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ág. 270) telework [teletrabajo] véase telecommuting [trabajo a distancia] temp, temps, temping [trabajo temporal] véase contingent employment [empleo contingente] thrift institution [entidad de ahorros] n. institución ﬁ nanciera que sirve a los ahorradores (pág. 478) tight-money policy [política de dinero escaso] véase contractionary monetary policy [política monetaria restrictiva] total cost [costo total] n. suma de los costos ﬁ jos y variables (pág. 140) total revenue [ingreso total] n. ingreso que recibe una empresa al vender sus productos (págs. 122, 142) total revenue test [prueba del ingreso total] n. método para medir la elasticidad comparando el ingreso total que obtendría una empresa al ofrecer su producto a diferentes precios (pág. 122) trade barrier [barrera al comercio] n. toda ley aprobada para limitar el libre comercio entre los países (pág. 520) trade deﬁ cit [déﬁ cit comercial] n. balanza de comercio desfavorable que se produce cuando un país importa más de lo que exporta (pág. 529) trade-off [compensación] n. alternativa que se rechaza al tomar una decisión económica (pág. 14) trade surplus [superávit comercial] n. balanza de comercio favorable que se produce cuando un país exporta más de lo que importa (pág. 529) trade union [sindicato] véase labor union [sindicato laboral] trade war [guerra comercial] n. serie de barreras al comercio entre los países (pág. 522) R58 Spanish Glossary trade-weighted value of the dollar [valor ponderado del dólar] n. medida del valor internacional del dólar que determina si el dólar es fuerte o débil al compararse con otra divisa (pág. 528) traditional economy [economía tradicional] n. sistema económico en el que las personas toman decisiones económicas basándose en costumbres y creencias que se han pasado de una generación a la siguiente (pág. 38) transfer payment [pago de transferencia] n. dinero enviado a personas que no dan bienes o servicios a cambio. (págs. 89, 432) transitional economy [economía transicional] n. país que ha pasado (o está pasando) de una economía autoritaria a una economía de mercado (pág. 545) Treasury bill (T bill) [letra del Tesoro] n. bono a corto plazo cuyo vencimiento es de menos de un año (pág. 464) Treasury bond [bono del Tesoro a largo plazo] n. bono a largo plazo cuyo vencimiento es de 30 años (pág. 464) Treasury note [pagaré del Tesoro] n. bono a medio plazo cuyo vencimiento es de entre dos y diez años (pág. 464) trough [punto mínimo] n. ﬁ n de una contracción de la economía (pág. 359); véase business cycle [ciclo económico] trust [grupo de empresas] n. grupo de compañías que se combinan para reducir la competencia en una industria (pág. 214) trust fund [fondo ﬁ duciario] n. fondo creado para un ﬁ n determinado y para un uso futuro (pág. 465) U underemployed [subempleados] n. personas que trabajan a tiempo parcial pero que quieren trabajar a tiempo completo, o personas que tienen un trabajo que requiere una capacidad inferior a la suya (pág. 383) underground economy [economía subterránea] n. actividades de mercado que no se declaran por ser ilegales o porque los participantes quieren evitar pagar impuestos (pág. 354) underutilization [infrautilización] n. condición en la que los recursos económicos se usan por debajo de su potencia total, dando lugar a menos bienes y servicios (pág. 20) unemployment rate [tasa de desempleo] n. porcentaje de la fuerza laboral que no tiene empleo y que está buscando activamente un trabajo (pág. 382) union [sindicato] véase labor union [sindicato laboral] union shop [compañía de exclusividad sindical] n. empresa en la que los trabajadores están obligados a asociarse a un sindicato durante un período de tiempo establecido después de ser contratados (pág. 279) unit elastic [elasticidad unitaria] n. situación en la que el cambio porcentual del precio y el de la cantidad demandada son iguales (pág. 118) unlimited liability [responsabilidad ilimitada] n. situación en la que el propietario de una empresa es responsable de todas las pérdidas y deudas de la empresa (pág. 228) unlimited life [vida ilimitada] n. situación en la que una sociedad anónima continúa existiendo aun después de un cambio de propietario (pág. 240) user fee [cargo de usuario] n. cantidad de dinero que se cobra por el uso de un bien o servicio (pág. 425) utility [utilidad] n. beneﬁ cio o satisfacción obtenido del consumo de un bien o un servicio (pág. 12) V variable costs [costos variables] n. costos comerciales que varían con el nivel de producción (pág. 140) vertical merger [fusión vertical] n. combinación de dos o más empresas relacionadas con diferentes fases de la producción o de la comercialización de un producto o un servicio (pág. 243) voluntary exchange [intercambio voluntario] n. intercambio en el que las partes participantes prevén que los beneﬁ cios serán más importantes que el costo (pág. 49) voluntary export restraint (VER) [retricción voluntaria a la exportación (RVE)] n. autolimitación sobre las exportaciones a ciertos países para evitar cuotas o aranceles (pág. 521) W wage and price controls [controles de precios y salarios] n. limitaciones gubernamentales sobre el aumento de los precios y los salarios (pág. 501) wage-price spiral [espiral de precios y salarios] n. ciclo que empieza con el aumento de los salarios, lo cual da lugar a costos de producción más altos, que a su vez produce precios más altos; esto provoca la demanda de salarios incluso más altos (pág. 400) wage rate [escala de salarios] n. salario establecido para un determinado puesto de trabajo o tarea realizada (pág. 261) wages [salarios] n. pagos que reciben los trabajadores a cambio de su trabajo (pág. 258) wants [deseos] n. deseos que pueden satisfacerse mediante el consumo de un bien o un servicio (pág. 4) welfare [asistencia social] n. programas económicos y sociales del gobierno que proporcionan ayuda a los necesitados (pág. 392) Spanish Glossary R59 withholding [retención] n. dinero descontado del pago de un trabajador antes de que reciba ese pago (pág. 421) workfare [programa de empleo público] n. programa que obliga a los beneﬁ ciarios de la asistencia social a realizar algún tipo de trabajo a cambio de sus beneﬁ cios (pág. 393) World Bank [Banco Mundial] n. institución ﬁ nanciera que proporciona préstamos, consejos relacionados con la política y ayuda técnica a países de ingresos bajos o medios, para reducir la pobreza (pág. 559) World Trade Organization (WTO) [Organización Mundial del Comercio (OMC)] n. organización que negocia y gestiona acuerdos comerciales, resuelve conﬂ ictos comerciales, supervisa las políticas comerciales y apoya los países en vías de desarrollo (pág. 535) Y yield [rendimiento] n. tasa de rentabilidad anual sobre un bono (pág. 338) R60 Spanish Glossary Index I n d e x Page numbers in bold indicate that the term is deﬁ ned on that page. Page numbers in italics indicate an illustration. A letter after a number indicates a speciﬁ c kind of illustration: c – chart; i – photograph; m – map. An a after an italicized page number indicates an Animated Economics feature. A ability-to-pay taxation, 411 absolute advantage, 512, 513, 519 Adidas, 244 advertising and consumer tastes, 111 dot-com products, 345 Animated Economics, 19a, 20a, 22a, 26a, 53a, 80a, 100a, 102a, 108a, 109a, 118a, 132a, 134a, 147a, 148a, 155a, 165a, 169a, 243a, 260a, 361a, 415a, 449a, 495a, 517a annual percentage rate (APR), 582–584, 585 normal/inferior goods, 110 averages, calculating, R3 B Bakal, Abe, 92 balanced budget, 436 antitrust legislation, 214–215 balance of payments, 529 Advisory Councils, Federal, 478 apartments, ﬁ nding, 608–609 balance of trade, 529–530 AFL-CIO, 276, 279 APEC, 535 aggregate demand, 360–361 appropriations, 431 Baldwin, James, 389 Baltic Republics, 565 curve, 360, 360a, 403 Archer Daniels Midland (ADM), 216 banana production, 511 demand-side economics and, 454–457 ﬁ scal policy and, 446, 448–450 inﬂ ation and, 452 aggregate supply, 360–361, 403 agricultural productivity, 374, 544, 550 aid, ﬁ nancial, 593, 593–595 aid, foreign, 559 Airline Deregulation Act of 1978, 218 allocation, resource, 3–9, 11, 38, 7881, 416, 432 Amazon.com, 75 American Federation of Labor (AFL), 275–276 American Federation of State, County, and Municipal Employees (AFSCME), 278–279 American Railway Union, 276 American Stock Exchange (AMEX), 332 Angola, 547 Archipelago Exchange, 332 Argentina, 289, 560 Bangladesh, A15 bank, 301 Ariel Capital Management, 326 central, 474–475, 478 Armenia, 565 ASEAN, 534 Ash, Mary Kay, 230, 230i Asia-Paciﬁ c Economic Cooperation (APEC) group, 535 assets, ﬁ nancial, 319, 322. See also ﬁ nancial markets. Association of Southeast Asian Nations (ASEAN), 534 ATM, 308, 577 Australia, 513–515, 517 Australian dollar, 526i authoritarian system, 43 automated teller machine (ATM), 308, 308i, 318i, 577 automatic stabilizers, 447 automobile industry consumer expectations and, 112 demand and, 124–125 checking accounts, 293, 304, 576–577 exams, 481 savings accounts, 293, 304, 578–579, 578 bank holding company, 481 banking, 296–310. See also Federal Reserve System. deregulation, 306 electronic, 308, 310, 315 ﬁ nancial intermediaries, 320 fractional reserve, 296, 305, 305a holiday, R25 mergers, 306, 306–307 origins of, 296 regulation of, 306–307, 475, 481 services, 304–307 start-up, 311 technology and, 308–310 types of, 301–303 Index R61 U.S., 298–299, 302 Brazil, A15, A16 sole proprietorship, 226–229, 229, 231 Banking Act of 1933, 300, 307 break-even point, 142 types of, 251 Bank of America, 307 Bank of England, 478 breakfast cereal industry, 209–210 Britain, 61, R19, R27 bar graph, 26, 26, R9, R29, S12–S13 broker, 332 business structure. See business organizations. buyer. See consumer. barrier to entry, 198, 208 Brussels Stock Exchange (BSE), 336 barter, 288 Bart’s Cosmic Comics, 227–229 baseball production, 196 budget, 439 deﬁ cit, 462, 463 federal, 431, 431 personal, 574–575, 575 state, 436 surplus, 462, 463 budgeting, 574–575, 575 Buenos Air
es Stock Exchange (BCBASE), 336 C call centers, 282 Canada, 533–534 capital, 8, 9, 553 budget, 436 deepening, 371 ﬂ ight, 558 gains, 330–331, 424 human, 8, 261, 264, 371, 552–553 bull market, 335 market, 322 Bureau of Labor Statistics (BLS), 382–383 capitalism, 49, 70. See also free enterprise system. Burr, Aaron, 297 Bush, George W., 76 business cycle, 358–366, 359, 366 aggregate supply and demand, 360–361 ﬁ scal policy and, 451, 451 historical, 365–366 monetary policy and, 496, 503 predicting, 364 stages of, 358–359 unemployment and, 385 businesses, 52–53, 53 business organizations, 225–250 advantages and disadvantages, 242 cooperatives, 250 corporations, 238–242, 239, 240, 243–245 franchises, 93, 248, 248–249 mergers, 214–215, 243–244, 243a, 247, 306, 306–307 nonproﬁ t organizations, 250 partnership, 232–235, 234, 237 car. See also automobile industry. buying a, 590–591 insurance, 516, 517 career change, 271 career counseling, 600 caricature, 114 cartel, 198, 535 cartoon, political, 33, 61, 114, 159, 204, 214, 218, 221, 241, 244, 283, 287, 298, 313, 317, 331, 335, 341, 345, 358, 365, 377, 405, 411, 423, 436, 452, 462, 469, 475, 505, 520, 543, 564, 570, 571, 582, 594, 598, R26 case studies Apple Inc., 252–253 automobile demand, 124–125 China, 570–571 entrepreneurs, 92–93 federal deﬁ cit, 468–469 Federal Reserve System, 504–505 inﬂ ation, 404–405 Internet companies, 344–345 bear market, 335 Becker, Gary, 264, 264i beef, 195, 522 Belarus, 565 Belgium, 547 beneﬁ ts-received taxation, 411 Bernanke, Ben, 504–505, 504i Beveridge, Sir William, R27 binding arbitration, 280 Black Entertainment Television (BET), 152 black market, 183–184, 354 blue chip stocks, 335 Board of Governors, 476–477 Bombay Stock Exchange (BSE), 336 bonds, 240, 338–340, 580 government, 339, 464, 482, 490 interest rates and, 340 ratings, 340, 340 risk and return, 327, 583 Treasury, 339, 464, 583 types of, 338–339 Bono, 523, 523i booksellers, 74–75 borrowing, 319. See also loans. costs of, 583 inﬂ ation and, 402 Botswana, 550 bounced check, 576 brand name, 207–208 R62 Index North Korea and South Korea, 64–65 532c, 544c, R26, R27 O’Hare airport expansion, 32–33 Venn diagram, R19 online sales, 440–441 Poland, 376–377 robots, 158–159 student loans, 312–313 tariffs, 538–539 web diagram, R24 Chase Bank, 307 Chavez, Cesar, 277 check card, 309, 581 checking account, 293, 304, 576–577 telecommunications competition, 220–221 check clearing, 480, 481 check writing, 576 Chicago School of Economics, 76 Chile, R19 China, A15, A16, 513–515, 520–521, 529 consumption in, 548 growth rate of, 567 infant mortality and life expectancy, 547 market economy and, 566–567, 570–571 Chinese yuan, 526i, 529 choice, 5, 12–16, 17, 117 Chrysler, 277 cigarette tax, 417, 417 circle graph, 26, 26 circular ﬂ ow model, 52–53, 53a, 80–81, 80a citric acid, 216 civilian labor force, 266 claim, 596 Claritin, 204 Clark, Phil, 93 Clinton, William, 307i, 394 closed shop, 279 ticket prices, 186–187 work environment, 282–283 causes and effects, 10, 498c, 520c, R20 cease and desist order, 217 cell phones, 220–221, 548, 599 cement supply, 144 central bank, 474–475, 478 centrally planned economy, 42, 54 cereal industry, 209–210 certiﬁ cate of deposit (CD), 293, 341, 578–579, 578, 579 Chamberlin, Edward, 212 Changan Automotive Group, 62 change in demand, 109, 109a change in quantity demanded, 108, 108a, 417, 417 change in quantity supplied, 146–147, 147a change in supply, 148–151, 148a, 151, 153 charts, 25, R22, R25, S8–S9 cause-and-effect, 498c, 520c, R20 comparison and contrast, 206c, 232c, 462c concepts, 24c, 48c, 106c, 146c, 174c, 198c, 226c, 296c, 324c, 338c, 434c, 454c, 480c, 510c I n d e x commercial bank, 301 commodity money, 291 Common Market, 532 common stock, 331, 331 communism, 43, 43–44, 563 Communist Manifesto, The, 44 Community Services Block Grant program, 393 comparative advantage, 512–514, 513, 519 comparing and contrasting, 56, 60, R19 competition, 49–50, 55, 150–151 consumer and, 192–195, 207–210 free enterprise and, 72, 75 government and, 432 imperfect, 195, 212 monopolistic, 206–208, 211–212 nonprice, 207 oligopoly and, 209–211 perfect, 192–195, 194, 197, 211 regulation and, 214–216 competitive pricing, 174 complements, 112–113 compound interest, 321, R6 computers, 149, 149i, 178 chip manufacturers, 362 labor and, 268–269 concepts, economic, R13 conclusions, drawing, 272, R21 conglomerate, 243–244 Congress of Industrial Organizations (CIO), 276–277 coincident indicators, 364 Connolly, Marie, 187 collective bargaining, 280, 285 consolidation. See mergers. college tuition, 312 Colombia, 549 consumer, 5, 39 cooperative, 250 ﬂ ow, R17 command economy, 39, 42–46, 54 free enterprise system and, 79 hierarchy, 42c, 138c, 180c, 214c, 266c, 304c, 318c, 352c, 428c, 490c summary, 18c, 248c, 274c, 368c, 388c, market economy and, 56, 562–563 prices and, 177 privatization and, 563–564 protection agencies, 217, 217, 219 Index R63 sovereignty, 50 tastes and expectations, 111–112, 363, 405 Consumer Advisory Council, 478 Consumer Comfort Index, 379 Consumer Conﬁ dence Index, 82, 379 consumer ﬁ nance, 574–609 buying a car, 590–591 contracts, 598–599 education, 592–595 insurance, 596–597, 597 consumer price index (CPI), 396–397 Consumer Product Safety Commission (CPSC), 217 consumption, 548 GDP and, 351 tax, 426 contingent employment, 270–271 contraction, 359. See also business cycle. contractionary ﬁ scal policy, 446, 449, 449–450, 457, 500, 500 contractionary monetary policy, 492–493, 500, 500 contracts, 432, 598–599 contrasting, 56, 64–65 cooperative, 250 co-pay, 596 corn, 195 corporate bond, 339, 579 corporate income tax, 412, 424, 424, 435 corporation, 238–242, 239, 240, 243–245 corruption index, 557, 557 cosigner, 583 Costa Rica, 511 cost-beneﬁ t analysis, 13, 15–16, R18 education, 593 energy, 373 ﬁ xed/variable, 140 input, 148 databases, R11, R31 De Beers cartel, 198–199 debit card, 308–309, 486, 577, 585 Debs, Eugene V., 276 marginal, 16, 140–141 debt opportunity, 12–17, 21, 512–513 investment and, 325, 579 production, 140–143 and revenues, 145 total, 140 Council of Economic Advisers, 452 coupon rate, 338 cover letter, 601–602 craft union, 274–273 credit, 582–589 identity theft and, 588–589 reports, 586–587, 587 score, 586 types of, 582–585 credit card, 305, 309, 582, 584–585 credit-rating company, 340 credit union, 302 creeping inﬂ ation, 398 crowding-out effect, 466–467, 467 cultural exception, 524 currency, 293, 475, 478, 483, 483. See also money. exchange rates and, 526–528, 531 stability, 555, 555i strong and weak, 528 curves. See graphs. customs duty, 425 customs union, 532 cyclical unemployment, 384–385 Czech Republic, 565 D Dahl, Gary, 73–74 less developed countries and, 559 debt restructuring, 559, 560 decimals, R2 decision-making, 15, 15–16, 439, 568, R17, R22 deductible, 596 deduction, tax, 421, 421 default, 559 deﬁ cit budget, 462, 463 federal, 462–464, 468–469 trade, 529, 530, R21 deﬁ cit spending, 462–464, 466, 466, 468–469 deﬂ ation, 398 Dell, Michael, 178, 178i demand, 97–122. See also price; supply. aggregate, 360–361, 403, 446, 448–450, 452, 454–457 demand-pull inﬂ ation, 399, 399, 449 derived, 259 elastic/inelastic, 116–122, 117, 415, 415a factors affecting, 106–113, 113, 115 labor, 258–259 law of, 99, 99 for money, 486, 487, 489 price and, 99, 116–117, 164–165, 169–171, 169a, 171, 487 supply and, 164–171 demand curve, 102–103, 102a, 103, 105–111, R15 aggregate, 360, 360a, 403 elastic/inelastic, 118a cost-push inﬂ ation, 399–400 costs, 13. See also price. data, 24–26, R14, R23, R31. See also graphs. R64 Index I n d e x labor, 259 355 economic investment, 318 supply curve and, 166, 166, 337 diversiﬁ cation, 327–328 economic models, 18, 24–25, 196, R16 demand deposits, 293 dividends, 238, 330–331 economics, 3, 4 demand-pull inﬂ ation, 399, 399, 449 dollar, 289, 292, 528, 528 demand schedule, 100–101, 100a, 101, 165, 165a dot-coms, 344–345 double taxation, 242, 424 microeconomics and macroeconomics, 27–28, 28 positive and normative, 29 demand-side ﬁ scal policy, 454–457, 458 democracy, 544 Dow Jones Industrial Average (DJIA), 334, 334–336, 335 Economics of Discrimination, The, 264 democratic socialism, 43 Doyle, Jim, 440 demographic trends, 390 drug manufacturer, 204 Deng Xiaoping, 566–567, 570 dumping, 521 Department of Justice, 215 dumpster diving, 588 dependent, 608 deposit expansion multiplier, 485 deposit multiplier formula, 485 E earned-income tax credit, 392 depreciation, 590 depression, 359 Depression, Great, 300, 365, 398, 454, 457, 463 deregulation, 218, 300, 306, 458 derived demand, 259 de Soto, Hernando, 394, 394i developed nation, 544–545 development. See economic development. development assistance, 25, 25 diamond market, 198–199 differentiated products, 206–207, 209–210, 212 diminishing marginal utility, law of, 106–107, 107 diminishing returns, 139 direct investment, 558 discount rate, 491 discretionary ﬁ scal policy, 446 discretionary spending, 428, 430 discrimination, 262, 390 disequilibrium, 169 Disney, R18 disposable personal income (DPI), Eastern Europe, 565 Eastman Kodak Company, 202 easy-money policy, 492, 498-499, 499 economic concepts, R13 economic cycle. See business cycle. economic development, 543–567 capital and, 552–553 categorizing, 561 ﬁ nancing, 558 levels of, 544–545, 551 market economy and, 562–567, 569 opportunity and, 556–557 stability and, 554–555 standards of, 546–550 economic growth, 22, 358, 368–375, 556 economic indicators, 349–374 business cycles, 358–366, 359, 366 gross domestic product (GDP), 65, 350–354, 351, 352, 356 types of, 364, 364 economic institutions. See business organizations. economic interdependence, 510–511 Economics of Imperfect Competition, The, 212 Economics Update, 5, 25, 30, 32, 39, 44, 54, 62, 64, 71, 76, 81, 92, 99, 104, 111, 119, 124, 131, 152, 158, 165, 178, 182, 186, 193, 203, 207, 210, 212, 216, 220, 227, 230, 234, 240, 246, 252, 259, 264, 267, 278, 282, 289, 294, 297, 301, 312, 318, 325, 326, 334,
344, 351, 362, 369, 374, 376, 383, 389, 394, 397, 404, 411, 422, 426, 429, 434, 440, 447, 456, 465, 468, 475, 482, 494, 504, 511, 512, 518, 530, 538, 545, 556, 560, 567, 570, 588, 593 economic systems, 37–62 command economy, 39, 42–46, 54, 56, 562–564 global, 61–62 market economy, 39, 43, 48–57, 51, 562–567, 569 mixed, 58–60 traditional economy, 38, 40 economies of scale, 201 economizing, 12 education, 547 ﬁ nancing, 592–595, 593 human capital and, 552–553 labor and, 261, 267 poverty rate and, 390 public schools, 438 school completion, 553 state spending on, 436 student loans and, 312–313 effects, 10 Index R65 efﬁ ciency, 20 Egypt, A15, 558 elasticity of demand, 117–122 calculating, 121, 123 factors affecting, 119–120 tax incidence and, 415, 415a elasticity of supply, 154–157 electronic banking, 308, 310, 315 electronic communications networks (ECN), 333 electronic markets, 333 embargo, 521 employer-sponsored retirement plan, 584 employment. See also labor; unemployment. agencies, 600 business size and, 93 contingent, 270–271 economic sectors and, 268, 268 full, 383 trade and, 517 types of, 272 United States, 268, 365–366, 517, A12–A13 Empowerment Zones, 393 energy costs, 373 energy use, 549–550 Engels, Friedrich, 44 England, 61, R19 Enron, 23 entitlement, 428 demand and, 164–165, 169–171, 169a, 171 perfect competition and, 194 supply and, 170, 170–171, 171 equilibrium wage, 258, 260, 260a, 265 equity, tax, 411 “Essay on the Principle of Population, An,” 374 estate tax, 425 Estonia, 565 Ethiopia, A15 euro, 292, 533 European Union (EU), 292, 377, 522, 532–533 exaggeration, 114 exchange rates, 526–528, 527, 531 excise tax, 149, 425 exemption, tax, 421 expansion, 358 FAQ, 418 farming, 7, 40, 58–59 featherbedding, 278 Federal Advisory Councils, 478 Federal Communications Commission (FCC), 217 Federal Credit Union Act of 1934, 302 federal deﬁ cit, 462–464, 468–469 Federal Deposit Insurance Corporation (FDIC), 300, 582 federal funds rate, 490 federal government. See also government. budget, 431, 431 creditors of, 464 deﬁ cit and, 462–464, 468–469 Federal Reserve and, 482–483 securities, 339, 464, 482, 490 expansionary ﬁ scal policy, 446, 448, 449, 452, 498–499, 499 spending, 428–432 taxes, 420–426, 425 expansionary monetary policy, 492, 498–499, 499 Federal Insurance Contributions Act (FICA), 423 expenses, personal, 574–575 exports, 516–517, 517 balance of trade and, 529–530 exchange rates and, 528 intraﬁ rm, 536 net, 351–352 voluntary export restraint (VER), 521 externality, 87–88, 91 Federal Open Market Committee (FOMC), 477–478, 482 Federal Reserve System, 300, 474–496 currency, 483, 483 districts, 477m, 479 duties of, 474–475 government and, 482–483 member banks, 477 monetary policy and, 490–502 money and, 475, 484, 484–487, 490–496 structure of, 476, 476–478 U.S. Treasury and, 488 Federal Trade Commission (FTC), 215, 217, 589 ﬁ at money, 291–292 entrepreneurship, 9, 92–93, 93 Environmental Protection Agency (EPA), 217 environmental tax, 426 Epson, 159 equilibrium price, 164–171, 167, 173, 189 F factor market, 52–53, 80, 81 factors of production, 8–9, 9, 510 facts, 236, R27 FAFSA, 594–595 Fair Labor Standards Act, 263, 276 business cycles and, 361 famine, 554 R66 Index I n d e x FICA, 423 ﬁ ling status, 604 ﬁ lm industry, 209 ﬁ nance charge, 582–583 ﬁ nance company, 320 ﬁ nancial asset, 319, 322 ﬁ nancial intermediary, 319–321 ﬁ nancial markets, 317–341, 319 assets in, 319, 322 ﬁ nancial system, 318–322, 319 personal investing in, 324–328 productivity and, 373 stocks, 330–336 types of, 322–323 Financial Services Act of 1999, 307 ﬁ nancial system, 318–322, 319 ﬁ reworks displays, 85 ﬁ rm closures, 71 First Bank of the United States, 297 ﬁ scal policy, 446–466, 450 contractionary, 446, 449, 449–450, 457, 500, 500 demand-side, 454–457 discretionary, 446 expansionary, 446, 448, 449, 452, 498–499, 499 federal deﬁ cit and, 462–464 interest rates and, 499–500 limitations of, 451–452 monetary policy and, 498–502, 502 national debt and, 465–466 supply-side, 458, 458–460 taxation and, 448, 450, 458–460 types of, 446–450, 460–461 ﬁ scal year, 431 ﬁ xed cost, 140 ﬁ xed investment, 351 ﬁ xed rate of exchange, 526–527 ﬂ at tax, 412 ﬂ exible rate of exchange, 527 Flintoff, Andrew, R22 G galloping inﬂ ation, 398 ﬂ oating rate, 527 ﬂ ow chart, R17 focus group, 208 Food and Drug Administration (FDA), 217 food production, 79, 79, 374, 374 food stamp program, 392, 429, 482 Gartner, Inc., 221 gasoline, 155 gas station, 269i Gates, Bill, 246, 246i GDP. See gross domestic product (GDP). General Agreement on Tariffs and Trade (GATT), 524, 535 Ford Motor Company, 62, 277 General Electric (GE), 245, 335 foreign exchange market, 526–528 generalizing, R24 foreign exchange rate, 526–528 foreign investment, 61, 558 General Motors Corporation, 124, 276–277, 382 foreign sector, 352 Form 1040, 604–606, 606 401(k) plan, 580 fractional reserve banking, 296, 305, 305a general partnership, 233 General Theory of Employment, Interest, and Money, 456 generic drug, 204 geographic monopoly, 201, 203 France, A15, 59, 524 franchise, 93, 248, 248–249 franchisee, 248 Franklin, Benjamin, 604 Free Application for Federal Student Aid (FAFSA), 594–595 free contract, 73, 74 free enterprise sector, 84 Germany, A15 gift tax, 425 glass ceiling, 262 global economy, 61–63 globalization, 244–245, 269. See also international trade. gold standard, 299, 526–527 Gompers, Samuel, 275 free enterprise system, 69–90 goods, 5 competition and, 72, 75 government and, 72, 80–81, 84–90 legal rights and, 74i modiﬁ ed, 80–81 free market, 30, 54 free rider, 85–86 Free to Choose, 76 free-trade zone, 532 frictional unemployment, 384 Friedman, Milton, 76, 76i, 496 full employment, 383 futures, 333 consumption of, 548, 548–549 ﬁ nal/intermediate, 350, 357 normal/inferior, 110, 177 public, 84–85 Google, 244 Gorbachev, Mikhail, 564 government. See also ﬁ scal policy; monetary policy; regulation; taxation. banking and, 306–307 bonds, 339, 464, 482, 490 command economies and, 39, 42–46 competition and, 432 Index R67 contract, 432 greenback, 299 Hungary, 565, 569 demand-side policy and, 457 Greenspan, Alan, 477, 494, 494i, 504 Hurricane Katrina, 363, 486 gross domestic product (GDP), 65, 350–354, 351, 356 hybrid automobile, 125 hyperinﬂ ation, 398 economic growth and, 375 Federal Reserve System and, 483–483 ﬁ nancial insurance and, 320, 341 free enterprise and, 72, 80–81, 84–90 laissez faire capitalism and, 49 market economies and, 55 mergers and, 215 monopoly, 201–202 national debt and, 465, A14, A15 nominal, 352, 352–353 per capita, A11m, A15, 369, 546, 546, 557 real, 352, 352–353, 358–361, 364, 368–373, 369 United States, A12 payroll and consumption, 81, 81 gross national product (GNP), 355 private sector and, 432, 466 Gulf and Western, 244 production costs and, 149–150 revenue, 410–411, 420–426, 425 securities, 339, 464, 482, 490 spending, 351–352, 428–433, 448–450, 456–457, 463 stability and, 554 state and local, 434–438 H hacking, 588–589 Hagen, Ralph, 313 Hamilton, Alexander, 297, 297i Haq, Mahbub ul, 547 Harris, Jasmine L., 313 supply-side policy and, 458 health, 547 wages and, 262–263 health insurance, 597 government-insured accounts, 578 Medicare, 393, 423, 429 grant-in-aid, 432 Hitachi, 62 graphs, 31. See also demand curve; supply curve. Hobson, Mellody, 326, 326i homemakers, 354 bar, A14, A16, 26, 26, R9, R29, S12–S13 home ownership, 417 drawing conclusions from, 272 Hong Kong, 567, R18 Hong Kong Stock Exchange (SEHK), 334, 336 Hong Kong dollar (HKD), 528 Hoover, Herbert, 365 horizontal merger, 243–244 households, A5m, 52–53, 53 housing, 48, 181 business cycles and, 363 inﬂ ation and, 401 equilibrium wages, 265 interpreting, 82, 83, 172, 272, 342, R29 line, A13, A14, A16, 25–26, 47, 303, R8, R29, S10–S11 Lorenz curve, 391, 391 pie, 26, 26, R10, R29, S12–S13 production possibilities curve (PPC), 19, 20, 22 shifting curves, 172 types of, 25–26, 26a Grassley, Charles, 25i Great Depression, 300, 365, 398, 454, 457, 463 R68 Index I identity theft, 310, 588–589 impact study, 95 imperfect competition, 195, 212 imports, 351–352, 516, 517, 522 balance of trade and, 529–530 exchange rates and, 528 intraﬁ rm, 536 incentives, 12, 176–177, 179, 417 incidence of a tax, 415, 415a income, 109–110 demand and, 119–120, 487 distribution, 390–391, 391 effect, 107 inequality, 390–391 inﬂ ation and, 401 loans and, 583 median household, A5m personal budget and, 574–575 redistribution, 89–90, 432 taxable, 421, 604 income tax, 410–417. See also tax; taxation. corporate, 412, 424, 424, 435 individual, 412, 420–422 progressive, 412, 413, 414, 421–422, 447, R7 state, 435, 435 increasing returns, 139 independent contractor, 270 indexing, tax, 422 human capital, 8, 261, 264, 371, 552–553 human development index (HDI), 547, 569 India, A15, A16, 282, 385, 548, 549, R20 individual income tax, 412, 420–422 individual retirement account (IRA), 580 Indonesia, A15 industrialization, 55 compounding, 585 objective, 324–325, 347 on savings, 587–579, 581, 581 online information about, 342 Industrial Revolution, 44, 371 interest rates industrial union, 274 bond prices and, 340 options, 579 overseas, 336 inelastic demand, 117–118, 415, 415a business cycles and, 363 personal, 318, 324–328, 578–581 I n d e x inelastic supply, 154–156 infant industries, 523 demand for money and, 486, 487 ﬁ scal policy and, 499–500 infant mortality rate, 547, 551 inﬂ ation and, 402 inferences, making, R21 loans and, 582–583, 583 inferior goods, 110 inﬂ ation, 289, 396–402 demand-pull, 399, 399, 449 effects of, 401–405 ﬁ scal policy and, 449–450, 457 income and, 401 indexing and, 422 interest rates and, 402 investment and, 327–328 monetary policy and, 495–496 national debt and, 465 oil supply and, 396, 400 rate, 397–398, 398 types of, 398–399 wage and price controls, 501, 563–564 information technology, 371 infrastructure, 86, 545, 562 initial public offering (IPO), 330 input costs, 148 insourcing, 269 Institute for Liberty and Democracy, 394
insurance banking and, 307 ﬁ nancial, 320, 341 types of, 596–597, 597 Integrated Device Technology, 62 interest, 304–305, 578 calculating, 321, R6 risk and return, 327, 327–329, 338–340, 579, 579 spending multiplier effect and, 455 stability and, 555 U.S. Treasury bonds, 464 Iran, A15, 524 monetary policy and, 495, 495–496, 499–500 Internal Revenue Service (IRS), 421 Ireland, 515 International Ladies’ Garment Workers Union, 275–276 International Monetary Fund (IMF), 559, 560 international trade, 509–536, 556 categories of, 518 effects of, 517a intraﬁ rm, 536 national economies and, 516–518 specialization and, 510–515, 514 trade barriers, 520–524, 556 trade organizations, 532–536 Internet companies, 344–345 research, 418, R28 sales tax, 440–441 interview, job, 602–603 inventory investment, 351 investment, 318–319. See also ﬁ nancial markets. brokers, 307 debt and, 325, 579 decision-making, 343 development and, 558 direct, 558 foreign, 61, 558 GDP and, 351 inﬂ ation and, 327–328 Italy, 296 Iverson, Jessica, 440 J Jackson, Andrew, 298 Japan, A15, 6, 370, 522, 547, 549 Jefferson, Thomas, 297 jobs, applying for, 600–603 Jobs, Steve, 252–253, 252i, 253i Johnson, Lyndon, 392 Johnson, Robert, 152, 152i Jones, Mary Harris, 276 junk bond, 339 K Kang, Yong, 344 Kantrowitz, Mark, 312 Kapital, Das, 44 Katzman, Larry, 405 Kavango people, 40 Kazakhstan, 565 Keith, John, 283 Kenya, 523 Keynes, John Maynard, 454–457, 456 Keynesian economics, 454–456 Khodorkovsky, Mikhail, 564 Index R69 Knights of Labor, 275 Kodak Company, 202 lease, 609 Lee Jong Jin, 65 Malthus, Thomas Robert, 374, 374 mandatory spending, 428–429 Korea, 44, 64–65, 184, 522 legal equality, 73, 74 manufacturing sector, 209, 268, 278, 390 lending. See loans. Mao Zedong, 568 Kozmo.com, 344 Krueger, Alan, 187 Krueger, Anne, 560, 560i Kyrgyzstan, 569 L labels, 114 labor, 8, 9, 257–280, 550 market, 266–271, 273 production and, 138–139 unemployment rate and, 382–383 wages and, 258–263 labor input, 371 labor productivity, 149, 373 labor unions, 274–280 history of, 276–277 membership in, 278, 281 negotiating methods, 280, 285 Laffer, Arthur, 459 Laffer Curve, 459, 459–460 lagging indicators, 364 laissez faire, 49 land, A4m, A9m 8, 9, 555 Land, Edwin, 202 landlord, 609 less developed country (LDC), 545, 553–559 Lewis, John L., 277 life expectancy, 547, 551 life insurance company, 320–321 limited liability, 240–241 limited liability partnership (LLP), 233 limited life, 228–229, 235 limited partnership, 233 line graph, 25–26, 26, 47, 303, R8, R29, S10–S11 liquidity, 325 literacy rate, 547, 551 Lithuania, 565, 565 loans, 305, 582 car, 590 credit history and, 583 to developing nations, 559 Federal Reserve System and, 475, 480–481 inﬂ ation and, 402 student, 312–313, 593–595, 593 local taxation and spending, 437–438 Landrum-Grifﬁ n Act, 277 Lorenz curve, 391, 391 Latvia, 565 law enforcement, 86 luxury, 120 lysine, 216 law of comparative advantage, 514 law of demand, 99, 99 law of diminishing marginal utility, 106–107, 107 law of increasing opportunity costs, 21 law of supply, 131, 131 leading indicators, 364 M MacGuineas, Maya, 426, 426i macroeconomic equilibrium, 361 macroeconomics, 27–28, 28, 352. See also economic indicators. Madison, James, 297 Majoras, Deborah Platt, 215i R70 Index maps United States, A2m–A5m world, A6m–A11m marginal analysis, 142, R18 marginal beneﬁ t, 16 marginal costs, 16, 140–141 marginal product, 138–139 marginal product schedule, 139, 139 marginal revenue, 142–143 market, 48–49. See also ﬁ nancial markets. allocation, 216 division, 216 equilibrium, 164, 166 factor, 80, 81 failure, 84 free, 30, 54 labor, 266–271, 273 product, 80, 81 research, 101, 133, 208 share, 209–210 size, 110–111 types of, 322 market demand curve, 102–103, 103, 105, 166, 166, 337 market demand schedule, 100–101, 101, 165, 165a market economy, 39, 43, 48–55, 51, 57 circular ﬂ ow in, 52–53, 53 command economy and, 56, 562–563 competition and, 49–50, 55 specialization and, 50–51 transition to, 562–567, 569 market structures, 191–218 comparing, 211, 211 deregulation, 218, 300, 306 Mint, U.S., 483 monopoly, 198–205 I n d e x imperfect competition, 195, 212 mixed economy, 58–60, 80 mode, R3 characteristics of, 199, 199 proﬁ t maximization by, 204 model, economic, See economic models. types of, 201–203, 205 modiﬁ ed free enterprise economy, 80–81 monetarism, 496 monetary policy, 474, 490–502 contractionary, 492–493, 500, 500 determining, 497 monopsony, 212 Moody’s, 340 More, Thomas, 38 mortgage, 305, 417 Most Favored Nation (MFN) status, 535 expansionary, 492, 498–499, 499 movie studios, 209 ﬁ scal policy and, 498–502, 502 multifactor productivity, 373 interest rates and, 495, 495–496, 499–500 multinational corporation, 243–245, 245, 536 short-term effects of, 495–496, 495a municipal bond, 339 tools of, 490–491, 491, 493 music distributors, 216 money, 288–294. See also banking. mutual fund, 320, 341, 579, 580 monopolistic competition, 206–208, 211–212 monopoly, 198–205 oligopoly, 209–210, 211–212 perfect competition, 192–195, 194, 197 regulation, 150, 214–217, 241–242, 306–307 types of, 213 market supply curve, 134–135, 137, 147 market supply schedule, 132–133 Marlin, Elizabeth, 92 Marx, Karl, 43–44 Mary Kay Cosmetics, 230 maturity, 338 Mazda Motor Corporation, 62 mean, R3 “means tested” program, 429 Meany, George, 277 median, R3 Medicaid, 392, 429, 429 Medicare, 393, 423, 429 medium of exchange, 288 mercantilism, 30, 368 Mercosur, 534 borrowing, 305 demand for, 487, 489 Federal Reserve System and, 475, 484, 484–487, 490–496 ﬁ at, 291–292 functions of, 288–289, 289, 295 inﬂ ation and, 399 M1 and M2, 486 order, 482 properties of, 290 types of, 291–293 mergers, 214, 243–244, 243a, 247 money management, 574–581 bank, 306, 306–307 government and, 215 Mexican peso, 526i Mexico, A15, 72, 533–534 microeconomics, 27–28, 28 Microsoft, 246 Milanesi, Carolina, 221 military bases, 433 Miller, Darlene, 283 budgeting, 574–575 checking accounts, 576–577 credit, 582–589 paying taxes, 604–607 saving and investing, 578–581 money market, 322 money market account, 578 money market mutual fund (MMMF), 341 minimum balance requirement, 576 minimum wage, 182, 182, 262–263 monopolistic competition, 206–208, 211–212 N NAFTA, 533, 533–534, 537 Namibia, 40, 60 NASDAQ, 333 NASDAQ Composite, 334 national accounts, 350, 355 National Association of Securities Dealers (NASD), 333 national bank, 297, 299 National Basketball Association (NBA), 136 National Bureau of Economic Research (NBER), 365 National Credit Union Association (NCUA), 302 national debt, A14, A15, 462, 465, 465–466 national defense, 85, 430 National Farm Workers Association (NFWA), 277 National Foundation for Credit Counseling, 587 Index R71 national income accounting, 350, 355 not-for-proﬁ t organization, 250 Pearl Jam, 186 national income (NI), 355 nationalization, 61 National Labor Relations Act, 276 O occupational segregation, 262 National Labor Union (NLU), 275 offshore outsourcing, 385 pension fund, 320–321 People’s Bank of China (PBC), 478 per capita GDP, A11m, A15, 369, 546m, 546, 557, percentages, calculating, 60, R2, R4 national parks, 425 natural monopoly, 201 Ohio, 523 oil supply, 10, 200, 363, 370, 396, 400 perestroika, 564–565 natural resources, A4m, A8m, 370 oligopoly, 209–212 near money, 293 necessity, 117, 120 needs, 4 online sales tax, 440–441 online sources, R28 OPEC, 200, 363, 400, 535 negative externality, 87–88 negotiable order of withdrawal (NOW) account, 293 net exports, 351–352 open market operations, 477, 490, 492–493 open opportunity, 73, 74 operating budget, 436 net national product (NNP), 355 opinions, 236, R27 new businesses, 71, 77, 231, 236. See also business organizations. New Deal, 300, 365–366 New York Stock Exchange (NYSE), 332 New Zealand, 511 Niger, 547 opportunity costs, 12–17, 14 comparative advantage and, 512–513 law of increasing opportunity costs, 21 options, 333 Organization of the Petroleum Exporting Countries (OPEC), 200, 200m, 363, 400, 535 Nigeria, A15, A16, 370, 396 Ortiz, David, 203i Nike, 244 OTC Bulletin Board, 333 Nixon, Richard M., 299, 501 outsourcing, 269, 282–283, 385 Nokia Corporation, 220 overdraft, 576 nominal GDP, 352, 352–353, 353 over-the-counter (OTC) market, 333 nonmarket activities, 354 nonprice competition, 207 nonproﬁ t organization, 250 normal goods, 110 Normal Trade Relation (NTR) status, 535 normative economics, 29 Norris-LaGuardia Act, 276 North American Free Trade Agreement (NAFTA), 533, 533–534, 537 North Korea, 45, 45, 64–65, 184 P Pakistan, A15 Park, Joseph, 344 partnership, 232–235, 234, 237 par value, 338 patent, 202 pay-as-you-go ﬁ nancing, 466 payroll tax, 421, 437 PCs, 178 peak, 359. See also business cycle. perfect competition, 192–195, 194, 197, 211 Permac Industries, 283 personal computers (PCs), 178 personal identiﬁ cation number (PIN), 579 personal income (PI), 355 personal investment, 318, 324–328, 578–581 peso, 526i pet rocks, 73 pharmaceutical companies, 204 Philippines, A15 phishing, 588 physical capital, 8 pie graph, 26, 26, R10, R29, S12–S13 Pietersen, Kevin, R22 PIN, 579 Poland, 61, 376–377, 545, 563, 563, 565, R17 Polaroid Corporation, 202 policy. See ﬁ scal policy; monetary policy. policy lag, 495–496, 498 political cartoons, 114. See also cartoon, political. pollution, 87, 87–88 population density, A5m, A10m economic growth and, 369, 374 food production and, 374, 374 shift, 110–111 portfolio investment, 558 R72 Index I n d e x positive economics, 29 positive externality, 87–88 price maker, 198 price taker, 193 postal service, 201 primary market, 322 Postal Service, U.S., 201, 482 primary sector, 268 poverty, 354, 388–394 prime rate, 491 antipoverty programs, 392–394 principal, 327 income inequality and, 390–391 Prius hybrid, 154, 154i line, 89, 388 rate, 389, 390 threshold, 89, 388 world, 395 predatory pricing, 216 predicting trends, R25 preferred stock, 331, 331 premium, insurance, 596 prepaid card, 309 price, 163–184. See also demand; inﬂ ation; supply.
