies (pp. 42–47) 3. What role does the government play in a command economy? 4. What are the advantages and disadvantages of a command economy? Market Economies (pp. 48–57) 5. What are the features of a market economy? 6. What are the advantages and disadvantages of a market economy? Modern Economies in a Global Age (pp. 58–65) 7. What are the features of a mixed economy? 8. What trends are shaping modern economies? A P P LY Look at the chart below showing statistics for four nations. Answer the following questions. 9. Which country appears to have the most productive economy? 10. Does a high percentage of GDP from agriculture make a country more or less productive? Support your answer with statistics from the chart. FIGURE 2 . 8 GROW TH AND PRODUC TIVIT Y Country GDP* Growth Rate PPP** % of GDP from Agriculture North Korea Poland Namibia China 1.0 3.3 4.2 9.2 1,800 30.0 12,700 7,800 6,200 2.8 9.3 14.4 * Gross Domestic Product (value of everything the country produced) ** Purchasing Power Parity (shows a country’s productivity relative to its population) Source: The CIA World Factbook, 2006 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 Choose the key concept that best completes the sentence. Not all key concepts will be used. capitalism centrally planned economy circular flow model command economy competition factor market global economy laissez faire market market economy mixed economy nationalize private property rights privatize product market profit socialism traditional economy voluntary exchange In a 1 , the three basic economic questions of what to produce, how to produce, and for whom to produce are answered in the same way they have been for generations. In a 2 , in contrast, the government makes most economic decisions. Two systems in which government plays a strong role are communism and 3 . In the transition between types of economic systems, the government may 4 industries, taking them out of private ownership. A 5 economy rests on private ownership, however, so 6 guaranteed by the government are vitally important. A market economy also depends on 7 to help produce the highest quality goods at the lowest price. Sellers are motivated by the chance to make a 8 , so they try to use their resources as efficiently as possible. The 9 shows the flow of money as well as the flow of products and resources in the 10 that takes place between buyers and sellers in a market economy. The most common kind of economy today is the 11 which blends elements from all three systems. Each modern economy is also part of the 12 , which entails all the economic interactions that cross international borders. 66 Chapter Privatize Your Community’s Recreation Facilities Suppose your community felt that its administration of your park district and recreation facilities—pools, gyms, and so on—had become inefficient. As an exercise to understand the issues involved in moving from a government-owned to a privately-owned enterprise, work through the decisions you would face in privatization. Step 1. With your whole class, divide the recreation facilities into manageable segments. One segment might be park maintenance, another might be fitness classes at the community center, and so on. Then organize pairs or small teams and assign each pair or team one of the segments. Step 2. In your pairs or teams, discuss how to use the elements of a market economy to make your segment of the project as efficient as possible—to provide the lowest priced services at the highest possible quality. Step 3. Draw up a plan describing the privately-owned company you think could take over your segment. Step 4. Share your plans with the teams working on the other segments to see what other ideas came up. Step 5. With your whole class, discuss whether privatizing services like park district facilities is a beneficial step or not. Discuss possible advantages and possible disadvantages. 11. Creating Charts Create a chart showing a continuum of countries with different types of economic systems. At the left will be the nations with the most command elements in their economic systems. On the right will be the nations with the most market elements in their economies. Use the chart below as a model. Country B Country D COMMAND MARKET Country A Country C Country E Begin with the countries listed in the chart on the previous page. Then add other countries mentioned in this chapter, such as France, Sweden, and the United States. Conduct extra research if you have difficulty placing these countries on the continuum. One useful source of information is Economic Freedom of the World Annual Report. 12. Synthesizing Economic Data Look again at Figure 2.8 on page 66. Why do you think Poland and Namibia had relatively high growth rates? In writing your answer, consider the economic changes that have taken place in these countries in recent years. 13. Evaluating Economic Decisions Using information in Figure 2.8, evaluate Poland’s decision to privatize a number of its industries, noting whether you think it was a wise or an unwise action. Explain your evaluation. 14. Explaining an Economic Concept In most of the former command economies in Eastern Europe, one of the first economic changes instituted was establishing the right to own private property. Why do you think the leaders of these countries considered this feature of market economies so important? 15. Challenge Write a brief essay explaining how a country’s political system and economic system are intertwined. Economic Systems 67 Free Enterprise In the American free enterprise system, everyone is free to start a business like the couple shown here. Businesses will succeed or fail based on how well they respond to market forces. 68 CHAPTER 3 SECTION 1 Advantages of the Free Enterprise System SECTION 2 How Does Free Enterprise Allocate Resources? SECTION 3 Government and Free Enterprise CASE STUDY The United States: Land of Entrepreneurs The American Free Enterprise System market economy is an economic system based on individual choice, voluntary exchange, and the private ownership of resources Free enterprise system is another name for capitalism, an economic system based on private ownership of productive resources. This name is sometimes used because in a capitalist system anyone is free to start a business or enterprise AT T E R S Free enterprise is all around you, from huge suburban malls to industrial developments to neighborhood corner stores. Think about ways that the American economic system affects your dayto-day life. Consider where you shop, what you buy, where you work, and what you do there. What do you think allows this huge economic engine to run? More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on entrepreneurs in the United States. (See Case Study, pages 92–93). Go to ANIMATED ECONOMICS for interactive versions of diagrams in this chapter. Business revenue Product Market Consumer spending Products Products Products Products Government Businesses Taxes Productive Resources i g n d n e p S Taxes Households (Individuals)) Lan
d, labor, capital, entrepreneurship s e c r u o s e R Payments Factor Market Income Go to INTERACTIVE REVIEW for concept review and activities. How do households, businesses, and government interact in the economy? See Figure 3.4 in Section 2 of this chapter. The American Free Enterprise System 69 S E C T I O N 1 Advantages of the Free Enterprise System TA K I N G N O T E S free enterprise system, p. 70 open opportunity, p. 73 legal equality, p. 73 free contract, p. 73 profit motive, p. 73 In Section 1, you will • explain why the United States is considered to have a capitalist, or free enterprise, system • identify the legal rights that safeguard the free enterprise system • analyze how the profit motive and competition help to make the free enterprise system work As you read Section 1, complete a cluster diagram using information on free enterprise. Use the Graphic Organizer at Interactive Review @ Classzone.com definition detail Free Enterprise detail detail What Is a Free Enterprise System? KEY CONCEPT S QUICK REFERENCE Free enterprise system is another name for capitalism, an economic system based on private ownership of productive resources. As you recall from Chapter 2, the United States has a capitalist economic system. Capitalism is an economic system based on the private ownership of the factors of production. The central idea of capitalism is that producers are free to produce the goods and services that consumers want. Consumers are influenced by the desire to buy the goods and services that satisfy their economic wants. Producers are influenced by the desire to earn profits, the money left over after the costs have been subtracted from business revenues. A capitalist system is also known as a free enterprise system because anyone is free to start a business or enterprise. EXAMPLE United States Let’s take a look at one American who took advantage of that freedom. Monica Ramirez, a makeup consultant for fashion magazines and television, noticed that very few Hispanic women purchased the cosmetics available in stores. She thought that this might present a business opportunity. So, in 2001, she created Zalia Cosmetics, a line of cosmetics specifically for 70 Chapter 3 Latinas. She put her whole savings account into starting the business. Her creativity and energy attracted attention, and she soon had backers willing to invest their money in the business. By 2004, Zalia Cosmetics had sales outlets in the major Hispanic markets of New York, Miami, Dallas, Los Angeles, San Antonio, and Houston. Today, the business continues to grow and Ramirez is sharing her success. She donates a percentage of her profits to organizations that help and encourage Latina entrepreneurs. As you can see in Figure 3.1 below, Zalia Cosmetics was just one of more than 585,000 new businesses started in the United States in 2001. No matter where you go in the United States, you can see similar signs of a free enterprise economy at work. If you walk through a suburban shopping mall you’ll see national and regional chain stores next to small boutiques and startup shops. Sometimes you’ll even see kiosks in the aisles, competing for business. Similarly, on a stroll through a city neighborhood you’ll observe corner grocery stores, dry cleaners, and barber shops. At an industrial park you’ll see factories that churn out an immense variety of products. In the countryside beyond the city, you’ll notice farms with fields of corn or soybeans, orchards of apples or peaches, or grazing areas for livestock. FIGURE 3.1 NEW FIRMS AND FIRM CLOSURES ( 700 600 500 400 300 200 100 0 This line graph shows the risk involved in starting a new business. Nearly as many businesses close as the number of new businesses that start each year. Less than half of all new businesses survive for four years or more. Find an update on new business firms and business firm closures at ClassZone.com New firms Firm closures * Source: U.S. Small Business Administration Year *Estimated ANALYZE GRAPHS 1. What is notable about 2002 in terms of the relationship between new firms and firm closures? 2. How does this graph illustrate the fact that entrepreneurship involves risk? What do these examples of free enterprise have in common? They are all illustrations of how individual choices are the basis of a market economy. Business owners freely make the choice to start these enterprises. Also, these owners are free to choose how they will use their scarce productive resources. The managers and workers who operate these businesses voluntarily decide to exchange their labor for the pay the owners offer. Finally, consumers make their own choices on which goods and services they will buy. The American Free Enterprise System 71 As you recall, government plays a relatively limited role in the American free enterprise system. The government sometimes takes actions that limit free enterprise. For the most part, however, these actions are designed to protect or encourage competition or to enforce contracts. EXAMPLE Emerging Markets As you read in Chapter 2, most countries today have mixed economic systems with at least some elements of free enterprise. Each economy has its own balance of tradition, free enterprise, and government involvement and its own distinctive ways in which market forces work. To illustrate this, let’s look at the countries of Mexico and Singapore In the Mexican economy, the government plays a much larger role than in the United States. The Mexican government has established many rules and regulations that make starting a new business quite difficult. As a result, an informal market that gets around these barriers has grown up. In Mexico City, for example, much of the city center is taken up with vendors’ stalls, and people jam the streets to buy imported toys, clothing, shoes, CDs, and more at much lower prices than they could find at regular retail stores. Indeed, the stiff competition from street vendors has driven some of the retail stores out of business. Competition Popular stalls on the streets of Mexico City, selling everything from candy to clothes, provide considerable competition for established stores. The country of Singapore has a thriving free enterprise system. However, the government is so closely involved in the economy that the country is sometimes called Singapore Inc. The government establishes what benefits employers must provide to workers. It also requires all workers to put a percentage of income in the Central Provident Fund, a government savings scheme. The fund is used to pay pensions and to finance public projects, such as education, housing, and health care. Even so, the government is considered very supportive of free enterprise. Many of its policies keep business rents, taxes, and other costs low so that Singaporean companies remain competitive in the world economy. APPLICATION Analyzing Cause and Effect A. What steps can a government take to support free enterprise? 72 Chapter 3 How a Free Enterprise System Works KEY C ONCEPT S You learned in Chapter 2 that the right to private property is one of the most fundamental freedoms in a capitalist economy. With that freedom comes the right to exchange that property voluntarily. This exchange lies at the heart of a free enterprise economy. Another key freedom of this type of economy is open opportunity, the ability of everyone to enter and compete in the marketplace of his or her own free choice. This ensures that the market will reflect a wide range of interests and talents and will provide incentives to everyone to be efficient and productive. Free enterprise also requires legal equality, a situation in which everyone has the same economic rights under the law. In other words, everyone has the same legal right to succeed or fail in the marketplace. Another important element of a market economy is the free contract. For voluntary exchange to work, people must be able to decide for themselves which legal agreements they want to enter into, such as business, job, or purchase commitments. These freedoms assure that people are able to engage in free enterprise. But what motivates people to start a business? For most people, it is the profit motive, the incentive that encourages people and organizations to improve their material wellbeing by seeking to gain from economic activities. Producers, motivated by profit, seek the highest possible price for their products. Competition offsets the drive to earn profits, since it forces prices down. This helps producers find a price that is not so high that it deters buyers and not so low that it inhibits profits. QUICK REFERENCE Open opportunity is the ability of everyone to take part in the market by free choice. Legal equality is a situation in which everyone has the same economic rights under the law. A free contract is a situation in which people decide which legal agreements to enter into. The profit motive is the force that encourages people and organizations to improve their material well being from economic activities. E XAMPLE Profit in Rocks One memorable example of how the various economic freedoms and the profit motive come together in the free enterprise system is the pet rock. Talking with friends in April 1975, advertising executive Gary Dahl joked that regular pets were too much trouble. Pet rocks, he suggested, were much easier to care for. Dahl’s friends were amused by the idea. In response, he wrote a manual on pet rocks, showing how they could be house trained and taught to do tricks. In August, Dahl began packaging his pet rocks, complete with a care manual, for sale at gift shows. Intrigued, a buyer from a major department store ordered 500. In a matter of weeks, Dahl’s joke had become a national story. Articles appeared in newspapers and magazines and Dahl did several interviews on television. By the end of the year, Dahl had sold more than two tons of pet rocks and had become a millionaire. However, as 1976 began, consumers l
ost interest, and it quickly became obvious that the pet rock was last year’s fad. Dahl decided to get out of the pet rock business, guided by the same market forces that had brought him into the business and made him rich. Open Opportunity Because of legal rights built into the free enterprise system, Gary Dahl was free to enter the market for pet rocks. The American Free Enterprise System 73 Free Enterprise and Legal Rights Open Opportunity Everyone should have the ability to enter and compete in any marketplace. Open participation serves as an incentive to be efficient and productive. What Legal Rights Are Built into the Free Enterprise System? Free Contract Everyone should have the right to decide for themselves which legal economic agreements they want to enter into. Voluntary exchange, a cornerstone of free enterprise, cannot function without freedom of contract Legal Equality Everyone should have the same economic rights under the law. In other words, the law should not give some people a better chance than others to succeed in the marketplace. ANALYZE CHARTS The American free enterprise system is based on the idea of freedom—producers and consumers are free to pursue their economic self-interest. Certain legal rights have been established to protect and encourage this freedom. Reread the paragraphs on pet rocks on page 73 and those on books on pages 74–75. How do these examples illustrate the legal rights shown in this chart? EXAMPLE Competition over Books Gary Dahl did face competition from other producers who jumped into the pet rock market. Competition, however, did not drive him out of business. Rather, consumers simply stopped buying pet rocks. The market for books is somewhat different. Demand for books remains high, but booksellers have been going out of business because of new and fierce competition. Before 1995, small chain stores and independent neighborhood booksellers dominated the book market. Around 1995, large chain stores such as Barnes & Noble Inc. and Borders Group Inc. began to compete more aggressively. Because of their huge purchasing volume, the large chain stores could buy their books at greatly discounted prices. They passed the savings on to consumers, lowering prices by anywhere from 10 percent to 40 percent. They also created a warm and welcoming atmosphere in their stores, with comfortable reading areas, cafés, and frequent readings and book signings by authors. 74 Chapter 3 The tactics of the large chain stores caused problems for independent booksellers. In 1991, independent booksellers accounted for more than 30 percent of all book sales in the United States. By 2005, their share of sales had fallen to less than 15 percent. And between 1995 and 2005, about 1,200 independent booksellers went out of business. Soon, however, the large chains faced a challenge themselves: Amazon.com. The online bookseller opened for business in July, 1995 and within a few months had become an important player in the book market. Amazon’s easy-to-use Web site, huge database of titles, quick and reliable delivery, and discounted prices attracted many book buyers. By the end of 2004, Amazon’s sales stood at $134 million a week. Now Amazon, however, is looking over its shoulder at a new challenger. Online competitors such as Overstock.com and Buy.com have undercut Amazon’s prices on hundreds of books by as much as 25 percent while matching Amazon’s level of excellence in service. Consumers have benefited from all of this competition, for they can now easily and conveniently buy books at the lowest prices. Those independent booksellers who have remained in business cannot match the lower prices offered by the large chains and online sellers. However, they can provide some things that their larger competitors cannot: personal service and a focus on local tastes or specialized subject areas. Consumers benefit from this, too. These independent booksellers who stayed in business illustrate an important aspect of free enterprise. Businesses that keep pace with changes in the market and adjust accordingly thrive. Those that do not eventually fail. YO U R EC FREE ENTERPRISE Where will you open your restaurant? You’ve decided to open a restaurant. You can lease one of two buildings. One is in a busy mall next to a highway exit. However, there are already six restaurants in that mall. The other location is in a small strip mall in a quiet neighborhood with no other restaurants nearby. Consider the chance to make profits and the level of competition, and choose. ? Mall food court Neighborhood strip mall AP P LI CATION Analyzing Cause and Effect B. Explain the chain of cause-and-effect reactions since the mid-1990s that led to lower book prices for American consumers. The American Free Enterprise System 75 ECO N O M I C S PAC ES E T T E R Milton Friedman: Promoter of Free Markets At a glittering White House birthday celebration for Milton Friedman in 2002, President George W. Bush declared that the 90-year-old economist “has shown us that . . . in contrast to the free market’s invisible hand . . . the government’s invisible foot tramples on people’s hopes.” Economics professors are rarely guests of honor at White House galas. Why did Friedman receive such a tribute? Economic Freedom Personal freedom is at the center of Friedman’s economic theories. Free to Choose Friedman spent most of his career teaching at the University of Chicago, where he helped develop the free-market ideas now linked with what is called the “Chicago School of Economics.” Central to his ideas was the belief that the market should be free to operate in all fields, even such professions as the law and medicine. Easing government restrictions in these fields— lowering licensing standards, for example—would bring more doctors and lawyers into the market. This, in turn, would bring down the cost of legal and medical services. Friedman also put forward the theory that the government’s most important economic role was to control the amount of money in circulation. Without this control of the money supply, Friedman noted, the economy would experience inflation—a sustained rise in the general level of prices. Friedman’s ideas were very influential. He advised two U.S. presidents and the heads of state of several other countries on economic policy. He gained worldwide recognition in 1976 when he won the Nobel Prize for Economics. Friedman became well known outside the academic world in 1980 when Free to Choose, which he wrote with his wife Rose, became the year’s best-selling nonfiction book in the United States. From 1977 until his death in 2006, Friedman served as a scholar at the Hoover Institution, a conservative public-policy research center at Stanford University. In 1996, he and his wife founded the Milton and Rose D. Friedman Foundation, an organization that promotes school choice. APPLICATION Making Inferences C. How might Milton Friedman have responded to the problems associated with the informal market in Mexico? FAST FACTS Milton Friedman Born: July 31, 1912 Died: November 16, 2006 Important Publications: Capitalism and Freedom (1962) Free to Choose (1980) Bright Promises, Dismal Performance: An Economist’s Protest (1983) Famous Quotation: I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it’s possible. Major Accomplishments: Economic advisor to Presidents Richard Nixon and Ronald Reagan, and to British prime minister Margaret Thatcher Find an update on Milton Friedman at ClassZone.com 76 Chapter 3 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the differences among the following terms. a. open opportunity b. legal equality c. free contract 2. What is the role of the profit motive in the American free enterprise system? 3. How is a free enterprise system linked to economic freedom? 4. Give examples of three different economic freedoms in a free enterprise system. 5. What force acts as a balance to the profit motive in the American free enterprise system? 6. Using Your Notes Write two or three paragraphs explaining how a free enterprise system works. Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com definition detail Free Enterprise detail detail . Applying Economic Concepts Explain the role of competition in a free market. Illustrate your answer with examples of businesses in your local economy. 8. Comparing and Contrasting Economic Information Monica Ramirez and Gary Dahl both saw business opportunities and started new companies. Compare and contrast Ramirez’s response to the market with that of Dahl. Use a Venn diagram to help you organize your ideas. 9. Predicting Economic Trends Turn back to page 74 and read again the paragraphs about competitive ideas in the bookselling market. What do you think might be the next new idea to compete with discounted books? 10. Challenge In a 1973 magazine interview, Milton Friedman said, What kind of society isn’t structured on greed? The problem of social organization is how to set up an arrangement under which greed will do the least harm; capitalism is that kind of a system. Do you agree with Friedman that societies are structured on greed and that capitalism can reduce the harm caused by greed? Explain your answer. A new business in the United States Analyzing Economic Information The following chart gives data about the rules and time for setting up new businesses in six countries. The rules are measured according to the number of government procedures a new business has to go through before it can begin operating. The time is the number of days it takes to complete the process of registering a new business. Draw Conclusions What is the relationship between the rules and the time for setting up a new business? Rules (Number of Procedures) Time (Number of Days) Country Canada Sweden United States Singapore Germany Mexico China 2 3 5 6 9 9 13 3 16 5 6 24 58 48 Source: World
Bank, 2005 Challenge Use the chart and what you know about the economies of the listed countries to write a short paragraph comparing the ease of entry into the marketplace in three countries of your choice. 77 S E C T I O N 2 How Does Free Enterprise Allocate Resources TA K I N G N O T E S In Section 2, you will profit, p. 78 modified free enterprise economy, p. 80 • explain how consumers help determine the way resources are used • explain how producers help determine the way resources are used • analyze a circular flow model of the U.S. economy As you read Section 2, complete a cluster diagram to show how consumers, producers, and the government interact to allocate resources. Use the Graphic Organizer at Interactive Review @ ClassZone.com Profit consumers producers government The Roles of Producers and Consumers KEY CONCEPT S QUICK REFERENCE Profit is the money left over after the costs of producing a good or service have been subtracted from the revenue gained by selling that good or service. In the marketplace, consumers buy products for their personal use from producers who make or provide goods or services. In these exchanges, consumers look to get the best deal for the money they spend. Producers, on the other hand, are looking to earn the most profit from these transactions. Profit is the money left over after the costs of producing a product are subtracted from the revenue gained by selling that product. Seeking opportunities to earn profits is one way producers help allocate scarce resources in the economy. EXAMPLE Producers Seek Profit A new neighborhood coffee shop illustrates how producers help to allocate resources. The owners of the coffee shop, motivated by the desire to earn profits, charge the highest price consumers are willing to pay. The possibilities for good profits encourage other people to open coffee shops of their own. As a result, productive resources that might have been used in some other kind of business are directed toward the coffee shops. The profit seeking of producers, then, has helped in the allocation of resources. 78 Chapter 3 E XAMPLE Consumers Vote with Their Wallets Consumers also play an important role in allocating resources in a free enterprise system. When consumers choose to buy a product, they are “voting” for their choice against competing products. These “votes” help determine what will be produced in the future, since producers, seeking opportunities to profit, try to provide what consumers want. For example, in the early 2000s, when low-carbohydrate diets were popular, consumers “voted” for low-carb and high-protein foods and against high-carb foods. (Figure 3.3 below illustrates this, showing that between 2002 and 2003 sales of typical low-carb/high-protein products increased, while sales of typical high-carb products fell.) How did food producers respond to these “votes”? They moved some of their productive resources into the low-carb market to try to meet consumer demand. FIGURE 3. 3 SALES OF SELEC TED FOOD PRODUC TS High-Carb Foods Low-Carb/High-Protein Foods Product Unit Sales, 2003 (in millions) Percentage Change Over 2002 Product Unit Sales, 2003 (in millions) Percentage Change Over 2002 Instant Rice 79.1 Bulk Rice 180.2 Cookies 1,839.7 Regular Carbonated Drinks 7,032.5 Dry Pasta 1,227.0 White Bread 1,606.1 Source: ACNielsen –8.2 –4.9 –5.5 –5.9 –4.6 –4.7 Frozen Meat/ Seafood 483.5 Meat Snacks 105.4 +7.7 +7.6 Nuts 679.3 +8.8 Diet Carbonated Drinks 2,828.6 +1.0 Cheese 3,424.0 Wheat Bread 873.1 +4.0 +4.0 ANALYZE TABLES 1. Which high-carb item showed the greatest percentage drop in sales between 2002 and 2003? Which low-carb/high-protein item showed the greatest percentage gain? 2. Consumer interest in low-carb diets began to decline after 2004. What differences might you expect to see in a similar table for 2004 and 2005? Interest in low-carb diets peaked early in 2004, but began to fade thereafter. Once again, consumers had cast their votes in the marketplace, buying fewer lowcarb and high-protein products. Producers quickly responded. By the beginning of 2005, some companies had gotten out of the low-carb market completely. Others had significantly cut back production of low-carb products. Consumer actions had caused a reallocation of productive resources. AP P LI CATION Analyzing Cause and Effect A. How would the allocation of resources have been affected if the interest in low-carb diets had continued to increase? The American Free Enterprise System 79 Government in the U.S. Economy KEY CONCEPT S QUICK REFERENCE A modified free enterprise economy is a free enterprise economic system with some government involvement. In Chapter 2 you learned that the United States economy, though based on the market system, is mixed. Government is an important element in the American economic system, but its role is relatively limited. This type of mixed economy, which includes some government protections, provisions, and regulations to adjust the free enterprise system, is sometimes called a modified free enterprise economy. Modified Free Enterprise In Figure 2.4 on page 53, you saw that the economy could be viewed as a stream of resources and products moving in a circular flow between households and businesses. Money also flows between households and businesses, facilitating this exchange of products and resources. Figure 3.4 shows how the government fits into this circular flow. It also shows how government exacts costs and dispenses benefits. Locate the two main economic decision-makers at the right and left of the chart: households (owners of resources) and businesses (makers of products). The two F I G U R E 3 . 4 Government in the Circular Flow Model Business revenue Product Market Consumer spending Products Products Products Products Government Businesses Taxes Productive Resources i g n d n e p S Taxes Households (Individuals)) Land, labor, capital, entrepreneurship s e c r u o s e R Payments Factor Market Income ANALYZE CHARTS This version of the circular flow model shows the flow of resources, products, and money among households, businesses, and the government. Describe the role of government in the economy using information from this chart. Use an interactive circular flow model at ClassZone.com 80 Chapter 3 markets in the economy, the product market (for goods and services) and the factor market (for economic resources), are located at the top and bottom of the chart. The outer green arrows show the flow of money. The inner blue arrows show the flow of resources and products. The government is located in the center of the chart. Like the other key actors in the circular flow, the government is both a consumer and a producer. Look at the arrows that run between government and the two markets. The government is a consumer in the resource market, spending money to buy the factors of production. It is also a consumer in the product market, spending money in exchange for products. Now locate the arrows that run between government and households and government and business firms. Government is a producer here, providing goods and services to both households and businesses. Government collects money from households and businesses, in the form of taxes, as payment for these goods and services. It covers the costs of what it produces with this money. Government also uses this money to make purchases in the resource and product markets, and the cycle continues. FIGURE 3.5 WORKERS ON THE GOVERNMENT PAYROLL FIGURE 3.6 GOVERNMENT CONSUMPTION ) 25 20 15 10 5 0 1996 1998 2000 2002 2004 Year ) .50 2.00 1.50 1.00 0.50 0.00 1996 1998 2000 2002 2004 Year Source: U.S. Bureau of Labor Statistics Source: U.S. Department of Commerce ANALYZE GRAPHS 1. About how many workers were on the government payroll in 2005? 2. Based on these two graphs, how is government’s role as a consumer of products and resources changing? Figures 3.5 and 3.6 above show that government is a major consumer of both resources and products. As you can see in Figure 3.5, all levels of government, local, state, and federal, employ almost 22 million workers. This is equal to about 16 percent of the labor force—all the labor resources available in the United States. Further, if you look at Figure 3.6 you’ll see that government consumption—what all levels of government spend on goods and services—is about two trillion dollars. Find an update on government workers and government consumption at ClassZone.com AP P LI CATION Applying Economic Concepts B. The paycheck that you get for working part-time at the pet store shows what you have earned and how much is withheld for taxes. Explain how the paycheck and the taxes withheld are represented in the circular flow model. The American Free Enterprise System 81 For more on interpreting graphs, see the Skillbuilder Handbook, page R29. Interpreting Graphs: Public Opinion Polls Public opinion polls are a useful tool for gathering information. Economists frequently use information obtained from opinion polls to measure public response to economic conditions. Polls conducted at regular intervals show changes in public opinion over a given period of time. The graph below shows the results of a poll that tracks consumer confidence. The poll, which is conducted monthly, is based on a representative sample of 5,000 households in the United States. Title This indicates the type of data shown. Consumer confidence refers to the way people feel about the economy. Increasing confidence is likely to result in increased purchases of goods. 110 105 100 95 90 85 Consumer Confidence Index April–December 2005 Subtitle This indicates the months and year of data collection. Line on Graph This shows the fluctuations in consumer confidence from month to month. Legend This provides a benchmark for comparison. For example, scores higher than 100 indicate that consumers have more confidence in the economy than they did in 1985. 1985 = 100 A pril M ay Ju n e July Se pte m b er A u g ust O cto
b er N ove m b er D ece m b er Source: The Conference Board, December 2005 Consumer Confidence Index According to researchers, consumer confidence in the economy tumbled after Hurricane Katrina hit the Gulf Coast in September 2005. Falling gasoline prices and growth in the job market led to a recovery in confidence in November and December. T HINKING ECONOMICALLY Interpreting 1. During which month was consumer confidence the highest? The lowest? 2. Describe the changes in consumer confidence from August through December. 3. The devastation caused by Hurricane Katrina and resulting increase in gasoline prices led to the abrupt drop in consumer confidence shown in the graph. What other events might cause a decline in consumer confidence? 82 Chapter 3 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Why is the U.S. economy sometimes referred to as a modified free enterprise system? 2. How does the profit motive work to allocate resources? 3. How do households and business firms interact in the product and resource markets? 4. Describe how the government interacts with the product and resource markets. 5. Study the circular flow models on pages 53 and 80. How are the two models different? 6. Using Your Notes Explain how producers, consumers, and the government interact to allocate resources in a free enterprise system. Profit consumers producers government Use the Graphic Organizer at Interactive Review @ ClassZone.com . Applying Economic Concepts Think of several examples in which consumers have voted with their dollars and driven a product from the market or into high demand. Record your ideas in a table like the one below. Consumers Drive Product from the Market Consumers Drive Product into High Demand Analyzing Economic Information Look at the graph below, which shows the sales figures for a company that makes a substance that reduces carbohydrates in baked goods 120 100 80 60 40 20 0 2003 2004 Year 2005 8. Comparing and Contrasting Economic Information Compare and contrast the role of consumers and producers in allocating resources. Which do you think has the greater power? 9 Interpreting Economic Models Use the circular flow chart on page 80 and what you have learned from this section to explain the ways in which government allocates resources. 10. Challenge What industries in today’s world do you think would be wise to make changes given consumers’ preferences? Give reasons for your selections. Interpret Information Write a sentence or two explaining the trend that the graph shows. Challenge If you were the head of the company that made the substance that reduces carbohydrates in baked goods, in what direction would you move your business? How might you reallocate your resources? The American Free Enterprise System 83 S E C T I O N 3 Government and Free Enterprise TA K I N G N O T E S In Section 3, you will • understand that one role of government in the U.S. economy is to address market failures • analyze why governments provide public goods and infrastructure • explain how governments seek to decrease negative externalities and increase positive externalities market failure, p. 84 public goods, p. 84 free rider, p. 85 infrastructure, p. 86 externality, p. 87 negative externality, p. 87 positive externality, p. 87 subsidy, p. 88 safety net, p. 89 transfer payment, p. 89 public transfer payment, p. 89 As you read Section 3, complete a cluster diagram to show the role of government in free enterprise. Use the Graphic Organizer at Interactive Review @ ClassZone.com providing public goods Government Providing Public Goods KEY CONCEPTS In the American economic system, most production decisions are made in the marketplace through the interactions of buyers and sellers. This is the free enterprise sector of our economy. Other decisions are made by different levels of government. This is the public sector of our economy. How do we decide which sector of the economy should produce a good or service? If all the costs are borne by, and all benefits go to, the buyer and seller, the free enterprise sector produces it. If people who are not part of a marketplace interaction benefit from it or pay part of the costs, there is a market failure. When market failures occur, the government sometimes provides the good or service. Goods and services that are provided by the government and consumed by the public as a group are public goods. Public goods are funded with taxes collected by the government. QUICK REFERENCE Market failure occurs when people who are not part of a marketplace interaction benefit from it or pay part of its costs. Public goods are products provided by federal, state, and local governments and consumed by the public as a group. 84 Chapter 3 Public Goods A city street lighting system is an example of a public good. E XAMPLE Characteristics of Public Goods Public goods have two characteristics. First, people cannot be excluded from the benefits of the product even though they do not pay for it. Second, one person’s use of the product does not reduce its usefulness to others. Perhaps the simplest example of a public good is street lighting. When the street lighting is on, it is impossible to exclude people from using it. In addition, the benefit you receive from the safety and security street lighting provides is not diminished because others receive it too. There is simply no way for a private business to establish a realistic price for street lighting and then collect it from all users. Rather, local governments provide street lighting, paying for it with taxes. Another example of a public good is national defense. Everyone benefits from the country being defended. Further, the security you feel knowing that there is a national defense system in place is not diminished because other people feel secure too. Given these benefits, you would readily pay for this sense of security. However, what if you discovered that your neighbors were not paying for national defense? Would you voluntarily pay then? To avoid this problem, everyone is required to pay taxes to the national government, which provides national defense. E XAMPLE Free Riders There is no incentive for businesses to produce public goods, because people will not voluntarily pay for them. After all, people receive the benefits of these products whether they pay for them or not. This situation is called the free-rider problem, and it is one type of market failure. A free rider is a person who chooses not to pay for a good or service but who benefits from it when it is provided. QUICK REFERENCE A free rider is a person who avoids paying for a good or service but who benefits from that good or service anyway. Consider a July 4th fireworks display, which can cost $200,000 or more. If you tried to set up a business to put on such displays, you’d immediately run into problems. There is no way to charge people for watching the display, since it is visible from so many locations. Even if you were able to charge a fee to watch from a particularly good location, many people would still be able to watch it from elsewhere without paying. Those people are free riders—they receive the thrill and enjoyment of the fireworks display, but they do not share in the costs of putting it on. Because of them, there is little interest in providing fireworks displays as a business opportunity. One way to address the free-rider problem is for government to provide certain goods and services. The city government, for example, could put on the July 4th fireworks display, using taxes to pay for it. In this way, the costs and benefits are shared throughout the community. Free Riders Free riders will choose not to pay for fireworks displays but will still enjoy the benefits. Because of this, private companies are reluctant to provide such services. The American Free Enterprise System 85 Another example of the free-rider problem is law enforcement. Once a policing system is established, everyone in the community is protected whether they pay for it or not. The best way to ensure that people who benefit from this protection pay a share of the costs is for government to provide the service, paying for it with taxes. Public and Private Sectors—Shared Responsibilities Some goods can be provided by either the public sector or the private sector. These often are toll goods—goods consumed by the public as a group, but people can be excluded from using them. For example, toll ways are open for all people to use, but those who do use them have to pay a toll. Similarly, parks are provided for the benefit of everyone, but those who want to enjoy this benefit may have to pay an entrance fee. The initial funding for toll goods is often provided by the public sector. Their day-to-day operation is often the responsibility of the private sector. The private and public sectors share the responsibility for the nation’s infrastructure, the goods and services that are necessary for the smooth functioning of society, such as highways; mass transit; power, water, and sewer systems; education and health care systems; and police and fire protection. How important is the infrastructure? Imagine, for example, what the United States would be like without its interstate highways, safe airports and seaports, and passenger and freight train systems. To begin with, the nation’s economy would grind to a halt. Further, the nation would lose its ability to move troops in case of attack or to evacuate people in an emergency. A solid infrastructure, then, is essential to economic health. QUICK REFERENCE The infrastructure consists of all the goods and services that are necessary for the functioning of society. YO U R EC PU BLIC vs. PRIVATE Will you support tax increases to improve recreational facilities? The mayor wants to build a water park to attract visitors, who will spend money at your town’s restaurants and stores. But what you pay in sales tax will rise by about $100 a year to cover the cost. With that m
oney, you could buy a couple of video games. What will you choose—public wants or private wants? ? Water park Video game APPLICATION Applying Economic Concepts A. Identify another example in which the free rider problem makes public goods or services the best solution. 86 Chapter 3 Managing Externalities KEY C ONCEPT S Another type of market failure occurs when economic transactions cause externalities. An externality is a side effect of a transaction that affects someone other than the producer or the buyer. A negative externality is an externality that is a negative effect, or cost, for people who were not involved in the original economic activity. For example, a manufacturing company discharges pollution into a nearby river. The costs of the pollution are borne by everyone who lives by the river, even if they have no connection to the manufacturing company. A positive externality, in contrast, is an externality that is a positive effect, or benefit, for people who were not involved in the original economic activity. Another of your neighbors, for example, plants and maintains a beautiful rose garden. All the surrounding homes benefit from the beauty. E XAMPLE Paying for Negative Externalities One of the most commonly discussed negative externalities is industrial pollution. The owner of a factory that belches filthy smoke in the air, influenced by such Paying for Pollution A 1990 amendment to the Clean Air Act set a limit on the amount of sulfur dioxide that industries could release into the air. The government distributed to those industries only enough “pollution permits” to meet that limit. Instead of using their permits, some companies used cleaner production methods and sold the permits to other companies. As the price of these permits rose, more and more companies developed production methods that did not pollute. FIGURE 3.7 SULFUR DIOXIDE EMISSIONS QUICK REFERENCE An externality is a side effect of a product that affects someone other than the producer or the buyer. A negative externality is an externality that imposes costs on people who were not involved in the original economic activity. A positive externality is an externality that creates benefits for people who were not involved in the original economic activity. 35,000 30,000 25,000 20,000 15,000 10,000 5,000 1970 1975 1980 1985 1990 1995 2000 Source: Environmental Protection Agency Year ANALYZE GRAPHS 1. How would you describe the trend in sulfur-dioxide pollution, especially since changes in government policy in 1990? 2. How did the government take a market approach to the problem of pollution? The American Free Enterprise System 87 market forces as the profit motive and competition, has little incentive in the shortterm to pay the extra money required to reduce the pollution. Everyone living in the surrounding region suffers from this pollution. Not only do they bear the monetary cost of cleaning up the pollution, they suffer other costs too. They are more likely to suffer pollution-related illnesses and, therefore, face higher medical costs. Limiting negative externalities, then, is one important role of the government in the American economy. The government taxes or fines the polluter, and in the process accomplishes two economic purposes. The money it raises through taxation and fines can offset the higher medical costs. In addition, the cost of the tax or fine to the factory owner provides an incentive to reduce pollution. EXAMPLE Spreading Positive Externalities Positive externalities are benefits that extend to people not involved in the original activity. For example, if a new college is built in your town, local businesses benefit from student purchases of goods and services. Workers benefit too, for as business expands to meet students’ wants, more and more jobs become available. The community as a whole benefits from all the taxes collected from students. Local government is able to spend some of these funds to provide more public goods. In addition, the whole community benefits from the potential contribution a more skilled and knowledgeable population can make to the economy. Positive Externalities The government will try to spread the benefit of a flu vaccination program—a healthier population—as widely as possible. Just as government attempts to limit negative externalities, it tries to increase positive externalities. One way government does this is through subsidies. A subsidy is a government payment that helps cover the cost of an economic activity that is considered to be in the public interest. Since subsidies are paid for with taxes, everyone shares in their cost. Subsidies also spread the benefit of a positive externality as widely as possible. For example, the federal government might provide subsidies to drug companies to develop a new vaccine. This benefits the whole population in the long run because once the vaccine is in use there will be fewer and fewer infected people to spread the disease. Similarly, a local government might subsidize influenza shots for the community. Obviously, those people who take advantage of the free or inexpensive shots benefit because they are protected against infection. Even those people who don’t get the shot still receive a benefit because they are less likely to encounter someone with the flu and therefore less likely to catch it themselves. QUICK REFERENCE A subsidy is a government payment that helps cover the cost of an economic activity that has the potential to benefit the public as a whole. APPLICATION Explaining an Economic Concept B. How might a drunk-driving law address negative externalities? 88 Chapter 3 Public Transfer Payments KEY C ONCEPT S In addition to providing public goods and managing externalities, the government plays another role in the economy. One limitation of free enterprise is that people who are too old or sick to make a full economic contribution do not always have access to all economic opportunities. For these people, and others who are temporarily struggling, there is a public safety net, government programs designed to protect people from economic hardships. Redistributing Income As many as 37 million people in the United States live below the poverty level, which was defined in 2005 as a yearly income of $9,570 for a single person, with $3,260 added for each additional household member. That is more than 12 percent of the nation’s population. However, people move up and down the income ladder in the United States. Many poor families remain poor for a relatively brief time. For example, the median duration of poverty through the 1990s was between four and five months. How does a modern society address economic issues such as poverty? One way is to encourage economic growth. Another is through transfer payments, transfers of income from one person or group to another even though the receiver does not provide any goods or services in return. Some transfer payments are between private individuals. When you receive cash and checks from relatives and friends for your birthday or graduation, you are receiving transfer payments. When someone dies, a transfer payment flows to his or her beneficiaries in the form of inheritance. In both cases, the receiver provides nothing in return for the payment. QUICK REFERENCE The safety net consists of government programs designed to protect people from economic hardship. Transfer payments are transfers of income from one person or group to another even though the receiver does not provide anything in return. A public transfer payment is a transfer payment in which the government transfers income from taxpayers to recipients who do not provide anything in return. A public transfer payment is a payment in which the government transfers income from taxpayers to recipients who do not provide anything in return. Public transfer payments, since they do not reflect exchanges within a marketplace, are not a characteristic of pure market economies. They are more characteristic of command economies, and their presence in the United States is one feature that makes the U.S. economy a mixed economy. Public Transfer Payments Type 2004 Expenditures (in billions of dollars) Social Security benefits Medicare Medicaid Supplemental Security Income Unemployment compensation 517.8 303.3 299.7 37.3 37.1 Public Transfer Payments Social Security is the largest public transfer program. 33.8 Veterans’ benefits Food Stamps Most public transfer payments are in the area of social spending—spending designed to address social issues, such as poverty. Social Security benefits, for example, have significantly reduced poverty among the elderly. This program is funded by the contributions of people currently employed. They pay a social security tax to the federal government, which in turn transfers it to people who are at or past retirement age. The Social Security program also provides income for the disabled. Source: U.S. Department of Commerce Temporary Assistance for Needy Families 25.8 18.5 The American Free Enterprise System 89 Social Spending in Sweden FIGURE 3.8 SOCIAL SPENDING In market economies, all economic actors—including governments—have to make choices. One economic choice governments must make involves the level of funding for social spending. Sweden’s government, for example, has chosen to spend a significant amount in this area. Close to 30 percent of the country’s total economy is spent on such programs as free public education through college, national health, and retirement and disability pensions. In comparison, social spending in the United States is about 15 percent of the total economy. U.S. social programs are not as comprehensive as Sweden’s. Such generosity, however, comes at a price. Sweden’s workers pay hefty taxes to fund this social spending. Average Swedish workers with two children pay about 22 percent of their income in taxes. In contrast, similar American workers pay only about 9 percent. 28.8% 14.7% Sweden Unite
