Econ PG

A
ECONOMICS
POWER GUIDE
I. WHAT IS A POWER GUIDE?.................................................... 2
II. AUTHOR’S NOTE ON USAGE................................................. 3
III. CURRICULUM OVERVIEW........................................................4
IV. FUNDAMENTAL ECONOMIC CONCEPTS................................ 5
V. MICROECONOMICS............................................................... 25
VI. MACROECONOMICS............................................................. 70
VII. INTERNATIONAL TRADE AND GLOBAL DEVELOPMENT............125
VIII. POWER LISTS.......................................................................... 145
IX. POWER EQUATIONS.............................................................. 173
X. POWER TABLES.......................................................................175
XI. BIBLIOGRAPHY, ACKNOWLEDGMENT.....................................182
XII. ABOUT THE AUTHOR.............................................................. 183
BY
JOSEPH F. SLOWIK AND DEAN SCHAFFER
MICHIGAN STATE UNIVERSITY ’04 STANFORD UNIVERSITY ’10
WHITNEY YOUNG HIGH SCHOOL ‘00 TAFT HIGH SCHOOL ‘06
DEDICATED TO ALPACAS.
© 2007 DEMIDEC RESOURCES

ECONOMICS POWER GUIDE PAGE 2 OF 185 DEMIDEC RESOURCES © 2007
WHAT IS A POWER GUIDE?

Hello there, Decathletes and alpacas alike! My name is Dean Schaffer, and as this year’s Power Guide
Coordinator, I’ll be a tour guide of sorts for your visit to the strange and exotic land of DemiDec. Today
we’ll be observing the Power Guide.
Veteran Decathletes and past visitors will know that the Power Guide is a relatively new species that
evolved not long ago from a need for a more concise, fact-oriented study guide in the Decathlon world. The
creature is still in relative infancy, but all Power Guides are written in bullet form. Each bullet generally
contains one testable fact. DemiDec Resources (a distant cousin of the Power Guide in the same genus) will
help you learn a subject; Power Guides will help you review and master it.
Because the nature of the Power Guide can make it unruly, they are written only by current or former
Decathletes who scored at least 8000 points in competition. These authors are all highly qualified to tame
the beast so that it best serves you.
At first glance, Power Guides often appear bigger, fiercer, and more intimidating than the USAD Resource
Guide (another of the Power Guide’s relatives, but in a different genus), but don’t be fooled: the Power
Guide’s format makes it look bigger than it actually is. Bullets take up more space than prose, and Power
Guides have large margins to facilitate note taking. Further, the Guide’s posterior portion (otherwise known
as its latter half) is chock full of nutritious study tools that will help you digest the material as efficiently and
quickly as possible. These tools include lists, tables, and timelines.
Two years ago, Joseph Slowik wrote the Economics Power Guide. Last year, I rewrote it. This year, I
revised it. 1 This guide includes both Joseph’s research and everything I learned from the two years of
economics courses I took as a Decathlete. Economics tests often include ridiculous questions from way out
in left field; I hope this guide will help to bring that distant left field a little bit closer to home. 2
Economics has long been one of my favorite Decathlon subjects. Many of the concepts and ideas just seem
to “click”—they reflect real life situations. Unemployment, satisfaction, indifference—these are a part of life
and a part of economics. Oftentimes, thinking of real life examples is the best way to clarify a tough concept.
My very first econ teacher once told my team an “economics joke”: Two normal guys and an economist are
stuck on a desert island. They’re all desperate to get back to civilization, but the first two have no ideas. All
of a sudden, the economist says, “I’ve got it!” “What, what?” ask the other two excitedly. The economist,
beaming with pride at his ingenious solution, declares, “First, let’s assume we have a boat…” Like you
(probably), I didn’t laugh when I was first told this “joke.” After two years of studying econ, I finally get it. 3
Hopefully, when you’re done, you’ll get it too.
This time, I’ll continue with you as your tour guide with some help from Joseph. Enjoy your stay!
Sincerely,
1
Diminishing returns, anyone? – Dean
2
Sorry. I played baseball for over ten years. – Dean
3
But, to be honest, I still don’t laugh. – Dean
AUTHOR’S NOTE ON USAGE

The very nature of the economics event makes this guide a little different from the others. Since there’s no
given curriculum for 85% of the event, earning a high score is dependent on learning a broad swath of
economic knowledge. That’s where this guide comes in. The USAD Economics Basics Guide is a pretty
pathetic excuse for a study tool, which is probably why this guide is now sitting in front of you.
This guide includes all parts of the USAD outline of the economics event (except for the American Civil
War, which can be found in the Civil War Economy Power Guide). However, it also covers many topics not
mentioned in the outline because past tests have often included such outside information. Our goal is to
prepare you for both the easy questions and the random ones.
Key economic terms, names, books, etc. are emphasized in bold type. These bolded terms all appear after
the main text of this guide in the Power Lists, which are organized by section (fundamentals, micro, macro,
and international). Other lists cover economic legislation, theorists, and more. The Power Tables (just after
the lists) offer a more comprehensive review of several general topics.
A note on content: in any instance where “goods” or “services” are discussed, we are really referring to
both goods AND services unless otherwise specified, as both are the products or results of economic
activity. Additionally, unless noted or context indicates otherwise, “individuals” can mean individual persons,
firms, or even states. We sometimes use the term “agent” instead to avoid confusion.
Studying economics certainly requires more discipline and willpower than studying the other subjects
because you quite simply have to do most (if not all) of the work on your own. There’s no USAD guide to
lead you in the right direction. That being said, I commend you for picking up this guide. Since economics
can certainly be difficult, we’ve included a large number of examples and graphs to make key concepts and
ideas as clear as possible.
Unlike in other events, concepts are just as important as terms in economics. Knowing the theories behind
the terms will help you out on many a question; as you prepare for competition, try to gain an
understanding of the terms you’re trying to memorize. You’ll need this comprehension to conquer the
inevitable question that comes out of nowhere.
So, study hard and good luck! May you have a “perfect competition”!
-Dean and Joseph

CURRICULUM OVERVIEW
Economics is a social science. It revolves around the study of markets, exchanges, and satisfaction. The study
of economics is traditionally divided into four areas: fundamental concepts, microeconomics,
macroeconomics, and international trade.
In the first section of this guide, we will discuss the basic principles underlying economics. We’ll learn about
the general types of economies, markets, and decision-making. The concepts we encounter here are critical
in understanding the rest of economics.
Microeconomics focuses on consumers and businesses (firms). What factors influence consumers’ decisions?
How do firms decide how much to produce? What are the different types of markets? How does consumer
activity affect firms? These are all questions we’ll be addressing in microeconomics.
Macroeconomics deals with the economy as a whole. What is GDP and how do we measure it? What role
does the government play in the economy? What are inflation and unemployment, and how do they impact
society? In many ways, macroeconomics takes many of the concepts of microeconomics and applies them on
a national scale. Many consider macro more difficult than micro because macro is a bit more abstract. The
ideas that we’ll discuss, however, are extremely relevant to our lives today.
International economics is the final area of economics we will study. International economics examines how
nations interact and trade with one another. We’ll also discuss international trade organizations and the
exchange of currency.
If competition is rapidly approaching and you find yourself running out of time, you may want to focus on
macroeconomics. The most difficult questions generally come from macro, and tests are often more heavily
focused on macro than on any of the other three areas (despite what USAD may say in its outline).
Don’t forget that seven to eight questions will also be about the economy of the U.S. during the Civil War.
Information about the Civil War economy can be found in Meaghan McNeill’s Power Guide.
Below is a pie chart that details the breakdown of test questions in the economics event.
Civil War Fundamentals

15% 15%
Trade &
Development
10%
Microeconomics
30%
Macroeconomics
30%
FUNDAMENTAL ECONOMIC CONCEPTS

POWER PREVIEW POWER NOTES
This section gives a brief overview of basic economic 15% of the exam (7 or 8 questions) will
principles and the logic of economic analysis. Some of be from this section, but the concepts in
the information introduced in this section will be this section can appear in questions on
covered in greater detail in later sections. other sections
7 questions from the USAD practice test
are on topics from this section
See the bibliography at the end of this
guide for sources used
Scarcity and Wants

Unlimited human wants, but scarce resources
Wants are unlimited because they can never be completely satisfied
When one want is satisfied, a person will think of another
Wants are fundamentally different from needs
A person can satisfy his needs
Resources are scarce simply because not enough exist to meet our limitless desires
Only a finite amount of resources are available at any given time
Resources can be put to unlimited possible uses
We can always think of new uses for existing resources
Even time is scarce: there are unlimited ways in which we can use the limited time we
have
Human beings (or economic agents) must therefore decide how to allocate resources
among competing wants
Decisions involve choices among competing allocations of resources
The ultimate goal in deciding which wants to satisfy is to maximize utility
Utility is essentially satisfaction
When making decisions, therefore, we attempt to get as much happiness out of
them as possible
The definition of economics
Economics is a social science that seeks the optimal allocation of scarce resources to
satisfy unlimited wants
Economics allocates resources by examining costs, benefits, and the trade-offs between
these two inherent in any decision
Our goal is to maximize benefit while minimizing costs
Doing so is called optimization
Costs
Any given activity has two distinct types of costs
Accounting cost is the simple monetary cost of a good or service
Another name for this type of cost is explicit cost
It is also referred to as “out-of-pocket” expense because it’s the money that,
well, comes right out of your pocket, so to speak
When you buy gas for your car, for example, the price of the gas is the accounting
cost of your purchase
Opportunity cost is the value of the next-best alternative to a given activity, good, or
service 4
Opportunity costs are present in all economic choices
For example, the opportunity cost of reading this Power Guide is spending the
same amount of time (and effort) on an alternative activity 5
Opportunity costs reflect the nature of a trade-off
By choosing to allocate resources in one way, you are deciding not to use them
in another way
Opportunity cost is also known as implicit cost
In our previous example of buying gas, your opportunity cost is the time you spend
driving to the gas station and filling up your tank
This time may or may not have a monetary value (depending on if you could
have been somehow making money instead of getting gas)
A good without an opportunity cost is known as a free good
Very few examples of free goods exist
One example, however, is air
Air is “free” because there is no alternative to breathing, 6 not because we
don’t pay for it
The sum of both accounting and opportunity costs yields total economic cost
Economic exchanges and deals also have transaction costs
Transaction costs are the costs of making the economic exchange itself
There are several types of transaction costs
The first is the search and information cost
This category includes the cost of the time spent to determine if the desired
good is available, who has the best price, etc.
If Barefoot Ben decides to buy Air Jordan basketball shoes, the time he spends
looking for the best place to buy them constitutes his search and information
cost
The second is the bargaining cost
The bargaining cost includes the cost of the time taken for the two parties to
come to an acceptable agreement, draw up a contract, etc.
If Barefoot Ben decides to buy a new car instead of shoes, the time he spends
haggling with the salesman and signing the contract constitutes his bargaining
cost
The third is the policing and enforcement cost
This type of cost includes the cost of all the time and effort spent to ensure that
the other party of an agreement sticks to the agreed terms
If Ben’s car is still under warranty and needs a repair, for example, his policing
and enforcement cost includes the time he spends to make sure the car
company pays for those repairs
If the company refuses to do so, his policing and enforcement cost will
include the monetary cost of hiring a lawyer and going to court
Transaction costs of one type or another are inevitable with nearly all economic
exchanges
4
In layman’s English: the opportunity cost of what you do is the value of what you gave up to do it.
5
Like having fun. – Zac
6
But if you can find one, you’ll be rich. – Dean
The four assumptions of economics 7

In studying and discussing economics, we make four assumptions
People are rational
People are greedy
In other words, their desires are limitless (as mentioned before)
People act in their own self-interest
Resources are scare (as discussed above)
Scarcity is a consequence of our second assumption
The four basic factors of production
Available resources are divided into four factors of production: land, labor, capital, and
entrepreneurship
Land consists of all “natural” resources
Land includes actual land as we normally conceive of it (such as a forest), but it also
includes resources on the land (such as water or minerals)
Goods extracted from land are known as raw goods or primary commodities (such
as copper, trees, or oil)
In economics, payment for land is called rent
Remember: by land, we mean all natural resources
Capital includes all goods, and even processes, that are used to make other goods or
services
Capital has two distinct forms
Physical capital includes machines, devices, or goods which are used to produce
other goods
Examples include company trucks, office servers, factory machinery, and cash
registers
Human capital includes human capabilities
These capabilities include training, experience, intelligence, and knowledge
Education, therefore, is an investment in human capital
Payment for capital is called interest
Labor consists of human resources
Labor can take the form of pure physical activity to produce goods or services
It can also involve mental work, such as writing a Power Guide
Human capital includes the skills and capabilities of individual workers while labor is
workers’ actual efforts
Payment for labor is called wages
Entrepreneurship is a type of human resource, but it is very different from labor
Entrepreneurship entails combining the other three factors of production in new or
unique ways to produce new goods or improve the production of existing goods
Entrepreneurial activity, by definition, involves risk-taking
Because entrepreneurs look for new ways of doing things or using resources, there’s
no guarantee that they will be successful
Entrepreneurs risk failure through their activities and, thus, demand payments above
their normal return as an incentive
Payment for entrepreneurship is called profit
The production possibilities frontier
The primary reason people use resources to produce anything is to satisfy a want
To produce goods, persons (or businesses) combine the four factors of production
Since resources are finite, all production decisions involve trade-offs
7
These assumptions will probably not be tested, but you should keep them in mind as we discuss decision-making later.
Producers must decide to make certain goods over others

They must also decide on particular processes to produce these goods
In examining the production of any two goods, we find that producers can produce different
combinations of goods depending on how they allocate their limited resources
Production possibilities can be depicted in a table noting what combinations of two
different goods one can produce with different combinations of resources
Graphing these combinations produces the production possibilities frontier (PPF)
or production possibilities curve (PPC)
This graph shows the possible combinations one can produce with available
resources
Each axis of the graph represents the quantity of each good that can be
produced with a given allocation of available resources
The PPF
D
C
Good X
B
A
Good Y
The PPF implies that increasing the production of one good requires decreasing the
production of the other
To produce at any point on the PPF curve (such as points B and C) requires 100%
efficient production and the utilization of all available resources
All points on the curve represent equally efficient production and allocation of
resources
Social mores and immediate circumstances dictate which points on the curve are
“better” for a specific business or nation
Points B and C, therefore, are equally efficient
Producing at a point inside the PPF (such as point A) denotes inefficient production
Not all available resources are being allocated efficiently
Production at a point outside the PPF (such as point D) is impossible
There are not enough resources to achieve this level of production
Specialization and trade with other nations, however, can allow a nation to attain a
combination of goods outside its PPF
The PPF can shift outward if more resources become available or if technology
improves, allowing for more efficient production
If the PPF of an entire nation shifts outward, the shift represents economic growth
The PPF can also shift outward with increases in a nation’s stock of capital goods
Remember that capital goods are used to make other goods
An increase in capital goods now allows for the production of more goods later
The PPF illustrates opportunity costs and trade-offs
Moving from one point to another on the curve necessarily entails giving up
something else
Going from point B to point C, for example, gains more of Good Y at the
expense of Good X
The PPF will usually be bowed out from (or concave to) the origin
The shape of the PPF results from increasing costs as more of one good is produced
instead of the other
The reason for this shape is that certain resources are better-suited for producing
one good than another
As inappropriate resources are used to produce one good, the cost of producing
that good increases
Note that this increased cost includes increased opportunity costs: resources
that are less suited for the production of one good are more suited for the
production of the other
Ford Mustangs and wheat, for example, require incompatible resources
The PPF is linear (a straight line) if the two goods in question are perfectly
interchangeable
Producing one requires the exact same resources and skills as producing the other
Apples and oranges are often used as examples for this situation (see below)
A Linear PPF
Apples
Oranges
The PPF in action: guns and butter