competitive, 174 controls, 501, 563 private company, 238 private property rights, 48–49 private sector, 86, 432, 432, 466 privatization, 61, 563, 564 producer, 5, 39, 130, 150 competition and, 192–195, 207–210 cooperative, 250 free enterprise system and, 78 inﬂ ation and, 400 monopolistic, 198–199 prices and, 176, 176–177 producer price index (PPI), 397 product demand and, 99, 116–117, 164–165, 169–171, 169a, 171, 487 equilibrium, 164–171, 173, 189, 194 differentiation, 206–207, 209–210, 212 market, 52–53, 80, 81 standardized, 192, 193, 209–210 exports and, 516, 517 ﬁ xing, 216 GDP and, 352–353 imports and, 516, 517, 522 as incentive, 176–177, 179 intervention, 180–184 market economy and, 563 monopolists and, 199, 208 oligopolists and, 210 production, 6–9 costs, 140–143 elasticity of supply and, 156 factors of, 8–9, 9, 510 marginal product, 138–139 production costs schedule, 141, 141–143, 143 production possibilities curve (PPC), 18–22, 22a, 23 producer price index, 397 guns vs. butter, 20–21, 20a stability, 555 shift in, 22, 22a supply and, 131, 170, 170–171, 171 productivity, 149, 372–373 system, 174–175, 175 tariffs and, 522, 522 price ceiling, 180–181 price ﬂ oor, 182, 185 professional sports, 203 professional worker, 261 proﬁ t, 49, 54–55, 78, 136, 142–143 proﬁ t-maximizing output, 143, 204 proﬁ t motive, 73 progressive tax, 412, 413, 414, 421–422, 447, R7 property, 48 property rights, 555 property tax, 412, 425, 437, 438 proportional tax, 412–413, 414 protectionism, 523–524, 556 protective tariff, 515, 521 public company, 238 public disclosure, 217 public goods, 84–85, 463 public opinion polls, 82 public safety, 436, 438 public schools, 438 public sector, 84, 86 public transfer payment, 89, 89–90, 447 public welfare, 436, 438 Pudliszki, R17 purchasing power, 289–290 pure competition, 192–195, 194, 197, 211 Putin, Vladimir, 564 Q quality of life, 354 quota, 520 R Ramirez, Monica, 70–71, 70i rational expectations theory, 452, 498–499, 501 rationing, 183, 183–184 ratios, using, R5 reading strategies active reading, S4 previewing, S2–S3 reviewing and summarizing, S5 Index R73 Reagan, Ronald, 365, 401, 494 Social Security and, 429 real capital, 8 real GDP, 352, 352–353, 353, 358–361, 364 return on investment, 327–329, 583, 583 Reuther, Walter Philip, 277 economic growth and, 368–373 revenue, 410. See also taxation. per capita, 369, 369 recession, 359, 451, 493 recording industry, 362 corporations and, 240 federal, 410–411, 420–426, 425 sole proprietorships and, 229 redistribution of income, 89–90, 432 state and local, 434–435, 437, 437 Red Sox, 203i Reebok, 244 table, 122, 145 tariff, 521 references, 601–602, 602 revenues schedule, 142–143, 143 savings bond, 464 scarcity, 3–9, 11, 38 Schering-Plough company, 204 school completion, 553 school enrollment, 533, 547 Schwadron, Harley, 469, 505 S corporation, 242 seasonal unemployment, 384 secondary market, 322 secondary sector, 268 Second Bank of the United States, 298 Ricardo, David, 512, 512 sector, 28 regional trade organizations, 532–535, 534m regressive tax, 412, 414, 414 regulation, 150, 214–217 banking and, 306–307, 475, 481 competition and, 214–216 consumer protection, 217, 217, 219 corporations and, 241–242 deregulation, 218, 300, 306, 458 development and, 557 monopoly and, 199 RenMinBi (RMB), 529 rent control, 181, 181 Richards, Evelyn, 253 right-to-work laws, 279, 279m ripple effect, 362–363 risk, 327–329 bonds, 338–340 investment and, 579, 579 Robinson, Joan, 212, 212i robot, 158–159 Romania, 569 roommates, 612 Roosevelt, Franklin D., 300, 307i, 365, R25 renter’s insurance, 597 Russia, A15, A16, 564 securities. See bonds; stocks. Securities and Exchange Commission (SEC), 217 security, banking, 310 segregation, occupational, 262 seller. See producer. semiconductor chips, 522 semiskilled worker, 261 Sen, Amartya, 554 September 11, 2001, 475 service cooperative, 250 Service Employees International Union (SEIU), 277, 279 service provider, 130i services, 5 service sector, 390 shadow economy, 354, 416 representative money, 291 required reserve ratio (RRR), 484–485, 491 reserve bank, 474. See also Federal Reserve System. resource allocation, 3–9, 11, 38, 78–81, 416, 432 resumé, 601, 601 retirement employer-sponsored plan, 580 individual retirement accounts (IRAs), 580 investing and, 581 pension funds and, 320–321 R74 Index S SADC, 535 safety net, 89 sales tax, 412, 414, 434, 435, 440–441 shareholder, 238 Samsung, 65 satire, 114 savings, 318–319, 324–325, 402. See also investment. savings account, 293, 304, 582, 578–579 savings and loans association (S&L), 300–302 savings bank, 301 shares, 238. See also stocks. Sharp, Richard, 220 Shaw, Theresa, 313 sheep production, 511 Shell Oil, 244 Sherman Antitrust Act of 1890, 214–215 shift in demand, 109 shock therapy, 563–564 I n d e x shortage, 4, 167, 167–168, 176 Internet research, 418, R28 Standard Oil Company, 214–215 shoulder surﬁ ng, 588 Sillett, Joe, R22 simple interest, 321 simulations business structure, 255 collective bargaining, 285 economic advising, 471 economic development, 573 economic impact study, 95 elasticity of demand, 127 electronic banking, 315 equilibrium price, 189 federal budget, 443 international trade, 541 investment objectives, 347 monetary and ﬁ scal policy, 507 monopolistic competition, 223 privatization, 67 quality-of-life threshold, 407 starting a business, 35 supply schedule, 161 survey, 379 Singapore, 72 sin tax, 417 Skillbuilder interpreting graphs, 82, 83, 172, 272, 342, R29 Standard & Poor’s 500 (S&P 500), 334, 340 interpreting models, 196, R16 start-up costs, 209–210 interpreting tables, R30 state predicting, R25 synthesizing, 356, R23 skilled worker, 261 bank, 296 revenues, 434–435, 437 taxation, 434–435, 435 Smith, Adam, 30, 39, 368 statistics, 24 Snow, John, 469 Stephens, Uriah, 275, 276 social insurance tax, 420, 423 stereotyping, 114 socialism, 43, 43 social mobility, 556 stockbroker, 332 stock exchange, 330 Social Security, 89, 392–393, 423, 429 stockholder, 238, 331 social spending, 89–90, 90 stock index, 334–336 sole proprietorship, 226–229, 229, 231 Stock Market Crash of 1929, 335 Somalia, 547 South African Development Community (SADC), 535 South Korea, 45, 64–65, 522 Soviet Union, 46 spamming, 592 special economic zones (SEZs), 567 specialization, 50–51, 138, 510–511, 514 spending stocks, 238, 330–336, 580 risk and return, 327, 579 trading, 332–333 types of, 331, 331 stored-value card, 308–310 store of value, 289 street lighting, 85 strike, 274, 280 structural unemployment, 384–385 deﬁ cit, 462–464, 466, 466, 468–469 Student Aid Report (SAR), 595 analyzing cartoons, 114, R26 analyzing data and databases, R14, R23, R31 causes and effects, 10, R20 comparing and contrasting, 56, 488, R19 discretionary, 428, 430 federal, 428–432, 462–463 ﬁ scal policy and, 448–450, 456–457 GDP and, 351–352 mandatory, 428–429 social, 89–90, 90 decision-making, 568, R17, R22 state and local, 436–438 evaluating sources, 144, R28 explaining and applying concepts, R13, R15 spending multiplier effect, 455, 455–456 stabilization program, 559 facts and opinions, 236, R27 stagﬂ ation, 359, 361, 404, 457 generalizing, R24 inferences and conclusions, R21 standardized product, 192, 193, 209–210 standard of value, 289 subsidy, 88, 149 substitutes, 112, 119 substitution effect, 107 sugar prices, 538–539, 539 supply, 129–152. See also demand; price. aggregate, 360 cost-push inﬂ ation, 399–400 demand and, 164–171 elasticity of, 154–157 equilibrium price and, 170, 170–171, 171 factors affecting, 146–151, 151, 153 labor, 259–260 Index R75 law of, 131, 131 summary paragraph, R29, R30 Taylor, Paul, 124 and production costs, 138–143, 148 Tanzania, 546 technological monopoly, 201–202 supply curve, 134–136, 134a, 135, 137, 147, 150, R15 tariff, 425, 515, 521, 522, 522–523. See also international trade. less developed countries and, 556 rates, 521, 525 sugar prices, 538–539 tax, 410. See also income tax. assessor, 437 base, 412 bracket, 422 deduction, 421, 421 equity, 411 estate, 425 excise, 149, 425 exemption, 421 ﬁ ling, 608–611 incentive, 417 incidence, 415, 415a indexing, 422 return, 421 schedule, 427 technology, 149 computers, 178, 268–269 economic growth and, 371 productivity and, 373 Tel Aviv Stock Exchange (TASE), 336 telecommuting, 270 telework, 270 temping, 270–271 Temporary Assistance for Needy Families (TANF), 393 1040 form, 605–606, 606 1099 form, 609 tertiary sector, 268 test-taking strategies extended response, S14–S15 interpreting charts, S8–S9 interpreting graphs, S10–S13 multiple choice, S6–S7 Texaco, 244 Texas Instruments, 62 taxable income, 421, 608 textile quotas, 520 taxation, 410–438 ability-to-pay, 411 bases and structures, 412–414 beneﬁ ts-received, 411 calculating, 427 corporate, 412, 424, 424 double, 242, 424 economic impact of, 368, 416–417 evaluating, 419 Federal, 420–426, 425 ﬁ scal policy and, 448, 450, 458–460 principles of, 410–411 regressive, 412, 414, 414 social spending and, 90 Thailand, A15 Theory of Monopolistic Competition, 212 thrift institution, 478 TicketMaster, 186–187 ticket prices, 180 tight-money policy, 493 time deposit, 293 Toos, Andrew, 283, 345 total cost, 140 total revenue, 142–143 total revenue test, 122 Toyota, 154, 158 toys, 168 state and local, 434–435, 435, 437, 437 trade. See also international trade. U.S. households, 90 balance of, 529–530 aggregate, 360, 361a, 403 elastic/inelastic, 155, 155a labor, 259 market demand curve and, 166, 166, 337 shifts in supply, 148a supply schedule, 132–133, 132a, 133, 165, 165a supply-side ﬁ scal policy, 458, 458–460 surplus, 167, 167–168, 176 trade, 529 surveys, 63, 208 Sweden, 59–60, 90 symbolism, 114 synthesizing data, 356, R23 T tables, 25, R30 Taft-Hartley Act, 277, 279 Tajikistan, 569 taking notes cause-and-effect chart, 498c, 520c, R20 cluster diagram, 4, 12, 38, 58, 70, 78, 84, 98, 116, 130, 154, 164, 192, 238, 258, 288, 330, 358, 382, 396, 410, 420, 446, 474, 526, 552, 562 comparison and contrast chart, 206c, 232c
, 462c concepts chart, 24c, 48c, 106c, 146c, 174c, 198c, 226c, 296c, 324c, 338c, 434c, 454c, 480c, 510c, R13 hierarchy chart, 42c, 138c, 180c, 214c, 266c, 304c, 318c, 352c, 428c, 490c summary chart, 18c, 248c, 274c, 368c, 388c, 532c, 544c, R26, R27 R76 Index Uniform Partnership Act (UPA), 235 trade balance, 530, 530, R21 unions. See labor unions. unemployment rates, 383, 386 union shop, 279 United Autoworkers Union (UAW), 276–277 union membership, 278 world economy and, A15, 518 United States maps I n d e x international organizations, 532– 536, 534m specialization and, 514 trade barrier, 520–524 trade deﬁ cit, 529, 530, R21 trade-off, 14 trade surplus, 529 United Farm Workers, 277 United Kingdom, 61, R19 trade unions. See labor unions. United Mine Workers, 277 trade war, 522 trade weighted dollar, 528 traditional economy, 38, 40 transactions money, 293, 486 transfer payment, 89–90, 352, 432, 447, 482 United Nations Development Program (UNDP), 559 United States antitrust legislation, 214–215 automobile industry, 124–125 banking in, 296–302, 365 transitional economy, 545 China and, 529, 529 consumer price index, 397 employment, 268, 365–366, 517, A12–A13 energy use, 549 household income, A5m land use, A4m natural resources, A4m political, A2m–A3m population density, A5m unit elasticity, 118 unlimited liability, 228–229, 235 unlimited life, 240–241 unskilled worker, 261 U.S. Agency for International Development (USAID), 559 U.S. Department of Agriculture (USDA), 538 user fee, 425 traveler’s checks, 293 Treasury, U.S., 482, 488 Treasury bills, 464 Treasury bonds, 339, 464, 583 Treasury notes, 464 trough, 359. See also business cycle. Truman, Harry S., 277 trust funds, 465 trusts, 214–215 Turkey, A15 Tyco Toys, 168 U Uganda, 523 Ugarte, Josu, 376 Ukraine, 565 unconsumed output, 351 underemployed workers, 383 underground economy, 354, 416 underutilization, 20 unemployment, 365–366, 382–386 compensation, 90, 393, 423, 429 rate, 382–383, 383, 386 types of, 384–385, 387 GDP, A12, 351, 351–352, 352, 546, A12 utility, 12, 106–107, 107 household tax burden, 90 imports and exports, 518, 518 income distribution, 391, 391 industrialization, 55 inﬂ ation, 404–405 interest rates, A14 labor force, 261, 267, 267, 272 market economy and, 59 money supply, 293–294, 294 national debt, 462, 465, 465–466, A14 online purchases, 441 population, A5m, A16 Postal Service, 201 poverty rate, 389 productivity, 372 rationing in, 183 right-to-work states, 279 social spending, 90 Utopia, 38 V variable cost, 140 Venn diagram, R19 vertical merger, 243–244 veterans’ beneﬁ ts, 429 Viacom, 244 Vietnam, A15 Vock, Myriam, 282 Volkswagen, 124 voluntary exchange, 49 voluntary export restraint (VER), 521 W wage and price controls, 501 wage-price spiral, 400, 400 sugar industry, 538–539 wage rate, 261–263 Index R77 wages, 258–263 calculating, 263 World War I, 475 World War II, 457, 501 equilibrium wage, 258, 260, 265 World Wide Web. See Internet. minimum wage, 182, 182, 262–263 Wozniak, Steve, 252–253, 252i Wroclaw, 376 WTO, 535 Y Yangtze River, 568 yield, 338, 339 Yuan, 526i Z Zalia Cosmetics, 70–71 Wagner Act, 276 Wang, Vera, 104, 104i wants, 4–5 water company, 201 Wealth of Nations, The, 30, 39 web diagram, R24 welfare, 90, 392–393 W-2 form, 605 W-4 form, 604, 604 Whaley, John, R18 wildcat banking, 298–299 Wilson, Woodrow, 299 withholding, 421 women in labor force, 267, 267, 556 wage discrimination and, 262 Wood, Ben, 221 Woodworm, R22 Woolcock, Keith, 65 wool production, 511 workfare, 90, 393 working conditions, 262, 270–271 work stoppage, 274, 280 World Bank, 559 world data table, A15 world maps GDP per capita, A11m land use, A9m natural resources, A8m political, A6m–A7m population density, A10m world markets, 336 world population, A16 World Trade Organization (WTO), 535 R78 Index Acknowledgments Text Acknowledgments Chapter 1, page 32: Excerpts from “O’Hare International Airport (ORD/ KORD), Chicago, IL, USA,” from the Airport-Technology Web site. Reprinted by permission of SPG Media Limited. Chapter 1, page 33: Excerpt from “Organization and Introduction,” from the AReCO Web site. Reprinted by permission of The Alliance of Residents Concerning O’Hare, Inc. (AReCO). Chapter 2, page 64: Excerpt from “The North Korean Famine,” from Peace Watch, June 2002. Reprinted by permission of the United States Institute of Peace. Chapter 2, page 65: Excerpt from “Masters of the Digital Age,” by Rana Foroohar and B. J. Lee, Newsweek, October 18, 2004. Copyright © 2004 Newsweek, Inc. All rights reserved. Reprinted by permission. logo are trademarks of Yahoo! Inc. Reprinted by permission of Yahoo! Inc. Chapter 11, page 342: “Apple Computer (AAPL-Q),” from The Globe and Mail, April 19, 2006. Reprinted by permission of the Globe and Mail Chapter 11, page 344: “Kozmo.com,” from the Wikipedia Web site. Reprinted by permission. Chapter 11, page 345: Excerpt from “The Bubble Bowl” by David M. Ewalt, Forbes Web site, January 27, 2005. Copyright © 2005 Forbes.com Inc. Reprinted by permission. Chapter 12, page 364: “U.S. Leading Economic Indicators (LEI) and Real GDP”. The Conference Board, United States Bureau of Economic Analysis, National Bureau of Economic Research. Reprinted by permission of The Conference Board Inc. Chapter 3, page 92: Excerpt from “The Industry: Message in a Bottle” by Matt Lee and Ted Lee, The New York Times, June 28, 2005. Copyright © 2005 by The New York Times Co. Reprinted with permission. Chapter 12, page 376: Excerpts from “Europe’s Capitalism Curtain” by Steve Pearlstein, The Washington Post, July 23, 2004. Copyright © 2004, The Washington Post. Excerpted with permission. Chapter 3, page 93: Excerpt from “Growing Occupation: Being Your Own Boss” by Stacey Hirsh, Baltimore Sun, April 21, 2006. Copyright © 2006 The Baltimore Sun. Reprinted by permission. Chapter 12, page 377: Excerpts from “Reaping the European Union Harvest,” The Economist, January 8, 2005. The Economist Newspaper Ltd. All rights reserved. Reprinted with permission. Further reproduction prohibited. www.economist.com. Chapter 4, page 124: Excerpts from “Volkswagen Tries 12 Months of Free Car Insurance to Lure Buyers” by Jeff Green, December 31, 2004, Bloomberg Web site. Copyright © 2004 Bloomberg L.P. All rights reserved. Reprinted by permission of Bloomberg L.P. Chapter 4, page 125: Excerpt from “2005 – The Year of the Hybrid,” from the InvoiceDealers Web site. Reprinted by permission of Dealix Corporation, a Division of The Cobalt Group. Chapter 5, page 144: Excerpt from “Why is the Supply of Cement Falling Short of Demand?” from the Portland Cement Association Web site. Reprinted by permission of the Portland Cement Association. Chapter 5, 158: Excerpts from “Robots for Babies: Toyota at the Leading Edge” by Burritt Sabin, Japan Inc. Web site. Reprinted by permission of Japan Inc. Chapter 5, page 159: Excerpt from “Cake Decorating” from the EPSON Robots Web site. Reprinted by permission of EPSON America Inc. Chapter 6, page 187: Figure 1 from “The Economics of Real Superstars: The Market for Concerts in the Material World” by Alan B. Krueger, Journal of Labor Economics, 23(1), 2005. Reprinted by permission of The University of Chicago Press. Chapter 7, page 220: Excerpts from “Anyone for Telly?,” The Economist, September 10, 2005. The Economist Newspaper Ltd. All rights reserved. Reprinted with permission. Further reproduction prohibited. www.economist.com. Chapter 7, page 221: Excerpt from “Gartner Says Mobile Phone Sales Will Exceed One Billion in 2009,” from the Gartner Web site. Reprinted with permission. Chapter 8, page 248: “World’s Leading Franchises,” from Franchise Facts. Copyright © International Franchise Association. Reprinted by permission of the International Franchise Association. Chapter 8, page 252: Excerpt from “Steve Jobs and Steve Wozniak: The Personal Computer” from the Lemelson-MIT Program Web site. Courtesy of Inventor of the Week, Lemelson-MIT Program, http://web.mit.edu/invent. Chapter 8, page 253: Excerpts from “Interview with Evelyn Richards” by Wendy Marinaccio, appearing on the “Making the Mac/Technology and Culture in Silicon Valley” Web page, Stanford University Library. Reprinted by permission of the Stanford University Library. Chapter 8, page 253: “Highlights in Apple Company History” adapted from Apple timeline appearing in Macworld, February 2004. Copyright © 2004 Mac Publishing LLC. All rights reserved. Reprinted by permission. Chapter 8, page 255: “Mergers in the United States” MergerStat Review, 2004. Copyright © 2004 Mergerstat Holdings, LLP. Reprinted by permission of FactSet Mergerstat LLC. Chapter 9, page 282: Excerpt from “Subcontinental Drift” by Nandini Lakshman, Business Week, January 16, 2006. Copyright © 2006 by The McGraw-Hill Companies, Inc. Reprinted by special permission. Chapter 9, page 283: Excerpt from “Foreign Firms Come Bearing Jobs” by Mike Meyers, Star Tribune, September 5, 2004. Copyright © 2004 Star Tribune. All rights reserved. Reprinted by permission of the Star Tribune, Minneapolis – St. Paul, Minnesota. Chapter 10, page 312: Excerpts from “Congress Cuts Funding for Student Loans” by Anne Marie Chaker, The Wall Street Journal, December 22, 2005. Copyright © 2005 The Wall Street Journal. Reprinted by permission. Chapter 10, page 313: Excerpts from “It’s Payback Time” by Jonathan D. Glater, The New York Times, April 23, 2006. Copyright © 2006 by The New York Times Co. Reprinted with permission. Chapter 11, page 334: “Dow Jones Industrial Average, 1929-2006,” from Yahoo! Finance Web site. Copyright © 2006 Yahoo! Inc. YAHOO! and the YAHOO! Chapter 13, page 404: Excerpt from “The Search for a New Economic Order” by Robert Tolles, Ford Foundation, New York, 1982, p. 24. Reprinted by permission of the Ford Foundation. Chapter 13, page 405: Excerpts from “Open Editorial” by Bernice Davidson, The New York Times, September 29, 1972. Copyright © 1972 by The New York Times Co. Reprinted with permission. Chapter 14, page 44
0: Excerpts from “iPod Tax Planned for Music Downloads?” from the CNET Web site, March 10, 2006. Copyright © 2006 CNET Networks, Inc. All rights reserved. Reprinted by permission of Reprint Management Services. Chapter 14, page 441: Excerpt from “Internet Sales Tax,” from The New York Times, July 5, 2005. Copyright © 2005 by The New York Times Co. Reprinted with permission. Chapter 15, page 468: Excerpts from “Federal Budget Deﬁ cit Sparks Worries,” The Associated Press, January 15, 2006. Copyright © 2006 The Associated Press. All rights reserved. Reprinted by permission of Reprint Management Services. Chapter 15, page 469: Excerpt from “Snow Sets Sights on Deﬁ cits” by Edward Alden, Andrew Balls, and Holly Yeaser, Financial Times, November 4, 2005. Copyright © The Financial Times Ltd. 2005. Reprinted with permission. Chapter 16, page 504: Excerpts from “Fed Expected to Boost Key Interest Rates,” The Associated Press, May 10, 2006. Copyright © 2006 The Associated Press. All rights reserved. Reprinted by permission of Reprint Management Services. Chapter 16, page 505: Excerpts from “Bernanke Talks Tough on Inﬂ ation” by Edmund L. Andrews, The New York Times, June 6, 2006. Copyright © 2006 by The New York Times Co. Reprinted with permission. Chapter 17, page 521: “Tariffs are Falling,” from the Human Development Report, 2005, United Nations Development Programme. Reprinted by permission of the United Nations Publications Department. Chapter 17, page 538: Excerpt from “Sugar Daddies” by Jason Lee Steorts, National Review, July 18, 2005. Copyright © 2005 National Review. Reprinted by permission. Chapter 17, page 539: Excerpts from “Sweetener Impact on US Economy,” from the American Sugar Alliance Web site. Copyright © 2005 American Sugar Alliance. Reprinted by permission. Chapter 18, page 570: Excerpt from “From T-shirts to T-bonds,” The Economist, July 28, 2005. The Economist Newspaper Ltd. All rights reserved. Reprinted with permission. Further reproduction prohibited. www.economist.com. Chapter 18, page: Excerpts from “China’s Economic Miracle: The High Price of Progress,” from CBC News, April 20, 2006, Canadian Broadcasting Corporation Web site. Copyright © CBC 2006. Reprinted by permission. Skillbuilder Handbook Page R15: Excerpts from “Crude Oil Prices Sink Below $66 a Barrel,” The Associated Press, September 11, 2006. Copyright © 2006 The Associated Press. All rights reserved. Reprinted by permission of Reprint Management Services. Page R21: Excerpt from “U.S. Trade Deﬁ cit Hit Record High in 2005”by Vikas Bajaj, The New York Times, February 10, 2006. Copyright © 2006 by The New York Times Co. Reprinted with permission. Page R23: Excerpt from “Not Business as Usual” by Elizabeth Bauman, Online NewsHour Extra, January 30, 2002. Copyright © 2002 MacNeil-Lehrer Productions. Reprinted by permission. Page R27: Excerpt from “1942: Beveridge Lays Welfare Foundations,” from BBC Web site. Copyright © BBC. Reprinted by permission. Acknowledgments R79 Acknowledgments Art Credits Frontmatter cov top © Randy Faris/Corbis; bottom left © Peter Horree/Alamy Images; top right © Scott Olson/Getty Images; center right © Jochem D. Wijnands/Getty Images; bottom right © ShutterStock; iii top © Mark Lewis/Getty Images; second from top © Paul A. Souders/Corbis; third from top © Veer; third from bottom © Joeseph Sohm-Visions of America/Getty Images; second from bottom © Jack Dagley Photography/ShutterStock; bottom © Jose Luis Pelaez, Inc./Corbis; iv Sally Meek Photo courtesy of Isaac Portrait Photography, Dallas, Texas, isaacphotography.com; Mark Schug Photo courtesy of Diana Johnson, Northwestern University; John Morton Photo courtesy of Kathryn S. Morton; 4 © Getty Images. 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Unit 6 408–409 © Tom Bean/Getty Images; 411 Frank and Ernest reprinted with permission of Thaves; 416 © Ljupco Smokovski/ShutterStock; 419 Phil Coale/AP/Wide World Photos; 420 © Tim Boyle/Getty Images; 422 © Myrleen Ferguson Cate/PhotoEdit; 423 © Harley Schwadron/CartoonStock; 426 Photo courtesy of Sarah Brennan; 427 © Elizabeth Simpson/Getty Images; 428 © George Mattei/Photo Researchers, Inc.; 429 © Spencer Platt/Getty Images; 430 left © Getty Images; center © Jose Luis Pelaez, Inc./Corbis; right © Mark Wilson/Getty Images; 432 © Royalty-Free/Corbis; 433 Rachel Denny Clow/Corpus Christi Caller-Times/AP/Wide World Photos; 436 © Mike Lane/Caglecartoons.com; 438 © Dan Brandenburg/istockphoto.com; 439 © Michael Newman/PhotoEdit; 440 © G. Schuster/zefa/Corbis; 444–445 © I. 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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 3 5 4 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) 40 30 20 50 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
e for bowling alley managers is $16 per hour, why would a wage of $20 per hour result in a labor surplus? Why would a wage of $12 per hour lead to a labor shortage? 8. Solving Economic Problems What economic problem does the minimum wage try to address? 9. Applying Economic Concepts Explain why working conditions can either justify higher wages or make up for lower wages. 10. Making Inferences and Drawing Conclusions Despite efforts to close the wage gap between men and women, the gap has actually been widening. Using what you have learned in this section, write a paragraph discussing what could be done to close the gap. 11. Challenge Gary Becker said that economics “is easy in the sense that there are only a few principles that really guide most economic analysis.” Identify the basic principles behind how wages operate. Graphing Equilibrium Wages Read each job description below. Then make a graph showing a hypothetical equilibrium wage for each job using the same values for both axes in each graph. Job Description #1 Job Description #2 Structural metal worker for highrise construction project. Must have at least 2 years of experience. Filing clerk, small accounting office. No experience necessary, but must have a high school diploma or GED. Apply Economic Concepts Using the economic knowledge you gained in this section, briefly explain why each graph appears as it does. Challenge In many dangerous industries, including mining, safety laws establish standards that protect workers. Explain what effect these laws might have on wages. Use to complete this activity. @ ClassZone.com The Role of Labor 265 S E C T I O N 2 Trends in Today’s Labor Market TA K I N G N O T E S In Section 2, you will civilian labor force, p. 266 • identify the changes that have taken place in the labor force • explain how occupations have changed • explain how the way people work has changed outsourcing, p. 269 insourcing, p. 269 telecommuting, p. 270 contingent employment, p. 270 independent contractor, p. 270 As you read Section 2, complete a hierarchy chart like the one below. In each box write the main ideas. Use the Graphic Organizer at Interactive Review @ ClassZone.com Trends in Labor Market changing labor force A Changing Labor Force KEY CONCEPT S The labor market in the United States has changed dramatically since the 1950s, and it continues to change. For example, in the 1950s, many companies hired workers with the expectation that they would stay with the company for most of their working lives. After a lifetime of service, workers could count on company pension plans to help fund their retirement. Today, few workers stay with the same company their entire career, and workers take more responsibility for funding their retirement. Those are only some of the profound changes that affect the civilian labor force, people who are 16 or older who are employed or actively looking for and available to do work. The civilian labor force excludes people in the military, in prison, or in other institutions. In 2005, about 150 million Americans made up the civilian labor force. That figure was up from 126 million workers in 1990 and is expected to rise to almost 165 million workers by 2020. Labor Force The civilian labor force is composed of people age 16 or older who are working or looking for work. QUICK REFERENCE The civilian labor force is made up of people age 16 or older who are employed or actively looking for and available to do work. 266 Chapter 9 FIGURES 9.7 AND 9.8 MEN AND WOMEN IN THE U. S. LABOR FORCE FIGURE 9.7 NUMBER OF MEN AND WOMEN IN THE LABOR FORCE FIGURE 9.8 PERCENTAGE OF MEN AND WOMEN IN THE LABOR FORCE MEN WOMEN ) 80 70 60 50 40 30 20 10 MEN WOMEN 100 80 60 40 20 1950 1960 1970 1980 1990 2000 Source: U.S. Bureau of Labor Statistics Year 0 1950 1960 1970 1980 1990 2000 Year Source: U.S. Bureau of Labor Statistics ANALYZE GRAPHS 1. About how many more men were in the labor force than women in 1950? in 2000? 2. What percentage of the labor force did women account for in 1950? in 2000? Changes in the U.S. Labor Force To understand some of the changes in the U.S. labor force, consider these two scenes. In the first scene, the year is 1955. A young woman pulls into a gas station, and the attendant fills up her car with gas. Then she picks up her children at school and heads home to get dinner ready in time for her husband’s arrival from work. The second scene is set in today’s world. A young mother pulls into a gas station, swipes her credit card, and fills up her tank. Her business meeting ran long, and she is late getting to the daycare center. Her husband will pick up dinner for the family on his way home from work. One obvious change these scenes demonstrate is the addition of many more women to the work force. As shown in Figures 9.7 and 9.8, women have been a significant factor in the growth of the labor market in the United States. Since the 1950s, the kinds of jobs open to women have expanded. As job opportunities have improved, wages for women have risen, and many more women have been drawn into the work force. The U.S. work force has also become better educated. About 30 percent of people in the labor force have a college degree, and an additional 30 percent of workers have some college credits. In a work force with such a high degree of human capital, productivity and wages are also high compared with many other nations. AP P LI CATION Evaluating Economic Decisions A. Explain how rising opportunity costs have led more women into the workplace. Find an update on the U.S. work force at ClassZone.com The Role of Labor 267 Changing Occupations KEY CONCEPT S Economists group occupations into three economic sectors. The primary sector is made up of jobs related directly to natural resources, such as farming, forestry, fishing, and mining. Jobs in the secondary sector are related to the production of goods, including the materials and energy needed to produce them. Examples include welders, truck drivers, and construction workers. The tertiary sector is made up of service-related jobs in such industries as banking, insurance, retail, education, and communications. As you can see in Figures 9.9 and 9.10, U.S. manufacturing jobs have declined since the 1950s, while service-sector jobs have increased dramatically. All of the ten fastest-growing occupations are service related, most of them in the area of medical services. FIGURES 9.9 AND 9.10 EMPLOYMENT IN THE UNITED STATES BY ECONOMIC SECTOR FIGURE 9.9 EMPLOYMENT IN 1950 FIGURE 9.10 EMPLOYMENT IN 2000 3% 14% 33% 53% 18% 79% Primary Secondary Tertiary Primary Secondary Tertiary Source: U.S. Bureau of Labor Statistics Source: U.S. Bureau of Labor Statistics ANALYZE GRAPHS 1. Which sector grew the most from 1950 to 2000? By how much did it grow? 2. How much of the civilian labor force was employed in the combined primary and secondary sectors in 1950? How much in 2000? Technology and Change Think back for a moment to the young mother at the gas station. In the years between 1955 and today, the job of gas station attendant has been mainly replaced by the computerized, credit-card operated gasoline pump. In the same way, ATMs have greatly affected the occupation of bank teller. Technological changes have eliminated or redefined many other jobs in all three sectors. The personal computer and the Internet have drastically changed the way onthe-job information is stored, transferred, and used. About half of all American workers use a computer on the job. As a result, those occupations that support the 268 Chapter 9 1950s gas station 2000s gas station use of computers—software engineers and network and data communications analysts, for example—have been among the fastest growing in the United States. More than 80 percent of managers and professionals use a computer at work. However, even in less skilled jobs, more and more workers are using computers. About 20 percent of machine operators, laborers, and farmers use a computer on the job. Basic computer skills have become necessary for many different types of jobs. Globalization and Jobs Today’s labor market is global. Technology allows companies to employ people not just all over the country, but all over the world. Many companies have sought to cut their costs by outsourcing, the practice of contracting with an outside company to provide goods or services. Most outsourcing by U.S. companies goes to other U.S. companies. For example, many American businesses hire other American firms to handle their accounting. However, the term outsourcing has become connected with the practice of moving jobs from the United States to foreign countries where wages are lower. As this happens more frequently, it would seem that their American operations would lose jobs. But many companies actually add more jobs in the United States than they outsource abroad, just in different parts of their businesses. In 2004, IBM decided to send about 3,000 jobs overseas. But at the same time, it created about 4,500 jobs in the United States. The American economy has also benefited from insourcing, the practice of foreign companies establishing operations in, and therefore bringing jobs to, the United States. Both outsourcing and insourcing are tied to the trends toward more service-related jobs and more technology-related work. AP P LI CATION Predicting Economic Trends B. Think of an example of an occupation that is likely to be eliminated or substantially redefined as a result of technology. QUICK REFERENCE Outsourcing is the practice of contracting with an outside company, often in a foreign country, to provide goods or services. Insourcing is the practice of foreign companies establishing operations in, and therefore bringing jobs to, the United States. The Role of Labor 269 Changes in the Way People Work KEY CONCEPT S QUICK REFERENCE Telecommuting means performing office work in a location other than the traditional office. Contingent employment refers to t
emporary or part-time work. An independent contractor is someone who sells their services on a contract basis. The way people work has been transformed by technology. In the past, many workers needed to physically commute to and from an office in order to accomplish their work. The Internet and laptop computers have allowed some of these workers to engage in telecommuting, the practice of doing office work in a location other than the traditional office. But the job market has also changed. In the past, companies offered most workers permanent positions. Today, companies offer fewer permanent positions and more contingent employment, work that is temporary or part-time. Similarly, more people work as independent contractors, selling their services to businesses on a contract basis. People used to enter a field and stay in more or less the same line of work for most of their work life. Now, most people will change careers several times as the world of work continues to evolve. Working at the Office from Home Many telecommuters enjoy the reduced stress, flexibility in work time, and increased free time they have by avoiding a commute to work. Employers benefit from an expanded labor pool, increased productivity, and lower real estate costs. Society benefits, too, from fewer drivers on crowded freeways and lower pollution. However, there are also costs. People who work at home may feel that their work too often spills over into their personal time. Some miss the social life of the office and the chance to network. Some at-home workers also fear that on-site workers might be more likely to get promoted. Still, experts estimate that the number of telecommuting workers grew by about 20 percent each year from 2000 to 2005. YO U R EC TELECOM M UTING Where would you want to work? Technology allows people to work in many different places. Alternative work places have different benefits—and drawbacks—than the traditional office. ? ▲ Work at the office ▲ Work at the coffee shop 270 Chapter 9 Alternatives to Permanent Employment Through much of the 1900s, U.S. companies would hire workers for permanent, full-time jobs. Employees would work 40 hours per week in exchange for both wages and benefits. In the 1990s, companies began to hire fewer full-time employees and more contingent employees and contract workers. Contingent workers, sometimes called temps, make up over 5 percent of the total work force. Independent contractors make up over 7 percent of the work force. Hiring contingent employees and contract workers makes it easier for businesses to adjust their work force to suit production demands. Discharging temporary workers is easier and less costly than discharging permanent employees. Since most temporary workers do not receive benefits, labor costs are also lower. Most contingent workers would prefer to have the steady income and benefits that come with permanent, full-time employment. But many independent contractors prefer the flexibility of being their own boss to working in a permanent position. They are willing to take the risk of not having enough work to support themselves, and they find alternative ways to pay for health insurance and retirement. Businesses sometimes offer permanent positions to contingent and contract workers who have done a good job. Changing Careers More Often As technology has advanced, jobs have changed, too. Much of the work done today in the United States and other advanced countries did not exist 100 years ago. Some of the work did not exist even ten years ago. With every new technology, new types of jobs are created. But as technology advances, many older professions become less in demand or even obsolete. To fill the new jobs, workers must learn and adapt to the new technologies. Someone who started out as a radio repair technician might need to learn how to work with cellular phone technology. In a similar way, the economy changes more quickly than it did in the past. Companies have become more flexible, changing their business plans constantly to maximize profits. Globalization allows companies to move jobs across national boundaries. As the economy changes, workers must change and adapt. The technician who adapted to cellular phone technology might need to change yet again in a few years. AP P LI CATION Analyzing Cause and Effect Changing Careers As the demand for healthcare workers increases, some people will change careers to ﬁ ll these jobs. C. A 2003 report concluded that telecommuters can save their employers $5,000 a year. Explain how that savings may come about. The Role of Labor 271 For more on interpreting graphs, see the Skillbuilder Handbook, page R29. Drawing Conclusions from Graphs Drawing conclusions means analyzing a source of information and forming an opinion. You have already had some practice analyzing line and pie graphs in Chapters 6 and 8. These graphs are bar graphs. PRACTICING THE SKILL Begin by using the following strategies to analyze the graphs. They are similar to the strategies you used in Chapter 6 to analyze a line graph. Your analysis will enable you to draw conclusions about the information shown on the graphs. F I G U R E 9.11 A N D 9.12 FA S T ES T G ROW I N G O CC U PAT . S., 2004-2014 Read the title to identify the main idea of the graphs. FIGURE 9.11 FIGURE 9.12 Check the vertical axes. Note that the axes use different scales. Check the horizontal axes. Both axes list a variety of occupations. 800 700 600 500 400 300 200 100 il n o e r s s e R 60 50 40 30 20 10 is ti it d e r s n n Occupations N H e h e s a lt ti sis t a y si c i a n n a s sis Occupations o C h P p li ti o e g i n Source: U.S. Bureau of Labor Statistics projections Source: U.S. Bureau of Labor Statistics projections NOW PUT IT ALL TOGETHER Both graphs claim to present the same information. Compare the two graphs, and consider their differences. Read the source lines to confirm that the data come from a reliable source. T HINKING ECONOMICALLY Drawing Conclusions 1. What is the main difference between the two graphs? 2. Which graph really shows the fastest growing occupations? Explain your answer. 3. What would be a better title for each graph? 4. Which of these jobs are most likely to have higher than average wages? Why? 272 Chapter 9 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. outsourcing insourcing b. contingent employment independent contractor 2. Name three of the fastest growing occupations. What do they have in common? 3. What are the economic reasons that explain why so many women joined the labor force in the late 1900s? 4. Name two ways technology has altered the U.S. labor market. 5. For an employee, what are the advantages and disadvantages of telecommuting? 6. Using Your Notes Write a paragraph explaining how you can use the information in this section to prepare for your future career. Refer to your completed hierarchy chart to help you anticipate the employment trends you will be facing. Trends in Labor Market changing labor force Use the Graphic Organizer at Interactive Review @ ClassZone.com . Making Inferences and Drawing Conclusions Given the trends in the labor market, do you think today’s employees will need to be more independent than the last generation’s or less independent? Why? 8. Analyzing Cause and Effect Explain how changing technologies have led to workers changing careers more often. 9. Evaluating Economic Decisions The United States has shifted to an economy driven by service industries. The primary sector, which deals in natural resources, and the secondary sector, which produces goods, are both shrinking. Do you think the shift toward a service economy is helping American workers or hurting them? Give reasons for your answer. 10. Challenge Adam Smith explained that countries maximize their wealth when they concentrate on producing the goods that they produce most efficiently and rely on international trade for goods they don’t produce efficiently. Explain how outsourcing is an example of this concept. Examining Labor Market Trends Make a copy of the table below. On your copy, list the reasons for the trend toward contingent labor in the left column. In the right column, describe its impact on the labor force. Move to Contingent Labor Why? Impact on Labor Force Analyze Cause and Effect In what ways have women in the work force influenced the growth of contingent labor? In what ways has the growth of contingent labor influenced women? Challenge What personal issues might lead a worker to seek part-time employment? The Role of Labor 273 S E C T I O N 3 Organized Labor in the United States TA K I N G N O T E S In Section 3, you will labor union, p. 274 • describe how the labor strike, p. 274 movement developed in the United States • discuss why organized labor has declined in the United States • explain how labor unions affect wage rates and employment closed shop, p. 279 union shop, p. 279 right-to-work law, p. 279 collective bargaining, p. 280 binding arbitration, p. 280 As you read Section 3, complete a summary chart like the one below. In each box, write the main ideas for each topic. Use the Graphic Organizer at Interactive Review @ ClassZone.com Topic Main Ideas Related Facts Labor movement’s rise to power The Labor Movement’s Rise to Power KEY CONCEPT S Organized labor helped to shape the modern workplace. Most of the benefits that workers in the United States take for granted today did not exist 200 years ago. The eight-hour workday, the five-day work week, vacations, even sick leave—none of these basic amenities would have existed without the efforts of organized labor. In the industries of the 1800s, workers put in long hours—often 60 hours per week or more—for low pay. Factory laborers often worked in dangerous conditions. Individual workers had little power to demand improvements from a business owner. If a worker complained too much, they would be fired.