d States Percent of total economy Source: Organization for Economic Co-operation and Development, 2001 figures FIGURE 3.9 HOUSEHOLD TAX BURDEN 21.6% 9.1% CONNECTING ACROSS THE GLOBE 1. Synthesizing Economic Information How do tax levels relate to the amount of resources devoted to social spending? 2. Drawing Conclusions Which country do you think has more of a market economy, Sweden or the United States? Why? Sweden United States Percent of total earnings Source: Organization for Economic Co-operation and Development, 2003 figures The government makes transfer payments to the very poor as well as to the aged and disabled. For many years, the program known as welfare made payments to the needy to assure their well-being. A debate developed about whether such a program fostered dependence on the government and removed incentives to break out of poverty. In response to this debate, the government introduced sweeping reforms in the mid-1990s. The new program, widely known as workfare, stressed the importance of helping welfare recipients enter or re-enter the workforce as quickly as possible. Since these reforms in 1997, 4.7 million Americans have moved from being dependent on welfare to self-sufficiency. Public transfer payments also provide a safety net for people who lose their jobs. Unemployment compensation from a mix of federal and state money tides people over until they can find a new job. While people receive it, they must show that they are making an effort to find another job. (You will learn more about unemployment, poverty, and government social spending in later chapters.) APPLICATION Applying Economic Concepts C. What are the opportunity costs of public transfer payments? 90 Chapter 3 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs: a. market failure free rider c. subsidy positive externality b. negative externality positive externality d. safety net public transfer payment 2. Illustrate the two characteristics of public goods with examples. 3. How is infrastructure linked to the economy? 4. Give an example of a free rider. 5. How can government limit a negative externality? How can it spread a positive one? 6. Using Your Notes Explain how the government gets involved in the economy in a modified free enterprise system. Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com providing public goods Government Cleaning up a toxic dump 7. Categorizing Economic Information Unemployment compensation and payment of living expenses for the disabled are examples of what kind of government involvement in the American economy? 8. Making Inferences After several incidents of hallway disputes among students, the board of a high school decides to hire hallway guards. In economic terms, what is the school board doing? How might this decision affect other programs at the school? 9. Evaluating Economic Decisions As part of the welfare reform of the mid-1990s, the federal government hired 10,000 people who had been dependent on welfare in an initiative called welfareto-work. How does this approach differ from transfer payments? What are the costs and benefits of this approach? 10. Challenge In 2003, Congress passed laws to encourage private charitable organizations to provide social services. They would compete for government funds to carry out community services through their own networks. Do you think this is an effective way to address social issues? Why or why not? Use economic concepts, such as markets, efficiency, and opportunity costs in developing your response. Categorizing Economic Information Externalities are categorized according to their impact, either positive or negative. Identify Externalities Decide whether each of the following is a positive or a negative externality and briefly explain its effect. • A beekeeper establishes a farm next to an apple orchard and the bees move freely into the orchard. • An airport is constructed near a residential neighborhood. • A construction company cleans up a toxic dump near a site it is working on. • Companies pay for programs to help employees get in shape. Challenge Identify and explain a negative externality and a positive externality that affect you. The American Free Enterprise System 91 Case Study Find an update on this Case Study at ClassZone.com The United States: Land of Entrepreneurs Background The free enterprise system and the belief that everyone has the right to pursue economic success through lawful means is the backbone of American society. Many people achieve that success through working for an employer who provides a place to work, a paycheck, and other benefits. However, an increasing number of people are working for themselves, and for a variety of reasons. These reasons include a desire to market their own products, or to have more freedom. What’s the issue? What are some of the options for opening your own business? Study these sources to learn how others found their way, and the obstacles and opportunities they faced. A. Magazine Article This article discusses the development of Fizzy Lizzy, a new soft drink, from initial concept through launch, and introduces the entrepreneur who came up with the idea. A Business Idea in a Bottle Getting Fizzy Lizzy Bubbling [Elizabeth] Marlin . . . got into the beverage business in the summer of 1996, when she set out for a long bicycle ride. . . . Not long into her trip, she realized that her favorite refreshment, which she had packed into a saddlebag—a half-gallon carton of grapefruit juice and a liter bottle of seltzer, which she’d mix together—was not only inconvenient, it was also slowing her down. “Juice and seltzer is so simple,” Marlin said. “I thought, Why can’t I buy this is in a bottle?” She . . . was fixated on the idea of creating a carbonated juice, and began researching the beverage industry. She soon discovered she would need to hire a food scientist to help her. . . . Although Marlin planned to devote her entire checking account to startup costs, that amount was nowhere near what [Abe] Bakal (consultant with 30 years’ experience) was asking for R & D alone. . . . [B]ut he was so impressed by her enthusiasm that he offered to consult in return for a 20-percent stake in the business. . . . Bakal recalled recently, “. . . one of the things I’ve learned in product development is that sometimes—not always, but sometimes—you can compensate with enthusiasm and commitment for money.” Source: “The Industry: Message in a Bottle,” New York Times, June 26, 2005 Thinking Economically How did Elizabeth Marlin and Abe Bakal use their productive resources to start this enterprise? 92 Chapter 3 B. Chart These statistics show the number of self-employed entrepreneurs and their businesses relative to sizes of firms with paid employees. FIGURE 3.10 BUSI NESS ENTERPRISES BY EM PLOYMEN T SIZE Number of Employees No employees 1–9 employees 10–99 employees 100–499 employees 500+ employees Number of Firms 770,229 3,759,630 1,135,443 84,829 16,926 Total Employment 0 12,500,539 28,516,802 16,430,229 55,950,473 All 5,767,127 113,398,043 Source: Statistical Abstract of the United States, 2003 figures Thinking Economically What is the percentage of entrepreneurial firms with no employees? What percentage of paid employees work in companies with 100 or more workers? C. Newspaper Article This article discusses franchises, businesses that offer entrepreneurs an option to start their own business by buying into an established company with an existing business model. Being The Boss With Backup The Costs and Benefits of Franchising In Maryland, there were more than 13,000 franchises employing about 179,000 [people] in 2001, according to [a] study, which was commissioned by the International Franchise Association. More than two dozen of those franchises are headquartered in the state, including Educate Inc., with more than 1,000 Sylvan tutoring center franchises worldwide and MaggieMoos’s International with 184 ice cream shops, according to the association. Opening such a business might be just the right fit for Phil Clark, a mortgage consultant from Elkridge. The mortgage business tends to fluctuate, Clark said. A franchise would give Clark more control over his future, a prospect he finds exciting. “A franchise gives me something more stable,” he said. . . . But it comes at a price. The cost of opening a franchise can vary from $25,000 to millions of dollars. For some, franchising can mean economic empowerment and a chance at the American dream. But buyer beware: There is no guarantee of success, and a franchise requires the same amount of commitment, sacrifice and sweat equity as any independent business. . . . Source: “Growing Occupation: Being Your Own Boss,” Baltimore Sun, April 21, 2006 Thinking Economically If you were to start your own business, would you buy a franchise or build a new enterprise based on your own ideas? What factors would help you in making your decision? THINKING ECONOMICALLY Synthesizing 1. How do the legal rights built into the free enterprise system affect the businesses in A and C? 2. Which of these two businesses do you feel would provide more stability for its owner? Why? 3. Do you think entrepreneurs make up a large percentage of the work force? Why are entrepreneurs important to the economy? The American Free Enterprise System 93 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 Choose the key concept that best completes the sentence. Not all key concepts will be used. capitalism externality free contract free enterprise system infrastructure legal equality modified free enterprise economy negative externality open opportunity positive externality profit profit motive public
goods public transfer payments safety net subsidy transfer payments 1 is another name for capitalism. Three features of this type of economy are open opportunity, legal equality, and 2 , or the right to enter into agreements of one’s choice. The 3 is a driving force in a free enterprise system, urging entrepreneurs to enter the market. The market allocates resources through the activities of both producers and consumers. Producers, seeking 4 , move their resources into the most productive areas. Consumers, through their dollar votes, help determine which products succeed and which fail. Left on its own, however, a free market cannot address many social issues. The United States has a 5 , mixing government involvement and market forces. One role for the government is to provide 6 , such as national defense. Without a strong 7 in place, modern economies cannot function. The government also addresses problems created by a 8 , such as the pollution from a factory that affects all those living nearby. It furthers a 9 , such as better health through vaccinations, by offering a 10 for inoculations. The government also makes direct 11 in the form of social security, unemployment compensation, and disability coverage. 94 Chapter 3 CHAPTER 3 Assessment Advantages of the Free Enterprise System (pp. 70–77) 1. What is a free enterprise system? 2. What are some of the rights that must be protected for a free enterprise system to work? How Does Free Enterprise Allocate Resources? (pp. 78–83) 3. What are the roles of consumers and producers in allocating resources? 4. What role does the government play in the economy’s circular flow? Government and Free Enterprise (pp. 84–93) 5. What problem makes public goods necessary? 6. Besides providing public goods, what two purposes can a government serve in a market economy? A P P LY Use the information in the table to answer the following questions about changes in the nation since the passage of the Clean Air Act in 1970. Since the passage of the Clean Air Act: • Nitrogen oxide emissions have declined by 17% • Sulfur dioxide emissions have declined by 49% • Lead emissions have declined by 98% • Carbon monoxide emissions have declined by 41% • Particulate emissions caused by combustion have declined by 82% At the same time: • U.S. population grew by 42% • Overall energy consumption grew by 43% • Total U.S. employment grew by 95% • The number of registered vehicles grew by 111% • The economy grew by 175% Source: Foundation for Clean Air Progress 7. How would you use these statistics to argue that the government has effectively managed a negative externality? 8. Recently, there has been pressure to loosen clean air standards. Use economic arguments to support or oppose this proposed action. Creating Graphs Use the statistics below to create a graph titled Businesses in the United States, 1997–2003. Use information from your graph and from Figure 3.1 on page 71 to write a generalization about businesses in the American free enterprise system. Year 1997 1999 2001 2003 Number of Businesses (in millions) 21.0 21.8 22.6 22.7 Source: U.S. Small Business Administration Use to complete this activity. @ ClassZone.com 10. Distinguishing Fact from Opinion Look again at the information on changes in the United States after the passage of the Clean Air Act. Which of the following statements represents a fact? Which is an opinion? Explain why. • Pollution has decreased since 1970. • Pollution has decreased as a result of the Clean Air Act. • The government can ease restrictions now that pollution is lower. 11. Applying Economic Concepts In the 1990s, efforts were made to reform the healthcare system in the United States so that much of it came under government control. Explain in terms of economic concepts you have learned in this chapter why these efforts failed. 12. Challenge Milton Friedman wrote, Many people want the government to protect the consumer. A much more urgent problem is to protect the consumer from the government. Explain what you think Friedman meant by this. Illustrate your answer with examples. Conducting an Economic Impact Study A manufacturing company has announced plans to open a factory in your town. The plant will consist of a manufacturing area and a warehouse area and will employ about 500 people. Production will be on a 24-hour basis, with workers working one of three 8-hour shifts. At the same time, a national megastore chain wants to open a store on the outskirts of town. The store will employ 60 people, be open 18 hours a day, and have a 200-car parking lot. Imagine that you have been asked by local government authorities to conduct an economic impact study to identify the positive and negative externalities that the factory or megastore might create. Step 1 Form a group with three or four classmates. Conduct research on how a factory or a megastore operates—the materials they use, the byproducts they create, and so on. Then do research to discover the impact a new factory or megastore might have on a community. Step 2 In your group, review your findings and identify the positive and negative externalities of the factory or megastore. Record the information in a chart similar to the one below. Externalities Created by the Factory/Megastore Positive Negative Step 3 Use your chart to write your economic impact report. Note the major externalities and suggest steps that the local government might take to limit negative externalities and to encourage positive externalities. The American Free Enterprise System 95 Microeconomics U n i t 2 Market Economies at Work 96 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 Demand This computer store customer meets the two requirements of demand—the customer is willing to buy and is able to pay. 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. Demand 97 S E C T I O N 1 What Is Demand TA K I N G N O T E S 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 KEY CONCEPT S 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. 98 Chapter 4 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. QUICK REFERENCE Law of demand states that when prices go down, quantity demanded increases. When prices go up, quantity demanded decreases. E XAMPLE Price and Demand 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. AP P LI CATION 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 Demand 99 Demand Schedules KEY CONCEPT S QUICK REFERENCE Demand schedule is a listing of how much of an item an individual is willing to purchase at each price. Market demand schedule is a listing of how much of an item all consumers are willing to purchase at each price. Price and Demand Storeowners often offer products at sale prices to encourage consumers to make more purchases. A demand schedule is a table that shows how much of a good or service an individual consumer is willing and able to purchase at each price in a market. In other words, a demand schedule shows the law of demand in chart form. A market demand schedule shows how much of a good or service all consumers are willing and able to buy at each price in a market. EXAMPLE Individual Demand Schedule A demand schedule is a two-column table that follows a predictable format. The left-hand column of the table lists various prices of a good or service. The right-hand column shows the quantity demanded of the good or service at each price. Cheryl’s demand for DVDs can be expressed in a demand schedule. Let’s take a look at the price list in Figure 4.2 below. How many DVDs will Cheryl buy if they cost $20 each? How many will she buy when the price stands at $10? Your answers to these questions show one thing very clearly. Cheryl’s demand for DVDs depends on their price. Price per DVD ($) Quantity Demanded a b 30 25 20 15 10 $5 0 1 2 3 4 7 a At the top price of $30, Cheryl is not willing to buy any DVDs. b At $10, she will buy four DVDs. Notice that when the price falls, the number of DVDs Cheryl will buy rises. When the price rises, the number she will buy falls. So quantity demanded and price have an inverse, or opposite, relationship. ANALYZE TABLES 1. How many DVDs will Cheryl be likely to buy if the price is $15? 2. What is the relationship between Cheryl’s demand for DVDs and various quantities demanded shown on this table? Use an interactive demand schedule at ClassZone.com 100 Chapter 4 E XAMPLE Market Demand Schedule The demand schedule in Figure 4.2 shows how many DVDs an individual, Cheryl, is willing and able to buy at each price in the market. The schedule also shows that the quantity of DVDs that Cheryl demands rises and falls in response to changes in price. Sometimes, however, an individual demand schedule does not give business owners enough information. For example, Rafael, who owns Montclair Video Mart, needs information about more than just one consumer before he can price his merchandise to gain the maximum number of sales. He needs a market demand schedule, which shows the quantity demanded by all the people in a particular market who are willing and able to buy DVDs. Take a look at the DVD market demand schedule below. Notice that it’s similar to the individual demand schedule except that the quantities demanded are much larger. It also shows that, like individual demand, market demand depends on price. Price per DVD ($) Quantity Demanded a b c 30 25 20 15 10 5 50 75 100 125 175 300 a At the top price of $30, Rafael’s customers will buy 50 DVDs. b At the middle price of $15, the quantity demanded of DVDs is 125. c At the low price of $5, the quantity demanded rises to 300. So, markets behave in the same way as individual consumers. As prices fall, the quantity demanded of DVDs rises. As prices rise, the quantity demanded falls. ANALYZE TABLES 1. How does the quantity demanded of DVDs change when the price drops from $25 to $10? 2. How does this market demand schedule illustrate the law of demand? CONNECT TO MATH How would a merchant use this schedule to decide on a price? First, the merchant would calculate the total revenue at each price. To ﬁ gure out total revenue, multiply the price per DVD by the quantity demanded. $30.00 50 Price Quantity $1,500.00 Total Revenue How did Rafael create a market demand schedule? First, he surveyed his customers, asking them how many DVDs they would buy at different prices. Next, he reviewed his sales figures to see how many DVDs he sold at each price. Techniques such as these for investigating a specific market are called market research. Market research involves the gathering and evaluating of information about customer preferences. (You’ll learn more about market research in Chapter 7.) By tabulating the results of his market research, Rafael created his market demand schedule. AP P LI CATION Applying Economic Concepts B. Imagine that you have discovered a restaurant that makes the best pizza you have ever tasted. Create a demand schedule showing how many pizzas a month you would buy at the prices of $25, $20, $15, $10, and $5. Demand 101 Demand Curves KEY CONCEPT S QUICK REFERENCE Demand curve graphically shows the data from a demand schedule. Market demand curve graphically shows the data from a market demand schedule. A demand curve is a graph that shows how much of a good or service an individual will buy at each price. In other words, it displays the data from an individual demand schedule. Creating a demand curve simply involves transferring data from one format, a table, to another format, a graph. A market demand curve shows the data found in the market demand schedule. In other words, it shows the quantity that all consumers, or the market as a whole, are willing and able to buy at each price. A market demand curve shows the sum of the information on the individual demand curves of all consumers in a market. EXAMPLE Individual Demand Curve Study the demand curve (Figure 4.4 below) created from Cheryl’s demand schedule. How many DVDs will Cheryl buy at the price of $15? How will Cheryl’s quantity demanded change if the price rises by $5 or falls by $5? Find the answers to these questions by running your finger along the curve. As you can see, the demand curve is a visual representation of the law of demand. When prices go up, the quantity demanded goes down; when prices go down, the quantity demanded goes up. You should note that this demand curve and the schedule on which it is based were created using the assumption that all other economic factors except price remain the same. You’ll learn more about these factors and how they affect demand in Section 2. FIGURE 4.4 CHERYL’ S DVD DEMAND CURVE CONNECT TO MATH One common mistake people make is to look at the downward-sloping graph and think it means that quantity demanded is decreasing. However, if you move your ﬁ nger downward and to the right on the demand curve, you’ll notice that the quantity demanded is increasing 30 25 20 15 10 5 0 102 Chapter 4 Price per DVD ($) Quantity Demanded a The vertical axis of the 30 25 20 15 10 5 0 1 2 3 4 7 graph shows prices, with the highest at the top. b The horizontal axis shows quantities demanded, with the lowest on the far left. c Notice that demand curves slope downward from upper left to lower right. a b c 2 1 6 Quantity demanded of DVDs 4 3 5 7 ANALYZE GRAPHS 1. How many DVDs will Cheryl buy when the price is $10? 2. How does this demand curve illustrate the law of demand? Use an interactive demand curve at ClassZone.com E XAMPLE Market Demand Curve Like Cheryl’s individual demand curve, the market demand curve for Montclair Video Mart shows the quantity demanded at different prices. In other words, the graph shows the quantity of DVDs that all consumers, or the market as a whole, are willing and able to buy at each price. Despite this difference, the market demand curve for Montclair Video Mart (Figure 4.5) is constructed in the same way as Cheryl’s individual demand curve. As in Figure 4.4, the vertical axis displays prices and the horizontal axis displays quantities demanded. FIGURE 4.5 DVD MARKET DEMAND CURVE ) 30 25 20 15 10 5 0 Price per DVD ($) Quantity Demanded 30 25 20 15 10 5 50 75 100 125 175 300 100 150 50 Quantity demanded of DVDs 200 250 300 Notice that market demand curves slope downward from upper left to lower right, just as individual demand curves do. The main difference between the two types of demand curves is that the quantities demanded at each price are much larger on a market demand curve. This is because the curve represents a group of consumers (a market), not just one consumer. NEED HELP? Throughout this chapter, you will be asked to create and to analyze demand curves. If you need help with those activities, see “Interpreting Graphs.” Skillbuilder Handbook, page R29 ANALYZE GRAPHS 1. At which price will Montclair Video Mart sell 175 DVDs? 2. Cheryl was unwilling to buy any DVDs at $30. Montclair Video Mart can sell 50 DVDs at that price. How do you explain the difference? Look at Figure 4.5 above one more time. What is the quantity demanded at the price of $15? How will quantity demanded change if the price increases by $
5 or drops by $5? Once again, find the answers to these questions by running your finger along the curve. As you can see, the market demand curve—just like the individual demand curve—vividly illustrates the inverse relationship between price and quantity demanded. If price goes down, the quantity demanded goes up. And if price goes up, the quantity demanded goes down. Also, like the individual demand curve, the market demand curve is constructed on the assumption that all other economic factors remain constant—only the price of DVDs changes. AP P LI CATION Applying Economic Concepts C. Look back at the demand schedule for pizzas you created for Application B on page 101. Use it to create a demand curve. Create a demand curve at ClassZone.com Demand 103 ECO N O M I C S PAC ES E T T E R Vera Wang: Designer in Demand In this section, you’ve learned about the law of demand. You’ve also seen demand in action in some hypothetical situations. The story of fashion designer Vera Wang, however, provides a real-world example of demand at work. When they married, Mariah Carey, Jennifer Lopez, and several other stars turned to Wang for their wedding dresses. What explains the demand for this one woman’s gowns? Responding to Demand Vera Wang had worked in the fashion industry for more than 15 years by the time she started planning her own wedding in 1989. So she was frustrated when she couldn’t find the type of sophisticated bridal gown she wanted. She knew that many modern brides were savvy career women who preferred designer clothing. Yet, no one was making wedding dresses for those women. Changing Styles Vera Wang wanted to change traditional wedding dress styles that, she thought, made brides look “like the bride on top of a cake, very decorated.” The next year, Wang decided to fill that unmet demand. She created her own line of gowns featuring elegant sleeveless styles rather than the hooped skirts, puffed sleeves, and lace flounces that had dominated weddingdress designs before. Soon celebrities such as Uma Thurman were choosing Vera Wang wedding gowns. This generated publicity, and demand for Wang’s creations grew. In response, other designers began to create sleeker wedding dresses, and the style spread. Vera Wang is now considered to be one of the country’s most influential designers of wedding gowns. Demand for the sophisticated Wang style has spread beyond weddings. In recent years, Wang has expanded her product line to include ready-to-wear dresses, perfume, accessories, and home fashions. APPLICATION Analyzing Cause and Effect D. In what ways did Vera Wang respond to consumer demand? In what ways did she generate consumer demand? FAST FACTS Vera Wang Title: Chairman and CEO of Vera Wang Ltd. Born: June 27, 1949, New York, New York Major Accomplishment: Designer of high-fashion wedding gowns Other Products: Clothing, perfume, eyewear, shoes, jewelry, home fashions Books: Vera Wang on Weddings (2001) Price Range for Vera Wang Wedding Gowns: about $2,000 to $20,000 Find the latest on Vera Wang’s business at ClassZone.com 104 Chapter 4 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. demand law of demand b. demand schedule demand curve c. market demand schedule market demand curve 2. Look at Figure 4.1 on page 99. Write a caption for the figure that explains the law of demand. 3. Review the information on Vera Wang on the opposite page. Why is it unlikely that most brides will have demand for an original Vera Wang gown? 4. How might an owner of a bookstore put together a market demand schedule for his or her store? 5. Why does the demand curve slope downward? 6. Using Your Notes How are price and quantity demanded related? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com demand 7. Drawing Conclusions List three products that you are familiar with and the approximate price of each. Which of the products, if any, do you have a demand for? Consider the two requirements of demand as you answer this question. 8. Making Inferences Why might Rafael’s market demand schedule and curve not be an accurate reflection of the actual market? To answer this question, consider the assumption that was made when the schedule and curve were created. 9. Applying Economic Concepts Return to the demand schedule for pizzas you created for Application B on page 101. Assume that your class is the market for pizzas. Tabulate these individual demand schedules to create a market demand schedule. Then use that schedule to draw a market demand curve. 10. Challenge Does quantity demanded always fall if the price rises? List several goods or services that you think would remain in demand even if the price rose sharply. Why does demand for those items change very little? (You will learn more about this topic in Section 3.) Making a Market Demand Curve Suppose that you own a store that sells athletic shoes. You survey your customers and analyze your sales data to see how many pairs of shoes you can expect to sell at various prices. Your research enables you to make the following market demand schedule. Price per Pair of Shoes ($) Quantity Demanded 175 150 125 100 75 50 0 10 20 40 70 110 Create a Demand Curve Use this market demand schedule to create a market demand curve. Challenge Write a caption for your market demand curve explaining what it shows. Use to complete this activity. @ClassZone.com Demand 105 S E C T I O N 2 What Factors Affect Demand TA K I N G N O T E S In Section 2, you will • determine a change in quantity demanded • explain the difference between change in quantity demanded and change in demand • determine a change in demand • analyze what factors can cause change in demand law of diminishing marginal utility, p. 106 income effect, p. 107 substitution effect, p. 107 change in quantity demanded, p. 108 change in demand, p. 109 normal goods, p. 110 inferior goods, p. 110 substitutes, p. 112 complements, p. 112 As you read Section 2, complete a chart that shows each factor that causes change in demand. Use the Graphic Organizer at Interactive Review @ ClassZone.com Factor That Changes Demand Reason Why Demand Changes More About Demand Curves KEY CONCEPT S The demand schedules and demand curves that you studied in Section 1 were created using the assumption that all other economic factors except the price of DVDs would remain the same. If all other factors remain the same, then the only thing that influences how many DVDs consumers will buy is the price of those DVDs. The demand curve graphically displays that pattern. Now think about the shape of demand curves. Why do they slope downward? The reason is the law of diminishing marginal utility, which states that the marginal benefit from using each additional unit of a good or service during a given time period tends to decline as each is used. Recall that utility is the satisfaction gained from the use of a good or service. Suppose it is a hot day, and you have just gulped down a glass of lemonade. Would you gain the same benefit from drinking a second glass? How about a third? In all likelihood, you’d find the second glass less satisfying than the first, and the third glass less satisfying than the second. Because consumers receive less satisfaction from each new glass of lemonade they drink, they don’t want to pay as much for additional purchases. So, they will buy QUICK REFERENCE Law of diminishing marginal utility states that the marginal benefit of using each additional unit of a product during a given period will decline. 106 Chapter 4 two glasses only if the lemonade is offered at a lower price, and they will buy three only if the price is even lower still. This pattern of behavior, which holds true for most consumer goods and services, creates the downward slope of the demand curve. For another example, see Figure 4.6 below, which displays the demand that a young man named Kent has for video games. FIGURE 4.6 DIMINISHING MARGINAL UTILITY ) 90 75 60 45 30 15 0 1 2 3 4 5 6 7 Quantity demanded of video games This graph displays the demand for video games by a high school senior named Kent. The demand curve slopes downward because of the law of diminishing marginal utility, which states that the marginal benefit of using each additional unit of a product during a given period will decline. Because of that declining satisfaction, Kent will buy additional games only at lower prices. ANALYZE GRAPHS How many video games is Kent willing to buy at a price of $45? How does the law of diminishing marginal utility explain his refusal to buy more games at that price? Why do consumers demand more goods and services at lower prices and fewer at higher prices? Economists have identified two patterns of behavior as causes: the income effect and the substitution effect. The income effect is the term used for a change in the amount of a product that a consumer will buy because the purchasing power of his or her income changes—even though the income itself does not change. For example, you can buy more paperback books if they are priced at $7 than if they are priced at $15. If you buy a $7 book, you will feel $8 “richer” than if you buy a $15 book, so you are more likely to buy another book. The income effect also influences behavior when prices rise. You will feel $8 “poorer” if you buy a $15 book instead of a $7 one, so you will buy fewer books overall. The substitution effect is the pattern of behavior that occurs when consumers react to a change in the price of a good or service by buying a substitute product— one whose price has not changed and that offers a better relative value. For example, if the price of paperback books climbs above $10, consumers might decide to buy fewer books and choose instead to buy $4 magazines. AP P LI CATION Drawing Conclusions A. Malik goes to the mall to buy a $40 pair of blue jeans and discovers that they are on sale for $25. If
Malik buys two pairs, is this an example of the income effect or the substitution effect? Explain your answer. QUICK REFERENCE Income effect is the change in the amount that consumers will buy because the purchasing power of their income changes. Substitution effect is a change in the amount that consumers will buy because they buy substitute goods instead. Demand 107 Change in Quantity Demanded KEY CONCEPT S Remember that each demand curve represents a specific market situation in which price is the only variable. A change in the amount of a product that consumers will buy because of a change in price is called a change in quantity demanded. Each change in quantity demanded is shown by a new point on the demand curve. A change in quantity demanded does not shift the demand curve itself. EXAMPLE Changes Along a Demand Curve Let’s look again at Cheryl’s demand curve for DVDs (Figure 4.7 below). Note the quantities demanded at each price. Notice that as quantity demanded changes, the change is shown by the direction of the movement right or left along the demand curve. FIGURE 4.7 CHANGE IN QUANTITY DEMANDED ) 30 25 20 15 10 Quantity demanded of DVDs A change in quantity demanded doesn’t shift the demand curve. The change refers to movement along the curve itself. Each point on the curve represents a new quantity demanded. a As you move to the right along the curve, the quantity demanded increases. b As you move to the left, the quantity demanded decreases. ANALYZE GRAPHS 1. What is the change in quantity demanded when the price drops from $20 to $10? 2. What is the direction of the movement along the demand curve when the quantity decreases? Use an interactive demand curve to see changes in quantity demanded at ClassZone.com Figure 4.7 shows change in quantity demanded for one person. A market demand curve provides similar information for an entire market. However, market demand curves have larger quantities demanded and larger changes to quantity demanded because they combine data from all individual demand curves in the market. APPLICATION Applying Economic Concepts B. Why do increases or decreases in quantity demanded not shift the position of the demand curve? QUICK REFERENCE Change in quantity demanded is an increase or decrease in the amount demanded because of change in price. 108 Chapter 4 Change in Demand KEY C ONCEPT S Consider what might happen if you lose your job. If you aren’t earning money, you aren’t likely to buy many CDs or movie tickets or magazines—no matter how low the price. Similarly, when national unemployment rises, people who are out of work are more likely to spend their limited funds on food and housing than on entertainment. Fewer people would be buying DVDs at every price, so market demand would drop. This is an example of a change in demand, which occurs when a change in the marketplace such as high unemployment prompts consumers to buy different amounts of a good or service at every price. Change in demand is also called a shift in demand because it actually shifts the position of the demand curve. QUICK REFERENCE Change in demand occurs when something prompts consumers to buy different amounts at every price. FIGURES 4.8 AND 4.9 CHANGE IN DEMAND FIGURE 4.8 DECREASE IN DEMAND FIGURE 4.9 INCREASE IN DEMAND 60 50 40 30 20 10 a D2 D1 60 50 40 30 20 10 b 0 1 2 3 4 5 6 7 Quantity demanded of baseball cards Quantity demanded of baseball cards ANALYZE GRAPHS 1. In Figure 4.8, how has demand for baseball cards changed at each of these prices: $20, $30, and $40? 2. In Figure 4.9, how has demand for baseball cards changed at each of these prices: $30, $40, and $50? Use an interactive version of shifting demand curves at ClassZone.com Six factors can cause a change in demand: income, market size, consumer tastes, consumer expectations, substitute goods, and complementary goods. An explanation of each one follows. FACT OR 1 Income If a consumer’s income changes, either higher or lower, that person’s ability to buy goods and services also changes. For example, Tyler works at a garden center. He uses his earnings to buy baseball cards for his collection. In the fall, people garden less and buy fewer gardening products, so Tyler works fewer hours. His smaller paycheck means that he has less money to spend, so he demands fewer baseball cards at every price. Figure 4.8 shows this change. The entire demand curve shifts to the left. When a change in demand occurs, the demand curve shifts. a As Figure 4.8 shows, a shift to the left (D2) indicates a decrease in demand. D1 D3 b As Figure 4.9 shows, a shift to the right (D3) indicates an increase in demand. Demand 109 QUICK REFERENCE Normal goods are goods that consumers demand more of when their incomes rise. Inferior goods are goods that consumers demand less of when their incomes rise. Suppose, however, that Tyler is promoted to supervisor and receives a raise of $2 an hour. Now he has more money to spend, so his demand for baseball cards increases and his demand curve shifts to the right—as shown in Figure 4.9 on page 109. As you might guess, changes in income also affect market demand curves. When the incomes of most consumers in a market rise or fall, the total demand in that market also usually rises or falls. The market demand curve then shifts to the right or to the left. Increased income usually increases demand, but in some cases, it causes demand to fall. Normal goods are goods that consumers demand more of when their incomes rise. Inferior goods are goods that consumers demand less of when their incomes rise. Before his raise, Tyler shopped at discount stores for jeans and T-shirts. Now that he earns more, Tyler can afford to spend more on his wardrobe. As a result, he demands less discounted clothing and buys more name-brand jeans and tees. Discounted clothing is considered an inferior good. Other products that might be considered inferior goods are used books and generic food products. YO U R EC NORMAL GOODS AND IN FE RIOR GOODS If your income rises, which car will you choose? Most people prefer to buy a new car if they can afford it. Used cars are an example of inferior goods—demand for them drops when incomes rise because people prefer new-car quality to getting a bargain. ? ▲ New car ▲ Used truck FACTOR 2 Market Size If the number of consumers increases or decreases, the market size also changes. Such a change usually has a corresponding effect on demand. Suppose that the town of Montclair is on the ocean. Each summer, thousands of tourists rent beachfront cottages there. As a result, the size of the population and the market grows. So what do you think happens to the market demand curve for pizza in Montclair in the summer? Check the two graphs at the top of the next page. Population shifts have often changed the size of markets. For example, in the last 30 years, the Northeast region of the United States lost population as many people moved to the South or the West. The causes of the population shift included the search for a better climate, high-tech jobs, or a less congested area. 110 Chapter 4 FIGURES 4.10 AND 4.11 IMPACT OF CHANGES IN MARKET SIZE FIGURE 4.10 MONTCLAIR’ S POPULATION DURING TOURIST SEASON FIGURE 4.11 CHANGE IN PIZZA MARKET DEMAND CURVE 20 15 10 Apr. May June July Aug. Sept. 28 24 20 16 12 August D2 May D1 50 100 150 200 250 300 Months Quantity demanded of pizzas ANALYZE GRAPHS 1. During what month was the population of Montclair at its highest? What happened to the demand for pizzas during that month? Explain. 2. What would you expect to happen to the market demand curve in September? Explain. One economic result of the migration is that the overall market size of the Northeast has shrunk, while the market size of the South and the West has grown. This change in market size has altered the demand for many products, from essentials such as homes, clothing, and food to nonessentials such as movie tickets. Demand for most items will grow in booming regions and decrease in regions that are shrinking. FACT OR 3 Consumer Tastes Because of changing consumer tastes, today’s hot trends often become tomorrow’s castoffs. When a good or service enjoys high popularity, consumers demand more of it at every price. When a product loses popularity, consumers demand less of it. Advertising has a strong influence on consumer tastes. Sellers advertise to create demand for the product. For example, some people stop wearing perfectly good pants that still fit because advertising convinces them that the style is no longer popular and that a new style is better. Think about your own closet. Doesn’t it contain some item of clothing that you just had to have a year ago, but would never pay money for now? You’ve just identified an instance of consumer taste changing demand. Consumer tastes also affect demand for other products besides clothing. When was the last time you saw someone buying a telephone that had to be attached to the wall by a cord? FACT OR 4 Consumer Expectations Your expectations for the future can affect your buying habits today. If you think the price of a good or service will change, that expectation can determine whether you buy it now or wait until later. When a change in market size occurs, it often causes a change in demand. a Figure 4.10 shows how the population of Montclair changed during the last tourist season. Notice which month had the highest population. b Notice that the market demand curve (D2) shifts to the right between May and August. Find an update on changing consumer tastes at ClassZone.com Demand 111 QUICK REFERENCE Substitutes are goods and services that can be used in place of each other. Let’s look at one example of how consumer expectations shape demand. Automobiles usually go on sale at the end of summer because dealers want to get rid of this year’s models before the new models arrive. Would you expect demand for new cars to be higher in May, before the sales, or in August, during the sales? It
is higher in August because consumers expect the sales and often choose to wait for them. FACTOR 5 Substitute Goods Goods and services that can be used in place of other goods and services to satisfy consumer wants are called substitutes. Because the products are interchangeable, if the price of a substitute drops, people will choose to buy it instead of the original item. Demand for the substitute will increase while demand for the original item decreases. People may also turn to substitutes if the price for the original item becomes too high. Again, demand for the substitute rises while demand for the original item drops. Substitutes can be used in place of each other. For example, when gasoline prices are high, some people decide to commute to school by bus or train. When gasoline prices are low, a higher number of people choose to drive instead of to take public transportation. As you can see from that example, when the price of one good rises, demand for it will drop while demand for its substitute will rise. YO U R EC SU BSTITUTE SERVIC ES How would you decide whether to take a cab or a bus? Taxis have certain advantages; they will take you to a speciﬁ c place at a speciﬁ c time. But if taxi fares rise, you might give up the convenience and go by bus instead. ? Taxi City bus FACTOR 6 Complementary Goods When the use of one product increases the use of another product, the two products are called complements. An increase in the demand for one will cause an increase in the demand for the other. Likewise, a decrease in demand for one will cause a decrease in demand for the other. In contrast to substitutes, complements are goods or services that work in tandem with each other. An increase in demand for one will cause an increase in demand for the other. One example is CDs and CD players. Consumers who bought CD players QUICK REFERENCE Complements are goods that are used together, so a rise in demand for one increases the demand for the other. 112 Chapter 12 Factors That Cause a Change in Demand Income Increased income means consumers can buy more. Decreased income means consumers can buy less. Complements When the use of one product increases the use of another product, the two are called complements. Substitutes Substitutes are goods and services that can be used instead of other goods and services, causing a change in demand. What Causes a Change in Demand? Market Size A growing market usually increases demand. A shrinking market usually decreases demand. Consumer Tastes The popularity of a good or service has a strong effect on the demand for it, and in today’s marketplace, popularity can change quickly. Consumer Expectations What you expect prices to do in the future can influence your buying habits today. ANALYZE CHARTS Choose a product used by most consumers, and create a hypothetical demand curve showing demand for that product in a town of 1,000 people. Label it A. On the same graph, add a demand curve showing demand if the population drops to 700. Label it B. Which factor on the chart does the shift in the demand curve represent? also demanded CDs to play on them. And, as CDs became more popular, demand for CD players grew until they began to appear in places they had never been before, such as in the family minivan. Therefore, with complements, if the price of one product changes, demand for both products will change in exactly the same way. If the price for one product rises, demand for both will drop. Conversely, if the price for one product drops, demand for both will rise. AP P LI CATION Categorizing Information C. Choose one of the following products: soda, hamburgers, pencils, or tennis rackets. On your own paper, list as many substitutes and complements for the product as you can. Compare your lists with those of a classmate. Demand 113 For more on analyzing political cartoons, see the Skillbuilder Handbook, page R26. Analyzing Political Cartoons Political cartoons often deal with economic themes. Because of this, you will find that the skill of interpreting political cartoons helps you to understand the economic issues on people’s minds. TECHNIQUES USED IN POLITICAL CARTOONS Political cartoonists use many techniques to deliver their message. The techniques used in this cartoon include: Exaggeration The cartoonist has shown the automobile as towering over humans to make the point that some Americans drive big cars that are gas-guzzlers. Source: © The Economist Other techniques that political cartoonists use include caricature, or creating a portrait that distorts a person’s features; symbolism, using an object or idea to stand for something else; and satire, attacking error or foolishness by ridiculing it. Labels Cartoonists use written words to identify people, groups, or events. Notice the sign on the gas pump referring to OPEC (Organization of Petroleum Exporting Countries) and the license plate on the car. Stereotyping Here a stereotype image of a man in Arab robes stands for OPEC, even though not all OPEC countries are in the Middle East. T HINKING ECONOMICALLY Analyzing 1. What does the phrase “Too high!!” mean? 2. What complementary goods are shown in this cartoon? Why are they complementary? 3. How does this cartoon relate to demand? Consider the effect of rising prices, especially rising prices for complementary goods. 114 Chapter 4 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of the pairs below: a. change in quantity demanded change in demand b. income effect substitution effect c. normal goods inferior goods d. substitutes complements 2. What feature of demand curves is explained by the law of diminishing marginal utility? 3. How does the income effect influence consumer behavior when prices rise? 4. Why might an increase in income result in a decrease in demand? 5. What else besides migration might account for a change in market size? Factor That Changes Demand Reason Why Demand Changes 6. Using Your Notes Why does a change in market size affect demand? Refer to your completed chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com . Analyzing Causes A new version of the computer game Big-Hit Football just came out. Malik buys it now because it has improvements over the current version, which he is bored with. Cheryl decides to wait to see if the price drops. Which of the factors shown in the chart on page 113 affected their decisions? 8. Applying Economic Concepts The U.S. government has used many strategies to reduce smoking. It banned television ads for cigarettes, ran public service messages about the health risks of smoking, and imposed taxes on cigarettes. Which factors that affect demand was the government trying to influence? 9. Analyzing Effects Take out the market demand curve for athletic shoes that you created on page 105. Add a new curve showing how demand would be changed if the most popular basketball player in the NBA endorses a brand of shoes that your store does not sell. Share your graph with a classmate and explain your reasoning. 10. Challenge Do you think changes in consumer taste are most often initiated by the consumers themselves or by manufacturers and advertisers? Explain your answer, using real-life examples. Explaining Changes in Demand Think about different types of bicycles: road bikes, mountain bikes, hybrid bikes. What factors affect demand for bicycles? Identify Factors Affecting Demand The table below lists examples of a change in demand in the market for bicycles. For each example, identify which factor that affects demand is involved. Example of Change in Demand Factor That Affected Demand Electric scooter sales rise, and bike sales fall. The cost of aluminum alloy bike frames is about to rise; consum– ers buy bikes now. Using a folding bicycle becomes a fad among commuters. Sales of this type of bike boom. The U.S. birth rate declined for 10 years in a row, eventually causing a drop in sales of children’s bikes. Challenge Identify the two factors affecting demand that do not appear on this table. Provide examples of how these factors might affect demand for bicycles. Demand 115 S E C T I O N 3 What Is Elasticity of Demand TA K I N G N O T E S In Section 3, you will elasticity of demand, p. 117 • define elasticity of demand • identify the difference between elastic and inelastic demand • define unit elastic • determine how total revenue is used to identify elasticity elastic, p. 117 inelastic, p. 117 unit elastic, p. 118 total revenue, p. 122 total revenue test, p. 122 As you read Section 3, complete a cluster diagram using the key concepts and other terms. Use the Graphic Organizer at Interactive Review @ ClassZone.com Elasticity of Demand Elasticity of Demand KEY CONCEPT S You have learned that there are many factors that influence the demand for a product. However, those factors alone are not the only influences on the sales of goods and services. How does the owner of an electronics store know how to price his or her goods so that the entire inventory of PDAs, or personal digital assistants, are sold? Store owners know that consumers are responsive to changes in price. Let’s examine the relationship between price and demand, and how it affects consumers’ buying habits. Consumer demand is not limitless. It is highly dependent on price. But as you know, demand is seldom fixed. As a result, price is also seldom fixed. Generally, people assume that if prices rise consumers will buy less, and if prices drop consumers will buy more. However, this isn’t always the case. The relationship between price and demand is somewhat more complicated than you might think. Change in consumer buying habits is also related to the type of good or service being produced and how important the good or service is to the consumer. The marketplace certainly is very sensitive to changes in price—but not all increases in price will result in a decrease in demand. 116 Chapter 4 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. E XAMPLE 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 U R EC EC ESSIT Y O R C HOIC E 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. ? ▲ Cosmetic whitening ▲ Filling a cavity Demand 117 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 10 300 250 200 150 100 50 b 4 8 12 16 20 0 20 40 60 80 100 120 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. Quantity demanded of movie tickets (in thousands) Quantity demanded of fillings 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. 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. 118 Chapter 4 What Determines Elasticity? KEY C ONCEPT S Just as there are factors that cause a change in demand, there are also factors that affect the elasticity of demand. The factors that affect elasticity include the availability of substitute goods or services, the proportion of income that is spent on the good or service, and whether the good or service is a necessity or a luxury. FACT OR 1 Substitute Goods or Services Generally speaking, if there is no substitute for a good or service, demand for it tends to be inelastic. Think back to the consumers who need insulin to regulate their blood sugar levels. No substitute exists for insulin, so consumers’ demand is inelastic even when the price goes up. If many substitutes are available, however, demand tends to be elastic. For example, if the price shoots up for beef, consumers can eat chicken, pork, or fish. In this case, demand is elastic. FACT OR 2 Proportion of Income The percentage of your income that you spend on a good or service is another factor that affects elasticity. Suppose that photography is your hobby, and you spend about 10 percent of your income on a digital camera, memory cards, software programs, and lenses. If the price for any of these rises even slightly, your demand will likely fall because you just don’t have any more money to spend on your hobby. Your demand is elastic. At the same time, demand for products that cost little of your income tends to be inelastic. For example, if the cost of pencils or ballpoint pens rose, would you buy fewer pencils and pens? Probably not. You spend so little on these items that you could easily pay the increase. Find an update on factors affecting elasticity at ClassZone.com YO U R EC PROPORTION OF INCO M E How much would you invest in a hobby? This amateur photographer spends about 10 percent of her income to pay for her digital camera and supplies. If the costs of taking photographs rise sharply, she won’t be able to increase her demand by an equal amount because she won’t have enough money to pay for the additional expenses. ? Demand 119 If the level of your income increases, you are likely to increase your demand for some goods or services. Suppose you ordinarily see one movie per month. If your income increases, you may choose to attend the movies several times a month. FACTOR 3 Necessities Versus Luxuries A necessity is something you must have, such as food or water. Demand for necessities tends to be inelastic. Even if the price rises, consumers will pay whatever they can afford for necessary goods and services. But that doesn’t mean that consumers will buy the same quantities no matter what the price. If the price of a necessity such as milk rises too much, consumers may choose to buy a substitute, such as a cheaper brand of milk or powdered milk. The quantity demanded of milk will change as the law of demand predicts; however, the change in quantity demanded is smaller than the change in price, so demand is inelastic. In contrast, a luxury is something that you desire but that is not essential to your life, such as a plasma television. The demand for luxuries tends to be elastic. Consumers will think twice about paying a higher price for something they don’t truly need. The change in quantity demanded is much greater than the change in price. F I G U R E 4 .15 Estimating Elasticity By examining the three factors that affect elasticity, you can often estimate whether demand for a certain good or service will be elastic or inelastic. Products Table Salt Ice Cream Sports Car Gasoline Insulin Braces on Teeth no yes yes no no no small small large small small large necessity luxury luxury necessity necessity luxury Are there good substitutes? yes = elastic no = inelastic What proportion of income does it use? large = elastic small = inelastic Is it a necessity or a luxury? luxury = elastic necessity = inelastic Conclusion inelastic elastic elastic inelastic inelastic elastic ANALYZE TABLES What patterns can you see in the factors that affect elasticity? Write a sentence summarizing your answer. APPLICATION Evaluating B. Create a chart like the one above for the following products: mountain bikes, airplane tickets, and home heating oil. Determine if the products are elastic or inelastic. 120 Chapter 4 Calculating Elasticity of Demand KEY C ONCEPT S Businesses find it useful to figure the elasticity of demand because it helps them to decide whether to make price cuts. If demand for a good or service is elastic, price cuts might help the business earn more. If demand is inelastic, price cuts won’t help. To determine elasticity, economists look at whether the percentage change in quantity demanded is greater than the percentage change in price. To calculate that relationship, economists use mathematical formulas. One such set of formulas is shown below. Anoth