The stereotypical goods used as examples when discussing the PPF are guns and butter 8
Guns represent goods produced in wartime
Butter represents goods produced in peacetime
Obviously, the inputs used to produce guns are not the same as those used to produce
butter 9
The graph below depicts the PPF of DecaLand, our imaginary nation
DecaLand is devoted to the production of two goods, and two goods only: guns and
butter
At point A, nearly all available inputs are being used to produce guns
These inputs include, of course, resources that are not very well-suited for producing
guns but are very good for producing butter
Dairy farmers are being employed to weld metal rather than milk cows
Sacrificing just a few guns would yield a relatively large quantity of butter
Conversely, we would have to sacrifice a lot of butter to get just a couple more guns
This situation illustrates the high opportunity cost that arises as we move toward
the ends of the curve (near the axes)
8
Or, as my old econ teacher used to say, “guns and butters.” – Dean
9
Though I have heard that cows make good ground-to-air missiles. – Dean
At point B, inputs are split more or less evenly between guns and butter
Gun factories are primarily producing guns
Dairy farms are mainly producing butter
At point C, we have a situation opposite that at point A
DecaLand has prioritized butter over guns
Some gun factories are being used, somewhat inefficiently, to produce butter rather
than guns
With this PPF, DecaLand cannot attain the combination of goods at point D on its own
Through specialization and trade, however, this point is attainable
Assume, for example, that DecaLand specializes in butter 10 and trades with Guns Galore
Kingdom for guns
Exchange theoretically allows DecaLand to have the combination of goods
represented by point D
The butter would be produced domestically and the guns would be imported
from another nation
However, DecaLand’s PPF may shift outward as a result of the discovery of new
resources, an increase in the nation’s capital stock, or an improvement in technology
If this new curve intersects or surpasses point D, point D is attainable
The capital stock of a nation is its total pool of capital resources
Remember that capital goods are used to produce other goods
This example helps illustrate the implications of the PPF in terms of opportunity cost
DecaLand
A D
Guns B
Butter
Economic Decision-Making
Cost-benefit analysis
While the PPF shows what production combinations of goods are physically possible, actual
production decisions are determined by individual values
Cost-benefit analysis is the decision-making process that guides all economic decisions
Simply put, this process entails making a list of the pros and cons of a decision
The costs (including opportunity costs) of producing or procuring a good are weighed
against the benefits of the next-best alternative
Rational persons, firms, etc. will choose to produce or acquire goods when the benefits
of doing so outweigh the costs
There are multiple types of costs that an individual must consider
An individual is ultimately concerned with the total economic cost of a good
Remember: Economic Cost = Accounting Cost + Opportunity Cost
Agents also face sunk costs in making decisions
10
We are, after all, a peaceful people. – Dean
Sunk costs are costs incurred in the past

They are, consequently, impossible to recover
For example, the non-refundable registration fee for an AP test is a sunk cost
For economists, a rational entity will NOT consider sunk costs in current decisions
As Stanley Jevons wrote, “Bygones are forever bygones”
The registration fee for your AP test should not influence your decision
afterward of whether or not you still want to take the test
Since sunk costs cannot be recovered, an agent must pay them regardless of their
decision 11
Marginal analysis
Economic decisions are usually based on the margin
Marginal essentially means “one more” unit of something
Marginal analysis is the study of what will happen if we change variables by small amounts
Marginal analysis typically looks at single units
In economics, marginal analysis typically applies to production and consumption
decisions
Marginal analysis is based on incremental increases or decreases of goods currently
consumed or produced
A decision on the margin is based on whether the consumption 12 or production of
another unit of a good will lead to a net increase in cost or benefit
In other words, marginal analysis is conducting a cost-benefit analysis for the
production or consumption of one more unit
Almost all economic decisions are based on marginal analysis
Decisions on the margin are based on two factors
Marginal cost is the cost incurred by producing or consuming one more unit of a
given good
Marginal benefit is the benefit created by producing or consuming one additional unit
of a good
For firms, these costs and benefits are normally expressed in terms of revenue
For consumers, these cost and benefits are usually in terms of utility
Marginal analysis is heavily influenced by the law of diminishing marginal utility
As stated above, utility is the pleasure or satisfaction an individual receives from a good
Marginal utility, therefore, is the satisfaction an individual gains from consuming one
more unit of a good or service
Utility values for goods are unique for each individual
Different individuals unknowingly assign different utility values for the same things
Joe may hate blue pens but love Magic Rub erasers
Sally, on the other hand, may be allergic to Magic Rub erasers and violently
opposed to black pens 13
Joe will assign a higher utility value to Magic Rub erasers than Sally
Conversely, Sally will get more utility out of blue pens than Magic Rub erasers
To illustrate the law of diminishing marginal utility, let’s assume that Frat-Boy Frank
hasn’t eaten in over a day
Frank decides that the best way to satiate his hunger is to order a fresh, piping hot
cheese pizza 14
11
However, recent research has shown that individuals do strongly consider sunk costs in decision-making. Whether
this is an inherent criticism of economics or instead calls into question the rationality of human beings is an open
question.
12
Note that the act of “consuming” a good includes purchasing it.
13
It should be illegal, what they put in those things. – Patrick
Since he’s very hungry, the first slice tastes great

In other words, his marginal utility from that slice was very large
His total utility at this point is equal to the marginal utility of his first slice
Total utility is the total satisfaction one has gained from a particular activity
Since Frank has only had one slice of pizza, his total utility is equal to the
utility he gained from that one slice
His second slice is also pretty good, but not quite as satisfying as the first
The marginal utility of the second slice is big, but not as big as the marginal utility
of the last slice
His total utility increases, but it doesn’t double
It increases by less than it did when he had his first slice
His third slice is decent, but it’s not as hot anymore as the first two
Frank is also a little bit less hungry by now
Again, his marginal utility for the third slice is less than it was for the second
His total utility has increased, but not by as much
Eventually, Frank has eaten so much pizza that he can’t even bear to look at melted
cheese and bread anymore 15
He concludes that the marginal utility of consuming one more slice of pizza
would be negative: it would decrease his total utility
Since Frank is a rational person, he decides not to eat something that will make
him less satisfied than he is already
So, Frank stops eating
To sum up Frank’s story, as we consume more of a single good, the marginal utility
value for the next unit consumed begins to decline
Total utility still increases (although at a decreasing rate) 16 until the marginal utility
value for the next unit consumed is negative
Decision-making in a social context
For many goods and services, individual and social goals and utilities are very different
What is best for a given society, community, etc. is not necessarily what is best for an
individual, and vice versa
Individual decisions may have effects beyond the satisfaction of that individual’s wants
An externality is a cost or benefit that affects a third party not involved in the
transaction or activity in question
A producer or consumer usually doesn’t factor externalities into decision-making
because he or she usually doesn’t pay the costs or receive the benefits
Externalities take two forms
Negative externalities occur when an individual’s (or firm’s) decision imposes some
harm on others
The individual does not have to pay for this harm and, consequently, does not factor
it into his or her decision 17
Negative externalities thus lead to situations that are not socially optimal
For example, Tito’s Toothpaste Factory may produce pollution (a negative
externality) as a by-product of its production process
When Consumer Catherine goes to the store to buy toothpaste, the price she
pays does not include the social cost of the pollution from Tito’s factory
14
Hopefully with pineapple. Mmmmmmm…. – Dean
15
In other words, he’s lost his culinary mind. – Dean
16
In calculus terms, the first derivative is positive, but the second derivative is negative.
17
Some good examples of negative externalities are second-hand smoke and pollution. – Zac
Ideally, Tito would factor the social cost of pollution into its decision-making and
have his factory produce fewer tubes of toothpaste
Since Tito does not factor in this cost, however, his factory makes more
tubes of toothpaste (and more pollution) than is optimal for society
Positive externalities result when an individual’s (or firm’s) decision results in
positive effects for society or other individuals
Since these benefits are not realized by the individual, they are not factored into his
or her decision
Positive externalities, therefore, also lead to situations that are not socially ideal
They do not provide a strong enough incentive to encourage decision-makers to
do more of whatever results in the externality
For example, Gardener Gary might plant a large patch of fresh roses on his front
lawn
Though Gary was the only person involved in planting them, passers-by and
neighbors enjoy the roses’ sweet fragrance
Their olfactory 18,19 pleasure is a positive externality
Gary’s neighbors, of course, want him to plant more roses so they can enjoy
even more of the scent
The positive externality (their happiness) does not, however, encourage
Gary to plant more roses
Consequently, there are fewer roses planted on Gary’s lawn than is socially
optimal
Unfortunately, far more decisions involve negative externalities than positive
externalities
Negative externalities are reduced and positive externalities are augmented by internalizing
their costs or benefits, respectively
An individual internalizes a cost when he or she pays it directly
An individual internalizes a benefit when he or she enjoys it
An individual will take these costs or benefits into account if they are internalized
Taxes, fines, and regulations can internalize the costs of negative externalities
These measures discourage an activity by increasing its cost
To go back to our example, Tito would likely cut production of toothpaste to a
level closer to the social ideal if his factory’s pollution were taxed
Subsidies, tax incentives, and other inducements can internalize some of the benefits
from positive externalities
These measures encourage an activity by increasing its benefit
Gardener Gary (from our example) would be more likely to plant more roses in
his garden if his neighbors all chipped in to help cover the cost of the flowers
Internalizing externalities help move the individual (or firm) toward the socially optimal
level of activity
Social goods are often the result of, or are realized through, collective action
Collective action is required when a common or mutual good can only be brought
about by individuals working together
Since individuals pursue individual interests or have divergent interests, coordinating the
actions of individuals can be difficult, leading to collective action problems
Agents broadly agree on achieving a certain goal but not always on how to attain it
specifically
18
SAT Word Alert! “Olfactory” means “of or pertaining to the sense of smell.” – Lawrence 2006
19
Whoa. Did I really say that in a footnote? – Lawrence 2007
Collective action problems can be resolved by imposing costs on those who fail to
cooperate or by facilitating cooperation
Positive vs. normative economics
In economic analysis, there are two types of statements: positive and normative
Positive economics is only concerned with “what is”
Positive economics concern only statements that can be tested for truth
These statements do not necessarily have to be true, but they must be testable
In other words, they can be proved valid or invalid
Positive economics does not include opinions
Example: “The unemployment rate of the United States in April 2005 was 5.2%”
We could easily conduct a study to verify whether or not this figure is true
Example: “There are more women than men in California”
Again, this may or may not be true
We could, however, commission a study to find out
Since we can prove or disprove this statement, it is a positive statement
Normative economics concerns judgments and opinions
Normative statements usually concern “what should be”
Example: “In order to promote growth, the U.S. government should allow free trade
with Mexico”
This statement does not express an idea that is factually testable
Therefore, it is normative
Example: “If the unemployment rate hits 6%, we should increase government
spending by 3%”
Though this statement involves statistics, its main idea (we should increase
government spending if unemployment climbs) is an opinion, not a fact
Normative statements are often simple statements of opinion
Example: “DemiDec Dean should take a vacation”
Regardless of whether or not you agree, this statement cannot be considered
testable fact
The easiest way to differentiate between positive and normative statements is to look for
certain normative “flags”
If a sentence contains words like “should,” “must,” or “ought,” then it is most likely
normative
Some normative statements take this general structure: “if X, then we ought to do Y”
Economic Systems
The three fundamental questions 20
There are three basic economic questions that all societies must answer
Who answers these questions determines the economic structure of a society
The three questions are listed below
What to produce?
How to produce?
Who receives the benefits of production?
Traditional economies
In traditional economies, these questions are answered by, well, traditions
20
Some economists believe there are actually four; others argue that there are five. For our purposes (and USAD
tests), assume there are three. The most common fourth question is “How much to produce?”
Social mores 21 and generally accepted norms govern who produces what and how they do
it
Basically, “We do it that way because we’ve always done it that way”
Very few traditional economies exist in the world today
Some remote areas of Brazil and Indonesia, however, are home to traditional
economies
Planned economies
In planned economies, the state answers production and allocation questions
Planned economies feature production targets for the economy to determine the supply of
goods
There are two types of planned economies
In an indicative economy, 22 decisions are made by groups for the benefit of society as
a whole
These groups steer the economy in a specific direction
Democratic decision-making and institutions are often present
An example was Sweden a few decades ago
In Sweden, most production was controlled by private firms, but the government
directed this production, set goals, and offered incentives to encourage firms and
individuals to meet these goals
In a command economy, decisions are made by figures with absolute authority and
no accountability
These systems are markedly more despotic
Consequences for not following the directions of the state are often severe
Examples include the former Soviet Union and communist China 23
In a planned economy, the state either owns or controls the means of production
Goods are often rationed
Individuals are allocated fixed amounts of goods
Prices (including wages) are fixed by state-controlled agencies
Production, investment, and labor decisions (such as where one works) are determined by
the state
Planned economies have several benefits
Externalities are generally eliminated
Costs and benefits which would be ignored by individual, private agents are taken
into consideration by central planners
Price and wage controls result in a controlled income distribution
Theoretically, this distribution should be relatively egalitarian
Planned economies also have some disadvantages
Price and wage controls may also require significant control over personal activity
This control is particularly necessary when the planned prices or wages differ from
what they would be in a functioning market economy
The only way to maintain controls is through restrictions of personal liberties
Price- and wage-setting is difficult and often inaccurate
Government authorities are motivated to price basic commodities very low
Doing so results in either shortages or severe rationing
In either case, most people cannot procure these basic goods
21
SAT Word Alert! Mores (pronounced mórays) are the traditional customs, traditions, etc. of a group. – Dean
22
You should note that USAD considers a “planned” economy equivalent to an “indicative” economy rather than an
umbrella term that includes both indicative and command economies.
23
As those who studied the 2006-2007 curriculum know, China is leaning more and more toward a market economy.
Shortages will be discussed in more detail with price ceilings later

Planning eliminates entrepreneurship as a factor of production
Profits are eliminated by price and wage controls
Thus, entrepreneurial activity is effectively stifled by a lack of rewards
The society suffers because of a lack of innovations
Market inefficiencies result, some of which the government must remedy through
even more intervention
Wage and price controls can eliminate individual motivation to work, also resulting in
inefficiency
Resources are allocated to activities which the state values, instead of what individual
consumers would choose for themselves
The result is a very limited variety of consumer goods
The political ideologies most frequently associated with planned economies are socialism,
Marxism, Leninism, and Maoism
Perhaps the most influential form of planned economics is attributed to Karl Marx
The most important Marxist work, which inspired and influenced most modern
communist thought, is The Communist Manifesto (1848)
This work was co-authored by Friedrich Engels
Marx was not, however the first modern socialist
He was predated by the utopian socialists, including Thomas More, Robert
Owen and Charles Fourier
For testing purposes, decathletes should associate socialism with indicative economies 24
and communism with command economies
Since the collapse of the Soviet Union and the introduction of market reforms in China,
only a few “planned” economies still exist today, such as Cuba and North Korea
Market economies
In free market economies, production and allocation questions are decided by individual
economic agents interacting in free markets
Self-interest and profits motivate the actions of all individuals and firms
Resources are allocated based solely upon the free supply and demand of goods in a market
environment
Private agents control the means of production
Individuals set their own production and consumption goals
The state is removed from all economic decisions
This concept is known as laissez faire 25
This phrase means “Leave them [businesses] do [whatever they want]”
The state merely sets the “rules of the game”
It enforces property rights, contracts, and other laws
Prices are determined by the willingness and ability of firms to produce and supply goods
and the willingness and ability of individuals to buy them
The quantity of a good demanded or supplied is also determined through market forces
Market economies have certain benefits
Resources are efficiently allocated to profit-maximizing endeavors
Inefficient industries, production methods, etc. are allowed to fail or go out of business
As a result, inefficient activities don’t tie up scarce resources from more productive
activities
Allocative efficiency prevails
24
Remember that USAD considers planned economies to be synonymous with indicative economies.
25
“Laissez faire” is the same as “Laissez passer” (“Let them [businesses] pass”).
Resources are allocated to those activities that society values most

What society values most is determined by what individuals demand
In an economy experiencing allocative efficiency, individuals’ overall satisfaction
cannot be increased by producing more of one good or less of another
Competition allows for creative destruction
Old practices or obsolete goods are eliminated in favor of new, more efficient, or
simply better goods which increase social welfare 26
Creative destruction results in social and economic progress
Individuals are free to pursue whatever economic activity they desire within their means
Decisions are not made for them
Market economies also have certain disadvantages
Competition can (and usually does) create inequality, particularly wealth inequality
The distribution of wages may not be totally just
Prices may be higher or lower than we think is fair
Externalities (especially negative externalities) are more prevalent in completely free
markets because there is no way to internalize them
Many activities with positive externalities are not pursued to the socially optimal
level
Similarly, firms ignore the negative externalities of their activities as long as they
continue to make profit
Market economies are generally not completely “free”
Even in laissez-faire economies, governments still step in to enforce laws so that anarchy
does not prevail
The state must always have some presence to ensure an orderly society even if the
economy is free
Governments in market economies do NOT answer any of the production or allocation
questions
These questions are left entirely to the market to decide
Very few (if any) pure markets exist today
The political ideologies or theories most often associated with market economies are
capitalism and libertarianism
Capitalism is generally seen as arising from the writings of Adam Smith in response
to mercantilism
Mercantilism was a prevalent government policy throughout the Middle Ages and
the Renaissance
Countries prioritized the accumulation of precious metals, or bullion
Mercantilism was characterized by heavy government intervention in the
economy
Capitalism favors the use of markets to decide almost all production and allocation
questions
It also admits, however, that governments have an important role to play in
providing public goods (to be discussed in macroeconomics)
Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations (The Wealth of
Nations, for short) was published in 1776
It is widely considered to be the work that established capitalism and the
modern study of economics
In this work, Smith proposes that an “invisible hand” guides market activities
toward an equilibrium
26
Though an important benefit, this leads to structural unemployment (discussed in macroeconomics).
The invisible hand represents the forces of supply and demand (discussed in
microeconomics)
We can’t see these forces, but they have a very real influence on the
economy
Government intervention merely hinders these forces
Libertarianism is a more extreme form of market economics that advocates that
governments should have no role at all in private decision-making
Prominent libertarian thinkers include Ayn Rand and Robert Nozick
Mixed economies
In mixed or mixed market economies, both the state and the market are involved in
answering production and allocation questions
These economies attempt to combine the “best of both worlds”
The innovation and efficiency of free markets are included by allowing markets to
operate relatively freely
The safety nets and egalitarianism of planned economies are included by allowing the
government to intervene when necessary
Both private individuals and the state participate in the economy and own portions of the
means of production
Some areas of the economy may be reserved for the government
These areas of the economy feature public monopolies
Public monopolies include services such as providing drinking water, the national
postal service, and the fire department
These areas are seen as too vital to be left to market forces and the private sector
With very few exceptions, all modern states feature mixed economies
While the terms are not as clear-cut, the political ideologies most often associated with
mixed economies are liberalism and social welfarism (or social democracy)
Liberalism (in the classical sense) generally favors private enterprise over public
involvement
Social welfarism, on the other hand, favors government or public involvement over
private businesses
The most prominent economic figure for mixed economies is the British economist
John Maynard Keynes 27 (1883-1946)
Keynes’ most significant work was the General Theory of Employment, Interest,
and Money (1936)
27
Pronounced “canes.”
COMPARING ECONOMIC SYSTEMS 28