Workers in industrialized nations around the world faced similar problems, but this section will focus on the labor movement in the United States. To improve their bargaining power, factory workers in the 1800s began to join together and act as a group. A labor union is an organization of workers who collectively seek to improve wages, working conditions, benefits, job security, and other work-related matters. Unions attempted to negotiate with businesses to achieve their goals, but businesses often resisted. As unions sought ways to gain negotiating power, they turned to the strike, or work stoppage. The threat of shutting down production demonstrated the power of organized labor. Different types of unions addressed different needs. Some workers joined a craft union, a union of workers with similar skills who work in different industries for different employers. Examples include typesetters or, more recently, electricians. Others joined an industrial union, a union for workers with different skills who work in the same industry. For example, workers in the textile industry formed some of the earliest industrial unions. QUICK REFERENCE A labor union is an organization of workers that seeks to improve wages, working conditions, fringe benefits, job security, and other work-related matters for its members. A strike is a work stoppage used to convince an employer to meet union demands. 274 Chapter 9 Early Developments Local craft unions were the main kind of worker association during the early years of the United States. By the 1830s, local unions began joining together into federations to advance their common cause. The first national federation was the National Trades Union (NTU), founded in 1834. A financial crisis that gripped the country in 1837 brought an end to the NTU and temporarily subdued union activity. In 1869, organized labor took a huge step forward when Uriah Stephens founded the Knights of Labor. Unlike other unions, it organized workers by industry, not by trade or skill level. The Knights of Labor became a nationwide union and adopted political goals including an eight-hour workday for all workers and the end of child labor. Its membership grew quickly, especially after the union helped workers win concessions from the big railroad companies in the 1880s. During the explosion of industrialism in the late 1800s, employers strongly resisted the efforts of workers to organize, and many labor protests turned violent. • In 1886, one person was killed and several others were seriously wounded when police attacked workers protesting for an eight-hour workday outside the McCormick Harvester Company in Chicago. The next day, people gathered at Haymarket Square to protest the deaths, and police troops arrived to disperse the crowd. Someone threw a bomb into the police, killing seven officers, and the riot that followed left dozens of other people dead and hundreds injured. • In 1892, ten workers were killed in a strike against Carnegie Steel in Homestead, Pennsylvania, and the union was broken up. • In 1894, a strike in Illinois against the Pullman Palace Car Company won the support of railway workers across the country, who collectively brought the nation’s railroads to a halt. The dispute turned violent when National Guard troops were brought in to keep the nation’s railroads running. A federal court ruled that the American Railway Union could not interfere with the trains, and the strike was broken. A New Model for Unions The violence associated with organized labor, as well as its often controversial political agenda, led to a decline in union membership. But Samuel Gompers offered a different model for union organization. In 1886, he founded the American Federation of Labor (AFL), an organization of craft unions that focused on the interests of skilled labor. The AFL continued to seek improvements in wages, benefits, and working conditions, but it focused on achieving these goals through the economic power of workers, instead of through legislation. By the early 1900s, the AFL had a membership of about 1.7 million workers. Legal action against organized labor forced Gompers to modify his stance against political activity, and the AFL began supporting pro-union candidates. The International Ladies’ Garment Workers Union was founded in 1900. The union gained strength following successful strikes in 1909 and 1910. Perhaps the most famous Union Organizing A union rally takes place at a shipyard in 1943. The Role of Labor 275 F I G U R E 9.13 History of the American Labor Movement 1893 ▲ Eugene V. Debs founds the American Railway Union. 1869 ▲ Uriah Stephens founds the Knights of Labor. 1900 ▲ International Ladies’ Garment Workers’ Union founded. 1825 1850 1875 1834 National Trades Union formed. 1886 ▲ Protest in Chicago, advertised by this flyer, turns into the Haymarket Riot. 1900 1894 Labor Day becomes a national holiday. 1886 American Federation of Labor (AFL) founded by Samuel Gompers. woman to participate in the U.S. labor movement was Mary Harris Jones, known as Mother Jones. In 1903, she led 80 children, many of whom had been injured while working, on a march to the home of President Theodore Roosevelt. The march helped to emphasize the need for child labor laws. Unions Gain Power During the Great Depression of the 1930s, union membership in the United States declined as millions of people lost their jobs. Yet unions gained power through laws passed as part of the New Deal, a series of reforms that attempted to revive the country’s economy. • The Norris-LaGuardia Act (1932) outlawed the practice of hiring only workers who agreed not to join a union. It also required employers to allow workers to organize without interference from their employer. • The National Labor Relations Act (1935), also known as the Wagner Act, protected the rights of workers in the private sector to form unions and to use strikes and other job actions. • The Fair Labor Standards Act (1938) set a minimum wage, required extra pay for overtime work, and made most child labor illegal. During this period, the Congress of Industrial Organizations (CIO) organized unions for industrial workers. Originally part of the AFL, which favored skilled workers in craft unions, the CIO broke away in 1938. The two organizations came together again in 1955 as the AFL-CIO. The AFL succeeded in organizing the United Auto Workers (UAW) union in 1935. After a tense sit-down strike in Flint, Michigan, in 1937, General Motors 276 Chapter 9 2005 Service Employees International Union breaks away from AFL-CIO. 2000 1962 ▲ Cesar Chavez founds National Farm Workers Association (NFWA), which later becomes United Farm Workers. 1975 1981 ▲ Air traffic controllers’ strike is unsuccessful. 1925 1950 1935 Congress passes the National Labor Relations Act, also called the Wagner Act. 1959 Congress passes Landrum-Griffin Act. 1935 United Auto Workers organized. became the first automaker to recognize the union. Chrysler and Ford soon followed. In the 1940s, Walter Philip Reuther, as president of the UAW, helped auto workers become some of the nation’s highest paid industrial workers. Also in the 1940s, John L. Lewis, the tough-talking, cigar-smoking leader of the CIO, brought his own United Mine Workers back from near failure and waged a fierce and successful fight to organize the nation’s steelworkers. Backlash Against Unions Following World War II The end of World War II ushered in a period of anti-union legislation. In 1947, over the veto of President Harry S. Truman, the Taft-Hartley Act was passed. It amended the Wagner Act and limited union activities, increasing the government’s power to intervene if a strike might threaten national security. America’s fear of Communism, the political and economic system of the Soviet Union, led to further restrictions on unions. The Landrum-Griffin Act (1959) forbade communists from holding union offices and required tighter financial and electoral accounting. George Meany, president of the AFL-CIO from 1955 to 1979, was a strong anti-communist and worked to get rid of unions that he considered sympathetic to communist ideas. AP P LI CATION Comparing and Contrasting Economic Information A. What motivated workers in the 1800s to form unions? Why did they continue to form unions in the early- to mid-1900s? The Role of Labor 277 The Labor Movement’s Steady Decline KEY CONCEPT S For 30 years following World War II, labor unions represented about 30 percent of the U.S. work force. Since the mid-1970s, membership in unions has declined steadily, falling to about 12.5 percent in 2005. The decline in unions can be traced to three causes: unions’ tarnished reputations, changes in the labor force, and laws restricting union influence. Loss of Reputation and Labor Force Changes In the late 1900s, labor unions began to lose their luster in the eyes of many Americans. Prolonged strikes both disrupted the public and placed a burden on the striking families. Some unions began requiring companies to employ more workers than necessary, a tactic known as featherbedding. Featherbedding, especially in the railroad industry, raised criticisms of wastefulness. Investigators discovered that a few labor unions had ties to organized crime, which reflected badly on all unions. The changing nature of the U.S. work force also led to reduced union membership. Union membership was traditionally rooted in manufacturing industries. But the number of manufacturing jobs in the United States fell sharply in the second half of the 20th century as the economy shifted toward service industries. The increase in the number of contingent and contract workers also led to lower union membership because such workers are less likely to pursue union representation. As manufacturing declined, unions shifted their organizing efforts toward service workers. The American Federation of State, County, and Municipal Employees FIGURE 9.14 UNION MEMBERSHI P I N THE U N I T
ED STATES Find an update on labor unions at ClassZone.com 40 30 20 10 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Bureau of Labor Statistics Year ANALYZE GRAPHS 1. During this time period, when was union membership highest? What percent of the labor force belonged to a union that year? 2. Which year was union membership lowest, and what percent of the labor force belonged to a union then? 278 Chapter 9 had about 1.4 million members in 2005. The Service Employees International Union (SEIU), which organizes such service workers as caregivers and janitors, had a membership of 1.8 million in 2005. The SEIU was the largest union in the AFL-CIO, but in 2005 it left the group. Several other smaller unions also left the AFL-CIO and joined SEIU to form a new coalition with different priorities. Right-to-Work Laws Another factor in the steady decline of union membership in the United States is legislation that tries to limit union influence. Unions had developed the closed shop, a business required to hire only union members. The closed shop was intended to maintain union standards for workers who only work at a business briefly, such as musicians or restaurant employees. Unions also developed the union shop, a business where workers are required to join a union within a set time period after being hired. Union shops allowed businesses to hire nonunion workers without diluting the strength of the union. The Taft-Hartley Act outlawed the closed shop and weakened possibilities for a union shop. It also gave states the power to make it illegal to require workers to join unions. Such laws became known as right-to-work laws, a name meant to emphasize that workers are free not to join a union. However, the effect of right-to-work laws and similar legislation is to weaken unions and to help businesses operate without unions. Most right-to-work states are in the Southeast and the central West, and union membership in these areas is low. F I G U R E 9 .15 RIGHT-TO-WORK STATES MAP QUICK REFERENCE A closed shop is a business where an employer can hire only union members. A union shop is a business where workers are required to join a union within a set time period after being hired. Right-to-work laws make it illegal to require workers to join unions. Wash. Oregon Montana N.Dak. Minn. Idaho Wyoming S.Dak. Wisc. Mich. Nev. Calif. Utah Colorado Nebr. Iowa Kansas Mo. Arizona N. Mex. Okla. Ark. Ill. Ind. Pa. Ohio Ky. Tenn. W.Va. Va. N.C. S.C. N.H. Maine Vt. N.Y. Mass. R.I. Conn. N.J. Del. Md. Alaska Hawaii Miss. Ala. Ga. Texas La. Fla. Right-to-Work State AP P LI CATION Predicting Economic Trends B. Consider the trends in today’s labor force that you learned about in Section 2. As more service industries unionize, is union membership, as a percent of the labor force, likely to return to the levels of the mid-1900s? Why or why not? The Role of Labor 279 Union Negotiating Methods KEY CONCEPT S QUICK REFERENCE Collective bargaining is the way businesses and unions negotiate wages and working conditions. Despite the decline in membership, organized labor still wields power in the American economy. Unions continue to use collective bargaining, the process of negotiation between businesses and their organized employees to establish wages and to improve working conditions. Since it represents many employees together, a union can arrive at a better deal for workers than if each employee bargained with the employer separately. As a result, unionized companies tend to pay higher wages than companies without unions. Collective Bargaining In the 1930s and 1940s, unions negotiated for higher wages, better working conditions, and fair grievance procedures for workers who felt that they had been treated unjustly. As these demands were increasingly met, unions negotiated for job security and such fringe benefits as health insurance. Benefits and job security are important issues in today’s negotiations as well, but in many cases today’s workers are not pressing for higher wages. Instead they are trying to hold the line against pay cuts and reductions in benefits, including pensions. Unions have the threat of a strike to provide a motivation for management to come to terms, but strikes occur much less frequently than in the past. Large-scale work stoppages in the United States occurred hundreds of times a year before the 1980s but dropped to about 20 per year by the 2000s. This is partly a result of the decline in union membership, but it also reflects the willingness of management to use replacement workers or to close a plant permanently. The vast majority of union contracts are settled without such action. However, some negotiations require additional interventions if the two sides cannot agree. First, a mediator may be brought in to help the sides come to terms. If that fails, the dispute may be settled by binding arbitration—a decision by a neutral third party that each side agrees ahead of time to accept. For industries related to public safety, the government might issue an injunction to force workers back to work after a stoppage, or to stop protest activities that may interfere with public safety. Collective Bargaining Union leaders meet with business management to negotiate the details of union contracts. APPLICATION Analyzing Cause and Effect C. Explain why high wages and high employment do not necessarily go hand in hand. QUICK REFERENCE Binding arbitration is a process in which an impartial third party resolves disputes between management and unions. 280 Chapter 9 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. closed shop union shop b. strike collective bargaining 2. Why was the formation of the Knights of Labor a key event for organized labor in the United States? 3. Name two laws that supported labor’s rights and two laws that restricted them. 4. Opponents of right-to-work laws sometimes call them “work-for- less” laws. Why do you think they use that name? 5. Why would a business care if its workers went on strike? 6. Using Your Notes Write a paragraph explaining why unions grew in the 1800s and the first half of the 1900s. Refer to your completed summary chart to help you develop your argument with strong supporting detail. Topic Main Ideas Related Facts Labor movement’s rise to power Use the Graphic Organizer at Interactive Review @ ClassZone.com . Analyzing Cause and Effect What effect might outsourcing have on union membership? 8. Evaluating Economic Decisions In 1981, a group of air traffic controllers, employees of the Federal Aviation Administration, went on strike. They wanted to reduce their workweek to 32 hours instead of the usual 40 because of the high stress of their jobs. President Ronald Reagan broke the strike and disbanded the union of air traffic controllers, claiming that they were striking illegally. About 100 strikers were arrested, and all of them were banned for life from jobs in air traffic control. Did Reagan do the right thing by firing the striking workers? Explain your answer. 9. Challenge The firing of the air traffic controllers and the breaking of their union was one of the key events for labor in the United States. What trends in organized labor are evident in that event? Automated factories reduced the need for assembly line workers. Analyzing Economic Data Look at Figure 9.14 on page 278, which shows changes in union membership in the United States. Analyze Union Membership Compare the upward and downward movements of the graph to the events going on in the United States and world. 1930s—The Great Depression 1940s—World War II; postwar recovery 1950s—Korean War; economy thrives 1960s—Civil Rights movement; Vietnam War; steady economy 1970s—End of Vietnam War; oil embargo; inflation 1980s—Recession and recovery 1990s—Fall of Communism in Europe and Russia; Internet boom 2000s—September 11; Iraq War; recession and recovery Challenge Does there seem to be a relationship between how well the economy is doing and union membership? Explain. The Role of Labor 281 Case Study Find an update on this Case Study at ClassZone.com Managing Change in Your Work Life Background The United States economy has shifted from manufacturing to service and knowledge-based industries. New technologies offer increasingly sophisticated tools. Telecommuting provides businesses the option of having employees work effectively from outside the office. Globalization has revolutionized the way companies do business. Companies are no longer tied to a specific location. Instead, they establish offices around the globe. The outsourcing and insourcing of jobs result both in benefits and challenges. The dynamics of the workplace are defined by a single factor—change. What’s the issue? How will you respond to the changing dynamics of the work environment? Study these sources to discover how change affects the type of work we do, as well as where and how we do it. A. Online Magazine Article Call centers in India help businesses reduce costs because local wages are low. But some Westerners accept the low wages for a chance to live in India. Subcontinental Drift More Westerners are beefing up their resumés with a stint in India After a year answering phones for Swiss International Air Lines Ltd. in a Geneva call center, Myriam Vock was eager to see something of the world. So she packed her bags and hopped a plane to India. Two and a half years later she’s still there, sharing a five-bedroom apartment in an upscale New Delhi suburb with four other foreigners. And how does she pay the bills? She works in a call center, getting paid a fraction of what she did back home. “I’m not earning much, but there is enough to live well and travel,” says Vock, 21. . . . “I don’t pay taxes here, and life is so much cheaper,” she says. Worried about your job fleeing to India? One strategy is to chase it—an option a growing number of twen
tysomething Westerners are choosing. Sure, the trend will never make up for the thousands of positions lost back home, but for adventurous young people, a spell in a call center in Bangalore or Bombay can help defray the costs of a grand tour of the subcontinent and beyond. Source: BusinessWeek.com, January 16, 2006 Call centers in India serve customers of companies all over the world. Thinking Economically Explain Myriam’s decision to work in a call center in India using cost-benefit analysis. 282 Chapter 9 B. Business Cartoon Canadian cartoonist Andrew Toos drew this cartoon about working in an increasingly technological society. Source: www.CartoonStock.com Thinking Economically What does the cartoon suggest about new technological developments in the world of work? Explain your answer. C. Online Newspaper Article Many worry that outsourcing may reduce the number of jobs in the United States. This article presents a different perspective. Outsourcing Beneﬁ ts Permac Employees Permac creates a win-win situation. Permac Industries in Burnsville [Minnesota] fashions parts ranging from rings that tie parachutes to small planes to parts for soda fountain machines and construction trucks. President and CEO Darlene Miller plans to send some work to China, but she said it’s to the benefit of her 27 Minnesota employees. “No one here will lose a job. We’re not planning to let anybody go—in fact, we’re hiring,” she said. Miller is investing in a $700,000 piece of equipment to give workers in Burnsville better tools for specialized work that demands higher skills than the work she plans to send to China. A side benefit for the company’s Burnsville workers is that the work going to China will reduce the need for what at times has seemed relentless overtime. “The simple parts eat up a lot of machine time,” said John Keith, a Permac team leader. “If we farm that out we have time to look at getting new business, more complicated business.” Source: www.startribune.com, September 5, 2004 Thinking Economically How will Permac employees benefit from outsourcing? Identify others who also will benefit and explain why. THINKING ECONOMICALLY Synthesizing 1. What skills are you likely to need in order to manage change successfully in your work life? Support your answer with examples from the documents. 2. In documents A and B, are the types of change similar or different? Are their effects on workers positive or negative? Explain your answer. 3. Compare the opportunities afforded by change in documents A and C. How are they similar? How are they different? The Role of Labor 283 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. civilian labor force closed shop collective bargaining contingent employment craft union derived demand equilibrium wage glass ceiling human capital industrial union insourcing labor union minimum wage outsourcing productivity right-to-work law strike telecommuting union shop wages 1 are the cost of labor. The demand for labor is a 2 , growing out of the demand for the goods or services workers can produce. The forces of supply and demand determine the 3 , at which there is neither a surplus nor a shortage of workers. Wages are directly correlated to a worker’s 4 . Workers with the lowest level often earn only the 5 . Since the 1950s, many women have entered the 6 . They are sometimes limited by the 7 , which keeps them from reaching the highest levels of management. Other trends in the labor market include 8 , working away from a central office, and 9 , working part-time or temporary jobs. U.S. firms sometimes use 10 to hire workers in other countries. When foreign companies open plants in the United States, it is called 11 . Changes in the work force have reduced the number of workers who belong to a 12 . Such organizations press for higher pay and better working conditions through 13 . If talks fail, union workers might 14 , putting pressure on employers to meet their demands. 284 Chapter 9 CHAPTER 9 Assessment How Are Wages Determined? (pp. 258–265) 1. What forces determine the equilibrium wage? 2. What four factors contribute to differences in wages? Trends in Today’s Labor Market (pp. 266–273) 3. How has the labor market in the United States changed since the 1950s? 4. Name two new developments in the way Americans work. Organized Labor in the United States (pp. 274–283) 5. Name an important U.S. labor leader and describe what he or she contributed to the labor movement. 6. What are some of the reasons membership in unions has declined since the 1950s? A P P LY The table below shows the median weekly earnings of full-time wage and salary workers by union affiliation and selected characteristics. FIGURE 9.16 UNION AND NONUNION WAGES Median Weekly Earnings of Full-Time Workers in the United States (in dollars) Race or Ethnicity Union Nonunion Men Women Men Women African-American Asian Hispanic White 689 819 713 884 632 789 609 749 523 827 473 714 478 643 414 576 Source: U.S. Bureau of Labor Statistics, 2005 data 7. What is the only group for which union affiliation does not yield higher pay? 8. Calculate the percentage difference between each group’s union and nonunion wages. Which group gains the most in wages from union membership. Creating Graphs Create a bar graph using the following information about alternative work arrangements in the United States. Include an appropriate title and a source line showing that the data, which are for 2005, come from the Bureau of Labor Statistics. Independent contractors (Self-employed workers, such as independent sales consultants or freelance writers): 10.3 million On-call workers (Workers called as needed, sometimes working several days or weeks in a row, such as substitute teachers): 2.5 million Temporary workers (Workers paid by the hour, such as file clerks, hired through a temporary employment agency): 1.2 million Contract workers (Workers paid a salary, such as training specialists, provided by contract firms and hired for a limited contract): 0.8 million Use to complete this activity. @ ClassZone.com 10. Synthesizing Economic Data Explain the differences in median weekly earnings in Figure 9.16 in terms of this chapter’s key concepts. 11. Explaining an Economic Concept Have you ever been paid to work? If so, explain how the rate you were paid was determined. If not, think of someone you know who has earned money and explain how that person’s wages were determined. 12. Applying Economic Concepts Think back to a time when you negotiated with someone in a position of authority for something you strongly wanted. Briefly describe the tactics you used and look for similarities or differences between those and the tactics unions use with employers. 13. Challenge In 2003, the Fair Labor Standards Act was amended to clarify who was entitled to overtime pay. At the center of the issue were computer programmers, who lost entitlement to overtime if their regular pay is $65,000 per year or more. What impact might this have had on the workers and the economy Collective Bargaining It’s time to renegotiate the union contract at the Acme auto parts factory in Springfield. Read these descriptions of the two sides, then follow the instructions to experience what union negotiations are like. Union workers currently earn $25 per hour, plus overtime pay if they have to work more than 35 hours per week. Benefits include health-care insurance paid for by the company, plus vision and dental coverage, also funded by the company. The workers’ pension fund is handled through the union. The Acme company is a conglomerate based in the United States. Its auto parts business has been struggling to make a profit, so it is considering outsourcing the work to a factory in China. It would then like to turn the Springfield factory into a computer manufacturing facility. Step 1 Divide the class evenly into union members and the Acme management team. Step 2 Separately and privately, each group discusses its objectives and negotiating strategies. Try to keep the conversation quiet so that the other side does not gain an advantage by learning your bargaining points. Step 3 Each group chooses three representatives to conduct the negotiations. Step 4 The representatives from both sides meet and negotiate the new contract. The rest of the two groups may listen to the negotiations, but they may not participate. If the two sides still disagree on an issue after several minutes of negotiations, put that issue aside for the moment. Keep a list showing the status of each issue. Step 5 If time permits, repeat steps 2–4 to address the unresolved issues. Discuss what happened. Did one side have more bargaining power? How did the two sides resolve their differences? Why were some issues more difficult to resolve than others? The Role of Labor 285 Macroeconomics U n i t 4 Money, Banking, and Finance What constitutes money? Money isn’t born, it’s made. Each society decides what it will accept as money, but effective moneys all share certain attributes and perform certain functions. 286 CHAPTER 10 SECTION 1 Money: Its Functions and Properties SECTION 2 The Development of U.S. Banking SECTION 3 Innovations in Modern Banking CASE STUDY Student Loans Money and Banking Macroeconomics is the study of the behavior of the economy as a whole and how major economic sectors, such as industry and government, interact. C H A P T E R 10 Money provides a low-cost method of trading one good or service for another. It makes the system of voluntary exchange efficient AT T E R S What were the last three economic transactions you completed using money? Perhaps you put four quarters in the fare machine on the bus to school or bought a slice of pizz
a and a drink in the cafeteria at lunch. Or maybe you caught an early movie after school yesterday. To gauge the importance of money to the economy, imagine trying to make such transactions without the familiar paper bills and coins. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on student loans. (See Case Study, pp. 312–313.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. Source: www.CartoonStock.com How important are student loans in the U.S. higher education system? See the Case Study on pages 312–313. Money and Banking 287 S E C T I O N 1 Money: Its Functions and Properties TA K I N G N O T E S In Section 1, you will money, p. 288 • outline the functions that money performs and the characteristics that money possesses • explain why the different types of money have value • describe how the money supply in the United States is measured medium of exchange, p. 288 barter, p. 288 standard of value, p. 289 store of value, p. 289 commodity money, p. 291 representative money, p. 291 fiat money, p. 291 currency, p. 293 demand deposits, p. 293 near money, p. 293 Functions of Money As you read Section 1, complete a cluster diagram summarizing key information about money. Use the Graphic Organizer at Interactive Review @ ClassZone.com Money QUICK REFERENCE Money is anything that people will accept in exchange for goods and services. A medium of exchange is a means through which goods and services can be exchanged. Barter is the exchange of goods and services without using money. KEY CONCEPT S What do the following things have in common: cattle, corn, rice, salt, copper, gold, silver, seashells, stones, and whale teeth? At different times and in different places, they have all been used as money. In fact, money is anything that people will accept as payment for goods and services. Whatever it is that people choose to use as money, it should perform three important functions. FUNCTION 1 Medium of Exchange Money must serve as a medium of exchange, or the means through which goods and services can be exchanged. Without money, economic transactions must be made through barter—exchanging goods and services for other goods and services. Barter is cumbersome and inefficient because two people who want to barter must at the same time want what the other has to offer. For example, suppose you want to trade two T-shirts for a pair of jeans. One classmate might have the jeans but not want your shirts; another might want your shirts but not have jeans to trade. It is much easier for you to buy a pair of jeans by giving money to the seller who, in turn, can use it to buy something else. Money allows for the precise and flexible pricing of goods and services, making any economic transaction convenient. 288 Chapter 10 A World of Money Currencies come in a wide variety of colors and sizes. This is a collage of the currencies of South America. FUNC T ION 2 Standard of Value Money also serves as a standard of value, the yardstick of economic worth in the exchange process. It allows people to measure the relative costs of goods and services. A $20 T-shirt is worth two $10 phone cards, four $5 burritos, or twenty $1 bus rides. The basic monetary unit in the United States is the dollar, which serves as the standard by which the economic worth of all goods and services can be expressed and measured. FUNC T ION 3 Store of Value Finally, money acts as a store of value, that is, something that holds its value over time. People, therefore, do not need to spend all their money at once or in one place; they can put it aside for later use. They know that it will be accepted wherever and whenever it is presented to purchase goods and services. One situation where money does not function well as a store of value is when the economy experiences significant inflation—a sustained rise in the general level of prices. For example, in Argentina in the first half of 2002, prices rose by about 70 percent. Basic goods that cost 150 pesos in January cost 255 pesos in June. In other words, in that time period, Argentina’s money lost over two-thirds of its purchasing power. You’ll learn more about inflation in Chapter 13. QUICK REFERENCE A standard of value determines the economic worth in the exchange process. A store of value is something that holds its value over time. Find an update on the functions of money at ClassZone.com 10 .1 Functions of Money ?What Functions Does Money Perform? Standard of Value Money provides both a way to express and measure the relative costs of goods and services and a way to compare the worths of different goods and services. Medium of Exchange Money provides a flexible, precise, and convenient way to exchange goods and services. Store of Value Money holds its value over time. It can be saved for later use because it can be exchanged at any time for goods and services. ANALYZE CHARTS You’ve read that salt was used as money in the past. How effectively do you think salt would function as money? Use the three functions of money in the chart to frame your answer. AP P LI CATION Applying Economic Concepts A. How does money help to make clear the opportunity cost of an economic decision? Money and Banking 289 Properties of Money KEY CONCEPT S To perform the three functions of money, an item must possess certain physical and economic properties. Physical properties of money are the characteristics of the item itself. Economic properties are linked to the role that money plays in the market. PROPERTY 1 Physical The following are physical properties of useful money: Durability Money should be durable, or sturdy, enough to last throughout many transactions. Something that falls apart when several people handle it or that spoils easily would not be a good item to use as money. Portability Money needs to be small, light, and easy to carry. It’s easy to see why paper bills are preferable to cattle as money. Divisibility Money should also be divisible so that change can be made. For example, the dollar can be divided an endless number of ways using different combinations of pennies, nickels, dimes, or quarters. Divisibility also allows flexible pricing. Uniformity Lastly, money must be uniform, having features and markings that make it recognizable. Coins that are used as money look different from other flat metal disks. Paper money is a consistent size and uses special symbols and printing techniques. All money that represents a certain amount in a given country has distinctive characteristics that help identify its value. These distinctive markings also make it more difficult to counterfeit. Chinese Coins Bronze, spadeshaped coins, 8th–7th century B.C. PROPERTY 2 Economic Useful money must also have the following economic properties: Stability of Value Money’s purchasing power, or value, should be relatively stable. In other words, the amount of goods and services that you can buy with a certain amount of money should not change quickly. Rapid changes in purchasing power would mean that money would not successfully serve as a store of value. Scarcity Money must be scarce to have any value. As you recall from Chapter 7, when the supply of a product outstrips demand, there is a surplus and prices for that product fall. Similarly, when the supply of money outstrips demand, money loses value, or purchasing power. Acceptability People who use the money must agree that it is acceptable—that it is a valid medium of exchange. In other words, they will accept money in payment for goods and services because others will also accept it as payment. APPLICATION Applying Economic Concepts B. Describe how U.S. dollars serve each of the three functions of money. 290 Chapter 10 Types of Money KEY C ONCEPT S In the discussion of the functions and properties of money, one theme recurs—value. Money draws its value from three possible sources. Commodity money derives its value from the type of material from which it is composed. Representative money is paper money backed by something tangible—such as silver or gold—that gives it value. Fiat money has no tangible backing, but it is declared by the government that issues it, and accepted by citizens who use it, to have worth. T YPE 1 Commodity Money Commodity money is something that has value for what it is. Items used as commodity money have value in and of themselves, apart from their value as money. Over the course of history, for example, gold, silver, precious stones, salt, olive oil, and rice have all been valued enough for their scarcity or for their usefulness to be used as money. QUICK REFERENCE Commodity money has intrinsic value based on the material from which it is made. Representative money is backed by something tangible. Fiat money is declared by the government and accepted by citizens to have worth. However, the most common form of commodity money throughout history has been coins made from precious metals. Such coins contain enough of the precious metal that if each was melted down it would be worth at least its face value. One problem with commodity money is that if the item becomes too valuable, people will hoard it rather than circulate it, hoping it will become more valuable in the future. Commodity money is rarely used today. Commodity Money Until recently, cattle was an important medium of exchange for the Masai people of East Africa. T YPE 2 Representative Money Representative money is paper money that can be exchanged for something else of value. The earliest forms of representative money were seen in the Middle Ages, when merchants, goldsmiths, and moneylenders began issuing receipts that promised to pay a certain amount of gold or silver. This came about because it was not always convenient or safe to transport large quantities of those precious metals from place to place for the purpose of trading. These practices signal the beginning of the wid