er way to determine elasticity is shown on page 122. M AT 16 Calculating the Elasticity of Demand Step 1: Calculate percentage change in quantity demanded. (If the final result is a negative number, treat it as positive.) Original quantity – New quantity Original quantity 100 = Percentage change in quantity demanded Example Calculations 2,000 – 6,000 2000 100 = 200% Step 2: Calculate percentage change in price. (If the final result is a negative number, treat it as positive.) Original price – New price Original price 100 = Percentage change in price 10 – 8 10 100 = 20% Step 3: Calculate elasticity. Percentage change in quantity demanded Percentage change in price = Elasticity 200% 20% = 10 Step 4: After doing your calculations, if the final number is greater than 1, demand is elastic. If the final number is less than 1, demand is inelastic. Advanced Calculations Economists use a more complex version of these formulas. In Step 1, instead of dividing the change in quantity demanded by the original quantity demanded, they divide it by the average of the original and new quantities. In Step 2, they divide change in price by an average of the original price and new price. NEED HELP? Math Handbook, “Calculating and Using Percents,” page R4 AP P LI CATION Applying Economic Concepts C. Choose two points on the demand curve shown in Figure 4.13 and determine the price and quantity demanded for each point. Then use that data to calculate elasticity of demand. Demand 121 Total Revenue Test KEY CONCEPT S 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 $200 in total revenue. Clearly, the price reduction has caused only a modest increase in quantities sold, which is not enough to compensate for lower revenues. EXAMPLE Revenue Table Let’s look at an example of demand for movie tickets. In Figure 4.17, you can see how total revenues show whether demand is elastic or inelastic. Price of a Movie Ticket ($) 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. APPLICATION Creating Tables D. Use the information from Figure 4.14 to estimate prices to make a total revenue table. 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. 122 Chapter 4 S E C T I O N 3 Assessment ClassZone.com AC T I C E 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. Demand 123 Case Study Find an update on this Case Study at ClassZone.com Fueling Automobile Demand Background Automobiles make up a huge portion of the American economy. In recent years the demand for automobiles and all the services connected with them has accounted for approximately one-fifth of all retail sales. Over the past decade, the total number of automobiles, including light trucks and SUVs (Sport Utility Vehicles), sold has been over 16 million units. Car dealers are constantly looking for ways to sustain and increase demand for their product. Paul Taylor, chief economist of the National Automobile Dealers Association, observed, “The key to sales of 16.9 million will be the continued strong economy and sustained incentives.” Incentives are awards designed to lure potential buyers into an automobile showroom and encourage sales. Manufacturers have tried everything from giving away mountain bikes to zero percent financing. What’s the issue? How does demand affect your selection of a vehicle? Study these sources to discover how the law of demand and the factors that affect demand shape the market. A. Online Article Most car dealers offer some sort of incentive. This article discusses Volkswagen’s new approach in dealer incentives to car buyers. Text not available for electronic use. Please refer to the text in the textbook. Thinking Economically Do incentives described in this document change the demand for automobiles or the quantity demanded? Explain your answer. 124 Chapter 4 B. Political Cartoon Brian Duffy, a cartoonist with the Des Moines Register, drew this cartoon about the rising price of gasoline. Thinking Economically Which of the factors that cause a change in demand does this cartoon address? Explain your answer. C. Online Report An auto-buying service linking buyers and sellers examines demand for hybrid automobiles. Hybrid cars get power from a combination of batteries and a gaspowered engine. The Year of the Hybrid Stellar Fuel Efficiency, Low Emissions, and More Power Why do we think 2005 will be The Year of the Hybrid? We can sum it up in two words: Power and SUV. There’s something reassuring about how auto manufacturers are helping Americans have their cake and eat it too by offering up more fuel-efficient SUVs. Let’s face it, America’s love affair with the SUV shows no sign of waning. Yet . . . we can’t live in denial that the SUV has a fat appetite for gasoline. And then there’s the power argument. Despite the crowd pleasing fuel efficiency standards offered by hybrids, there was still the complaint that they lacked juice, or horsepower. . . . 2005’s hybrids will appeal to those of us . . . who absolutely demand a lot of horsepower. As if overcompensating for being picked on when they were little, 2005’s hybrids are coming out with more horsepower than their gas-only counterparts. Though hybrids tend to be more expensive than their gas- or diesel-only powered cousins, the savings in fuel (and sometimes in taxes) can more than offset this difference in the long run. Source: Invoicedealers.com Thinking Economically Which of the factors affecting demand is evident in this article? Use evidence from the article to support your answer. THINKING ECONOMICALLY Synthesizing 1. How would the demand for automobiles be affected by information presented in each of these documents? Support your answer with examples from the documents. 2. Identify and discuss the factors that affect elasticity of demand illustrated in these documents. 3. Explain how Documents B and C illustrate a cause and effect relationship in
the demand for SUVs. Use evidence from these documents to support your answer. Demand 125 CHAPTER 4 Assessment What Is Demand? (pp. 98–105) 1. What two things are necessary for a consumer to have demand for a good or service? 2. What do economists mean when they say that quantity demanded and price have an inverse relationship? What Factors Affect Demand? (pp. 106–115) 3. What is the difference between change in quantity demanded and change in demand? 4. How do consumer expectations affect demand? What Is Elasticity of Demand? (pp. 116–125) 5. Explain the difference between elastic and inelastic demand. 6. What are two methods for calculating elasticity of demand? A P P LY Look at the graph below showing personal spending for two types of products: computers and stationery. 7. What is the general trend of how spending for each of these product types has changed? Are the two trends alike or different? 8. In what way might these products be complements? In what way might they be substitutes? FIGURE 4.18 PERSONAL SPENDING ON COMPUTERS AND STATIONERY STATIONERY COMPUTERS 50 40 30 20 10 1993 1995 1997 1999 2001 2003 Year Source: U.S. Department of Commerce, Bureau of Economic Analysis 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 Choose the key concept that best completes the sentence. Not all key concepts will be used. change in demand change in quantity demanded demand demand curve demand schedule elastic elasticity of demand income effect inelastic inferior goods law of demand market demand curve market demand schedule normal goods substitutes substitution effect total revenue total revenue test unit elastic 1 is the desire for a product and the ability to pay for it. According to the 2 , when price decreases, demand rises, and when price increases, demand falls. Demand can be displayed in a table called a 3 or on a graph called a 4 . A 5 is a table that shows how much demand all consumers in a market have. When that same information is displayed on a graph, it is called a 6 . The different points on a demand curve show a 7 . A 8 occurs when consumers are willing to buy different amounts of a product at every price. The six factors that change demand are income, market size, consumer expectations, consumer taste, complement, and 9 . The term 10 describes how responsive consumers are to price changes. Demand that changes significantly when prices change is 11 . Demand that doesn’t change significantly when prices change is 12 . The dividing line between the two is where demand is 13 . 14 is calculated by multiplying price by quantity sold. 126 Chapter . Creating Graphs A tornado destroys a town. Think of three goods for which demand will rise in the weeks after the storm and three goods for which demand will fall. For each good, create a graph with two demand curves: curve A representing demand before the storm and curve B representing demand after the storm. Under each graph, write a caption explaining the change in demand. Use to complete this activity. @ ClassZone.com 10. Identifying Causes A certain stuffed toy is popular during the holiday season, but sells for half the listed price after the holidays. Which factor in change in demand is at work here? Explain. 11. Identifying Causes In the last few decades, demand for ketchup has dropped in the United States, while demand for salsa has risen. Which factors that affect demand account for this? 12. Using Economic Concepts Airlines give discounts to travelers who book in advance and stay over a weekend. Travelers who book at the last minute and do not stay over a weekend usually pay fullprice. How does the concept of elasticity explain the difference between the two groups’ demand for tickets and the airlines’ pricing decisions? 13. Challenge Suppose that you read the following article in the newspaper: Meteorologists announced today that this has been the warmest winter in 57 years. The unusual weather has affected local businesses. According to Pasha Dubrinski, owner of Pasha’s Outerwear, sales of winter parkas are 17 percent lower than last year. Dubrinski said, “Instead of buying down-filled parkas, people have been buying substitute items such as leather coats.” Across town, Michael Ellis, owner of Home Hardware, said that his sales of snow blowers are also down. “Next week, I will cut the price. That will increase demand.” Are these two storeowners correct in the way they use economic terms? Explain your answer Equip Your Team Step 1 Choose a partner. Imagine you are equipment managers for your school’s baseball team. You must equip the nine starters with a budget of $5,000. The equipment supplier sends you the list of prices shown in column A of the table below. Create a list telling how many of each item you will buy. SP ORTING GOODS PRICES Prices (in dollars) Item Bat Baseball Glove or Mitt Catcher’s Mask Full Uniform Jersey Only Cleats Sunglasses Team Jacket A 130 2 80 80 65 30 25 20 50 B 170 3 130 90 100 60 60 30 75 C 200 4 160 100 135 90 90 40 100 Step 2 When you call in the order, you learn that a big sporting goods factory has burned. Prices have risen to those shown in column B. You must redo your order using the new prices but the same budget. Step 3 The economy is hit with sudden and severe price hikes. Redo your order using the prices in column C. Step 4 Share your three purchasing lists with the class. As a class, use the collected data to create a market demand curve for each item. Step 5 Use the collected data to calculate elasticity for each item. (You may use either method explained in this chapter.) Then as a class discuss your results. What factors influenced elasticity? Use to complete this activity. @ ClassZone.com Demand 127 Supply The cost of raw materials, the wages paid to workers, and the production decisions made by managers all affect the supply of televisions. 128 CHAPTER 5 SECTION 1 What Is Supply? SECTION 2 What Are the Costs of Production? SECTION 3 What Factors Affect Supply? SECTION 4 What Is Elasticity of Supply? CASE STUDY Robots— Technology Increases Supply Supply Demand is the willingness to buy a good or service and the ability to pay for it Supply is the willingness and ability of producers to offer goods and services for sale AT T E R S You may not think of yourself as a producer, but you are. You offer your labor when you do chores around the house or work at a parttime job. If you have a car, you sometimes provide transportation for your friends. Also, if you belong to a sports or academic team, you supply your skills and knowledge. List five things that you supply. Then list the costs you incur and the rewards you receive for supplying them. How would your willingness and ability to supply these things be affected if these costs and rewards changed? More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on the use of robots in industry. (See Case Study, pp. 158–159.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. How does the use of robots affect the supply of goods and services? See the Case Study on pages 158–159. Supply 129 S E C T I O N 1 What Is Supply TA K I N G N O T E S In Section 1, you will supply, p. 130 • define supply and outline what law of supply, p. 131 the law of supply says • explain how to create and interpret supply schedules • explain how to create and interpret supply curves supply schedule, p. 132 market supply schedule, p. 132 supply curve, p. 134 market supply curve, p. 134 As you read Section 1, complete a cluster diagram like the one shown using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Supply law of supply supply schedule The Law of Supply KEY CONCEPT S In Chapter 4, you learned about the demand side of market interactions and how consumers serve their interests by purchasing the best products at the lowest possible price. You also discovered that there are other factors that change demand at every price. Demand, however, is only one side of the market equation. In this chapter, you will learn about the supply side of the equation in order to understand why producers want to provide products at the highest possible price. Supply refers to the willingness and ability of producers to offer goods and services for sale. Anyone who provides goods or services is a producer. Manufacturers who make anything from nutrition bars to automobiles are producers. So, too, are farmers who grow crops, retailers who sell products, and utility companies, airlines, or pet sitters who provide services. QUICK REFERENCE Supply is the desire and ability to produce and sell a product. The two key words in the definition of supply are willingness and ability. For example, the Smith family grows various fruits and vegetables on their small farm. They sell their produce at a local farmers’ market. If the prices at the market are too low, the Smiths may not be willing to take on the expense of growing and 130 Chapter 5 Supplying a Service Service providers, such as utility companies, are producers too. transporting their produce. Also, if the weather is bad and the Smiths’ crops of fruits and vegetables are ruined, they will not be able to supply anything for the market. In other words, they will not offer produce for sale if they do not have both the willingness and the ability to do so. As is true with demand, price is a major factor that influences supply. The law of supply states that producers are willing to sell more of a good or service at a higher price than they are at a lower price. Producers want to earn a profit, so when the price of a good or service rises they are willing to supply more of it. Whe
n the price falls, they want to supply less of it. In other words, price and quantity supplied have a direct relationship. This relationship is illustrated in Figure 5.1. QUICK REFERENCE The law of supply states that when prices decrease, quantity supplied decreases, and when prices increase, quantity supplied increases. FIGURE 5.1 LAW OF SUPPLY As prices fall… quantity supplied falls. quantity supplied rises. As prices rise… E XAMPLE Price and Supply Let’s take a closer look at how price and quantity supplied are related by returning to the Smiths and their produce business. The Smiths travel to the Montclair Farmers’ Market every Wednesday and Saturday to sell a variety of fruits and vegetables— blueberries, peaches, nectarines, sweet corn, peppers, and cucumbers. However, their specialty crop is the tomato. How should the Smiths decide on the quantity of tomatoes to supply to the farmers’ market? The price they can get for their crop is a major consideration. The Smiths know that the standard price for tomatoes is $1 per pound. What quantity of tomatoes will the Smiths offer for sale at that price? They decide that they are willing to offer 24 pounds. What if the price of tomatoes doubled to $2 per pound? The Smiths might decide that the price is so attractive that they are willing to offer 50 pounds of tomatoes for sale on the market. In contrast, if the price fell to 50 cents, the Smiths might decide to supply only 10 pounds. Furthermore, at prices under 50 cents per pound, they may not be willing to supply any tomatoes. Look again at the definition of the law of supply. As you can see, it provides a concise description of how producers behave. AP P LI CATION Analyzing Effects A. You sell peppers at the Montclair Farmers’ Market. If the price of peppers increased from 40 cents to 60 cents each, how would your quantity supplied of peppers change? How would your quantity supplied change if the price decreased to 25 cents? Find an update on farmers’ markets at ClassZone.com Supply 131 Supply Schedules KEY CONCEPT S QUICK REFERENCE A supply schedule lists how much of a good or service an individual producer is willing and able to offer for sale at each price. A market supply schedule lists how much of a good or service all producers in a market are willing and able to offer for sale at each price. A supply schedule is a table that shows how much of a good or service an individual producer is willing and able to offer for sale at each price in a market. In other words, a supply schedule shows the law of supply in table form. A market supply schedule is a table that shows how much of a good or service all producers in a market are willing and able to offer for sale at each price. EXAMPLE Individual Supply Schedule A supply schedule is a two-column table that is similar in format to a demand schedule. The left-hand column of the table lists various prices of a good or service, and the right-hand column shows the quantity supplied at each price. The Smiths’ supply of tomatoes can be expressed in a supply schedule (Figure 5.2). How many pounds of tomatoes are the Smiths willing to sell when the price is $1.25 per pound? What if the price is $0.50 per pound? Or $2.00 per pound? Your answers to these questions show that the Smiths’ quantity supplied of tomatoes depends on the price. FIGURE 5. 2 THE SMITHS’ TOMATO SU PPLY SC HEDULE Price per Pound ($) Quantity Supplied (in pounds) a b 2.00 1.75 1.50 1.25 1.00 0.75 0.50 50 40 34 30 24 20 10 a At the top price of $2.00, the Smiths are willing to sell 50 pounds of tomatoes. b At $0.50, the Smiths are willing to provide only 10 pounds of tomatoes for sale. Notice that when the price falls, the quantity of tomatoes that the Smiths are willing to sell also falls. When the price rises, the quantity they are willing to sell rises. So quantity supplied and price have a direct relationship. ANALYZE TABLES 1. How many pounds of tomatoes will the Smiths offer for sale if the price is $1.75? 2. How is this supply schedule different from a demand schedule for tomatoes? Use an interactive supply schedule at ClassZone.com 132 Chapter 5 E XAMPLE Market Supply Schedule The supply schedule in Figure 5.2 shows how many pounds of tomatoes an individual producer, the Smith family, is willing and able to offer for sale at each price in the market. The schedule also shows that, in response to changes in price, the Smiths will supply a greater or lesser number of tomatoes. However, sometimes an individual supply schedule does not provide a complete picture of the quantity of a good or service that is being supplied in a given market. For example, several fruit and vegetable stands at the Montclair Farmers’ Market sell tomatoes. If you want to know the quantity of tomatoes available for sale at different prices at the entire farmers’ market, you need a market supply schedule. This shows the quantity supplied by all of the producers who are willing and able to sell tomatoes. Take a look at the market supply schedule for tomatoes in Figure 5.3. Notice that it is similar to the Smiths’ supply schedule, except that the quantities supplied are much larger. It also shows that, as with individual quantity supplied, market quantity supplied depends on price. Price per Pound ($) Quantity Supplied (in pounds) a b c 2.00 1.75 1.50 1.25 1.00 0.75 0.50 350 300 250 200 150 100 50 a At the top price of $2.00, the fruit and vegetable stands will offer 350 pounds of tomatoes for sale. b At $1.25, the quantity supplied of tomatoes is 200 pounds. c At the low price of $0.50, the quantity supplied falls to 50 pounds. So, markets behave in the same way as individual suppliers. As prices decrease, the quantity supplied of tomatoes decreases. As prices increase, the quantity supplied increases. ANALYZE TABLES 1. How does the quantity supplied of tomatoes change when the price rises from $0.75 a pound to $1.75 a pound? 2. How does this market supply schedule illustrate the law of supply? In Chapter 4, you learned that Rafael, the owner of Montclair Video Mart, used market research to create a market demand schedule. Market research can also be used to create a market supply schedule. Producers in some markets are able to use research conducted by the government or by trade organizations to learn the prices and quantity supplied by all the producers in a given market. AP P LI CATION Applying Economic Concepts B. Imagine that you own a health food store that sells several brands of nutrition bars. Create a supply schedule showing how many bars you would be willing to sell each month at prices of $5, $4, $3, $2, and $1. Supply 133 QUICK REFERENCE A supply curve shows the data from a supply schedule in graph form. A market supply curve shows the data from a market supply schedule in graph form. Supply Curves KEY CONCEPT S A supply curve is a graph that shows how much of a good or service an individual producer is willing and able to offer for sale at each price. To create a supply curve, transfer the data from a supply schedule to a graph. A market supply curve shows the data from the market supply schedule. In other words, it shows how much of a good or service all of the producers in a market are willing and able to offer for sale at each price. EXAMPLE Individual Supply Curve Study the supply curve (Figure 5.4) created from the Smiths’ supply schedule. How many pounds of tomatoes will the Smiths supply at $1.50 per pound? How will the Smiths’ quantity supplied change if the price increases or decreases by 25 cents? Find the answers to these questions by running your finger along the curve. As you can see, the supply curve is a graphic representation of the law of supply. When the price increases, the quantity supplied increases; when the price decreases, the quantity supplied decreases. Note that the supply curve in Figure 5.4, and the schedule on which it is based, were created using the assumption that all other economic factors except price remain the same. You’ll learn more about these other factors in Section 3. FIGURE 5.4 THE SMITHS’ TOMATO SUPPLY CURVE a 2.00 1.75 1.50 1.25 1.00 .75 .50 .25 ) Notice that supply curves always slope upward from lower left to upper right. a The vertical axis of the graph shows prices, with the highest at the top. b The horizontal axis shows quantities supplied, with the lowest on the far left. The specific quantities supplied at specific prices listed on the supply schedule are plotted as points on the graph and connected to create the supply curve. c . Price per pound ($) Quantity Supplied 2.00 1.75 1.50 1.25 1.00 0.75 0.50 50 40 34 30 24 20 10 c b 0 10 30 Quantity supplied of tomatoes (in pounds) 50 40 20 ANALYZE GRAPHS 1. How many pounds of tomatoes will the Smiths offer for sale when the price is $1.50? 2. How does this supply curve illustrate the law of supply? Use an interactive supply curve at ClassZone.com 134 Chapter 5 E XAMPLE Market Supply Curve Like the Smiths’ individual supply curve, the market supply curve for all the stands that sell tomatoes at the Montclair Farmers’ Market shows the quantity supplied at different prices. In other words, the graph shows the quantity of tomatoes that all of the producers, or the market as a whole, are willing and able to offer for sale at each price. The market supply curve (Figure 5.5) differs in scope from the Smiths’ individual supply curve, but it is constructed in the same way. As in Figure 5.4, the vertical axis displays prices and the horizontal axis displays quantities supplied. FIGURE 5.5 TOMATO MARKET SUPPLY CURVE ) .00 1.75 1.50 1.25 1.00 .75 .50 .25 0 Notice that market supply curves slope upward from lower left to upper right, just as individual supply curves do. The main difference between the two types of curves is that the quantities supplied at each price are much larger on a market supply curve. This is because the curve represents a group of producers (a market), not just one producer. Price per Pound ($) Quant
ity Supplied 2.00 1.75 1.50 1.25 1.00 0.75 0.50 350 300 250 200 150 100 50 50 100 150 200 250 300 350 Quantity supplied of tomatoes (in pounds) ANALYZE GRAPHS 1. At which price will all the fruit and vegetable stands want to sell 200 pounds of tomatoes? 2. How is the slope of this supply curve different from the slope of a market demand curve? Look at Figure 5.5 one more time. What is the quantity supplied at $1.50? How will quantity supplied change if the price increases by 25 cents or decreases by 25 cents? Once again, find the answers to these questions by running your finger along the curve. As you can see, the market supply curve, just like the individual supply curve, vividly illustrates the direct relationship between price and quantity supplied. If the price of tomatoes increases among all of the suppliers at the farmers’ market, then the quantity supplied of tomatoes also increases. And, conversely, if the price decreases, then the quantity supplied decreases as well. As with the individual supply curve, the market supply curve is constructed on the assumption that all other economic factors remain constant—only the price per pound of tomatoes changes. Supply 135 The NBA Goes International Until recently, nearly all of the National Basketball Association’s (NBA) players were U.S-born. Before 1984, there were only 12 foreign-born players in the league, but that has changed. Opening day rosters in the 2005–06 season listed 82 international players, and they hailed from all over the world—from Spain and Slovenia in Europe to Senegal and the Sudan in Africa. Why has the supply of international players risen so dramatically? The average annual salary of an NBA player, which has risen from about $2 million in 1997 to over $4 million in 2006, is a likely explanation. The international players are not the only group reaping monetary rewards. With people in China watching Yao Ming (at right), and French fans following Tony Parker, the NBA’s overseas merchandise sales have increased rapidly. In 2004, the NBA sold an estimated $600 million in merchandise outside of the United States—about 20 percent of its overall merchandise sales. FIGURE 5.6 INTERNATIONAL PL AYERS IN THE NBA 63 65 81 82 38 41 46 1999–2000 2000–2001 2001–2002 2002–2003 2003–2004 2004–2005 2005–2006 Source: nbahoopsonline.com NBA season CONNECTING ACROSS THE GLOBE 1. Synthesizing Economic Information How do price and quantity supplied relate to salaries and labor in the NBA? 2. Drawing Conclusions What effect might a large drop in NBA salaries have on international sales of NBA merchandise? Supply curves for all producers follow the law of supply. Whether the producers are manufacturers, farmers, retailers, or service providers, they are willing to supply more goods and services at higher prices, even though it costs more to produce more. A farmer, for example, spends more on seeds and fertilizer to grow more soybeans. Why are farmers and other producers willing to spend more when prices are higher? The answer is that higher prices signal the potential for higher profits, and the desire to increase profits drives decision making in the market. You will learn more about the costs of production and about maximizing profits in Section 2. APPLICATION Applying Economic Concepts C. Look back at the supply schedule for nutrition bars you created for Application B on page 133. Use it to create a supply curve. Create a supply curve at ClassZone.com 136 Chapter 5 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. supply law of supply b. supply schedule supply curve c. market supply schedule market supply curve 2. Why does a supply curve slope upward? 3. What do the points on a market supply curve represent? 4. If the price of a video game increased, what would the law of supply predict about the quantity supplied of the game? 5. How is the law of supply similar to the law of demand? How is it different? 6. Using Your Notes How is a supply schedule different from a market supply schedule? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com supply schedule Supply law of supply . Explaining an Economic Concept Focus on one item you buy regularly for which the price has changed. How did this shift in price influence supply? 8. Making Inferences The market supply schedule on page 133 shows that the quantity supplied of tomatoes priced at 50 cents per pound was 50 pounds. However, market research of customers at the farmers’ market showed that the market demand at that price was 250 pounds of tomatoes. How do you explain the difference? 9. Applying Economic Concepts Return to the supply schedule for nutrition bars you created for Application B on page 133. Assume that the class represents all the sellers of nutrition bars in the market. Tabulate these individual supply schedules to create a market supply schedule. Then use that schedule to draw a market supply curve. 10. Challenge Why might producers not always be able to sell their products at the higher prices they prefer? Think about the laws of demand and supply and the different attitudes that consumers and producers have toward price. How might the market resolve this difference? (You will learn more about this in Chapter 6.) Making a Market Supply Curve Suppose that you are the head of the sporting goods dealers’ association in your city. You survey all the stores that sell skis and determine how many pairs of skis they are willing to sell at various prices. Your research enables you to make the following market supply schedule. Price per Pair ($) Quantity Supplied 500 425 350 275 200 125 600 450 325 225 150 100 Create a Supply Curve Use this market supply schedule to draw a market supply curve. Be sure to label each axis of your graph. Challenge Write a caption for your supply curve explaining what it shows. Use to complete this activity. @ ClassZone.com Supply 137 S E C T I O N 2 What Are the Costs of Production TA K I N G N O T E S In Section 2, you will • analyze how businesses calculate the right number of workers to hire • determine how businesses calculate production costs • explain how businesses use those calculations to determine the most profitable output marginal product, p. 138 specialization, p. 138 increasing returns, p. 139 diminishing returns, p. 139 fixed cost, p. 140 variable cost, p. 140 total cost, p. 140 marginal cost, p. 140 marginal revenue, p. 142 total revenue, p. 142 profit-maximizing output, p. 143 As you read Section 2, complete a hierarchy diagram like this one to track main ideas and supporting details. Use the Graphic Organizer at Interactive Review @ ClassZone.com Production Costs main idea main idea main idea details details details Labor Affects Production KEY CONCEPT S Let’s look at an individual producer and the costs involved in supplying goods to the market. Janine owns a small factory that produces custom blue jeans. The factory has three sewing machines, and when there are three workers, one day’s product is 12 pairs of jeans. She wonders how hiring one more worker will affect production. The change in total product that results from hiring one more worker is called the marginal product. With four workers, the factory produces 19 pairs of jeans a day, so the new employee’s marginal product is 7 pairs of jeans. With a fifth worker, output jumps from 19 to 29— a marginal product of 10. Why did marginal product increase? Each of Janine’s original three workers had a sewing machine to operate, but they also had to cut cloth, package the finished jeans, and keep the shop clean. So, Janine’s employees only spent half of their time sewing. The fourth employee helped with the other tasks, so marginal product increased. But the sewing machines were often still idle. The fifth worker allowed labor to be divided even more efficiently, which caused marginal product to increase markedly. Having each worker focus on a particular facet of production is called specialization. But does hiring more workers always cause marginal product to increase? QUICK REFERENCE Marginal product is the change in total output brought about by adding one more worker. Specialization is having a worker focus on a particular aspect of production. 138 Chapter 5 E XAMPLE Marginal Product Schedule A marginal product schedule shows the relationship between labor and marginal product. As you can see from Janine’s marginal product schedule (Figure 5.7), one or two workers produced very little. But marginal product was still slightly larger with each added worker. Then with between three and six workers, the benefits of specialization become increasingly apparent. With up to six employees, Janine’s operation experiences increasing returns, meaning each new worker adds more to total output than the last, as shown by the marginal product. FIGURE 5.7 JAN I NE’S MA RG I NAL PRODUC T SC HEDULE QUICK REFERENCE Increasing returns occur when hiring new workers causes marginal product to increase. a Four workers can produce 19 pairs of jeans. Specialization causes a healthy increase in marginal product. b With seven workers, total product still increases, but marginal product begins to decrease. c With eleven workers, total product decreases, and the marginal product is a negative number. Number of Workers Total Product Marginal Product 10 11 0 3 7 12 19 29 42 53 61 66 67 65 0 3 4 5 7 10 13 11 8 5 1 2 a b c ANALYZE TABLES 1. At what number of workers is total product highest? 2. On the basis of this table, does it make sense for Janine to hire more than six workers? Explain your answer. Figure 5.7 shows that increasing returns stop with the seventh worker. This is also related to specialization. Workers seven, eight, nine, and ten can still add to productivity, but their work overlaps with that of the first six workers. With between seven and ten employees, Janine’s operation experiences dimi
nishing returns, as each new worker causes total output to grow but at a decreasing rate. With eleven workers, total output actually decreases, and Janine experiences negative returns. This may happen as employees become crowded and operations become disorganized. It is rare, however, for a business to hire so many workers that it has negative returns. QUICK REFERENCE Diminishing returns occur when hiring new workers causes marginal product to decrease. AP P LI CATION Drawing Conclusions A. Why do Janine’s increasing returns peak with six employees? Supply 139 QUICK REFERENCE Fixed costs are those that business owners incur no matter how much they produce. Variable costs depend on the level of production output. Total cost is the sum of fixed and variable costs. Marginal cost is the extra cost of producing one more unit. Production Costs KEY CONCEPT S The goal of every business is to earn as much profit as possible. Profit is the money that businesses get from selling their products, once the money it costs to make those products has been subtracted. Businesses have different kinds of costs. Fixed costs are expenses that the owners of a business must incur whether they produce nothing, a little, or a lot. Variable costs are business costs that vary as the level of production output changes. Businesses find the total cost of production by adding fixed and variable costs together. Finally, businesses are interested in knowing their marginal cost, or the additional cost of producing one more unit of their product. EXAMPLE Fixed and Variable Costs Janine’s fixed costs include the mortgage on her factory, her insurance, and the utilities that are on even when the factory is closed at night and on weekends. These costs are the same whether she is producing no jeans, 3 pairs, or 42 pairs of jeans per day. She must also pay the salaries of managers who keep the company running but are not involved directly in production. Wages are one of Janine’s chief variable costs. As she hires additional workers to increase the level of production, her costs for wages increase. She also incurs additional costs for more fabric, thread, zippers, and buttons as well as increased electricity costs to run the machines and light the factory. Shipping her jeans to customers is another variable cost. The more pairs of jeans that Janine’s factory produces, the more her variable costs increase. Conversely, if she decides to cut back the hours or the number of workers, or if she closes the factory for a week’s vacation, her variable costs decrease. To determine the total cost to produce a certain number of pairs of jeans, Janine can add her fixed and variable costs. And by figuring out her marginal cost, she can determine what it costs to produce each additional pair of jeans. Fixed Costs Variable Costs ▼ Management Workers ▼ Mortgage on factory ▼ ▼ Cloth ▼ Machinery Thread ▼ 140 Chapter 5 E XAMPLE Production Costs Schedule By looking at Figure 5.8, we can see Janine’s costs and how they change as her quantity of jeans produced changes. Remember that her total product increased through the addition of the tenth worker and declined after the eleventh worker was added. The change in the number of workers is a major factor in the increase in variable costs at each quantity. You’ll notice that the fixed costs remain the same no matter what the total product amounts to. FIGURE 5. 8 JAN I NE’S PRODUC T I ON COST S SC HEDULE Number of Workers Total Product a Fixed Costs ($) a Variable Cost ($) Total Cost ($) Marginal Cost ($) 10 11 0 3 7 12 19 29 42 53 61 66 67 65 40 40 40 40 40 40 40 40 40 40 40 40 0 30 b 62 97 132 172 211 277 373 473 503 539 40 70 102 137 172 212 251 317 413 513 543 579 — 10 8 7 5 4 3 6 12 20 30 — a Fixed costs remain constant, while variable costs change at each quantity. b Calculate total costs by adding together fixed costs and variable costs. ANALYZE TABLES 1. How do the variable costs change when the total product increases from 7 pairs to 12 pairs? 2. When Janine has no workers, why are her fixed and total costs the same? Marginal cost is determined by dividing change in total cost by change in total product. Notice in Figure 5.8 that marginal cost declines at first and then increases. The initial decline occurs because of increasing worker efficiency due to specialization. After that the marginal cost increases because of diminishing returns. Janine now knows when her returns are increasing or diminishing and what it costs her to produce each additional pair of jeans. Her next step is to figure out her revenue, the money she makes from selling jeans, at each level of production. AP P LI CATION Analyzing and Interpreting Data B. Why does it cost Janine more to produce 65 pairs of jeans with 11 workers than to produce 66 pairs of jeans with 9 workers? CONNECT TO MATH To determine marginal cost, divide the change in total cost by the change in total product. 1. In Figure 5.8, total cost with four workers is $172; with three workers it is $137. 17213735 2. Total product with four workers is 19; with three workers it is 12. 19127 3. Marginal cost in this case is figured by dividing 35 by 7. 3575 Supply 141 Earning the Highest Profit KEY CONCEPT S QUICK REFERENCE Marginal revenue is the money made from the sale of each additional unit of output. Total revenue is a company’s income from selling its products. Before a business can decide how much to produce in order to earn as much profit as possible, it must figure its marginal revenue and total revenue. Marginal revenue is the added revenue per unit of output, or the money made from each additional unit sold. In other words, marginal revenue is the price. If, for example, baseball hats were priced at $5 each, the money earned from each additional hat sold would be $5. Total revenue is the income a business receives from selling a product. It can be expressed by the formula Total Revenue = P Q, where P is the price of the product and Q is the quantity purchased at that price. (Recall that you used this same formula to calculate total revenue on page 101.) EXAMPLE Production Costs and Revenues Schedule You have seen how Janine explored the relationship between labor and marginal product. You have also seen what it cost her to produce various quantities of jeans. Next, you will learn how she calculates her revenue and her profits. Look at Figure 5.9, which shows Janine’s costs, revenues, and profit for various levels of total product. Janine calculates her total revenue by multiplying the marginal revenue—$20 per pair of jeans—by the total product. Then she can determine her profit by subtracting her total costs from her total revenue. Remember that Janine is trying to decide how many workers she should hire and how many pairs of jeans she should produce in order to make the most profit. To make these decisions, she needs to perform a marginal analysis, which is a comparison of the added costs and benefits of an economic action. In other words, she needs to look at the costs and benefits of adding each additional worker and producing additional pairs of jeans. Using Figure 5.9, Janine can see that when she has no employees, and therefore does not produce any jeans, she loses money because she still incurs fixed costs. If she hires one worker who produces three pairs of jeans, her costs are $70, but she only collects $60 in total revenue. Therefore, she still doesn’t earn a profit. When she hires a second worker and together the two workers produce seven pairs of jeans, costs are $102 and revenues are $140, so she earns a very small profit of $38. Janine has finally passed the break-even point, the point at which enough revenue is being generated to cover expenses. At the break-even point, total costs and total revenue are exactly equal. Like all business owners, Janine wants to do a lot better than break even. She wants to earn as much profit as possible. She can see that as she adds additional workers and produces more jeans, her profits increase. 142 Chapter 5 FIGURE 5.9 JAN I NE’S PRODUC T ION COST S AND RE VENUES SCHEDULE Number of Workers Total Product Total Cost ($) Marginal Cost ($) Marginal Revenue ($) a Total Revenue ($) 10 11 0 3 7 12 19 29 42 53 61 66 67 65 40 70 102 137 172 212 251 317 413 513 543 579 — 10 8 7 5 4 3 6 12 20 30 — d — 20 20 20 20 20 20 20 20 20 20 20 0 60 140 c 240 380 580 840 1,060 1,220 1,320 1,340 1,300 b Profit ($) 40 10 38 103 208 368 589 743 807 807 797 721 a Total revenue = marginal revenue (price) x total product. b Profit = total revenue – total cost. c When total revenue first exceeds total cost, a producer has passed the breakeven point. d At profit-maximizing output, marginal cost = marginal revenue. ANALYZE TABLES 1. How does Janine calculate her total revenue and profits when she produces 42 pairs of jeans? 2. What happens to Janine’s profits when she increases production from 66 to 67 pairs of jeans? Why does this happen? When you look at Figure 5.9 again, you can see that Janine’s profits continue to rise as she adds workers—up to and including the ninth worker—and produces more jeans. Why does this happen? Recall that during the stage of diminishing returns (see Figure 5.7 on page 139), total production continues to rise, but it rises more slowly. Although Janine is getting less production from each additional worker, marginal revenue is still greater than marginal cost, so Janine hires more workers, produces more, and increases profits. When Janine’s factory has nine workers producing 66 pairs of jeans, it has reached the level of production where it realizes the greatest amount of profit. This is called profit-maximizing output. This level of output is reached when the marginal cost and the marginal revenue are equal (here, both at $20). After that point, profits begin to decline. When Janine adds a tenth worker, the marginal product of one pair of jeans increases total revenue, but the increase in marginal cost is greater than the inc
rease in marginal revenue. Since the goal of every business is to maximize profit, having a tenth employee runs counter to Janine’s best interests. AP P LI CATION Analyzing and Interpreting Data C. If the price of jeans increased to $22 per pair, how would it affect Janine’s total revenue and profit? QUICK REFERENCE Profit-maximizing output is the level of production at which a business realizes the greatest amount of profit. Supply 143 For more on evaluating sources, see the Skillbuilder Handbook, page R28. Evaluating Sources There are many sources of economic information, including news articles, reports, books, and electronic media. Knowing how to interpret sources is how we gain economic information. TECHNIQUES FOR READING SOURCE MATERIAL The following passage appeared on the Web site of the Portland Cement Association. The passage is a source of information about the supply of cement in the United States in 2004. To interpret this source of information, use the following strategies. Identify the subject of the passage. Then ask yourself what, if any, economic concept is involved. This passage is about cement. The economic concept discussed is supply. Evaluate the passage’s credibility. Do you think the source of the passage is reliable? Are other cited sources reliable? Information from this association and the U.S. Geological Survey is likely to be reliable. Cement Supply Falls Short Several factors have converged to create tight supplies of cement, the key ingredient in concrete, which is used in nearly every type of construction. First, strong construction markets have increased demand. The flare in demand arrived on the heels of an unusually active winter for construction, traditionally a down period when plants can stockpile cement in anticipation of the spring construction surge. Instead, there was no letup in demand during the 2003/04 winter and little opportunity to prepare a strong inventory for spring when construction activity traditionally increases. Another factor is freight—limited availability of transport ships and escalating shipping rates. According to figures from the U.S. Geological Survey, 2003 U.S. portland cement consumption was 107.5 million metric tons. Of that total, 23.2 million tons or 21.6 percent was imported cement. Since the beginning of the spring 2004, shipping rates have skyrocketed and availability of ships is limited. The booming Asian economies are straining worldwide cement capacity and shipping availability. Source: www.cement.org Identify economic factors that are relevant to the discussion. The cement shortage is explained in part by an increase in market demand and by the rising cost and limited availability of ships to carry imported cement. T HINKING ECONOMICALLY Interpreting 1. According to the passage, what variables affect the supply of concrete in the United States? 2. Do you think cement will continue to be in short supply in the United States? Explain your answer using information from the passage. 3. Who do you think is most likely to benefit from the information provided in the passage? Why? 144 Chapter 5 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these groups: a. marginal product c. fixed cost profit-maximizing output variable cost b. increasing returns diminishing returns 2. Why does the marginal cost in Janine’s factory decrease as marginal product increases? 3. Explain why marginal revenue and price are the same in Figure 5.9 on page 143. 4. What changes for a company when it reaches the break-even point? 5. How does a business use marginal analysis to decide how many workers to employ? Calculating Costs and Revenues Suppose you are a manufacturer of video games. You have analyzed your costs of production to create the following table. 6. Using Your Notes How does a business calculate its total costs? Refer to your completed hierarchy diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Production Costs Total Product Fixed Cost ($) Variable Cost ($) main idea main idea main idea details details details 7. Categorizing Economic Information Categorize the following costs incurred by a bookstore owner as fixed or variable: accountant, electricity for extra holiday hours, wages, clerks’ insurance, manager’s salary, purchase of books, rent, telephone. 8. Applying Economic Concepts Suppose that you own a video store that has total costs of $3,600 per month. If you charge $12 for each DVD you sell, how many do you need to sell each month in order to break even? Explain how you arrived at your answer. 9. Applying Economic Concepts The owner of a factory that produces soccer balls determines that his marginal product is at its peak when he has 100 employees. He determines that his marginal cost and marginal revenue are equal when he has 150 employees. What number of employees should he hire in order to maximize his profits? Explain the reason for your answer. 10. Challenge Many companies choose to manufacture their products in countries where workers are paid lower wages than in the United States. Which variable costs decrease and which ones increase as a result of this decision? Why do companies make this choice? Consider what you know about the relationship of costs to profits as you formulate your answer. 0 25 50 100 175 275 350 400 500 500 500 500 500 500 500 500 0 800 1,200 1,800 2,550 3,350 4,250 5,750 Calculate Costs Copy the information in the table on your own paper and add two columns: Total Costs and Marginal Costs. Use the information given to calculate the values and fill in those two columns. Challenge You sell the video games for $40 each. Add columns for Marginal Revenue, Total Revenue, and Profit to your chart and calculate the values for each quantity of total product. Supply 145 S E C T I O N 3 What Factors Affect Supply TA K I N G N O T E S In Section 3, you will change in quantity supplied, p. 146 • explain the difference between change in quantity supplied and change in supply • understand how to determine a change in supply • identify the factors that can cause a change in supply change in supply, p. 148 input costs, p. 148 labor productivity, p. 149 technology, p. 149 excise tax, p. 149 regulation, p. 150 As you read Section 3, complete a chart like this one showing each factor that causes change in supply. Use the Graphic Organizer at Interactive Review @ ClassZone.com Factor That Changes Supply Reason Why Supply Changes Changes in Quantity Supplied KEY CONCEPT S The supply schedules and supply curves that you studied in Section 1 were created using the assumption that all other economic factors except the price of tomatoes would remain the same. If all other factors remain the same, then the only thing that influences how many tomatoes producers will offer for sale is the price of those tomatoes. The supply curve shows that pattern. In Chapter 4, you learned the difference between change in demand and change in quantity demanded. Change in quantity demanded is shown by the points along an existing demand curve, while change in demand actually shifts the demand curve itself. Similarly, the different points on a supply curve show change in quantity supplied. Change in quantity supplied is an increase or decrease in the amount of a good or service that producers are willing to sell because of a change in price. QUICK REFERENCE Change in quantity supplied is a rise or fall in the amount producers offer for sale because of a change in price. A change in the price of bicycles. . . . . . causes a change in the quantity supplied. 146 Chapter 5 E XAMPLE Changes Along a Supply Curve Each new point on the supply curve shows a change in quantity supplied. A change in quantity supplied does not shift the supply curve itself. Let’s look again at the Smiths’ supply curve for tomatoes (Figure 5.10). Note the quantities supplied at each price. Notice that as quantity supplied changes, the change is shown by the direction of movement, right or left, along the supply curve. A movement to the right indicates an increase in both price and quantity supplied. A movement to the left shows a decrease in both price and quantity supplied. FIGURE 5.10 CHANGES IN QUANTITY SUPPLIED 2.00 1.75 1.50 1.25 1.00 .75 .50 .25 ) change in quantity supplied doesn’t shift the supply curve. The change refers to movement along the curve itself. Each point on the curve represents a new quantity supplied. a As you move to the right along the curve, the quantity supplied increases. b As you move to the left along the curve, the quantity supplied decreases. 10 0 Quantity supplied of tomatoes (in pounds) 20 50 30 40 ANALYZE GRAPHS 1. What is the change in quantity supplied when price increases from $0.75 to $1.50? 2. What is the change in price when quantity supplied changes from 50 to 24 pounds? Use an interactive supply curve to see changes in quantity supplied at ClassZone.com Just as Figure 5.10 shows change in quantity supplied by one individual, a market supply curve shows similar information for an entire market. However, market supply curves have larger quantities supplied, and therefore larger changes to quantity supplied, because they combine the data from all the individual supply curves in the market. For example, when the price increases from $0.75 to $1.75 on the market supply curve (Figure 5.5), the quantity supplied increases from 100 pounds to 300. Compare this with the change in quantity supplied at those prices in Figure 5.10. AP P LI CATION Applying Economic Concepts A. Changes in quantity supplied do not shift the position of the supply curve. Why? Supply 147 Changes in Supply KEY CONCEPT S QUICK REFERENCE Change in supply occurs when a change in the marketplace prompts producers to sell different amounts at every price. Consider what might happen if the workers at an automobile factory negotiate a large wage increase so that it’s more expensive to produce each automobile. A