Who Owns the Who Makes Who Makes Who Receives the
Type of Economy Means of Economic Political Benefits of
Production? Decisions? Decisions? Production?
Individual persons Whoever is willing to
Market Economies and firms
Individuals Individuals
pay the most
The state decides

Indicative If democratic,
The state The state how benefits are
Economies individuals
distributed
The state decides

Command
The state The state Dictators, kings, etc. how benefits are
Economies distributed
Primarily whoever is
Primarily individuals
The state and willing to pay, but the
Mixed Economies individuals
with some state Individuals
state will intervene if
action
necessary
Traditional Traditional bodies Traditional Traditional

Traditional authorities
Economies (e.g., the village) authorities allocations
Competition
Competition is the central focus of all non-planned, modern economies
Pure market economies, by definition, are founded on competition in a free marketplace
between individual producers to meet consumer demands
Mixed economies manage competition in various ways
Regulation of goods and services ensures that competition does not undermine social
welfare
Examples of regulation include product standards, health and safety standards, etc.
Competition policy involves the regulation of the activities of firms
These policies usually work to ensure fair market conditions by regulating (and
sometimes preventing) monopolies and oligopolies (more on this later)
Incentives and Individual Decision-Making

Positive and negative incentives
Individuals respond to incentives in predictable ways
Incentives alter the behavior of an economic agent based upon that agent’s utility values
Or, in simple terms, incentives attempt to persuade an individual (or firm) to do or not
do something
All incentives change the costs and benefits of a given action
Positive incentives increase the benefits an agent receives from an action
Positive incentives result in a utility gain for an individual
Positive incentives cause an individual to act in a way that he otherwise would not
For example, Lazy Louis is really thirsty but doesn’t feel like getting up from his
comfortable couch
He offers his younger brother, Greedy Gill, $5 to get a soda for him from the
fridge
The $5 is a positive incentive to encourage Gill to do something he wouldn’t do
otherwise
By offering Gill the money, Louis hopes to increase his younger brother’s utility
enough that Gill will bring Louis a drink
Negative incentives 29 increase the costs an agent receives from an action
Negative incentives result in a utility loss for an individual
They can cause an individual to not act in a way that he otherwise would choose to
without the disincentive
For example, Lazy Louis’s mom, Mean Marie, might tell Louis that she’ll make
him scrub the bathroom floor the next time he tries to bribe Gill 30
To avoid a loss in utility (and nasty germs), Louis might choose not to bribe
Gill into bringing him soda in the future
Conversely, negative incentives can be used as threats to encourage an individual to
act in a certain way
For example, Lazy Louis could tell his other brother, Weakling Wesley, that he’ll
punch Wesley in the stomach if he doesn’t bring Louis a soda 31
In order to avoid a loss in utility, Wesley may comply with Louis’s request
How incentives work
Incentives work by appealing to the rational self-interest of individuals
Individuals will perform activities or consume goods which promote their self-interest
Positive incentives can be used to appeal to another’s self-interest
Individuals will avoid activities or goods which work against their self-interest or do not
promote their self-interest as much as alternatives do
Negative incentives can be used as a potential threat to another’s self-interest
Different forms of incentives
Since they are based upon individual utility values, incentives can take a variety of forms
Incentives must be tailored to meet an individual’s unique utility values
Monetary incentives are financial benefits or costs linked to certain activities or goods
An example of a positive monetary incentive is the $5 that Louis offered to his brother
Gill
Non-monetary incentives are non-financial benefits or costs that cannot easily be
reduced to monetary terms
Nonetheless, they can still invoke costs or create benefits
An example of a negative non-monetary incentive is the punishment Marie used to
threaten Louis (scrubbing the bathroom floor)
Exchange and Markets

Voluntary exchange
In seeking to promote or realize utility, economic agents will enter into voluntary
exchange to attain desired goods
Voluntary exchange is the free choice of individuals to exchange goods via a means of
exchange (such as money)
29
Negative incentives are also known as “disincentives” and “deterrents.”
30
What a nice, happy family. – Lawrence
31
Louis is an example of what we refer to in economics as a “jerk.” – Patrick
Voluntary exchange should occur whenever both parties of a potential exchange expect
to gain
If either party expects to lose, they will not participate voluntarily in such an exchange
Involuntary exchange
Involuntary exchange can occur in practice
Involuntary exchange occurs when one (or even both) parties of an exchange do not expect
to gain from it
Involuntary exchange can only occur as a result of coercion or force
This force can be from one of the two parties to the exchange or from a third party
For example, airlines sometimes force passengers to “accept” travel vouchers
instead of taking a flight because there’s not enough room on the plane32
A judge forcing a defendant in a lawsuit to compensate the plaintiff would be an
example of intervention by a third party
Markets
Markets operate based on the laws of supply and demand
These laws will be discussed in detail in the microeconomics section
When a given activity is governed by market forces, the laws of supply and demand
determine the price and allocation of resources to be exchanged
A market exists wherever and whenever two or more parties wish to make an exchange
Markets include formal markets such as supermarkets and national markets such as the
entire United States economy
With the advent of Internet shopping, markets don’t even have to exist in a physical
place
Markets also include underground or informal markets
Selling your friend a bottle of water for a dollar constitutes a market
Voluntary exchange takes place in, and is facilitated by, markets
Exchange in markets
Markets require a means of exchange to exist to facilitate transactions
A means of exchange allows individuals to transfer goods
Barter is a means of exchange where goods are exchanged directly for other goods
Bartering requires a double coincidence of wants
In other words, each party in the exchange has to want what the other has
Complex transactions become exceedingly difficult using bartering
Imagine, for example, trying to obtain all the different materials necessary to
build a house using a barter system 33
Barter, however, has the advantage of being immune to inflation
Since there is no single, central currency, relative prices remain stable
Money is a medium of exchange which can be traded for any good or service
It eliminates the requirement of a double coincidence of wants
Money will be discussed in more detail in macroeconomics
A means of exchange smoothes transactions and allows markets to function more efficiently
Three interpretations of markets
Classical economists believe that goods of the same quality will have the same price in a
market
This idea is also known as the law of one price
Businesses view markets as a collection of buying and/or selling opportunities
The political or legal view is that markets are free trading zones
32
As has happened to DemiDec Dan several times. – Dean
33
You’d probably have to trade a cow for five rabbits for a hammer and box of nails…or something. – Dean
There are no restrictions placed upon exchanges
Specialization, Interdependence, and Trade

Specialization
Markets and voluntary exchange allow economic agents (including nations) to specialize in
producing certain goods
They then trade for the necessary goods that they don’t produce
Specialization is based on the division of labor
The division of labor is the allocation of workers so that each worker is responsible
for only one type of good or only one step in the production process
The division of labor allows for increased productivity
Productivity is how much a worker can produce in a given time period
Workers can acquire and perfect specialized skills through the division of labor,
increasing efficiency and production
Workers do not have to physically move from one activity to another, saving time
Instead of each individual person providing every good he needs for himself, he can
specialize in one particular good and exchange it for others
This system assumes that others are also willing to exchange the goods they produce
If two people were stranded on a desert island, for example, one can specialize in
hunting and the other in fishing
The two can then trade with one another so each has fish and meat
Over time, the hunter will become a better hunter, and the fisher will become a
better fisher
This system is far more efficient than if each were to both hunt and fish
The benefits of specialization do not apply to individuals alone
They also apply to firms and even countries
Specialization may result from different factor or resource endowments
The distribution of resources geographically is inherently unequal
Some nations have an abundance of minerals, others have a highly skilled workforce,
and still others have a large population of potential workers
A nation’s factor endowment is its unique combination of resources
Specialization and trade allow individuals and nations to compensate for unequal access
to the various factors of production
Comparative advantage
Specialization and trade are fueled by the theory of comparative advantage
The theory of comparative advantage was first presented by David Ricardo in The
Principles of Political Economy and Taxation (1817)
Comparative advantage is founded upon the idea that any economic agent can produce at
least one good more efficiently than other goods
By “more efficiently,” we really mean at a lower opportunity cost
An entity should focus on producing what it produces most efficiently and then trade
with other agents to meet its other needs
If an agent has an absolute advantage in a certain good, it 34 can produce more of that
good than other agents can with the same quantity of resources
Even an agent holding absolute advantage is better off trading with others due to
relative price
Relative price is related to the PPF
34
We use the pronoun “it” here because an agent can be a person, firm, nation, or anything in between.
The relative price of one good is the amount of an alternative good foregone
Relative price is essentially a specific instance of opportunity cost
For example, let’s assume that we could produce 10 cars or 20 jackhammers with
the exact same resources
The relative price of one car is two jackhammers
Conversely, the relative price of one jackhammer is half of a car
Absolute advantage looks at relative prices between countries
For example, the US produces airplanes more efficiently than China
Comparative advantage, on the other hand, looks at relative prices within countries
For example, the US produces airplanes more efficiently than basketball shoes
Since every country must produce one good more efficiently than another, trade is
almost always advantageous, even when one country has an absolute advantage in all
goods
When looking at the goods produced by two countries, each country will always
hold a comparative advantage in at least one good
When examining possibilities for trade, an individual agent should specialize in producing the
good it can produce at the lowest relative price (opportunity cost)
Even if an agent has an absolute advantage in all goods, it is still better off focusing on
doing what it does best and trading this good to meet its other needs
Similarly, even if an agent is dreadful in producing all goods, it will still be least dreadful in
producing something
It should specialize in this one good
When relative prices for goods between any two agents are equal, the two should not trade
No gains can be made
When the relative prices for goods differ, agents should always specialize in the good for
which they have the lowest opportunity cost to gain efficiencies in production and then
trade
Absolute and comparative advantages will be discussed in more detail in the international
trade section
Positive- and zero-sum games
A positive-sum game is a situation in which all parties can benefit
Improving the welfare of one agent does not mean that another automatically loses out
Specialization and trade are a positive-sum game
A zero-sum game is a situation in which the improvement in the position of one agent
means that another will have to lose out
Free trade and specialization
The gains from specialization and trade are best achieved through free trade
Individual agents can only specialize and become more efficient or productive when they
know they can trade for the other goods they need later
If trade is restricted, then individual agents won’t be able to specialize as well or at all
They can’t be sure that they’ll be able to trade in the future to satisfy all of their wants
Miscellaneous Basic Economic Concepts35

Ceteris paribus
When economic analysis seeks to isolate a single factor, all other factors are assumed to be
ceteris paribus 36
35
The economics outline includes some other topics about international trade here. These topics have been relocated
to p. 132 (in the International Trade and Economic Development section).
Ceteris paribus is Latin for “all other things constant” or “equal”

As a social science, economics involves a huge array of variables
Economists assume that all other variables are held constant in an effort to isolate matters
of interest 37
However, the consequence of doing so is that analyses are somewhat less realistic
Different time frames
Time frames in economics are based upon the ability of economic agents, primarily firms, to
vary their use of the factors of production
Time frames are defined by what, or how many, factors are fixed and how many are variable
The short run is the amount of time in which some factors of production (or factors of
anything) are fixed
For example, a firm does not have enough time to build a new factory in the short run
It can, however, hire more workers or increase production
In the long run, everything is variable 38
All factors of production can be manipulated
The firm in the above example can build and open a new factory
Fallacies
As we begin to examine micro- and macroeconomics, we must remember that the
principles of one do not necessarily apply to the other
The fallacy of composition points out that what is true for the parts is not necessarily
true for the whole
We must remember that what may be best for a firm or individual may not be a good
idea for the economy as a whole
The fallacy of division, in contrast, reminds us that what is true for the whole is not
necessarily true for the parts
In other words, what may be best for a nation or aggregate economy may be less than
ideal for an individual economic agent
36
Remember the economist’s boat… – Patrick
37
This method is analogous to conducting a controlled experiment with one variable.
38
Or, as Keynes rather spitefully put it, “In the long run, we’re all dead.” – Lawrence
MICROECONOMICS
This section covers microeconomics. Microeconomics 30% of the exam (15 questions) will
focuses on the behavior of individual economic agents, focus on microeconomics
such as consumers and firms (businesses), and how these 11 questions from the USAD practice
agents interact in markets. test are on this section
Microeconomic Basics
Overview of microeconomics
Microeconomics focuses on the economic decisions of individual agents
Microeconomics is concerned with individual consumers, groups of consumers, and
producers
Businesses (usually producers) are referred to as “firms”
Microeconomics focuses on the choices of individual decision-makers and the reasons
underlying these choices
Microeconomics also discusses the allocation of scarce resources among possible uses
Microeconomics specifically involves the determination of price through the interacting
behavior of economic agents
The behavior of individuals is governed by utility
Consumers seek to maximize utility
The behavior of firms is governed by profit
Firms seek to maximize their profits
Microeconomics and markets
Microeconomics examines the behavior of individual consumers and firms in markets
Markets exist when buyers and sellers interact to participate in voluntary exchange
Consumers, or buyers, demand goods
Firms, or suppliers, supply goods
Interaction between firms and consumers creates a market
Markets function through, and because of, prices
Prices provide a common, standard measurement for valuing goods and making
exchanges
When prices do not formally exist, individuals must barter for goods
Barter is inefficient because a double coincidence of wants must exist for exchange
to take place
Each party in an exchange must have something that the other wants
Prices provide a means of comparing otherwise incomparable goods
Compare the value of one good in terms of another good is difficult
How many apples is an orange worth?
How many oranges is a hammer worth?
Prices allow for uniform comparisons of goods
Consumers compare prices to individual utility values
Using this comparison, they can decide whether or not a good is worth buying
Price comparison also makes it easier for producers to make production decisions
Producers can compare the price for which a good will sell to the cost of producing
it
Prices allow producers to calculate expected profits
Without prices, producers would be unable to plan production decisions in advance
Markets and prices are governed by the laws of supply and demand
Types of Firms
Overview
In economics, there are three basic organizational structures for firms
The first is the proprietorship
It is owned and controlled by one individual
The second is the partnership
It is owned and controlled by two or more individuals
The third is the corporation
It is owned and controlled by stockholders and controlled by a board of directors
Proprietorships
A proprietorship is owned by only one individual
While proprietorships only account for about 5% of business sales annually, they make
up about 70% of all firms in the US
Proprietorships have several advantages
They are very easy to form and dissolve
Decision-making is very easy because the owner makes all decisions
Communication between employees and the owner is very direct
Profit is only taxed once
This tax is in the form of an income tax on the owner
There is no corporate tax (discussed below)
The owner has a high incentive to make his business profitable since all profits go
directly to him or her
Proprietorships also have some disadvantages
Because there is only one owner, proprietorships often only have limited financial
resources
As a result, proprietorships do not usually produce a wide variety of products
A small budget limits product diversification
The owner is also 100% liable for anything that happens to his or her business
Any losses will come directly out of his or her personal assets
If someone sues the business, the owner is responsible for taking on the lawsuit
and compensating the plaintiff (if the owner loses the suit, of course)
As a result, proprietorships often have high insurance costs
Examples of proprietorships include most small, local businesses
Partnerships
Partnerships are owned by two or more individuals
While partnerships only account for about 5% of business sales annually, they make up
about 15% of all firms
Partnerships have several advantages
They have more human and financial resources than proprietorships
More resources allow for more product diversification
Profit is only taxed once
This tax is the income tax of the owners
There is no corporate tax
Because there are just a few owners, these owners have a big incentive to make
their business profitable
Partnerships have a few disadvantages
They are slightly more difficult to form and dissolve than are proprietorships
The communication between employees and owners and among owners is not as
direct as it is in proprietorships
Decision-making is slightly more complicated in partnerships because there is more
than one person in charge
The owners still have full liability for their company
Each partner is responsible for the acts of his or her other partner(s)
Examples include many professional firms, such as law firms and medical practices 39
Corporations
Corporations are owned by stockholders
Stocks will be discussed in the “Stocks and bonds” section below
While they only make up about 15% of firms, corporations are responsible for about
90% of sales annually
Thus, corporations are responsible for a large economic impact, especially relative
to how many exist
Corporations have several advantages
Of the three types of firms, corporations have the most financial resources due to
the sale of stocks and bonds
As a result, corporations are free to develop a very diversified product line
Stockholders have only limited liability
An individual’s liability is determined by the number of stocks he or she owns
The corporation itself is a separate legal entity
Corporations also have some disadvantages
Decision-making is difficult and extremely complex
A board of directors usually controls a corporation
These directors have to vote on courses of action
Decisions can take a long time
There is very little direct communication between management and employees
Profit is taxed at two levels
The first is the income tax of the stockholders
The income of these stockholders includes the dividends they receive from
the corporation
These dividends are taxed along with the rest of the individuals’ income
The second is in the corporate profit tax
The corporate profit tax is, well, a tax on a corporation’s profits
Corporations are considered separate legal entities—non-human individuals
in the legal system
Like regular individuals, corporations must pay an income tax
For corporations, this “income tax” is the corporate profit tax
Corporations are also subject to the principal-agent problem
In this case, the “principals” are the company’s shareholders
The agents are the company’s managers
Because of the nature of corporations, managers often make decisions with their
own benefit in mind rather than the benefit of the company
CEOs, for example, might give themselves huge raises
39
My dad’s law firm is a partnership. My mom works in an accounting firm that is also a partnership. – Dean
Other times, managers embezzle from their own company