espread modern use of paper money. Eventually, governments got involved with representative money by regulating how much metal needed to be stored to back up the paper money. One problem with representative money is that its value fluctuates with the supply and price of gold or silver, which can cause problems of inflation or deflation—a sustained rise or fall, respectively, in the general level of prices. Money and Banking 291 The Euro as a Common Currency EU Members That Adopted the Euro in 2002 On January 1, 2002, a new currency—the euro—was put into full use in 12 European countries, each a member of the European Union (EU). The symbol for the euro is . Each country that adopted the euro gave up its own national currency The EU seeks the economic and political integration of Europe, and the euro is a key step toward this goal. The common currency makes trade among member nations easier and cheaper. As the EU expands, new members must meet specific economic standards before they can adopt the euro. Several small European countries that are not members of the EU have also begun using the euro. Like all modern currencies, the euro is categorized as fiat money. Its value is derived from public confidence in the EU. Control of the supply of euros is maintained by the European Central Bank, located in Frankfurt, Germany. Each member nation of the EU has a seat on the Central Bank’s decision-making board. CONNECTING ACROSS THE GLOBE 1. Making Inferences How do you think having a common currency might benefit the EU? 2. Recognizing Effects Why does the euro have value as currency? Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain TYPE 3 Fiat Money Unlike representative money, fiat money has value only because the government has issued a fiat, or order, saying that this is the case. The value of the U.S. dollar was linked to the value of gold until 1971. Since then, a $10 bill can no longer be exchanged for gold; it can only be converted into other combinations of U.S. currency that also equal $10. In fiat money, coins contain only a token amount of precious metal that is worth far less than the face value of those coins. Paper money has no intrinsic value, and people cannot exchange it for a certain amount of gold or silver. Fiat money has value because the government says it can be used as money and because people accept that it will fulfill all the functions of money. Dollar bills in the United States carry the statement “This note is legal tender for all debts, public and private.” This statement assures people that sellers will accept such money from buyers as payment for goods or services and lenders will accept it as payment for debts. A crucial role of the government in maintaining the value of fiat money is controlling its supply—in other words, maintaining its scarcity. APPLICATION Analyzing Cause and Effect C. Which type of money’s value would be most affected by political instability? Why? 292 Chapter 10 Money in the United States KEY C ONCEPT S In this section so far, you have learned what has been used as money, what functions money performs, what properties it possesses, and why money has value. But what serves as money in the United States today? In its narrowest sense, money consists of what can be used immediately for transactions—currency, demand deposits, and other checkable deposits. Currency is paper money and coins. Checking accounts are called demand deposits because funds in checking accounts can be converted into currency “on demand.” There are other monetary instruments that are almost, but not exactly, like money. Known as near money, it includes savings accounts and other similar time deposits that cannot be used as a medium of exchange but can be converted into cash relatively easily. QUICK REFERENCE Currency is paper money and coins. Demand deposits are checking accounts. Near money is savings accounts and time deposits that can be converted into cash relatively easily. Money in the Narrowest Sense In the narrowest sense, money is what can be immediately used for transactions. This definition of money sometimes uses the term transactions money. Most of the money that you and your friends and family spend is transactions money. About half of such money is currency, both paper money and coins, that is used by individuals and businesses. Most demand deposits are noninterest-bearing checking accounts that can be converted into currency simply by writing a check. Traveler’s checks, which are drafts that can be purchased in a number of money amounts and redeemed in many parts of the world, represent a small share of overall demand deposits. Other checkable deposits include negotiable order of withdrawal (NOW) accounts, which are interest-bearing savings accounts against which drafts may be written. Are Savings Accounts Money? Near money, such as savings accounts and other interest-bearing accounts, cannot be used directly to make transactions. Your local sporting goods store will not accept a savings passbook as payment for a new basketball or for your tennis racket to be restrung. But money in a savings account can be easily transferred into a checking account or removed directly from an automatic teller machine and put toward a desired good or service. Near money takes many forms in addition to traditional savings accounts. Time deposits are funds that people place in a financial institution for a specific period of time in return for a higher interest rate. These deposits are often placed in certificates of deposit (CDs). Money market accounts place restrictions on the number of transactions you can make in a month and require you to maintain a certain balance in the account (as low as $500 but often substantially more) in order to receive a higher rate of interest. Near Money A savings account contains money but is not, strictly, money. Money and Banking 293 How Much Money? How much money is in supply in the United States? Economists use various instruments to measure the money supply, but the most often cited are M1 and M2. M1 is the narrowest measure of the money supply, consisting of currency, demand deposits, and other checkable deposits. It is synonymous with transactions money. The elements of M1 are referred to as liquid assets, which means that they are or can easily become currency. M2 is a broader measure of the money supply, consisting of M1 plus various kinds of near money. M2 includes savings accounts, other small-denomination time deposits (CDs of less than $100,000), and money market mutual funds. You will learn about these financial instruments in Chapter 11. Figure 10.2 shows the amounts of the different forms of money that make up M1 and M2. You can see that M1 is almost evenly split between currency and checkable deposits. Notice that more of M2 comes from savings than from M1. You will learn the importance of the money supply in the economy and how the government manages it in Chapter 16. Find an update on measures of the money supply at ClassZone.com FIGURE 10.2 COMPONENTS OF THE U. S. MONEY SUPPLY M1 (in billions of dollars) Currency Demand deposits* Other checkable deposits TOTAL * includes traveler’s checks 723.8 328.2 316.9 1,368.9 M2 (in billions of dollars) Savings deposits M1 Small time deposits Money market mutual funds 3,620.5 1,368.9 973.7 717.4 23.1% 52.9% 24.0% 14.6% 10.7% 54.2% TOTAL includes money market accounts 6,680.5 20.5% Source: U.S. Federal Reserve Board (data from 2005) Currency Demand deposits Other checkable deposits Savings deposits M1 Small time deposits Money market mutual funds ANALYZE TABLES 1. What amount of M2 does not come from currency and checkable deposits? 2. If currency is 52.9 percent of M1, and M1 is 20.5 percent of M2, what percentage of M2 is currency? APPLICATION Applying Economic Concepts D. Classify each of the following as M1 and M2: a. dollar bill; b. savings account; c. money market account; d. traveler’s check; e. $50,000 CD. 294 Chapter 10 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the difference between the terms in each of these pairs. a. standard of value store of value b. commodity money c. demand deposits representative money near money 2. Why are economic transactions easier with money than with barter? 3. Why is it important that money be divisible? 4. Why are checking accounts called demand deposits? 5. What aspect of fiat money allows it to have more stability than representative money? 6. Using Your Notes How are the economic properties of money related to its functions? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Money 7. Categorizing Economic Information Which of these forms of money are included in M1: • checking accounts • coins • money market accounts • paper money • savings accounts • time deposits • traveler’s checks • NOW accounts 8. Making Inferences The U.S. government has tried to get people to use dollar coins rather than dollar bills. Most consumers prefer to use dollar bills. Which physical properties of money are involved in these different preferences? 9. Applying Economic Concepts Maria’s parents told her that for the ten years prior to her high school graduation, they saved $200 per month for her college education—$24,000 (plus interest). Which function of money does this example best illustrate? Why? 10. Challenge Why is there more near money than transactions money in the U.S. money supply? Evaluating Economic Decisions In the past, indigenous people of Central and South America used cacao beans (the source of chocolate) as currency. Evaluate Money In Section 1, you learned that money should function as a medium of exchange, a standard of value, and a store of value. Use what you’ve learned about these functions to evaluate how useful cacao beans might be as money today. Show your answer by filling in the table below. Possible Problems Function Medium of ex
change Standard of value Store of value Challenge How well do cacao beans exhibit each of the physical and economic properties of money? Money and Banking 295 S E C T I O N 2 The Development of U.S. Banking TA K I N G N O T E S In Section 2, you will • describe how banking developed in the United States • identify the banking institutions that operate in the United States state bank, p. 296 national bank, p. 299 gold standard, p. 299 As you read Section 2, complete a chart using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Development of U.S. Banking Origins 19th Century 20th Century The Origins of Banking KEY CONCEPT S Modern banking arose in Italy in the late Middle Ages. Italian merchants stored money or valuables for wealthy people and issued receipts that promised to return the property on demand. They realized that they did not have to hold all the deposits, since all depositors did not reclaim their property at the same time, but could lend some of the deposits and earn interest on those loans. This was the beginning of fractional reserve banking (see Section 3), the practice of holding only a fraction of the money deposited in a bank and lending the rest. In colonial America, many Early “Bankers” The Italian word banco, means “bench.” From benches in the street, Italian merchants used some practices that are part of banking today. QUICK REFERENCE A state bank is a bank chartered by a state government. 296 Chapter 10 merchants followed the same practice. However, these banks were far from secure. If a merchant’s business failed, depositors lost all of their savings. After the Revolutionary War, many state banks—banks chartered, or licensed, by state governments—were established. Some of these banks, however, followed practices that tended to create instability and disorder. Many issued their own currency that was not linked to reserves of gold or silver held by the bank. ECO N O M I C S PAC ES E T T E R Alexander Hamilton: Shaping a Banking System Imagine what it would be like if every bank issued its own currency. How would buyers know if sellers would accept their money? How would sellers know if the money they received was worth anything? That was the confusing situation that Alexander Hamilton faced when he became Secretary of the Treasury in 1789. He immediately set to work to bring stability to U. S. banking. The First Bank of the United States Hamilton was a leading Federalist who believed in a strong central government. He proposed chartering a privately owned national bank to put the government on a sound financial footing. This bank would issue a national currency and help control the money supply by refusing to accept currency from state banks that was not backed by gold or silver. It also would lend money to the federal government, state banks, and businesses. The Constitution did not specifically authorize Congress to charter a national bank. The Antifederalists, led by Thomas Jefferson and James Madison, interpreted the Constitution strictly and feared putting too much power in the hands of the central government. Hamilton argued that the Constitution implied that the federal government had the authority to create a national bank to carry out its duty to regulate the currency. Hamilton won the fight, and the First Bank of the United States was chartered in 1791. Over time, it achieved the financial goals that Hamilton had set. However, opponents argued that the bank’s policies restrained economic growth, and Congress refused to renew the charter in 1811. The fact that Hamilton was the architect of the bank was always a strike against it, as he had made many enemies during his career. (One, Aaron Burr, killed him in a duel.) Maybe Hamilton was right when he said, “Men often oppose a thing merely because they have had no agency in planning it, or because it may have been planned by those whom they dislike.” Alexander Hamilton (above) and the First Bank of the United States (right) FAST FACTS Alexander Hamilton Position: First Secretary of the Treasury (1789–1795) Born: January 11, 1755 in Nevis, British West Indies Died: July 12, 1804 Writings: The Federalist Papers (1787), with James Madison and John Jay; Report on a National Bank (1790) Major Accomplishment: Strengthened the national government and established the First Bank of the United States Hamilton’s Visible Legacy: Portrait on the $10 bill AP P LI CATION Making Inferences A. How did the First National Bank force state banks to become more stable? Learn more about Alexander Hamilton at ClassZone.com Money and Banking 297 F I G U R E 10 . 3 Major Developments in American Banking 1816 ▲ Congress charters Second Bank of the United States. 1863 ▲ Congress creates national banks and currency. 1775 1800 1825 1850 1875 196 1791 Congress charters First Bank of the United States. 1837–1865 Wildcat banking leads to unstable currency. ▲ 19th-Century Developments KEY CONCEPT S Without a central bank, the government had difficulty financing the War of 1812 against Britain. Furthermore, state banks soon returned to the unrestrained issuing of currency that was not linked to reserves of gold or silver held by the banks. The resulting increase in the money supply led to inflation during the war. The Second Bank of the United States Congress finally agreed to charter the Second Bank of the United States in 1816. The new bank had greater financial resources than the First Bank and succeeded in making the money supply more stable. Opponents continued to see the central bank as too powerful and too closely aligned with the wealthy. President Andrew Jackson was an outspoken critic who mistrusted banks and paper money He vetoed the renewal of its charter in 1832. Wildcat Banking After the Second Bank’s charter lapsed in 1836, there was no federal oversight of the banking industry. During this period, all banks were state banks, each of which issued its own paper currency, called bank notes. States passed free banking laws that allowed individuals or groups that met its requirements to open banks. 298 Chapter 10 Jackson and the Second Bank This 1828 cartoon lampoons Jackson’s battle against the bank. 1913 President Wilson establishes Federal Reserve System. ▲ 1950 Banks issue ﬁ rst credit cards. 1980s Savings and Loan crisis rocks U.S. banking industry. 60 1900 1925 1950 1975 Present 1900 ▲ United States adopts gold standard. 1933 Banking Act creates Federal Deposit Insurance Corporation. 1971 ▲ President Nixon ends the dollar’s link to gold. 1999 Deregulation opens up bank competition. Some of these banks were located in remote areas to discourage people from redeeming their bank notes, which were often worth less outside the region where they had been issued. It was this practice, along with the questionable quality of many bank notes that resulted in the term wildcat bank. In addition, such banks were susceptible to bank runs when depositors demanded gold or silver for their currency. Since the banks often did not have sufficient reserves of these precious metals, financial panics and economic instability were common results. The Struggle for Stability During the Civil War, it was particularly difficult for the government to finance its operations without a national currency and a federal bank. The government’s first solution to this problem was to issue a new currency backed by government bonds. These U.S. bank notes, called greenbacks, were printed with green ink. In 1863, Congress passed the National Banking Act, which led to the creation of a system of national banks, banks chartered by the national government. The act provided for a national currency backed by U.S. Treasury bonds and regulated the minimum amount of capital required for national banks as well as the amount of reserves necessary to back the currency. Congress taxed state bank notes issued after 1865, effectively eliminating these notes from circulation. In 1900, the government officially adopted the gold standard, a system in which the basic monetary unit—for example, one dollar—is equal to a set amount of gold. The national currency and gold standard helped to bring some stability to the banking system. Money was now uniform throughout the country, backed by something of intrinsic value, and limited by the supply of gold. AP P LI CATION Analyzing Effects B. How did the National Banking Act of 1863 attempt to eliminate the problems caused by wildcat banking? QUICK REFERENCE National banks are banks chartered by the national government. The gold standard is a system that backs the basic monetary unit with a set amount of gold. Money and Banking 299 20th-Century Developments KEY CONCEPT S The system of national banks and a national currency linked to the gold standard initially brought stability to U.S. banking. Yet the economy still experienced periods of inflation and recession and financial panics. This economic instability was largely due to the lack of a central decision-making institution that could manage the money supply in a flexible way to meet the economy’s changing needs. A New Central Bank In 1913, Congress passed the Federal Reserve Act, which established the Federal Reserve System (commonly known as the Fed)—a true central bank. It consists of 12 regional banks with a central decision-making board. The Fed provides financial services to the federal government, makes loans to banks that serve the public, issues Federal Reserve notes as the national currency, and regulates the money supply to ensure that money retains its purchasing power. You’ll learn more about the structure and functions of the Federal Reserve in Chapter 16. The Great Depression and the New Deal At the start of the Great Depression in 1929, many banks failed due to bank runs, as consumers panicked and withdrew all of their money. When the banks failed, many more depositors lost their money. Part of President Franklin Roosevelt’s N
ew Deal program was the Banking Act of 1933, which instituted reforms such as regulating interest rates that banks could pay and prohibiting banks from selling stocks. The Federal Deposit Insurance Corporation (FDIC) provided federal insurance so that if a bank failed, people would no longer lose their money. This legislation set the tone for almost 50 years by increasing the regulation of banking in the United States. Deregulation and the S&L Crisis In 1980 and 1982, Congress passed laws that lifted government limits on savings interest rates. This allowed savings and loans associations (S&Ls) to operate much like commercial banks. Deregulation encouraged the S&Ls to take more risks in the types of loans they made. As a result, many S&Ls failed and lost their depositors’ money. Congress agreed to fund the S&L industry’s restructuring in order to protect consumers, which cost taxpayers hundreds of billions of dollars. The S&L Crisis Depositors camp out to withdraw their money in May 1985. APPLICATION Comparing and Contrasting C. How are the First Bank of the United States and the Federal Reserve different? 300 Chapter 10 Find an update on U.S. financial institutions at ClassZone.com Financial Institutions in the United States KEY C ONCEPT S The term bank is used to refer to almost any kind of financial institution that takes in deposits and makes loans, helping individuals, businesses, and governments to manage their money. In the end, though, the goal of a bank is to earn a profit. All financial institutions receive a charter from the government, either state or federal. Government regulations set the amount of money the owners of a bank must invest in it, the size of the reserves a bank must hold, and the ways that loans may be made. The term may refer to commercial banks, savings and loan associations, or credit unions. In the past, these institutions provided very different and distinct services. Today, however, because of the deregulation of banking, these distinctions are much less apparent. The distinctive characteristics of each type of financial institution are described in more detail below. Figure 10.4 on page 302 compares the three types of banks based on numbers of institutions and total assets. T YPE 1 Commercial Banks Privately owned commercial banks are the oldest form of banking and are the financial institutions most commonly thought of as banks. As their name implies, commercial banks were initially established to provide loans to businesses. Now they provide a wide range of services, including checking and savings accounts, loans, investment assistance, and credit cards to both businesses and individual consumers. You will learn more about these services in Section 3. In 2003, there were about 2,000 national commercial banks and about 5,800 state-chartered banks insured by the FDIC. All national commercial banks belong to the Federal Reserve System, but only about 16 percent of state-chartered banks choose to join the Fed. About 1,500 of these commercial banks are large ones with assets of $300 million dollars or more. In 2005, the seven largest banks in the United States held 50 percent of the total assets controlled by all these large banks. T YPE 2 Savings Institutions Savings and loan associations (S&Ls) began in the United States in the 1830s. They were originally chartered by individual states as mutual societies for two purposes— to take savings deposits and provide home mortgage loans. In other words, groups of people pooled their savings in a safe place to earn interest and have a source of financing for families who wanted to buy homes. The S&Ls continue to fulfill these purposes, but they now also offer many of the services provided by commercial banks. Since 1933, the federal government may also charter S&Ls, and since 1982, many federally chartered S&Ls have chosen to call themselves savings banks. Many savings institutions are now financed through the sale of stock, just as commercial banks are. Money and Banking 301 In 2003, there were about 800 federally chartered savings institutions and 600 state-chartered institutions. These institutions are now insured under a specific fund of the FDIC as part of the reforms that followed the S&L crisis of the 1980s. TYPE 3 Credit Unions Credit unions are cooperative savings and lending institutions, rather like the early S&Ls. They offer services similar to commercial banks and S&Ls, including savings and checking accounts, but specialize in mortgages and auto loans. The first credit union in the United States was chartered in 1909. The Federal Credit Union Act of 1934 created a system of federally chartered credit unions. In 2003, there were about 5,800 federally chartered credit unions and about 3,600 chartered by the states. Most credit unions have deposit insurance through the National Credit Union Association (NCUA), similar to the FDIC. The major difference between credit unions and other financial institutions is that credit unions have membership requirements. To become a member, a person must work for a particular company, belong to a particular organization, or be part of a particular community affiliated with the credit union. Credit unions are cooperatives—nonprofit organizations owned by and operated for members, who numbered more than 80 million nationwide in 2003. F I G U R E 10 TAT ES $8,413 7,630 9,014 Key: Number of Institutions Assets (in billions of dollars) 1,345 $1,692 Commercial banks Savings institutions $647 Credit unions Source: Statistical Abstract of the United States, 2006 (Data from 2004) ANALYZE CHARTS 1. Which type of bank has the largest number of institutions? Why? 2. How do the assets held in savings institutions compare to the assets held in commercial banks? APPLICATION Analyzing and Interpreting Data D. Which type of bank described above has the largest percentage of its institutions chartered by the federal government? Why might this situation have developed? 302 Chapter 10 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term. a. state bank b. national bank c. gold standard 2. Explain the relationship between the gold standard and the concept of representative money. 3. How does the Federal Reserve System serve as a central bank? 4. What is the difference between a national bank and a state bank? 5. How did the FDIC make fractional reserve banking less risky for consumers? 6. Using Your Notes What role Development of U.S. Banking did state banks play in the era of wildcat banking? Refer to your completed chart. Origins 19th Century 20th Century Use the Graphic Organizer at Interactive Review @ ClassZone.com . Creating Graphs Use the information in Figure 10.4 to create two pie graphs, one showing the percentage that each type of bank contributes to the total number of financial institutions and another showing the percentage that each type of bank contributes to total bank assets. State one conclusion that you can draw from the two graphs. Use activity. @ ClassZone.com to complete this 8. Synthesizing Economic Information On the basis of what you learned about the history of U.S. banking in the 19th and 20th centuries, were Alexander Hamilton’s ideas about the need for a central bank and a national currency shown to be mostly accurate? Cite specific examples to support your answer. 9. Applying Economic Concepts Suppose that Mariel deposits $100 in her local bank. If the Fed’s reserve requirement is 15 percent, how much can the bank loan out on the basis of Mariel’s deposit? What concept does this scenario illustrate? 10. Challenge How do banks facilitate saving and borrowing in the same way that money facilitates buying and selling? Constructing Graphs Consider what you have learned about different types of financial institutions. The table below shows how the numbers of commercial banks and savings institutions have changed over time. Year 1985 1990 1995 2000 2004 Commercial Banks Savings Institutions 14,417 12,347 9,942 8,315 7,630 3,626 2,815 2,030 1,589 1,345 Create Line Graphs Use the information in the table to create two line graphs that show the changes in the numbers of each type of bank. Use ClassZone.com to complete this activity. @ Challenge On the basis of this information, what trends can you identify? Which type of financial institution experienced a greater percentage loss from 1985 to 2004? Money and Banking 303 S E C T I O N 3 Innovations in Modern Banking TA K I N G N O T E S In Section 3, you will automated teller machine, p. 308 • describe the services that debit card, p. 308 stored-value card, p. 308 banks provide • discuss the changes that deregulation has brought to banking • explain how technology has changed banking in the United States As you read Section 3, complete a hierarchy diagram to track main ideas and supporting details. Use the Graphic Organizer at Interactive Review @ ClassZone.com Innovations in Banking main idea main idea main idea details details details What Services Do Banks Provide? KEY CONCEPT S Banks offer a number of services that allow them to act like “money stores.” In other words, just as stores are places where goods are bought and sold, banks are places where money can be bought (borrowed) and sold (lent). By using these services, customers are able to do three things—store money, earn money, and borrow money. Banks are businesses that earn money by charging interest or fees on these services. SERVICE 1 Customers Can Store Money As you read in Section 2, banks began as safe places to store money and other valuables. They still serve the same purpose today. Customers deposit money in the bank, and the bank stores currency in vaults and is also insured against theft and other loss. Customers’ bank accounts are also insured in case the bank fails. Banks are also a safe place to store important papers and valuables—through the use of safe deposit boxes. SERVIC
E 2 Customers Can Earn Money When customers deposit their money in bank accounts, they can earn money on their deposits. Savings accounts and some checking accounts pay some level of interest. Banks offer other accounts, such as money market accounts and certificates of deposits (CDs), that pay a higher rate of interest. You will learn more about saving and investing in Chapter 11 and in Consumer and Personal Finance, which begins on page 574. 304 Chapter 10 S E RVI CE 3 Customers Can Borrow Money Banks also allow customers to borrow money through the practice of fractional reserve banking. (See Figure 10.5.) The percent of deposits that banks must keep in reserve is set by the Fed. Banks provide customers, each of whom must be approved by the bank, with different loans for different circumstances. One common loan is a mortgage. A mortgage loan allows a buyer to purchase a real estate property, such as a house, without paying the entire value of the property up front. The lender and the borrower agree on a time period for the loan (often up to 30 years) and an interest rate to be paid to the lender. From this, a monthly mortgage payment amount is settled. In this arrangement, the real estate property acts as collateral. So if the borrower defaults on the loan (stops making the payments), the lender takes control of the property. It can then be sold by the bank to cover the balance of the mortgage. It may not seem so, but a purchase made on a credit card is a loan too. Credit cards are issued by banks to users who are, in effect, borrowers. When you use a credit card to buy a new skateboard or a tank of gasoline, the issuing bank pays the seller and lends you the money. When you pay the bank back, you’re repaying a loan. And if you don’t pay it back within a month, you’ll owe the bank extra in interest. F I G U R E 10 . 5 Fractional Reserve Banking Deposit of $10,000 A bank customer deposits $10,000 into her account in Bank A. Loan of $8,100 Bank B lends $8,100 to a customer who uses it to buy a used car. Deposit of $8,100 The seller of the car deposits the $8,100 in Bank C. Bank A Fed’s reserve requirement is 10%, or $1,000. Bank B Fed’s reserve requirement is 10%, or $900. Bank C Fed’s reserve requirement is 10%, or $810. Loan of $9,000 Bank A lends $9,000 to a customer who uses it to ﬁx his roof. Deposit of $9,000 The rooﬁng contractor deposits the $9,000 into his account in Bank B. Loan of $7,290 Bank C lends $7,290 to a customer who uses it to open a small business. ANALYZE CHARTS The customer who deposited $10,000 in Bank A can withdraw her money even though a loan may have been made based on her deposit. This is known as creating money. Why? Use an interactive fractional reserve banking chart at ClassZone.com AP P LI CATION Applying Economic Concepts A. Explain the ways in which bank transactions are beneficial to customers and banks. Money and Banking 305 Banking Deregulation KEY CONCEPT S Prior to the 1980s, government tightly regulated the amount of interest that banks could pay on deposits and could charge on loans. Regulations also prevented banks from operating in more than one state. Several states also had limitations on the number of branches that a bank could have within a state. Deregulation in the 1980s and 1990s ended these restrictions and brought major changes to what we think of as banks and how they operate. Bank Mergers The end of restrictions on interstate banking led to a large number of mergers, as larger banks acquired smaller ones and smaller ones joined together to be able to enter different geographic markets. The number of mergers has steadily declined since 1998, when there were almost 500, to less than 200 in 2003. Yet as Figure 10.6 shows, mergers that created very large banking organizations continued. In 2004, F I G U R E 10 . 6 Major Bank Mergers Bank of America Continental Bank Security Bank Nations Bank Barnet Bank Boston Bay Bank Fleet Shawmut Bank of America Fleet Boston Manufacturers Hanover Trust Chemical Bank Chase Manhattan Bank J.P. Morgan J.P. Morgan Chase Bank One First Commerce First Chicago NBD First Bank US Bank Bank One US Bank Bank of America J.P. Morgan Sources: The Canadian Treasurer, March 19, 2003; Encyclopaedia Britannica ANALYZE CHARTS In most of the mergers shown here, the acquiring banks hoped to increase their customer base by gaining offices in regions where they had no presence. What reasons might target banks (the banks acquired) have for entering into a merger? 306 Chapter 10 Bank of America Investment Services Inc. and J. P. Morgan Chase & Co. became two of the largest banks in the United States, with assets of around $1 trillion each. In contrast, some 95 percent of commercial banks have assets of $1 billion or less. One benefit from the mergers has been increased competition that has kept interest rates low and resulted in more consumer services. There has also been an increase in the number of bank branches, even while the number of banks has declined. Larger banks and more branches offer customers greater availability of services. Many banks also cite economies of scale made possible by the mergers, as banks are able to spread their costs, especially for new technology, over more customers. However, some see potential problems associated with mergers. Although competition between these merged banks has heated up, there are increasingly fewer banks to choose from. Further, it is feared that larger banks may show less interest in small customers and local community issues. If this is the case, consumers will choose a bank that provides them with what they want, and the large banks will either respond or lose customers. Banking Services The Financial Services Act of 1999 lifted the last restrictions from the Banking Act of 1933 that had prevented banks, insurance companies, and investment companies from selling the same products and competing with one another. This change allowed banks to sell stocks, bonds, and insurance. At the same time, some investment companies and insurance companies began offering traditional banking services. The change in banking services was based on the idea that consumers would prefer to have a single source for all their financial services needs—something that might function as a kind of “financial supermarket.” However, banks have not always been able to effectively realize the benefits they had envisioned from offering this array of services. While banks establish relationships with customers through deposit accounts and loans for homes and autos, they have not been as successful in selling insurance or in helping customers to buy and sell stocks and bonds. Most bank customers continue to look to traditional insurance companies for their insurance needs and investment brokers and mutual fund companies to meet investment desires. Financial Freedom President Clinton signs the bill that eliminated restrictions in place since 1933. ▲ Roosevelt and the Banking Act of 1933 ▲ Clinton and the Financial Services Act of 1999 AP P LI CATION Analyzing Effects B. How did deregulation change the ways that banks competed? Money and Banking 307 Technology and Banking KEY CONCEPT S Deregulation is not the only thing that has changed the nature of banking. Technology—particularly computer technology—has changed the way customers use banks, producing a system generally referred to as electronic banking. For example, banks have begun using automated teller machines (ATMs), electronic devices that allow bank customers to make deposits, withdrawals, and transfers and check their account balances at any time without seeing a bank officer. Other innovations include debit cards, cards that can be used like an ATM card to withdraw cash or like a check to make purchases, and stored-value cards—cards that represent money that the holder has on deposit with the issuer, such as a department store. These cards give customers the ability to use the money in their accounts in more convenient ways. (You’ll learn more about ATM and debit cards in Consumer and Personal Finance.) Automated Teller Machines Between school, sports practice, and a parttime job, you might find it difficult to get to the bank while it is open to deposit your paycheck and to withdraw spending money. The ATM solves that problem. ATMs are the oldest and most familiar of the developments in electronic banking. They began to be used widely in the 1970s and are now located not just at banks but also at retail stores, workplaces, airports, and entertainment venues, such as movie theaters and sports stadiums. ATMs are basically data terminals that ATM Boom Between 1998 and 2003, the number of ATMs in the United States nearly doubled, from 187,00 to 371,000. By 2007, there were over 1.5 million ATMs worldwide. are linked to a central computer that is in turn linked to individual banks’ computers. The bank provides you with a plastic ATM card with a magnetic strip on the back that contains your account information. You insert your card into the ATM, enter your personal identification number (PIN), and follow the instructions on the screen. You may check your account balance, make deposits, withdraw cash, transfer money between accounts, and make loan payments through the ATM. All ATM networks are connected so that consumers can use their ATM cards at any machine, no matter what bank owns it. Some banks charge fees for ATM use, especially to consumers who do not have an account at the bank that owns the particular ATM. ATMs allow people to bank even when the bank is closed and to avoid waiting in line for simple transactions. Many drive-through ATMs allow customers to bank from their cars. ATMs save banks money because it is much less expensive to process ATM transactions than transactions that involve a teller. They also allow banks to provide services at more locations without constructing complete bank branch offices. QUICK REFERENCE An automated teller machine (ATM) is an ele