s the firm’s costs increase, it is less willing and able to offer as many automobiles for sale. Any action such as this, which changes the costs of production, will change supply. Change in supply occurs when something prompts producers to offer different amounts for sale at every price. When production costs increase, supply decreases; when production costs decrease, supply increases. Just like change in demand, change in supply actually shifts the supply curve. Six factors cause a change in supply: input costs, labor productivity, technology, government actions, producer expectations, and number of producers. FACTOR 1 Input Costs QUICK REFERENCE Input costs are the price of the resources used to make products. Input costs are a major factor that affects production costs and, therefore, supply. Input costs are the price of the resources needed to produce a good or service. For example, Anna makes nutrition bars that contain peanuts. If the price of peanuts increases, Anna’s costs increase. She cannot afford to produce as many nutrition bars, and her supply curve shifts to the left (Figure 5.11). When the price of peanuts decreases, her costs decrease. She is willing and able to increase the quantity she can supply at every price, and the curve shifts to the right (Figure 5.12). FIGURES 5.11 AND 5.12 SHIFTS IN SUPPLY FIGURE 5.11 DECREASE IN SUPPLY FIGURE 5.12 INCREASE IN SUPPLY ) S2 a S1 10 20 30 40 50 60 ) S1 S3 b 10 20 30 40 50 60 Quantity supplied of nutrition bars Quantity supplied of nutrition bars ANALYZE GRAPHS 1. In Figure 5.11, how has the supply of nutrition bars changed at every price? 2. In Figure 5.12, how has the supply of nutrition bars changed at every price? Use an interactive version of shifting supply curves at ClassZone.com 148 Chapter 5 When a change in supply occurs, the supply curve shifts. a As Figure 5.11 shows, a shift to the left (S2) indicates a decrease in supply. b As Figure 5.12 shows, a shift to the right (S3) indicates an increase in supply. FACT OR 2 Labor Productivity Labor productivity is the amount of goods and services that a person can produce in a given time. Increasing productivity decreases the costs of production and therefore increases supply. For example, a specialized division of labor can allow a producer to make more goods at a lower cost, as was the case at Janine’s factory in Section 2. Her marginal costs decreased when there were six workers, each of whom had a separate job to do. Better-trained and more-skilled workers can usually produce more goods in less time, and therefore at lower costs, than less-educated or less-skilled workers. For example, a business that provides word-processing services can produce more documents if its employees type quickly and have a lot of experience working with wordprocessing software. QUICK REFERENCE Labor productivity is the amount of goods and services that a person can produce in a given time. Technology entails applying scientific methods and innovations to production. FACT OR 3 Technology One way that businesses improve their productivity and increase supply is through the use of technology. Technology involves the application of scientific methods and discoveries to the production process, resulting in new products or new manufacturing techniques. Influenced by the profit motive, manufacturers have, throughout history, used technology to make goods more efficiently. Increased automation, including the use of industrial robots, has led to increased supplies of automobiles, computers, and many other products. (See the Case Study on pages 158–159.) The Typewriter’s End The move from typewriter to computer shows how technology helps to boost productivity. Improved technology helps farmers produce more food per acre. It also allows oil refiners to get more gasoline out of every barrel of crude oil and helps to get that gasoline to gas stations more quickly and more safely. In addition, technological innovations, such as the personal computer, enable workers to be more productive. This, in turn, helps businesses to increase the supply of their services, such as processing insurance claims or selling airline tickets. FACT OR 4 Government Action Government actions can also affect the costs of production, both positively and negatively. An excise tax is a tax on the production or sale of a specific good or service. Excise taxes are often placed on items such as alcohol and tobacco— things whose consumption the government is interested in discouraging. The taxes increase producers’ costs and, therefore, decrease the supply of these items. Taxes tend to decrease supply; subsidies have the opposite effect. You learned in Chapter 3 that a subsidy is a government payment that partially covers the cost of an economic activity. The subsidy’s purpose is to encourage or protect that activity. Most forms of energy production in the United States receive some form of subsidy. For example, subsidies helped to double the supply of ethanol, a gasoline substitute made from corn, between 2000 and 2004. QUICK REFERENCE An excise tax is a tax on the making or selling of certain goods or services. Supply 149 QUICK REFERENCE Regulation is a set of rules or laws designed to control business behavior. Government regulation, the act of controlling business behavior through a set of rules or laws, can also affect supply. Banning a certain pesticide might decrease the supply of the crops that depend on the pesticide. Worker safety regulations might decrease supply by increasing a business’s production costs or increase supply by reducing the amount of labor lost to on-the-job injuries. FACTOR 5 Producer Expectations If producers expect the price of their product to rise or fall in the future, it may affect how much of that product they are willing and able to supply in the present. Different kinds of producers may react to future price changes differently. For example, if a farmer expects the price of corn to be higher in the future, he or she may store some of the current crop, thereby decreasing supply. A manufacturer who believes the price of his or her product will rise may run the factory for an extra shift or invest in more equipment to increase supply. FACTOR 6 Number of Producers When one company develops a successful new idea, whether it’s designer wedding gowns, the latest generation of cell phones, or fast-food sushi, other producers soon enter the market and increase the supply of the good or service. When this happens, the supply curve shifts to the right, as you can see in Figure 5.13. FIGURE 5.13 NUMBER OF PRODUCERS 3.00 ) .50 2.00 1.50 1.00 .50 S1 S2 a b a This supply curve (S1) shows the number of ice cream cones sold in a week at each price when Casey is the only supplier in the market. b This curve (S2) shows the number of ice cream cones sold in a week at each price when three more suppliers enter the market. 0 50 100 150 200 250 300 Quantity supplied of ice cream cones ANALYZE GRAPHS 1. About how many ice cream cones were sold at $1.00 when Casey was the only producer in the market? 2. How do these two curves show the effect of the number of producers on the supply of ice cream cones in the market? An increase in the number of producers means increased competition, which may eventually drive less-efficient producers out of the market, decreasing supply. (You’ll learn more about competition in Chapter 7.) Competition has a major impact on supply, as producers enter and leave the market constantly. 150 Chapter 14 Factors That Cause a Change in Supply Input Costs Input costs, the collective price of the resources that go into producing a good or service, affect supply directly. Number of Producers A successful new product or service always brings out competitors who initially raise overall supply. Producer Expectations The amount of product producers are willing and able to supply may be influenced by whether they believe prices will go up or down. What Causes a Change in Supply? Government Action Government actions, such as taxes or subsidies, can have a positive or a negative effect on production costs. Labor Productivity Better-trained or more-skilled workers are usually more productive. Increased productivity decreases costs and increases supply. Technology By applying scientific advances to the production process, producers have learned to generate their goods and services more efficiently. ANALYZE CHARTS A newspaper article states that the supply of snowboards has risen dramatically over the past six months. Choose four of the six factors that cause a change in supply and explain how each might have resulted in the recent influx of snowboards. Figure 5.13 shows what happens to the supply of ice cream cones in a neighborhood as more producers enter the market. When Casey opened his ice cream store it was the only one in the area. It was an instant success. Within six months, three competing stores had opened in the neighborhood, and the supply of ice cream cones increased at all price levels. A year later, though, this intense competition forced one of the producers to leave the market. AP P LI CATION Applying Economic Concepts B. Choose an item of food or clothing that you buy regularly. List as many input costs as you can that might affect the supply of that product. Compare your list with a classmate’s and see if you can add to each other’s lists. Supply 151 ECO N O M I C S PAC ES E T T E R Robert Johnson: Supplying AfricanAmerican Entertainment In this section, you’ve learned about the factors that influence supply. You’ve also seen some examples of how these factors work. The story of media entrepreneur Robert Johnson provides a real-world example of how the entrance of a new supplier can affect a market. EXAMPLE Expanding the Number of Producers In the late 1970s, Robert Johnson was working as a Washington lobbyist for the National Cable Television Association. He recognized that current suppliers in the cable TV industry
were ignoring a substantial market—African Americans. To fill this void, Johnson conceived the idea for Black Entertainment Television (BET), the first cable channel owned by and focused on African Americans. To launch his dream, Johnson took out a $15,000 bank loan. He also persuaded a major investor to put up $500,000. Next, he secured space on a cable TV satellite for his new channel. BET’s first program appeared on January 8, 1980. The company grew from offering two hours of programming a week to round-the-clock programming on five separate channels. Cable operators in the United States, Canada, and the Caribbean saw the value of this kind of targeted programming, and began to buy BET’s shows. A Vast Reach BET supplies programming to more than 80 million households in Canada, the United States, and the Caribbean. At first, BET targeted young viewers with programs similar to those on MTV. As the cable TV industry grew and became more profitable, Johnson invested in more diverse programming. Of this transition he explained, “Now we’re a music video channel with a public affairs footprint. . . .” BET could “play music, but also . . . cover issues that are of concern to African Americans.” BET.com, the number one Internet portal for African Americans, soon followed. In 2001, Johnson sold BET to the giant media company Viacom International Inc. for $3 billion and became the nation’s first black billionaire. After the sale, Johnson stayed on at BET and continued to run the company for five more years. His success demonstrated that there was a strong market for African-American entertainment. As a result, many suppliers—some with no traditional ties to the African-American community— now offer the kind of programming Johnson pioneered. APPLICATION Making Inferences C. What effects might BET’s success have on the supply of African-American programming? FAST FACTS Robert Johnson Title: Chairman of BET Holdings II, Inc., retired Born: April 8, 1946, Hickory, Mississippi Major Accomplishment: BET is the leading supplier of cable TV programming aimed at African Americans. Other Enterprises: Digital music networks, publishing, events production, BET.com Web portal, NBA team Charlotte Bobcats, and WNBA Charlotte Sting Honors: Broadcasting and Cable Magazine Hall of Fame Award, NAACP Image Award Find an update on Robert Johnson at ClassZone.com 152 Chapter 5 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. change in quantity supplied change in supply b. input costs technology c. excise tax regulation 2. What else besides raw materials would be included in input costs? 3. Why might an increase in oil prices lead to a decrease in the supply of fruits and vegetables in your local supermarket? 4. Why do excise taxes and subsidies affect supply differently? 5. Does expectation of a change in price affect supply? Illustrate your answer with examples. Factor That Changes Supply Reason Why Supply Changes 6. Using Your Notes How does a change in number of producers affect supply? Refer to your completed chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com . Applying Economic Concepts How do each of these examples of government actions affect the supply of gasoline? a. In 2005, the government continued support for ethanol, a gasoline substitute. b. The state of California requires a special blend of gasoline that meets stricter environmental standards than other regions in the country. c. Many states use gasoline taxes to help fund highway construction and maintenance. 8. Making Inferences Why do you think governments want to influence the supply of alcohol and tobacco products by imposing excise taxes? 9. Analyzing Effects Take out the market supply curve for skis that you created on page 137. Add new curves showing how supply would be changed in each of the following cases. Share your graph with a classmate and explain your reasoning. a. The price of titanium, used in skis, declines dramatically. b. A large manufacturer decides to stop producing skis. 10. Challenge How does an increased number of producers affect the prices of goods in a market? What is the reason for this effect? Think about what you know about demand and supply and review Figure 5.12 as you formulate your answer. Explaining Changes in Supply Suppose that you are a manufacturer of personal digital music players (PDMPs). What factors affect supply for PDMPs? The chart below lists examples of a change in supply in the market for PDMPs. For each example, identify which factor that affects supply is involved and state whether supply increases or decreases. Factor and How It Affected Supply Example of Change That Affects Supply You give each worker in your factory a specialized job. Price of computer chips used in PDMPs rises. New machinery speeds up the manufacturing process. Your success prompts three new companies to start producing PDMPs. A new law requires producers to recycle the wastewater from their factories. Challenge Identify which of the six factors that affect supply does not appear on this chart. What would be an example of how that factor might affect the market for PDMPs? Supply 153 S E C T I O N 4 What Is Elasticity of Supply TA K I N G N O T E S In Section 4, you will elasticity of supply, p. 154 • define the term elasticity of supply • explain the difference between elastic and inelastic supply • identify the factors that affect elasticity of supply As you read Section 4, complete a cluster diagram like the one shown. Use the Graphic Organizer at Interactive Review @ ClassZone.com Elasticity of Supply Elasticity of Supply KEY CONCEPT S According to the law of supply, as price increases so will the supply of a good or service. When Toyota Motor Corporation introduced its Prius hybrid in 2000, it was surprised by the automobile’s instant popularity. Consumers were willing to pay more than the manufacturer’s suggested price. Yet Toyota was not able to increase supply at the same pace that consumer demand and prices rose. Even five years later, Toyota could not meet rising demand. This inability to effectively respond to and meet increased demand suggests that the supply of the Prius was inelastic. In Chapter 4, you learned that elasticity of demand measures how responsive consumers are to price changes. In a similar way, elasticity of supply is also a measure of how responsive producers are to price changes. If a change in price leads to a relatively larger change in quantity supplied, supply is said to be elastic. In other words, supply is elastic if a 10 percent increase in price causes a greater than 10 percent increase in quantity supplied. If a change in price leads to a relatively smaller change in quantity supplied, supply is said to be inelastic. If the price and the quantity supplied change by exactly the same percentage, supply is unit elastic. Inelastic Supply The supply of expensive and complicated items, such as this Prius hybrid, is often inelastic. QUICK REFERENCE Elasticity of supply is a measure of how responsive producers are to price changes in the marketplace. 154 Chapter 5 E XAMPLE Elastic Supply Let’s look at an example of elastic supply. Figure 5.15 illustrates how the quantity supplied of a new style of leather boots was elastic. As the boots gained in popularity, a shortage developed. The boot makers raised the price of the boots from $60 to $150 dollars, and the quantity supplied more than kept up, escalating from 10,000 to 50,000 pairs. The producer was able to rapidly increase the quantity supplied because, unlike car manufacturing for instance, the raw materials needed to make boots are neither particularly expensive nor hard to come by. The actual manufacturing process is also, relatively speaking, fairly uncomplicated and easy to increase. E XAMPLE Inelastic Supply In Chapter 4, you learned that demand for gasoline was inelastic. The supply of gasoline is also inelastic. Although gasoline prices rose 20 to 30 percent between 2004 and 2005, producers were not able to increase supply by the same amount because of the limited supply of crude oil and refining capacity. Figure 5.16 shows how the supply of olive oil is also inelastic. When the price of olive oil rose by a factor of four, supply could not keep pace, as the oil comes from the previous season’s olives and is exported from the Mediterranean region. FIGURE 5.15 ELASTIC SUPPLY CURVE FIGURE 5.16 INELASTIC SUPPLY CURVE a 150 120 90 60 30 ) 10 20 30 40 50 Quantity supplied of boots (in thousands 10 20 30 40 50 Quantity supplied of olive oil (in thousands of gallons) a The curve in Figure 5.15 slopes gradually. It slopes more horizontally than vertically because of greater changes in quantity supplied. b The curve in Figure 5.16 slopes steeply. It slopes more vertically than horizontally because of lesser changes in quantity supplied. ANALYZE GRAPHS 1. If the price of leather rose dramatically for the boots in Figure 5.15, how might this affect elasticity of supply? 2. In the United States, would the supply of corn oil be more elastic than the supply of olive oil? Why or why not? Use elastic and inelastic supply curves at ClassZone.com AP P LI CATION Drawing Conclusions A. A bakery produces 200 muffins per week that sell for $1.50 each. When the price increases to $2.00, it produces 300 muffins per week. Is supply elastic or inelastic? Explain your answer. Supply 155 What Affects Elasticity of Supply? KEY CONCEPT S Just as there are factors that cause a change in supply, there are also factors that affect the elasticity of supply. There are far fewer of these factors than for elasticity of demand. The ease of changing production to respond to price change is the main factor in determining elasticity of supply. Given enough time, the elasticity of supply increases for most goods and services. Supply will be more elastic over a year or several years than it will be if the time f
rame to respond is a day, a week, or a month. Industries that are able to respond quickly to changes in price by either increasing or decreasing production are those that don’t require a lot of capital, skilled labor, or difficult-to-obtain resources. For example, the quantity supplied of dog-walking services can increase rapidly with the addition of more people to walk dogs. A small business that sells crafts made from recycled materials would be able to respond quickly to changes in the price of its various products by applying its resources to increase the supply of its higher priced items. For other industries, it takes a great deal of time to shift the resources of production to respond to price changes. Automakers and oil refiners are examples of industries that rely on large capital outlays or difficult-to-obtain resources. It might take such suppliers a considerable amount of time to respond to price changes. YO U R EC STIC IT Y O F SU PPLY Which supply of cupcakes is more elastic? You’re planning to sell cupcakes at your school’s football game to raise funds for a charitable cause, but it’s hard to say in advance how many fans will attend the game. You can place an order with a bakery (which you need to do a week early) or have volunteers do the baking the night before the game. Which supply of cupcakes is more elastic? Why? ? APPLICATION Applying Economic Concepts B. Is the elasticity of a farmer’s crop of sweet corn greater at the beginning of the growing season or in the middle of the growing season? Why? 156 Chapter 5 S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Use each of the following three terms in a sentence that gives an example of the term as it relates to supply: a. elastic b. inelastic c. elasticity of supply 2. How is elasticity of supply similar to elasticity of demand? How is it different? 3. Is the supply of genuine antique furniture elastic or inelastic? Why? 4. What is the difference between industries that have elastic supply and those that have inelastic supply? 5. What is the main factor that affects elasticity of supply and how does it affect elasticity? 6. Using Your Notes How is time related to elasticity of supply? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Elasticity of Supply . Analyzing Causes Between 1997 and 2002, many gold producers cut their budgets for exploring for new sources in order to stay profitable when the price of gold was less than $350 per ounce. When the price rose above $400 per ounce in 2004, gold producers were not able to respond quickly to the increase. Use what you know about elasticity of supply to explain this causeand-effect relationship. 8. Analyzing Data In May, Montclair Electronics sold 100 portable DVD players at $150 each. High consumer demand at the start of the summer travel season increased the price to $180. In June, the store sold 115 DVD players at the higher price. Is the supply of DVD players elastic or inelastic? Show your math calculations to support your answer. 9. Applying Economic Concepts Analyze the factors that determine elasticity of supply to explain why it is difficult for orange growers to respond quickly to changes in the price of orange juice. 10. Challenge Prices are up 8 percent at the local juice shop. Its raw materials are inexpensive and easy to find, and the labor is unskilled. Should the shop be able to raise quantity supplied more than 8 percent? Why? Calculating Elasticity The growing market for bottled yogurt smoothies is shown in the supply schedule below. Use the information in the table to determine whether the quantity supplied is growing proportionately more than increases in price. Would you expect supply for yogurt smoothies to be elastic or inelastic over a period of six months? Price ($) Quantity Supplied of Smoothies 2.00 1.75 1.50 1.25 600 450 300 200 Create a Supply Curve Use the information in the supply schedule to create a supply curve for yogurt smoothies. What does the slope of this curve indicate about elasticity of supply for yogurt smoothies? Challenge Adapt the information in the Math Challenge on page 121 to calculate the elasticity of supply using the data in the supply schedule above. Substitute quantity supplied for quantity demanded in the formula. Use ClassZone.com to complete this activity. @ Supply 157 Case Study Find an update on this Case Study at ClassZone.com Robots—Technology Increases Supply Background The increasing sophistication of technology continues to have a profound impact on the production and supply of manufactured goods. Robots— machines that can be programmed to perform a variety of tasks—are a prime example of technology’s effect on industry. Today, industrial robots perform a wide variety of functions. Although robots do everything from packaging pharmaceuticals to dispensing genetic material in biotechnical laboratories, half of all industrial robots are used to make automobiles. Robots are ideal for lifting heavy objects and for performing repetitive activities that humans find boring. Lately, though, robots are being used more for tasks that require refined skills. What’s the issue? How does technology increase supply? Study these sources to discover how robots can increase productivity. A. Online Article Japan’s low birthrate is likely to result in a shortage of workers. This article discusses how Toyota plans to use robots to solve this problem. 158 Chapter 5 Toyota to Use “Super” Robots As the Japanese labor pool declines, Toyota turns to robots. Toyota is deploying at all 12 of its domestic plants robots capable of performing several simultaneous operations. It aims to be the first automaker to introduce robots that, in addition to machine work and engine assembly, perform the finishing touches on the assembly line. . . . In the automobile industry robots mainly perform relatively dangerous tasks such as welding and coating, while, in order to preserve quality, human workers accomplish such complicated final processes as attaching interior trim. But Toyota plans to introduce robots to final assembly processes after establishing the necessary control technology and safeguards, and developing parts easily assembled by android [robotic] hands. Even this super robot will not result in the total replace- ment of man by machine; rather it will reinforce the strengths of the production line and compensate for manpower shortages in a truly Toyota-style production innovation. The company plans to use robots to keep production costs at the level of those in China. . . . Toyota presently uses between 3,000 and 4,000 standard robots. It expects a total of 1,000 super robots to join them. Source: japaninc.net Thinking Economically Will the use of robots as described in this article affect the supply of Toyota automobiles? Explain your answer. B. Political Cartoon John Morris drew this cartoon about the use of robots in manufacturing. Parity means “equality.” In the cartoon, parity refers to equal pay and benefits. C. Industry Report Epson, a maker of industrial robots, presents a case study involving the use of robots in a bakery. Source: www.CartoonStock.com Thinking Economically How are the robots in the cartoon affecting productivity? Robots Decorate Cakes English bakery turns to robots during peak seasons. Problem: A large English commercial bakery decorates cakes with written messages iced on the top—a task generally undertaken by skilled staff. . . . During seasonal holiday periods consumer demand for these decorated cakes increases fourfold. Training of additional staff to cope with the expanded demand . . . takes a significant period of time and so volume planning is critical. Solution: System Devices, the EPSON Robots agent for the [United Kingdom], worked with Integrated Dispensing Systems to design and build a robotic cake decorating cell that . . . used an EPSON SCARA robot. . . . Cakes are fed to the EPSON robot via a conveyor. A simple optical positioning system ensures that the cakes are presented to the robot in a consistent position. A CAD [computer-aided design] file of the decoration shape is downloaded to the robot. Because individual cake heights may vary, a laser range finder tells the robot the height of each cake as it enters the work cell. The robot moves over the top of the cake and writes the decorative inscription. . . . Benefits: Ability to boost production during peak seasonal demand periods; consistently high product quality due to reduced variability on decorations; reduced . . . training costs. Source: www.robots.epson.com Thinking Economically In this report, how does the use of robots help the supplier respond to a seasonal change in demand? Would this robotic solution help a department store facing a holiday staffing shortage? Why or why not? THINKING ECONOMICALLY Synthesizing 1. Which of the six factors that can cause a change in supply is highlighted in the three documents? Does this factor generally increase or decrease supply? 2. Which document, B or C, addresses the issue of elasticity? Explain. 3. In which article, A or C, are the robots an example of variable costs? Why? Supply 159 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 Choose the key concept that best completes the sentence. Not all key concepts will be used. break-even point change in quantity supplied change in supply diminishing returns elasticity of supply fixed cost increasing returns input costs law of supply marginal cost marginal product marginal revenue productivity profit-maximizing output supply supply curve supply schedule total product total revenue variable cost 1 is the quantity of a product that producers are willing and able to offer for sale. According to the 2 , when price increas
es, quantity supplied increases, and when price decreases, quantity supplied decreases. Quantity supplied can be displayed on a chart called a 3 or on a graph called a 4 . 5 is the change in 6 caused by hiring one additional worker. When marginal product begins to decrease, production is in the stage of 7 . Total cost is the sum of 8 and variable costs. 9 is the additional cost of producing one more unit. When marginal cost equals 10 , a company has reached 11 . A 12 occurs when producers are willing to sell different amounts of a product at every price. The six factors that change supply are input costs, 13 , technology, government action, producer expectations, and number of producers. The term 14 describes how responsive producers are to price changes. It is measured by comparing 15 to change in price. CHAPTER 5 Assessment What Is Supply? (pp. 130–137) 1. What two requirements of supply must someone meet to be considered a producer? 2. What does it mean to say that quantity supplied and price have a direct relationship? What Are the Costs of Production? (pp. 138–145) 3. How does marginal product change during the three stages of production? 4. What is the relationship of total costs to profit? What Factors Affect Supply? (pp. 146–153) 5. What is the difference between change in quantity supplied and change in supply? 6. How do input costs affect supply? What Is Elasticity of Supply? (pp. 154–159) 7. How are elastic and inelastic supply different? 8. How might you calculate elasticity of supply? A P P LY Look at the graph below showing price changes for two commodities: crude oil and gasoline. 9. How is the price of gasoline related to the price of crude oil? 10. What factor that affects the supply of gasoline is shown in this graph? How does this factor affect the supply of gasoline? FIGURE 5.17 U. S. PRICES OF CRUDE OIL AND GASOLINE GASOLINE CRUDE OIL 2.50 2.00 1.50 1.00 .50 160 Chapter 5 2001 2002 2003 Year 2004 2005 Source: Energy Information Administration, June 2006 11. Analyzing Data Suppose that you own a factory producing backpacks that sell for $20 each. Use the information in this table to calculate marginal cost, total revenue, and profit at each level of output. Identify the break-even point and profit-maximizing output. BAC K PAC K PRODUC T I O N COST S Production Costs How Much Are You Willing to Supply? Choose a partner. Imagine that the two of you run a software company. Your best-selling product is a program that helps businesses manage their inventory. Next year you will produce 20,000 units. The following partial supply schedule shows the prices at which you will likely sell your product during that period. Total Product Total Cost ($) SOF T WA RE SU PPLY SCHEDULE 100 200 300 400 500 600 700 800 900 3,500 5,300 7,000 8,000 8,800 9,800 11,800 14,300 17,000 12. Analyzing Effects A city puts a new rule into effect about the kinds of beverages that may be sold in schools. Sugary sodas must be replaced by bottled water, fruit juices, and sports drinks. How will this decision affect the supply of each category of beverage at the schools? What factor that affects supply is demonstrated in this situation? 13. Drawing Conclusions Both demand and supply for gasoline are inelastic. Would the elasticity of supply and demand be the same for sports cars? Why or why not? 14. Challenge When a string of hurricanes hit Florida, preparation for and cleanup from the storms increased demand for plywood. Yet prices rose only slightly, partly because large chains shipped plywood from stores around the country in anticipation of the increased demand. How does this story illustrate the law of supply and elasticity of supply? Price ($) Quantity Supplied 70 65 60 55 50 7,500 1,000 Step 1 Copy the schedule onto a sheet of paper and fill in the missing amounts in the Quantity Supplied column. Be sure that the amounts you choose adhere to the law of supply. Step 2 Draw a supply curve to illustrate your schedule. Be sure to label each axis of your curve. Step 3 Get together with three other groups. These are your competitors. Bring all of your individual supply schedules together to make a market supply schedule. Then convert the market supply schedule into a market supply curve. Step 4 You and your competitors find out that several other companies are getting ready to introduce similar inventory-control software. On your market supply curve, show how this development causes a shift in supply. Step 5 Although writing your program was difficult, now that it is written, it is relatively quick and easy to produce copies for sale. Is the supply of your product elastic or inelastic? Why? Use to complete this activity. @ ClassZone.com Supply 161 How are prices set? Prices greatly influence consumers’ buying decisions. A reduced price on this sweater may act as an incentive for these young women to make a purchase. 162 CHAPTER 6 Demand, Supply, and Prices SECTION 1 Seeking Equilibrium: Demand and Supply SECTION 2 Prices as Signals and Incentives SECTION 3 Intervention in the Price System CASE STUDY Prices for Concert Tickets Demand is the willingness to buy a good or a service and the ability to pay for it. Supply is the willingness and ability to produce and sell a product The equilibrium price is the price at which quantity demanded and quantity supplied are the same AT T E R S You’ve been looking for a vintage concert T-shirt to buy. You see the shirt you want offered on an Internet site, but the price is too high. After exchanging several e-mails, you and the seller set a price. It’s higher than you wanted to pay and lower than the seller wanted to receive, but it’s acceptable to you both. In a market economy, the forces of demand and supply act in much the same way. They work together to set a price that buyers and sellers find acceptable. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on ticketing companies’ pricing practices. (See Case Study, pp. 186–187.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. Why have some rock bands questioned the pricing practices of certain ticketing companies? See the Case Study on pages 186–187. Demand, Supply, and Prices 163 S E C T I O N 1 Seeking Equilibrium: Demand and Supply TA K I N G N O T E S market equilibrium, p. 164 equilibrium price, p. 164 surplus, p. 167 shortage, p. 167 disequilibrium, p. 169 In Section 1, you will • explore market equilibrium and see how it is reached • explain how demand and supply interact to determine equilibrium price • analyze what causes surplus, shortage, and disequilibrium • identify how changes to demand and supply affect the equilibrium price As you read Section 1, complete a cluster diagram like the one shown using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com market equilibrium Equilibrium disequilibrium The Interaction of Demand and Supply KEY CONCEPT S In Chapters 4 and 5, you learned about how demand and supply work in the market. Recall that a market is any place or situation in which people buy and sell goods and services. Since the market is the place where buyers and sellers come together, it is also the place where demand and supply interact. As buyers and sellers interact, the market moves toward market equilibrium, a situation in which the quantity demanded of a good or service at a particular price is equal to the quantity supplied at that price. Equilibrium price is the price at which the quantity of a product demanded by consumers and the quantity supplied by producers are equal. EXAMPLE Market Demand and Supply Schedule QUICK REFERENCE Market equilibrium occurs when the quantity demanded and the quantity supplied at a particular price are equal. Equilibrium price is the price at which the quantity demanded and the quantity supplied are equal. Let’s look at an example of how this concept works in a particular market. Karen runs a sandwich shop near an office park. Recently, she decided to offer a new product at lunchtime—prepared salads. On the first day, she makes up 40 salads and offers them at $10 each. She is disappointed when she sells only 10 and has to throw the rest away. The next day she is more cautious. She lowers 164 Chapter 6 the price to $4 each and makes only 15 salads. She discovers that 35 customers wanted her salads at the lower price. How can Karen find the right price? Over the course of a week, Karen experiments with different combinations of price and quantity of salads supplied until she discovers market equilibrium at $6 per salad. At that price, she is willing to offer 25 salads for sale, and she sells all of them. When she has either too many or too few salads, she is motivated to change her price. Market equilibrium is the point at which quantity demanded and quantity supplied are in balance. FIGURE 6.1 K A REN’S MA RKE T DEMAND AND SU PPLY SCHEDULE Price per Salad ($) Quantity Demanded Quantity Supplied 10 8 6 4 2 10 15 25 35 40 a b c 40 35 25 15 10 a At prices above $6, quantity supplied exceeds quantity demanded. b At the price of $6, the quantity demanded and the quantity supplied are equal. c At prices below $6, the quantity demanded exceeds the quantity supplied. Only at the equilibrium price of $6 are the quantity demanded and the quantity supplied equal. ANALYZE TABLES 1. What is the difference between quantity supplied and quantity demanded when the price is $10? What is the difference when the price is $2? 2. How does this market demand and supply schedule illustrate the laws of demand and supply? Use an interactive market demand and supply schedule and curve at ClassZone.com Look at Figure 6.1 to see the information that Karen gathered from her first week selling prepared salads. This table is a combined market demand and supply schedule that shows the quantities of salads supplied and
demanded at various prices. Notice that quantity demanded and quantity supplied are different at every line of the schedule except one. That line represents market equilibrium and shows the equilibrium price of $6. When Karen offers salads at prices above $6, she produces more salads than she can sell and has to throw some away. When she offers salads at prices below $6, there is unmet demand because people want more salads than Karen is willing to offer at those prices. Karen’s experience shows how the laws of demand and supply interact in the market. She wants to offer more salads at higher prices than at lower prices because she wants to earn more profit. Her costs would make it impossible to earn much, if any, profit if she were to sell the number of salads that the office workers would like to buy at the lower prices. In a similar way, while the office workers may like the idea of fresh salads for lunch, they are not willing to buy the quantity of salads that Karen wants to sell at higher prices. Find an update on market equilibrium at ClassZone.com Demand, Supply, and Prices 165 EXAMPLE Market Demand and Supply Curve Just as it is possible to convert a market demand schedule to a market demand curve or a market supply schedule to a market supply curve, it is possible to graph a combined market demand and supply schedule. Figure 6.2 portrays Karen’s market demand and supply schedule on a combined graph. On the graph, the vertical axis shows the various prices at which salads are offered for sale and bought. The horizontal axis shows the quantity of salads, whether it is the quantity demanded or the quantity supplied. The demand curve (D) is plotted using the prices and the quantities demanded (Figure 6.1, columns 1 and 2). The supply curve (S) is plotted using the prices and the quantities supplied from the combined schedule (Figure 6.1, columns 1 and 3). You can read each individual curve the same way that you did in Chapters 4 and 5, when demand and supply were shown on separate graphs. Each point on the demand curve shows the intersection of price and quantity demanded. Each point on the supply curve shows the intersection of price and quantity supplied. FIGURE 6.2 MARKET DEMAND AND SUPPLY CURVES ) 10 8 6 4 2 0 S Price per Salad ($) 10 8 6 4 2 Quantity Demanded 10 15 25 35 40 Quantity Supplied 40 35 25 15 10 c b a D 10 20 30 40 50 Quantity of salads a The demand curve (D) shows quantity demanded at various prices and slopes down. b The supply curve (S) shows quantity supplied at various prices and slopes up. c This is the point of market equilibrium, where quantity supplied and demanded are equal. ANALYZE GRAPHS 1. What is the quantity supplied at $8? What is the quantity demanded at $8? 2. How do these market demand and supply curves illustrate the concept of equilibrium price? Look at Figure 6.2 again and notice that the two curves intersect at only one point; this is the point of market equilibrium. It occurs when quantity demanded and quantity supplied are the same—25 salads at $6. Showing the two curves together allows you to see the interaction of demand and supply graphically. APPLICATION Applying Economic Concepts A. Create a combined market demand and supply schedule for pizza at prices of $25, $20, $15, $10, and $5, where $10 is the price at which there is equilibrium. 166 Chapter 6 Reaching the Equilibrium Price KEY C ONCEPT S It’s clear from the example of Karen’s salads that markets don’t arrive at equilibrium price instantly; they often require a process of trial and error. The market may experience a surplus, which is the result of quantity supplied being greater than quantity demanded, usually because prices are too high. Or a shortage may occur, the result of quantity demanded being greater than quantity supplied, usually because prices are too low. E XAMPLE Surplus, Shortage, and Equilibrium In Figure 6.3, we can see how Karen’s experience demonstrates the concepts of surplus and shortage. It also shows that equilibrium occurs when there is neither a surplus nor a shortage, because quantity demanded and quantity supplied are equal. QUICK REFERENCE Surplus is the result of quantity supplied being greater than quantity demanded. Shortage is the result of quantity demanded being greater than quantity supplied. FIGURE 6.3 SURPLUS, SHORTAGE, AND EQUILIBRIUM ) 10 10 20 30 40 50 Quantity of salads a When the price is above $6, quantity supplied exceeds quantity demanded, and there is a surplus (shaded in orange). b When the price is below $6, quantity demanded exceeds quantity supplied, and there is a shortage (shaded in blue). c At the equilibrium price, there is neither a surplus nor a shortage. ANALYZE GRAPHS 1. Is there a surplus or a shortage when the price is $10? How big is that surplus or shortage? How great is the surplus or shortage when the price is $2? 2. What does this graph illustrate about surplus, shortage, and equilibrium price? In Figure 6.3, there is a surplus in the area shaded orange. As Karen discovered when she tried to sell salads at prices above $6, she had too many and had to throw some away. The amount of surplus is measured by the horizontal distance between the two curves at each price. For example, at the price of $8, the distance shown by the black line between 15 and 35 shows a surplus of 20 salads. When there is a surplus, prices tend to fall until the surplus is sold and equilibrium is reached. Producers might also choose to cut back their production to a quantity that is more in line with what consumers demand at the higher prices. Demand, Supply, and Prices 167 The blue area in Figure 6.3 represents where there is a shortage. When Karen decided to charge less than $6, she had too few salads and lots of unhappy customers who weren’t able to get the salads they wanted. As with the surplus, the amount of shortage is measured by the horizontal distance between the two curves at each price. For example, at the price of $4, the distance shown by the black line between 15 and 35 salads shows a shortage of 20 salads. When there is a shortage, producers raise prices in an attempt to balance quantity supplied and quantity demanded. Producers may also try to increase quantity supplied to meet the quantities demanded at the lower prices. EXAMPLE Holiday Toys The concepts of surplus and shortage and the move to equilibrium are active in many markets at different times. Perhaps they are most visible in the market for toys during the holiday shopping season. Toys are often fads, and children’s tastes change rapidly. It is difficult for marketers to know how much to supply and at what price to best meet the quantities demanded by consumers. Sometimes they overestimate a toy’s popularity and end up with a surplus. If they underestimate popularity, they are faced with a shortage. In 1996, for example, Tyco Toys Inc. introduced Tickle Me Elmo. The toy included a microchip that made the toy laugh when it was touched. Tyco expected the toy to be popular and ordered about 500,000 for the holiday season. It was priced around $30. Sales started slowly, and stores thought they might have a surplus. But after several popular television personalities promoted it, Tickle Me Elmo became the hottest toy of that holiday season, and a shortage developed. Even when prices increased markedly, buyers were undeterred. They continued to purchase the toys until they were all gone. Tyco tried to increase its supply, but the factories that made Tickle Me Elmo were located in Asia, and the shortage persisted throughout the holiday season. By spring, the quantity supplied had doubled. By then, however, the height of the fad was over. Initially, stores tried to sell the toys at the same high prices charged during the holiday season. But consumers were reluctant to buy, and a surplus resulted. Eventually, the market reached equilibrium at a price of about $25. When you see suppliers reducing prices, it is often because they have a surplus of products to sell. Consider, for example, what happens to the prices of clothing items that are out of season or no longer in fashion. On the other hand, if an item becomes particularly popular or is in short supply for some other reason, suppliers will raise prices. The market does not always reach equilibrium quickly, but it is always moving toward equilibrium. APPLICATION Applying Economic Concepts B. Look back at the market demand and supply schedule you created for Application A on p. 166. Use it to create a graph showing the interaction of demand and supply and mark it to show surplus, shortage, and equilibrium. Holiday Shortages Consumer tastes often cause spikes in demand for certain items during the holidays. Create a demand and supply curve at ClassZone.com 168 Chapter 6 Equilibrium Price in Real Life KEY C ONCEPT S In theory, the relationship between demand and supply in the market seems straightforward. The real world, however, is more complex. In earlier chapters, you learned that there are several factors that can cause demand and supply to change. When there is an imbalance between quantity demanded and quantity supplied, a state of disequilibrium exists, and the process of finding equilibrium starts over again. E XAMPLE Change in Demand and Equilibrium Price Let’s take a look at how the market moves from disequilibrium by considering the effect of changes in demand on the equilibrium price for athletic shoes. Recall that a change in demand occurs when one of six factors—income, consumer taste, consumer expectations, market size, substitutes, and complements—prompts consumers to change the quantity demanded at every price. In Figures 6.4 and 6.5, the intersection of the demand curve (D1) and the supply curves (S) shows an equilibrium price of $75, with quantity demanded and supplied of 3,000 pairs of shoes. When a change in consumer taste causes a decrease in demand for athletic shoes at every price, the demand curve shifts to the left, as shown