When a corporation makes profit, it has two options
The first option is to distribute its profit in the form of dividends
A dividend is a share of profit paid out to stockholders
The second option is to keep the profit as retained earnings
Retained earnings are also known as undistributed profit
A company that keeps retained earnings usually does so to invest in new
opportunities and technology
Basically, it uses the extra money to promote growth
Examples of corporations include Burger King, Pepsi, and WalMart
Stocks and bonds
Corporations can sell stocks and bonds to raise money for the company’s operation
A stock is a legal document of ownership
Every stockholder in a company legally owns part of that company
There are two types of stocks
The first is common stock
Those who own common stock have a say in how the company is run
When important issues are discussed, each share of stock entitles its
owner to one vote
Of course, those who own more shares have more votes
The second is preferred stock
Those who own preferred stock do not have a vote in the company
They do, however, have priority over owners of common stock in receiving
company dividends
There are several motivations to buy stock
The price of the stock may go up
The owner can then sell the stock and make a profit
Shareholders often receive dividends from the company
The Initial Public Offering (IPO) price is the price of a stock when it first goes
on the market
Each stock also has a P/E ratio
This is a ratio of the price (P) of a stock to its earnings (E) or dividends per share
The P/E ratio tells stockholders how long, at the current earnings rate, it will
take for them to make back the money they spent to buy the stock
Let’s assume, for example, a share of stock in Calvin’s Corporation costs $20
The earnings on each share per year are $2
The P/E ratio, then, is 20/2 = 10
It will take 10 years for a stockholder to make back the money he or she
spent to buy the stock
The P/E ratio assumes, of course, that the earnings of the stock remain constant
The P/E ratio, therefore, is only a projection, not an absolute certainty
A bond is a promissory note, or I.O.U.
When an individual buys a bond, the company promises to repay the individual the
amount of the bond plus some interest in a certain period of time
The amount of the bond itself is called the principal
Investor Inessa, for example, could buy a $500 bond from a company
The company promises her, in return, that it will pay back the $500 plus 4%
in interest when the bond comes due in six years
If a company goes bankrupt, however, bondholders may or may not get their money
back
Bonds are rated in safety from AAA to DDD

These ratings relate the risk of buying a bond from a certain company
“AAA” means that the bond is very safe
“DDD” means the bond is extremely risky
There are several motivations to buy bonds
Buying a bond forces the bondholder to save money
He or she cannot use the money spent on the bond until the bond comes
due (is paid back) later
Bondholders gain interest from owning the bond once it comes due
Corporation dividends are paid out in a specific order
Bondholders get dividends first, followed by preferred stockholders, and, lastly,
common stockholders
Mergers
A merger occurs when two or more businesses unite under the same ownership
One can buy the other or the two can simply combine (merge)
Mergers fall into three categories: horizontal, vertical, and conglomerate
A horizontal merger occurs when two companies at the same stage of production
merge to eliminate competition
For example, McDonald’s buying Burger King would be a horizontal merger
These two companies are at the same stage of fast-food production
A vertical merger occurs when two companies at different stages of production of
the same product merge
For example, McDonald’s buys a meat processing company
Meat processing companies sell their output to McDonald’s and other companies
Therefore, they are all involved in the production of the same product, only
at different phases
A conglomerate merger occurs when two totally unrelated companies merge
For example, McDonald’s and Sony merge together
The Celler-Kefauver Act (1950) prohibited any type of merger that gave the merging
firms an unfair advantage in the marketplace
A merger which creates an “unfair advantage” is one which creates a monopoly
Supply and Demand 40

Supply
The study of supply is sometimes referred to as the theory of the firm
Supply is the quantity of a good or service that producers are willing and able to produce
at any given price
The quantity supplied of a good is the amount of a good supplied at a specific price
Price and quantity supplied are directly or positively related
The quantity supplied is a point on the supply curve while supply refers to the entire
supply curve 41
The law of supply governs changes in quantity supplied
The law of supply reflects the direct 42 relationship between price and quantity supplied: as
the price of a good increases, the quantity supplied of a good increases
40
If you encounter a supply and demand question on an exam, I HIGHLY recommend that you graph it (using the
information to follow). Doing so will help you visualize what is being asked and come to the correct answer.
41
This is a very important distinction. Very important. Even more important than carrying a towel. – Joe
42
Note that the term “direct” does not mean there is a 1:1 relationship between quantity supplied and price. Supply
curves are often not straight lines: changes in price do not always result in a proportional change in quantity supplied.
Higher prices allow for higher profits at higher levels of production

Subsequently, firms already producing the good will produce more of it
Economically speaking, more firms are willing and able to supply more goods at
higher prices
In the long run, higher prices will also attract new firms or producers to enter the
market, which increases total market supply
The short run is too brief a time period for new producers to enter the market
Supply can be represented by a table called a supply schedule
The supply schedule lists the number of goods producers are willing to supply at each
price
The prices are unit prices, which represent the price of each good supplied
Below is an example of a supply schedule for William’s Widgets
Supply Schedule for William’s Widgets

Price per Widget $5 $10 $15 $20 $25
Quantity Supplied 1 3 7 10 13
Supply is represented visually by the supply curve

Supply is graphed with price located on the vertical axis and quantity supplied on the
horizontal axis
The supply curve slopes upward: the slope of the curve is positive
The supply curve slopes upward because producers are more willing to supply a
good at higher prices
Thus, the quantity supplied increases as price increases
A change in quantity supplied is represented by a movement along the supply curve
A movement along the curve is from one point to another on the curve
A change in supply is represented by a shift of the entire supply curve
A shift in the supply curve means that the quantity supplied of a good at all prices
changes
An inward shift (left, or toward the origin) means that the quantity supplied at
any given price decreases
An outward shift (right, or away from the origin) means that the quantity
supplied at any given price increases43
43
Economists generally use the terms “left” and “right” to describe decreases and increases in supply, respectively. Be
careful not to use “up” and “down”: a shift upward in the supply curve actually represents a decrease in supply. This gets
really confusing. Just stick to left and right.
The Supply Curve
Price
Quantity Supplied
Several factors can cause a shift in the supply curve

If the cost of the factors of production increase or decrease, the supply curve will shift
to the left or right, respectively
If the price of inputs (the factors of production) increase, then the cost of producing
the final good also increases
If the price of inputs decreases, then firms are willing to produce more goods at
existing prices, pushing the supply curve outward
If technological progress occurs, the supply curve will shift
A breakthrough in productive technology will decrease the cost of producing a
good, shifting supply to the right
Firms may expect or anticipate a change in price
An expected decrease in the price of a good will lead firms to produce more now so
they can sell the good at the current higher price
Thus, this expectation will cause the supply curve to shift to the right
An expected increase in prices will lead firms to produce less now so they can wait
for the higher prices
Thus, this expectation will cause the supply curve to shift to the left
A change in the number of firms supplying a good can cause a shift in the supply curve
If the number of firms supplying a good increases, the supply curve will shift to the
right
But if the number of firms supplying a good decreases, the supply curve will shift to
the left
Government regulations can also affects supply
Taxes on the firm or its product reduce supply and shift it to the left
Regulations also reduce supply and shift the curve to the left
Subsidies are monetary incentives given by the government
Subsidies increase supply and shift the curve to the right
Increases or decreases in the price of other goods can also result in a shift in the curve
This concept is best explained with an example
Hannah’s Hamburger and Hotdog Hut sells, quite creatively, hamburgers and
hotdogs
If the price of hotdogs increases, Hannah will concentrate more on hotdogs than
on hamburgers in order to gain more profit
The supply curve for hamburgers will shift to the left
Note that the supply curve for hotdogs does NOT shift because only the
price of hotdogs has changed
If the price of hotdogs decreases, Hannah will concentrate more on hamburgers

than on hotdogs in order to make more profit
The supply curve for hamburgers will shift to the right
Note that the supply curve for hotdogs does NOT shift because only the
price of hotdogs has changed
Recall that a change in the price of a good only leads a movement along the supply curve
for that good, not a shift in the curve itself
When dealing with these factors, ceteris paribus is in effect
If a test question asks what happens to supply when a technological advance occurs,
for example, remember to assume that all other factors (number of firms, price of
inputs, etc.) are constant
Movement Along the Supply Curve Shift in the Supply Curve
Price Price
Quantity Supplied Quantity Supplied
Just because a firm supplies a good does not necessarily mean that good is sold
Supply, therefore, can also be referred to as planned supply
Planned supply is what firms plan to supply in the market, which is not necessarily the
same as what consumers will buy
At a given price, firms will supply as many goods as it is profitable to do so
Graphically, the point on the supply curve corresponding to the price represents this
quantity
However, not all goods supplied may be bought
The quantity supplied may not be the same as the quantity sold
Planned supply equals consumed (purchased) supply when the market is at equilibrium
Equilibrium occurs when the quantity supplied equals the quantity demanded
Supply of a good can be elastic or inelastic, depending upon the time frame in which a
firm makes its decisions
Elasticity is the sensitivity of one quantity to changes in another
Elasticity is calculated by dividing the percentage change in the dependent variable by
the percentage change in the independent variable
% Change in Dependent Variable
Elasticity =
% Change in Independent Variable
One can have elasticity of anything with respect to anything else
For supply, elasticity measures how sensitive quantity supplied is to changes in price
Ideally, firms will always change quantity supplied with changes in price
In practice, however, firms are not always able to do so immediately
In the short run, firms will have already made their production decisions
In these cases, firms will be unable to change the quantity supplied much, if at all,
to respond to changes in price
In the short run, the quantity supplied is often inelastic, or not very responsive
to changes in price
In the long run, firms are able to plan all of their production decisions
Firms can change their decisions to meet real or expected changes in price
In the long run, the quantity supplied is elastic, or very responsive to changes in
price
Demand
The study of demand is sometimes referred to as the theory of the consumer
Demand is the willingness and ability of consumers to purchase a good at any given price
The quantity demanded is the amount of a good demanded at a specific price
The quantity demanded is a point on the demand curve while demand refers to the
entire curve (see below)
The law of demand determines changes in quantity demanded with respect to price
The law of demand states that as the price of a good increases, the quantity demanded of
that good decreases
The law of demand indicates an inverse or negative relationship between quantity
demanded and price
Basically, as one goes up, the other goes down
As the price of a good increases, consumers cannot afford to consume more
Consumers will seek alternative goods instead
Additionally, most consumers will not pay above a certain price for a specific good
This price is determined by the individual’s unique utility values
When the price of a good decreases, the quantity demanded of a good increases
In other words, more consumers are willing and able to purchase more of the good
as prices fall
Consumers can afford to consume more of the good
Consumers will consume this good instead of an alternative good
Also, the lower price may fall within more consumers’ acceptable price range for
that good
Demand can be represented by a table known as a demand schedule
The demand schedule lists the number of goods demanded by consumers at each price
As with supply, prices are unit prices, or the price for one unit of that good
Demand Schedule for William’s Widgets

Price per Widget $5 $10 $15 $20 $25
Quantity Demanded 15 12 7 4 2
Demand can be represented visually by the demand curve

The demand curve is plotted on a plane with price on the vertical axis and quantity
demanded on the horizontal axis
The demand curve is a downward-sloping curve
The slope of the demand curve is negative
The negative slope represents the inverse relationship between quantity demanded
and price
Two factors explain the curve’s downward slope
The substitution effect occurs because, as the price of one good increases,
consumers will purchase a different (but comparable) good instead
Consequently, the quantity demanded decreases as price increases (and vice
versa)
The income effect occurs because, as the price of one good increases,
consumers can get fewer units of that good with the same amount of money
As a result, the quantity demanded decreases as price increases (and vice
versa)
Movement along the demand curve shows a change in quantity demanded
As with supply, a change in the price of a good only causes a movement along the
demand curve for that good
It does NOT cause the demand curve itself to shift
When demand changes, the entire demand curve shifts
A shift represents a change in the quantity demanded at all prices
An inward shift (to the left or toward the origin) means that the quantity demanded
at all prices has decreased
An outward shift (to the right or away from the origin) means that the quantity
demanded at all prices has increased
The Demand Curve
Price
Quantity Demanded
Several factors can cause the demand curve to shift
A change in the income of consumers will cause a shift
The direction of the shift depends on the type of good in question
There are two basic type of goods: normal goods and inferior goods
As a consumer’s income increases, he will buy more normal goods and fewer
inferior goods
For example, new cars are normal goods
Used cares, on the other hand, are inferior goods
If Car-Crazy Carmen doesn’t have very much money and decides to buy a
car, she’ll probably get a used car rather than a new one
If Carmen gets a raise and starts doing a little better financially, she’ll be
more likely to buy a new car
In other words, consumers prefer to buy normal goods over inferior goods if
they have the income to do so
For normal goods, an increase in consumer income will lead to an increase in
demand
The demand curve will shift to the right
For inferior goods, an increase in income will lead to a decrease in demand
The demand curve will shift to the left
Luxury goods comprise a subset of normal goods
They are very expensive and certainly not necessities
As consumer income increases, consumers will spend a larger portion of their
incomes on luxury goods (such as yachts, jewelry, etc.)
Those in the lower rungs of the economic ladder will spend very little money on
luxury goods
Demand for a good can change because of a change in the price of a substitute good
Substitute goods are goods that consumers will buy in place of another
Two substitute goods are usually of about the same quality
Switching from one to another usually won’t result in a large decrease or
increase in satisfaction (utility)
A classic example is Pepsi and Coke 44
Hamburgers and hotdogs are also usually considered substitutes 45
To illustrate the relationship between substitute goods, let’s assume that Sprite and
Mountain Dew are substitutes
If the price of Sprite increases, the quantity demanded of Sprite will decrease in
accordance with the law of demand
To avoid the higher price of Sprite, many consumers will switch to Mountain
Dew instead because Mountain Dew is, to them, just as satisfying
As a result, the demand of Mountain Dew increases, and its demand curve
shifts to the right
Conversely, a decrease in the price of Sprite will result in a decrease in the
demand of Mountain Dew
Many consumers will shift from Mountain Dew to Sprite in order to take
advantage of the lower price
The demand curve for Mountain Dew will shift to the left
The quantity demanded of Sprite will increase, but its demand curve will
NOT shift
Demand for a good can change because of a change in the price of a complementary
good
Complementary goods are goods which are closely related to or used with each
other
Purchasing one usually involves purchasing the other
A classic example is peanut butter and jelly
To illustrate the relationship between complementary goods, let’s assume that pens
and Wite-Out are complementary goods
If the price of Wite-Out increases, the quantity demanded of Wite-Out will
decrease in accordance with the law of demand
Because people usually buy Wite-Out and pens together, fewer people will
buy pens
As a result, the demand for pens will decrease, and the demand curve for
pens will shift to the left
Conversely, if the price of Wite-Out decreases, the quantity demanded of Wite-
Out will increase in accordance with the law of demand
As the quantity demanded of Wite-Out increases, the demand for pens will
increase as well
Since only price has changed, the demand for Wite-Out does NOT change:
quantity demanded changes 46
Changes in consumer preferences or tastes can effect demand
Preferences reflect the utility values that consumers assign to goods
Essentially, a good that is preferred is popular or “in style”
44
For me, anyways. – Dean
45
What one person considers substitute goods may not be substitutes for another person. Some people, for example,
drink Pepsi but hate Coke. Substitutes in general are determined by social and cultural norms.
46
This may seem confusing at first, but this an EXTREMELY important concept that is frequently tested.
An increase in the popularity of Fossil watches, for example, will lead to an increase
in demand
The demand curve for Fossil watches will shift to the right
A shift of preferences away from Abercrombie jeans, for example, will lead to a
decrease in demand
The demand curve for Abercrombie jeans will shift to the left
Changes in consumer expectations can also effect demand
If consumers expect a newer, better good to emerge in the near future, the demand
for the current good will decrease
If consumers expect a decrease in the price of a good in the future, the current
demand for that good will decrease
Consumers are waiting for the lower price
If consumers expect an increase in the price of a good in the future, they will
demand more now in order to take advantage of the price while it lasts
Changes in the sheer number of consumers may also effect demand
If the number of consumers drops, then the demand for a good will decrease
If the number of consumers increases, the demand for a good will increase
As with supply, remember the of ceteris paribus
If a question asks what happens to demand when the price of a substitute good
increases, for example, remember that all other factors (number of demanders,
price of complements, etc.) remain constant
Movement Along the Demand Curve Shift in the Demand Curve
Price Price
Quantity Demanded Quantity Demanded
The demand for a good can be either elastic or inelastic