ctronic device that allows bank customers to make transactions without seeing a bank officer. A debit card can be used like an ATM card or like a check. A stored-value card represents money that the holder has on deposit with the issuer. 308 Chapter 10 Debit Cards Debit cards are similar to ATM cards but offer additional benefits. Like ATM cards, debit cards can be used to withdraw cash and make other transactions at ATM machines. Debit cards are sometimes called check cards because they are linked to bank accounts and can be used like checks to make purchases at many retail outlets. Retailers often prefer debit cards because they avoid the problem of people writing checks with insufficient funds in their accounts. Debit cards often look like credit cards, and they are similar in that they can be used to make purchases at stores. An important difference is that credit card purchases involve getting a loan. Your money stays in your account until you pay your credit card bill. With a debit card you make an immediate payment, since the price of your purchase is deducted from the account that is linked to your card. Therefore, it is important to keep track of debit card purchases along with checks so that you know how much money is available in your account at any given time. Because of the way debit cards work, they are often seen as safer ways to manage your money than with credit cards. With credit cards, if you do not pay your balance in full each month, you pay interest on the outstanding balance and can build up considerable debt. With debit cards, you can only spend money that you actually have in a bank account. YO U R EC EDIT C ARD VS. DE BIT C ARD Which one should you use? You have $250 in your checking account, and you don’t get your next paycheck for a week. You want to buy a $75 birthday gift for a friend, and you have to pay $225 for a car repair. With your classmates, talk through each of the ways to handle the situation to find out what works best. ? Entering a PIN for a debit card Signing for a credit card Stored-Value Cards Stored-value cards, which represent money that the holder has on deposit with the card issuer, give consumers another convenient way to use electronic banking. These cards are sometimes called prepaid cards because customers have paid a certain amount of money for the card and can then use it to make payments for various goods and services. Some examples of stored-value cards include transit fare cards, gift cards from retail stores, and telephone cards. Consumers benefit from using transit fare cards and telephone cards because they do not have to worry about having the exact change needed each time they ride the bus or use a pay phone. Money and Banking 309 In 2004, there were more than 2,000 different stored-value card programs in the United States with about 20 million users. The number of users was expected to be 49 million by 2008. The $42 billion in transactions in 2003 was expected to grow to more than $72 billion by 2006. Multipurpose stored-value cards—cards that can be used like debit cards—are becoming more popular. This type of card may take the place of a checking account, especially for people who have not traditionally used banks. While stored-value cards are a convenient way for people to make purchases and pay bills, consumers need to evaluate the fees involved in using such cards to determine whether they are less expensive than having a checking account or using a check-cashing service. In addition, the money paid into such cards is not always covered by FDIC insurance to protect customer deposits in case of a bank’s failure. Electronic Banking Electronic banking allows customers who have set up accounts with a bank to perform practically every transaction without setting foot in a bank. Indeed, some banks are virtual banks with no physical buildings at all. Through the use of the Internet, customers can arrange for direct deposit of their paychecks, transfer funds from account to account, and pay their bills. Most bank Web sites allow customers to review the most recent transactions on their accounts, view images of canceled checks, and download or print their periodic statements. Through electronic fund transfers, consumers can pay a credit card bill at one bank with funds from a checking account at another bank. Recurring bills, such as mortgage payments, may be paid automatically from a customer’s checking account each month or through their bank’s bill paying service. However, electronic banking presents several challenges. Information security and identity theft are related, high-profile issues for the industry. Electronic banking allows banks to amass large amounts of information about their customers. Banks contend that this allows them to provide customers with better service. New laws require that banks make customers aware of privacy policies and offer them the opportunity to decide what information may be shared with others. Consumer concerns have led banks to developing increasingly sophisticated information security systems. (For information on identity theft, see Consumer and Personal Finance, which begins on p. 574.) Online Convenience Online bill paying cuts time and expense by eliminating the need to mail checks. APPLICATION Contrasting Economic Information C. How are debit cards different from most stored-value cards? 310 Chapter 10 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. How are these three terms related? How are they different? a. automated teller b. debit card c. stored-value card machine 2. What are two reasons that people deposit money in banks? 3. It is said that fractional reserve banking allows banks to create money? What is meant by this? 4. How did deregulation lead to a decrease in the number of banks between 1980 and the present? 5. How are debit cards related to automated teller machines? 6. Using Your Notes How does computer technology support home banking? Refer to your completed hierarchy diagram. Innovations in Banking main idea main idea main idea details details details Use the Graphic Organizer at Interactive Review @ ClassZone.com . Analyzing Data Over the course of one year, Hometown Bank paid Mary Lee 3 percent interest on a $1,000 deposit and charged Owen’s Bakery 8 percent interest on a $900 loan. How much net income did Hometown bank make? Show your calculations. 8. Applying Economic Concepts Suppose that Liz inherits $2,000 from her grandmother and deposits it into her college savings account at Hamilton Savings Bank. Assume that the reserve requirement is 20 percent. Create a chart showing five successive loans that could be made from this initial deposit. 9. Making Inferences Some parents think that allowing teenagers to use a debit card prepares them for using a credit card. What are the possible reasons behind this thinking? Do you think this reasoning is sound? Why or why not? 10. Challenge Look again at Figure 10.5, Fractional Reserve Banking, on page 305. Suppose that when Bank A made the $9,000 loan to the man with the leaky roof, it turned out the job cost only $7,000. The contractor deposited that money into Bank B. How much could Bank B then lend to the used-car buyer? If she bought a car for that amount, and the seller of the car deposited the money in Bank C, what size small-business loan could Bank C then turn around and make? Starting a Bank Think about what you have learned about the services that banks provide and how banks make money. Imagine that you are starting a bank for the other members of the class. Consider the following questions: • What services would you provide? Why? • How would your bank make a profit? • What challenges might you face in making your bank profitable? Write a Proposal Answer the above questions in a one-page proposal outlining what your bank would be like. Share your proposal with a classmate. Challenge Include a section in your proposal about what you would do to make your bank more attractive to customers than the other banks run by your classmates. Money and Banking 311 Case Study Find an update on this Case Study at ClassZone.com Student Loans Background In the United States, the cost of higher education may still be affordable to some, but it certainly is not cheap. Because of rising costs, more and more students (and their parents) borrow money to finance at least part of their college education. According to the U.S. Department of Education, about 10 million students take out Stafford loans each year, while about 800,000 parents take out PLUS loans. Although banks, S&Ls, and credit unions are the primary lenders of money in the United States, this is not the case for student loans. Students and parents have the option of borrowing wherever they choose, but federally guaranteed loans are their main source of funding. What’s the issue? What is the current situation with student loans? What are the future ramifications of the increasing cost of paying for college? Study these sources to learn about student loans. A. Online News Story This story explains a change in the way the government figures the interest rate on student loans. Text not available for electronic use. Please refer to the text in the textbook. FIGURE 10.7 AVERAGE COST OF TUITION, ROOM, AND BOARD AT A FOUR- YEAR INSTITUTION ) 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 1989– 1990 1991– 1992 1993– 1994 1995– 1996 1997– 1998 1999– 2000 2001– 2002 2003– 2004 School Year Source: National Center for Education Statistics Thinking Economically If interest rates hit 10 percent, would the new fixed rate established by Congress still harm student borrowers? Why or why not? 312 Chapter 10 B. Cartoon Ralph Hagen drew this cartoon about student loans as a factor in higher education. Thinking Economically What does the cartoon suggest about student reliance on college loans? Explain your answer. Source: www.CartoonStock.com C. Newspaper Article This article discusses the problems associa
ted with debt and loan repayment after college graduation. It’s Payback Time More student loans increase debt pressure on graduates. Student loans are two-edged: the more money a student can borrow, the more schooling falls within reach. But of course, the more debt a student has, the more painful repayment becomes. . . . “More students will be required to take out more money from the federal government and from private lenders,” says Jasmine L. Harris, legislative director at the United States Student Association, a student advocacy group in Washington. Over time, she continues, ‘’It’s a great formula for unmanageable levels of debt and hence higher default rates.’’. . . The consequences of defaulting, too, are worse than they have been in years past. A provision of a law that took effect last year, for example, makes it next to impossible to discharge private student loans in personal bankruptcy proceedings (federal loans were already barred). . . . [Theresa] Shaw of the Education Department advises that a struggling borrower should try to make a payment of any kind, however small, to avoid default. Source: The New York Times, April 23, 2006 Thinking Economically Explain in your own words why you think the article calls student loans “two-edged.” THINKING ECONOMICALLY Synthesizing 1. Compare the financial news presented in documents A and C. What bearing do you think the information in document A might have on what you learned from document C? 2. Document B humorously points to the prominence of student loans in U.S. higher education. Specifically, what parts of documents A and C support this view? 3. In document A, what does the federal government seem to be saying about who should pay for a college education? With this in mind, what does Figure 10.7 mean for students and parents? Money and Banking 313 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. automated teller machine barter commodity money currency debit card demand deposits fiat money fractional reserve banking gold standard M1 M2 medium of exchange money national bank near money representative money standard of value state bank store of value stored-value card 1 is anything that people will accept as payment for goods and services. Money makes trade easier by serving as a 2 . As a 3 , money allows people to compare the prices of goods and services. Money must be a 4 , or something that holds its value over time. Gold coins and salt are both examples of 5 . Most money in the world today is 6 , which has no tangible value but is declared by the government to have worth. 7 consists of 8 , which includes paper money and coins and 9 , which is another name for checking accounts. Savings accounts and time deposits are called 10 because they can be converted into cash easily. 11 allows banks to hold only part of their deposits and make loans based on the rest. The Federal Reserve Bank is the central 12 in the nation. The 13 is the oldest form of electronic banking. A 14 can be used like an ATM card or like a check. 314 Chapter 10 CHAPTER 10 Assessment Money: Its Functions and Properties (pp. 288–295) 1. What three functions does money serve in the economy? 2. Why do economists make a distinction between M1 and M2? The Development of U.S. Banking (pp. 296–303) 3. Why does fractional reserve banking leave banks vulnerable to failure if too many consumers demand their money at the same time? 4. How is the Federal Reserve System different from the system of national banks created in the 1860s? Innovations in Modern Banking (pp. 304–313) 5. How did the automated teller machine change the nature of banking? 6. Which type of stored-value card is most like a debit card? A P P LY Look at the table below showing changes in use of electronic payments between 1995 and 2001. 7. Which type of electronic banking increased the most among all households between 1995 and 2001? 8. How did education generally affect the use of electronic payments? FIGURE 10.8 PERCENTAGE OF HOUSEHOLDS USING ELEC TRONIC BANKING Education of head of household All households No college degree College degree ATM Debit card Automatic bill paying 1995 2001 1995 2001 1995 2001 61.2 69.8 17.6 47.0 21.8 40.3 52.8 63.7 14.3 42.3 18.2 33.7 80.1 81.6 25.2 56.2 30.1 53.2 Source: Statistical Abstract of the United States, 2006 . Analyzing Effects Suppose that the government changes the tax policy so that people pay lower taxes if they save more money. The benefits are significant enough that people shift about 10 percent of their money from their checking accounts into certificates of deposit. How would this change affect the amount of money in M1 and M2? 10. Drawing Conclusions Today, there are about three times as many state chartered commercial banks as there are nationally chartered commercial banks. How does the current U.S. economy avoid the kinds of problems caused by state banks in the 19th century? 11. Applying Economic Concepts One Saturday, four friends go shopping at the local mall. Catherine uses her ATM card to withdraw some cash. Tara has a gift card that she received for her birthday. It is worth $50 at her favorite clothing store. Charlotte uses a credit card, and Alyssa pays with a debit card. a. Which of the shoppers has a stored-value card? Why does she have less flexibility in her shopping than the other shoppers? b. If Catherine, Charlotte, and Alyssa each spend $50, which one has not reduced the amount of money in her checking account at the end of the day? Why? c. Which shopper may end up paying more than face value for her purchases? 12. Analyzing Causes What are the different motives behind these two mergers: a stock brokerage firm buys a bank; a California bank buys a Florida bank? 13. Challenge Why are credit cards and debit cards not considered to be money? Promote Electronic Banking Step 1 Choose a partner. Imagine that you work for a bank in the late 1990s. Your bank intends to be a pioneer in Internet banking and asks you to design its first Web page. Your boss gives you the following criteria for the Web page: • Allow existing customers to access account balances and transfer funds between accounts. • Promote traditional bank products, including checking, savings, CDs, credit cards, mortgages, and auto loans. • Allow customers to find the most convenient branch or ATM location. Step 2 Sketch out a design for the Web page to meet your boss’s criteria, showing appropriate links. Step 3 Two years later, deregulation has led to significant changes in the banking industry. In addition, more consumers are interested in Internet banking. Your boss asks you to redesign the Web page with these additional criteria: • Allow customers to pay bills, apply for loans, buy stocks, and shop for insurance through the bank’s Web site. • Allow customers to view transactions on all their accounts, including credit and debit card transactions, and receive statements and other bank communications electronically. • Reassure customers that online banking is secure and that their privacy will be protected. Step 4 Sketch out a new Web page that shows the complete range of services the bank now offers and that meets all six criteria. Step 5 Share your Web page designs with another pair of students and discuss what aspects would be most important and effective for you as a customer. Money and Banking 315 Stock Market The stock market, which consists of institutions such as the NASDAQ, is where stocks and bonds are traded. 316 CHAPTER 11 SECTION 1 Savings and Investment SECTION 2 Investing in a Market Economy SECTION 3 Buying and Selling Stocks SECTION 4 Bonds and Other Financial Instruments CASE STUDY The Rise and Fall of Dot-Coms Financial Markets Voluntary exchange is a trade in which both parties involved believe that what they are getting is worth more than what they are giving up. C H A P T E R 11 The financial system consists of institutions, such as banks, insurance markets, bond markets, and stock markets, that help transfer funds between savers and investors AT T E R S Do you have a savings account? If so, you play a very important role in our economy. Your savings—what you gave up to get those assets—will be borrowed and invested by businesses and the government to build factories, offices, roads, and so on. The jobs and new products and services created by these investments, in turn, further help to fuel the nation’s economy. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on investing in Internet companies. (See Case Study, pp. 344–345.) Go to SMART GRAPHER to complete graphing activities in this chapter. Source: www.CartoonStock.com Go to INTERACTIVE REVIEW for concept review and activities. Why did the dot-com companies experience such a rapid rise and fall? See the Case Study on pages 344–345. Financial Markets 317 S E C T I O N 1 Savings and Investment TA K I N G N O T E S In Section 1, you will • identify what constitutes the financial system • describe the various financial intermediaries • explain how economists categorize the various markets where financial assets are sold savings, p. 318 investment, p. 318 financial system, p. 318 financial asset, p. 319 financial market, p. 319 financial intermediary, p. 319 mutual fund, p. 320 capital market, p. 322 money market, p. 322 primary market, p. 322 secondary market, p. 322 As you read Section 1, complete a hierarchy diagram to track main ideas and supporting details. Use the Graphic Organizer at Interactive Review @ ClassZone.com Savings and Investments main idea main idea main idea details details details The Financial System QUICK REFERENCE Savings is income not used for consumption. Investment is the use of incom
e today that allows for a future benefit. The financial system is all the institutions that help transfer funds between savers and investors. Find an update on saving at ClassZone.com 318 Chapter 11 KEY CONCEPT S There are two things you can do with your money—spend it or save it. Savings is income not used for consumption, in other words not spent on immediate wants. Savings that are put to use are investments. In general, investment is the use of income today in a way that allows for a future benefit. More specifically, economic investment refers to money lent to businesses—to finance the construction of a new factory, for example. Personal investment refers to the act of individuals putting their savings into financial assets, such as CDs, stocks, bonds, or mutual funds. Consider what happens when you put money in a savings account. Through this act, you benefit—your savings account earns interest—but others do too. By saving, you make funds available for the bank to lend. Borrowers use these funds for many purposes, such as investing in new businesses or in new equipment for established businesses. The financial system, which consists of institutions such as banks, insurance markets, bond markets, and stock markets, allows for this transfer of funds between savers and investors. ATM Deposits Using an ATM to make deposits makes saving easy and convenient. F I G U R E 11.1 The Financial System savings Financial Intermediaries loans Commercial Banks Savings and Loans Credit Unions Finance Companies Life Insurance Companies Mutual Funds Pension Funds Borrowers Savers Financial Intermediaries assets interest and dividends ANALYZE CHARTS 1. What do savers get in exchange for the funds they deposit with financial intermediaries? 2. Why do you think that financial intermediaries perform their vital function? Think back to Chapter 10 if you need help. Bringing Savings and Investment Together Individuals and businesses can save surplus funds in many ways, including savings accounts at commercial banks or S&Ls, certificates of deposit (CDs), corporate or government bonds, and stocks. The agent receiving these funds is a borrower, who issues savers written confirmation of the transaction. This written confirmation is called a financial asset, or a claim on the property of the borrower. Sometimes savers and borrowers come together directly in a financial market, a situation in which buyers and sellers exchange particular types of financial assets. For example, an individual or business might buy corporate bonds or shares of stock. More often, however, financial intermediaries bring savers, borrowers, and financial assets together. A financial intermediary is a financial institution that collects funds from savers and then invests these funds in loans and other financial assets. Figure 11.1 shows how funds flow from savers to investors through the financial markets and financial intermediaries that make up the financial system. QUICK REFERENCE A financial asset is a claim on the property of the borrower. A financial market is where buyers and sellers exchange financial assets. A financial intermediary is an institution that collects funds from savers and invests the funds in financial assets. AP P LI CATION Applying Economic Concepts A. Look again at the example opposite of a person depositing money into a savings account. How is this an example of Adam Smith’s “invisible hand”? Financial Markets 319 Financial Intermediaries KEY CONCEPT S Financial intermediaries bring savers and investors together. In Chapter 10, you learned about one group of financial intermediaries—commercial banks, S&Ls, and credit unions. These financial institutions take in deposits from savers and provide loans to individuals and businesses. Many offer other financial assets as well. Other common financial intermediaries include finance companies, which make small loans; pension funds, which invest money for groups of workers; and life insurance companies, which invest funds collected from policyholders. A mutual fund is a pool of money managed by an investment company that gathers money from individual investors and purchases a range of financial assets. Investors own shares of the entire fund based on the amount of their investment. These institutions gather their money in different ways and provide many different financial assets to a variety of investors. EXAMPLE Banking Financial Intermediaries This group of financial intermediaries includes commercial banks, S&Ls, and credit unions. All of these institutions provide checking and savings accounts. Depositors earn interest on their savings deposits and some checking deposits. Most also offer CDs and money market deposit accounts that pay slightly higher rates of interest. (Figure 11.2 explains how savers earn money from interest.) The federal government insures deposits, including CDs and money market accounts, up to $100,000 per depositor in any given bank. These institutions lend a portion of their deposits to borrowers. Banks charge borrowers a higher rate of interest than they pay to savers and hope to earn a profit. The loans are financial assets to the bank. If a borrower does not pay back the loan on time, the bank may repossess the property, such as a home or a car. Deregulation has allowed banks to offer other financial assets, such as money market mutual funds, stocks, bonds, and insurance. The federal government does not insure funds invested in these financial assets. EXAMPLE Nonbank Financial Intermediaries This group of financial intermediaries includes finance companies, mutual funds, pension funds, and life insurance companies. Finance companies make loans to households and small businesses. Generally, the loans are under $2,000 and are paid back in monthly installments, including interest, over a few years. A mutual fund pools money from many personal investors. In return, each investor receives shares in a fund that is made up of a large number and variety of stocks, bonds, or other financial assets. Mutual funds make it easier and more affordable for individual investors to own a wide variety of financial assets. Once investors purchase shares of a fund, they allow its managers to make investment decisions. QUICK REFERENCE A mutual fund is an investment company that gathers money from individual investors and purchases a range of financial assets. The New York Stock Exchange Stocks are an important element of the assets that make up a mutual fund. 320 Chapter 11 Pension funds allow employees to save money for retirement and sometimes include contributions from employers. The pension fund then invests these pooled contributions in various financial assets that will increase in value and provide workers with more money when they retire. Life insurance companies allow individuals to accumulate savings by building cash values and protect against losses from death or disability. Just as banks lend some of their deposits, insurance companies lend or invest some of the income earned from policyholders in a variety of financial assets. M AT 11 Banks pay savers interest in order to use their money. A saver’s initial deposit is called the principal. Simple interest is the interest paid on the principal alone. Compound interest is paid on the principal plus any earned interest. The following steps show how an annual rate of 5 percent interest is paid on the principal ($1,000) over three years. Year 1 Simple interest is calculated using the following formula: Principal Interest rate = Interest earned $1,000 .05 = $50.00 Year 2 The amount in this account is now $1,050.00. Compound interest, which is paid on the principal plus the earned interest, is calculated as follows: (Principal + Year 1 interest) Interest rate = Interest earned ($1,000.00 + $50.00) .05 = $52.50 Year 3 There is now $1,102.50 in the account. Interest continues to compound. (Principal + Year 1 interest + Year 2 interest) Interest rate = Interest earned ($1,000.00 + $50.00 + 52.50) .05 = $55.13 After three years, the total in the account is $1,157.63. Using a Formula Instead of using the multiple steps shown above, you can calculate the total value of an account using the following formula (wherein P=principal, r=interest rate, and t=number of years): P(1+r) t = total value $1,000.00(1+.05)3 = $1,157.63 NEED HELP? Math Handbook, “Calculating Compound Interest,” page R6 AP P LI CATION Comparing and Contrasting B. How is a pension fund like a savings account? How is it different? Financial Markets 321 Financial Asset Markets KEY CONCEPT S The different financial assets discussed in this section are bought and sold on various financial markets. Economists tend to categorize these markets based on two factors—time (how long the loan is for) and whether the financial assets can be resold. Based on time, economists distinguish between the capital market, the market for buying and selling long-term financial assets, and the money market, the market for buying and selling short-term financial assets. In regard to resalability, economists distinguish between the primary market, which is the market for buying newly created financial assets directly from the issuing entity, and the secondary market, which is the market where financial assets are resold. FACTOR 1 Time There are two time-sensitive markets. Capital markets are markets where assets are held for longer than a year. Some examples of assets sold on the capital market include certain kinds of securities, namely stocks and bonds, mortgages, and longterm CDs. Because these loans are for longer periods of time, the money may be invested in projects that require large amounts of capital, such as buying homes, building new factories, retooling established factories, or financing government projects. Money markets are markets where loans are made for less than a year. Examples of assets traded in these markets include short-term CDs that depositors can redeem in a few months
and Treasury bills, which allow the U.S. government to borrow money for short periods of time. Return on Investment Time is an important factor in the level of return for many investments. FACTOR 2 Resalability There also are two kinds of markets based on whether the financial assets can be resold. Primary markets are markets for financial assets that can be redeemed only by the original buyer. Examples include savings bonds and small denomination CDs. The term primary market also refers to the market where the first issue of a stock is sold to the public through investment bankers. Secondary markets are resale markets for financial assets. These markets offer liquidity to personal investors. So, investors are able to turn their assets into cash relatively quickly. Stocks and bonds, which you’ll learn more about later in this chapter, are two of the most prominent financial assets sold on the secondary market. APPLICATION Analyzing Effects C. Why are stocks and bonds part of the capital market and the secondary market? QUICK REFERENCE The capital market is where long-term financial assets are bought and sold. The money market is where short-term financial assets are bought and sold. The primary market is for buying financial assets directly from the issuer. The secondary market is where financial assets are resold. 322 Chapter 11 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the difference between the terms in each of these pairs. a. savings investment b. capital market money market c. primary market secondary market 2. What is the purpose of the financial system? 3. Why do banks receive financial assets when they make loans? 4. How does a mutual fund serve as a financial intermediary? 5. What determines whether a loan is part of the capital market or the money market? 6. Using Your Notes What is the relationship between financial intermediaries and the financial system? Refer to your completed hierarchy diagram. Savings and Investments main idea main idea main idea details details details Use the Graphic Organizer at Interactive Review @ ClassZone.com . Categorizing Information Which of the following are banking financial intermediaries and which are nonbanking financial intermediaries? • Consumer Finance Company • Family Life Insurance Company • First National Bank • Home Savings and Loan • Investors’ Mutual Fund • Employee Credit Union • Employee Pension Fund 8. Making Inferences A local bank offers savings accounts that have no minimum balance requirement and pay 3 percent interest per year. Account holders can withdraw any amount of money from their accounts at any time. The bank also offers money market accounts that require a $500 minimum balance and pay 4 percent interest each year. Account holders are allowed two withdrawals per month, but each must be for at least $100. Why does the money market account pay a higher interest rate? 9. Applying Economic Concepts Suppose that you deposit $100 into your savings account, which earns 3 percent interest per year. Use what you’ve learned about calculating interest to determine how much money you’ll have in your account at the end of one year and at the end of six years. 10. Challenge Why might a decrease in household savings have an adverse effect on small businesses in a local community? Stock certificates Identifying Markets Consider how economists categorize financial markets. Copy the table shown below. Review the bulleted list of financial assets and place each one in the correct location(s) in the table. Assets may be placed in more than one category. • 15-year mortgage • 6-month CD for $1,000 • 2-year CD for $25,000 • 5-year corporate bond • 10-year savings bond • Shares of stock • 26-week Treasury bill • 30-year Treasury bond Capital Market Money Market Primary Market Secondary Market Challenge Why do savings bonds and small certificates of deposit have less liquidity than shares of stock? Financial Markets 323 S E C T I O N 2 Investing in a Market Economy TA K I N G N O T E S In Section 2, you will investment objective, p. 324 • discuss the issues that should be considered when making investment decisions • explain how risk and return are related risk, p. 327 return, p. 327 diversification, p. 327 As you read Section 2, complete a chart like the one shown using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Investing in a Market Economy objectives risk vs. return Why Are You Investing? KEY CONCEPT S In Section 1, you saw that there are two types of investing: personal and economic. Note that for the remainder of the chapter, we’ll be using all forms of the word invest as a quick way to refer to personal investing—which is, in effect, saving. You’ve now learned that there are a number of assets you can own. But how do you determine which is, or are, right for you? The first thing that you might do is to decide why you are investing. This reason is your investment objective, a financial goal that an investor uses to determine if an investment is appropriate. Some possible financial goals are saving money for retirement, for a down payment on a house or an automobile, for college tuition, or for a vacation. Your goal helps you to determine the right investments. Investment Objectives Two issues play a major role in determining which investments work best to achieve different investment objectives. The first issue is time. For example, is this a short-term financial goal, such as saving for a vacation, or a longterm financial goal, such as saving for Savings Goals Saving for a car down payment suggests certain kinds of longer-term investments. QUICK REFERENCE An investment objective is a financial goal used to determine if an investment is appropriate. 324 Chapter 11 YO U R EC INVESTM ENT OB J EC TIVES What reasons do you have for investing? Do you have any investment objectives? Maybe you have a short-term objective, such as saving money to go on spring break. Or your objective is more long term, such as saving for college. What kinds of investments might be appropriate for your objective? ? Saving for vacation Saving for college Find an update on investing at ClassZone.com retirement? The amount of time you have to build your savings influences the kinds of investments that would be most appropriate. The second issue is income. How much money do you have available to save after meeting current expenses? The answer to this question is influenced by a series of other questions: Will your income change in the future? Is there money available for emergencies? To respond to all these questions, having a savings plan that is realistic and that is flexible enough to adjust to changing circumstances can be a big help. Other important questions are: Do you have any outstanding debts? Are you paying taxes on time? Paying off debts is an important first step to investing. Generally, the interest you pay on debts, such as credit card balances, is higher than what you can earn through most investments. Tax considerations are most important for investors with higher incomes who are subject to higher tax rates. Different types of investments are suitable to various investment objectives. For example, savings for emergencies should be in highly liquid investments, such as savings accounts or money market accounts. With these investments, the risk of loss is low and money can be withdrawn at any time. Saving for a vacation would also require investments that are short-term and liquid. Investors who are saving for longer-term goals may be less concerned with immediate liquidity and may want to invest in stocks that increase in value over a longer period of time. CDs that commit funds for a certain length of time may be chosen to coincide with the timing of certain savings goals, such as making a major purchase or starting college. Many bonds offered by state and local governments offer tax-free earnings. AP P LI CATION Drawing Conclusions A. Would a CD be a more appropriate way to save for a down payment on a car or for emergencies? Why? Financial Markets 325 ECO N O M I C S PAC ES E T T E R Mellody Hobson: Investing in the Future What do the Chicago Bulls, hip-hop stars, and inner-city elementary school students have in common? All are part of Mellody Hobson’s efforts to get investment “discussed around every dinner table.” Hobson believes that many people lack the necessary knowledge to determine their investment objectives and manage their money to create wealth. How is she trying to change this situation? Creating Educated Investors Mellody Hobson discovered her career in investing as a college intern. When she got her degree in 1991, Hobson landed a position in the marketing department at Ariel Capital Management LLC. In 2000, she became the president of the company, making her the most powerful African-American woman in the mutual-fund industry. As president of Ariel, Hobson runs an operation with over $21 billion in assets. Ariel was the first minority-owned mutual fund company in the Mellody Hobson country and pioneered programs to teach inner-city schoolchildren about investing. Hobson’s passion for investment education led her to give presentations in locations from PTA meetings to union halls. She developed the first ongoing study of investing by African Americans and looked for ways to increase their participation in the stock market. “The stock market represents a major source of wealth creation in this country,” Hobson has stated, “but . . . African Americans have been largely left out.” Ariel’s marketing efforts to the black community included cosponsoring events with the Chicago Bulls and creating a stock-picking contest involving well-known hip hop stars. When Hobson became the financial contributor to the Good Morning America television program in 2000, she was able to reach millions of people with easy-to-understand information about economic matters. Hobson bel