in Figure 6.4. Notice that this new demand curve (D2) intersects the supply curve at a lower price, around $65. This becomes the new equilibrium price. At this QUICK REFERENCE Disequilibrium occurs when quantity demanded and quantity supplied are not in balance. FIGURES 6.4 AND 6.5 CHANGES IN DEMAND AND EQUILIBRIUM PRICE FIGURE 6.4 DECREASE IN DEMAND FIGURE 6.5 INCREASE IN DEMAND ) 125 100 75 50 25 0 S a c D2 D1 125 100 75 50 25 0 S d b D1 D3 1 2 3 4 5 6 7 Quantity of shoes (in thousands) Quantity of shoes (in thousands) ANALYZE GRAPHS 1. What happens to quantity demanded at $100 when demand decreases? What happens to quantity demanded at $100 when demand increases? 2. Does change in demand have a direct or inverse relationship to equilibrium price? Explain your answer. Use an interactive market demand and supply curve to see changes in demand, supply, and equilibrium price at ClassZone.com a In Figure 6.4, de- mand decreases; the demand curve shifts left and intersects the supply curve at a lower point. b In Figure 6.5, de- mand increases; the demand curve shifts right and intersects the supply curve at a higher point. c When demand decreases (Fig. 6.4), the equilibrium price falls to about $65. d When demand increases (Fig. 6.5), the equilibrium price rises to about $90. Demand, Supply, and Prices 169 new, lower equilibrium price, the quantity demanded decreases to 2,500 pairs of shoes. In other words, when consumers demand fewer goods and services at every price, the equilibrium price will fall and suppliers will sell fewer units—even though the price is lower. Suppose that an increase in the number of young adults causes demand for athletic shoes to increase. When there is an increase in demand, the demand curve shifts to the right, as shown in Figure 6.5. Notice that the new demand curve (D3) intersects the supply curve at a higher price, around $90. As the equilibrium price increases to this higher level, the quantity demanded also increases to 3,500 pairs of shoes. When consumers demand more goods and services at every price, equilibrium price will rise and suppliers will sell more, even at higher prices. EXAMPLE Change in Supply and Equilibrium Price Now let’s consider how changes in supply might affect equilibrium price. Recall that a change in supply occurs when something in the market prompts producers to offer different amounts for sale at every price. Remember from Chapter 5 that the six factors that can change supply are input costs, productivity, technology, government action, producer expectations, and number of producers. In Figures 6.6 and 6.7, the intersection of the supply curve (S1) and the demand curve (D) shows an equilibrium price of $75, with quantity supplied and demanded of 3,000 pairs of shoes. If the price of the raw materials needed to produce athletic shoes increases, the result is a decrease in supply of these shoes at every price. FIGURES 6.6 AND 6.7 CHANGES IN SUPPLY AND EQUILIBRIUM PRICE FIGURE 6.6 DECREASE IN SUPPLY FIGURE 6.7 INCREASE IN SUPPLY ) 125 100 75 50 25 0 S2 S1 125 100 75 50 25 0 S1 S3 Quantity of shoes (in thousands) Quantity of shoes (in thousands) ANALYZE GRAPHS 1. What happens to quantity supplied at $100 when supply decreases? What happens to quantity supplied at $100 when supply increases? 2. How do these graphs illustrate the relationship between change in supply and change in equilibrium price? a In Figure 6.6, supply decreases; the supply curve shifts left and intersects the demand curve at a higher point. b In Figure 6.7, supply increases; the supply curve shifts right and intersects the demand curve at a lower point. c When supply decreases (Fig. 6.6) the equilibrium price rises to about $90. d When supply increases (Fig. 6.7) the equilibrium price falls to about $55. 170 Chapter 6 In this situation, the supply curve shifts to the left, as shown in Figure 6.6. Notice that the new supply curve (S2) intersects the demand curve at a higher price, around $90. This is the new equilibrium price. Because of this increase in price, the quantity demanded at equilibrium decreases to 2,500 pairs of shoes. In other words, when there are fewer goods and services available at every price, equilibrium price will rise. When new technology allows the manufacturer to produce shoes more efficiently, supply increases, and the supply curve shifts to the right, as shown in Figure 6.7. Notice that the new supply curve (S3) intersects the demand curve at a lower price, about $55. This is the new equilibrium price. Because of this decrease in price, the quantity demanded at equilibrium increases to about 4,100 pairs of shoes. In other words, when there are more goods and services available at every price, equilibrium price will fall. Technology Both supply and equilibrium price are affected when technology improves the manufacturing process. Look at Figures 6.4, 6.5, 6.6, and 6.7 once more and notice which situations cause equilibrium price to fall and which cause equilibrium price to rise. The relationships between changes in demand or supply and changes in equilibrium price are illustrated in Figure 6.8. Equilibrium price falls when there is a decrease in demand or an increase in supply. Equilibrium price rises when there is an increase in demand or a decrease in supply. In other words, when consumers want less or producers supply more, prices will fall. When consumers want more or producers supply less, prices will rise. FIGURE 6.8 EQUILIBRIUM PRICE AND CHANGES IN DEMAND AND SUPPLY If demand decreases supply increases OR THEN equilibrium price falls. If demand increases supply decreases OR THEN equilibrium price rises. AP P LI CATION Analyzing Effects C. If one of the three pizza parlors in your neighborhood closes, what will happen to the supply of pizza? How will that affect the equilibrium price of pizza? Demand, Supply, and Prices 171 For more on interpreting graphs, see the Skillbuilder Handbook, page R29. Interpreting Graphs: Shifting Curves Graphs show statistical information in a visual manner. A graph that shows a shifting curve should immediately alert the reader to one of the following: a change in quantity demanded at every price, or a change in quantity supplied at every price. In Figure 6.9, a change in the number of producers has caused an increase in supply at every price. The sandwich shop across the street from Forest View High School now has a competitor. TECHNIQUES FOR ANALYZING SHIFTING CURVES Use the following strategies, along with what you learned throughout Section 1, to analyze the graph. Use the title to identify the main idea of the graph. If supply has shifted, then we know that quantity supplied at every price has either increased or decreased. Read the axis labels carefully. When both quantity supplied and demanded are present, look for an intersection to find equilibrium price. FIGURE 6.9 SHIFT IN SUPPLY OF SANDWICHES ) S1 S2 b c D 20 40 60 80 100 120 Quantity of sandwiches demanded and supplied Use the annotations to find key elements of the graph. Annotation a shows the equilibrium price where curve S1 meets curve D. a This is the initial equilibrium price. b Curve shifts to the right. c This is the new equilibrium price. Notice that b shows a shift to the right. An increase in supply always shows a rightward shift; a decrease in supply always causes a leftward shift. Notice the new equilibrium price, c . An increase in supply results in a lower equilibrium price. T HINKING ECONOMICALLY Analyzing 1. What are the pre-shift and post-shift equilibrium prices for a sandwich? Will an increase in quantity supplied at every price always result in a lower equilibrium price? Why? 2. Imagine that instead of an increase in supply, there is a decrease in demand. How will the equilibrium price change? Why? 3. On a separate sheet of paper, sketch intersecting quantity supplied and demanded curves with an equilibrium price of $4 at 80 sandwiches. How have the curves shifted from those that appear in Figure 6.9? 172 Chapter 6 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. market equilibrium disequilibrium b. surplus shortage 2. How are surplus and shortage related to equilibrium price? 3. Why is equilibrium price represented by the intersection of the supply and demand curves in a particular market? 4. Why do changes in demand or supply cause disequilibrium? 5. Why is the market always moving toward equilibrium? 6. Using Your Notes How is equilibrium price related to market equilibrium? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com market equilibrium Equilibrium disequilibrium . Analyzing Data Look at Figures 6.4, 6.5, 6.6, and 6.7 again. What happens to surplus and shortage as equilibrium price changes in each graph? What general conclusions can you draw from this information? 8. Analyzing Causes Suppose that the federal government decides to increase the excise tax on cellular phone services by 0.1 percent. Why will this action cause the equilibrium price of cellular phone services to rise? 9. Applying Economic Concepts Between 2003 and 2005, there was huge growth in the market for premium blue jeans priced at $200 or more per pair. The growth was largely fueled by popular magazines showing celebrities wearing certain brands. Then, in the summer of 2005, major department stores started cutting prices on the jeans; they were also found on Web sites that offer jeans at discount prices. Use the economic concepts that you learned in this section to describe what is happening in this market. 10. Challenge Study Figures 6.4, 6.5, 6.6, and 6.7 again. What would happen if a change in consumer taste caused an increase in demand for athletic shoes and more suppliers entered the market at the same time? Assume that the increases in demand and in supply are proportionately the same. How would this result be different if each of thes
e changes happened separately? Finding Equilibrium Price Suppose that you are a manufacturer of a new mini refrigerator for college dorm rooms. You expect your product to be popular because of its compact size and high tech design. After a few weeks in the market you are able to develop the following market demand and supply schedule. Price per Refrigerator ($) Quantity Demanded Quantity Supplied 225 200 175 150 125 500 1,000 1,500 2,500 4,000 6,000 4,500 3,500 2,500 1,500 Create a Demand and Supply Curve Use this market demand and supply schedule to create a market demand and supply curve and determine the equilibrium price. Challenge Calculate surplus or shortage at every price and suggest ways the manufacturer could try to eliminate the surplus and raise the equilibrium price. Demand, Supply, and Prices 173 S E C T I O N 2 Prices as Signals and Incentives TA K I N G N O T E S In Section 2, you will competitive pricing, p. 174 • analyze how the price system incentive, p. 176 works • explain how prices provide information about markets • describe how prices act as incentives to producers As you read Section 2, complete a chart like the one shown to keep track of how each key concept affects producers and consumers. Use the Graphic Organizer at Interactive Review @ ClassZone.com Producers Consumers Competitive pricing Incentive How the Price System Works KEY CONCEPT S To better understand how price works in the market, let’s look at how one kind of change in supply affects the equilibrium price. More producers in a market increases supply, which leads to increased competition and a lower equilibrium price. Competitive pricing occurs when producers sell goods and services at prices that best balance the twin desires of making the highest profit and luring customers away from rival producers. By entering a market at a lower price, a new supplier can add to its customer base while it maintains overall profits by selling more units. EXAMPLE Competitive Pricing Let’s look at an example of competitive pricing. As winter approaches, Elm Street Hardware prices its snow shovels at $20. But Uptown Automotive sees an opportunity to take some customers (mostly for tools, which both stores sell) from Elm Street. Uptown enters the snow shovel market, raising the overall supply. It also prices the shovels at $13. Uptown has a lower profit margin per shovel, but hopes to sell hundreds of them in order to maintain overall profit. Elm Street can choose to lower its prices as well or risk losing customers. QUICK REFERENCE Competitive pricing occurs when producers sell products at lower prices to lure customers away from rival producers, while still making a profit. 174 Chapter 6 E XAMPLE Characteristics of the Price System In a market economy, the price system has four characteristics. 1. It is neutral. Prices do not favor either the producer or consumer because both make choices that help to determine the equilibrium price. The free interactions of consumers (who favor lower prices) and producers (who favor higher prices) determines the equilibrium price in the market. 2. It is market driven. Market forces, not central planning, determine prices, so the system has no oversight or administration costs. In other words, the price system runs itself. 3. It is flexible. When market conditions change, prices are able to change quickly in response. Surpluses and shortages motivate producers to change prices to reach equilibrium. 4. It is efficient. Prices will adjust until the maximum number of goods and services are sold. Producers choose to use their resources to produce certain goods and services based on the profit they can make by doing so10 Characteristics of the Price System in a Market Economy Neutral Both the producer and the consumer make choices that determine the equilibrium price. Efficient Resources are allocated efficiently since prices adjust until the maximum number of goods and services are sold. Market Driven Market forces, not government policy, determine prices. In effect, the system runs itself. Flexible When market conditions change, so do prices Are the Characteristics of the Price System? What ANALYZE CHARTS Choose two of the characteristics of the price system shown in the chart and explain how each is illustrated through the example of competitive pricing. AP P LI CATION Analyzing and Interpreting Data A. If Karen sold 25 salads at $6 each, how many would she need to sell at $5.50 to make at least the same amount of total revenue? Demand, Supply, and Prices 175 Prices Motivate Producers and Consumers KEY CONCEPT S QUICK REFERENCE An incentive encourages people to act in certain ways. The laws of demand and supply show that consumers and producers have different attitudes toward price. Consumers want to buy at low prices; producers want to sell at high prices. Therefore, prices motivate consumers and producers in different ways. You learned in Chapter 1 that an incentive is a way to encourage people to take a certain action. Here, you’ll learn that in the price system, incentives encourage producers and consumers to act in certain ways consistent with their best interests. EXAMPLE Prices and Producers For producers, the price system has two great advantages: it provides both information and motivation. Prices provide information by acting as signals to producers about whether it is a good time to enter or leave a particular market. Rising prices and the expectation of profits motivate producers to enter a market. Falling prices and the possibility of losses motivate them to leave a market. A shortage in a market is a signal that consumer demand is not being met by existing suppliers. Recall that a shortage often occurs because prices are too low relative to the quantities demanded by consumers. Producers will view the shortage as a signal that there is an opportunity to raise prices. Higher prices act as an incentive for producers to enter a market. In other words, the prospect of selling goods at higher prices encourages producers to offer products for that market. As more producers are motivated by high prices to enter a market, quantity supplied increases. When prices are too high relative to consumer demand, a surplus occurs. Producers can respond to a surplus either by reducing prices, or by reducing production to bring it in line with the quantity demanded at a particular price. Either way, falling prices signal that it is a good time for producers to leave the market. Sometimes, less efficient producers leave a market completely, as increased competition and lower prices drive them out of business. More often, producers shift their business to focus on opportunities in markets with higher potential profits. FIGURE 6.11 CD PRICES AND PRODUCERS 1. Competition from DVDs and video games causes a slump in CD sales–a surplus in CDs. 3. Discount chains begin to sell CDs, often below cost, to attract customers; competitive pricing of CDs. CD prices decrease CD prices increase CD prices decrease 2. Some CD makers switch production to DVDs, video games; fewer CDs are produced–a shortage of CDs. 4. Many small record stores go out of business or devote less shelf space to CDs, more to DVDs and video games. 176 Chapter 6 Competitive pricing in the market often informs the choices made by producers. When a market is growing, and when there is unmet demand, a producer may decide to enter the market with a price that is lower than its competitor’s. The new producer can still, however, earn a profit by selling more units at the lower price. So, while prices are the signals that are visible in the market, it is the expectation of profits or the possibility of losses that motivates producers to enter or leave a market. E XAMPLE Prices and Consumers Prices also act as signals and incentives for consumers. Surpluses that lead to lower prices tell consumers that it is a good time to buy a particular good or service. Producers often send this signal to consumers through advertising and store displays that draw consumers to certain products. Producers may also suggest that the low prices won’t last, encouraging consumers to buy sooner rather than later. High prices generally discourage consumers from buying a particular product and may signal that it is time for them to switch to a substitute that is available at a lower price. A high price may signal that a particular product is in short supply or has a higher status. Brand marketers rely on the consumer perception that a certain logo is worth a higher price. Recall what you learned about normal and inferior goods in Chapter 4. Most consumers prefer to buy normal goods at the best possible price. They will buy inferior goods only when they cannot afford something better. While price is a powerful incentive to consumers, the other factors that affect demand also influence consumers’ buying habits. YO U R EC PRIC ES AND CONSU M E RS How Does Price Affect Your Decision? A new digital video camera with state-of-the-art features costs $500, but you’ve saved only $250. You can either buy a less expensive substitute with the money you have now, or you can save up to buy the advanced camera later. If other consumers also choose to wait to buy the new camera, a surplus may develop, and the price may decrease. ? ▲ Buy now ▲ Save for later AP P LI CATION Making Inferences B. A cup of gourmet coffee commands a higher price than a regular coffee. How will this fact influence the take-out coffee market? Demand, Supply, and Prices 177 ECO N O M I C S PAC ES E T T E R Michael Dell: Using Price to Beat the Competition High-tech entrepreneur Michael Dell saw an opportunity to use competitive pricing to take business away from much larger companies. By 2005, IBM Corporation, Compaq Computer Corporation, and others had either left the PC market or were facing major problems. How did Dell thrive as its competitors struggled? Lowering Costs to Reduce Prices Michael Dell began assembling and sell
ing computers as a freshman in college. He became so successful that he quit college in 1984 to focus on his business. He had sales worth $6 million in his first year. Dell’s success was largely due to his approach to marketing and production. He bypassed computer retailers and sold over the telephone directly to knowledgeable computer users in business and government. Each computer was built to customer requirements and assembled after it was ordered. In this way, Dell lowered his costs significantly and became the low-price leader in the market. The company’s sales grew from $69.5 million in 1986 to almost $258 million in 1989. Dell was also a pioneer in recognizing In Dell's TechKnow program, students learn to assemble and upgrade a computer, which they can then keep. the potential for sales via the Internet. This strategy allowed the company to maintain close contact with its customers and to adjust its prices frequently, up and down, as market conditions dictated. Competitors who sold only in retail stores found it hard to compete on price because their costs were much higher. By 2005, Dell was the world’s leading supplier of PCs, with annual sales of almost $50 billion. Now Dell is using his experience to make waves in the consumer electronics (flat-panel TVs, MP3 players, and the like) market. He sees the line between these two markets eventually fading. “The whole new ballgame is these worlds [computing and consumer electronics] converging,” Dell believes, “and that’s a world we’re comfortable in.” APPLICATION Drawing Conclusions C. What incentive did Michael Dell have to sell computers at lower prices than his competitors? FAST FACTS Michael S. Dell Title: Chairman of Dell Inc. Born: February 23, 1965, Houston, Texas Major Accomplishment: Pioneered the direct sale of personal computers to consumers Key Product Lines: Desktop PCs, notebook computers, workstation systems, servers, printers, flat-screen TVs, PDAs Honors: Youngest CEO of a Fortune 500 company (1992), America’s Most Admired Company (2005) Personal Fortune: $16 billion (2005) Employees: 65,200 (2006) Find an update on Michael Dell at ClassZone.com 178 Chapter 6 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Use each of the two terms below in a sentence that illustrates the meaning of the term: a. competitive pricing b. incentive 2. Explain the four characteristics of the price system. 3. Why is the price system an efficient way to allocate resources? 4. How do prices serve as signals and incentives to producers to enter a particular market? to leave a certain market? 5. How does the story of Dell Inc. demonstrate the effects of competitive pricing? 6. Using Your Notes How does Producers Consumers competitive pricing affect consumers? Refer to your completed chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com Competitive pricing Incentive . Making Inferences A local supermarket decides to sell a premium brand of meats and cheeses in its deli department. This brand is priced about $2 more per pound than the store brand. About 80 percent of the space in the deli display cases is devoted to the premium brand and 20 percent to the store brand. a. How did price serve as an incentive to the supermarket? b. What kind of signals is the supermarket sending to its customers with this pricing strategy? 8. Applying Economic Concepts A candy company whose products sold in supermarkets for about $3 a bag decided to enter the growing gourmet chocolate market. It purchased two small companies that made premium chocolates that sold for much higher prices. How does this story reveal the way the price system works as an incentive for producers while allocating resources efficiently? 9. Challenge A large discount store has built its reputation on offering consumers low prices. However, its customers come from many different income levels. Recently, the store began offering higher priced jewelry and consumer electronics products. What signal might this send to producers of other premium products who have never sold in discount stores before? Using Prices as Incentives As you’ve learned in Section 2, prices motivate producers to act in certain ways. What actions do producers take in response to rising prices? How about falling prices? Identify Price Incentives Consider each situation that follows. Decide whether the scenario described is associated with rising prices or with falling prices. • A farmer switches to organic methods when a report says organic foods are healthier. • To maintain market share, a car wash adjusts its prices to meet a competitor’s. • After a hot, dry spring, a landscaper decides to get out of the business. • A retailer decides to begin selling this holiday season’s must-have toy. Challenge Which of the above situations descibes a case of competitive pricing? What might happen to the producer if it did not take the action described? Demand, Supply, and Prices 179 S E C T I O N 3 Intervention in the Price System TA K I N G N O T E S price ceiling, p. 180 price floor, p. 182 minimum wage, p. 182 rationing, p. 183 black market, p. 183 In Section 3, you will • explain how government uses price ceilings to keep prices from rising too high • describe how government uses price floors to keep prices from going too low • discuss how government uses rationing to allocate scarce resources and goods As you read Section 3, complete a hierarchy diagram like this one to track main ideas and supporting details. Use the Graphic Organizer at Interactive Review @ ClassZone.com Price Controls main idea main idea main idea details details details Imposing Price Ceilings KEY CONCEPT S QUICK REFERENCE A price ceiling is the legal maximum price that sellers may charge for a product. You’ve seen how prices adjust to changes in demand and supply as the market constantly strives for equilibrium. Sometimes, however, people think it is a good idea to interfere with the free market mechanism in order to keep the price of a good or service from going too high. An established maximum price that sellers may charge for a good or service is called a price ceiling. The price ceiling is set below the equilibrium price, so a shortage will result. EXAMPLE Football Tickets and Price Ceilings Let’s look at an example of a price ceiling in ticket prices for college football. The Trenton University Tigers are a winning team with many loyal fans. The university prints 30,000 tickets for every game and sells them for $15 each. At that price, 60,000 fans want to buy the tickets, so there is a shortage of 30,000 tickets for every game. The university could resolve the shortage by letting the price rise until quantity demanded and quantity supplied are equal. When this solution is proposed, the university president says she would rather keep the tickets affordable for students. Indeed many students get tickets for $15. On game day, however, ticket scalpers stand outside the stadium and sell some tickets for $50 or more. 180 Chapter 6 E XAMPLE Rent Control as a Price Ceiling In the past, many cities passed rent control laws in an effort to keep housing affordable for lower-income families. These laws control when rents can be raised and by how much, no matter what is going on in the market. Of course, the people who live in rent-controlled housing appreciate the lower price in the short term. But rent control can have unexpected consequences. Without the possibility of raising rents to match the market, there is no incentive to increase the supply of rental housing, and a shortage soon develops. In addition, landlords are reluctant to increase their costs by investing money in property maintenance, so housing conditions often deteriorate. By 2005, rent control was becoming far less common as most cities realized it made housing shortages worse in the long run. Santa Monica, California, is an example of a city that had strict rent control laws. In the late 1990s, state legislators passed a law that changed the way local communities could regulate rental housing. As a result, property owners in Santa Monica could let the market determine the initial rent when a new tenant moved in, although the city’s rent control board still regulated yearly rent increases thereafter. Figure 6.12 illustrates what happened to rents when the new law fully took effect. Rents increased by 40 to 85 percent, showing that the apartments had been priced artificially low. The increases reflect the shortage that rent control had created. FIGURE 6.12 RENT CONTROL IN SANTA MONIC ,000 1,800 1,600 1,400 1,200 1,000 800 600 400 0 1890 Key: Rent controlled Decontrolled 1397 b 775 a 553 1000 991 630 772 Studio 1-bedroom Types of Apartments 2-bedroom 3+-bedroom a The red bars show the median rent for each type of apartment when rent control was in effect. b The blue bars show the median rent for each type of apartment when the new law allowed the market to set the rent for new tenants. The graph shows that rent control had kept the rate lower than what the market would bear. Source: Santa Monica Rent Control Board, April 13, 1999 ANALYZE GRAPHS 1. What happened to the rent for one-bedroom apartments when the new law ended rent control? 2. Who would be more in favor of the changes that happened in the rental market in Santa Monica, landlords or tenants? Why? AP P LI CATION Applying Economic Concepts A. Create a demand and supply graph for Trenton University football tickets showing how the price ceiling of $15 is below the equilibrium price. Demand, Supply, and Prices 181 Setting Price Floors QUICK REFERENCE A price floor is a legal minimum price that buyers must pay for a product. The minimum wage is a legal minimum amount that an employer must pay for one hour of work. Find an update on the minimum wage at ClassZone.com KEY CONCEPT S Sometimes the government decides to intervene in the price system to increase income to certain producers. A price floor is an established minimum price that buyer
s must pay for a good or service. For example, the government has used various programs designed to provide price floors under corn, milk, and other agricultural products. The goal of these price floors is to encourage farmers to produce an abundant supply of food. EXAMPLE Minimum Wage as a Price Floor One well-known example of a price floor is a minimum wage. A minimum wage is the minimum legal price that an employer may pay a worker for one hour of work. The United States government established its first minimum wage in 1938. The 1930s were a period of low wages, and the government hoped to increase the income of workers. If the minimum wage is set above the equilibrium price for certain jobs in a market, employers may decide that paying the higher wages is not profitable. As a result, they may choose to employ fewer workers, and unemployment will increase. If the minimum wage is set below the equilibrium price, then it will have no effect. FIGURE 6.13 M I N I MUM WAG E A S A PR I C E FLOOR This point shows the equilibrium price for a labor market. b The black dotted line shows a minimum wage set above the equilibrium price. c The blue dotted line shows a minimum wage set below the equilibrium price. The length of black dotted line that falls between the demand curve and the supply curve represents a surplus—in other words, unemployment. Quantity supplied of minimum-wage workers ANALYZE GRAPHS 1. Assume the minimum wage is set at the dotted black line. What are the costs and benefits of increasing it? 2. Is the minimum wage set at the dotted blue line an effective price floor? Why? APPLICATION Analyzing Effects B. Suppose that the Trenton University Tigers were so bad that only 10,000 people want to buy tickets for $15. What effect would keeping $15 as a price floor have? 182 Chapter 6 Rationing Resources and Products KEY C ONCEPT S The market uses prices to allocate goods and services. Sometimes in periods of national emergency, such as in wartime, the government decides to use another way to distribute scarce products or resources. Rationing is a system in which the government allocates goods and services using factors other than price. The goods might be rationed on a first-come, first-served basis or on the basis of a lottery. Generally, a system is set up that uses coupons allowing each person a certain amount of a particular item. Or the government may decree that certain resources be used to produce certain goods. When such a system is used, some people try to skirt the rules to get the goods and services they want, creating what is known as a black market. In a black market, goods and services are illegally bought and sold in violation of price controls or rationing. QUICK REFERENCE Rationing is a government system for allocating goods and services using criteria other than price. The black market involves illegal buying or selling in violation of price controls or rationing. E XAMPLE Rationing Resources During World War II, the United States government empowered the Office of Price Administration, which was established in 1941, to ration scarce goods. The hope was that these goods would be distributed to everyone, not just those who could afford the higher market prices born of shortages. It also allocated resources in ways that favored the war effort rather than the consumer market. Figure 6.14 shows some of the goods that were rationed. Rationing also led consumers to look for substitutes. Margarine, a butter substitute, was purchased in huge quantities during the war. FIGURE 6.14 R AT IONED GOODS DU R I NG WO RLD WA R I I Food Other Goods sugar meat butter, fats, and oils most cheese chocolate coffee automobile tires gasoline fuel oil clothing, especially silk and nylon shoes Demand, Supply, and Prices 183 Rationing for All The U.S. government’s World War II rationing program affected nearly every household in the United States. Rationing in China Shortages of tofu, a staple of the Chinese diet, led to rationing in 1989. 184 Chapter 6 North Korea maintained a strict rationing system between 1946 and 2002. Most importantly, staple foods—meat, rice, and cabbage—were strictly rationed. However, the system was plagued by inefficiency and corruption. The amount of your ration was generally determined by who you knew, where you lived, and what your occupation was. Government officials in the largest cities often received more than their allotment, while the majority of people got by with less (or received lessnutritious substitutes). Some families had meat or fish only a few times a year. Between 1996 and 2000, widespread famine in North Korea made the situation desperate. Ration coupons were still distributed, but in most cases, the rations were not. As many as a million people died due to the famine. In response, people established unofficial markets where they traded handicrafts for food. In 2002, the government officially legalized these market activities, and prices rose sharply. Wages also increased. Skeptical of markets, however, the leaders of North Korea were, in 2005, considering a return to the rationing system that failed them in the past. EXAMPLE Black Markets—An Unplanned Result of Rationing When rationing is imposed, black markets often come into existence. During World War II, black markets in meat, sugar, and gasoline developed in the United States. Some people found ways, including the use of stolen or counterfeit ration coupons, to secure more of these scarce goods. During the height of North Korea’s rationing system, free trade in grain was expressly forbidden, and most other markets were severely restricted. Prices were very high at the markets that did exist. In 1985, it cost half of the average monthly salary of a typical North Korean to buy a chicken on the black market. Even after the government began allowing some market activities in 2002, the black market flourished because many forms of private property, including homes and cars, were still illegal. Some people started smuggling clothes, televisions, and other goods from China to sell in North Korea. (You’ll read more about the black market in the discussion of the underground economy in Chapter 12.) APPLICATION Making Inferences C. How does the example of rationing during World War II show that the price system is a more efficient way to allocate resources? S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. price floor b. rationing minimum wage black market 2. What is the difference between a price floor and a price ceiling? 3. What kind of surplus might be created by the minimum wage? 4. How does the existence of the black market work against the intended purpose of rationing? 5. Aside from turning to the black market, how do consumers make up for goods that are rationed? 6. Using Your Notes What is the usual result of a price ceiling? Refer to your completed diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Price Controls main idea main idea main idea details details details . Analyzing Causes Opponents of rent control cite comparisons of cities that regulate rents with cities that do not. Their evidence shows that there is more moderately priced housing available in cities that let the market set the rates for rent. What would account for the differences in availability? 8. Making Inferences The percentage of workers who were paid the minimum wage or less decreased from 6.5 percent in 1988 to 3 percent in 2002 to 2.7 percent in 2004. What does this trend tell you about the relationship of the minimum wage to the equilibrium wage for those kinds of work? 9. Applying Economic Concepts In the wake of sharply rising gasoline prices in the summer of 2005, several states considered putting a ceiling on the wholesale price of gasoline. What would be the likely result of such a price control? Would it be an effective strategy for lowering gas prices? 10. Challenge Many states have laws against so-called price gouging. These laws make it illegal to sell goods and services at levels significantly above established market prices following a natural disaster. What economic argument might be used against such laws? Understanding Price Floors In agriculture, price floors are known as price supports. The government sets a target price for each crop, and if the market price is below that target, it will pay farmers the difference. Suppose that you are a farmer with 400 acres planted in corn. The following graph shows the supply and demand for your crop.50 3.75 3.00 2.25 1.50 0.75 0 Target price S D 20 10 30 Bushels of corn (in thousands) 50 40 60 Calculate the Effect of the Price Support How many bushels of corn will you sell at the equilibrium price? How much revenue will you make? How many bushels do you want to sell at the target price? How many bushels are consumers willing to buy at that price? What is the difference? How much will the government have to pay you for that surplus? Challenge What changes in supply or demand would move the market equilibrium price closer to the target price? Demand, Supply, and Prices 185 Case Study Find an update on this Case Study at ClassZone.com Prices for Concert Tickets Background Americans spend billions of dollars on concert tickets yearly—an estimated $3 billion in 2005. With ticket prices for the most popular acts averaging more than $50, most younger or less affluent fans can no longer afford to attend many live concerts. And yet, remarkably, forecasters believe that concert ticket prices have yet to peak. Ticket prices reflect a number of costs. Performers must cover expenses such as travel, costumes, instruments, and equipment before they reap a profit. Venues, or places where concerts are held, also seek to make a profit, as do ticket distributors. However, in the United States, the sale of concert tickets, along with most other goods and services, is driven by three basic elements of a mar
ket economy— demand, supply, and pricing. What’s the issue? How do demand, supply, and pricing affect the concert ticket market? Study these sources to discover the factors that affect demand and supply, and their impact on the price of concert tickets. A. Congressional Transcript Pearl Jam believed that TicketMaster Corporation, their ticket distributor, was setting too high a price on the band’s concert tickets. This statement, submitted to Congress along with oral testimony on June 30, 1994, explains Pearl Jam’s stance. Pearl Jam Tries to Place Ceiling on Ticket Prices To keep ticket prices affordable, Pearl Jam appeals to Congress. Many of Pearl Jam’s most loyal fans are teenagers who do not have the money to pay the $50 or more that is often charged today for tickets to a popular concert. Although, given our popularity, we could undoubtedly continue to sell out our concerts with ticket prices at that premium level, we have made a conscious decision that we do not want to put the price of our concerts out of the reach of many of our fans. . . . For these reasons, we have attempted to keep the ticket prices to our concerts to a maximum of $18. . . . Even where a service charge is imposed, our goal is . . . that no one will pay more than $20 to see a Pearl Jam concert. Our efforts to try to keep prices . . . to this low level and to limit the possibility of excessive service charge mark-ups have put us at odds with TicketMaster . . . a nationwide computerized ticket distribution service that has a virtual monopoly on the distribution of tickets to concerts in this country. Thinking Economically How would placing a ceiling on the price of Pearl Jam concert tickets have affected demand and supply? Explain your answer based on the information in the document. 186 Chapter 6 FIGURE 6.15 CON ES B. Academic Study Marie Connolly and Alan Krueger, of Princeton University, compiled these data on concert ticket prices for their study “Rockonomics: The Economics of Popular Music.” 70 60 50 40 30 20 10 ) High Average Low Change in prices for economy in general 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 Source: Journal of Labor Economics, 2005. 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 1993 1992 Year Thinking Economically In what three years was the high price per ticket about the same as the low price in 2003? C. Online Newspaper Article TicketMaster hoped to increase profits by auctioning tickets online. This article discusses the program’s potential effect on ticket prices. TicketMaster Plans to Launch Ticket Auction The sky’s the limit, as bidders compete for the best seats in the house. Fed up with watching ticket scalpers and brokers rake in the huge bucks for prime seats at their venues, TicketMaster plans to debut an online auction program for choice seats to selected concerts and sports events later this year. The move may drive up the price of front row seats when they start going to the highest bidder, but some analysts say the impact would likely be minimal. . . . Princeton University economics professor Alan B. Krueger . . . called the open auction a “positive development.” “For the top artists, tickets are still sold below what the market would bear, even though prices have shot up over the last six years,” Krueger told POLLSTAR. “This is especially the case for the best seats in the most expensive cities. “If the auction is widely used, I suspect price variability will increase; we will see greater dispersion in prices across artists, across cities and seats for the same artist.” . . . Source: Pollstar.com Thinking Economically How might TicketMaster’s online auction program lead to market equilibrium for the best tickets? THINKING ECONOMICALLY Synthesizing 1. Do you think TicketMaster’s plan in document C would help or harm Pearl Jam’s wish “that no one will pay more than $20” to see them (document A)? Explain your answer. 2. What do you think happened to quantity supplied of tickets over the span of the graph in document B? Why? 3. In what year in Figure 6.15 did the high price for concert tickets hit $50—the high price that Pearl Jam speaks of in document A? What year was it $20—the desired price they mention? Demand, Supply, and Prices 187 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes CHAPTER 6 Assessment Seeking Equilibrium: Demand and Supply (pp. 164–173) 1. How does the concept of market equilibrium reflect the interaction of producers and consumers in a market? Complete the following activity either on your own paper or online at ClassZone.com 2. Why are surpluses and shortages examples of disequilibrium? Choose the key concept that best completes the sentence. Not all key concepts will be used. black market competitive pricing disequilibrium equilibrium price incentive market equilibrium minimum wage price ceiling price floor rationing shortage surplus 1 is a situation that occurs when quantity demanded and quantity supplied at a particular price are equal. The price at which that situation occurs is the 2 . If quantity supplied is greater than quantity demanded, a 3 occurs. If quantity demanded exceeds quantity supplied, then a 4 occurs. When a producer enters a market at a lower price (hoping to increase its customer base while maintaining profits by selling more units), it is engaging in 5 . Rising prices are 6 that draws producers into markets. Sometimes government intervenes in the price system. A 7 is the legal maximum that producers may charge for certain goods or services. A 8 is the legal minimum amount that may be paid for a particular good or service. When certain goods or resources are scarce, the government may institute a system of 9 , using some criteria besides price to allocate resources. An unplanned consequence of this action by the government is the development of a 10 , where goods are bought and sold illegally. 188 Chapter 6 Prices as Signals and Incentives (pp. 174–179) 3. How are producers and consumers equally involved in the price system? 4. When do prices serve as signals and incentives for producers to enter a market? Intervention in the Price System (pp. 180–187) 5. What is the usual result of a price floor? 6. What motivates producers and consumers in the black market? A P P LY Look at the table below showing prices and sales figures for VCRs between 1998 and 2003. 7. Why did dollar sales increase between 1998 and 1999? 8. What is the trend in the average unit price of VCRs between 1998 and 2003? What does this trend signal? FIGURE 6.16 VC R SALES TO DE ALERS Unit Sales (in thousands) Sales (in millions $) Average Unit Price ($) 1998 1999 2000 2001 2002 18,113 22,809 23,072 14,910 13,538 2003* 11,916 2,049 2,333 1,869 1,058 826 727 113 102 81 71 61 61 * projected Source: Consumer Electronics Association Market Research, January, 2003 . Creating Graphs Suppose that you are the owner of a toy store. Create demand and supply curves for three products that you expect will sell well during the upcoming holiday shopping season. Then consider the following scenarios: one product becomes much more popular than you expected, one is much less popular than you expected, and the third loses half of its production capacity when a factory is leveled by an earthquake. Draw an additional curve on each of your graphs to show the change in demand or supply represented by these scenarios. Under each graph write a caption explaining the change shown and the effect on the equilibrium price. Use to complete this activity. @ ClassZone.com 10. Analyzing Effects Consumer concerns about nutrition and obesity contribute to a decrease in white bread sales and an increase in sales of whole wheat bread. This change in consumer taste prompts a major manufacturer known for its white bread to enter the market with a whole wheat bread product. What effect will this action have on the supply and equilibrium price of whole wheat bread? 11. Using Economic Concepts In 2004, the price of U.S. butter imports increased by more than 30 percent compared to the previous year. In 2003, Canada and New Zealand together supplied more than 80 percent of the butter imported into the United States. In 2004, their combined market share decreased to about 67 percent. What happened in the market to cause this change? How did price serve as a signal and incentive to producers? 12. Analyzing Effects How would U.S. government price supports for U.S.-made tennis rackets affect producers and consumers? 13. Challenge How would elasticity of demand help producers decide whether competitive pricing is a good strategy for their businesses Find the Best Price Step 1 Form a group with five other students. Imagine that together you are the market for jeans. Three are buyers and three are sellers, according to the following table. Your goal is to bargain with one another for a pair of jeans. Buyers try to get the lowest price possible, without going above their maximum, and sellers try to get the highest price possible, without going below their minimum. SIX- PERSON JE ANS MARKE T Price ($) A B C D E F 20 30 40 15 25 35 Maximum price you are willing to pay for a pair of jeans Minimum price you are willing to sell a pair of jeans for Buyers Sellers Step 2 Choose a letter to determine your role. On a piece of paper write your letter and name, identify yourself as a buyer or seller, and show the dollar amount from the table. Step 3 Keep track of each proposed transaction in order on a sheet of paper. Recall what you know about demand, supply, and competitive pricing as you bargain to see who will buy and sell jeans and at what price. Bargaining ends when you reach equilibrium. What is quantity and price at equilibrium? Step 4 Use the information on the chart to create a demand and supply curve for this market. Does the curve reflect your group’s bargaining experience? Step 5 As a class, discuss what yo
u learned from this exercise about how markets reach equilibrium. Use to complete this activity. @ ClassZone.com Demand, Supply, and Prices 189 Market Structures In markets where businesses offer similar products, sellers compete by trying to make their products stand out from the competition. 190 CHAPTER 7 Market Structures SECTION 1 What Is Perfect Competition? SECTION 2 The Impact of Monopoly SECTION 3 Other Market Structures SECTION 4 Regulation and Deregulation Today CASE STUDY Competition in Gadgets and Gizmos Competition involves all the actions that sellers, acting independently, take to get buyers to purchase their products market structure is an economic model that helps economists examine the nature and degree of competition among businesses in the same industry AT T E R S On trips to the mall, you’ve probably noticed something about the prices of products you’re looking to buy. If there are several different brands of the same kind of product, prices tend to be lower. If there’s just one brand, however, prices tend to be higher. The level of competition in a market has a major impact on the prices of products. The more sellers compete for your dollars, the more competitive prices will be. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on competition in the cellular telephone industry. (See Case Study, pp. 220–221.) Go to SMART GRAPHER to complete graphing activities in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. How do cellular phone makers compete for your business? See the Case Study on pages 220–221. Market Structures 191 S E C T I O N 1 What Is Perfect Competition TA K I N G N O T E S In Section 1, you will market structure, p. 192 • learn that perfect competition perfect competition, p. 192 standardized product, p. 192 price taker, p. 193 imperfect competition, p. 195 is the ideal by which economists measure all market structures • explain the characteristics of perfect competition and why it does not exist in the real world • analyze examples of markets that come close to perfect competition As you read Section 1, complete a cluster diagram to identify the major characteristics of perfect competition. Use the Graphic Organizer at Interactive Review @ ClassZone.com Perfect Competition The Characteristics of Perfect Competition KEY CONCEPT S When you buy new clothes, you probably shop around for the best deal. But when you buy milk, you know that a gallon will be about the same price no matter where you shop. The market for clothes has a different level of competition than the market for milk. Economists classify markets based on how competitive they are. A market structure is an economic model that allows economists to examine competition among businesses in the same industry. Perfect competition is the ideal model of a market economy. It is useful as a model, but real markets are never perfect. Economists assess how competitive a market is by determining where it falls short of perfect competition. Perfect competition has five characteristics. 1. Numerous buyers and sellers. No one seller or buyer has control over price. 2. Standardized product. Sellers offer a standardized product—a product that consumers consider identical in all essential features to other products in the same market. 3. Freedom to enter and exit markets. Buyers and sellers are free to enter and exit the market. No government regulations or other restrictions prevent a business or customer from participating in the market. Nor is a business or customer required to participate in the market. 4. Independent buyers and sellers. Buyers cannot join other buyers and sellers cannot join other sellers to influence prices. QUICK REFERENCE A market structure is an economic model of competition among businesses in the same industry. Perfect competition is the ideal model of a market economy. A standardized product is one that consumers see as identical regardless of producer. 192 Chapter 7 5. Well-informed buyers and sellers. Both buyers and sellers are well-informed about market conditions. Buyers can do comparison shopping, and sellers can learn what their competitors are charging. When these five conditions are met, sellers become price takers. A price taker is a business that cannot set the prices for its products but, instead, accepts the market price set by the interaction of supply and demand. Only efficient producers make enough money to serve perfectly competitive markets. QUICK REFERENCE A price taker is a business that accepts the market price determined by supply and demand. C HAR ACTERISTIC 1 Many Buyers and Sellers A large number of buyers and sellers is necessary for perfect competition so that no one buyer or seller has the power to control the price in the market. When there are many sellers, buyers can choose to buy from a different producer if one tries to raise prices above the market level. But because there are many buyers, sellers are able to sell their products at the market price. Let’s consider the Smith family, whom you met in Chapter 5. The Smiths grow raspberries in the summer to sell at the Montclair Farmers’ Market. Because many farmers grow and sell raspberries at the same market, all of the farmers charge about the same price. If one farmer tries to charge more than the market price for raspberries, consumers will buy from the other farmers. Because there are many buyers—in other words, sufficient demand—the Smiths and other producers know that they can sell their product at the market price. Lack of demand will not cause them to lower their prices. C HAR ACTERISTIC 2 Standardized Product In perfect competition, consumers consider one producer’s product essentially the same as the product offered by another. The products are perfect substitutes. Agricultural products such as wheat, eggs, and milk, as well as other basic commodities such as notebook paper or gold generally meet this criterion. Considering the Montclair Farmers’ Market, while no two pints of raspberries are exactly alike, they are similar enough that consumers will choose to buy from any producer that offers raspberries at the market price. Price becomes the only basis for a consumer to choose one producer over another. Perfect Competition Farmers’ markets exhibit many of the characteristics of perfect competition. C HAR ACTERISTIC 3 Freedom to Enter and Exit Markets In a perfectly competitive market, producers are able to enter the market when it is profitable and to exit when it becomes unprofitable. They can do this because the investment that a producer makes to enter a market is relatively low. Market forces alone encourage producers to freely enter or leave a given market. The Smiths and other farmers consider the market price for raspberries when planning their crops. If they believe they can make a profit at that price, they grow raspberries. If not, they try some other crop. Find an update about perfect competition at ClassZone.com Market Structures 193 .1 Characteristics of Perfect Competition Many Buyers and Sellers A large number of buyers and sellers ensures that no one controls prices. Well-informed Buyers and Sellers Both buyers and sellers know the market prices and other conditions. Characteristics of Perfect Competition? What Are the Standardized Products All products are essentially the same. Freedom to Enter and Exit Markets Producers can enter or exit the market with no interference. Independent Buyers and Sellers Buyers and sellers do not band together to influence prices. ANALYZE CHARTS Imagine that you own a farm and that you have decided to sell raspberries at the Montclair Farmers’ Market. Construct your own diagram to show how the five characteristics of perfect competition will apply to your enterprise. CHARACTERISTIC 4 Independent Buyers and Sellers In a perfectly competitive market, neither buyers nor sellers join together to influence price. When buyers and sellers act independently, the interaction of supply and demand sets the equilibrium price. Independent action ensures that the market will remain competitive. At the Montclair Farmers’ Market, the farmers do not band together to raise prices, nor do the consumers organize to negotiate lower prices. CHARACTERISTIC 5 Well-informed Buyers and Sellers Buyers and sellers in a perfectly competitive market have enough information to make good deals. Buyers can compare prices among different sellers, and sellers know what their competitors are charging and what price consumers are willing to pay. Buyers and sellers at the Montclair Farmers’ Market make informed choices about whether to buy or sell raspberries in that market. With all five characteristics met, the Smiths accept the market price for raspberries. All raspberry producers become price takers. APPLICATION Making Inferences A. Can you think of another market that comes close to perfect competition? Which of the characteristics does it lack? 194 Chapter 7 Competition in the Real World KEY C ONCEPT S In the real world, there are no perfectly competitive markets because real markets do not have all of the characteristics of perfect competition. Market structures that lack one of the conditions needed for perfect competition are examples of imperfect competition. (You’ll learn more about imperfect competition in Sections 2 and 3.) However, there are some markets—the wholesale markets for farm products such as corn and beef, for example—that come close to perfect competition. QUICK REFERENCE Imperfect competition occurs in markets that have few sellers or products that are not standardized. E XAMPLE 1 Corn In the United States, there are thousands of farmers who grow corn, and each one contributes only a small percentage of the total crop. Therefore, no one farmer can control the price of corn, and all farmers accept the market price. Individual farmers decide only how much corn to produce to offer for sale at that price. At the same time,