Elasticity, as noted above, is the sensitivity of one thing to changes in another
Elasticity of demand measures how sensitive the quantity demanded of one good is to
changes in price
Demand-price elasticity is equal to the percent change in the quantity demanded divided
by the percent change in price:
% change in QD (QD1 − QD0 ) ÷ QD0
E= =
% change in P (P1 − P 0 ) ÷ P 0
In the above equation, “E” is called the elasticity coefficient, which is just a
numerical representation of a curve’s elasticity
The above equation is called the “point” formula for calculating elasticity
The following equation is called the “arc” or “midpoint" formula

(change in QD) QD1 − QD0
(average QD) (QD1 + QD0 ) ÷ 2
E= =
(change in P) P1 − P 0
(average P) (P1 + P 0) ÷ 2
This equation is slightly more accurate than the point formula
Looking at the demand curve, we see that demand-price elasticity is inversely related
to the slope of the curve
As a result, a steeper line has a lower elasticity
A flatter line has a higher elasticity
If demand elasticity (or elasticity coefficient) is less than one, the good is said to be
price-inelastic (or just inelastic)
A price-inelastic good is not very sensitive to changes in price
The percentage change in quantity demanded will be less than the percentage
change in price
As a result, increasing the price of an inelastic good will lead to an increase in the
total revenue received by the producer
Total revenue = (total units sold)(price of each unit)
Goods which are price-inelastic are generally necessities such as basic foodstuffs
(like salt) or clothes
One has to consume these regardless of income
These goods generally do not have many substitutes: if price increases,
consumers don’t have much of a choice but to keep buying the good anyway
When their price increases, consumers don’t have much of a choice but to
keep buying them anyway
Graphically, an inelastic curve is very steep
If demand elasticity is equal to zero, the good is perfectly price-inelastic
Any change in price will not result in any change in quantity demanded
Graphically, a perfectly inelastic demand curve is vertical 47
This label is purely theoretical
Even for absolute necessities (such as insulin for diabetics), price will eventually
become prohibitively high
If demand elasticity is greater than one, a good is price-elastic (or just elastic)
An elastic good is very sensitive to changes in price
The percentage change in quantity demanded will be greater than the percentage
change in price
Increasing the price of a good will lead to a decrease in total revenue
Goods which are price-elastic are generally goods which are luxuries or which have
a number of readily available substitutes
If their price increases, consumers can either choose to stop purchasing the item
or switch to an alternative with a lower price
If the price of Ferraris goes up, for example, consumers can choose not to buy a
luxury car or switch to Porsches instead
Graphically, an elastic demand curve is very flat
If demand elasticity equals infinity, a good is perfectly price-elastic
Any change in price will result in an infinite change in the quantity demanded
No goods will be demanded except at one given price
47
One way to remember this is that a vertical line looks like an “i,” the first letter of “inelastic.”
Like perfectly inelastic goods, perfectly elastic goods are purely theoretical
If elasticity is equal to 1, a good is said to be unit elastic
The percentage change in quantity demanded will be equal to the percentage change
in price
Increasing or decreasing the price of a good will not have any effect on total revenue
The elasticity of a good is also related to time
In the short run, individuals have less time to look for alternative goods
As a result, goods are generally more inelastic in the short run
In the long run, individuals can either find alternatives or change their lifestyles to
adjust to changes in price
Consequently, goods are generally more elastic in the long run
For example, gas is fairly inelastic in the short run
If the price of gas increases, people have no choice but to fill up
They can drive a little less and carpool a little more, but their overall demand for
gas does not change dramatically
In the long run, however, consumers can buy hybrid cars, switch to a job closer to
home, etc.
Perfectly Inelastic Perfectly Elastic
Price Price
Quantity Demanded Quantity Demanded
Inelastic Unit Elastic Elastic
Price Price Price
Quantity Demanded Quantity Demanded Quantity Demanded

Cross-price elasticity (Ec) examines the effects a change in the price of one good has on
the demand for another good
(% change in QDx)
Ec =
(% change in Py)
QDx is the quantity demanded of good X
Py is the price of good Y
If Ec is greater than zero (positive), then the goods are probably substitutes
An increase in the price of the second good (good Y) leads to an increase in the
demand of the first good (good X)
If Ec is less than zero (negative), then the goods are probably complements
An increase in the price of the second good (good Y) leads to a decrease in the
demand of the first good (good X)
If Ec is equal to (or close to) zero, then the two goods are probably unrelated
The greater the absolute value of the cross-price elasticity coefficient, the stronger the
relationship between the two goods
For example, a coefficient of 5.7 indicates a stronger relationship than a coefficient
of 2.3
A coefficient of -3.5 implies a stronger relationship than -1.2
A coefficient of -3.5 suggests a stronger relationship than 2.3
Though the negative coefficient suggests complement goods and the positive
coefficient suggests substitute goods, the former shows a stronger relationship
Income elasticity (EI) examines the effects a change in overall consumer income has on
the demand for a good
(% change in QD)
EI =
(% change in income)
If quantity demanded increases as income increases, then EI is positive
The good in question, then, is a normal good
Income and quantity demanded vary in the same direction
If quantity demanded increases as income decreases (or vice versa), then EI is negative
The good in question is an inferior good
Income and quantity demanded vary in the opposite direction
ELASTICITY
Relation to Total Graphical
Number Range Name Other Notes
Revenue (TR) Representation
Increase in price leads to
increase in TR; decrease Perfectly vertical
E=0 Perfectly inelastic
in price leads to decrease line
Purely theoretical
in TR
Applies to goods that

Increase in price leads to are necessities and
increase in TR; decrease goods that have few
E<1 Inelastic
in price leads to decrease
Steep line
available substitutes;
in TR goods are more inelastic
in the short run
Changes in quantity
Change in price has no Line with a slope of demanded are exactly
E=1 Unit elastic
effect on TR 1 or -1 proportional to changes
in price

Increase in price leads to are luxuries and goods
decrease in TR; decrease that have many available
E>1 Elastic
in price leads to increase
Relatively flat line
substitutes; goods are
in TR more elastic in the long
run
Change in price leads to Perfectly horizontal

E=∞ Perfectly elastic
loss of all TR line
Purely theoretical
Market Equilibrium
Overview of equilibrium
Supply and demand represent two sides of the same market
When plotted together in the same graph, the intersection of the market supply and market
demand curves shows the point of market equilibrium
At this price and quantity, all goods which are supplied will be consumed
Similarly, all goods that are demanded will be supplied
There are two aspects to the market equilibrium
The exchange price or equilibrium price is the price for which goods are
exchanged at market equilibrium
The equilibrium price is also known as the market clearing price
This definition comes from the fact that, at equilibrium, all interested buyers can
buy and all interested sellers can sell
As a result, the market “clears” because no goods are left over
The exchange quantity or equilibrium quantity is the quantity of goods
exchanged at market equilibrium
Prices are signals through which buyers and sellers communicate
By buying a product at the market price, you are essentially telling (“signaling”) the seller
that the price you’ve paid is acceptable
A refusal to buy signals that the price is too high
In fact, prices are the means through which Smith’s “invisible hand” functions
Market equilibrium and shifts
Shifts in supply and demand have varying effects on market equilibrium
When only one curve (either supply or demand) shifts, the effects of such a shift on the
exchange price and exchange quantity can be determined
If supply increases but demand remains constant, the exchange price will fall but the
exchange quantity will rise 48
If demand increases but supply remains constant, both the exchange price and the
exchange quantity will rise
If both curves shift at the same time, either market price or quantity (but not both) will be
ambiguous
If supply and demand shift in the same direction, then the change in exchange price is
ambiguous
If supply and demand both increase, exchange quantity will increase, but the change
in the exchange price is uncertain
If supply and demand both decrease, exchange quantity will decrease, but the effect
on exchange price is indeterminate
If supply and demand shift in opposite directions, the change in exchange quantity will be
ambiguous
If supply increases but demand decreases, then exchange price will decrease, but the
change in exchange quantity is uncertain
If supply decreases but demand increases, then the exchange price will increase, but
exchange quantity is ambiguous
To resolve the ambiguity, we must calculate how much each curve is shifting
This calculation, however, is beyond the scope of basic microeconomics, and we will
not discuss it here
48
Go ahead: draw it! – Dean
Market Equilibrium
Price
A B
2
4
1
3
C D
Quantity
In the graph above, line A represents the original demand curve, line C the original supply
curve, and point 1 the original market equilibrium
If demand shifts from A to B and supply (line C) remains the same, then the new market
equilibrium is at point 2
Price and quantity have both increased
If supply shifts from C to D while demand (line A) remains the same, then the new
market equilibrium is point 3
Price has decreased while quantity has increased
If both curves shift (demand from A to B and supply from C to D), then the new market
equilibrium is point 4
Quantity has increased, but price is ambiguous
In our model, it may look as though price has increased
Shifting the supply and demand curves by different amounts, however, would
result in higher or lower prices
If we do not know the magnitudes of the shifts, therefore, the change in price is
ambiguous
Rather than memorize all the different combinations, draw one graph for each shift if you
see a question which presents you with two shifts
In other words, draw one graph in which you shift only demand and one in which you
shift only supply
Then analyze the effect on quantity and price in each graph
One of the two will change in the same direction in both graphs while the other will
change in opposite directions
The one which changes in opposite directions is indeterminate
Shortages and surpluses
If the price of a good is anything other than the market-clearing price, a surplus or shortage
will result
If the price of a good is below the market-clearing price, a shortage results
Quantity demanded increases because consumers are willing to purchase more of a
good at the lower price
Quantity supplied will decrease because firms are unwilling to supply as much of a good
at the lower price
The result is that some consumers who would be willing to buy the good at the current
price are unable to do so because firms will not supply the quantity demanded at that
price
In other words, quantity demanded is greater than quantity supplied
If the price of a good is higher than the market-clearing price, a surplus results
Quantity demanded decreases because some consumers are unwilling to purchase the
good at the higher price
Quantity supplied will increase because firms will gladly supply more of a good at the
higher price
The result is that firms who would be willing to sell at the current price are unable to
do so because consumers will not consume the quantity supplied at that price
In other words, quantity supplied is greater than quantity demanded
In a free market governed only by supply and demand, surpluses and shortages will never
develop (except in the very short run)
Consumers and firms in a free market interact to set a new market-clearing price to
deal with changes in circumstances
If surpluses occur, firms will leave the market as they are unable to sell their goods to
recoup costs
This exodus of firms will lower supply until a new market-clearing price is reached
If shortages occur, firms will enter the market to meet consumer demand, which will
increase supply
Note that these changes depend upon prices being flexible
So long as prices can respond to changes in supply and demand, surpluses and
shortages will eventually be eliminated and a new equilibrium price will be reached
Surpluses and shortages can develop and persist if prices are fixed
Governments often set prices at certain levels to achieve various goals
If a price ceiling, or maximum price, is set below the market-clearing price, a shortage
will result
Consumers will demand more than firms are willing to supply
Classic examples include rent controls and price controls on basic necessities
The unsatisfied consumer demand can create informal or black markets for desired
goods, where prices will more accurately reflect demand
A price ceiling placed above the equilibrium price will have no effect on the market
Price Ceiling
Price
Shortage
Price Ceiling
QS QD
Quantity
If a price floor, or minimum price, is set above the market clearing price, a surplus will
result 49
If a price floor is enacted, firms will supply more of a good than consumers are
willing or want to purchase
49
Remember that the “house of economics” is always upside-down: the floor is on top and the ceiling is on bottom.
Examples of price floors include price supports for agricultural commodities and
minimum wages
In the labor market, firms are the consumers and laborers are the suppliers
Minimum wage results in a surplus of labor, also known as unemployment
This surplus is particularly large at wage levels above minimum wage: most
employers won’t pay higher than minimum wage if they don’t have to
A price floor placed below the equilibrium price will have no effect on the market
Price Floor
Price Surplus
Price Floor
QD QS
Quantity
Because price ceilings and floors prevent the market from reaching equilibrium,
many economist argue that markets function most efficiently when left alone
Consumer and producer surpluses
In looking at a demand curve, one can see that some consumers would willingly pay
more than the equilibrium price for the good in question
The consumer surplus is how much above its market price consumers value a
good
The extra utility gained by these consumers in paying a lower price for
something for which they would happily pay more is the consumer surplus
The consumer surplus can be calculated by determining the area of the shape (often
triangle) formed by the demand curve, the vertical axis, and a horizontal line
extending from the current market price to the vertical axis
In the graph below, the area of triangle A is the consumer surplus
Consumer and Producer Surpluses
Price Supply
Demand
Quantity
The producer surplus is the extra revenue received by a firm which would be willing
to supply a good at a price below its current market price
While all firms sell a good at the price determined by the market, presumably some
would be willing to supply the same amount at a lower price
The extra revenue gained by these firms is the producer surplus
The producer surplus is calculated in the same manner as the consumer surplus
The producer surplus area, however, is below the market price
The producer surplus in the graph above would be the area of triangle B
The Consumption Decisions of the Individual

Indifference curves
Individual consumption decisions based upon market prices depend upon the utility
values attached to goods
When making purchasing or consumption decisions, consumers face an array of choices
among competing goods
For any two goods, an indifference curve graphically represents the different
combinations of two goods that bring the consumer the same amount of satisfaction
The indifference curve allows consumers to determine what combinations of goods
will make them most satisfied (within budgetary limits)
The total utility value of an indifference curve depends on how far away the curve is
from the origin
If the indifference curve is relatively close to the origin, the utility (or satisfaction)
for every point on the indifference curve is relatively low
If an indifference curve is relatively far away from the origin, the utility for every
point on the curve is relatively high
If a curve shifts away from the origin, the utility of all possible combinations of the
two goods under consideration increases
Indifference curves generally slope downward
As a consumer loses some amount of one commodity, he or she must receive more
of the other to be equally satisfied
A consumer should always prefer a bundle, or mixed basket, of goods with more of
both commodities than one which features only one commodity
Basically, consumers like variety
Indifference curves bend in toward the origin
As one good is increasingly removed from the basket combination of goods,
increasing amounts of the other must be added to maintain the same utility value
As the individual accumulates more and more of one good, he will require ever
larger amounts of the other good to make up for having less of the first good
For example, as you take away more CDs from me, you’ll have to compensate
me with ever larger numbers of books
The graph below shows Ian’s indifference curves for hamburgers and hotdogs
Every point on curve A yields Ian the same amount of total utility (satisfaction)
The same relationship holds true for the other curve
Any point on curve B yields more satisfaction than any point on curve A
Each combination on curve B has a greater overall number of hamburgers and
hotdogs than the combinations of curve A
Since more goods are involved with curve B, Ian is more satisfied
Ian’s Indifference Curves
Hamburgers
B
A
Hotdogs
The willingness to give up one good for another is represented by the marginal rate of
substitution
For example, let’s assume that Bookworm Bill is good friends with Audiophile Aaron
One day, Aaron decides he wants to trade some of his extra books for a few of
Bill’s CDs
The two decide on a fair trade
Bill will trade four of his CDs for two of Aaron’s books
Afterward, Bill’s satisfaction (total utility) is the same as it was before the trade
Bill’s marginal rate of substitution is two books for four CDs, or one book
for every two CDs
For Bill, one book and two CDs bring him the same amount of utility
The marginal rate of substitution defines the individual points along the indifference
curve: it determines which baskets of goods maintain the same utility
Note that the marginal rate of substitution increases as the basket of goods
becomes weighted toward a single good
This phenomenon is another manifestation of the law of diminishing marginal
utility, which explains the shape of the indifference curve
If one examines two or more indifference curves on the same plane, these curves can
never intersect
If the curves intersect at some point, then all of the points on both curves must have
the same utility value as that point
This is because all points on an indifference curve are different combinations of
two goods that yield the same utility value
Since a curve represents combinations of goods with the same utility value, it is
simply not possible for two different indifference curves to share any point and
still be separate curves
Indifference curves reveal only what consumers want or would be willing to consume
To determine what consumers can actually consume, their incomes must be taken
into account
The different combinations of two goods that a consumer can purchase given his or
her income is represented by the budget line
The budget line is calculated by noting how many of each good the consumer
can afford alone and then connecting these two points
The result is a downward-sloping line which reveals the different combinations of

the two goods the consumer can purchase
Consumers will seek to maximize utility per dollar by purchasing the combination of
goods at the point where the budget line is tangent to the indifference curve 50
Any alternative combination is above the budget line (unaffordable) or on a
lower indifference curve and thus have less utility
Indifference Curve and Budget Line
Good A Indifference curve
Ideal point
Budget line
Good B
Indifference curves have extreme variants for certain types of goods