ieves that more knowledge about the benefits of investing in stocks and greater diversity in the investment industry will help bring the benefits of investing to people of all racial and economic backgrounds. APPLICATION Making Inferences B. Why might Mellody Hobson think it is important for families to talk about investing at the dinner table? FAST FACTS Mellody Hobson Title: President of Ariel Capital Management, LLC Born: April 3, 1969, Chicago, Illinois Major Accomplishment: Educates millions of people about the benefits of investing. Ariel’s Assets Under Management: $21.3 billion (2005) Other Roles: Financial contributor to Good Morning America on ABC Board Member: Chicago Public Library, the Field Museum, the Chicago Public Education Fund, and the Sundance Institute Director: DreamWorks Animation SKG, Inc., the Estée Lauder Companies Inc., and Starbucks Corporation Find an update on Mellody Hobson at ClassZone.com 326 Chapter 11 Risk and Return KEY C ONCEPT S Once investors have decided their financial objectives, there are two other related issues they might consider—risk and return. Risk is the possibility for loss on an investment, and return is the profit or loss made on an investment. While savings deposits in banks are insured against loss, most investments carry some possibility of losing part of the money invested. Return may refer to the interest paid on a savings account or CD or the increase in value of a stock over time. Most investors try to balance risk and return through diversification, the practice of distributing investments among different financial assets to maximize return and limit risk. QUICK REFERENCE Risk is the possibility for loss on an investment. Return is profit or loss made on an investment. Diversification is the practice of distributing investments among different financial assets. What Kind of Risk Are You Willing to Take? When most investors think about risk, they think about the possibility of losing some of their initial investment, often referred to as their principal. Even if they don’t earn a lot of money on the investment, they want to get back at least what they put in. Investments that guarantee no loss of principal include insured savings deposits and CDs. Bonds that are backed by the U.S. government are also considered to be almost risk-free because it is highly unlikely that the government would not pay back its loans. Almost all other investments carry some risk. One of the biggest risks investors face, even with safe investments like those described above, is loss of the purchasing power of the money invested due to inflation. (Remember that inflation is a general rise in the level of prices.) That is why many financial advisers warn against investing everything in safe investments that pay a guaranteed rate of interest that may not keep up with inflation. FIGURE 11. 3 THE REL AT IONSHI P OF R ISK AND RE TURN Other investments, such as stocks and corporate bonds, carry a higher degree of risk because the return depends on how profitable the company is. Investors who purchase stock with the expectation that it will appreciate in value over time may lose some of their money if the company runs into problems or other economic factors affect the value of the stock. In that case, investors may find that they cannot sell the stock for as much as they paid for it, and they suffer a loss. Investors in corporate bonds face similar risks, although bonds are considered less risky than stocks because creditors such as bondholders are paid off before stockholders if a company has financial problems. k s i R Return Risk and Return Risk and return have a direct relationship—the higher the risk of the investment, the greater the possible return. Financial Markets 327 YO U R EC RISK AND R ETU RN How can you balance risk and return? When you consider what financial assets further your investment objective, you must address both risk and return. A high-risk investment may bring large returns, but can you absorb the potential losses? A low-risk investment may provide a steady return, but because of inflation you may be losing money. How would you decide which type of investment to make? ? ▲ Return ▲ Risk What Kind of Return Do You Want? When making investment decisions, investors estimate what kind of return they expect to earn. The safest investments, such as Treasury bills, interest-bearing savings accounts, and shorter-term CDs, generally offer the lowest return in the form of fixed rates of interest. The returns on stocks and bonds are not guaranteed and may vary considerably at different times, depending on how the company you invest in performs and the state of the economy as a whole. Generally, stocks provide a higher return over time than do other investments. As Figure 11.3 on page 327 shows, risk and return are directly related—the greater the possible return, the higher the risk that the investment will lose value. Investors always want the highest return possible, but they must balance that desire with a realistic understanding about the level of risk they can tolerate. The factors of time and income come into play here. People who are investing for retirement over a period of 20 to 30 years may be willing to take more risk by investing in stocks because their investments are likely to increase over that period, even though they might have losses in some years. People with less time and less income to invest might not be willing to risk possible losses. Diversification is the most common way for investors to maximize their returns and limit their risks. For example, you might put 70 percent of your investments for retirement in a variety of stocks, 20 percent in bonds, and 10 percent in CDs. By spreading out your money in a variety of assets, you have a better chance of offsetting losses from one investment with gains from another. Mutual funds, which invest in a large number of stocks or bonds, help small investors diversify their investments. APPLICATION Drawing Conclusions C. Is it possible to have a low-risk, high-return investment? Why or why not? 328 Chapter 11 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term: a. investment objective b. return c. diversification 2. What is the relationship between risk and return? 3. How would the risk of investing in a single stock compare with the risk of investing in a mutual fund? Why? 4. How is diversification related to risk and return? 5. How are risk and return related to investment objectives? 6. Using Your Notes How do time and income influence investment objectives? Refer to your completed chart. Investing in a Market Economy objectives risk vs. return Use the Graphic Organizer at Interactive Review @ ClassZone.com . Comparing and Contrasting Matthew’s parents started saving for his college education when he was born. When Matthew turned 16, he got a part-time job and saved part of his earnings for his college expenses. Compare and contrast the investment objectives of Matthew and his parents and describe the factors that influenced their investment decisions. 8. Drawing Conclusions Ryan owns shares in a single mutual fund that includes stocks and bonds. Maggie invests her money in Treasury bonds, state bonds, and corporate bonds. Joshua invests in shares of stock in five different high-tech companies. Which of these investors best understands the concept of diversification? Give reasons for your answer. 9. Applying Economic Concepts Inez bought 100 shares of a mutual fund for $10 each and sold them five years later for $15 each. Ethan put $1,000 in a 5-year CD and received a total of $235 in interest. Which investment provided the better return? How does this illustrate the relationship between risk and return? 10. Challenge Stocks that are sold on the secondary market and savings accounts both provide liquidity. For each of these investments, what kinds of risks does this liquidity entail? Evaluating Investments Consider what you have learned about risk and return as they relate to various investments, then study the table below and evaluate each investment. Identify Risk and Return Place a check mark in the appropriate columns for each investment. Investment Risk Return Low High Low High $1,000 CD 100 shares of a mutual fund 100 shares of stock Corporate bond Government bond Regular savings account Challenge Rank the investments in order from the lowest risk to the highest risk and from the lowest return to the highest return. Make a generalization about risk and return based on your rankings. Financial Markets 329 S E C T I O N 3 Buying and Selling Stocks TA K I N G N O T E S In Section 3, you will stock exchange, p. 330 • discuss why people buy stocks capital gain, p. 330 • describe how stocks are traded • explain how the performance of stocks is measured common stock, p. 331 preferred stock, p. 331 stockbroker, p. 332 future, p. 333 option, p. 333 stock index, p. 334 bull market, p. 335 bear market, p. 335 As you read Section 3, complete a cluster diagram using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Stocks The Stock Market KEY CONCEPT S Recall that in Chapter 8 you learned that corporations raise money through stock and bond issues. You will learn more about the sale—and resale—of stocks in this section. When a company first issues stock, it is sold to investment bankers in the primary market. Known as an initial public offering, or IPO, this is the stock sale that raises money for the corporation. However, most stock is then resold to investors through a stock exchange, a secondary market where securities (stocks and bonds) are bought and sold. Most people buy stocks as a financial investment, with the expectation that the stock price will rise and that they can resell the stock for a profit. Gains made from the sale of securities are c
alled capital gains. QUICK REFERENCE A stock exchange is a market where securities are bought and sold. Capital gain is profit made from the sale of securities. Why Buy Stock? Investors buy stock for two reasons. The first is to earn dividend payments, which are a share of the corporation’s profits that are paid back to the corporation’s stockholders. The second reason is to earn capital gains by selling the stock at a price greater than the purchase price. If stock is sold below the buying price, the seller makes a capital loss. Investors who want to earn income 330 Chapter 11 from their investment will be most interested in dividends. Those who want to see their investment grow over time will be most interested in potential for capital gain. As you learned in the previous section, investing in stocks carries a higher risk than most other investments but provides the opportunity for higher returns over time. Corporations are not required to pay dividends, so an investor has no guarantee that they will earn income from stocks. Similarly, there is no guarantee that the stock price will be higher when the investor wants to sell the stock. Types of Stock Source: www.CartoonStock.com No Guarantees Dividend payments are a possibility, not a certainty; stocks come with risk. There are essentially two types of stock—common stock and preferred stock. Common stock is share of ownership in a corporation, giving holders voting rights and a share of profits. Preferred stock is share of ownership in a corporation giving holders a share of profits (paid before common stockholders) but no voting rights. Most people who buy stock choose to buy common stock. Figure 11.4 shows the similarities and differences between the two types of stock. Notice that both types of stock give a share of ownership in the corporation that entitles a shareholder to receive dividends. The difference is that holders of preferred stock receive guaranteed dividends and will be paid before common stockholders if the company is liquidated. As a tradeoff for this preference, holders of preferred stock generally have no voting rights in the corporation, and their dividends do not increase if the company’s stock increases in value. Each holder of common stock generally gets one vote per share owned to elect the board of directors, which makes important decisions about how the company conducts business. QUICK REFERENCE Common stock gives shareholders voting rights and a share of profits. Preferred stock gives shareholders a share of profits but, in general, no voting rights. F I G U R E 11. 4 Common Stock and Preferred Stock Characteristic Preferred Stock Common Stock Share of ownership Eligible for dividends Guaranteed dividends Voting rights Yes Yes Yes No Yes Yes No Yes ANALYZE CHARTS 1. What preference do holders of preferred stock have? 2. What do holders of common stock have that holders of preferred stock do not have? AP P LI CATION Drawing Conclusions A. What kind of stock do you think investors who wanted a steady income from their investment would buy? Why? Financial Markets 331 Trading Stock KEY CONCEPT S Most people who invest in stock do so with the hope of earning capital gains when they sell it. Like anything else sold in a free market, stock prices are determined by demand and supply. Some factors that affect stock prices include company profits or losses, technological advances that may affect a company’s business or a whole industry, and the overall state of the economy. When investors perceive that a company’s value is likely to increase, the demand for the stock will increase and its price will rise. As the price rises, more people will want to sell the stock for a profit. Few companies sell stock directly to investors. When investors want to buy or sell stock, they use a stockbroker, an agent who, for a commission, buys and sells securities for customers. Stockbrokers, sometimes just called brokers, generally work for brokerage firms. Investors may interact with brokers in person, by phone, or online. The broker’s primary job is to carry out the investor’s instructions to make trades. Some brokers also provide investment advice. Brokers buy and sell stocks for their customers on a variety of stock exchanges. QUICK REFERENCE A stockbroker buys and sells securities for customers. Organized Stock Exchanges The New York Stock Exchange (NYSE) is the oldest and largest of the organized stock exchanges in the United States. It is located on Wall Street in New York City, and the street name has become synonymous with the U.S. stock market. Almost 1.5 billion shares of about 2,800 of the largest and most successful U.S. companies are traded on the NYSE each day. Brokerage firms pay for the privilege of being one of the 1,336 members of the exchange. Traditionally, trading on the NYSE was in an organized auction format. Each stock had a specified location or trading post on the floor of the exchange. A specialist representing that stock ran the auction that matched buyers and sellers through open bidding to determine the price of shares. Prices for a stock often varied from minute to minute as the auction process continued throughout the day. Changes in technology have brought changes to the NYSE. Since 1996, floor traders have used small hand-held computers to execute many trades, and more than half of the orders to buy and sell are now sent electronically. In 2006, the NYSE merged with Archipelago Exchange, an electronic trading company. This allowed the NYSE not only to speed up its transactions, but also to trade stocks normally traded in electronic markets. The smaller American Stock Exchange (AMEX) is also located in New York City. Trading at the AMEX is structured in a similar way to the NYSE, although AMEX-traded companies are generally smaller than those listed on the NYSE. In 2006, AMEX introduced new practices that combined the benefits of floor trading and electronic trading. Controlled Chaos Don’t be fooled by the seeming disorder of the exchange floor. It is a secure and organized trading system. 332 Chapter 11 Electronic Markets The term over-the-counter (OTC) is used to describe the market for stocks that are not traded on the NYSE or AMEX. In 1970, the National Association of Securities Dealers (NASD) introduced a centralized computer system that allows OTC traders around the country to make trades at the best prices possible. This automated quotation system is known as NASDAQ. In 2005, NASDAQ was the second-largest stock exchange in the world in number of companies listed (about 3,200) and number of shares traded daily. The companies listed on NASDAQ cover many sectors of the U.S. economy, although the majority are involved in technology. The NASD also regulates the OTC Bulletin Board as an electronic market for trading shares in companies that are too small to be traded on NASDAQ. Futures and Options Markets Most investors do not trade futures and options because they are complicated and high-risk investments that involve trying to predict the future. A future is a contract to buy or sell a stock on a specified future date at a preset price. An investor who wants to buy in the future wants to lock in a low price. An investor who wants to sell in the future wants to lock in a high price. An option is a contract giving the investor the right, but not the obligation, to buy or sell stock at a future date at a preset price. As you can see, the difference between a future and an option is that a futures contract requires the investor to buy or sell, while an option contract offers the possibility of buying or selling but does not require it. In options trading, an investor pays a small fraction of a stock’s current price for an option to buy or sell the stock at a better price in the future. Recent Developments In the late 1990s, new stock market regulations and advances in computer technology changed the way that stocks were traded. Stocks listed on any exchange are now available to any trading firm. The growth of electronic communications networks (ECNs) increased electronic stock trading, especially on the NASDAQ market. Trades now take place 24 hours a day, not just when the stock exchanges are open. Many individual investors have access to the Internet and have become more knowledgeable about investing. They wanted ways to trade stocks without relying on traditional stockbrokers. The result has been huge growth in online brokerage companies. Investors now have the ability to make trades at any time and generally pay lower commissions than those charged by traditional brokers. Computer technology matches buyers and sellers automatically, providing rapid trades at the best possible prices. AP P LI CATION Drawing Conclusions B. How is NASDAQ similar to the NYSE? How are they different? FIGURE 11. 5 SOME NA SDAQ STOC K S Apple Inc. Dell Inc. Fujifilm Corporation Google Intel Corporation Peets Coffee & Tea Priceline.com Sirius Satellite Radio Sun Microsystems Inc. United Stationers Inc. QUICK REFERENCE A future is a contract to buy or sell a stock on a specific future date at a preset price. An option gives an investor the right to buy or sell stock at a future date at a preset price. Financial Markets 333 Measuring How Stocks Perform KEY CONCEPT S About half of all U.S. households now own stocks, and the stock market’s performance is followed closely on the nightly news, not just in specialized business media. Perhaps you have heard a statement like this one: “Wall Street responded positively to the latest employment figures, with the Dow making robust gains for the first time in several weeks.” The Dow is a stock index, an instrument used to measure and report the change in prices of a set of stocks. Stock indexes measure the performance—whether gaining or declining in value—of many individual stocks and the stock market as a whole. Stock Indexes Stock indexes provide a snapshot of how the stock market is performing. The Dow— sh
ort for the Dow Jones Industrial Average (DJIA)—is the most well known. (For help reading Figure 11.6, turn to the Skillbuilder on page 342.) Other U.S. indexes often cited include the Standard & Poor’s 500 (S&P 500) and the NASDAQ Composite. Global stock indexes include the Hang Seng Index (Hong Kong), the DAX (Germany), the Nikkei 225 (Japan), and the FTSE 100 (Britain). Each index measures the performance of a different group of stocks. QUICK REFERENCE A stock index measures and reports the change in prices of a set of stocks. Find an update on stocks in the Dow Jones Industrial Average at ClassZone.com FIGURE 11.6 DOW JONES INDUSTRIAL AVERAGE, 1929–2006 12,000 10,000 DJI 8,000 6,000 4,000 2,000 1B 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 1935 Volume © 2006 Yahoo! Inc. YAHOO! and the YAHOO! logo are trademarks of Yahoo! Inc. FIGURE 11.7 THE DOW’ S BEST AND WORST YEARS The Dow’s Best Years Rank 1 2 3 4 5 Rank 1 2 3 4 5 Year 1915 1933 1928 1908 1954 % Change 81.66 66.69 48.22 46.64 43.96 The Dow’s Worst Years Year 1931 1907 1930 1920 1937 % Change –52.67 –37.73 –33.77 –32.90 –32.82 ANALYZE CHARTS 1. Does Figure 11.6 suggest a relationship between the level of the DJIA (above) and the volume of shares traded (below)? Explain. 2. What were the most recent best and worst years for the Dow? 334 Chapter 11 F I G U R E 11. 8 THE 30 STOC K S I N THE DJ I A Alcoa Inc. Altria Group, Inc. American Express Co. American International Group Inc. AT&T Inc. Boeing Co. Caterpillar Inc. Citigroup Inc. Coca-Cola Co. Dupont Co. Exxon Mobil Corp. General Electric Co. General Motors Corp. Hewlett-Packard Co. Home Depot Inc. Honeywell International Inc. Intel Corp. International Business Machines Corp. J.P. Morgan & Co. Johnson & Johnson McDonald’s Corp. Merck & Co. Microsoft Corp. 3M Pfizer Inc. Procter & Gamble Co. United Technologies Corp. Verizon Communications Inc. Wal-Mart Stores Inc. Walt Disney Co The Dow Jones Company, publisher of the Wall Street Journal newspaper, first published the DJIA in 1896. The index included the stocks of 12 companies that reflected the economy of the time, which was focused heavily on agriculture and mining. Since 1928, the Dow has included 30 companies. General Electric is the only one of the original companies that is on the current index. As the U.S. economy has changed from agriculture to industry to services, the companies in the index have changed to reflect the most successful companies in the most important sectors of the economy. These stocks are often referred to as blue chip stocks. The DJIA is a price index, in other words it measures changes in the prices at which the stocks on the index are traded. The original DJIA was the actual average of the prices of the 12 stocks. Now the average is weighted so that higher-priced stocks have more influence on the average than lower-priced stocks. The number that is quoted is not a price but an average measured in points not dollars. QUICK REFERENCE A bull market occurs when stock market prices rise steadily over time. A bear market occurs when stock market prices decline steadily over time. Tracking the Dow Changes in the Dow reflect trends in stock market prices. The terms bull market and bear market are commonly used to describe these trends. A bull market is a situation where stock market prices rise steadily over a relatively long period of time. A bear market is a situation where stock market prices decline steadily over a relatively long period of time. Those who follow the stock market track the Dow and other indexes to determine if the market is trending toward bull or bear. The first DJIA measure was 40.94. In 1972, it reached 1,000 for the first time, and in May 1999, it topped 11,000. When the Dow hit its all-time high of 11,722.98 on January 14, 2000, it marked the end of the longest bull market in history. During the 1990s the Dow had climbed from 2,800 to its peak. Most bull markets last two to three years. A well-known bear market followed the Stock Market Crash of 1929. During the 1920s, the Dow had risen from 60 to a high of 381.17 in early September of 1929. In the month after October 29, 1929, it fell to a low of just under 199. The next time it achieved a closing price of 400 was December 29, 1954. Source: www.CartoonStock.com Financial Markets 335 Investing Money Overseas In an increasingly international economy, the NYSE is no longer the “only game in town” for U.S. investors. There are over 20 major stock markets overseas. With U.S. stocks representing only about half of the total value of global markets, international investing has become an important option for Americans. Investing money overseas offers both advantages and risks. For example, an investment in an emerging country—one with an economy that is rapidly growing—offers the prospect of a greater and more rapid return. Such an investment also may involve greater risk, for political instability in an emerging country can drive stock prices down in a hurry. However, many investors view increased diversification as the primary advantage of investing overseas. F I G U R E 11. 9 Leading World Stock Markets Market Number of Companies Listed Value of Stocks (in billions of US dollars) Main Index New York Stock Exchange (United States) Tokyo Stock Exchange (Japan) London Stock Exchange (United Kingdom) Bombay Stock Exchange (India) Sao Paulo Stock Exchange (Brazil) Cairo and Alexandria Stock Exchanges (Egypt) 2,278 2,392 3,231 4,786 347 618 15,138 Dow Jones Industrial Average 4,550 3,718 801 660 Nikkei 225 FTSE 100 Sensex Ibovespa 88 CASE 30 Source: World Federation of Exchanges, November 2006 data CONNECTING ACROSS THE GLOBE 1. Synthesizing Economic Information Do you think it likely that U.S. investment in overseas stock markets will become increasingly common? Explain your answer. 2. Drawing Conclusions Compare the total value of stocks to the number of companies listed. Which two exchanges have the least expensive stocks, on average? Which exchange has the most expensive stocks? Many factors affect the Dow’s performance. Among these are the market’s previous close, actions by the Federal Reserve that affect interest rates or the money supply, the performance of foreign indexes, and the trade balance between imports and exports. APPLICATION Drawing Conclusions C. Why have the stocks on DJIA changed over time? 336 Chapter 11 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. stock exchange stockbroker b. future option c. bear market bull market 2. Are owners of common stock generally more interested in dividends or capital gains? Why? 3. Why do most people who buy stock choose common stock over preferred stock? 4. What is the difference between a bear market and a bull market? 5. How has the growth of individual online trading affected stockbrokers? 6. Using Your Notes What are the four different ways that stocks are traded? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com Stocks . Applying Economic Concepts Rachel paid $10 per share for 100 shares of common stock in her favorite clothing store. a. If she receives 10 cents per share in dividends each year, about how many years would it take her to earn $100 on her investment? b. If the share price increases to $11 in two years and she chooses to sell the stock, how much capital gain would she make? 8. Analyzing and Interpreting Data Rearrange the data in Figure 11.7 into one table in chronological order. Use a plus sign to indicate a best year and a minus sign to indicate a worst year. a. What relationship, if any, do you see between best years and worst years? b. What does the data reveal about the stock market in the 1930s? 9. Challenge The Standard and Poor’s 500 (S&P 500) is an index composed of 500 stocks, while the Dow Jones Industrial Average is composed of 30 stocks. Many analysts feel the S&P 500 is a better representation of the U.S. stock market. Do you agree? Why? Analyzing Demand for Stock The graph below shows the combined market demand and supply curve for the stock of a company that makes mp3 players 25 20 15 10 5 0 S D 100 300 200 Number of shares 400 500 600 Draw New Demand Curves Copy the graph above on your own paper and draw new demand curves to reflect each of the following scenarios: a. A competitor announces a technological breakthrough that will dramatically cut its production costs. b. The company announces a new product that offers features that consumers have been asking for. Challenge How does the change in demand in each scenario affect the price of the stock? Financial Markets 337 S E C T I O N 4 Bonds and Other Financial Instruments TA K I N G N O T E S In Section 4, you will par value, p. 338 • discuss why people buy bonds maturity, p. 338 • describe the different kinds of coupon rate, p. 338 bonds • explain the factors that affect bond trading • outline investment options other than stocks and bonds yield, p. 338 junk bond, p. 339 As you read Section 4, summarize what you learn by completing a chart using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Bonds Other Financial Instruments Why Buy Bonds? KEY CONCEPT S QUICK REFERENCE Par value is the amount a bond issuer must pay the buyer at maturity. Maturity is the date when a bond is due to be repaid. The coupon rate is the interest rate a bondholder receives every year until maturity. Yield is the annual rate of return on a bond. 338 Chapter 11 You learned in Chapter 8 that a bond is a contract issued by a corporation promising to repay borrowed money, plus interest, on a fixed schedule. Governments also issue bonds. The amount that the bond issuer promises to pay the buyer at maturity is its par value. Maturity is the date when the bond is due to be repaid. The coupon rate is the interest rate a bondhold
er receives every year until a bond matures. There are two reasons to invest in bonds—the interest paid on bonds and the gains made by selling bonds. Most people buy bonds for the interest. Generally, bonds are considered less risky than stocks because bondholders are paid before stockholders. It is important to determine the yield—the annual rate of return—for a bond when deciding to buy and sell bonds. If a bond is sold at par value, the yield is the same as the coupon rate. If a bond is sold for less than par value, the yield will be higher than the coupon rate. On the other hand, if demand is strong and the price of a bond is higher than the par value, the yield will be lower than the coupon rate. Generally speaking, bonds with longer maturity dates have higher yields than those with shorter dates. This is because there is more uncertainty and risk involved with repayment dates that are farther in the future. Types of Bonds Investors may choose to invest in many different kinds of bonds. The yields and risks associated with these bonds vary considerably. As is the case with stocks, the higher the risk the greater the potential yield of a bond. Figure 11.10 shows the yields for different types of bonds. Bonds are classified based on who issues the bonds. FIGURE 11.9 AVERAGE BOND YIELDS, 1993–2003 Corporate bonds help businesses expand. CORPORATE BONDS 10-YEAR TREASURY NOTES MUNICIPAL BONDS Treasury bonds help keep the federal government operating. 1997 1998 1999 2000 2001 2002 2003 2004 Source: Statistical Abstract of the United States Year ANALYZE GRAPHS 1. Which type of bond had the lowest average yield in most years? 2. Which type of bond carries the highest risk? How do you know? Municipal bonds make state and local projects possible. The U.S. government issues securities called Treasury bonds, notes, or bills. The different terms denote loans with different maturity dates, with Treasury bonds having the longest maturity (more than ten years) and Treasury bills having the shortest (one year or less). The money borrowed through the sale of these securities helps keep the government running. Because they are backed by the “full faith and credit” of the federal government, these securities are considered to be virtually risk free. Governments all over the world issue bonds for the same reasons as the U.S. government. The risk level of international bonds depends on the financial strength of the particular government. Bonds issued by state and local governments are called municipal bonds. Funds raised by these bonds finance government projects such as construction of roads, bridges, schools, and other public facilities. The interest earned on many municipal bonds is not subject to federal income tax. Generally, municipal bonds are considered low-risk investments. A major reason for this is that state and local governments collect taxes, so it is assumed that they’ll be able to make interest payments and repay the buyer upon maturity. However, there have been instances of governments being unable to repay bondholders the full amount of their loans. One way that companies finance expansion is by issuing corporate bonds. These bonds generally pay a higher coupon rate than government bonds because the risk is higher. One kind of corporate bond, a junk bond, is considered high risk but has the potential for high yields. The risk involved with investing in junk bonds is similar to that of investing in stocks. QUICK REFERENCE Junk bonds are highrisk, high-yield corporate bonds. Financial Markets 339 Buying Bonds Investors need to determine their reason for buying bonds in order to purchase the right type of bond. Most investors purchase bonds because they want the guaranteed interest income. Yield will be most important to those investors. Coupon rate and price relative to the par value will determine the yield. Investors who want to sell bonds before they reach maturity study the bond market to see if they can sell their investment at a profit. Market interest rates are another important consideration for bond investors. There is an inverse relationship between the price of existing bonds and interest rates. For example, as interest rates rise, the price of existing bonds falls because bonds that were issued with a lower interest rate will be less in demand. Conversely, if interest rates fall, the price of existing bonds rises because there will be more demand for those bonds issued at a higher interest rate. The main risk that bond buyers face is that the issuer will default, or be unable to repay the borrowed money at maturity. Therefore, the level of risk is directly tied to the financial strength of the bond issuer. When governments or corporations want to issue bonds, they pay a credit-rating company to evaluate how likely it is that they will repay the loans. In this way, investors have a standard by which to judge the risk of the bonds. The two most well-known systems of bond ratings are those established by Standard & Poor’s and Moody’s. These companies use a system of letters to designate the relative credit risk of bonds. Bonds are rated from the lowest risk of U.S. Treasury securities (Aaa or AAA) to the higher risks associated with junk bonds. (See Figure 11.11.) F I G U R E 11.11 Bond Ratings Bond Rating Grade Risk Moody’s Standard & Poor’s Aaa Aa A Baa Ba, B Caa/Ca C AAA AA A BBB BB, B CCC/CC/C D Investment Investment Investment Investment Junk Junk Junk Lowest risk Low risk Low risk Medium risk High risk Highest risk In default ANALYZE TABLES 1. What are the lowest-rated investment grade bonds in each system? 2. Why do junk bonds have lower ratings than investment grade bonds? APPLICATION Drawing Conclusions A. Why is bond yield not always the same as the coupon rate? 340 Chapter 11 Other Financial Instruments KEY C ONCEPT S Investors have investment options other than bonds and stocks. The most common of these are certificates of deposit (CDs) and money market mutual funds. Both of these investments have very low risk and provide income in the form of interest. Individual investors do not generally sell these financial instruments for profit. Certificates of Deposit As you learned earlier, CDs are a form of time deposit offered primarily by banks, savings and loans, and credit unions. Like bonds, CDs have a maturity date (usually 6 months to 5 years), when the investor receives the principal back with interest. The issuer of the CD pays the investor a rate of either fixed or variable interest during the period that the CD is held. Usually the interest is reinvested in the CD so that the investor enjoys the benefits of compound interest. In general, CDs with longer maturity dates pay higher rates of interest. For example, a 6-month CD might pay 3.4 percent interest while a 5-year CD might pay 4.4 percent. The federal government insures funds deposited in CDs at most banks and credit unions up to $100,000 per depositor in any given institution. The main risk that investors in CDs face is the loss of interest or possibly some principal if funds are withdrawn before the maturity date. In addition, investors might face interestrate risk if rates rise and funds are locked in for a length of time at a lower rate. Money Market Mutual Funds Recall from Section 1 that the money market involves financial assets with maturities of one year or less. Also, remember that mutual funds allow investors to buy shares that represent an investment in all the financial assets held by the fund. Money market mutual funds (MMMF) allow investors to own a variety of short-term financial assets, such as Treasury bills, municipal bonds, large-denomination CDs, and corporate bonds. These mutual funds give investors a higher yield than bank savings accounts, but provide a similar level of liquidity. Investors can redeem their shares by check, by phone, or by electronic transfer to a separate checking account. Although the federal government does not insure MMMFs, the funds are tightly regulated, and these investments are considered to be quite safe with regard to loss of principal. There is less interest-rate risk than with CDs because the money is not committed for a specified length of time. The yield of the MMMF varies based on the yield of the assets in the fund. AP P LI CATION Making Inferences B. Why do longer-term CDs pay higher interest rates than shorter-term CDs? Source: www.CartoonStock.com Financial Markets 341 For more information on interpreting graphs, see the Skillbuilder Handbook, page R29. Interpreting Graphs: Online Financial Information Evaluating means to make a judgment about information. Investors make judgments about stocks based on their analysis of financial information. Many use the Internet as a resource for acquiring minute-to-minute information about stock market trading. The graphs on this page provide information about Apple Computer Inc., a stock traded on the NASDAQ. These graphs, which are updated online throughout trading, offer an example of the type of online information investors use to evaluate stocks. TIPS FOR EVALUATING ONLINE INFORMATION Use the following guidelines to evaluate economic information online: Read the title to identify the company for which stock information is shown. Here it is Apple Computer (AAPL), traded on the NASDAQ (Q). Read the vertical axis. This graph has two parts. The upper part shows the stock’s price; the lower part shows the volume of shares traded. Look for other information This statement shows the lag time for information—15 minutes in this case. 342 Chapter 11 Read the horizontal axis. This graph shows stock prices and volume traded from May 2005 through April 2006. Quotes delayed 15 minutes except NYSE and Amex which are 20 minutes. Source: TheGlobeandMail.com T HINKING ECONOMICALLY Evaluating 1. As an investor, which month would have been best for you to acquire Apple stock? Why? 2. How does the price per share at the beginning of June 2005 compare w