there are a large number of buyers, and the price on the wholesale market is easy to determine. Corn is a fairly standardized product, and buyers usually have no reason to prefer one farmer’s corn to another’s. Buyers will not pay more than the market price. In reality, there are several reasons that imperfect competition occurs in the corn market. For one thing, the U.S. government pays subsidies to corn farmers to protect them from low corn prices. In addition, sometimes corn farmers band together to try to influence the price of corn in their favor, and corn buyers sometimes pursue the same strategy. Subsidies, group action, and other deviations from perfect competition interfere with the market forces of supply and demand. E XAMPLE 2 Beef The wholesale market for raw beef is another that comes close to perfect competition. There are many cattle producers, and there is little variation in a particular cut of beef from one producer to the next. Because the beef is so similar, the wholesale buyer’s primary concern will be price. Both buyers and sellers can easily determine the market price, and producers sell all their beef at that price. Cattle sellers can adjust only their production to reflect the market price. As in the corn market, there are several reasons that imperfect competition occurs in the beef market. Cattle ranchers, like corn farmers, may try to join together to influence the price of beef in their favor. In addition, many beef producers try to persuade buyers that there are significant differences in their products that warrant higher prices. For example, cattle that eat corn supposedly produce better tasting beef. AP P LI CATION Drawing Conclusions B. Why is the market for corn closer to perfect competition than the market for corn flakes? Close to Perfect Competition Wholesale markets for agricultural products, such as corn, come close to perfect competition. Market Structures 195 For more information on creating and interpreting economic models, see the Skillbuilder Handbook, page R16. Creating and Interpreting Economic Models Economic models help solve problems by focusing on a limited set of variables. A production costs and revenue schedule, which you learned about in Chapter 5, is a model that helps businesses decide how much to produce. Creating a graph as part of the model paints a picture of the data that makes it easier to understand. In this example, imagine you own a business that produces baseballs in a perfectly competitive market. The market price of a baseball is $1, but your costs vary depending on how many you produce. Follow the instructions to create a graph that will help you visualize the way a perfectly competitive market works. CREATING AN ECONOMIC MODEL OF BASEBALL PRODUCTION 1. Copy the graph below onto your own paper, or use @ ClassZone.com. 2. Using data from the table below, plot the curve showing the marginal costs of producing different numbers of baseballs. Label the curve “MC.” 3. Using data from the table below, plot the curve showing the marginal revenue of producing different numbers of baseballs. Label the curve “MR.” BASEBALL PRODUCTION COSTS AND REVENUES SCHEDULE Total Produced Total Revenue (in dollars) Total Cost (in dollars 10 11 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 11.00 1.00 2.00 2.80 3.50 4.00 4.50 5.20 6.00 6.86 7.86 9.36 11.50 Total Profit (in dollars) 21.00 21.00 20.80 20.50 0.00 0.50 0.80 1.00 1.14 1.14 0.64 20.50 Marginal Revenue (in dollars) Marginal Cost (in dollars) — 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 — 1.00 0.80 0.70 0.50 0.50 0.70 0.80 0.86 1.00 1.50 2.14 BA SEBALL PRODUC T I ON 2.25 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 ) 10 11 Quantity of baseballs T HINKING ECONOMICALLY Analyzing 1. How many baseballs should you produce each day to maximize profits? 2. Using the same graph, plot the demand curve for this perfectly competitive market. Remember that the market price will not change no matter how many baseballs are demanded. 3. How does the graph help explain the term “price takers”? 196 Chapter 7 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. market market structure b. perfect competition imperfect competition 2. Why are sellers in a perfectly competitive market known as price takers? 3. Why is it necessary to have standardized products in order to have perfect competition? 4. Why is independent action of buyers and sellers important to achieving perfect competition? 5. How is imperfect competition different from perfect competition? 6. Using Your Notes What are the five characteristics of perfect competition? Refer to your completed cluster diagram. Perfect Competition Use the Graphic Organizer at Interactive Review @ ClassZone.com . Drawing Conclusions Suppose that you went to a farmers’ market and found several different farmers selling cucumbers. Would you be likely to find a wide range of prices for cucumbers? Why or why not? 8. Analyzing Effects What would happen to a wheat farmer who tried to sell his wheat for $2.50 per bushel if the market price were $2.00 per bushel? Why? 9. Making Inferences Why are brand-name products not found in a perfectly competitive market? You will learn more about this topic in Section 3 of this chapter. 10. Challenge At an auction, sellers show their goods before an audience of buyers. The goods for sale may be similar to each other, as in an auction of used cars, or they may be one-of-a-kind, as in an art auction. Buyers usually have an opportunity to inspect items prior to the auction. During the auction, buyers bid against one another to see who is willing to pay the highest price. In what ways is an auction similar to a perfectly competitive market? In what ways is it different? How competitive is the market for snowboards? Identifying Perfect Competition Perfectly competitive markets can be identified by specific characteristics. The chart below lists these characteristics. Characteristics of Perfect Competition Markets Many buyers and sellers Standardized product Freedom to enter and leave the market Independent action Well-informed buyers and sellers Complete a Chart Five different markets are shown in the chart. On your own paper, complete the chart by marking which of the characteristics each market has. Challenge Choose one market from the chart and explain what would need to be done to make it perfectly competitive. Market Structures 197 S E C T I O N 2 The Impact of Monopoly TA K I N G N O T E S In Section 2, you will monopoly, p. 198 • describe the characteristics of cartel, p. 198 a monopoly • analyze four different types of monopolies and discuss how they come about • explain how a monopoly sets its prices and production goals price maker, p. 198 barrier to entry, p. 198 natural monopoly, p. 201 government monopoly, p. 201 technological monopoly, p. 201 geographic monopoly, p. 201 economies of scale, p. 201 patent, p. 202 As you read Section 2, complete a chart to show how different types of monopolies exhibit the characteristics of monopoly. Use the Graphic Organizer at Interactive Review @ ClassZone.com One Seller Restricted Market Control of Prices Natural Monopoly Government Monopoly Technological Monopoly Geographic Monopoly Characteristics of a Monopoly KEY CONCEPT S Perfect competition is the most competitive market structure. The least competitive is monopoly, a market structure in which only one seller sells a product for which there are no close substitutes. The term monopoly may be used for either the market structure or the monopolistic business. Pure monopolies are as rare as perfect competition, but some businesses come close. For example, a cartel is a formal organization of sellers or producers that agree to act together to set prices and limit output. In this way, a cartel may function as a monopoly. Because a monopoly is the only seller of a product with no close substitutes, it becomes a price maker, a business that does not have to consider competitors when setting its prices. Consumers either accept the seller’s price or choose not to buy the product. Other firms may want to enter the market, but they often face a barrier to entry—something that hinders a business from entering a market. Large size, government regulations, or special resources or technology are all barriers to entry. Let’s take a closer look at the three characteristics of monopoly through the De Beers cartel, which held a virtual monopoly on the diamond market for most of the 20th century. At one time it controlled as much as 80 percent of the market in uncut diamonds. De Beers used its monopoly power to control the price of diamonds and created barriers to entry that kept other firms from competing. QUICK REFERENCE Monopoly occurs when there is only one seller of a product that has no close substitutes. A cartel is a group that acts together to set prices and limit output. A price maker is a firm that does not have to consider competitors when setting the prices of its products. A barrier to entry makes it hard for a new business to enter a market. 198 Chapter . 2 Characteristics of a Monopoly What Are the Characteristics of a Monopoly? T E K M RESTRICTED A R Only One Seller A single business controls the supply of a product that has no close substitutes. Control of Prices Monopolies act as price makers because they sell products that have no close substitutes and they face no competition. Restricted, Regulated Market Government regulations or other barriers to entry keep other firms out of the market. ANALYZE CHARTS Imagine that you are a business person with unlimited funds. Could you gain a monopoly over the market for housing in your neighborhood? Using the chart, explain the steps you would need to take. How might your neighborhood change if one person controlled property prices? C HAR ACTERISTIC 1 Only One Seller In a monopoly, a single business is identified with the indu
stry because it controls the supply of a product that has no close substitutes. For example, De Beers once produced more than half of the world’s diamond supply and bought up diamonds from smaller producers to resell. In this way, it controlled the market. C HAR ACTERISTIC 2 A Restricted, Regulated Market In some cases, government regulations allow a single firm to control a market, such as a local electric utility. In the case of De Beers, the company worked with the South African government to ensure that any new diamond mines were required to sell their diamonds through De Beers. The company also restricted access to the market for raw diamonds for producers outside of South Africa. By controlling the supply of diamonds, De Beers made it difficult for other producers to make a profit. C HAR ACTERISTIC 3 Control of Prices Monopolists can control prices because there are no close substitutes for their product and they have no competition. When economic downturns reduced demand for diamonds, De Beers created artificial shortages by withholding diamonds from the market. The reduced supply allowed the cartel to continue charging a higher price. AP P LI CATION Analyzing Effects A. What effect did the De Beers diamond monopoly have on the price of diamonds? Market Structures 199 OPEC: Controlling the Oil Pipelines The Organization of the Petroleum Exporting Countries (OPEC) does not have a monopoly on oil reserves or oil production. However, the 11 member nations of the cartel possess more than two-thirds of the world’s oil reserves and produce about two-fifths of the world’s oil supply. By regulating the amount of oil that flows through its pipelines, OPEC exerts control over the market price for oil. Market forces often counteract OPEC’s supply adjustments. For example, in the early 1980s demand for oil fell as consumers and businesses implemented strategies to reduce energy use. Despite OPEC’s efforts to reduce supply and stabilize the price, crude oil prices fell through most of the 1980s. Another factor that limits OPEC’s control over oil prices is member unity. Members sometimes choose not to follow OPEC moves to reduce oil output—because that would reduce their revenues. Despite these limitations, OPEC continues to play a major role in the world market for petroleum. F I G U R E 7. 4 OPEC Member Nations FIGURE 7. 3 OPEC MEMBERS Country Joined OPEC Location Algeria Indonesia Iran Iraq Kuwait Libya Nigeria Qatar 1969 Africa 1962 Asia 1960 Middle East 1960 Middle East 1960 Middle East 1962 Africa 1971 Africa 1961 Middle East Saudi Arabia 1960 Middle East United Arab Emirates 1967 Middle East Venezuela 1960 South America Source: OPEC ARCTIC OCEAN IRAQ Neutral Zone I RAN UNITED ARAB EMIRATES KUWAIT P e r sia n Gulf ATLANTIC OCEAN ALGERIA LIBYA IRAQ I R A N SAUDI ARABIA KUWAIT QATAR U.A.E. VENEZUELA NIGERIA QATAR SA UDI A RAB I A PA INDONESIA ATLANTIC OCEAN OPEC nations CONNECTING ACROSS THE GLOBE 1. Applying Economic Concepts In what ways does OPEC act like a monopoly? 2. Making Inferences What will happen to OPEC’s monopolistic power as the world discovers new sources of energy? Explain your answer. 200 Chapter 7 Types of Monopolies KEY C ONCEPT S There are several reasons why monopolies exist, and not all monopolies are harmful to consumers. A natural monopoly is a market situation in which the costs of production are lowest when only one firm provides output. A government monopoly is a monopoly that exists because the government either owns and runs the business or authorizes only one producer. A technological monopoly is a monopoly that exists because the firm controls a manufacturing method, an invention, or a type of technology. A geographic monopoly is a monopoly that exists because there are no other producers or sellers within a certain region. E XAMPLE 1 Natural Monopoly: A Water Company In some markets, it would be inefficient to have more than one company competing for consumers’ business. Most public utilities fall into this category. Let’s look at the water company in your community as an example. It pumps the water from its source through a complex network of pipes to all the homes, businesses, and public facilities in the community. It also monitors water quality for safety and removes and treats wastewater so that it may be recycled. It would be a waste of community resources to have several companies developing separate, complex systems in order to compete for business. A single supplier is most efficient due to economies of scale, a situation in which the average cost of production falls as the producer grows larger. The more customers the water company serves, the more efficient its operation becomes, as its high fixed costs are spread out over a large number of buyers. These economies of scale result in government support for natural monopolies. While supporting natural monopolies, the government also regulates them to ensure that they do not charge excessively high prices for their services. E XAMPLE 2 Government Monopoly: The Postal Service Government-run businesses provide goods and services that either could not be provided by private firms or that are not attractive to them because of insufficient profit opportunities. One of the oldest government monopolies in the United States is the U.S. Postal Service, which has the exclusive right to deliver first-class mail. Originally, only the government could provide this service in an efficient and costeffective manner. However, new services and new technologies have been chipping away at this monopoly. Private delivery companies offer services that compete with the U.S. Postal Service. Many people now send information by fax, e-mail, and text messages. In addition, many pay their bills online. QUICK REFERENCE A natural monopoly occurs when the costs of production are lowest with only one producer. A government monopoly exists when the government either owns and runs the business or authorizes only one producer. A technological monopoly occurs when a firm controls a manufacturing method, invention, or type of technology. A geographic monopoly exists when there are no other producers within a certain region. Economies of scale occur when the average cost of production falls as the producer grows larger. Natural Monopolies Most public utilities require complex systems, such as this water treatment facility. Market Structures 201 YO U R EC GOVERNM ENT MONO POLY Which mail service will you choose? If you need to send thank-you notes, you could send them by regular mail, which is a government monopoly. Or you could send electronic thank-you notes by computer. ? ▲ E-mail message ▲ Handwritten note QUICK REFERENCE A patent gives an inventor the exclusive property rights to that invention or process for a certain number of years. EXAMPLE 3 Technological Monopoly: Polaroid In 1947, Edwin Land, the founder of the Polaroid Corporation, invented the first instant camera. Land’s camera used a special type of film that allowed each picture to develop automatically in about a minute. Through a series of patents, Polaroid created a monopoly in the instant photography market. A patent is a legal registration of an invention or a process that gives the inventor the exclusive property rights to that invention or process for a certain number of years. The government supports technological monopolies through the issuing of patents. Through patents, businesses are able to recover the costs that were involved in developing the invention or technology. Polaroid’s control of instant photography technology through its patents was a barrier to entry for other firms. In 1985, Polaroid won a lawsuit against Eastman Kodak Company for patent infringement. The court ruled that Kodak’s instant camera and film had violated Polaroid’s property rights, which were protected by several patents. The lawsuit effectively blocked Kodak from the instant photography market. Technological monopolies last only as long as the patent—generally 20 years—or until a new technology creates close substitutes. The rise of easier-to-use 35mm cameras, onehour photo processing, and digital cameras all contributed to a steep decline in Polaroid’s business. While the company remains the leading seller of instant cameras and film, the technology has become a minor segment of the consumer photography market. Technological Monopoly Polaroid instant cameras use patented technology. 202 Chapter 7 E XAMPLE 4 Geographic Monopoly: Professional Sports One type of geographic monopoly in the United States is the professional sports team. The major sports leagues require that teams be associated with a city or region and limit the number of teams in each league. In other words, the leagues create a restricted market for professional sports. Most cities and towns are not directly represented by a team, so many teams draw their fans from a large surrounding geographic region. Because of their geographic monopolies, the owners of these teams are able to charge higher prices for tickets to games than if they faced competition. They also have a ready market for sports apparel and other merchandise featuring the team logo and colors. Another type of geographic monopoly is created by physical isolation. For example, Joe operates the only gas station at an interstate exit in the middle of a desert. The next station in either direction is more than 50 miles away. Joe has a geographic monopoly because he is the only supplier of a product with no close substitutes. Drivers on the interstate in that area depend on Joe’s gas and have no other choice of supplier. They can either buy gas from Joe or risk running out of gas before they reach the next station. Because of his geographic location as the single supplier of a product that has no close substitutes, Joe is able to control the price that he charges—and gas at Joe’s is always very expensive. Geographic Monopolies The Boston Red Sox is the only baseball team in New Engla
nd, so it draws fans from across the six-state region. Isolated locations or small communities may have other examples of geographic monopolies if the market is too small to support two similar businesses. Geographic monopolies have become less common in the United States. Cars allow people to travel greater distances to shop, and catalog marketers and Internet businesses, combined with efficient delivery companies, offer consumers more alternatives to shopping at local stores. AP P LI CATION Drawing Conclusions B. Which type of monopoly do you think is least harmful to consumers? Why? Find an update on monopolies at ClassZone.com Market Structures 203 Profit Maximization by Monopolies KEY CONCEPT S Although a monopoly firm is the only supplier in its market, the firm cannot charge any price it wishes. A monopolist still faces a downward-sloping demand curve. In other words, the monopoly will sell more at lower prices than at higher prices. The monopolist controls price by controlling supply. A monopoly produces less of a product than would be supplied in a competitive market, thereby artificially raising the equilibrium price. It’s difficult to study this process in the real world because most countries have laws to prevent monopolies. We have to look at small instances in which a company has a monopoly over one particular specialized product. Such a limited monopoly lasts only for the life of the patent or until a competitor develops a similar product. EXAMPLE Drug Manufacturer Pharmaceutical manufacturers offer an example of how companies with limited monopolies try to maximize their profits. On average, drug patents last for about 11 years in the United States. Drug companies try to maximize their profits during that period because when the patent expires they face competition from other manufacturers who begin marketing generic versions of the drug. A generic drug contains the same ingredients and acts in the same way as the patented drug, but it is sold at much lower prices. As an example, consider the Schering-Plough company and its antihistamine Claritin. The drug was originally approved for use as a prescription medication in the United States in 1993, although it had been patented earlier. Unlike many other such drugs, Claritin did not make users drowsy. This advantage, combined with a strong marketing campaign, led Claritin to become a top seller, making as much as $3 billion in annual worldwide sales. When the patent on Claritin expired in 2002, numerous generic equivalents entered the market. In response, Schering-Plough lowered Claritin’s price and gained approval for a nonprescription form of the drug. But sales of Claritin fell to about $1 billion as consumers switched to less costly generic equivalents. APPLICATION Applying Economic Concepts C. Using the three characteristics of monopoly, explain what happened to the market for Claritin when its patent expired. 204 Chapter 7 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. monopoly cartel b. natural monopoly geographic monopoly c. technological monopoly government monopoly 2. What is the relationship between economies of scale and a natural monopoly? 3. How does a patent awarded to one company act as a barrier to entry to another company wishing to enter the same market? 4. Why is a monopolist a price maker rather than a price taker? 5. Why do technological monopolies exist only for a limited time? One Seller Restricted Market Control of Prices 6. Using Your Notes Why is a geographic monopoly able to control the price of its product? Refer to your completed chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com Natural Monopoly Government Monopoly Technological Monopoly Geographic Monopoly 7. Analyzing Causes and Effects Companies that produce generic drugs are not required to repeat the clinical tests that the original manufacturer of the drug is required to run before the drug receives its patent. How does this fact affect the prices of generic drugs and why? 8. Analyzing Effects A powerful monopoly is broken up into several smaller, competing companies. What are the costs and benefits for the general public? 9. Drawing Conclusions In 2003, 95 percent of the households in America had access to only one cable TV company in their area. What kind of monopoly did cable TV companies have? Explain your answer. 10. Challenge Among the drugs to fight high cholesterol, the most effective are known as statins. The drugs are similar, but each is different enough to have its own patent. In 2005, there were seven such drugs on the market. In 2006, the patents ended for two of the drugs. What effect did this have on the entire category of statin drugs, including those whose patents were still in effect through 2006? Explain why this might be the case. Identifying Types of Monopolies You learned in this section that there are four types of monopolies: natural, government, technological, and geographical. What Type? The table below lists examples of several monopolies. For each example, identify the type of monopoly. Some types have more than one example. Type of Monopoly Example of Monopoly U.S. interstate highway system Electric utility company The only bank in a small town The company that received a patent for the Frisbee A city’s public transportation system Natural gas company Challenge In which type of monopoly is the government least likely to be involved? Give reasons for your answer. Market Structures 205 S E C T I O N 3 Other Market Structures TA K I N G N O T E S In Section 3, you will monopolistic competition, p. 206 • learn that monopolistic product differentiation, p. 206 competition and oligopoly are market structures that fall between perfect competition and monopoly • identify the characteristics of monopolistic competition • describe the characteristics of oligopoly nonprice competition, p. 207 focus group, p. 208 oligopoly, p. 209 market share, p. 209 start-up costs, p. 209 As you read Section 3, complete a chart to compare and contrast monopolistic competition and oligopoly. Use the Graphic Organizer at Interactive Review @ ClassZone.com Monopolistic Competition Oligopoly Characteristics of Monopolistic Competition QUICK REFERENCE Monopolistic competition occurs when many sellers offer similar, but not standardized, products. Product differentiation is the effort to distinguish a product from similar products. KEY CONCEPT S Most markets in the real world fall somewhere between the models of perfect competition and monopoly. One of the most common market structures is monopolistic competition, in which many sellers offer similar, but not standardized, products. The market for T-shirts printed with images or slogans is one example. The market is competitive because there are many buyers (you, your friends, and many other buyers) and many sellers (stores at the mall, online merchants, sports teams, and many other sellers). The market is monopolistic because each seller has influence over a small segment of the market with products that are not exactly like those of their competitors. Someone looking for a pink T-shirt with fuzzy kittens would not accept a black monster-truck rally Tshirt as a close substitute. Product differentiation and nonprice competition are the distinguishing features of monopolistic competition. Product differentiation is the attempt to distinguish a product from similar products. Sometimes, the effort focuses on substantial differences between products, such as vehicle gas mileage ratings. 206 Chapter 7 But companies also try to differentiate their products when there are few real differences between products. For example, a battery company might spend millions of dollars on advertising to convince consumers that their batteries last longer than other batteries—even though the real difference in longevity may be minimal. Another way companies in monopolistic competitive markets try to gain business is through nonprice competition. Nonprice competition means using factors other than low price—such as style, service, advertising, or giveaways—to try to convince customers to buy one product rather than another. If you’ve ever decided to eat at a particular fast food restaurant just to get the cool gizmo it’s giving away, you have participated in nonprice competition. Monopolistic competition has four major characteristics: many buyers for many sellers, similar but differentiated products, limited lasting control over prices, and freedom to enter or exit the market. Let’s take a closer look at each of these characteristics by focusing on the market for hamburgers. C HAR ACT ER IST IC 1 Many Sellers and Many Buyers In monopolistic competition there are many sellers and many buyers. The number of sellers is usually smaller than in a perfectly competitive market but sufficient to allow meaningful competition. Sellers act independently in choosing what kind of product to produce, how much to produce, and what price to charge. When you want a hamburger, you have many different restaurants from which to choose. The number of restaurants assures that you have a variety of kinds of hamburgers to choose from and that prices will be competitive. No single seller has a large enough share of the market to significantly control supply or price. However, there are probably a few restaurants that make burgers you really like and others with burgers you really don’t like. The restaurants that make your favorite burgers have a sort of monopoly on your business. C HAR ACTERISTIC 2 Similar but Differentiated Products Sellers in monopolistic competition gain their limited monopoly-like power by making a distinctive product or by convincing consumers that their product is different from the competition. Hamburger restaurants might advertise the quality of their ingredients or the way they cook the burger. They might also use distinctive packaging or
some special service—a money-back guarantee if the customer is not satisfied with the meal, for example. One key method of product differentiation is the use of brand names, which QUICK REFERENCE Nonprice competition occurs when producers use factors other than low price to try to convince customers to buy their products. Find an update about monopolistic competition at ClassZone.com Hamburger Valhalla Chili-Cheese Burger White bread bun Cheese and chili All-beef patty Standard pickles, onions, tomatoes, lettuce Healthy Eats Veggie Burger Whole wheat bun Organic pickles, onions, tomatoes Veggie patty Organic lettuce Market Structures 207 encourage consumer loyalty by associating certain desirable qualities with a particular brand of hamburger. Producers use advertising to inform consumers about product differences and to persuade them to choose their offering. How do hamburger restaurants decide how to differentiate their products? They conduct market research, the gathering and evaluation of information about consumer preferences for goods and services. For local restaurants, market research may be limited to listening to their customers’ praise or complaints and paying attention to what competing restaurants offer. The large chain restaurants can afford to use more sophisticated research techniques to gain information about consumers’ lifestyles and product preferences. One technique is the focus group—a moderated discussion with small groups of consumers. Another market research technique is the survey, in which a large number of consumers are polled, one by one, on their opinions. The results of market research help the restaurants differentiate their hamburgers and attract more customers. CH A R A CT ER IST IC 3 Limited Control of Prices Product differentiation gives producers limited control of price. Hamburger restaurants charge different prices for their product depending on how they want to appeal to customers. The price of some hamburgers is set as low as possible to appeal to parents of younger eaters or to those on tight budgets. Prices for name-brand hamburgers or burgers with better quality ingredients may be set slightly higher. If consumers perceive that the differences are important enough, they will pay the extra price to get the hamburger they want. Yet producers in monopolistic competition also know that there are many close substitutes for their product. They understand the factors that affect demand and recognize that consumers will switch to a substitute if the price goes too high. CHARACTERISTIC 4 Freedom to Enter or Exit Market There are generally no huge barriers to entry in monopolistically competitive markets. It does not require a large amount of capital for someone to open a hamburger stand, for example. When firms earn a profit in the hamburger market, other firms will enter and increase competition. Increased competition forces firms to continue to find ways to differentiate their products. The competition can be especially intense for small businesses facing much larger competitors. Some firms will not be able to compete and will start to take losses. This is the signal that it is time for those firms to exit the market. Leaving the restaurant market is relatively easy. The owners sell off the cooking equipment, tables, and other supplies at a discount. If their finances are solid, they may then look for another market where profits might be made. APPLICATION Applying Economic Concepts A. Think about an item of clothing that you purchased recently. How did the seller differentiate the product? List several ways, then compare lists with a classmate. QUICK REFERENCE A focus group is a moderated discussion with small groups of consumers. Ease of Entry and Exit In monopolistic competition, sellers may enter and exit the market freely. 208 Chapter 7 Characteristics of an Oligopoly KEY C ONCEPT S Oligopoly (OL-ih-GOP-ah-lee), a market structure in which only a few sellers offer a similar product, is less competitive than monopolistic competition. In an oligopoly, a few large firms have a large market share—percent of total sales in a market—and dominate the market. For example, if you want to see a movie in a theater, chances are the movie will have been made by one of just a few major studios. What’s more, the theater you go to is probably part of one of just a few major theater chains. Both the market for film production and the market for movie theaters are oligopolies. There are few firms in an oligopoly because of high start-up costs—the expenses that a new business must pay to enter a market and begin selling to consumers. Making a movie can be expensive, especially if you want to make one that can compete with what the major studios produce. And getting it into theaters across the country requires a huge network of promoters and distributors—and even more money. An oligopoly has four major characteristics. There are few sellers but many buyers. In industrial markets, sellers offer standardized products, but in consumer markets, they offer differentiated products. The few sellers have more power to control prices than in monopolistic competition, but to enter or exit the market is difficult. C HAR ACTERISTIC 1 Few Sellers and Many Buyers In an oligopoly, a few firms dominate an entire market. There is not a single supplier as in a monopoly, but there are fewer firms than in monopolistic competition. These few firms produce a large part of the total product in the market. Economists consider an industry to be an oligopoly if the four largest firms control at least 40 percent of the market. About half of the manufacturing industries in the United States are oligopolistic. QUICK REFERENCE Oligopoly is a market structure in which only a few sellers offer a similar product. Market share is a company’s percent of total sales in a market. Start-up costs are the expenses that a new business faces when it enters a market. The Breakfast Cereal Industry Just a few large companies produce the majority of breakfast cereals available. The breakfast cereal industry in the United States is dominated by four large firms that control about 80 percent of the market. Your favorite cereal is probably made by one of the big four manufacturers. Although they offer many varieties of cereals, there is less competition than there would be if each variety were produced by a different, smaller manufacturer. C HAR ACTERISTIC 2 Standardized or Differentiated Products Depending on the market, an oligopolist may sell either standardized or differentiated products. Many industrial products are standardized, and a few large firms control these markets. Examples include the markets for steel, aluminum, and flat glass. When products are standardized, firms may try to differentiate themselves based on brand name, service, or location. Breakfast cereals, soft drinks, and many other consumer goods are examples of differentiated products sold by oligopolies. Oligopolists market differentiated prod- Market Structures 209 ucts using marketing strategies similar to those used in monopolistic competition. They use surveys, focus groups, and other market research techniques to find out what you like. The companies then create brand-name products that can be marketed across the country or around the world. CHARACTERISTIC 3 More Control of Prices Because there are few sellers in an oligopoly, each one has more control over product price than in a monopolistically competitive market. For example, each breakfast cereal manufacturer has a large enough share of the market that decisions it makes about supply and price affect the market as a whole. Because of this, a seller in an oligopoly is not as independent as a seller in monopolistic competition. A decision made by one seller may cause the other sellers to respond in some way. For example, if one of the leading breakfast cereal manufacturers lowers its prices, the other manufacturers will probably also lower prices rather than lose customers to the competition. Therefore, no firm is likely to gain market share based on price, and all risk losing profits. But if one manufacturer decides to raise prices, the others may not follow suit, in order to take customers and gain market share. Consequently, firms in an oligopoly try to anticipate how their competitors will respond to their actions before they make decisions on price, output, or marketing. CHARACTERISTIC 4 Little Freedom to Enter or Exit Market Start-up costs for a new company in an oligopolistic market can be extremely high. Entering the breakfast cereal industry on a small scale is not very expensive—but the profits are low too. The factories, warehouses, and other infrastructure needed to compete against the major manufacturers require large amounts of funds. In addition, existing manufacturers may hold patents that act as further barriers to entry. Firms in an oligopoly have established brands and plentiful resources that make it difficult for new firms to enter the market successfully. For example, breakfast cereal manufacturers have agreements with grocery stores that guarantee them the best shelf space. Existing manufacturers also have economies of scale that help them to keep their expenses low. Smaller firms, with smaller operations, lack the economies of scale. However, all of the investments by firms in an oligopoly make it difficult for them to exit the market. When a major breakfast cereal manufacturer begins losing money, its operations are too vast and complex to sell and reinvest easily, as a small business might. It must trim its operations and work to stimulate demand for its product. APPLICATION Categorizing Information B. Which of these products produced by oligopolies are standardized and which are differentiated: automobiles, cement, copper, sporting goods, tires? Find an update about oligopolies at ClassZone.com High Start-up Costs New ﬁ rms may not have the funds to construct large factories. 2
10 Chapter 7 Comparing Market Structures KEY C ONCEPT S Each of the four market structures has different benefits and problems. And each type creates a different balance of power—namely, the power to influence prices— between producers and consumers. Consumers get the most value in markets that approach perfect competition. No actual markets are perfectly competitive, but in those that come close, prices are set primarily by supply and demand. However, such markets usually deal in a standardized product, so consumers have little choice other than the best price. In monopolistic competition, consumers continue to benefit from companies competing for their business. But businesses gain some control over prices, so they are more likely to earn a profit. Opening a business in such a market is usually relatively affordable, which is another benefit for businesses. In markets dominated by oligopolies, consumer choices may be more limited than in more competitive markets. Businesses in such markets gain more control of price, making it easier for them to make a profit. However, the cost of doing business in such a market is high. A market ruled by a monopoly is very favorable for the business that holds the monopoly. It faces little or no competition from other companies. And monopoly gives consumers the least influence over prices. They decide only whether they are willing to buy the product at the price set by the monopolist. F I G U R E 7. 5 Comparing Market Structures Number of Sellers Type of Product Sellers’ Control over Prices Barriers to Enter or Exit Market Perfect Competition Many Standardized Monopolistic Competition Oligopoly Many Similar but differentiated None Limited Few Few Few Standardized for industry; Some Many Monopoly One differentiated for consumers Standardized, but no close substitutes Significant Very many—market restricted or regulated ANALYZE CHARTS 1. If you were starting a business, which market structures would make it easiest for you to enter the market? 2. Which market structures offer the highest potential profits? Why? AP P LI CATION Drawing Conclusions C. What difference does it make to consumers whether a market is ruled by monopolistic competition or by an oligopoly? Market Structures 211 ECO N O M I C S PAC ES E T T E R Joan Robinson: Challenging Established Ideas In this section, you learned about monopolistic competition and oligopoly. British economist Joan Robinson was one of the first to write about these market structures. As strange as it may seem to us now, most economists before 1930 described market competition only in terms of the extremes of perfect competition and monopoly. Explaining Real-World Competition In 1933, Joan Robinson challenged the prevailing ideas about competition. Her first major book, The Economics of Imperfect Competition, described market structures that existed between monopoly and perfect competition. Robinson’s work appeared shortly after Harvard economist Edward Chamberlin published his book Theory of Monopolistic Competition. The two economists had developed their ideas independently. Robinson and Chamberlin described the type of competition that exists among firms with differentiated products. Such firms gain more control over the price of their product, but their control is limited by the amount of competition. They also described the nature of oligopoly and of monopsony, a market structure in which there are many sellers but only one large buyer. Robinson continued to contribute important ideas throughout her long career in economics. Her theory of imperfect competition remains a key element of the field of microeconomics today. Economists recognized that Robinson’s theory more accurately reflected modern market economies in which firms compete through product differentiation and advertising and in which many industries are controlled by oligopolies. Joan Robinson developed the theory of imperfect competition. APPLICATION Making Inferences D. Why do you think Joan Robinson chose the term imperfect competition to describe the nature of most real-world markets? FAST FACTS Joan Robinson Career: Economics professor, Cambridge University Born: October 31, 1903 Died: August 5, 1983 Major Accomplishment: Developed theory of imperfect competition Books: The Economics of Imperfect Competition (1933), The Accumulation of Capital(1956), Economic Philosophy(1963), Introduction to Modern Economics (1973) Famous Quotation: “It is the business of economists, not to tell us what to do, but show why what we are doing anyway is in accord with proper principles.” Learn more about Joan Robinson at ClassZone.com 212 Chapter 7 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs: a. product differentiation nonprice competition b. focus group market share c. oligopoly start-up costs 2. How is monopolistic competition similar to perfect competition and how is it similar to monopoly? 3. Describe some of the techniques sellers use to differentiate their products. 4. Why are standardized products sometimes found in oligopoly but not in monopolistic competition? 5. Is it easier for a new firm to enter the market under monopolistic competition or oligopoly? Why? Monopolistic Competition Oligopoly 6. Using Your Notes How does the number of sellers compare in monopolistic competition and oligopoly? Refer to your completed chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com . Contrasting Economic Information What makes the market for wheat different from the markets for products made from wheat, such as bread, cereal, and pasta? 8. Applying Economic Concepts In 2005, a major U.S. automaker announced a new discount plan for its cars for the month of June. It offered consumers the same price that its employees paid for new cars. When the automaker announced in early July that it was extending the plan for another month, the other two major U.S. automakers announced similar plans. What market structure is exhibited in this story and what specific characteristics of that market structure does it demonstrate? 9. Analyzing Effects Blue jeans are produced under monopolistic competition, so their prices are higher than if they were produced under perfect competition. Do the positive effects for consumers of blue jeans justify the higher prices? Why or why not? 10. Challenge Why do manufacturers of athletic shoes spend money to sign up professional athletes to wear and promote their shoes rather than differentiating their products strictly on the basis of physical characteristics such as design and comfort? Perfect competition or monopoly? The Impact of Market Structure Each of the four market structures carries different consequences for businesses and consumers. Imagine what would happen if there were only one type of market structure. Use Figure 7.5 on page 211 as a guide as you do this exercise. a. What would your town look like if every market was perfectly competitive? What would happen to your consumer choices? b. What would happen if every market was ruled by monopolistic competition? c. What would the town look like if oligopolies controlled every market? d. What if every market in your town was ruled by a monopoly? How could you tell the difference between situation A and D? Challenge Now think about what your town actually looks like. What types of market structures are most prevalent? Are you satisfied with the mix of market structures, or do you think some markets would be better served by different structures? Market Structures 213 S E C T I O N 4 Regulation and Deregulation Today TA K I N G N O T E S In Section 4, you will regulation, p. 214 • explain how government acts antitrust legislation, p. 214 to prevent monopolies • analyze the effects of anti- competitive business practices • describe how government acts to protect consumers • discuss why some industries have been deregulated and the results of that deregulation trust, p. 214 merger, p. 214 price fixing, p. 216 market allocation, p. 216 predatory pricing, p. 216 cease and desist order, p. 217 public disclosure, p. 217 deregulation, p. 218 As you read Section 4, complete a hierarchy diagram to track main ideas and supporting details. Use the Graphic Organizer at Interactive Review @ ClassZone.com Regulation and Deregulation Promoting Competition details Promoting Competition KEY CONCEPT S The forces of the marketplace generally keep businesses competitive with one another and attentive to consumer welfare. But sometimes the government uses regulation— controlling business behavior through a set of rules or laws—to promote competition and protect consumers. The most important laws that promote competition are collectively called antitrust legislation, laws that define monopolies and give government the power to control them and break them up. A trust is a group of firms combined for the purpose of reducing competition in an industry. (A trust is similar to a cartel, which you learned about in Section 2.) To keep trusts from forming, the government regulates business mergers. A merger is when one company combines with or purchases another to form a single firm. Origins of Antitrust Legislation During the late 1800s, a few large trusts, such as Standard Oil, dominated the oil, steel, and railroad industries in the United States. The U.S. government became concerned that these combinations would use their power to control prices and output. As a result, in 1890, the government passed the Sherman Standard Oil Company This cartoon dramatizes how Standard Oil controlled the oil industry. QUICK REFERENCE Regulation is a set of rules or laws designed to control business behavior. Antitrust legislation defines monopolies and gives government the power to control them. A trust is a group of firms combined in order to reduce competition in an industry. A merger is the joining of two firms to form a single firm. 214 Chapter 7 Antitrus
t Act. This gave government the power to control monopolies and to regulate business practices that might reduce competition. Over time, other laws strengthened the government’s ability to regulate business and to encourage competition. To understand why government officials pushed for antitrust laws, consider one of the trusts that developed in the late 1800s—the Standard Oil Company. By merging with other companies and eliminating competitors, Standard Oil gained control of about 90 percent of the U.S. oil industry. Such a huge holding, government officials contended, gave Standard Oil the ability to set production levels and prices. In 1911, the U.S. government won a court case under the Sherman Antitrust Act that required the breakup of the trust. In order to increase competition, Standard Oil was forced to relinquish control of 33 companies that had once been part of the trust. Antitrust Legislation Today At various times, the U.S. government has used antitrust legislation to break up large companies that attempt to maintain their market power through restraint of competition. The government might allow a large dominant firm to remain intact because it is the most efficient producer. Or it might order that the company change its business practices to allow other firms to compete more easily. The responsibility for enforcing antitrust legislation is shared by the Federal Trade Commission (FTC) and the Department of Justice. A major focus of their work is the assessment of mergers. The government tends to support mergers that might benefit consumers. For example, larger firms are often able to operate more efficiently, and lower operating costs may lead to lower prices for consumers. On the other hand, the government tends to block mergers that lead to greater market concentration in the hands of a few firms. A merger that makes it more difficult for new firms to enter a market will also be looked upon with concern. To evaluate a potential merger, the government looks at how a particular market is defined. A company that is proposing a merger would try to define its market as broadly as possible, in order to make its control of the market seem smaller. For example, a soft drink producer might claim that its market competition includes all beverages, such as water, tea, coffee, and juice. To determine whether the merger will increase the concentration in the market and decrease competition, the government considers the market share of the firms before and after the proposed merger. Government regulators also look at whether the merger allows a firm to eliminate possible competitors. If this analysis shows that a merger will reduce competition and more than likely lead to higher prices for consumers, the regulators will deny the companies’ effort to merge. The Federal Trade Commission (FTC) In 2004, Deborah Platt Majoras became head of the FTC, an agency that enforces antitrust laws. AP P LI CATION Drawing Conclusions A. Which of these mergers would the government be more likely to approve and why: two airlines that serve different cities or two banks in a small town? Market Structures 215 Ensuring a Level Playing Field KEY CONCEPT S In addition to evaluating mergers, the government also tries to make sure that businesses do not engage in practices that would reduce competition. As you have learned, competition enables the market economy to work effectively. When businesses take steps that counteract the effects of competition, prices go up and supplies go down. In the United States, laws prohibit most of these practices. The FTC and the Department of Justice enforce these laws. Prohibiting Unfair Business Practices Businesses that seek to counteract market forces can use a variety of methods. One is price fixing, which occurs when businesses work together to set the prices of competing products. A related technique is when competing businesses agree to restrict their output, thereby driving up prices. For example, in the mid-1990s the five major recorded music distributors began enforcing a “minimum advertised price” for compact discs sold in the United States. As a result, CD prices remained artificially high. The FTC estimated that consumers paid about $480 million more for CDs than they would have if prices had been established by market forces. In 2000 the FTC reached an agreement with the distributors to end this anticompetitive practice. Another way businesses seek to avoid competition is by market allocation, which occurs when competing businesses negotiate to divide up a market. By staying out of each other’s territory, the businesses develop limited monopoly power in their own territory, allowing them to charge higher prices. For example, in the early 1990s agribusiness conglomerate Archer Daniels Midland (ADM) conspired with companies in Japan and Korea to divide the worldwide market for lysine, an additive used in livestock feeds. Around the same time, ADM also conspired with European companies to divide the worldwide market for citric acid, an additive used in soft drinks, canned foods, and other consumer products. Both of these illicit agreements also included price fixing. In 1996, the Department of Justice charged ADM with antitrust violations in both the lysine and citric acid markets. ADM pleaded guilty and paid a $100 million fine. Occasionally, businesses use anticompetitive methods to drive other firms out of a market. One technique used by cartels or large producers is predatory pricing, setting prices below cost so that smaller producers cannot afford to participate in a market. Predatory pricing can be difficult to distinguish from competitive pricing. Larger businesses are usually able to offer lower prices because they have economies of scale unavailable to smaller firms. APPLICATION Applying Economic Concepts B. If you owned an ice cream store, could you negotiate with other ice cream store owners to set a standard price for a scoop of ice cream? Why or why not? QUICK REFERENCE Price fixing occurs when businesses agree to set prices for competing products. Market allocation occurs when competing businesses divide a market amongst themselves. Predatory pricing occurs when businesses set prices below cost for a time to drive competitors out of a market. Find an update about unfair business practices at ClassZone.com 216 Chapter 7 Protecting Consumers KEY C ONCEPT S When the government becomes aware that a firm is engaged in behavior that is unfair to competitors or consumers, it may issue a cease and desist order, a ruling that requires a firm to stop an unfair business practice. The government also enforces a policy of public disclosure, which requires businesses to reveal product information to consumers. This protects consumers and promotes competition by giving consumers the information they need to make informed buying decisions. Consumer Protection Agencies Besides enforcing laws that ensure competitive markets, the government protects consumers by regulating other aspects of business. Figure 7.6 shows some of the most important federal agencies that protect consumers. The Federal Trade Commission has primary responsibility for promoting competition and preventing unfair business practices. The Federal Communications Commission and Securities and Exchange Commission regulate specific industries. The Food and Drug Administration, Environmental Protection Agency, and Consumer Product Safety Commission protect consumers by regulating multiple industries to ensure the safety and quality of specific products and to protect consumer health. QUICK REFERENCE A cease and desist order requires a firm to stop an unfair business practice. Public disclosure is a policy that requires businesses to reveal product information. F I G U R E 7. 6 Federal Consumer Protection Agencies Agency Created Purpose Food and Drug Administration (FDA) 1906 Protects consumers from unsafe foods, drugs, or cosmetics; requires truth in labeling of these products Federal Trade Commission (FTC) 1914 Federal Communications Commission (FCC) Securities and Exchange Commission (SEC) Environmental Protection Agency (EPA) Consumer Product Safety Commission (CPSC) 1934 1934 1970 1972 Enforces antitrust laws and monitors unfair business practices, including deceptive advertising Regulates the communications industry, including radio, television, cable, and telephone services Regulates the market for stocks and bonds to protect investors Protects human health by enforcing environmental laws regarding pollution and hazardous materials Sets safety standards for thousands of types of consumer products; issues recalls for unsafe products ANALYZE TABLES 1. What’s the difference between the FTC and the SEC? 2. Pick one agency, note the year it was created, and explain what might have led to its creation. AP P LI CATION Making Inferences C. Why do you think the government has decided to set up agencies to protect consumers from unsafe products? Market Structures 217 QUICK REFERENCE Deregulation reduces or removes government control of business. Deregulating Industries KEY CONCEPT S Much government regulation in the 20th century focused on controlling industries that provided important public services. For example, in the 1930s, in response to bank closings and other problems during the Great Depression, the U.S. Congress passed many laws for oversight of the financial services industry. In the 1970s, a trend toward deregulation began. Deregulation involves actions taken to reduce or to remove government oversight and control of business. Deregulation has benefits and drawbacks. Deregulation generally results in lower prices for consumers because the markets become more competitive. Firms in industries with regulated prices have little or no incentive to reduce costs. But deregulation may lead to fewer protections for consumers. Deregulating the Airlines The Airline Deregulation Act of 1978 removed all government control of airlin