For perfect substitutes, the indifference curve will simply be a straight downward-
sloping line
In other words, the variety effect doesn’t matter
For perfect complements, the indifference curve will have an “L” shape
Having ever greater quantities of peanut butter gives me no utility gains as I lose
jelly
If a consumer actually despises one of the goods, his or her indifference curves will
slope upward
A consumer gains utility by having less of a disliked good
The Production Decisions of the Firm

Profit
Firms, or sellers, all produce with the goal of maximizing profits
If a firm is consistently unprofitable, it will not be able to stay in business
Profit is equal to total revenue minus total costs
Remember that total revenue equals total quantity sold times price per unit
Profit is the excess gains remaining after the costs of land, labor, and capital have
been met
Profit is technically the payment or reward for the entrepreneur, which allows him
or her to overcome the opportunity cost of other available production decisions
In economics, there are a few different types of profits
Economic profit is any profit which is above the normal profit
Economic profit can only be earned in the short run
50
For those of you who are math-challenged, “tangent” means “intersecting at one point and one point only.”
In the long run, other firms will see the opportunity to make economic profits
and enter the market
Firm entries will increase supply and thus decrease price, eventually erasing
economic profits
Economic profits can only be maintained if barriers to entry exist to prevent new
firms from entering the market
Normal profits are equal to zero economic profit
In other words, the firm has met is economic costs exactly
Keep in mind that a firm making normal profit is still making accounting profit
(see below)
In the long run, firms must make a normal profit to remain in business
If a firm is not making a normal profit, then it will stop its current activity
and move on to something else
Accounting profit is equal to total revenue minus accounting (or explicit) costs
Accounting profit is not used by economists because it does not take
opportunity (implicit) costs into consideration
Profit and costs
To maximize profits, all rational firms will produce until marginal revenue equals
marginal cost 51
Marginal revenue (MR) is the increase in total revenue a firm receives by selling one
more unit of output
Marginal cost (MC) is the increase in total cost a firm must pay to produce one more
unit of output
Marginal cost itself depends upon two other costs
Fixed costs are costs a firm must pay regardless of how many units it produces
The more a firm produces, the lower its average fixed cost becomes for each
additional unit
The cost is spread over more and more units of output
By definition, fixed costs cannot be changed in the short run
A lease on a factory is a fixed cost: it must be paid regardless of how
many units are produced, even if no units at all are produced
In the long run, however, all costs (including fixed costs) are considered
variable
Variable costs change with the amount produced
A firm only incurs variable costs when it produces something
Examples of variable costs include wages (workers can be hired and fired),
and purchases of raw materials
Producing more units of a good requires more laborers and more raw
materials
If no units at all are produced, then a firm will not incur any variable costs
but will still have fixed costs
Variable costs, by definition, can be altered in the short run
Average cost is the total production cost of each unit of output
Average cost is calculated by adding fixed costs to total variable costs, and then
dividing by the total number of units produced
51
This sentence is often called the Golden Rule of economics. Do something until marginal revenue equals marginal
cost (MR = MC) is the maximization strategy for nearly every economic activity you can think of (in some form or
another).
(Total Fixed Costs + Total Variable Costs)

Average Total Cost =
Total Number of Units Produced
Fixed costs can be spread out over output
The more a firm produces, the lower the average fixed cost (fixed cost per unit
of output)
Variable costs increase as more variable inputs (such as labor) are added to fixed
inputs (such as capital)
Variable costs drag average cost upward after a certain point of production
This upward trend is due to the law of diminishing returns
As more and more variable inputs are added to the production process,
they become less productive
Adding more workers in a factory, for example, doesn’t help boost
production if there are no machines for them to work with
In the long run, all factors are variable, so all costs are variable
What would be considered a fixed cost in the short run is considered a
variable cost in the long run
For all short-run decisions, firms face a mix of fixed costs and variable costs
The marginal cost curve is usually U-shaped and resembles a rounded checkmark
As a firm produces more of a good initially, the marginal cost drops because the
fixed costs of production are spread out over more units produced
After a certain point, the marginal cost curve climbs upward as variable costs
increase
A firm must hire more labor, purchase more resources, etc., to increase
production
The graph below features all the different types of costs just discussed
Note the U shape of the marginal cost (MC) curve
Costs decline at first, then begin to rise after a certain point
Also notice how the average fixed cost (AFC) curve continues to decline
This shape reflects the fact that average fixed costs continue to decline as more
and more units are produced
Since average total cost (ATC) is equal to average variable cost (AVC) plus AFC, the
distance between the ATC and AVC curves is the AFC
This distance decreases as the firm produces more and more units and AFC
decreases
It is important to observe that the MC curve intersects the ATC and AVC curves at
the minimum of each
This relationship between these curves is a result of the law of averages and
marginals
The law of averages states that a marginal increase over the average will
increase the average
Conversely, a marginal increase below the average will decrease the
average
Sam’s class grade is the average, and his prospective score on the final is
the marginal increase
To illustrate this law, let’s use an example
Studious Sam is nearing the end of his AP Economics class, and he’s diligently
studying for his final
Like many other students, he wants to know the grade he needs to get
on his final in order to get an A in the class
He knows that his average in the class is currently 90%

Through his calculations, he realizes that any score on the final above
90% will raise his overall average grade
Any score below 90% will lower his overall average
When looking at the graph, we can see the law of averages in action
At all points to the left of the intersection of the MC and AVC curves, MC is
less than AVC
As a result, AVC decreases until the two intersect
After the two intersect, MC remains above AVC
As a result, AVC continues to rise
The same observations hold true when comparing MC and ATC
Cost Curves
Average
total cost
Marginal cost
Costs ($)
AFC Average
variable cost
Average
fixed cost
Quantity Produced
Profit maximization
To graphically determine any given firm’s profit-maximizing level of output, plot the
marginal cost and marginal revenue curves and note where they intersect
At this point of intersection, the additional cost of the next unit produced will equal
the revenue it will bring in (its price)
If a firm produces below this point, it is under-utilizing resources and, consequently, not
making as much profit as it could if it produced more
If a firm produces above this point, it is incurring more costs than revenue and, thus,
losing money
Shutting down
Let’s assume that Entrepreneur Eddie opens a bagel store
He has a few fixed costs
He rents two bagel ovens for $1000 per month each
His lease on the building costs him $3000 per month
Each month, therefore, Eddie has $5000 in fixed costs
He also has a few variable costs
He spends $500 each month on dough
He also spends $300 each month on various bagel accessories, including cream
cheese, lox, and regular cheese
His monthly electric bill comes out to $200
Electricity is a variable cost because it is related to how long Eddie stays
open, how many bagels he bakes, etc.
Each month, Eddie has $1000 in variable costs (at his current level of bagel
production)
His total monthly accounting costs amount to $6000
Let’s also assume that Eddie’s next-best job would be working at Drew’s Donuts,
where he would be paid $500 per month
Eddie’s opportunity cost, therefore, is $500 per month
Since total economic costs equal opportunity (implicit) cost plus accounting (explicit)
cost, his total economic costs equal $6500 per month ($6000 + $500 = $6500)
If Eddie makes $7500 in one month, he’s earned $1000 in economic profit
($7500 – $6500 = $1000)
If he takes in $6500 of revenue in one month, he’s earned normal profits ($0)
Earning normal profits is also called “breaking even”
The level of production at which this occurs is called the break-even point
If Eddie makes $4500 in one month, he’s actually lost $2000
However, Eddie should not close his bagel shop
Though he can’t cover all of his costs, he’s covered all of his variable costs
($1000) and $3000 of his fixed costs (plus his $500 opportunity cost)
If he were to shut down, he wouldn’t have any variable costs, but he would still
have to pay all of his fixed costs ($5000) without making any revenue at all 52
If Eddie makes less than $1000 in one month, he should close his store
At this point, he can’t even pay his variable costs
If he remains open, he’ll have to pay both fixed and variable costs
If he closes, he won’t have to pay his variable costs ($1000)
He can put whatever he has toward his fixed costs, which he has to pay no
matter what
For Eddie, $1000 in monthly revenue is the shut-down point
If he makes anything below $1000 in revenue, he should shut down his store
In other words, the shut-down point is equal to the minimum of a firm’s average
variable costs 53
Price discrimination
Price discrimination occurs when a firm charges different prices to different
consumers for the same good
Essentially, a firm that price discriminates works to capture as much of the
consumer surplus as possible and convert it into profit
“Perfect” price discrimination occurs when every consumer pays a different price
The price that each consumer pays is the maximum amount he or she would be
willing to pay
Consequently, no consumer surplus remains
The discrimination margin is the difference between different prices
For price discrimination to be successful, a firm must be able to meet two requirements
First, it must separate the market into two or more groups based on their demand
elasticity
Second, it must prevent the resale of its products
In other words, those who are buying the good for less than others must not be
able to resell the good to those who would otherwise pay more
52
We’re talking about the short-run here. If Eddie closes down, he still has to pay his lease (and other fixed costs) at
the end of the month.
53
In our example, we assume his level of production corresponds to the minimum of average variable costs for the
sake of simplicity.
For example, let’s assume that Farsighted Farah is planning to go on a vacation to San
Francisco on April 10
She books her flight a month in advance with Generic Airlines and pays $150 for her
round-trip ticket
On April 7, Businessman Brandon’s boss tells him that he needs to go to San
Francisco on April 10 to meet with some clients
Brandon also books his round-trip ticket with Generic Airlines
His round-trip ticket costs $225
This scenario is an example of price discrimination
Brandon and Farah are purchasing the exact same good, but Brandon is paying
more
Brandon’s demand for the flight is relatively inelastic
He has to go on a specific day, and there aren’t many days left before the
flight by the time he’s bought his seat
Farah’s demand, on the other hand, is relatively elastic
She has plenty of time to choose the airline she wants
Her schedule is, presumably, somewhat flexible
Because of their differing demand elasticity, Brandon is willing to pay more for a
ticket while Farah is willing to pay less
The airline successfully price discriminates by charging these two customers
different amounts, thereby attempting to capture each consumer’s surplus
Price discrimination is legal and happens every day
Senior citizens and students, for example, pay less for movie tickets because their
demand is more elastic
As in our example, airlines charge different fares depending on how far in advance
the customer books the flight
The Robinson-Patnam Act (1956) made certain forms of price discrimination illegal
It defined “harmful discrimination” as discrimination that leads to unfair competition
Practicing price discrimination based on a consumer’s race, for example, is
considered “harmful” and, therefore, illegal
Market Structures
Introduction
Consumers and firms/producers interact and exchange goods within markets
Markets are created whenever potential buyers and potential sellers of a good come
into contact with one another to exchange goods or services
The most effective method of exchange is money
Alternative methods of exchange exist, such as barter (direct exchange of goods)
Exchange agreements (price and quantity exchanged) are determined through supply
and demand
In microeconomics, a market is only concerned with one particular good
Thus, economists refer to markets as a collection of homogenous transactions
General terms
All markets for goods have a particular structure
The most important aspect of market structure is the number of buyers and sellers
of the good in question
Markets are structured by the kind of competition between sellers in the market
and whether any barriers to entry exist
Competition takes two general forms
Price competition is when firms compete based on price alone

Products are only differentiated by price, so sellers attract more buyers simply
by lowering their price
Non-price competition is when firms compete in ways other than price
The strategies of non-price competition aim to attract customers through
advertising or differentiation
Advertising seeks to create a unique brand for which consumers are willing
to pay more
Differentiation aims to convince consumers that one firm’s version of a
product is different from and better than other firms’ versions of the same
product
Non-price competition can also be imposed by law
If the government or a group of sellers sets a market price for a good, the
only way for firms to compete is through non-price competition
Note that price still plays an important role in non-price competition
Barriers to entry are economic or technical factors which either prevent or make it
prohibitively expensive for new firms to enter a market
Technical barriers to entry are obstacles which prevent a firm from entering a
market
Patents are one example of a technical barrier
See the section on laws and social norms (p. 60) for a more detailed
discussion of patents
If the production of a good requires ownership or possession of a unique
resource, other firms will be unable to enter that market until they can acquire
the necessary resource
The presence of well-known, existing brands in a market also presents a barrier
to entry
New entrants will have to spend a lot on advertising to make their product
known, making entry into the market expensive and extremely difficult
Legislation can also create barriers to entry
Governments may enact licensing requirements or only allow a specific
number of firms to participate as sellers in a given market
Economic barriers to entry are based upon economic theory and how firms produce
goods
The production of some goods is only efficient when they are produced in large
numbers
This condition is called economies of scale
It is difficult for other firms to enter because the high level of production
requires an extremely high capital investment
The production process for cars, for example, is only efficient at high levels
of output
Alternatively, one can define economies of scale as when the total average cost
curve is downward sloping
A downward sloping average cost curve means that the production process
becomes more efficient as the company produces more and more units
An example is auto manufacturing
Since a car company has to build a large factory and hire thousands of
laborers to work the assembly line, it is only profitable to make cars if
the company can produce and sell a large number of them
Consequently, new firms have a tough time entering the market because
the preexisting companies are already producing at high volumes
If, on the other hand, the total average curve is upward sloping, the
production of the good is efficient at low output but inefficient at high output
This condition is called diseconomies of scale
Diseconomies of scale is NOT a barrier to entry
Collusion among existing sellers in the market also represents a barrier to entry
Existing firms can work together (collude) to set prices to prevent new firms
from entering the market
Firms can also work together with firms in related industries to prevent new
The combination of competition and barriers to entry determines the degree and type
of competition in a given market
The illustration below shows the different market structures along a continuum of
competitiveness
Market Structures
Monopoly Oligopoly Monopolistic Competition Perfect Competition
Less competitive More competitive

Less efficient More efficient
Monopoly
Monopolies are markets 54 in which only one large seller operates
Monopolies have three general characteristics
Monopoly companies are motivated by profit
They are profit-maximizers 55
Monopolies either create or benefit from barriers to entry which prevent other
Monopolies can determine the market price for their product
The monopolist will sell at the profit-maximizing level of both output and price
Non-monopolies can only sell at the profit-maximizing level of output
Monopolies are price-setters
As the only supplier, they can control the market price for their good by
restricting or expanding supply
Monopolies can arise for purely economic (natural) reasons or artificial reasons
Natural monopolies emerge when economic conditions make it practical for only
one seller to operate in a given market
Natural monopolies emerge primarily through economies of scale
If a natural monopoly exists, it is economically preferable for only one firm to
operate
In this case, the government will usually work to regulate the natural
monopolist to ensure public welfare
Examples include the Amtrak trains and (on a more local level) utility
companies (electricity, gas, water, etc.)
Artificial monopolies result from purely artificial barriers to entry
54
And companies. And a board game. – Zac
55
No, this is not a real word, but don’t worry about it. – Zac
Examples include patents, copyrights, and similar property protections, all of

which allow a firm to operate exclusively in a given market for a period of time
Government licensing or similar regulations can create artificial monopolies if
only one firm is authorized to provide a good in a given geographical region
Natural monopolies result from market forces or the nature of producing certain goods
Artificial monopolies result from the decisions or choices of persons, firms, and/or
governments
Monopoly power is largely measured by whether the demand for the good a firm
produces is elastic or inelastic
Monopoly power is the degree to which a firm can charge a higher price for its good
than would prevail if competitors were present
The more inelastic demand is, the more monopoly power a monopolist has
Monopolies are generally viewed in a negative light and can impose costs upon society
as a whole
Monopolies can purposefully engineer scarcity, or produce contrived scarcity
In contrived scarcity, the monopolist produces less than what consumers
demand at the given market price
Contrived scarcity drives up profits while at the same time leaving some
consumer demand unmet (thus decreasing the general welfare)
In other words, monopolies produce less and charge more than is socially
optimal
Monopolies impose a welfare loss on society, primarily through contrived scarcity 56
By producing less and charging more, monopolies are able to capture some of
the consumer surplus as producer surplus
Even more of the consumer surplus vanishes, with no one in society benefiting
This lost surplus is called a deadweight loss
It is surplus lost by consumers but not regained by producers
Monopolies can also be inefficient due to a lack of competition
While monopolies are profit-maximizers, they can still produce inefficiently due to
laziness, incompetence, or just the lack of having someone else around to “keep
them on their toes”
In competitive markets, inefficient firms are run out of business by more efficient
firms
Monopolies can remain inefficient, which results in wasted resources, higher
production costs, and higher prices for consumers
One can distinguish between monopolies which have “earned” their position, and those
which have not
Microsoft is a monopoly which some have argued has earned its position
It has provided products that consumers demand and maintained a measured
level of innovation
Microsoft has earned its monopoly position in PC operating systems
Economic profits can act as a reward for such successes
In looking at such “good” monopolies, many have argued that society can benefit
from the long-term innovation which may result from the reward of continued
economic profit if a firm maintains its monopoly position
The flip-side of a monopoly is a monopsony: a market with only one buyer
The buyer (rather than the seller) has control over the market
A bilateral monopoly is a market with only one buyer and one seller
56
“Contrived scarcity” is economics-talk for “purposefully undersupplying the market.” – Joseph
An example is the government’s exclusive contract with Halliburton to rebuild Iraq 57