ith the price in mid-January 2006? Use information from the graph in your answer. 3. From January through April of 2006, the price of Apple shares fluctuated greatly. Volume of trading was also very heavy. Are these two facts related? Why? S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Use each of the three terms below in a sentence that illustrates the meaning of the term: a. coupon rate b. maturity c. yield 2. What does par value represent to the issuer of a bond? 3. What is the relationship between par value and maturity? 4. When does yield equal the coupon rate? 5. Why do junk bonds offer a higher yield than other types of bonds? 6. Using Your Notes Compare the risk of investing in a CD with the risk of investing in a money market mutual fund. Refer to your completed chart. Bonds Other Financial Instruments Use the Graphic Organizer at Interactive Review @ ClassZone.com . Comparing and Contrasting Dmitri bought a $1,000 bond at par value with a coupon rate of 5 percent. He determines the yield by dividing the amount of interest he earns by the price. a. How much interest would he earn in the first year and what would be the yield? b. How much interest would he earn in the first year and what would be the yield if he had paid $950 for the bond? What would be the interest and yield if he paid $1,050? 8. Making Inferences In 2003, Molly bought a 10-year Treasury note for $1,000. The market interest rate was 3.5 percent. In 2005, Molly wanted to sell the note to pay for college expenses. Interest rates had risen to 4.5 percent. How would the change in interest rates affect the price that Molly was likely to receive for her note? Give reasons for your answer. 9. Applying Economic Concepts Julie has accumulated $1,000 in a bank savings account, which pays 2.7 percent interest. She investigates several options and finds that she can invest her money in a 1-year Treasury note paying 4.4 percent interest, a 1-year CD paying 3.9 percent interest, or a money market mutual fund with an average yield of 3.7 percent. What are the pros and cons of each of these investment options? 10. Challenge How would a lower bond rating by Moody’s or Standard & Poor’s affect the coupon rate that a corporation has to offer when it issues its bonds? Give reasons for your answer. Making Investment Decisions Suppose that you have been advised to invest in bonds. Recall what you have learned about the factors to consider when buying and selling bonds and then complete the following activities. Ask Investment Questions Fill in the chart by developing a series of questions you might ask to help you decide which type of bond to buy. My Questions Categories of Questions to Ask About Bonds Investment objectives Tolerance for risk Desired return Resalability of bonds Challenge How might you apply the concept of diversification to a portfolio of bond investments? Financial Markets 343 Case Study Find an update on this Case Study at ClassZone.com The Rise and Fall of Dot-Coms Background The availability of products and services on the Internet is old news. But when the Internet first emerged, it provided a unique and exciting tool for almost instant access to potential buyers worldwide. Young people in particular were quick to grasp the possibilities of the electronic marketplace. As a result, many new companies, known as dot-coms, quickly appeared on the Internet. Like the stock of many companies based on new technologies, the value of dot-com stocks rose quickly. Investors, attracted by the initial success of dot-coms and spurred on by low interest rates in the late 1990s, were quick to join the dotcom boom. The boom, however, proved to be a financial bubble. In 2000 and 2001, the bubble burst as dot-com stocks fell dramatically. Many dot-coms went out of business, and their investors sustained heavy financial losses. What’s the issue? Why did so many dot-com companies fail? Study these sources to discover what investors learned when the dot-com bubble burst. A. Online Encyclopedia Article Many young entrepreneurs jumped into the dot-com market, often with disastrous results. This article describes one such venture. 344 Chapter 11 Kozmo.com Offered New Yorkers Free, One-Hour Delivery Despite millions in capital investment, Kozmo.com’s choices led to failure. Kozmo.com was a venture-capital-driven online company that promised free one-hour delivery of anything from DVDs to Starbucks coffee. It was founded by young investment bankers Joseph Park and Yong Kang in March 1998 in New York City. The company is often referred to as an example of the dot-com excess. Kozmo promoted an incredible business model; it promised to deliver small goods free of charge. The company raised about $280 million, including $60 million from Amazon.com. The business model was heavily criticized by business analysts, who pointed out that onehour point-to-point delivery of small objects is extremely expensive and there was no way Kozmo could make a profit as long as it refused to charge delivery fees. Not surprisingly, the company failed soon after the collapse of the dot-com bubble, laying off its staff of 1,100 employees and shutting down in April 2001. Source: Wikipedia.org Thinking Economically Why do you think Park and Kang were so successful in raising capital to fund their business venture? B. Cartoon Cartoonist Andrew Toos drew this commentary about the dot-com bubble. Source: www.CartoonStock.com Thinking Economically What comment does the cartoon make about investing in the dot-com financial market? C. Online News Story Early dot-coms typically spent huge amounts of money on advertising. This article compares purchases of advertising during the 2000 Super Bowl telecast to Napoleon’s 1815 defeat at Waterloo. The Bubble Bowl Expensive advertising failed to market dot-com products. It was just five years ago, although it seems like a different age entirely. It was a time of singing-sock-puppets, 21-year-old chief executives, gravity-defiant stock prices, revolutionary technologies and half-baked business plans. And in this atmosphere, during the final, halcyon days of the Internet boom, the St. Louis Rams played the Tennessee Titans in Super Bowl XXXIV, a moment that will be forever remembered as the dot-com bubble’s Waterloo. Football fans got a heavy dose of the fever that day: More than a dozen internet companies spent an average of $2.2 million for 30-second spots, amounting to more than $40 million of stockholder cash and not-so-hard-won venture capital. These startups hoped that Super Bowl exposure would sear their web address into the minds of consumers. But most viewers were left with only vague memories of chimpanzees dancing to “La Cucaracha” to promote whatchamacalit.com... while the businesses themselves were left with empty wallets. Today, most of these Internet pioneers are dead and gone, forgotten as the score of the game (St. Louis 23, Tennessee 16). Source: “The Bubble Bowl,” by David M. Ewalt. Forbes.com, January 27, 2005 Thinking Economically Why do you think the author compares the dot-com Super Bowl advertising to Waterloo, a major military defeat? THINKING ECONOMICALLY Synthesizing 1. During the dot-com bubble, do you think it was relatively easy or difficult for Internet start-up companies to raise capital? Explain your answer, using information from the documents. 2. Why do you think so many dot-coms failed? Use evidence from the documents in your answer. 3. What lessons might investors learn from the information presented in documents A and C? Financial Markets 345 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. capital gain capital market common stock coupon rate diversification financial asset financial intermediary investment investment objective maturity money market par value preferred stock primary market return risk savings secondary market stock index yield 1 is income not used for consumption. 2 is the use of income today that allows for greater production in the future. A 3 is a claim on the property of a borrower. A 4 collects funds from savers and invests the funds in loans and other financial assets. Examples include banks and mutual funds. The 5 is the market for buying and selling shortterm financial assets. The 6 is the market where financial assets are resold. The two issues that play a major role in setting an 7 are time and income. Investors try to maximize 8 and limit 9 through 10 , the practice of distributing investments among different financial assets. 11 is profit made from the sale of securities. 12 is share of ownership in a corporation that gives holders voting rights and a share of the profit. The Dow Jones Industrial Average is a 13 that measures the performance of a group of 30 stocks. 14 is the interest rate paid on a bond. The 15 is the amount that a bond issuer promises to pay the buyer at maturity. 346 Chapter 11 CHAPTER 11 Assessment Savings and Investment (pp. 318–323) 1. How are savings and investment related? 2. What is the role of financial intermediaries in the circular flow of the financial system? Investing in a Market Economy (pp. 324–329) 3. Why do investors need to determine their investment objective before they invest? 4. Explain the relationship between risk and return. Buying and Selling Stocks (pp. 330–337) 5. How do people earn money by investing in stocks? 6. How does the Dow Jones Industrial Average reveal trends in the stock market? Bonds and Other Financial Instruments (pp. 338–345) 7. What are the two reasons people buy bonds? 8. How are interest rates and bond prices related? A P P LY Look at the graph below showing savings as a percentage of after-tax income in various countries. 9. Which
country has the lowest rate of savings? 10. What is the overall trend from 1980 to 2000? FIGURE 11.12 SAV I NGS R ATES I N DIFFERENT COUNTRIES 20 18 16 14 12 10 8 6 4 2 0 1980 1985 1990 1995 2000 Source: Statistical Abstract of the United States Key: Japan France United Kingdom United States 11. Analyzing Causes and Effects In 2005, many leading advertisers announced plans to increase use of online advertising and to decrease the amount of advertising dollars spent in traditional print media, such as newspapers. In addition, newspaper circulation figures declined steadily as more people read news on the Internet. a. How was this situation likely to affect the stock prices of online search-engine companies that featured banner ads and sponsored links on their Web pages? b. How would it affect the stock prices of newspa- pers? Explain your answers. 12. Comparing and Contrasting What are the similarities and differences between stock dividends, a bond coupon rate, and interest on a CD? 13. Drawing Conclusions Alex, Kate, and Rashid all invested money in a software company. Alex bought a corporate bond, Kate bought shares of common stock, and Rashid bought shares of preferred stock. Which of these investors would be least at risk of losing money if the company became unprofitable? 14. Making Inferences Suppose that you heard the following statement on the financial news: “Bonds fell as the yield on 10-year Treasury notes rose to 4.56 percent, the highest in two years.” What does “bonds fell” mean and how is it related to the increase in yield? 15. Challenge Steve purchases an option contract to buy 100 shares of stock in a big high-tech company for $50 per share in six months. The stock is currently selling for $40 per share. Steve pays $5 per share for the option contract. If the share price rises to $60, Steve exercises his option to buy the shares at $50 and then resells the stock on the market for $60 per share. How much profit does Steve make per share? If the price never rises to $50 before the option expires, how much money does Steve lose? Advise Your Clients Choose a partner. Imagine that you are financial planners whose job is to help clients meet their investment objectives and use diversification to maximize return and limit risk. Step 1 Make a list of several possible financial instruments that you might recommend and rate them for risk and return. Step 2 Review each client’s objectives and risk tolerance to consider what investments to recommend. a. Carlos and Juanita Diaz want to invest for their two young children’s college education. They would like a return of 7 to 10 percent a year and have a moderate tolerance for risk. b. Patrick Hurd is 30 years old and wants to begin saving for his retirement. He wants the highest return possible and is willing to take risks. c. Alison Leveridge has recently retired. She wants to invest the money from her pension fund so that she can have a guaranteed amount of income and little risk of losing her capital. Step 3 Decide what percentage of each client’s money to invest in different types of financial instruments. Create pie graphs to show your recommendations for each client. Step 4 Present your recommendations to another pair of students. Discuss the choices that each of you made. Step 5 As a class, discuss how changes in your clients’ financial circumstances or changes in the stock market might affect your recommendations. Use to complete this activity. @ ClassZone.com Financial Markets 347 Macroeconomics U n i t 5 Measuring and Monitoring Economic Performance Measuring the Economy Millions of workers and businesses participate in the U.S. economy. Measuring the country’s economy requires special economic tools. 348 CHAPTER 12 SECTION 1 Gross Domestic Product and Other Indicators SECTION 2 Business Cycles SECTION 3 Stimulating Economic Growth CASE STUDY Poland: Economic Freedom and Economic Growth Economic Indicators and Measurements Macroeconomics is the study of the economy as a whole and how major sectors of the economy interact. C H A P T E R 12 National income accounting uses statistical measures of income, spending, and output to help people understand what is happening to a country’s economy AT T E R S Your economic decisions—combined with those of millions of other people—determine the fate of the nation’s economy. Can you afford to buy a new car? Is now a good time to change jobs? Should you take a risk in the stock market or keep your money safe in the bank? Understanding what is happening to the country’s economy will help you make better economic decisions. More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on the economy of Poland. (See Case Study, pp. 376–377.) 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 has free enterprise transformed Poland’s economy? See the Case Study on pages 376–377. Economic Indicators and Measurements 349 S E C T I O N 1 Gross Domestic Product and Other Indicators TA K I N G N O T E S In Section 1, you will • define GDP and describe how it is measured • explain how GDP has certain limitations • identify other national income accounting measures national income accounting, p. 350 gross domestic product (GDP), p. 350 nominal GDP, p. 352 real GDP, p. 352 nonmarket activities, p. 354 underground economy, p. 354 gross national product (GNP), p. 355 net national product (NNP), p. 355 national income (NI), p. 355 personal income (PI), p. 355 disposable personal income (DPI), p. 355 As you read Section 1, complete a hierarchy chart like the one below to record what you learn about national income accounting. Use the Graphic Organizer at Interactive Review @ ClassZone.com National Income Accounting GDP What Is GDP? KEY CONCEPT S As you have read, microeconomics and macroeconomics look at the economy through different lenses. While microeconomics examines the actions of individuals and single markets, macroeconomics examines the economy as a whole. Macroeconomists analyze the economy using national income accounting, statistical measures that track the income, spending, and output of a nation. The most important of those measures is gross domestic product (GDP), the market value of all final goods and services produced within a nation in a given time period. The Components of GDP To be included in GDP, a good or service has to fulfill three requirements. First, it has to be final rather than intermediate. For example, the fabric used to make a shirt is an intermediate good; the shirt itself is a final good. Second, the good or service must be produced during the time period, regardless of when it is sold. For example, cars made this year but sold next year would be counted in this year’s GDP. Finally, the good or service must be produced within the nation’s borders. Products made in foreign countries by U.S. companies are not included in the U.S. GDP. Products Included in GDP Cars made in the United States are an example of goods counted toward U.S. gross domestic product (GDP). QUICK REFERENCE National income accounting is a way of evaluating a country’s economy using statistical measures of its income, spending, and output. Gross domestic product (GDP) is the market value of all final goods and services produced within a nation in a given time period. 350 Chapter 12 Calculating GDP Although there are several different ways to calculate GDP, economists often use the expenditures approach. With this method, they group national spending on final goods and services according to the four sectors of the economy: spending by households, or consumption; spending by businesses, or investment; government spending; and total exports minus total imports, or net exports. Economists identify consumption with the letter C; investment with the letter I; government spending with the letter G; and net exports with the letter X. To calculate GDP, economists add the expenditures from all sectors together: C+I+G+X=GDP. F I G U R E 12 .1 CO . S. G ROSS D OM ES T I C P RO 10 Key: Consumption (C) Investment (I) Government Spending (G) Net Exports (X) C I G X Source: U.S. Bureau of Economic Analysis, 2005 data ANALYZE GRAPHS 1. In 2005, net exports was a negative number. What does this say about the relative amounts of exports and imports? 2. Did households, businesses, or the government contribute the most to U.S. GDP in 2005? Consumption includes all spending by households on durable goods, nondurable goods, and services. You drive to the movies in a durable good (an item that does not wear out quickly). You purchase a service when you pay for the movie (since you are not buying to own something). And you obtain a nondurable good (a good that is used up relatively soon after purchase) when you buy popcorn. Investment, which measures what businesses spend, has two categories. One is fixed investment, which includes new construction and purchases of such capital goods as equipment, machinery, and tools. The other is inventory investment. This category, also called unconsumed output, is made up of the unsold goods that businesses keep on hand. Government spending includes all the expenditures of federal, state, and local governments on goods and services. Examples include spending for defense, highways, Find an update on the U.S. GDP at ClassZone.com Economic Indicators and Measurements Economic Indicators and Measurements 351 and public education. However, government spending on transfer payments, such as social security and unemployment benefits, is not included. These payments allow the recipients to buy goods and services, and these are counted as consumption. Net exports, the final component of GDP, represents foreign trade. This component takes into account the goods and services produced in the United States but sold in foreign countries—in other words, exports. However, U.S. consumers and businesses als
o buy, or import, goods made in foreign countries. Cars, car parts, and crude oil are the largest imports in dollar value. The GDP counts only net exports— the value of U.S. exports minus the value of U.S. imports. Two Types of GDP Economists use GDP to gauge how well a country’s economy is doing. When GDP is growing, an economy creates more jobs and more business opportunities. When GDP declines, jobs and more business opportunities become less plentiful. To get a clearer picture of a country’s economic health, economists calculate two forms of GDP—nominal and real. The most basic form is nominal GDP, which is stated in the price levels for the year in which the GDP was measured. If prices never changed, nominal GDP would be sufficient. But prices tend to increase over time. In Figure 12.2, find the line that represents nominal GDP. If you estimate the difference from 1990 to 2005, the nominal GDP of the United States about doubled. However, during this time prices went up, adding dollars to GDP without adding value to the nation’s output. To factor out rising prices, economists use real GDP, which is nominal GDP adjusted for changes in prices. Real GDP is an estimate of the GDP if prices were to FIGURE 12.2 U. S. NOMINAL AND REAL GROSS DOMESTIC PRODUCT QUICK REFERENCE Nominal GDP states GDP in terms of the current value of goods and services. Real GDP states GDP corrected for changes in prices from year to year. 14 12 10 NOMINAL GDP REAL GDP (IN 2000 DOLLARS) 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Bureau of Economic Analysis Year ANALYZE GRAPHS 1. About how much did nominal GDP increase from 1990 to 2000? 2. About how much did real GDP increase over the same period? 3. Why do the two lines cross at the year 2000? 352 Chapter 12 M AT 12 . 3 Understanding Nominal and Real GDP To better understand nominal and real GDP, imagine a country that produces only one good: TVs. If you know the price of TVs and the number produced, you can calculate that country’s nominal and real GDP. Use the table to find the data for these calculations. Step 1: Calculate nominal GDP for 2004. Nominal GDP is the product of the number of TVs produced and the price of TVs that year. 2004 500 $100 2005 600 $100 2006 600 $120 $50,000 $60,000 $72,000 $50,000 $60,000 $60,000 TVs Produced TV Price Nominal GDP Real GDP, base: 2004 Number produced Price in that year Nominal GDP 500 $100 $50,000 The table shows that nominal GDP grew each year. If you judged only by nominal GDP, the economy of this country would seem to be growing. Step 2: Analyze the nominal GDP figures. Why did nominal GDP increase from 2004 to 2005? The number of TVs produced increased. Why did nominal GDP increase from 2005 to 2006? The price of TVs increased. The output of the country’s economy grew from 2004 to 2005, but it stayed the same from 2005 to 2006, despite the increase in prices. Calculating real GDP produces a better estimate of how much a country’s economy is growing. Step 3: Calculate real GDP for 2006. Real GDP is the product of the number of TVs produced in the current year and the price of TVs in the base year. In this case, use 2004 as the base year. Number produced Price in the base year Real GDP 600 $100 $60,000 Since 2004 is the base year, nominal and real GDP are the same for 2004. Real GDP allows you to compare the output of the country’s economy in different years. remain constant from year to year. To find real GDP, economists compare nominal GDP to a base year. Look again at Figure 12.2, which uses 2000 as a base year. Since real GDP eliminates price differences, the line for real GDP rises more gradually than the line for nominal GDP. Real GDP provides a more accurate measure of economic performance. AP P LI CATION Applying Economic Concepts A. If output remained the same, how would a year of falling prices affect nominal GDP? How would it affect real GDP? Economic Indicators and Measurements 353 What GDP Does Not Measure KEY CONCEPT S Although GDP provides an important estimate of how well the economy is performing, it does not measure all output. It does not measure nonmarket activities, such as home childcare or performing one’s own home repairs. GDP also does not measure output from the underground economy, market activities that go unreported because they are illegal or because those involved want to avoid taxation. Further, GDP does not measure “quality of life” issues related to economic output. Nonmarket Activities Some productive activities do not take place in economic markets. For example, there is no effective way to measure the output of plumbers who install or repair plumbing systems in their own homes or people who do volunteer work for schools or hospitals. By far the biggest nonmarket activity, also left out of GDP, consists of the many services—cooking, cleaning, childcare—provided by homemakers. Underground Economy Nonmarket Activities Housework is an example of a productive activity not measured by GDP. Also missing from GDP is the underground sector of the economy. Some activities are kept underground because they are illegal—drug dealing, smuggling, gambling, and selling stolen goods, for example. When goods are rationed or otherwise restricted, illegal trading occurs on what is called the black market. Other underground activities are themselves legal, but the way the payment is handled is not. For example, a plumber who does repairs for a neighbor might receive payment in cash and not declare it as taxable income. Estimates suggest that the underground economy would make up 8 to 10 percent of the U.S. GDP. Quality of Life Countries with high GDPs have high living standards. But GDP does not show how the goods and services are distributed. The United States has the largest GDP of any country, but more than 10 percent of its people still live in poverty. GDP also does not express what products are being built and services offered: for example, are there more jails being built than schools? APPLICATION Explaining an Economic Concept B. If you get paid in cash to baby-sit, mow lawns, or do other chores for neighbors, are you part of the underground economy? Why or why not? QUICK REFERENCE Nonmarket activities are services that have potential economic value but are performed without charge. Underground economy describes market activities that go unreported because they are illegal or because those involved want to avoid taxation. 354 Chapter 12 Other Economic Performance Measures KEY C ONCEPT S GDP is not the only measure that economists use to gauge economic performance. Several other measures are derived by making adjustments to GDP. • Gross national product (GNP) is the market value of all final goods and services a country produces in a given time period. GNP equals GDP plus the income from goods and services produced by U.S. companies and citizens in foreign countries but minus the income foreign companies and citizens earn here. • Net national product (NNP) is GNP minus depreciation of capital stock—in other words, the value of final goods and services less the value of capital goods that became worn out during the time period. • National income (NI) is the total income earned in a nation from the production of goods and services in a given time period. It is calculated by subtracting indirect business taxes, such as property and sales taxes, from NNP. • Personal income (PI) is the income received by a country’s people from all sources in a given time period. It can be calculated from NI by subtracting social security taxes, corporate profit taxes, and corporate profits not paid to stockholders and by adding social security, unemployment, and welfare payments. • Disposable personal income (DPI) is personal income minus personal income taxes. It shows how much money is actually available for consumer spending. F I G U R E 12 . 4 National Income Accounting QUICK REFERENCE Gross national product (GNP) is the market value of all final goods and services produced by a country. Net national product (NNP) is the value of final goods and services less the value of capital goods that have become worn out. National income (NI) is the total income earned in a nation from the production of goods and services. Personal income (PI) is the income received by a country’s people from all sources. Disposable personal income (DPI) is personal income minus taxes. GDP + income earned abroad by U.S. businesses and citizens – income earned in U.S. by foreign businesses and citizens = GNP – depreciation of capital stock = NNP – indirect business taxes = NI – income earned but not received + income received but not earned = PI – personal taxes = DPI ANALYZE CHARTS What three figures do you need in order to calculate personal income (PI)? AP P LI CATION Making Inferences C. Under what circumstances might a country’s GNP be greater than its GDP? Economic Indicators and Measurements 355 For more on synthesizing economic data, see the Skillbuilder Handbook, page R23. Synthesizing Economic Data Synthesizing is a skill used by economists to interpret economic trends. Synthesizing involves interpreting various data to form an overview of economic performance. A synthesis is often stated as a broad summary statement. PRACTICING THE SKILL National income accounting involves the collection and analysis of data on key economic variables. Economists synthesize the data to arrive at an overview of national economic performance. The table below presents data for variables used to determine gross domestic product (GDP), a key factor in national income accounting. Read the title to learn the main idea of the table. This table shows the components of U.S. GDP for selected years. F I G U R E 12 . 5 COMPONENTS OF U.S. GDP (IN BILLIONS OF DOLLARS) Read the column heads carefully. The four types of expenditures are used to determine GDP. Determine how the types of data relate to one another. For 1990, calculating the sum of the four expen
ditures yields $5,803 billion, the nominal GDP for 1990. Check the source of the data to evaluate its reliability. Year 1980 1985 1990 1995 2000 2005 Consumption Expenditure Investment Expenditure Government Expenditure Net Export Expenditure Nominal GDP 1,757 2,720 3,840 4,976 6,739 8,746 479 736 861 1,144 1,736 2,105 566 879 1,180 1,369 1,722 2,363 13 115 78 91 380 727 2,789 4,220 5,803 7,398 9,817 12,487 Source: U.S. Bureau of Economic Analysis Look for patterns in the data. For example, notice that net exports have been negative. T HINKING ECONOMICALLY Synthesizing 1. What trend can be seen in U.S. nominal GDP? What can you tell from this about the growth of the U.S. economy? Do you need more information? 2. Which expenditure accounts for most of GDP? 3. Does the proportion of this expenditure to the other two positive expenditures remain about the same in the six years shown here? Briefly explain how you estimated this. 356 Chapter 12 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. nominal GDP real GDP b. gross national product net national product c. personal income disposable personal income 2. What are the four components of GDP? 3. What is an example of a durable good? a nondurable good? 4. Name two economic activities that GDP does not measure. 5. Why are transfer payments not included as a government expenditure when calculating GDP? 6. Using Your Notes Write a brief summary of the methods used to calculate national income and the purposes of each accounting method. Refer to your completed hierarchy chart. National Income Accounting GDP Use the Graphic Organizer at Interactive Review @ ClassZone.com . Drawing Conclusions List some things that have become more expensive during your lifetime. Explain how a rise in price level affects nominal GDP and real GDP. 8. Making Inferences If consumption is especially high compared with other years, what might you generalize about the health of the economy? 9. Explaining an Economic Concept What is the underground economy? What impact does it have on a nation’s GDP? 10. Drawing Conclusions Imagine that a new country is discovered on an island in the middle of the Pacific Ocean. The country’s people have never left the island, and no foreigners have ever been there. What would the relationship be between the country’s GDP and its GNP? Why? 11. Challenge How would the following affect GDP? a. Government transfer payments increase. b. Student sells used CD to record store. c. Car owner pays auto repair shop $500 to fix his car. Identifying Intermediate and Final Goods Look at the following list of goods and who purchased them. Goods Purchaser copier paper accounting firm refrigerator home consumer stainless steel manufacturer eggs eggs battery paint home consumer factory that makes frozen baked goods car owner furniture maker Categorize Economic Information Decide whether each good is an intermediate good or a final good. Challenge Why is it important to make a distinction in national income accounting between intermediate and final goods? 357 S E C T I O N 2 Business Cycles TA K I N G N O T E S In Section 2, you will • describe the phases of the business cycle • discuss aggregate demand and aggregate supply • identify the causes of the changes in the business cycle • explain how economists predict business cycle changes • outline major business cycles in U.S. history business cycle, p. 358 economic growth, p. 358 recession, p. 359 depression, p. 359 stagflation, p. 359 aggregate demand, p. 360 aggregate supply, p. 360 macroeconomic equilibrium, p. 361 leading indicators, p. 364 coincident indicators, p. 364 lagging indicators, p. 364 As you read Section 2, complete a cluster diagram like the one below to record what you learn about business cycles. Use the Graphic Organizer at Interactive Review @ ClassZone.com stages Business Cycle What Is the Business Cycle? QUICK REFERENCE The business cycle is the series of growing and shrinking periods of economic activity, measured by increases or decreases in real GDP. Economic growth is the increase in a nation’s real GDP over a period of time. 358 Chapter 12 KEY CONCEPT S Economic changes often follow a broad pattern. During the 1990s, the U.S. economy expanded. In 2001, the economy slowed down. It then returned to a period of growth. Such changes are an example of the business cycle, a series of periods of expanding and contracting economic activity. The business cycle is measured by increases or decreases in real GDP. The cycle has four distinct stages: expansion, peak, contraction, and trough. STAGE 1 Expansion In the expansion phase, real GDP grows from a low point, or trough, as you can see in the graph in Figure 12.6. The expansion is a period of economic growth, an increase in a nation’s real gross domestic product (GDP). During an expansion, jobs are relatively easy to find, so unemployment goes down. More and more resources are needed to keep up with spending demand. As resources become more scarce, their prices rise. The length of each phase may vary both within a cycle and from cycle to cycle. The longest expansion in U.S. history took place over the course of ten years from 1991 to 2001. Business Cycles Workers and businesses ride the ups and downs of the economy. FIGURE 12.6 THE BUSINESS CYCLE In the expansion phase, real GDP grows rapidly. b The peak is where real GDP reaches its highest point in the cycle. c In the contraction phase, real GDP declines. d The trough marks the end of the contraction. Time ANALYZE CHARTS 1. What stage occurred before point A? 2. What stage will occur after point D? 3. How might the business cycle curve change if nominal GDP was used instead of real GDP? S TAGE 2 Peak The point at which real GDP is the highest represents the peak of the business cycle. As prices rise and resources tighten, businesses become less profitable. From that point on, real GDP declines as businesses curtail production. S TAGE 3 Contraction The contraction phase begins after the peak. As producers cut back, resources become less scarce and prices tend to stabilize or fall. Unemployment rises because employers produce less. Sometimes the contraction phase becomes a recession, a contraction lasting two or more quarters (six months or more). On rare occasions, as in the 1930s, a contraction turns into a depression, an extended period of high unemployment and limited business activity. While prices usually remain about the same or go down during the contraction phase, sometimes they go up. These are periods of stagflation—stagnation in business activity and inflation of prices. S TAGE 4 Trough The final phase of the business cycle is the trough, the point at which real GDP and employment stop declining. A business cycle is complete when it has gone through all four phases, from trough to trough or from peak to peak. AP P LI CATION Explaining an Economic Concept A. In terms of the business cycle, what is unusual about stagflation? QUICK REFERENCE QUICK REFERENCE Recession is a prolonged economic contraction lasting two or more quarters (six months or more). Depression is an extended period of high unemployment and reduced business activity. Stagflation describes periods during which prices rise at the same time that there is a slowdown in business activity. Economic Indicators and Measurements Economic Indicators and Measurements 359 QUICK REFERENCE Aggregate demand is the sum of all the demand in the economy. Aggregate supply is the sum of all the supply in the economy. Aggregate Demand and Supply KEY CONCEPT S One way to understand business cycles is through the concepts of demand and supply. In this case the concepts apply not to a single product or business but to the economy as a whole. Aggregate Demand Aggregate demand is the total amount of goods and services that households, businesses, government, and foreign purchasers will buy at each and every price level. In Figure 12.7, the vertical axis, labeled “Price level,” shows the average price of all goods and services. The horizontal axis, labeled “Real GDP,” shows the economy’s total output. The aggregate demand curve (AD) is downward sloping. As the price level decreases the purchasing power of money increases. Aggregate Supply Aggregate supply is the total amount of goods and services that producers will provide at each and every price level. Note that in Figure 12.8 the aggregate supply curve (AS) does not look like the supply curves in Chapter 5. The aggregate supply curve is almost horizontal when real GDP is low—during times of recession or depression—because businesses try not to raise their prices when the economy is weak. The middle part of the aggregate supply curve slopes upward, with prices increasing as real GDP increases. But during times of high inflation, prices rise without contributing to real GDP, and the aggregate supply curve becomes almost vertical. FIGURES 12.7 AND 12.8 AGGREGATE DEMAND AND SUPPLY CURVES FIGURE 12.7 AGGREGATE DEMAND FIGURE 12.8 AGGREGATE SUPPLY AD Real GDP AS Real GDP ANALYZE GRAPHS 1. What does a normal demand or supply graph use as an x-axis? What does it use as a y-axis? 2. Why are the x and y axes different for the aggregate demand and supply graphs? Use an interactive aggregate demand and aggregate supply graph at ClassZone.com 360 Chapter 12 QUICK REFERENCE QUICK REFERENCE Macroeconomic equilibrium is the point where the quantity of aggregate demand equals the quantity of aggregate supply. Macroeconomic Equilibrium When the quantity of aggregate demand equals the quantity of aggregate supply, the economy reaches macroeconomic equilibrium. Figures 12.9 and 12.10 illustrate a variety of different possibilities, but let’s consider one particular example shown in Figure 12.9. Macroeconomic equilibrium occurs where the aggregate demand curve (AD1) intersects the aggregate supply curve (AS). P1 indicates the equilibrium price level, a