e routes and rates. Only safety regulations remained in place. Prior to 1978, there was limited competition, and airlines differentiated based on service rather than price. As a result of deregulation, the industry expanded as many new carriers entered the market. Increased competition led to greater efficiency. Economists estimate that prices fell by 10 to 18 percent, falling most sharply on heavily traveled routes where there was the greatest amount of competition. More people than ever before, lured by lower prices, chose to travel by plane. However, the quality of service declined as airlines cut back on food and other in-flight amenities to reduce costs. In addition, many travelers encountered crowded airports as a result of the increase in air travel. It took time for local governments to expand facilities to accommodate the increase in traffic. The financial pressures led to a large number of bankruptcies among the airline companies. Airline employees faced increased layoffs, lower wages, and loss of pensions. APPLICATION Analyzing Causes C. Why did deregulation of the airline industry lead to lower prices for many consumers? 218 Chapter 7 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. trust b. price fixing c. regulation merger predatory pricing deregulation 2. What is the main purpose of antitrust legislation? 3. How does market allocation lead to reduced competition? 4. When would the government issue a cease and desist order? 5. How do public disclosure requirements protect consumers? 6. Using Your Notes Why is it important for the government to evaluate and approve mergers? Refer to your completed hierarchy diagram. Regulation and Deregulation Promoting Competition details Use the Graphic Organizer at Interactive Review @ ClassZone.com . Analyzing Causes and Effects In 2005, the FTC approved the merger of The Gillette Company with Procter & Gamble. Experts who reviewed the merger said it made sense that it was approved because the two companies had few products in the same market categories. In order to satisfy the government, the companies had to sell only two of their brands to other companies. What factors that affect mergers are illustrated in this story? 8. Applying Economic Concepts In the early 2000s, a new form of marketing emerged called word-of-mouth marketing or buzz marketing. Companies hired ordinary people to talk about the benefits of their products to others. Marketing industry lawyers warned their clients that it was important that the hired spokespeople reveal that they were paid for their endorsements. What are the lawyers concerned about? Use the concepts from this section to formulate your answer. 9. Challenge The Telecommunications Act of 1996 included provisions to deregulate the cable television industry. In 2003, consumer organizations complained that cable rates had increased by 45 percent since the law was passed. Only 5 percent of American homes had a choice of more than one cable provider in 2003. Those homes paid about 17 percent less than those with no choice of cable provider. How effective had deregulation been in the cable industry by 2003? Cite evidence to support your answer. Identifying Regulatory Agencies Several federal agencies provide protection for consumers. Many of them are listed in Figure 7.6 on page 217. Decide which agency or agencies from Figure 7.6 would best protect consumers in each of the situations below. a. Children’s necklaces sold over the Internet are found to contain high levels of lead. Consumers are concerned about the chance of lead poisoning. b. Advertising for a skin cream claims that it will eliminate acne problems. Consumers find that the product does not live up to its claim and in fact seems to irritate people’s faces and cause rashes. c. Some apple farmers use a pesticide on their trees that causes illness. More and more of the pesticide has been found in groundwater supplies. Challenge Find out about a government regulatory agency not listed in Figure 7.6. Discuss the agency’s purpose with your class. Market Structures 219 Case Study Find an update on this Case Study at ClassZone.com Competition in Gadgets and Gizmos Background Cellular phones are a highly successful telecommunications product. Since they first appeared on the market in the 1980s, cell phone sales have grown steadily. Now, billions of people around the world own cell phones. As the global market becomes saturated with cell phones, sales growth will slow. To counteract this, cell phone producers rely on product differentiation to increase sales. New gadgets and gizmos aim to make the cell phone both irresistible and indispensable. A director of business development at one cell phone maker summed up his strategy this way: “We are trying to drive the cell phone in[to] every aspect of your life.” What’s the issue? What affects your selection of a cell phone? Study these sources to discover how producers use product differentiation to compete for your business. Nokia Hopes to Attract Consumers with Mobile-TV Web-browsing, picture-messaging, videos, and now TV Nokia, the world’s largest handset-maker, has just released the results of a mobile-TV trial in Helsinki which found that 41% of participants were willing to pay for the service, and thought is the European Union a monthly fee of 10 [ currency, the euro] ($12.50) was reasonable. As revenue from voice calls has stopped growing in developed markets, the industry has been searching for new avenues for growth. In recent years, it has championed mobile web-browsing, picture-messaging and videotelephony. . . . But . . . consumers have not taken to these things in large numbers. . . . Ah, but mobile TV is different from all those other services . . . because there is no need to educate the consumer. “Everyone gets it if you say ‘mobile TV’,” says Richard Sharp of Nokia. Source: “Anyone for Telly? ” The Economist, September 10, 2005 Thinking Economically What caused Nokia to develop mobile-TV? Explain, using evidence from the article. A. Magazine Article Nokia Corporation, a maker of phone handsets, developed several add-ons to boost sales. This article describes one of Nokia’s plans. 220 Chapter 7 B. Cartoon This cartoon makes light of the dozens of features packed into most cellular phones. Source: www.CartoonStock.com Thinking Economically Why do cellular phone makers include so many features in their phones? Text not available for electronic use. Please refer to the text in the textbook. C. Online Press Release Gartner, Inc. provides research and analysis on the information technology industry. This press release presents its projections on mobile phone sales. Thinking Economically Are manufacturers more likely to offer differentiated products in new markets or in those already established? Explain your answer. THINKING ECONOMICALLY Synthesizing 1. Compare the product described in document A and the one illustrated in B. Are cell phones likely to become more or less complex? Explain why or why not. 2. Which of the four market structures best fits the market for cellular phones? Use evidence from documents A and C to explain your answer. 3. In documents A and C, compare the role that market research plays in the development of new products. Use evidence from the documents. Market Structures 221 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 Choose the key concept that best completes the sentence. Not all key concepts will be used. antitrust legislation barrier to entry cartel cease and desist order deregulation economies of scale geographic monopoly market structure merger monopolistic competition monopoly natural monopoly nonprice competition oligopoly patent perfect competition price fixing price taker standardized product start-up costs 1 is an economic model of the nature and degree of competition among businesses in the same industry. In 2 there are many buyers and sellers of standardized products. In a 3 there is a single seller of a product with no close substitutes. The local water company is an example of a 4 because 5 make it most efficient for a single company to provide the service. A 6 is a group of sellers that acts together to set prices and limit output. A 7 is anything that makes it difficult for a business to enter a market. In 8 there are many buyers and sellers of similar but differentiated products. In such a market the sellers engage in 9 . In 10 there are only a few sellers for many buyers. It is hard for new firms to enter such a market due to high 11 . Sellers in such a market engage in 12 when they all agree to charge the same price for their products. 13 gives the government the power to control monopolies and to promote competition. 222 Chapter 7 CHAPTER 7 Assessment What Is Perfect Competition? (pp. 192–197) 1. What determines the difference between one market structure and another? 2. Why is perfect competition not found in real markets? The Impact of Monopoly (pp. 198–205) 3. How does a monopoly control the price of its product? 4. Name three ways in which a monopoly differs from perfect competition. Other Market Structures (pp. 206–213) 5. Why is product differentiation necessary for monopolistic competition? 6. Why are firms in an oligopoly less independent in setting prices than firms in monopolistic competition? Regulation and Deregulation Today (pp. 214–221) 7. What factors does the government consider in deciding whether to approve a merger? 8. Why do economists generally favor deregulation of most industries? A P P LY Look at the table below showing retail sales. 9. Which retail market is the least concentrated? Which market is most concentrated? 10. Which markets are closer to monopolistic competition and wh
ich are closer to oligopoly? FIGURE 7.7 SALES CONCENTR ATION IN RE TA IL TR ADE Retail Market Percent of Total Sales by the Four Largest Firms Furniture Clothing Supermarkets Music Athletic footwear Books Discount department stores Source: U.S. Census Bureau, 2002 data 8 29 33 58 71 77 95 11. Applying Economic Concepts In 2004, a new trend started in the marketing of music CDs. A variety of retailers, from coffee shop and restaurant chains to large discount stores, began negotiating marketing deals that allowed them to sell a particular recording artist’s CDs exclusively for a period of time. a. What part of monopolistic competition does this trend reinforce: the monopolistic aspect or the competition aspect? b. How is this trend likely to affect prices for these Compete for Buyers CDs? Give reasons why. 12. Analyzing Causes and Effects After deregulation of the airline industry, many of the largest U.S. airlines struggled financially. These airlines then increased their business in the international market in order to boost their profits. What effect of deregulation caused the airlines to make this move? 13. Making Inferences The company that invented the first xerographic photocopier initially enjoyed 70 percent profit margins and a 95 percent market share. Several years later a Japanese camera company invented another way to make photocopiers. Over time, the original company’s market share fell to 13 percent. What specific kind of market structure is illustrated by this example? When a company invents a new product or process, what concerns might they have, if they studied this example? 14. Drawing Conclusions An herbal supplement company claimed that its product would cure serious diseases and promote weight loss. In 2005, the Federal Trade Commission (FTC) required the company to stop making those claims. Why did the FTC rather than the Food and Drug Administration (FDA) handle this case? 15. Challenge Why might a local electric company be in favor of regulations that would allow it to remain a natural monopoly? Why might it oppose regulations that would require monitoring the pollution from its generating plants? Step 1. Choose a partner. Imagine that together you run a company that produces flat-screen televisions under monopolistic competition. Use the criteria in this table to decide how to differentiate your product. Product and Marketing Considerations • Physical characteristics • Where it will be sold • Packaging or labeling • Service • Advertising and promotion • Price (from $500 to $1,500) Step 2. Create a poster that outlines your product and marketing decisions. Include a sketch of one of your televisions along with the price. Step 3. Display all the posters in the classroom. Allow all students to buy a television from the company of their choice. Tally the results and see how many buyers each company attracted. Step 4. Merge with two or three other companies to form a larger company. There should now be only three or four producers. Discuss how this new situation might affect your marketing decisions. Step 5. As a class, discuss what would happen if the three or four firms became a cartel and acted like a monopoly. Challenge Which of these scenarios would you prefer as a producer? Which would you prefer as a consumer? Market Structures 223 Microeconomics U n i t 3 Partners in the American Economy Types of Businesses Businesses are organized in different ways. The organization that suits a small business, such as this florist, may not be appropriate for a large manufacturer. 224 CHAPTER 8 SECTION 1 Sole Proprietorships SECTION 2 Forms of Partnerships SECTION 3 Corporations, Mergers, and Multinationals SECTION 4 Franchises, Co-ops, and Nonprofits CASE STUDY Apple: The Evolution of One Company Types of Business Organizations producer is a maker of goods or provider of services Most of the producers in a market economy are business organizations, commercial or industrial enterprises and the people who work in them. The purpose of most business organizations is to earn a profit AT T E R S Do you have a part-time job after school or on weekends? Perhaps you work behind the counter at the local flower shop or as a server at the juice bar downtown. Or perhaps you work as a stocker at one of the large clothing stores at the shopping mall. These businesses are of varying sizes and are organized differently. The American free enterprise system allows producers to choose the kind of business organization that best suits their purpose. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on Apple Inc. (See Case Study, pp. 252–253.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. How did Apple Inc., which began in a garage, grow into a major multinational corporation? See the Case Study on pages 252–253. Types of Business Organizations 225 S E C T I O N 1 Sole Proprietorships TA K I N G N O T E S In Section 1, you will business organization, p. 226 • identify the characteristics of sole proprietorship, p. 226 limited life, p. 228 unlimited liability, p. 228 sole proprietorships • describe how sole proprietorships are established • compare the economic advantages and economic disadvantages of sole proprietorships As you read Section 1, complete a chart showing the advantages and disadvantages of sole proprietorships. Use the Graphic Organizer at Interactive Review @ ClassZone.com Sole Proprietorships Advantages Disadvantages The Characteristics of Sole Proprietorships KEY CONCEPT S Every business begins with a person who has an idea about how to earn money and the drive to follow through on the idea and to create a business organization. A business organization is an enterprise that produces goods or provides services. Most of the goods and services available in a market economy come from business organizations. The purpose of most business organizations is to earn a profit. They achieve this purpose by producing the goods and services that best meet consumers’ wants and needs. In the course of meeting consumer demand, business organizations provide jobs and income that can be used for spending and saving. Business organizations also pay taxes that help finance government services. The most common type of business organization in the United States is the sole proprietorship, a business owned and managed by a single person. Sole proprietorships include everything from mom-and-pop grocery stores to barbershops to computer repair businesses. They account for more than 70 percent of all businesses in the United States. However, they generate less than 5 percent of all sales by American businesses. Sole Proprietorships Beauty salons are frequently operated by one owner. QUICK REFERENCE A business organization is an enterprise that produces goods or provides services, usually in order to make a profit. A sole proprietorship is a business organization owned and controlled by one person. 226 Chapter 8 E XAMPLE Bart’s Cosmic Comics To understand how sole proprietorships are set up and run, let’s look at the example of Bart’s Cosmic Comics. Bart started collecting comic books in grade school. Over the years, he amassed a huge collection of comics as well as other related items—lunch boxes, action figures, and so on. At the same time, he learned a lot about the comic book business. So, few of his friends expressed surprise when Bart announced that he wanted to open a business selling comic books and related merchandise. Raising Funds Bart needed money to rent and renovate the space he found downtown and to buy new and used comics to stock the store. A hefty withdrawal from his savings account got him started, but he needed to borrow to get the job finished. He tried to get a loan from a local bank. However, because he was not yet an established business owner, bank officers were reluctant to approve the loan. Finally, he turned to his family and friends, who together lent him $15,000. Preparing to Open After raising the necessary funds, Bart completed the few legal steps required to open his business. These included obtaining a business license and a site permit, a document stating that the local government allowed him to use the space he was renting for business. He also registered the name he had chosen for his business—Bart’s Cosmic Comics. Initial Difficulties At first, business was slow. Bart worried that the store would fail and he would be stuck with no income and no way to repay the loans. He thought the safest course of action might be to hang on to what cash he had so he could keep the store open for as long as possible. After much consideration, however, he decided to take another risk, spending $1,000 on advertisements in local newspapers. He also ran several in-store promotions. His business began to take off. Success Within 18 months, Bart had paid back his loans and was earning a profit. Shortly after, he decided to expand his inventory to include T-shirts and posters and to hire an assistant to help run the store. This time when he asked the bank for a loan to pay for the expansion, bank officers were ready to approve the financing. Bart’s success indicated that giving him a loan would be a good business decision. AP P LI CATION Applying Economic Concepts A. Identify two or three examples of businesses you might want to establish as sole proprietorships. Find an update on sole proprietorships at ClassZone.com Types of Business Organizations 227 QUICK REFERENCE Limited life is a situation where a business closes if the owner dies, retires, or leaves for some other reason. Unlimited liability means that a business owner is responsible for all the business’s losses and debts. Sole Proprietorships: Advantages and Disadvantages KEY CONCEPT S The sole proprietorship has certain advantages and disadvantages that set it apart from other kinds of business structures. For example, s
ole proprietorships are not governed by as many regulations as other types of businesses. Also, sole proprietorships have limited life, a situation in which a business ceases to exist if the owner dies, retires, or leaves the business for some other reason. Finally, sole proprietors have unlimited liability, a situation in which a business owner is responsible for all the losses, debts, and other claims against the business. ADVANTAGES Sole Proprietorships There is a reason that sole proprietorships are by far the most common type of business structure: they have several significant advantages. Easy to Open or Close Bart’s start-up requirements were typical: funding, a license, a site permit, and a legally registered name. If Bart wanted to get out of the business, he would find that process easy as well. As long as he has settled all his bills, Bart may close the business when he sees fit. Few Regulations Compared with other business organizations, sole proprietorships are lightly regulated. Bart, for example, must locate his store in an area zoned, or officially set aside, for businesses. He also must treat his employees according to various labor laws. Freedom and Control Bart makes all the decisions and does so quickly without having to check with partners or boards of directors. Having complete control and seeing his ideas come to life gives Bart, like many other sole proprietors, a strong sense of personal satisfaction. In other words, he enjoys being his own boss. Owner Keeps Profits Bart also enjoys the chief economic advantage of the sole proprietorship. Since he is the sole owner of the business, he gets to keep all the profits the business earns. Sole Proprietors Are Fully Responsible The owner bears full responsibility for running the business but also keeps all of the proﬁ ts. 228 Chapter 8 FIGURE 8.1 SOLE PROPRIETORSHIPS BY REVENUES 1.0% 0.5% 3.6% 5.8% 67.5% 9.2% 12.4% Source: Internal Revenue Service, 2003 data ANALYZE GRAPHS More than $1 million $500,000–$1 million $200,000–$499,999 $100,000–$199,999 $50,000–$99,999 $25,000–$49,999 Less than $25,000 The majority of sole proprietorships do not make a lot of money. In fact, almost 70 percent of sole proprietorships make less than $25,000 in sales during the year. Such small businesses are usually run part time out of the owners’ homes. 1. About what percentage of sole proprietorships make less than $50,000 in annual sales? 2. Make a generalization about sole proprietorships based on information in the graph. DIS ADVANTAGES Sole Proprietorships Bart’s story hints at some of the disadvantages of sole proprietorships as well. Limited Funds Especially at start-up, Bart had very limited funds. This disadvantage is one of the key reasons that sole proprietorships are far more likely to fail than other types of business organizations. Until he had established his business, Bart had trouble securing a bank loan. Without monetary reserves to fall back on, he found it a struggle to stay in business. Even when the business became successful, Bart felt that the lack of funds hurt him. He worried that he would not be able to attract and keep good workers because his limited funds meant he could not pay competitive wages or offer benefits such as health insurance. Limited Life Bart found that some of the advantages of the sole proprietorship may also prove to be disadvantages. He appreciated the ease with which you can set up or close a sole proprietorship. However, this means that sole proprietorships have limited life. If he leaves the business, Bart’s Cosmic Comics ceases to exist. Unlimited Liability Bart enjoys having total responsibility for running the business, even though that means that he works long hours. Having total responsibility for the business produces perhaps the greatest disadvantage of a sole proprietorship—unlimited liability. Bart is legally responsible for all the financial aspects of the business. If Bart’s Cosmic Comics fails, he must still pay all its debts, even without income from the business. If necessary, he may have to sell property and use his personal savings to pay off debts. Sole proprietors, then, may lose their homes, cars, or personal savings if their businesses fail. AP P LI CATION Analyzing Cause and Effect B. Why do you think that sole proprietorships are the most common form of business organization in the United States? Types of Business Organizations 229 ECO N O M I C S PAC ES E T T E R Mary Kay Ash: Going It Alone Do you have what it takes to “go it alone” as an entrepreneur? See how many of these questions you can answer with a “yes.” • Are you willing to take risks? • Can you live with uncertainty? • Are you self-confident? • Are you self-directed, able to set and reach goals for yourself? • Are you optimistic, energetic, and action-oriented? Like other entrepreneurs, Mary Kay Ash had all of these qualities. She used them to turn $5,000 in personal savings into Mary Kay Inc., a business that now sells billions of dollars of cosmetics and other merchandise every year. Building a Business While raising three children on her own, Ash built a very successful career in direct sales. In 1963, however, Ash suffered a blow when she lost out on a promotion that was given instead to a man she had trained. Feeling she had been treated unfairly, Ash resolved to create an enterprise that would reward women for their hard work. Later that year, she started a cosmetics company with her son Richard and nine sales people—whom Ash referred to as “beauty consultants.” In 1964, sales exceeded $198,000. By the end of 1965, sales had skyrocketed to more than $800,000. Since its founding, Mary Kay® products have been sold at in-home parties rather than in stores. Mary Kay has always had distinctive programs for recognizing women who reached certain goals. Pink Cadillacs, diamond-studded jewelry, luxury vacations, and other incentives spur the sales representatives to greater and greater efforts. In 1987, Ash assumed the title of chairman emeritus, Mary Kay Ash Mary Kay Ash grew her business into a major corporation. though she remained active in the company until her death in 2001. Her company and its culture continued to flourish. In 2005, over 1.6 million Mary Kay beauty consultants operated in more than 30 countries worldwide. As the company expanded globally, China became Mary Kay’s largest market outside the United States. APPLICATION Making Inferences C. Why do you think Mary Kay Ash proved so successful in her cosmetics venture? FAST FACTS Mary Kay Ash Title: Founder of Mary Kay Inc. Born: May 12, 1918 Died: November 22, 2001 Major Accomplishment: Creating Mary Kay Inc., a company that offers women unique rewards for business success Sales Milestones: 1965—$800 thousand 1991—$500 million 2005—$2 billion Mary Kay Career Cars: Sales people who have qualified for a pink Cadillac or other Mary Kay career car: more than 100,000 Famous Quotation: “If you think you can, you can. And if you think you can’t, you’re right.” Find an update on Mary Kay Inc. at ClassZone.com 230 Chapter 8 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. business organization sole proprietorship b. limited life unlimited liability 2. What are the main advantages of a sole proprietorship? 3. What are the main disadvantages of a sole proprietorship? 4. Who gets the profits from a sole proprietorship? Who has to pay all the debts? 5. What steps do new sole proprietorships usually need to take before they can open? 6. Using Your Notes Select one of the businesses you identified in Application A on page 227. If you were starting that business, do you think the advantages of a sole proprietorship would outweigh the disadvantages or vice versa? Why? Refer to your completed chart as you formulate your answer. Use the Graphic Organizer at Interactive Review @ ClassZone.com Sole Proprietorships Disadvantages Advantages . Evaluating Economic Decisions Suppose Cosmic Comics becomes very successful, and Bart decides to try opening a second store. What issues should Bart consider? What challenges will he face? 8. Making Inferences and Drawing Conclusions In what ways might limited life be considered an advantage for sole proprietors? 9. Applying Economic Concepts Explain how a sole proprietorship rests on the principles of free enterprise. 10. Writing About Economics Write a brief paragraph explaining what Bart might learn from Mary Kay Ash. 11. Challenge How many “yes” answers did you provide to the questions at the top of page 230? If you had one or more “no” answers, explain how you would change a sole proprietorship in order to suit your skills and abilities. If you answered “yes” to all of the questions, explain what you would like about running your own business. Business fairs promote new opportunities. Starting Your Own Business Each year, thousands of Americans start businesses as sole proprietorships. Write a Business Plan Choose a business that you might like to start as a sole proprietorship. Use the following questions to develop a plan that shows how the business will make a profit. • How much money will it take to start the business? Detail each expense. • How much money will it take to run the business each month? Detail each expense. • Who will the customers be and how will you attract them? • Once the business is established, how much will it earn each month? Detail each source of income. • How much profit will you earn? Challenge What challenges do you think you would face in making this business a success? Write a paragraph explaining how you would address these challenges. Types of Business Organizations 231 S E C T I O N 2 Forms of Partnerships TA K I N G N O T E S In Section 2, you will partnership, p. 232 • identify the characteristics and general partnership, p. 233 types of partnerships • compare the economic advantages and disadvantages of partnerships limited partnersh
ip, p. 233 limited liability partnership, p. 233 As you read Section 2, complete a comparison and contrast chart to show similarities and differences between partnerships and sole proprietorships. Use the Graphic Organizer at Interactive Review @ ClassZone.com Sole Proprietorships One owner Partnerships Two or more owners The Characteristics of Partnerships KEY CONCEPT S In Section 1, you read how Bart set up his business as a sole proprietorship. His sister, Mary, who is a whiz at bookkeeping, began helping him with the accounting tasks. As her role in the business expanded, Bart proposed that they join forces in a partnership. A partnership is a business co-owned by two or more people, or “partners,” who agree on how responsibilities, profits, and losses will be divided. Bart lacks the bookkeeping skills his sister has, and the extra funds she brings could help Cosmic Comics to grow. Forming a partnership might be a good business decision. QUICK REFERENCE A partnership is a business co-owned by two or more partners who agree on how responsibilities, profits, and losses of that business are divided. Partnerships are found in all kinds of businesses, from construction companies to real estate groups. However, they are especially widespread in the areas of professional and financial services—law firms, accounting firms, doctors’ offices, and investment companies. There are several different types of partnerships—general partnerships, limited partnerships, and limited liability partnerships—but they are all run in the same general way. 232 Chapter 8 QUICK REFERENCE In a general partnership partners share management of the business and each one is liable for all business debts and losses. A limited partnership is one in which at least one partner is not involved in the day-to-day running of business and is liable only for the funds he or she has invested. In a limited liability partnership (LLP), all partners are limited partners and not responsible for the debts and other liabilities of other partners. T YPE 1 General Partnerships The most common type of partnership is the general partnership, a partnership in which partners share responsibility for managing the business and each one is liable for all business debts and losses. As in a sole proprietorship, that liability could put personal savings at risk. The trade-off for sharing the risky side of the business enterprise is sharing the rewards as well. Partners share responsibility, liability, and profits equally, unless there is a partnership agreement that specifies otherwise. This type of partnership is found in almost all areas of business. T YPE 2 Limited Partnerships In a general partnership, each partner is personally liable for the debts of the business, even if another partner caused the debt. There is a way, however, to limit one’s liability in this kind of business organization. This is through a limited partnership, a partnership in which at least one partner is not involved in the day-to-day running of business and is liable only for the funds he or she has invested. All limited partnerships must have at least one general partner who runs the business and is liable for all debts, but there can be any number of limited partners. Limited partners act as part owners of the business, and they share in the profits. This form of partnership allows the general partner or partners to raise funds to run the business through the limited partners. T YPE 3 Limited Liability Partnerships Another kind of partnership is the limited liability partnership (LLP), a partnership in which all partners are limited partners and not responsible for the debts and other liabilities of other partners. If one partner makes a mistake that ends up costing the business a lot of money, the other partners cannot be held liable. In LLPs, partners’ personal savings are not at risk unless the debts arise from their own mistakes. Not all businesses can register as LLPs. Those that can include medical partnerships, law firms, and accounting firms. These are businesses in which malpractice—improper, negligent, or unprincipled behavior—can be an issue. LLPs are a fairly new form of business organization, and the laws governing them vary from state to state. Partnerships Doctors’ offices are often run as limited liability partnerships. AP P LI CATION Comparing and Contrasting Economic Information A. What are the differences in liability that distinguish general partnerships, limited partnerships, and limited liability partnerships? Types of Business Organizations 233 Partnerships: Advantages and Disadvantages KEY CONCEPT S Some of the economic advantages of partnerships are similar to those of sole proprietorships. Like sole proprietorships, partnerships are easy to set up and dissolve and have few government regulations. Compared with sole proprietorships, however, partners have greater access to funds. Also, possibilities exist for specialization among partners, which can promote efficiency. The disadvantages of partnerships are similar to the disadvantages of sole proprietorships. Like the sole proprietor, at least one of the partners, except in LLPs, faces unlimited liability. Partnerships, too, have limited life. However, partnerships have at least one disadvantage that sole proprietorships avoid. Disagreements among partners can lead to serious problems in running the business. ADVANTAGES Partnerships Bart and Mary realized that if they formed a partnership they would benefit from some of the same advantages that sole proprietorships have, plus some important additional advantages. Easy to Open and Close Partnerships, like sole proprietorships, are easy to start up and dissolve. Ending the partnership would be equally straightforward for Bart and FIGURE 8.2 PARTNERSHIPS BY REVENUES 7.3% 4.7% Find an update on partnerships at ClassZone.com 6.2% 11.0% 8.7% 54.0% More than $1 million $500,000–$1 million $250,000–$499,999 $100,000–$249,999 $50,000–$99,999 $25,000–$49,999 Less than $25,000 8.1% Source: Internal Revenue Service, 2003 data The majority of partnerships are quite small, making less than $25,000 in sales during a year. However, close to 20 percent of partnerships take in yearly revenues in excess of $250,000. ANALYZE GRAPHS 1. What percentage of partnerships made more than $100,000 in sales? 2. Some 7 percent of partnerships took in more than $1 million in revenues, compared to just 0.5 percent of sole proprietorships. Why do you think partnerships generate more revenues than sole proprietorships? 234 Chapter 8 his sister. As long as they have settled all their bills, Bart and Mary may dissolve the partnership when they see fit. Few Regulations Bart and Mary would not be burdened with a host of government regulations. They would enter into a legal agreement spelling out their rights and responsibilities as partners. Partners are covered under the Uniform Partnership Act (UPA), a law, adopted by most states, that lays out basic partnership rules. Access to Resources Mary would bring additional funds to Cosmic Comics. In addition, partnerships generally make it easier to get bank loans for business purposes. A greater pool of funds also makes it easier for partnerships to attract and keep workers. Joint Decision Making In most partnerships, partners share in the making of business decisions. This may result in better decisions, for each partner brings his or her own particular perspective to the process. The exception is limited partnerships, in which the limited partner does not participate in running the business. Specialization Also, each partner may bring specific skills to the business. For example, Bart brings knowledge of comic books, while Mary, who studied business accounting in college, brings skills in bookkeeping and finance. Having partners focus on their special skills promotes efficiency. DIS ADVANTAGES Partnerships Bart and Mary also considered the disadvantages of partnerships. Unlimited Liability The biggest disadvantage of most partnerships is the same as that of sole proprietorships: unlimited liability. Both Bart and Mary are personally responsible for the full extent of the partnership’s debts and other liabilities. So they risk having to use their personal savings, and even having to sell their property, to cover their business debts. Joint Decision Making Partners benefit by making decisions together. But sometimes disagreements can interfere with running the business. Potential for Conflict As partners, they may encounter a new disadvantage as well. Having more than one decision maker can often lead to better decisions. However, it can also detract from efficiency if there are many partners and each decision requires the approval of all. Further, disagreements among partners can become so severe that they lead to the closing of the business. Limited Life Like sole proprietorships, partnerships have limited life. When a partner dies, retires, or leaves for some other reason, or if new partners are added, the business as it was originally formed ceases to exist legally. A new partnership arrangement must be established if the enterprise is to continue. AP P LI CATION Applying Economic Concepts B. Consider the businesses you identified in Application A on page 227 of Section 1. Would these businesses work as partnerships? Why or why not? Types of Business Organizations 235 For more information on distinguishing fact from opinion, see the Skillbuilder Handbook, page R27. Distinguishing Fact from Opinion Facts are events, dates, statistics, and statements that can be proved to be true. Facts can be checked for accuracy. Economists use facts to develop opinions, which may be expressed as judgments, beliefs, or theories. By learning to distinguish between facts and opinions, you will be able to think critically about the economic theories, interpretations, and conclusions of others. TIPS FOR ANALYZING TEXT Use the following guidelines to analyze economic inf
ormation in written works: FIGURE 8 . 3 STARTS AND CLOSURES OF SMALL EMPLOYER FIRMS 2000 New Firms 574,300 Firm Closures 542,831 Bankruptcies 35,472 2001 585,140 553,291 40,099 2002 569,750 586,890 38,540 2003 553,500 572,300 35,037 2004 580,990 576,200 34,317 Sources: U.S. Bureau of the Census; Administrative Office of the U.S. Courts; U.S. Department of Labor, Employment and Training Administration. Opinions. Look for words, such as suggest, suggesting, belief, and believe, which often express assertions, claims, and hypotheses. Many Americans have faith that their ideas will bring them wealth or at least a comfortable living. According to the U.S. government, Americans created more than half a million small firms, or businesses, in the United States each year from 2000 to 2005. While prospective entrepreneurs may interpret these figures as a small business bonanza, overall closures of small businesses also exceeded the half-million mark each year during the same period. And in 2002 and 2003, more small firms closed their doors than opened them, suggesting that market conditions for those two years were particularly unfavorable for the prolonged success of small businesses. Yet bankruptcies among small firms declined in 2002 and 2003. Although such data are likely to be of interest to prospective entrepreneurs, it is limited in nature. Anyone planning to start a business venture would be wise to conduct more extensive research. Facts used by economists are often in the form of statistics, like the ones in this table. Facts include economic data that can be proved. The writer bases this statement on verifiable facts from the table. Judgments, another form of opinion, often use descriptive words such as wise, foolish, sensible, and fortunate, which have an emotional quality. T HINKING ECONOMICALLY Distinguishing Fact from Opinion 1. What facts, if any, does the author use to support the first sentence in the paragraph? 2. Using information from the table and article, write one statement of fact and one statement of opinion. As a class, share your statements and discuss. 236 Chapter 8 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. partnership b. limited partnership general partnership limited liability partnership 2. What are the main advantages of a partnership? 3. What are the main disadvantages of a partnership? 4. In what ways do the increased resources of a partnership help a business? 5. What determines how partners will divide responsibilities, profits, and debts? 6. Using Your Notes Which type of partnership is most like a sole proprietorship? Explain your answer with specific characteristics. Refer to your completed chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com Sole Proprietorships One owner Partnerships Two or more owners . Applying Economic Concepts If you were looking to start a business as a partnership, what traits would you look for in potential partners? Draw up a list of five traits and give a brief explanation for each. Be sure to take the advantages and disadvantages of partnerships into consideration. 8. Comparing and Contrasting Economic Information Briefly explore the differences in potential for job satisfaction between sole proprietorships and partnerships. One size does not fit all—try to determine which of these two business organizations would suit you best. 9. Writing About Economics American business leader John D. Rockefeller said, “A friendship founded on business is a good deal better than a business founded on friendship.” What do you think he had in mind? Write a brief paragraph agreeing or disagreeing, with reference to partnerships. 10. Challenge Do you think that major retail or manufacturing businesses would work as partnerships? Why or why not? Types of Partnerships The different types of partnerships suit different types of businesses. Identify Partnerships Identify the type of partnership represented in each description. 1. Doctors choose this type of partnership because it protects them from malpractice suits brought against other partners. 2. The only role that George plays in the partnership is to collect profits or bear losses based on the amount of funds he contributed. 3. Stephen and Mike start a consulting service to help businesses manage their trademarks and patents. They are the only partners, sharing equally in the work, profits, and losses. 4. Rosa and Serena carefully review expansion plans after new partners provide extra funds. However, they know that they remain fully liable if their decisions are not sound. Challenge Write a description of three different business partnerships without naming them. Exchange your descriptions with a classmate and identify each other’s partnerships. Types of Business Organizations 237 S E C T I O N 3 Corporations, Mergers, and Multinationals TA K I N G N O T E S In Section 3, you will • identify the characteristics of corporations • compare the advantages and disadvantages of corporations • describe how corporations consolidate to form larger business combinations • explain the role of multinational corporations in the world economy corporation, p. 238 stock, p. 238 dividend, p. 238 public company, p. 238 private company, p. 238 bond, p. 240 limited liability, p. 240 unlimited life, p. 240 horizontal merger, p. 243 vertical merger, p. 243 conglomerate, p. 243 multinational corporation, p. 243 As you read Section 3, complete a cluster diagram that categorizes information about corporations. Use the Graphic Organizer at Interactive Review @ ClassZone.com Characteristics Advantages Corporations Characteristics of Corporations KEY CONCEPT S Corporations are the third main kind of business organization. A corporation is a business owned by individuals, called shareholders or stockholders. The shareholders own the rights to the company’s profits, but they face limited liability for the company’s debts and losses. These individuals acquire ownership rights through the purchase of stock, or shares of ownership in the corporation. For example, suppose a large company sells a million shares in the form of stock. If you bought 10,000 shares, you would own 1 percent of the company. If the company runs into trouble, you would not be responsible for any of its debt. Your only risk is that the value of your stock might decline. If the company does well and earns a profit, you might receive a payment called a dividend, part of the profit that the company pays out to stockholders. A corporation that issues stock that can be freely bought and sold is called a public company. One that retains control over who can buy or sell the stock is called a private company. Corporations make up about 20 percent of the number of businesses in the United States, but they produce most of the country’s goods and services and employ the majority of American workers. EXAMPLE F & S Publishing, Inc. To better understand how corporations operate, let’s look at F & S Publishing, Inc., a successful publishing business. Frank and Shirley, the founders, decided to turn their business into a corporation because they wished to avoid unlimited liability. A corporation, unlike a partnership or sole proprietorship, is a formal, legal entity separate from the individuals who own and run it. The financial liabilities of F & S QUICK REFERENCE A corporation is a business owned by stockholders, who own the rights to the company’s profits but face limited liability for the company’s debts and losses. Stock is a share of ownership in a corporation. A dividend is part of a corporation’s profit that is paid out to stockholders. A public company issues stock that can be publicly traded. A private company controls who can buy or sell its stock. 238 Chapter CO R P O R AT E S T RUC T U R E Stockholders Board of Directors Corporate Ofﬁ cers Vice President Production Vice President Operations Vice President Marketing Vice President Distribution Research & Development Department Personnel Department Advertising Department Warehousing Department Purchasing Department Finance Department Sales Department Delivery Department Employees ANALYZE CHARTS This chart shows the organization of a typical corporation. Smaller corporations may only have stockholders, corporate officers, and employees. Larger corporations may be much more complex. Imagine you own a company that makes a product you like. Draw an organization chart for your corporation. Publishing, Inc., are separate from the personal financial liabilities of Frank, Shirley, and other F & S stockholders. If the business fails, only the assets of F & S itself—the office building, equipment, and company bank accounts—are at risk. Setting up a corporation involves more work and expense than establishing a sole proprietorship or partnership. Frank and Shirley hired a law firm to draw up and file papers requesting permission from the state government to incorporate. The state government agreed to the request and issued a corporate charter. This document named F & S Publishing, Inc., as the business, stated its address and purpose, and specified how much stock Frank and Shirley could sell. F & S Publishing, Inc., is organized like the majority of corporations. Stockholders—the owners of the corporation—elect a board of directors. The board hires corporate officers, such as the president and the vice-presidents in charge of sales, production, finance, and so on. These officers are responsible for the smooth running of the corporation. In most corporations, the stockholders and the board of directors are not involved in the day-to-day running of the business. F & S Publishing, Inc., however, is a small company, and Frank and Shirley became members of the board of directors as well as managers. Frank and Shirley decided to make their business a public company. They bought enough of the stock themselves so that they would each have a seat on the