Hardly any true monopolies exist in reality
Competition is almost always present in some way, in the forms of alternative goods
or otherwise
Perfect competition 58
Perfect competition features many small sellers producing a single good
In a perfectly competitive market, it is assumed that the goods produced by all firms are
identical, or homogenous
In other words, there is no product differentiation
Perfect competition generally features three elements
There are many firms, none of which has any power over market prices
The marginal revenue for each individual seller will thus be equal to the per-unit
market price
The revenue brought in by selling one more unit is equal to how much it sells
for on the market (its market price)
All firms aim to maximize profit
They will produce at a point where MR = MC
There are no barriers to entry (or exit), allowing firms to move in and out of the
market with practically no cost
Perfectly competitive firms are price-takers
Since all goods are homogenous, firms cannot engage in product differentiation
They must accept the market price because they have no market power
Normal profits are necessary for a perfectly competitive firm, but economic profits are
impossible except in the short run
All firms must make normal profits to remain in the market
If a firm does not make at least normal profits, it is not overcoming the
opportunity costs of staying in the market and will thus leave for better
opportunities
Economic profits can be achieved in a perfectly competitive market, but only in the
short run
Changes in the market might allow firms to charge a higher price for a short
period of time
In the long run, other firms will notice the economic profits and enter the
market, since there are no barriers to entry
The entry of new firms to the market will increase supply, which in turn will
drive down price
The result is that economic profits are eliminated in the long run
The demand curve for a perfectly competitive market is perfectly elastic
Consumers are very price responsive
Any change in the price charged by a single seller will result in that seller losing all of
its customers
Since goods exchanged are homogenous, consumers will have no preference for
one good over another, so they will simply buy the cheapest one
In a perfectly competitive market, firms must obey the market price
If the market price is below the point where MR = MC, firms will leave the market,
decreasing the supply and driving prices up until MR = MC again
57
My teammate, Atish, gave a speech about Halliburton at the speech showcase at the 2006 national competition in San
Antonio, Texas. It involved Halliburton’s new exclusive contract to reconstruct Atlantis. Enough said. – Dean
58
Sometimes known as “pure competition.”
If the market price is above the point where MR = MC, economic profits will result,
leading more firms to enter the market and drive down supply until MR = MC again
Because demand is perfectly elastic, it is equal to MR
Firms will only sell their good at one price, so every unit purchased (regardless
of total quantity) brings in the same revenue
Further, MR and demand are both equal to the price of the good
Perfectly competitive markets include most primary commodity markets
A classic example is the market for wheat
All wheat is essentially the same, so all prices for wheat are the same
Another is the market for milk
Perfectly competitive firms are unable to practice price discrimination
Any attempt by one firm to do so will just cause consumers to switch to another
(nearly identical) firm
Perfect Competition (Market) Perfect Competition (Firm)
MC
Price Supply Price
Demand = MR = Price
Demand
Quantity Quantity
Monopolistic competition
Monopolistic competition is an intermediate stage between perfect competition and
monopoly
Many competing sellers exist in the market, so firms do not have absolute market
power
There are fewer sellers than in perfect competition, however
Some barriers to entry exist, giving monopolistic firms some control over price (some
market power)
Product differentiation exists
Products satisfy the same basic wants, but they are not identical as in perfectly
competitive markets
Firms in a monopolistically competitive market still produce at a point where MR = MC
since they are profit-maximizers
In a monopolistically competitive market, a firm can charge a price above the market
price
Product differentiation means that firms engage in non-price competition
Advertising, branding, and other activities allow a firm to make its product stand
out from alternatives
Doing so allows a firm to charge consumers a high price for its differentiated
product
Essentially, monopolistic firms use advertising and marketing to gain market

power so they can imitate monopolist pricing techniques 59
Advertising does not make sense in a perfectly competitive market because all
goods are the same
Advertising is also not necessary for the monopolist because there are no other
sellers
Advertising may play other roles, however, such as boosting demand for the
product among consumers who may otherwise not demand it
Differentiated products present a barrier to entry for new firms because they must
be able to successfully differentiate their product before they can compete
Product differentiation is an extremely expensive process that requires large
investments in advertising
Due to barriers to entry and product differentiation, monopolistic competition allows
sellers to become price-makers
They have some (though not complete) control over price
The fashion industry is a great example of monopolistic competition
Brands spend huge sums of money on advertising to differentiate their products
from the rest
Oligopoly
Oligopolies are markets with a small number of interdependent sellers
Firms in an oligopoly generally feature either highly differentiated products or
homogenous products
In either case, oligopolies are characterized by long periods of price stability
In other words, there is almost no price competition, only non-price
competition
The car market, for example, is an oligopoly of highly differentiated products
The market for steel is an oligopoly of homogenous products
The most notable oligopoly is OPEC
OPEC (Organization of Petroleum Exporting Countries) is an oil cartel that
manipulates crude oil prices
American automakers also form an oligopoly
Collusion is a common characteristic of many oligopolies
Collusion occurs when firms cooperate to artificially raise market prices by
restricting supply
A group of firms that colludes to control prices is called a cartel
A cartel essentially acts as a monopoly because all the firms work together
The main problem with collusion is the high incentive to “cheat”
Since the market price is artificially high and the quantity supplied is artificially
low, a firm could make a lot of profit by supplying more than the other firms
Doing so, however, would drive up the market supply and, in turn, decrease the
market price
The other firms in the oligopoly would have to follow suit and lower their
prices, resulting in price competition
Thus, the collusive agreement effectively self-destructs
This situation is an example of the Prisoner’s Dilemma 60
59
This is where the name “monopolistic” (“like a monopoly or monopolist”) comes from: monopolistic firms try to
attain a monopoly over a very small segment of the market.
60
This topic, while extremely fascinating, is beyond the scope of USAD Economics, so it will not be covered here. It’s
actually mentioned very briefly in the film A Beautiful Mind (it was originally theorized by John Nash).
All firms benefit from cooperating, but each faces a strong motivation to
cheat
Despite the incentive to cheat, some firms do collude successfully (outside the U.S.)
Collusion was made illegal in the United States in the Sherman Act of 1890
(more on this act in macroeconomics)
There are three types of collusion: open, covert, and tacit
When firms collude openly, everyone knows about it
The collusion is not a secret
Covert collusion is done in secret, often to avoid anti-trust laws
Tacit collusion is implied but never openly declared
In the bank industry, for example, certain firms often act as “leaders”
Other firms “follow” changes in leaders’ interest rates
Tacit collusion is extremely difficult to prove
There are three types of oligopolies
The first is the non-collusive, unorganized oligopoly
This is the most common type
Firms in the oligopoly are not cooperating
They engage mostly in non-price competition
They face a “kinked” demand curve (discussed below)
The second is the collusive, organized oligopoly
This type of oligopoly is illegal in the U.S.
Firms cooperate to raise market prices by restricting supply
Since the firms all act together, this type of oligopoly is essentially considered
and studied as a monopoly
OPEC is the most prominent example of this type of oligopoly
The third is the collusive, unorganized oligopoly
Since collusion is illegal in the U.S., firms occasionally collude tacitly
They are not organized into a cartel, but some unspoken rule governs certain
market decisions
Oligopolies emerge primarily due to high barriers to entry
Differentiation of products provides one barrier, but the weakest
Most oligopolies result from natural barriers to entry
The primary natural barrier is economies of scale
Examples of oligopolies due to economies of scale include the automobile
and steel markets
It is worth noting that globalization and the expansion of free trade work to
undercut most oligopolies (and monopolies) by creating larger, global markets
that which can sustain a larger number of firms
Other oligopolies can result from artificial barriers to entry
Patents and licenses can create oligopolies in the same ways that they create
monopolies, except a few firms are given patent protection or licenses instead of
just one
Trade protectionism can also create oligopolies
It prevents foreign firms from entering the market and keeps the relevant
product market artificially small
The Kinked Demand Curve
Price
A
Output
Non-collusive, unorganized oligopolies face a “kinked” demand curve (see graph

above) 61
This demand curve was postulated by Paul Sweezy
Let’s assume that the established market price for a given oligopoly market is $5 per
unit (represented by point A above)
If Firm 1 decides to raise its price to $7, most consumers will just buy from
other firms
These other firms will keep their prices at $5
They won’t follow Firm 1’s price increase
Firm 1’s total revenue will probably decrease
The demand curve for prices above the established market price, therefore,
is elastic
If Firm 2 decides to lower its price to $3, most consumers will probably switch
to Firm 2’s product
In order to reclaim lost market share, other firms will also lower their prices
to $3, perhaps even lower
These firms, in other words, will follow Firm 2’s price decrease
Since all firms’ prices have decreased, every firm will probably experience a
decrease in total revenue
The demand curve for prices below the market price, therefore, is inelastic
Since firms lose revenue if they raise or lower their prices, the market price will
usually hover at point A ($5 in our example)
The intersection of the elastic demand curve (for prices above the market price) and
the inelastic demand curve (for prices below the market price) creates a “kink,” or
bend, in the overall demand curve
Market price will usually stay at the kink (point A)
Due to the threats of a price war and the incentive to maintain profits, oligopolies
generally work together (outside the U.S.)
Firms in an oligopoly benefit from working together, making them interdependent
Each firm relies upon every other firm to maintain the same prices
But given incentives to “cheat,” oligopolies become very unstable
Oligopolies become more stable when members have a way to sanction cheaters –
to impose costs or punishments
Oligopolies, like all other firms, will seek to produce at a point where MR = MC
61
See that shape? Yup. That’s a kink. What’s a kink? That is a kink. – Lawrence
Institutions and Markets

Overview
Markets rely upon institutions to ensure that they function properly
The category of “institutions” in economics is broadly construed
Institutions can include government institutions, private institutions, laws,
regulations, and even general codes of conduct or social norms
Institutions set the “rules of the game”
They ensure the smooth functioning of markets by facilitating exchange
Financial institutions
Financial institutions indirectly link savers with borrowers
Without financial institutions, borrowers would have to actively seek individual
creditors, and creditors would have to individually seek borrowers
The result would be gross inefficiency
Financial institutions provide information to creditors/savers about potential
investment opportunities, saving creditors from having to do their own research
Financial institutions also reduce risks for creditors or lenders by spreading their
funds among many potential borrowers
Depository institutions are a type of financial institution which receive money from
savers
These savers indirectly lend their money to borrowers through the depository
institution
Depository institutions attract savers through the payment of interest
The most familiar example of a depository institution is the bank
Contractual savings institutions are a different kind of financial institution; they
operate on a contract between savers and the owners/operators of the institution
Examples include pension funds and similar savings vehicles
They differ from banks in that a contract is involved, especially when returns to
savings are guaranteed
Another example not often associated with saving and lending is insurance
companies
Insurance companies provide various financial and non-financial benefits such as
medical coverage and payments for damaged property
Insurance companies take the money paid by savers (the buyers of insurance)
and invest it in various ways, providing funds to borrowers
In 1933, the Federal Deposit Insurance Corporation (FDIC) was established to
restore confidence in financial institutions
Each deposit at a financial institution that is a member of the FDIC is insured up to
$100,000 if the institution is unable to cover its assets
Not all financial institutions are members of the FDIC62
Laws and social norms
Less concrete institutions include the creation and enforcement of laws and norms
The primary institutional “law” concerns property rights
Market economies are founded upon private property
Property rights ensure the security of private goods
Owners of private goods can exclude other persons from using or otherwise
enjoying ownership of their private goods
62
The FDIC is pretty important. Not more important than holding a towel, but close. Basically, the FDIC makes sure
that if a bank collapses, not all its money is lost. – Lawrence
A car owner, for example, has the right to prevent other people from driving
(or stealing) his or her car
Owners of private goods also have the right to dispense, rent out, or lease their
own private property to others
This freedom applies not only to goods, but also to one’s labor power
Public goods also exist 63
Public goods are held by society (or the world) at large
Public goods include publicly funded transportation systems (like highways),
public education, public parks, clean water, or even the global environment
Persons cannot be excluded from using or enjoying public goods
In other words, public goods are non-excludable
Public goods are also non-rival: one person’s consumption of a public good
does not reduce its availability to anyone else
The fact that public goods are available to consumers at essentially no marginal
cost creates a rational incentive to overuse or abuse them
The tragedy of the commons 64 results from individual users exploiting or
overusing a common resource, thus degrading (or even destroying) that
resource
Environmental situations, including excessive fishing and overgrazing of
communal farmland, are the most common examples of this situation
Property rights ensure that individuals retain control over their property and can
dispense with it as they see fit
Property rights generally cover possession of physical goods
Property rights also extend to various forms of “intellectual property,” such as
artistic or scientific achievements65
These are made exclusive through copyrights and patents
Patents created by law give firms or individuals the exclusive right to
produce a given good, preventing other firms from entering the market
In exchange for this legal privilege, the legal entity holding the patent
must reveal every detail of the manufacturing process for the patented
good
In the US, patents are usually effective for 17 years
Copyrights apply to works of literature, art, or music in any medium
The holder of the copyright has the exclusive right to reproduce the
copyrighted material or license it to others
Copyrights granted in 1978 or later last for the lifetime of the work’s
creator and extend for 50 years after his or her death
Property rights as an institution require not only that such rights exist but that they
are also enforced
Enforcement institutions are the most elaborate (and expensive) aspects of
property rights
Enforcement institutions include police, the courts, and other legal institutions
Property rights do not just protect one’s private property from others
The government can, in many cases, pose a great threat to private property
63
Public and private goods are discussed in more detail in the Macroeconomics section on free riders (p. 99).
64
This term dates back several hundred years to Britain. The “commons” were shared grazing land. The commons
were exploited by farmers who let their livestock over-graze the land, thus destroying its usefulness for everyone.
65
Or a Power Guide… You have been warned. – Patrick
Though private property rights constrain the state in many ways, some
exceptions allow the government to take control of property
These exceptions include eminent domain 66 and compulsory purchase
Property rights are the most basic of legal institutions, but there are others which are
also critical for the existence of a functioning market economy
Enforceable contracts are required to facilitate transactions
For exchange to take place, individuals must be able to enter into contracts
Contracts are especially important for exchanges that will occur in the future
or exchanges that occur over a long period of time
If such contracts are to mean anything, a system of laws and courts must exist to
enforce and uphold private contracts
The state also needs to abide by the rule of law
All economic agents know what the state can and can’t do because it is bound by
existing laws
Knowing that the state cannot act arbitrarily gives individuals confidence
Worrisome Walter would certainly be reluctant to buy a new car if he
thought the government might take it and use it as a new police car
Part of this condition is the legal principal of due process
Due process encompasses many ideas, but its fundamental basis is that the
government will not deprive any citizen of his or her legal rights
Laws must also be equitable
In other words, laws must apply to all individuals and all situations equally
Equality before the law assures individuals that the state will not act arbitrarily
and treat similar cases differently
Equality also assures foreign nationals and firms that their actions in a country
will be judged by the same standards facing citizens and firms of that country
Labor unions
Labor unions are collections of workers (often in the same or similar industries)
which bargain collectively with employers to determine wages and working conditions
Craft or trade unions usually focus on specific crafts or jobs
An example is the International Brotherhood of Electrical Workers
Industrial unions operate in more complex industries that require workers to
perform many different tasks which often demand varying skill levels
An example is the United Auto Workers
Many government jobs and offices are also unionized on both the local and national
levels in public employee unions
Unions essentially act as labor cartels
Workers join forces (collude) to raise prices (wages)
Labor unions, however, are exempt from most anti-collusion legislation
A significant early labor union was the Knights of Labor, which was established in
1869
Today, the AFL-CIO (American Federation of Labor and Congress of
Industrial Organizations) is one of the most important unions
Union membership has declined since the 1960s
In 1960, about 33% of American workers belonged to a union
In 2003, less than 13% of American workers were members of a union
66
Eminent domain is the idea that the government can seize your house for public works use as long as they
compensate you. This concept was important with the building of the freeway systems and, in general, almost all public
infrastructure from sewers to subways. The practice was upheld by the Supreme Court in Kelo v. City of New London.
Unionization increases the bargaining power of individual workers through collective

bargaining and restricting the labor force (creating an artificial shortage of labor)
Collective bargaining means that a union negotiates with employers on behalf of
every union member
The Wagner Act (1935) guaranteed unions’ right to engage in collective
bargaining
Successful unionization of a given industry or place of employment usually means
that the union becomes the sole supplier of labor to a firm
In open shops, however, workers do not need to belong to a union
They do not have to belong to a union to be hired, nor must they join a
union after they are hired
Closed shops are places of employment where employers can only hire union
members
These were outlawed in the 1947 Taft-Hartley Act
In union shops, employers can hire either union members or non-members
Once hired, however, non-members must join the union
The Taft-Hartley act allows states to pass right-to-work laws
These laws prohibit union shops
Check-off provisions allow employers to deduct union fees from employees’
salaries automatically and pay the fees directly to the union
The Taft-Hartley Act made these illegal, too
When a union is the sole supplier of labor, a firm must negotiate with the union in
order to hire workers
In effect, the union is a monopoly, or the sole supplier of a good (in this case,
labor)
By collectivizing, individual workers who are normally weak bargainers relative to
employers join together into one force, strengthening bargaining power
If a union does not represent all workers or enforce certain rules, some individuals
may accept lower pay or benefits than others
The availability of alternative choices (workers who will accept less) for
employers reduces the power of unionized workers and the union as a whole
Unions can also exert leverage by organizing members in certain actions
Picketing (organized demonstrations) can draw attention to labor problems,
discourage customers of the firm, and rally support for workers67
Strikes can shut down a firm as a union orders its members not to work
Strikes prevent a firm from operating, increasing the cost to the firm of not
complying with union demands
Strikes, combined with picket lines, can have a “domino effect”
Other unions may respect the strike and refuse to cross the picket line
Unions also exert pressure on employers by artificially restricting the pool of
available labor, reducing supply and thus increasing price, or wages
This is most successful when unions include all of a firm’s workers
Unions can also restrict the labor supply by limiting membership or by requiring
potential members to go through lengthy training programs before being allowed
to become full members of the union
Unions negotiate with employers about several factors, including how much workers
are paid, how many hours laborers work, how the employer handles grievances, and
how the employer fires employees
67
This is the stage in which workers march around outside a firm carrying posters and shouting slogans. – Lawrence
A yellow-dog contract is a contract that an incoming worker signs in which he