nd Q1 shows the equilibrium level of real GDP. Think about business cycles. An increase in aggregate demand shifts the aggregate demand curve to the right (AD2). Aggregate demand becomes greater at all price levels, and equilibrium real GDP rises (Q2), marking an expansion phase. If aggregate demand were to decrease, the aggregate demand curve would shift to the left (AD3). This would result in a lower equilibrium real GDP (Q3)—in other words, an economic contraction. Shifts in aggregate supply affect real GDP in a similar way, as you can see in Figure 12.10. An increase in aggregate supply shifts the aggregate supply curve to the right (AS2). As aggregate supply increases, the price level goes down (P2) and equilibrium real GDP rises (Q2), marking an expansion phase. If aggregate supply were to decrease, the aggregate supply curve would shift to the left (AS3). The result would be a higher price level (P3) and lower equilibrium real GDP (Q3)—in other words, stagflation. FIGURES 12.9 AND 12.10 CHANGES IN AGGREGATE DEMAND AND SUPPLY FIGURE 12.9 CHANGE IN AGGREGATE FIGURE 12.10 CHANGE IN AGGREGATE DEMAND SUPPLY AS AS3 AS1 AS2 AD2 AD1 AD3 P2 P1 P3 P3 P1 P2 AD Q3 Q1 Q2 Real GDP Q3 Q1 Q2 Real GDP ANALYZE GRAPHS 1. As aggregate demand decreases, what happens to price level and real GDP? 2. As aggregate supply decreases, what happens to price level and real GDP? AP P LI CATION Analyzing Cause and Effect B. Assuming aggregate demand remains the same, why does the price level go up when aggregate supply decreases? Economic Indicators and Measurements 361 Why Do Business Cycles Occur? KEY CONCEPT S You have seen that shifts in aggregate demand and aggregate supply indicate changes in the business cycle. But what causes these shifts? Four factors are especially important: (1) decisions made by businesses, (2) changes in interest rates, (3) the expectations of consumers, and (4) external shocks to the economy. These factors involve the “ripple effect,” the cause-and-effect interactions that ripple through the economy. FACTOR 1 Business Decisions When businesses decide to decrease or increase production, their decisions can have far-reaching effects. If enough businesses make similar decisions, it can lead to a change in the business cycle. Demand slump Consider the ripple effect of a decision by businesses in the recording industry. In response to a slump in demand, the producers decide to reduce production of compact discs. First, they reduce the number of hours worked at their compact disc manufacturing facilities. Some workers get laid off, others work shorter hours. In a related move, the recording businesses cut back on their investment in new CD manufacturing equipment. That decision will lead to a decrease in the demand for machinery, which puts producers of the machinery in the same situation that the recording businesses were in. The machinery businesses will also cut back on production and lay off workers. The recording industry businesses also decide to reduce the number of new recordings they commission, thereby reducing the income of musicians, recording engineers, record promoters, and other associated workers. All of the workers that are now unemployed or working less must cut back on their purchases. The single decision by the recording industry businesses had numerous consequences. By itself, it might not be enough to change the business cycle for the entire country. But if enough businesses make similar decisions, a contraction in the business cycle might result. New technology Alternatively, business decisions can also increase aggregate supply and fuel an expansion. For example, suppose computer chip manufacturers adopt a new technology that greatly reduces production costs. Those manufacturers become more productive—the supply of their products increases and the cost of their products goes down. Businesses that make products that use computer chips can make their products more cheaply. Other businesses may now be able to make new products with the more readily available computer chips. All of these businesses hire more workers to handle the increased production. The aggregate supply increases, and the economy experiences an expansion. Find an update on factors affecting the business cycle at ClassZone.com 362 Chapter 12 FACT OR 2 Changes in Interest Rates Another event that has a ripple effect in the economy and causes shifts in aggregate demand and supply is a change in interest rates. Rising interest rates, for example, make it more costly for consumers to borrow money to make purchases—from televisions to cars to houses. This decreased purchasing power lowers the level of aggregate demand and promotes a contraction in the economy. When interest rates fall, the opposite happens. Aggregate demand rises, promoting an expansion. Consider what may happen to businesses when interest rates rise. With the higher cost of borrowing money, businesses may cut back on their investment in capital goods. As you saw earlier, such a cutback would lead to less business activity for the producers of capital goods. As the aggregate supply decreases, a contraction in the economy is likely. But falling interest rates would lead to an increase in aggregate supply and an economic expansion. Higher or lower interest rates also affect the housing market. When interest rates are low, people are inclined to purchase housing rather than rent, so housing sales and all related economic activities increase, contributing to an economic expansion. When interest rates rise, the high cost of loans limits mortgage eligibility, so more people rent. Housing sales slow down, contributing to an economic contraction. FACT OR 3 Consumer Expectations Every month, 5,000 households are surveyed to find out how people are feeling about the economy, and the results are published in the Consumer Confidence Survey report. Why? The way consumers are feeling about prices, business activity, and job prospects influences their economic choices, and their choices can bring about changes in aggregate demand. For example, when consumers are confident about the future and believe that they are economically secure, they tend to consume more, driving up aggregate demand and encouraging an economic expansion. FACT OR 4 External Issues A nation’s economy can also be strongly influenced by issues and events beyond its control or outside of its borders. Examples include such natural disasters as Hurricanes Katrina and Rita, which struck the Gulf Coast in the summer of 2005. The hurricanes damaged oil refineries, oil wells, and offshore oil platforms. The effects of Katrina and Rita, combined with conflicts in other oil-producing countries, led to higher oil prices and slowed down the growth of the U.S. economy. The oil embargo of 1973 is another example. The Organization of the Petroleum Exporting Countries (OPEC) reduced the amount of oil supplied to Western nations that had supported Israel in the Yom Kippur and October wars. The price of oil rose by 400 percent. The higher prices raised production costs and resulted in an economic contraction in the United States. AP P LI CATION Analyzing Cause and Effect C. Describe the ripple effect of a natural disaster like Hurricane Katrina on the economy. External Issues Natural disasters can affect the economy. Hurricane Katrina washed this oil-drilling platform into this bridge. . Economic Indicators and Measurements 363 Predicting Business Cycles KEY CONCEPT S QUICK REFERENCE Leading indicators are measures of economic performance that usually change before real GDP changes. Coincident indicators are measures of economic performance that usually change at the same time as real GDP changes. Lagging indicators are measures of economic performance that usually change after real GDP changes. Economists try to predict changes in the business cycle to help businesses and the government make informed economic choices. They base their predictions on sets of economic indicators. • Leading indicators are measures of economic performance that usually change six to nine months before real GDP changes. Examples include new building permits, orders for capital goods and consumer goods, consumer expectations, average manufacturing workweek, stock prices, and the money supply. Economists look for trends in these indicators that last several months before they predict a change. • Coincident indicators are measures of economic performance that usually change at the same time as real GDP changes. These indicators include such items as employment, sales volume, and personal income. • Lagging indicators are measures of economic performance that usually change after real GDP changes. Such indicators are useful for confirming the end of an expansion or contraction in the business cycle. They include length of unemployment and the ratio of consumer credit to personal income. F I G U R E 12 .11 U. S. L E A D I N G ECO ATO INDEX OF LEI FIRST QUARTER GDP SECOND QUARTER GDP THIRD QUARTER GDP FOURTH QUARTER GDP RECESSION (MAR.-NOV. 2001 12.0 11.5 11.0 10.5 10.0 9.5 9.0 8. 1998 1999 2000 2001 2002 2003 2004 Sources: The Conference Board; U.S. Bureau of Economic Analysis; National Bureau of Economic Research Year and quarter ANALYZE GRAPHS 1. Find a period of at least four quarters in which the index of leading economic indicators accurately predicted a change in real gross domestic product. 2. Do changes in the real gross domestic product always echo changes in the index of leading economic indicators? What does this say about predicting changes in the nation’s economy? APPLICATION Using a Decision-Making Process D. If you were the manager of an electronics store, how might you use the news that leading indicators suggest a contraction in the economy in six months? 364 Chapter 12 The Great Depression Millions of Americans were thrown into poverty during the 1930s. These people received soup from a charity kitchen. Business Cycles in U.S. Histor
y KEY C ONCEPT S The agency that tracks economic indicators and business cycles in the United States is the National Bureau of Economic Research (NBER). It measures contractions from peak to trough and expansions from trough to peak. NBER identified about 20 extended contractions, or recessions, in the American economy in the 20th century. The worst of these by far was the Great Depression. The Great Depression “Back in those dark depression days,” President Ronald Reagan once recalled, “I saw my father on a Christmas Eve open what he thought was a Christmas greeting from his boss. Instead, it was the blue slip telling him he no longer had a job. The memory of him sitting there holding that slip of paper and then saying in a half whisper, ‘That’s quite a Christmas present’ –it will stay with me as long as I live.” Millions of people who lived through the Great Depression were haunted by such memories. For more than a decade, beginning with the stock market crash in 1929, the United States and much of the world suffered a terrible economic contraction. Not until the United States entered World War II in 1941 did the American economy begin a full recovery. Between the years 1929 and 1933, when the depression was at its worst, U.S. real GDP declined by about a third. Sales in some big businesses, including General Motors Corporation, declined by as much as 50 percent. In the resulting cutbacks, millions of workers lost their jobs. The unemployment rate skyrocketed from 1929 to 1933, leaving one in four American workers jobless. Businesses failed at a higher than usual rate, and banks failed at a tremendously high rate. The number of bank closings, either temporary or permanent, soared from 659 in 1929 to 4,000 in 1933. The New Deal President Herbert Hoover, who had been elected in 1928, was not able to bring about a recovery. Franklin D. Roosevelt, accepting the nomination to run for president against Hoover in 1932, promised Americans “a new deal,” and the programs he enacted after winning the election came to be known by that name. Roosevelt’s New Deal programs focused on federal spending to help the economy revive. Through a number of government agencies created just for this purpose, the American economy came under closer government regulation and many Americans were put back to work—employed by the federal government itself. Spending by the federal government rose from about 3 percent of GDP in the 1920s to about 10 percent in the mid-1930s. In this cartoon, Franklin D. Roosevelt is surrounded by children representing programs created as part of the New Deal. Economic Indicators and Measurements 365 Economists debate whether the New Deal programs led to sustained economic growth. But when the United States entered World War II in 1941, spending on the war effort also helped the economy to recover. Unemployment plunged to 1.2 percent by 1944. Business Cycles Since the Great Depression According to NBER, there have been about a dozen economic contractions and expansions in the U.S. economy since the Great Depression. The recessions have been less severe and have occurred less often than those before the 1930s. However, the contraction of the mid-1970s was an especially difficult time, triggered in part by the Oil Embargo of 1973. The unemployment rate rose from an average of 5.4 percent in the first half of the decade to an average of 7.4 percent from 1975 to 1979. At the same time, prices also rose, creating stagflation. FIGURE 12.12 U. S. BUSINESS CYCLES ) RECESSION PERIODS REAL GDP (IN 2000 DOLLARS) 12 10 8 6 4 2 1925 1935 1945 1955 1975 1985 1995 2005 1965 Year Sources: U.S. Bureau of Economic Analysis; National Bureau of Economic Research ANALYZE GRAPHS 1. According to the graph, how many recessions occurred from 1929 to 2005? 2. About how long was the longest business cycle shown on this graph? The 1990s, in contrast, saw strong economic expansion, fueled in part by the explosive growth of information technology. The economy experienced a brief recession in the early 2000s, which was extended slightly by the terrorist attacks on September 11, 2001. Through 2005, the U.S. economy continued to expand, although not at the heated pace of the 1990s. APPLICATION Making Inferences and Drawing Conclusions E. One industry that flourished during the Great Depression was the movie industry. Comedies were especially popular, and stories often portrayed the lives of the wealthy. Why do you think the movie industry fared so well? 366 Chapter 12 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. MACROECONOMIC EQUILIBRIUM a. contraction expansion b. aggregate demand aggregate supply c. leading indicators lagging indicators 2. Between which two points of the business cycle is a contraction measured? 3. What is the difference between demand and aggregate demand? 4. Name four factors that can trigger changes in the business cycle. 5. Name three coincident indicators of the Great Depression. 6. Using Your Notes Write a brief stages statement of your expectations for the economy from the point of view of the consumer. Use your completed cluster diagram and make references to what you have learned about the business cycle. Business Cycle Use the Graphic Organizer at Interactive Review @ ClassZone.com . Comparing and Contrasting Economic Information What were the similarities and differences between the Great Depression and the recession in the 1970s? 8. Solving Economic Problems Did President Roosevelt’s New Deal focus on generating aggregate demand, or was its main focus on increasing aggregate supply? Explain. 9. Analyzing Cause and Effect Are the components that are considered leading economic indicators causes or effects of changes in the business cycle? 10. Challenge In the 1990s many people speculated that the economy had been transformed by new technologies. Paul A. Volcker, former chairman of the U.S. Federal Reserve Bank, described it this way: “The speed of communication, the speed of information transfer, the cheapness of communication, the ease of moving things around the world are a difference in kind as well as degree.” Do you think that business cycles are inevitable? Can they ever be eliminated entirely? Explain your answer P1 AS1 AD1 Real GDP Q1 Interpreting Graphs The graph shows an economy at its macroeconomic equilibrium, where the aggregate demand curve (AD1) intersects the aggregate supply curve (AS1). P1 indicates the equilibrium price level, and Q1 shows the equilibrium level of real GDP. Draw Aggregate Demand and Aggregate Supply Curves Read the following scenarios. Copy the graph onto your own paper, then graph the changes that would occur in the Scenario 1 in blue. Graph the changes that would occur in the Scenario 2 in red. Scenario 1: In a booming economy, interest rates begin to rise. Manufacturers and other producers, wary of borrowing money at higher rates, begin to cut back on production. Scenario 2: Consumer confidence is high. Most people are optimistic about their job prospects and security, and they are willing to spend money on luxuries. Challenge As a consumer, how might your confidence be affected in Scenario 1? Use to complete this activity. @ ClassZone.com 367 S E C T I O N 3 Stimulating Economic Growth TA K I N G N O T E S In Section 3, you will real GDP per capita, p. 369 • explain how economists labor input, p. 371 measure growth • analyze the causes of economic growth • discuss how productivity and economic growth are related capital deepening, p. 371 productivity, p. 372 multifactor productivity, p. 372 As you read Section 3, complete a summary chart like the one below to record what you learn about economic growth. Use the Graphic Organizer at Interactive Review @ ClassZone.com What Is Economic Growth? What Is Economic Growth? KEY CONCEPT S In Section 2 you learned about the business cycle, the pattern of expansion and contraction in a nation’s economy. In this section you will learn more about economic growth, as measured by changes in real gross domestic product (GDP). Gauging Economic Growth Before Adam Smith (whom you learned about in Chapter 1, Section 4), many people believed that population growth and higher taxation were the secrets to economic growth. The theory held that more people paying more taxes was the best way to fill a nation’s treasury. Another view, called mercantilism, argued that increased national wealth came through exporting more goods than a country imports. In this way, the country would gain gold or silver currency from other countries. Adam Smith, however, saw that the real “wealth of nations” lay in their productive capacities. Taxes could be so high that they limit the amount of funds available for business investment and consumer spending, thereby reducing economic growth. In Smith’s view, foreign trade allows a country to focus its resources on what it does best. The more efficiently a nation uses its resources, the more productive it will be and the larger its economy will grow. Smith’s views proved to be accurate, and they serve as the basis for modern economics. The best measure of economic growth is not simply the amount of money a nation has or how much its population increases, but rather the increase in its real GDP. The rate at which real GDP changes is a good indicator of how well a country’s resources are being utilized. 368 Chapter 12 FIGURE 12.13 U. S. REAL GDP PER CAPITA 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 ) 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: U.S. Bureau of Labor Statistics ANALYZE GRAPHS 1. About how much was real GDP per capita in 1990? 2. About how many years did it take for real GDP per capita to double from its level in 1960? Population and Economic Growth Population growth influences economic growth. A country’s real GDP might be growing, but if its population is growing at an even faster rate, the increase in real
GDP might simply reflect more workers contributing to the economy. Think of a potluck dinner. If each person brings one dish, the amount of food per person will be the same whether you invite 10 people or 100. To get a clearer picture of economic growth, economists use a measure called real GDP per capita, which is real GDP divided by total population. Real GDP per capita reflects each person’s share of real GDP. In terms of the potluck dinner, if each person brings more than one dish to the next potluck, the amount of food per person will have increased. Real GDP per capita is the usual measure of a nation’s standard of living. Nations with higher real GDP per capita tend to have populations that are better educated and healthier. However, real GDP per capita does not mean that each person gets that amount of money. Some people will get more, others less. It also does not measure quality of life. For example, people might have to work longer hours to achieve higher rates of economic growth, leaving them with less leisure time. AP P LI CATION Explaining an Economic Concept A. Why does a nation’s real GDP have to increase at a faster rate than its population for significant economic growth to take place? Find an update on U.S. real GDP per capita at ClassZone.com QUICK REFERENCE Real GDP per capita is real GDP divided by total population. Economic Indicators and Measurements Economic Indicators and Measurements 369 What Determines Economic Growth? KEY CONCEPT S What drives economic growth? Why are some nations growing at a faster pace than others? Four key factors influence the rate of economic growth—natural resources, human resources, capital, and technology and innovation. FACTOR 1 Natural Resources One factor in economic growth is access to natural resources, especially arable land, water, forests, oil, and mineral resources. However, some countries, such as Japan, have very limited natural resources, yet their economies have grown rapidly. Others, such as India, which has the fourth-largest reserve of coal in the world and arable land covering more than half its territory, have developed more slowly Do Natural Resources Guarantee Wealth? Not necessarily. In fact, countries with abundant natural resources generally do not perform as well economically as countries with fewer natural resources—a phenomenon economists refer to as “the resource curse.” In Nigeria, for example, although oil is plentiful, personal income is low. GDP per capita is about $1,400 (in U.S. dollars). Poverty is widespread, with an estimated 60 percent of Nigeria’s population below the poverty line—and Nigeria has the largest population of any African country. At the other end of the spectrum is Japan. Although the country has few natural resources, the strength of Japan’s economy is second only to that of the United States. GDP per capita is about $30,000 (in U.S. dollars). What Nigeria lacks, but Japan has, are the basic structures of a free market economy—private ownership, the profit motive, an effective government, and economic competition. These economic institutions are more important than natural resources for generating economic growth. Japan, with few natural resources, achieved economic success by developing alternative sources of wealth—industry and foreign trade. FIGURE 12.14 OIL PRODUCTION AND CONSUMPTION ) Nigeria Japan production consumption Source: U.S. Central Intelligence Agency, 2003 data CONNECTING ACROSS THE GLOBE 1. Synthesizing Economic Information What role do natural resources play in a country’s economic strength? Explain your answer. 2. Drawing Conclusions Figure 12.14 illustrates oil production and consumption in Nigeria and Japan. What would happen to each country’s economy if it produced less oil? What if each produced more? 370 FACT OR 2 Human Resources Another key factor in economic growth is the labor force. Economists measure this partly through labor input—the size of the labor force multiplied by the length of the workweek. The steady declines in the length of the workweek in most countries since the early 1900s have been more than made up for by the growth in the population, so labor input has grown. Perhaps even more important than the raw numbers, however, is the level of human capital—the skills and knowledge—that the labor force brings to its tasks. Some economists believe that human capital is the single most important component in economic growth. QUICK REFERENCE Labor input is the size of the labor force multiplied by the length of the workweek. FACT OR 3 Capital You learned in Chapter 1 that natural resources, labor, and capital come together through the creativity of an entrepreneur to produce goods and services. Capital is critical to this process and to economic growth. More and better capital goods increase output: the more machines a factory has and the better designed they are, the more goods the factory can churn out. Multiply this by the number of factories across a nation and the increased output equals higher GDP. The economy also grows when more capital is available per worker. An increase in the capital to labor ratio is called capital deepening. In other words, workers are provided with more and better equipment to work with. The Industrial Revolution is a prime example of capital deepening. Sewing machines, for example, allowed clothing manufacturers to make more clothing per worker than if the workers had been sewing by hand. QUICK REFERENCE Capital deepening is an increase in the ratio of capital to labor. FACT OR 4 Technology and Innovation Technology and innovation are also important factors in economic growth. These factors promote the efficient use of other resources, which in turn leads to increased output. Some of the key technological developments that have contributed to economic growth include steam power, electricity, and the automobile. Innovations can also increase economic growth. Something as simple as adjusting an order form can contribute to economic growth by reducing the amount of time needed to complete a task. Other innovations might improve customer service or reduce the amount of material needed to create a product. Information technology has had a strong impact on economic growth. Technological advances in producing the information technology itself have led to a dramatic decline in prices. With lower prices for technology, firms are engaging in capital deepening without having to spend more money. AP P LI CATION Writing About Economics B. Using the four factors, explain how developing countries like Nigeria might improve their economic growth. Technology and Innovation Technological advancements have increased economic growth. Economic Indicators and Measurements 371 QUICK REFERENCE Productivity is the ratio of the amount of output produced to the amount of input. Productivity and Economic Growth KEY CONCEPT S Productivity refers to the amount of output produced from a set amount of inputs. When the same amount of inputs produces more output, productivity has increased. In Chapter 9, you learned about labor productivity—the amount of goods or services produced by a worker in an hour. But the broader sense of productivity includes the productivity of both labor and capital. For example, imagine that you begin building bookshelves. The inputs would include your labor plus capital, in the form of the workshop, hammers, glue, and other supplies. At first, it may take you a week to complete one bookshelf. In the process, you may waste materials as you make mistakes, and you may find that some of your tools are not ideal for the task. But after you have built several bookshelves and acquired the right tools for the job, your productivity increases. Using the same amount of input, you might now be able to produce two bookshelves per week. This section concerns the productivity of a country’s entire economy. As a country becomes more productive, its economy is likely to grow. How Is Productivity Measured? QUICK REFERENCE Multifactor productivity is the ratio between the amount of output produced by an industry or business sector and the amount of inputs used. To measure the productivity of a single business, you would compare the inputs to the outputs. Using the bookshelf example, you would compare the amount of capital and number of hours worked to the number of bookshelves produced. But how can we measure the productivity of a nation’s economy, which is made up of millions of different people and businesses? Economists use a measurement called multifactor productivity, the ratio between an industry’s economic output and its labor and capital inputs. By collecting multifactor productivity data on a country’s major industries and business sectors, economists can estimate the productivity of the entire economy. What Contributes to Productivity? Several factors contribute to changes in productivity. Quality of Labor A better educated, healthier workforce tends to be more productive. Using the bookshelf example, if you were to take classes in woodworking, your enhanced knowledge would enable you to produce more and better shelves. In general, the more educated the workforce, the more productive it is. As for health, people are usually more productive when they feel well than when they feel sluggish or ill. Technological Innovation Historically, as during the Industrial Revolution, new machines and technologies helped countries produce more output from the same amount of inputs. In recent times, the desktop computer and computer technology generally have generated productivity gains. Energy Costs Gas, electricity, and other fuels power the technologies that increase productivity. When energy costs rise, those tools become more expensive to use and productivity declines. By the same token, when energy costs fall, using advanced tools becomes less expensive and productivity rises. 372 Chapter 12 Financial Markets The easier it is for funds to flow to where they are
needed, the more productive the economy becomes. Banks, stock markets, and similar institutions allow a country’s funds to be put to their best use. When such institutions do not exist or when they do not function efficiently, productivity is reduced. FIGURE 12.15 U. S. PR IVATE BUSI NESS MULTIFAC TOR PRODUC TIVIT Y 100 90 80 70 60 50 40 30 20 10 ( 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Source: U.S. Bureau of Labor Statistics Year ANALYZE GRAPHS 1. What happened to productivity in the three years after the 1973 oil embargo? Why? 2. Compare this graph with Figure 12.13 on page 369, which shows real per capita GDP. How closely is economic growth related to productivity? How Are Productivity and Growth Related? Economic growth is a measure of change in production. It does not consider how much effort or how many resources it took to produce that quantity of production. Productivity, on the other hand, is a measure of efficiency. It reflects the amount of effort and resources it took to produce a certain quantity. A country could experience economic growth—as measured by real GDP— without increasing its productivity. Such growth would be tied to an increase in the quantity of natural resources, labor, capital, or technology. If the productivity of a country increases, its real GDP can grow without increasing the quantity of inputs. As shown in Figure 12.15, productivity in the United States grew at a steady pace from 1950 to 2000. Among other things, a better educated labor force and advances in information technology contributed to the increase. The dips in the graph represent productivity setbacks, such as tighter financial markets during recessions. AP P LI CATION Drawing Conclusions C. Some countries have limited natural resources but high economic growth. Does this prove that worldwide economic growth is unlimited by natural resources? Why or why not? Economic Indicators and Measurements 373 ECO N O M I C S PAC ES E T T E R Thomas Robert Malthus: The Population Problem In the late 1700s, many European thinkers and writers predicted a future of peace and harmony in which poverty and hunger would be eliminated. Discussing humanity’s future with his father led Thomas Robert Malthus to question whether the prevailing view was perhaps too rosy. Malthus saw a problem that others had overlooked, namely, that the world’s population seemed likely to outgrow the available supply of food. He published his ideas in 1798 in “An Essay on the Principle of Population as It Affects the Future Improvement of Society.” A Natural Limit to Economic Growth? Malthus’s essay argued that human population would increase geometrically—that is, it would double— every 25 years. Malthus also estimated that food production would only increase arithmetically—that is, by the same amount each time—over that time period. Figure 12.16 uses hypothetical numbers to illustrate the problem. As time went on, agriculture would produce less food per person, and millions would be thrown into poverty and starvation. “An Essay on the Principle of Population” caused a tremendous backlash. People could not accept that the rosy future they had imagined might not come to pass. Malthus and his essay were widely attacked and criticized—but no one could ignore his argument. Malthus’s estimates turned out to be flawed. Human population increased at a slower pace than he predicted. World population was about 1 billion in 1800, but it took until 1930 to reach 2 billion. Agricultural productivity rose dramatically with the introduction of mechanized farming and advances in fertilization and pest control. Although world population accelerated around 1950, reaching about 6.5 billion by 2005, agricultural production kept pace with the growing population. Elapsed Years 100 50 25 75 0 Thomas Robert Malthus Malthus predicted a population explosion that would result in poverty and famine. F I G U R E 12 .16 MALTHUS’ S POPULATION PROBLEM Bushels of Wheat (in millions) Population (in millions) Bushels per Person 10 20 30 40 50 10 20 40 80 160 1.00 1.00 0.75 0.50 0.31 APPLICATION Applying Economic Concepts D. How is Malthus’s population problem an example of the problem of scarcity? FAST FACTS Thomas Robert Malthus Career: British economist Born: February 17, 1766 Died: December 23, 1834 Major Accomplishment: Calling attention to the issue of population growth Major Work: Essay on the Principle of Population (1798, revised 1803) Famous Quotation: “Population, when unchecked, increases in geometrical ratio. Subsistence increases only in an arithmetical ratio.” Influenced: David Ricardo Charles Darwin Find an update on Thomas Robert Malthus at ClassZone.com 374 Chapter 12 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. economic growth real GDP per capita b. capital deepening labor input 2. Name the key measurement of economic growth. 3. What four factors drive economic growth? 4. How are productivity and growth related? 5. Briefly explain the problem Malthus identified. What Is Economic Growth? 6. Using Your Notes Write a persuasive paragraph arguing one side or the other of economic growth possibilities. Refer to your completed summary chart. Use the Graphic Organizer at Interactive Review @ ClassZone.com . Solving Economic Problems In 2000, the world’s population was about 6 billion, and about 800 million of those people did not have enough to eat. By 2050, the world’s population is expected to grow to about 9 billion. What steps should we take now to avoid having more than 1 billion people without enough to eat by 2050? Employ the ideas you learned about in this section in formulating your solution. 8. Explaining an Economic Concept Why is real GDP per capita a useful measure? Why couldn’t real GDP or GDP per capita be used for the same purpose? 9. Analyzing Cause and Effect Globalization opens international boundaries to companies, creating markets that stretch around the world. What role might global competition play in the development of innovations? 10. Challenge Going to school is your job. Your product is increasing your knowledge, and your grades are the main measure of this. Increasing your productivity would result in better grades—and more free time. Adapt the factors that contribute to economic productivity to explain how you might increase your productivity as a student. A busy factory is one route to economic growth. Stimulating Economic Growth Government policies affect economic growth. Some policies have immediate effects that last for a short time. Other policies take longer to show results but have lasting impact. Create a Healthy Economy Reflecting on what you learned in this section, consider the following possible government actions. • open a protected wilderness area for coal mining • increase funding for scholarships for low-income students • provide tax breaks for companies purchasing new equipment • strengthen laws protecting the rights of inventors Explain how each potential action might lead to economic growth. Challenge Estimate the costs and the benefits of each action. Which actions would have the most lasting positive effect on the economy? 375 Case Study Find an update on this Case Study at ClassZone.com Poland: Economic Freedom and Economic Growth Background Communists ruled Poland and controlled its economy from 1948 to 1989. After holding its first free elections in 1990, Poland made rapid progress toward full democracy and a free market economy. Economic reforms included ending government price controls, privatizing industries formerly controlled by the government, and entering the international marketplace. As Poland moved away from government control of the economy, it experienced a surge in economic growth—outdistancing many other former Communist countries in eastern and central Europe. In 2004, Poland became a member of the European Union, further increasing its economic potential. What’s the issue? How successful is Poland’s economy? Read these documents to learn about the challenges and rewards of the country’s economic transition. A. Online News Article Wroclaw, a city in southwest Poland, offers one example of the country’s success through embracing global capitalism. This article describes that phenomenon. Wroclaw, Poland: Europe’s Next Appliance Capital? Appliance Manufacturers Pour into Southwest Poland Money and companies are pouring in—not just the prestige nameplates like Bombardier, Siemens, Whirlpool, Toyota, and Volvo, but also the network of suppliers that inevitably follows them. At first, most of the new jobs were of the semi-skilled variety. Now they have been followed by design and engineering work that aims to tap into the largest concentration of university students in Eastern Europe. “Everyone is coming, and they are coming very fast,” reports Josu Ugarte . . . who heads the appliance manufacturing operations here of Mondragon, the giant Spanish industrial cooperative. He predicts, confidently, that the region around Wroclaw will soon surpass Northern Italy as Europe’s appliance capital. . . . The secret isn’t just lower wages. It’s also the attitude of workers who take pride and are willing to do what is necessary to succeed, even if it means outsourcing parts production or working on weekends or altering vacation schedules. . . . Source: “Europe’s Capitalism Curtain” WashingtonPost.com July 23, 2004 Many manufacturers have opened factories in Wroclaw, Poland. This Volvo factory produces buses. Thinking Economically How has Poland’s human capital contributed to the country’s economic growth? 376 Chapter 12 Source: The Economist B. Political Cartoon Poland’s farmers were sceptical about the benefits of European Union membership. This cartoon reflects their change of heart as agricultural exports increased and they received new subsidies from the European Union. Thinking Economically Does the cartoon emphasize the free mar

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