board of directors. They sold the rest of the stock to raise money to expand the business. AP P LI CATION Applying Economic Concepts A. Frank and Shirley were worried about unlimited liability. How did incorporating protect them from this problem? Types of Business Organizations 239 Corporations: Advantages and Disadvantages KEY CONCEPT S QUICK REFERENCE A bond is a contract issued by a corporation that promises to repay borrowed money, plus interest, on a fixed schedule. Limited liability means that a business owner’s liability for debts and losses of the business is limited. Unlimited life means that a corporation continues to exist even after an owner dies, leaves the business, or transfers his or her ownership. The advantages of corporations often address the major disadvantages of sole proprietorships and partnerships. For example, corporations are more effective than either of the other business structures at raising large amounts of money. The key methods of raising money are the sale of stock and the issuing of bonds. A bond is a contract the corporation issues that promises to repay borrowed money, plus interest, on a fixed schedule. Also, unlike sole proprietorships and most partnerships, corporations provide their owners with limited liability, which means that the business owner’s liability for business debts and losses is limited. Further, corporations have unlimited life—they continue to exist even after a change in ownership. Sole proprietorships and partnerships do not. Most of the disadvantages of corporations are related to their size and organizational complexity. Corporations are costly and time-consuming to start up; they are governed by many more rules and regulations; and, because of the organizational structure, the owners may have little control over business decisions. Despite these drawbacks, corporations can be efficient and productive business organizations. FIGURE 8.5 CORPORATIONS BY REVENUES 18.2% 23.7% Find an update on corporations at ClassZone.com 11.5% 13.3% 17.2% Source: Internal Revenue Service, 2003 data More than $1 million $500,000–$1 million $250,000–$499,999 $100,000–$249,999 $50,000–$99,999 $25,000–$49,999 Less than $25,000 6.4% 9.7% Most people think of corporations as very large companies with factories and offices that occupy great expanses of land. Actually, more than a third of all corporations in the United States take in less than $100,000 in revenues each year. ANALYZE GRAPHS 1. What percentage of corporations made more than $250,000 in sales? 2. Compare Figure 8.5 with Figure 8.1 on p. 229 and Figure 8.2 on p. 234. According to the graphs, which type of business has the highest percentage of firms that earn over $1 million in revenues each year? 240 Chapter 8 ADVANTAGES Corporations Frank and Shirley had operated F & S as a partnership for several years. They decided to incorporate to gain the advantages of the corporate business structure. Access to Resources Frank and Shirley have ideas to expand their business, but implementing the ideas may require more money than profits from the business will provide. As a corporation, they have better opportunities for obtaining additional money. Besides borrowing from banks, F & S can raise money by selling more stock or by issuing bonds. This greater access to funds leads to greater potential for growth. Professional Managers Frank and Shirley are involved in the running of F & S Publishing, Inc. Frank serves as chief executive officer (CEO), while Shirley is chief operations officer (COO). However, they decided to hire managers with strong backgrounds in finance and sales as company treasurer and vice-president for sales. Having professionals in charge of financial and sales matters will probably lead to higher profits. Limited Liability Because of limited liability, F & S Publishing, Inc., alone is liable for any debts or losses it incurs. Frank, Shirley, and F & S stockholders are liable only for the money they paid for their stock. The board of directors and officers of the corporation, too, are protected from liability. Source: www.CartoonStock.com Unlimited Life If any of the owners—the stockholders—of F & S dies or decides to end his or her relationship with the company, the business would continue to operate as before. This even applies to Frank and Shirley. If either or both of them move on to another business, F & S Publishing, Inc., can continue without them for as long as it is a viable business. DIS ADVANTAGES Corporations Frank and Shirley discovered some of the disadvantages to incorporating when they first began the process. They learned about other disadvantages of corporations as they ran their business. Start-Up Cost and Effort When they first started, Frank and Shirley set up their business as a partnership. Compared to setting up the partnership, Frank and Shirley found the process of setting up a corporation more time-consuming, difficult, and expensive. The paperwork they had to prepare and file with the state government was extensive, and they had to hire a law firm to help with this task. Heavy Regulation As a public company, F & S Publishing, Inc., must prepare annual reports for the Securities and Exchange Commission (SEC), the government agency Types of Business Organizations 241 F I G U R E 8.6 Business Organizations: Advantages and Disadvantages Type of Organization Sole Proprietorship Partnership Corporation Advantages Disadvantages • Easy to start up, close down • Sole proprietor has satisfaction of running business his or her own way • Few regulations • Sole proprietor keeps all the profits • Easy to start up, close down • Few regulations • Greater access to funds • Partners share in decision making • Partners may bring complementary skills to the business • Greatest access to funds • Business run by professionals • Limited liability • Unlimited life • Limited funds • Limited life • Unlimited liability • Unlimited liability • Shared decision making may create conflict among partners • Limited life • Difficult to start up • More regulations • Double taxation • Owners may have less control of running the business ANALYZE TABLES All three forms of business organizations have distinct advantages and disadvantages. If you were starting a business, which form of business organization would you choose? Why? that oversees the sale of stocks. It also has to prepare and issue quarterly financial reports for stockholders. Further, the company must hold yearly meetings for its stockholders. All of these regulations help ensure that corporations are run for the benefit of the shareholders. Private companies are subject to fewer regulations related to their ownership. Double Taxation Frank and Shirley experience an effect known as double taxation. As officers of the company, they are well aware of the taxes on profits that the corporation must pay. As stockholders, they know that their dividend income, paid out of the company profits, is also taxed. Some small corporations qualify for S corporation status, a tax status which avoids double taxation. Loss of Control Frank and Shirley, as founders, owners, and directors, expect to have a major voice in deciding the direction that F & S Publishing, Inc., will take. However, they experienced some loss of control when the rest of the board of directors voted against them and brought in a new sales manager. APPLICATION Evaluating Economic Decisions B. F & S was successful as a partnership. What will Frank and Shirley gain by making their company a corporation? 242 Chapter 8 Business Consolidation KEY C ONCEPT S You’ve probably seen news stories about them—business consolidations that merge, or combine, several large companies into one mega-company. These consolidations take place for several possible reasons. These include increasing efficiency, gaining a new identity as a business or losing an old one, keeping rivals out of the marketplace, and diversifying the product line. There are two main kinds of mergers (see Figure 8.7). A horizontal merger describes the joining of companies that offer the same or similar products or services. A vertical merger describes the combining of companies involved in different steps of production or marketing of a product or service. An alternative to the two main types is a conglomerate, which results from a merger of companies that produce unrelated goods or services. Through growth, consolidations, and other means, an enterprise can grow so big that it becomes a multinational corporation, a large corporation with branches in several countries. F I G U R E 8 .7 T Y PES O F M E RG E R S Vertical Merger FORESTRY AGRICULTURE PETROCHEMICAL QUICK REFERENCE A horizontal merger is the combining of two or more companies that produce the same product or similar products. A vertical merger is the combining of companies involved in different steps of producing or marketing a product. A conglomerate is a business composed of several companies, each one producing unrelated goods or services. A multinational corporation is a large corporation with branches in several countries. PRODUCTION Horizontal Merger PROCESSING DISTRIBUTION ANALYZE CHARTS What kind of mergers took place in each of the following situations? 1. In 1999, Ford Motor Co. purchased Swedish-based car manufacturer Volvo. 2. In 1989, Japanese electronics giant Sony purchased Columbia Pictures Entertainment. Use an interactive merger chart at ClassZone.com Types of Business Organizations 243 Mergers An example of a horizontal merger is the one between Reebok and Adidas in 2005. At the time, they were the second- and third-biggest makers of sports shoes. The subtitle of an article about the merger summed up the potential benefits of all mergers: “Adidas-Reebok merger could trim costs for companies and maybe even some dollars for consumers.” The two companies planned to cut production and distribution costs by combining their operations. This, they hoped, would improve t
heir ability to compete against the largest sport-shoe maker, Nike. More efficient production usually leads to lower prices, which would draw consumers away from Nike. An example of a vertical merger took place in the late 1990s during a period when the oil and gas industry was undergoing major consolidations. Shell Oil, which owned more refineries, joined with Texaco, which owned more gas stations. This type of merger is vertical, since companies involved in different steps of production (refining) or distribution (getting gasoline to customers) combined. Conglomerates Another kind of business consolidation, the conglomerate, is formed when two or more companies in different industries come together. In theory, the advantage of this form of consolidation is that, with diversified businesses, the parent company is protected from isolated economic pressures, such as changing demand for a specific product. In practice, it can be difficult to manage companies in unrelated industries. Conglomerates were popular during the 1960s. One conglomerate of the 1960s was Gulf and Western, which included companies in such diverse fields as communications, clothing, mining, and agricultural products. As with many other conglomerates formed in the 1960s, however, Gulf and Western did not produce the desired financial gains. Gulf and Western sold all its companies but the entertainment and publishing endeavors and became known as Viacom. Multinational Corporations When you use Google to do an Internet search, you are using the services of a multinational corporation, a large corporation with branches in several countries. Google’s headquarters are in Mountain View, California, but it has branch offices in many other countries. Coca-Cola, McDonald’s, Nike, and Sony are all examples of multinational, or transnational, corporations. Multinational corporations like Google are a major force in globalization, commerce conducted without regard to national boundaries. Multinational corporations have many beneficial effects. They provide new jobs, goods, and services around the world and spread technological advances. When such companies open businesses in poorer countries, the jobs and the tax revenues help raise the standard of living. Source: www.CartoonStock.com 244 Chapter General Electric: Multinational Corporation The operations of General Electric (GE), one of the world’s largest multinational corporations, span the globe. While its headquarters is located in the United States, GE has manufacturing and production centers located in countries far and near. To supply these centers, GE purchases raw materials from all over the world. Further, the corporation has sales centers on six of the seven continents. GE is both a multinational and a conglomerate, offering a wide range of services and products. The diagram below offers a view of GE’s six major businesses and the units that make up these businesses. GE owns many companies that you know. For example, GE owns 80 percent of NBC Universal, which is made up of the NBC television network, Universal Pictures, and many related businesses. GE’s Consumer and Industrial unit manufactures such common products as refrigerators, ovens, and light bulbs. But many of GE’s businesses are less well-known because they provide services and products for businesses and governments. FIGURE 8 . 8 GENER AL ELEC TRIC General Electric Commercial Finance Consumer Finance Healthcare Industrial Infrastructure NBC Universal • Capital Solutions • Corporate Financial Services • Healthcare Financial Services • Insurance • Real Estate • Healthcare • Healthcare Technologies • Healthcare Bio-Sciences • Private Label Credit Cards • Personal Loans • Sales Finance • MasterCard and Visa Credit Cards • Auto Loans and Leases • Mortgages • Corporate Cards • Debt Consolidation • Home Equity Loans • Credit Insurance • Advanced Materials • Consumer and Industrial • Equipment Services • GE Fanuc Automation • Inspection Technologies • Plastics • Security Sensing • Aviation • Network • Aviation Financial • Film Services • Energy • Energy Financial Services • Oil and Gas • Rail • Water • Television Stations • Entertainment Cable • Television Production • Sports/Olympic Games • Theme Parks CONNECTING ACROSS THE GLOBE 1. Applying Economic Information What characteristics of General Electric define it as “multinational”? 2. Analyzing Charts General Electric operates in a wide range of industries. Name some industries in which it does not participate. Make sure to check your answer against the chart. However, multinational corporations can also create problems. Some build factories that emit harmful waste products in countries with lax government regulation. Others operate factories where workers toil for long hours in unsafe working conditions. You will learn more about the impact of multinationals on the world economy in Chapter 17. AP P LI CATION Applying Economic Concepts C. Make up an imaginary conglomerate based on three real companies. Types of Business Organizations 245 ECO N O M I C S PAC ES E T T E R Bill Gates: Entrepreneur and Corporate Leader A reporter once asked multibillionaire Bill Gates, founder of Microsoft Corporation, if he thought there was a larger meaning in the universe. Gates joked, “It’s possible … that the universe exists only for me. If so, it’s sure going well for me, I must admit.” From a small beginning, Bill Gates created the world’s largest software company. Microsoft employs more than 60,000 people in more than 100 countries. Microsoft Corporation Gates was always fascinated with computers and software. He developed software for his high school to schedule classes and for his hometown of Seattle to monitor traffic. At Harvard, he and his friend Paul Allen developed the BASIC language for personal computers. In 1975, during his third year, Gates left college to form a business with Allen to supply BASIC programming for an early brand of personal computers. Gates and Allen called their company Micro-soft (later changed to Microsoft). “I think my most important work was the early work,” Gates said in 2005, “conceiving of the idea of the PC and how important that would be, and the role software would play. . . . ” Microsoft incorporated in 1981. When it struck a deal to provide the operating system for IBM personal computers, it secured its dominance. Microsoft became an international corporation in 1985, when it opened a production facility in Dublin, Ireland. That same year, it released what would become the world’s most popular operating system, Microsoft Windows. Initially, Microsoft focused on corporate computing. With the release of Windows 95, however, it turned to the consumer market. Bill Gates Bill Gates cofounded Microsoft in 1975. It became one of the world’s most successful corporations. Gates led Microsoft as it continued to dom- inate the computer industry. In 1994, Gates established a foundation for charitable giving that quickly became the largest charitable foundation in the world. The foundation focuses on global health and education. In 2006, Gates began shifting away from the day-to-day responsibilities of running Microsoft and toward running the foundation. APPLICATION Categorizing Economic Information D. Create a timeline showing the development of Microsoft from its founding to its status as a major multinational corporation. FAST FACTS Bill Gates Title: Chairman, Microsoft Corporation Born: October 28, 1955, Seattle, Washington Major Accomplishments: Cofounder, Microsoft, 1975; Time Magazine’s Person of the Year, 2005 (for his charitable work) Books: The Road Ahead (1995); Business @ the Speed of Thought (1999) Estimated Personal Fortune: $46.5 billion in 2005 (ranked #1 in the world) Famous Quotation: “I have always loved the competitive forces in this business. That’s what keeps my job one of the most interesting in the world.” Find an update on Bill Gates and Microsoft at ClassZone.com 246 Chapter 8 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these groups. a. stock bond b. public company private company c. merger conglomerate 2. What are the main advantages of a corporation? 3. What are the main disadvantages of a corporation? 4. How do corporations raise money? 5. What is a multinational corporation? 6. Using Your Notes What is the difference between a vertical merger and a horizontal merger? Refer to your completed cluster diagram. Characteristics Advantages Corporations Use the Graphic Organizer at Interactive Review @ ClassZone.com . Analyzing Cause and Effect Review the table below. If the two largest bottled water manufacturers consolidated in a horizontal merger, what might the effect be on competition? Company Annual Sales (in millions of dollars) Percent of Market Nature’s Springs 1,000 Well Water, Inc. Best Taste Empyrean Isles No-Tap Water 600 400 400 200 25 15 10 10 5 8. Writing About Economics In what ways might a vertical merger in the oil industry influence gas prices? 9. Explaining an Economic Concept What are the benefits of combining several companies to form a conglomerate? Name an example of a conglomerate. 10. Challenge So far in this chapter, you have learned about business enterprises that seek profits. In Section 4, you will learn about nonprofit organizations. How do you think the structure of such organizations might differ from the structure of profitseeking organizations? Analyzing Data When companies decide to merge, they must carefully evaluate how to combine their operations. Will This Merger Work? Leviathan Motion Pictures wants to purchase Pipsqueak Computer Games. Leviathan Pipsqueak Ivana Getrich, age 60 Bob L. Head, age 30 15 business executives Bob and a couple of his buddies 200,000,000 250,000 $5,000,000,000 $250,000,000 Head of Company Board of Directors Publicly Owned Shares Market Capitalization 2008 Sales $1,000,000,000 $10,000,000 Production Studios 4 in California
, 1 in New York 1 in Austin Employees 15,000 worldwide 150 in Austin Review the table and imagine what would happen if the companies merge. Write a paragraph describing the challenges and the benefits. Challenge If you were Bob, would you retire after selling Pipsqueak, or would you want to continue running the company? Explain your answer. Types of Business Organizations 247 S E C T I O N 4 Franchises, Co-ops, and Nonprofits TA K I N G N O T E S In Section 4, you will • explain how franchises function • identify the characteristics and purpose of cooperatives • describe the types and purposes of nonprofit organizations franchise, p. 248 franchisee, p. 248 cooperative, p. 250 nonprofit organization, p. 250 As you read Section 4, complete a summary chart with information on specialized organizations. Use the Graphic Organizer at Interactive Review @ ClassZone.com Franchises Co-ops Nonprofits Franchises KEY CONCEPT S QUICK REFERENCE A franchise is a business that licenses the right to sell its products in a particular area. A franchisee is a semiindependent business that buys the right to run a franchise. A franchise is a business made up of semi-independent businesses that all offer the same products or services. Each franchisee, as the individual businesses are known, pays a fee to the parent company in return for the right to sell the company’s products or services in a particular area. Fast-food restaurants are the most common franchised business. However, this kind of business organization is also found in many other industries, including hotels, rental cars, and car service. EXAMPLE An Almost Independent Business The Mango Grove Juice and Nut Bar in the city center provides an illustration of how a franchise works. Tim, who runs the Mango Grove, had worked as assistant manager at a local restaurant for several years. He really wanted to run his own business, but he didn’t think he had the experience or the funds to go it alone. On trips to other cities, he had been impressed by the popularity of the Mango Grove Juice and Nut Bar, an organic juice and sandwich restaurant. So he looked into becoming a franchisee of that business in his home city World’s Leading Franchises 4. Cendent (Howard Johnson, Avis, etc.) 2. Yum! Brands (KFC, Taco Bell, etc.) Source: International Franchise Association, 2004 data 1. McDonald’s Corporation Franchisees 3. 7-Eleven 5. Subway 30,300 28,200 29,300 24,600 21,000 248 Chapter 8 YO U R EC FR ANC HISES Which franchise would you like to run? Hundreds of different businesses operate as franchises. Fast-food restaurants and coffee bars are among the most common. Which type of franchise would you like to run? Why? ? ADVANTAGES Franchises Becoming a franchisee of Mango Grove Juice and Nut Bar appealed to Tim for several reasons. First, he would have a level of independence he did not have in his job at the restaurant. Second, the franchiser, Mango Grove Fruit and Nut Bar, would provide good training in running the business, since his success affected their own. They would also provide proven products—their famous mango smoothie mixes and nut bread for sandwiches—as well as other materials, such as the décor common to all the Mango Grove juice bars, at a relatively low cost. Further, the franchiser would pay for national or regional advertising that would bring in customers. DIS ADVANTAGES Franchises Tim also thought through the disadvantages. He would have to invest most of the money he had saved, with no assurance of success in the business. He would also have to share some of the profits with the franchiser. Further, he would not have control over some aspects of the business. For example, he would have to meet the franchiser’s operating rules, such as buying materials only from the franchiser and limiting the products he offered to those from the franchiser. After considerable thought, Tim decided to apply to become a franchisee. He was accepted, and before long his business became a success. In time, a number of other Mango Grove bars opened in other parts of the city. Since both the franchiser and franchisees had the same incentive—financial reward if the business was successful—they worked well together to make the juice bars succeed. AP P LI CATION Evaluating Economic Decisions A. What advantage does the franchiser have over a business that owns and operates all of its own shops? Types of Business Organizations 249 Cooperatives and Nonprofits KEY CONCEPT S The primary purpose of most businesses is to earn money for the owners—in other words, to make a profit. But not all businesses exist solely to make a profit. A cooperative is a type of business operated for the shared benefit of the owners, who are also its customers. A nonprofit organization is an institution that acts like a business organization, but its purpose is usually to benefit society, not to make a profit. A Business Organization for Its Members When people who need the same goods or services band together and act as a business, they can offer low prices by reducing or eliminating profit. Such organizations are called cooperatives, or co-ops. There are three basic types of cooperatives: consumer, service, and producer. Consumer Consumer, or purchasing, co-ops can be small organizations, like an organic food cooperative, or they can be giant warehouse clubs. Consumer co-ops require some kind of membership payment, either in the form of labor (keeping the books or packaging orders) or monetary fees. They keep prices low by purchasing goods in large volumes at a discount price. Service Service co-ops are business organizations, such as credit unions, that offer their members a service. Employers often form service cooperatives to reduce the cost of buying health insurance for their employees. Producer Producer cooperatives are mainly owned and operated by the producers of agricultural products. They join together to ensure cheaper, more efficient processing or better marketing of their products. A Purpose Other Than Profit There are several different types of nonprofits. Some, like the American Red Cross, have the purpose of benefiting society. They provide their goods or services for free or for a minimal fee. Other nonprofits, like the American Bar Association, are professional organizations. Such organizations exist to promote the common interests of their members. Business associations, trade associations, labor unions, and museums are all examples of organizations pursuing goals other than profits. The structure of a nonprofit resembles that of a corporation. A nonprofit must receive a government charter, for example, and has unlimited life. Unlike a corporation, however, many nonprofit organizations are not required to pay taxes because they do not generate profits and they serve society. Nonprofits raise most of their money from donations, grants, or membership fees. Some nonprofits sell products or services, but only as a way of raising funds to support their mission. APPLICATION Making Inferences B. The National Association of Home Builders promotes the interests of construction companies. Habitat for Humanity builds homes for the disadvantaged. Which of these nonprofits is the government more likely to excuse from paying taxes? Why? QUICK REFERENCE A cooperative is a business operated for the shared benefit of the owners, who also are its customers. A nonprofit organization is a business that aims to benefit society, not to make a profit. 250 Chapter 8 S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Give an example of each of the following terms. a. franchise b. cooperative c. nonprofit organization 2. What are the main advantages of a franchise? 3. What are the main disadvantages of a franchise? 4. How do consumer and service cooperatives save their members money? 5. What are some purposes of nonprofit organizations? 6. Using Your Notes What are the chief distinctions among franchises, cooperatives, and nonprofits? Refer to your completed summary chart. Franchises Co-ops Nonprofits Use the Graphic Organizer at Interactive Review @ ClassZone.com . Explaining an Economic Concept Explain how franchisees share the risk of the business venture with the franchiser. 8. Making Inferences and Drawing Conclusions How do nonprofits get the money needed to pay the people who work for them and to provide services? 9. Evaluating Economic Decisions You’re shopping for a new camera. You could buy it from a specialty camera store that offers expert advice or from a discount retail store that carries hundreds of other products. Or you could join a camera club that offers a buying cooperative. What are the advantages and disadvantages of each option? 10. Challenge Helping society can be big business. The largest nonprofits generate annual revenues in the billions of dollars. Even small nonprofit organizations can make as much money as many for-profit businesses. Nonprofits employ professional managers, accountants, and marketers, just as any other business would. Should the chief executive officer (CEO) of a nonprofit with $500 million in annual revenue be paid the same salary as the CEO of a for-profit company with the same amount of revenue? Explain your answer. Identifying Business Organizations Franchises, co-ops, and nonprofits have distinctive features. What Kind of Organization? Review the following descriptions of business organizations. Decide what kind of business organization fits each description. Remember that there are three different types of cooperatives. • Several companies in your city join together to get a better deal on the health insurance they offer to their workers. • Dan pays a fee for the right to sell Soft Freeze ice cream. Soft Freeze provides all the equipment Dan needs. • Rachel and Serafina join an association that offers relatively cheap organic products. In return, they pay a small monthly membership fee. • The Portswood Road Church Club provides a free food service for the poor of t
he neighborhood. Challenge Imagine a cooperative you and your friends might form. Describe how it would operate and how it would save you money. Types of Business Organizations 251 Case Study Find an update on this Case Study at ClassZone.com Apple: The Evolution of One Company Background Steve Jobs and Steve Wozniak joined forces when they were students. Together, they created a personal computer, named it Apple, and in 1976 started a company with the same name. In the years that followed, their company attained worldwide prominence. While the success story of Jobs and Wozniak often sounds like a fairy tale, the evolution of the company was not without its ups and downs. But by 2005, Apple had annual revenues of nearly $14 billion. What’s the issue? How does a company evolve from an idea into a billiondollar enterprise? Study these sources to discover the factors behind the success of Apple Inc. A. Online Biography This article describes how two young men with an interest in computers created the basis for Apple Inc. Two American Entrepreneurs Start Out in a Garage Young inventors build their first of many computers. When the two first met, Wozniak (born 1950) was 18, Jobs (born 1955) only 13. The pair put their electronics and inventing talents to work making unusual devices, and a few years later purchased a $25 microprocessor with the intention of building a computer. Although this first computer was crude and came without memory, a power supply or even a keyboard, it was very reliable. Jobs and Wozniak decided on a name that would convey the simplicity of the product’s design and use: the Apple. Jobs had a passionate belief in bringing computer technology to everyone. So in 1976, Jobs and Wozniak started a company to build and distribute their invention. In true American-dream fashion, their company began in a garage. To finance their venture, Jobs sold his Volkswagen van and Wozniak sold his programmable calculator to raise $1,300. Weeks later, Jobs secured the company’s first sale: 50 Apple I computers at [the retail price of] $666 each. Source: Inventor of the Week Archive, MIT Steve Wozniak (left) and Steve Jobs (right) founded Apple Computer in 1976. Thinking Economically According to the document, why were Jobs and Wozniak able to succeed in starting their own company? 252 Chapter 8 B. Interview In this interview, Evelyn Richards, who covered computers for Mercury News in the 1980s, describes Apple’s innovative approach to introducing Macintosh, the company’s new personal computer. 1984–Apple Launches Macintosh Marketing plays key role in product’s success. They [Apple] were really more attuned to magazines much more than other tech companies, because magazines can reach a mass market. . . . Steve Jobs got on the cover of Time right around then. The press kit was all really well-packaged. There was the press release for the non-techie people that just talked about how wonderful Macintosh was and how it was going to change the world. Then there were techier press releases, where they talked about the RAM, or the keyboard, or other things. . . . It was really easily digestible, and easy to use by the press. Lots of great photos, professionally done. Now all that is standard. Source: Stanford Library; Interview with Evelyn Richards, 22 June 2000 Thinking Economically How did Apple’s marketing of Macintosh contribute to its success? C. Timeline This timeline shows some of the highlights and challenges that Apple Inc. has experienced. Highlights in Apple Company History 1976–Jobs and Wozniak incorporate Apple Computer 1977–Apple II computer, the first PC with color graphics, introduced 1980–Apple becomes public company, offering 4.6 million shares for sale 1984–Commercial during Super Bowl XVIII introduces the first Macintosh 1985–Both Jobs and Wozniak leave Apple 1988–Apple sues Microsoft when Windows begins using features similar to those developed by Apple 1989–First portable Macintosh introduced 1993–Debut of Newton, an early personal digital assistant 1995–Apple loses its case against Microsoft 1997–Jobs returns to Apple as chief executive officer 1998–Newton discontinued 2001–Portable digital music player iPod introduced 2003–Safari browser introduced; iTunes Music Store debuts 2006–Apple computers begin using Intel Core Duo processors Sources: Macworld March 30, 2006; Apple Inc. Thinking Economically How might Apple’s history have been different if it had become a partnership instead of a corporation? Explain your answer. THINKING ECONOMICALLY Synthesizing 1. Based on information in the documents, how would you describe the evolution of Apple Inc.? 2. How did Apple’s advertising and marketing affect its success or failure? Use examples from the documents in your answer. 3. What single overriding concern has defined the evolution of Apple and determined its success? Use information from the documents to support your answer. Types of Business Organizations 253 CHAPTER 8 Assessment Sole Proprietorships (pp. 226–231) 1. What are the advantages of a sole proprietorship? 2. What are the disadvantages? Forms of Partnerships (pp. 232–237) 3. What are three different kinds of partnerships, and how do they differ? 4. What are the advantages and disadvantages of a partnership? Corporations, Mergers, and Multinationals (pp. 238–247) 5. What are the advantages and disadvantages of a corporation? 6. In what three ways can companies consolidate? Franchises, Co-ops, and Nonprofits (pp. 248–253) 7. How is a franchise “an almost independent” business? 8. What is the difference between a cooperative and a nonprofit organization? A P P LY . What might be the outcome of raising the fees and requiring more paperwork in order to start a corporation? What would happen if fees were lowered and the application process was simplified? 10. Do you think the number of multinationals will continue to increase? Give reasons for your answer. 11. As you have read, sometimes merged companies are not more efficient than they were separately. In some cases, the chief executive officers (CEOs) who arranged the deal make an enormous amount of money from the merger even though the deal itself does not improve profits. What incentives might a board of directors offer to CEOs to make sure they make deals that pay off in profits? 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 Choose the key concept that best completes the sentence. Not all key concepts will be used. bond conglomerate cooperative corporation dividend franchise general partnership horizontal merger limited liability limited liability partnership limited life limited partnership merger multinational corporation nonprofit organization partnership regulation sole proprietorship stock unlimited liability unlimited life vertical merger In a 1 , the business is owned and managed by a single person. One key drawback of this is that the owner has 2 , putting even personal savings at risk. A 3 is a business structure in which two or more owners share the management of the business, profits, and full liability. The 4 and 5 provide ways for some partners to risk only the amount of their investment. A 6 is a business that can raise money by selling 7 and allows for limited liability of its owners and 8 of the enterprise. Two or more businesses can consolidate through a 9 . If they provide the same kinds of goods or services, their consolidation is known as a 10 . When a business has branches in other countries, it is known as a 11 . If someone pays for the right to sell a company’s goods or services in a certain area, that person is operating a 12 . A business whose owners are also its customers is known as a 13 . A 14 is structured like a business but pursues goals other than profits. 254 Chapter Use the following graph showing the number of mergers in the years from 1970 to 2000 to answer questions 12–14. FIGURE 8 .10 MERGERS I N THE UN I TED STATES 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 . 1970 1975 1980 1985 1990 1995 2000 Source: Mergerstat Review Year 12. Analyzing Graphs Which of the following can you determine from the information about mergers in the graph? a. how many companies merged in any given year from 1970 to 2000 b. how many more mergers took place in 2000 than in 1990 c. how long each of the new companies lasted after the merger 13. Predicting Economic Trends Which decade saw the greatest increase in the number of mergers? What probably happened after that decade? 14. Challenge The number of mergers can reflect the economic times, which in turn are often affected by national and world events. What events may have contributed to tighter economic times—and therefore a decrease in mergers—in the 1970s? Design a New Business Structure Each business structure you have read about in this chapter has both advantages and disadvantages. Follow the steps below to design a new business structure that attempts to avoid the worst disadvantages and to capitalize on the most important advantages of the other structures. You can imagine changing laws to accommodate your new structure, but try to make sure your creation makes economic sense. Step 1. Break into small groups. In your group, draw up a list of advantages and disadvantages of all the business structures. The table on page 242 will help you begin the list. Step 2. Discuss how the advantages and disadvantages would affect the ability of a business to earn a profit. Choose the three advantages and three disadvantages that your group feels have the most impact. Step 3. Brainstorm possible ways to avoid the disadvantages and make the most of the advantages. Remember that in brainstorming any idea is allowed, no matter how crazy or simple it might sound. Step 4. Sort through your brainstorming ideas. Use them to
develop a new “ideal” business structure. Step 5. Share your business structure with the rest of the class, and compare your efforts to those of your classmates. Types of Business Organizations 255 The Role of Labor The service sector makes up the largest part of the U.S. economy. More people work in offices than ever before. 256 CHAPTER 9 SECTION 1 How Are Wages Determined? SECTION 2 Trends in Today’s Labor Market SECTION 3 Organized Labor in the United States CASE STUDY Managing Change in Your Work Life The Role of Labor Labor productivity is the value of the goods or services a worker can produce in a set amount of time Labor, the human effort used to produce goods and services, is subject to the same forces of demand and supply that govern the rest of the economy AT T E R S The value of your labor depends on the demand for what you do and the supply of other people able to do the same thing. It’s up to you to figure out what you do best and to distinguish yourself from other workers. Maybe what you really want to do will require special training or years of experience. Think of your dream job, and write a plan for how you will get that job. Evaluate the demand for the job and the supply of people capable of performing it. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on managing change in your worklife. (See Case Study, pp. 282–283.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. The world of work is changing. Will you be able to keep pace? See the Case Study on pages 282–283. The Role of Labor 257 S E C T I O N 1 How Are Wages Determined TA K I N G N O T E S In Section 1, you will wages, p. 258 • identify what wages are equilibrium wage, p. 258 • describe how the interaction derived demand, p. 259 of supply and demand determines wages • explain why wage rates differ wage rate, p. 261 human capital, p. 261 glass ceiling, p. 262 minimum wage, p. 262 As you read Section 1, complete a cluster diagram like the one below to record what you learn about wages. Use the Graphic Organizer at Interactive Review @ ClassZone.com Wages Labor: Demand and Supply QUICK REFERENCE Wages are payments received in return for work. Equilibrium wage is the wage at which the quantity of workers demanded equals the quantity of workers supplied; the market price for labor. KEY CONCEPT S Have you ever wondered why working at a fast food restaurant pays so little? This section will help answer that question. In Chapter 1 you learned about the four factors of production: land, labor, capital, and entrepreneurship. Each of those has a price that must be figured into production costs. The price of labor is wages, the payments workers receive in return for work. Wages, just like the other factors of production, are governed by the forces of supply and demand. The interaction of these two economic forces produces an equilibrium, or balance. An equilibrium wage is the wage at which the number of workers needed equals the number of workers available. In other words, an equilibrium wage produces neither a surplus nor a shortage of workers. Let’s look at demand and supply separately and see how they affect wages at fast food restaurants. Demand for Labor In a competitive labor market, wages reflect a worker’s labor productivity—the value of the goods or services a worker produces in a set amount of time. A business hires workers to help it produce goods or provide 258 Chapter 9 services. A producer’s demand for labor is therefore a derived demand, a demand for a product or resource because of its contribution to the final product. Workers with higher productivity tend to earn higher wages. In one hour, a fast food chef might be able to produce $50 worth of food that customers want. An attorney, by contrast, might be able to provide services worth $300 in the same hour’s time. Employers, then, are willing to pay attorneys higher wages than fast food chefs. The demand for labor depends in part on its price. As with anything else, when the price goes down, the quantity demanded goes up; and when the price goes up, the quantity demanded goes down. For example, suppose that fast food chefs are paid $12 per hour. If the wage should fall to $10 per hour, many restaurants would hire additional chefs. On the other hand, if the wage rose to $14 per hour, some restaurants would stop hiring and others would have to lay off some chefs. This is illustrated in Figure 9.1. The demand curve for labor, then, is a downward slope—the lower the price of labor, the greater the quantity of labor employers would demand. FIGURES 9.1 AND 9.2 DEMAND AND SUPPLY CURVES FOR LABOR FIGURE 9.1 DEMAND CURVE FIGURE 9.2 SUPPLY CURVE ) 20 15 10 5 0 a 2 4 6 8 10 ) 20 15 10 5 0 b 2 4 6 8 10 Number of workers Number of workers QUICK REFERENCE Derived demand is a demand for a product or resource based on its contribution to the final product. These graphs show demand and supply curves for fast food chefs. a The restaurant is willing to hire more chefs if the hourly wage is lower. b As the wage increases, so does the number of workers willing to work as fast food chefs. ANALYZE GRAPHS 1. How many fast food chefs would the restaurant hire at the wage $10 per hour? 2. How many workers would be willing to be fast food chefs at the wage of $10 per hour? 3. What would happen if the restaurant tried to hire chefs at $10 per hour? Use interactive demand and supply curves for labor at ClassZone.com Supply of Labor Now let’s consider the situation from the worker’s point of view, to see how the supply of labor works. Suppose a new fast food restaurant opens and wants to hire chefs. If it puts an ad in the newspaper for chefs who would be paid $10 per hour, fewer people will respond—and probably none of the chefs currently employed at $12 per hour. Workers who are earning less than $10 per hour in some other kind of job might leave their jobs and become fast food chefs because the wages are higher than their current wages. Find an update on demand and supply of labor at ClassZone.com The Role of Labor 259 But suppose the new restaurant offers fast food chefs $15 per hour. Any worker earning less than that will be interested—including experienced chefs currently employed at $12 per hour. More workers will be willing to work at higher wages than at lower wages. For this reason, the supply curve for labor is upward sloping, as illustrated in Figure 9.2 on page 259. Equilibrium Wage You learned in Chapter 6 that the equilibrium price for goods or services is the price at which there is neither a surplus nor a shortage—in other words, the point at which the supply curve and the demand curve intersect. Since wages are the price of labor, they too gravitate toward equilibrium. For example, fast food restaurants might offer higher wages to attract chefs. Given the upward-sloping supply curve, before long there would be more people wanting to be chefs than there are jobs, resulting in a labor surplus. With so many chefs to choose from, restaurants could lower the wage and still attract workers. If they offered a wage that was too low, however, people would have less incentive to work as fast food chefs. A shortage would eventually result, so restaurants would need to raise the wages to attract more. The downward and upward forces push until an equilibrium wage is reached, as illustrated in Figure 9.3. FIGURE 9.3 EQUILIBRIUM WAGE ) 20 15 10 5 0 a 2 4 6 8 10 Number of workers This graph shows how demand and supply interact to determine the equilibrium wage for fast food chefs. a In this case, five workers are demanded and five are available at the wage of $12 per hour. The equilibrium wage for fast food chefs is $12 per hour. ANALYZE GRAPHS 1. How many fast food chefs would the restaurant hire at the wage of $15 per hour? 2. How many workers would be willing to be fast food chefs if the wage rose to $15 per hour? 3. What would result if the wage rose to $15 per hour? APPLICATION Applying Economic Concepts A. Suppose that a new high school opens next to a popular fast food restaurant. Explain what will happen to the derived demand for chefs at the restaurant. 260 Chapter 9 QUICK REFERENCE Wage rate is the established rate of pay for a specific job or work performed. Human capital is the knowledge and skills that enable workers to be productive. Why Do Wage Rates Differ? KEY C ONCEPT S Different jobs have different wage rates, the rates of pay for specific jobs or work performed. Wage rates are determined by supply and demand, which in turn are influenced by four key factors: (1) human capital, which is the knowledge and skills that enable workers to be productive, (2) working conditions, (3) discrimination in the workplace, and (4) government actions. FACT OR 1 Human Capital Economists group workers according to the amount of human capital they have. Unskilled workers, such as house cleaners and sanitation workers, have a low level of human capital. Semiskilled workers—construction and clerical workers, for example—have received some training, so their human capital is higher. Skilled workers, such as plumbers and electricians, have made a significant investment in human capital in the form of specialized training. Professional workers—doctors, lawyers, and others with intensive specialized training—have the highest human capital. The demand for skilled and professional workers is high, but the supply of these workers is relatively low. For this reason and because training increases their productivity, highly skilled workers tend to receive higher wages. The prospect of higher wages leads many people to invest in their human capital and enroll in vocational school, specialist training programs, and higher education. FIGURE 9.4 AND 9.5 U.S. LABOR FORCE BY EDUCATION FIGURE 9.4 MEDIAN EARNINGS FIGURE 9.5 NUMBER OF WORKERS BY EDUCATION BY EDUCATION ) 70,000 60,000 50,000
40,000 30,000 20,000 10,000 0 Less th an hig h sch o ol So m e colleg e Hig h sch o ol grad u ate ) olleg e grad u ate A dvanced d egree 50 40 30 20 10 0 Less th an hig h sch o ol So m e colleg e Hig h sch o ol grad u ate C olleg e grad u ate A dvanced d egree Source: U.S. Bureau of Labor Statistics, 2005 data Source: U.S. Bureau of Labor Statistics, 2005 data ANALYZE GRAPHS 1. In terms of average annual salary, about how much is graduating from high school worth? 2. There are almost as few people without a high school diploma as with an advanced degree. Why doesn’t the reduced supply make their salaries as high as the salaries for people with an advanced degree? The Role of Labor 261 FACTOR 2 Working Conditions “It’s a tough job, but someone has to do it.” That statement is often used humorously by people who have dream jobs, such as vacation planners who get to go on fabulous trips as “research” or taste testers who sample chocolate or other goodies. However, some jobs really are tougher than others. Some jobs, such as washing windows on a skyscraper, are very dangerous. Other jobs can be very unpleasant, such as collecting garbage. Higher wages are often paid to workers in dangerous and unpleasant occupations in order to attract qualified people to those jobs. While the disadvantages of some jobs may be offset by higher wages, the advantages of other jobs may make up for low wages. These advantages vary widely, depending on the worker. For example, a student who loves movies might take a job as a clerk at a video store. Although the pay is low, the student might get to borrow movies free of charge. Someone tired of a long commute in rush hour traffic might welcome a lower-paying job that is only minutes away from home. FACTOR 3 Discrimination Another factor affecting differences in wage rates is discrimination. Wage discrimination may be based on race, ethnicity, gender, or other factors. For example, the average pay of women tends to be lower than that of men doing the same job. Racial prejudices sometimes lead to discrimination in wages. A prejudiced employer might be unwilling to hire a minority candidate except at a lower wage. However, employers who discriminate may actually lose money. By eliminating qualified candidates because of their gender, ethnic group, or other trait irrelevant to performance, employers may miss out on the best worker for the job. Wage differences may also result from occupational segregation. Some low-paying jobs have been viewed as the “realm” of women or certain racial or ethnic groups. Occupational segregation becomes a vicious cycle: groups can become trapped in these jobs, unable to earn enough to invest in human capital that could move them upward. In the United States, the federal government has tried to break this cycle by passing such antidiscrimination laws as the Equal Pay Act (1963) and the Civil Rights Act (1964). Artificial barriers to advancement may also limit the wages of women and minorities. They may have the skills and experience necessary to advance, but find that they are never promoted. The term glass ceiling describes these unseen barriers to advancement. FACTOR 4 Government Actions In a pure market economy, wages would be set strictly by economic forces. However, in many countries, including the United States, the government steps in when market forces produce results that people disagree with. The minimum wage, the lowest wage legally allowed for one hour of work, is one example. As you read in Chapter 6, the minimum wage acts as a price floor designed to boost wages for lowincome workers. The forces of supply and demand might set the equilibrium wage Working Conditions Painters who work at high altitudes receive higher wages. QUICK REFERENCE Glass ceiling is an artificial barrier to advancement faced by women and minorities. The minimum wage is the legal minimum amount that an employer must pay for one hour of work. 262 Chapter 9 M AT . 6 Calculating Annual Wages Suppose you are offered two jobs, one that pays $12.50 per hour or another that pays $30,000 per year. In both jobs, you will work 40 hours per week and get two weeks off per year. Assuming both offer the same benefits, which job pays better? You could either figure out how much you would make in a year at the hourly job or you could convert the annual salary into an hourly wage. In this exercise, we will calculate how much a wage of $12.50 per hour pays for a year’s worth of work. Step 1: Multiply to determine the number of hours worked per year. Assume the job includes two weeks of unpaid vacation. Example Calculations Hours per week Weeks per year Total hours per year 40 50 2,000 Step 2: Then, multiply to find the amount of pay annually. Total hours per year Hourly wage Annual wages 2,000 $12.50 $25,000 The job that pays a salary of $30,000 per year pays better than the one that pays a wage of $12.50 per hour. Comparing Earnings Use the calculations to determine the annual wages of a job that pays $15 per hour for 40 hours per week. What about one that pays $20 per hour but only offers 20 hours of work each week? What other factors do you need to consider when comparing pay between jobs? for certain jobs so low that no one could reasonably make a living at these jobs. The minimum wage attempts to help the people who hold these jobs to make ends meet. However, businesses point out that they might hire more workers if they were allowed to pay a lower wage. The first national minimum wage law in the United States was passed in 1933 during the Great Depression. In part, it was intended to raise wages so that workers could consume products and help the economy recover. In 1938, the minimum wage became part of the Fair Labor Standards Act, which included other protections for workers. The U.S. Congress has increased the minimum wage several times, but the increases have not kept up with the general rise in prices. In response, some state and local governments have passed their own laws requiring minimum wages higher than the federal standard. AP P LI CATION Applying Economic Concepts B. Explain how each of the four factors influences wages at fast food restaurants. The Role of Labor 263 ECO N O M I C S PAC ES E T T E R Gary Becker: The Importance of Human Capital “I believe an economist should . . . express concepts in simple language and show how to deal with important problems in a fairly simple way.” With those words, Nobel laureate economist Gary Becker aptly described his own approach. He proposed that the general economic principle of rational choice could be applied to the decisions people make in all spheres of life. Becker extended an economic way of thinking into new areas, including crime and punishment, households and family relations, and human competence. Investing in Yourself When Gary Becker graduated from high school, he was torn between following a career in mathematics and doing something to help solve social problems. He studied economics at Princeton University and the University of Chicago, and he went on to teach at Chicago and at Columbia University. In 1957, Becker published The Economics of Discrimination, which examined the “effects of prejudice on the earnings, employment, and occupations of minorities.” However, most economists did not pay much attention, feeling that such a study belonged in the fields of sociology or psychology. Today, though, Becker’s approach is widely appreciated and has led economists to explore new areas. Becker is best known for his contri- butions to the idea of human capital and for formulating the economic theory that explains differences in wages in terms of investments in human capital. To Becker, human capital is more than education and training: it is all the investments people make in themselves to improve their output, including the development of good work habits and receiving good medical treatment. The more abundant the capital, the more productive the labor. Becker helped to quantify the importance of education and on-the-job training and, by doing so, broadened the reach of economics. Gary Becker won the Nobel Prize for Economics in 1992 and the National Medal of Science in 2000. APPLICATION Conducting Cost-Benefit Analysis C. Becker debated with himself about whether to park illegally, weighing the possible costs against the advantages. Explain a decision you made using cost-benefit analysis. Is that always the best way to make a decision? Why or why not? FAST FACTS Gary Becker Born: December 2, 1930 Pottsville, Pennsylvania Major Accomplishment: Extending an economic way of thinking into other areas of life and using economics to explain social behavior Inspiration for Ideas About Economics and Crime: When he arrived late one day at Columbia University in New York, Becker decided to save time by parking illegally, even though he knew he might get caught and fined. This led him to wonder if people committing other crimes considered the consequences of their decisions rationally. Famous Quotation: “No discussion of human capital can omit the influence of families on the knowledge, skills, values, and habits of their children.” Find an update on Gary Becker at ClassZone.com 264 Chapter 9 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. wages derived demand b. equilibrium wage minimum wage c. wage rate human capital 2. What market forces influence wages? 3. What nonmarket forces influence wages? 4. Why are education and training considered a kind of capital? 5. Why would a star athlete receive wages so much higher than an insurance sales representative? 6. Using Your Notes Suppose you are the owner of a video store. Explain how you would decide what to pay your workers, making reference to the terms in your completed cluster diagram. Wages Use the Graphic Organizer at Interactive Review @ ClassZone.com . Analyzing Cause and Effect If the equilibrium wag

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