pledges not to join a union
The Norris-La Guardia Act (1932) outlawed yellow-dog contracts
In addition to wage bargaining, unions provide a number of services to members, as well
as employers and society at large
Unions sometimes work to find members employment in the case of layoffs or job
losses
Unions run pension and/or retirement programs for members, often bargaining with
employers to fund such programs
Unions can train workers and ensure a higher quality of labor
Unions also impose costs on society
By restricting the supply of labor, unions increase labor costs, which in turn
increases the market price of final goods and services
By unnecessary apprenticeship and other programs, unions can restrict the freedom
of individual workers to find employment under conditions of their own choosing
Unions can make the labor force less flexible
As a result, the broader economy becomes less capable of coping with changes,
such as a move from labor-intensive industry to services
Union membership in the United States has been declining steadily over the past twenty
years
Unions were officially legalized by the National Labor Relations Act (1935)
The Landrum-Griffith Act (1959) made union leaders more accountable in order to
help fight union corruption
Income
Definitions
Income is the flow of money, goods, and/or services to any economic agent
Potential economic agents include individual consumers, firms, and states
Income is more than just payments or cash receipts
Economic income includes a variety of purely economic factors (in terms of
utility)
A person who lives alone in a cabin in the woods derives no monetary income
However, this person does derive a certain income in terms of “consuming” the
value of his land and the labor he spends to improve or maintain it
Economic income is often classified by its sustainability over time
Permanent income is income which is sustainable for a long period of time
When extracting natural resources, an entrepreneur can gain short-run income by
using or selling the resources immediately
If the extractor takes short-run income and invests it, he or she can earn long-
run (“permanent”) income in terms of the receipts of such investments
These gains can persist long after the original resource has been exhausted
General information
The income of individual consumers is normally the return received from a factor of
production
Individual consumers such as households sell factors of production (such as their labor)
to firms in factor markets
Factor markets exist for each factor of production individually
It is important to note that buyer and seller positions are reversed in factor markets
Households sell factors (inputs) while firms buy or consume them
Since firms demand factors of production in order to produce goods and services,
demand for factors is referred to as derived demand
The demand for any given factor is dependent upon the demand for the good to
be produced using that factor
For example, increased consumer demand for ice cream “derives” (leads to)
higher demand for ice cream machines and ice cream factory workers
The total demand for any factor is the sum of the demand for that factor in each
of its uses
The demand for rubber, for example, is the sum of the demand from the
rubber band industry, tire industry, eraser industry, etc.
Supply and demand for factors of production are exactly the same as supply and
demand for final goods and services
The only difference is that demand for corresponding final goods and services
has an important effect on supply of and demand for factors
Wages and the productivity of labor
When an individual sells his or her labor in the labor market, he or she earns wages
Wages are the return for human effort
In the labor market, workers are the suppliers and firms are the demanders
The labor supply curve shifts if all workers decide they want to work more
or less at a given wage rate
This type of change would require a massive change in social norms
While wages can be quoted in hourly or salaried terms, the wage rate in economics
is the return to labor for every hour employed
For example, Carlie the Camp Counselor makes $7.97 per hour 68
Real wages are wages that are independent of inflation
Real wages can be wages quoted in terms of the goods and services they can
purchase
Real wages can also refer to wages indexed to inflation but still quoted in
monetary terms
Both are essentially the same, but present the information in a different way
The former is in terms of goods
The latter is in terms of prices at some given base year
Either way, real wages are not affected by inflation
Nominal wages are the money received for work at the current price level
An increase in one’s nominal wage does not necessarily mean that one’s real
wage has increased as well
If the increase in nominal wage is actually less than inflation, then real wages
have actually decreased
Real wages, in other words, represent the purchasing power of nominal wages
In economics, real wages are (ideally) determined by the productivity of labor
For all factors of production, the price a firm is willing to pay for that factor is equal
to the marginal 69 revenue product (MRP) of the factor
MRP is calculated by multiplying marginal product by marginal revenue (price)
Marginal product is the extra physical output produced by employing one
additional unit of a factor (such as one more worker)
68
This is actually the exact wage rate I earned when I worked as a junior counselor at a day camp near my house.
Eventually, I realized that running around all day long with screaming kids in the hot summer sun for less than $8 an
hour just wasn’t for me. Fancy that. – Dean
69
Recall that “marginal” means “one more” of something. Keep this definition in mind for this section.
Marginal revenue is the revenue gained by selling one additional unit of

output (the price of that unit)
MRP of labor (or any other factor of production) is best illustrated with an example
Let’s assume that Ted’s T-Shirt Factory produces plain white t-shirts 70
Each shirt sells for $5
One day, Ted decides that he wants to increase his factory’s output
He hires one more worker (Laborer Lawrence71 ) to see what happens
Lawrence’s marginal product is ten t-shirts
The MRP of labor, therefore, is $50 (10 t-shirts x $5 per t-shirt)
Another day, Ted decides to buy another sewing machine for his workers
The machine is a piece of capital, and its marginal product is 20 t-shirts
The MRP of capital, therefore, is $100 (20 t-shirts x $5 per t-shirt)
MRP is dependent upon three factors
The first is the productivity of the factor, or how much additional output can be
created by employing one additional unit of a factor
More productive factors will result in a higher MRP and, ultimately, higher
returns
The second is the current sale price of the good being produced
The third is the rate at which the market price of the good will fall as additional
units are supplied
Remember that a shift of the supply curve to the right (increased supply)
results in a decreased market price (ceteris paribus, of course)
According to the marginal productivity theory of wages, a profit-maximizing
firm will hire workers until the wage rate 72 equals the MRP of labor
This rule is yet another manifestation of MR = MC
The marginal cost is the wage rate of each additional worker
Firms will continue to hire workers so long as the MRP of each additional
worker exceeds the current wage rate
Firms will stop hiring once the market wage rate and the MRP of the next unit of
labor (the next worker) are equal
The employment of labor, like any other factor of production, is subject to
diminishing returns
As more workers are employed at a given task, the marginal productivity of
labor will fall
As more workers are added to a fixed stock of capital (the factories and
machines which are fixed in the short run), the productivity of those workers
begins to fall
Consequently, the MRP of labor begins to decrease
Additionally, hiring more and more laborers eventually leads to overcrowding in
the workplace 73
Other, non-economic factors may influence firms’ decisions when hiring labor
Certain firms or managers may discriminate between workers based upon non-
economic criteria such as race, sex, gender, religion, etc.
Such decisions are not profit-maximizing 74
70
Buy they don’t produce the band, Plain White T’s. – Dean
71
Great name, if I may say so myself. – Lawrence
72
In this context, wage rate is synonymous with “marginal resource cost” (the “resource” being labor). A profit-
maximizing firm will keep hiring workers until MRC = MRP.
73
Or, as my old econ teacher said, “You eventually get that guy who brings in the six-pack and the boom box.” – Dean
74
Nor are they legal in the US of A. – Zac
The rational firm will almost always take the MRP into account and employ
the most productive workers irrespective of other factors
By discriminating based on non-economic factors, the discriminating firm suffers
a loss in potential productivity
The MRP of labor (and, thus, wages) can be increased by increasing the productivity of
labor
Investments in physical capital (factories, machines, etc.) can increase the
productivity of labor and, subsequently, the MRP of labor
By making labor more productive, a firm will require fewer workers to produce
the same (or greater) output
Consequently, a firm can pay its laborers higher wages
The higher productivity of labor with improved physical capital is one reason
why manufacturing workers in the US or the EU are paid higher wages than
workers in China
Tasks are less labor-intensive in a more developed economy, so firms in
developed countries can hire fewer workers than firms in less-developed
nations
Labor itself can be improved by investing in human capital
Human capital consists of the skills and knowledge possessed by a unit of labor
or the labor force as a whole
Investing in human capital makes labor more productive even without improving
surrounding physical capital
These investments result in increases in the MRP of labor and in wages
These higher wages are a type of a return on the investment of education
The primary means of improving human capital are education and job training
To improve the performance of the economy as a whole, countries can invest in
mandatory primary and secondary education to improve the human capital of
the entire population
Labor productivity can also be improved through technological progress
As technology improves, labor (as well as capital) becomes more productive
The development of new machines, robots, computers, etc. has contributed to
increasing labor productivity and higher wages
Wages may also vary for seemingly random and inexplicable reasons
One primary example is how wages can vary in different regions in the same country
even when workers are equally productive
If prices and labor productivity are the same in different places, wages should
theoretically be equal
Often, price differences among areas are the reason for wage differences 75
Different price levels result in different nominal wages
However, real wages across regions should remain the same as long as the real price
of the final good and the productivity of labor are the same
Like all other factors, the demand for labor is derived demand
Thus, it depends upon the demand for the final goods produced
Rent 76
When individuals (or households) sell land, payments are received as rent
75
For instance, the cost of living in Southern California is much higher than that in rural Utah. That was not an
advertisement for moving here. In fact, if you value your sanity, I suggest you stay far, far away. – Patrick
76
Rent in economics is a complex topic. We give several definitions here in hopes of achieving clarity and helping you
recognize whatever USAD might throw at you on a test.
In economics, rent encapsulates all payments for land (natural resources)

Rent includes money from selling extracted oil or felled trees to the payments
received for leasing land
Economic rent is return to any input over and above its opportunity cost
Although this may seem totally different from our traditional conception of rent, it’s
actually just a broader term that includes traditional rent
The opportunity cost of land is zero: there is no alternative
So, rent for land is automatically a payment over and above its opportunity
cost
Another definition of rent is the price of a perfectly inelastic resource
Saying a resource is perfectly inelastic is the same as saying it has an opportunity
cost of zero: no alternative exists
Senior members of a firm (those who have worked there for a long time) are often
paid more than others with the same job
The extra pay that these senior members receive is a form of economic rent
Their opportunity cost is the salary they would receive as normal employees
In other words, these senior members are willing to work for a certain salary
They are attracted to the job by that amount
Because of their senior status, they are paid more than they demand
This extra pay is economic rent
Yet another definition of rent is profit that a resource owner makes without
producing anything 77
A landlord who leases out an apartment complex makes profit, but he or she
does not actually produce any new goods
Similarly, a senior member of a firm who gets a higher salary by virtue of his
seniority has not done anything to “produce” his seniority
Interest
The returns an economic agent receives from capital are referred to as interest
Interest derives from investment in capital development
Investment is the creation of capital which will produce goods for future
consumption
Investment demands that individuals sacrifice current consumption for future
consumption
The only way individuals will be persuaded to sacrifice current consumption for future
consumption is if future returns are greater than those passed up in the present
Interest is the extra payment that entices economic agents to invest
In classical economics, interest is the rate of return on capital investment
With modifications to classical economics, interest is now seen in a broader light
Interest is now determined by the interaction of supply and demand for funds
The interest rate can also be viewed as the price of money (discussed in
macroeconomics)
Profit
The returns to individuals from entrepreneurship are known as profit
Profits are the residuals after returns to land, labor, and capital have been distributed
Entrepreneurs take risks by combining or using the other factors of production in new
or unique ways to create new goods or to produce existing goods more efficiently
Entrepreneurs are not always successful; there is always the risk of failure
77
Paraphrased from Economics: Principles and Policy by Baumol and Blinder (pgs. 403-406).
For entrepreneurs to take risks, a reward (incentive) must be offered in the form of
profits
One way of reducing risks to entrepreneurial activity is through property rights
By granting property rights to the entrepreneur over new products or methods of
production, an additional risk is eliminated
Property rights prevent others from copying the entrepreneur’s ideas (which are
a form of intellectual property) and subsequently reducing his profits
Property right protections in this case are mostly in the form of intellectual property
rights, such as patents
Income on a larger scale
The income of firms equals total sales minus costs
The income of states or countries is the sum of all incomes in the country or of all
citizens of that country (discussed in macroeconomics)
MACROECONOMICS
This section will focus on macroeconomics. 30% of the exam (15 questions) will
Macroeconomics studies entire economic systems, which focus on macroeconomics
are the aggregate actions (or results of the aggregate
16 questions from the USAD practice
decisions) of the individual agents studied in
test are on topics from this section
microeconomics.
Macroeconomic Basics
Overview
Macroeconomics is the study of the entire economy
It focuses on the aggregate (or total) effects of the behavior of individual economic
agents
Macroeconomic concepts can be analyzed independently of the behavior of
individual agents
Macroeconomics generally distinguishes four sectors in the economy: businesses,
households, the state (government), and foreign entities
Although it operates on the same principles as microeconomics, macroeconomics can
reach different conclusions
Many decisions that are beneficial for individual economic agents would be harmful
to society if all economic agents simultaneously made the same choices
However, basic principles (such as the laws of supply and demand) operate in
macroeconomics just as they do in microeconomics
Aggregate Demand and Supply

Aggregate demand
Aggregate demand (AD) is the total demand of an economy at any given price level
It is the sum of all expenditures in an economy
Aggregate demand has four components
Consumer spending on goods
Investment spending (usually by firms) on capital equipment and inventories
Government spending on goods for the state or the public welfare
Net exports, or the total value of goods exported minus the total value of goods
imported
Adding these four components yields aggregate demand
Adding these four components is also one method of calculating GDP (Gross
Domestic Product, which will be discussed later)
Aggregate demand can be graphed
It looks similar to the demand curve for an individual market
While the curves look the same (both are downward sloping), they represent
relationships between two different sets of variables
The aggregate demand curve shows the relationship between the price level
(vertical axis) and the level of output (horizontal axis)
Price level is an index of the average prices in the economy

A higher price level means that all goods are, on average, more expensive
Level of output is the sum of all goods and services produced in an economy in
real terms (adjusted for inflation)
Some textbooks refer to it as “Real GDP” instead (which is essentially the
same thing)
The Aggregate Demand Curve
Price
Level
Level of Output
Aggregate demand is downward-sloping for three reasons

The first is the wealth effect
As the price level decreases, consumers’ real incomes increase, allowing
them to buy more goods
Remember that real incomes are adjusted for the price level
If the price level goes down but nominal wages stay constant, the real
value of the nominal wages increases
This increase in purchasing power leads consumers to an increase in the level
of output demanded
The second is the interest effect
As the price level increases, more money is needed for transactions
As a result, more people try to borrow more money
This competition is essentially an increase in the demand for money, so real
interest rates (the “price” of money) increase
This increase makes borrowing more expensive, discouraging consumption
and (primarily) investment
Consequently, aggregate value demanded decreases as price level increases
The third is the trade effect (or open economy effect)
As the price level of domestic goods decreases, domestically-produced goods
become cheaper internationally
The result is an increase in domestic consumption and exports which
increases the level of output demanded
Like the market demand curve, the aggregate demand curve can shift
There are six changes that cause shifts
First, the distribution of income can change
If households with a higher propensity to consume increase their share of
total household income, aggregate demand will shift to the right (outward)
The propensity to consume is what percentage of after-tax income
households spend on consuming goods
In this situation, consumption (one of the components of aggregate demand)
increases
If households with a lower propensity to consume increase their share of total

household income, aggregate demand will shift to the left (inward)
Generally, poorer households will spend a higher percentage of their income on
goods
In comparison, wealthier households will save a higher portion of their
income
In other words, they have a higher propensity to save
Propensity to save and consume will be discussed in more detail with fiscal policy
on p. 114
Second, firms can change their investment spending
To increase investment spending, a firm spends more on capital goods, which
will shift aggregate demand to the right
In this situation, investment (one of the components of aggregate demand)
increases
Firms increase planned investment spending because they expect to do well in
the future or see future opportunities for which they need to prepare
If future expectations are poor (firms expect rough times ahead), firms will
decrease planned investment, which will shift aggregate demand to the left
Third, the income of foreign entities may change
If the income of foreigners changes, exports will change
Remember that net exports is one of the components of aggregate demand
If foreign nation B becomes more affluent, its citizens will spend more on goods
exported from nation A
This change will shift the aggregate demand in nation A to the right
If foreign nation B becomes poorer, its citizens will spend less on goods
exported from nation A
This change will shift the aggregate demand in nation A to the left
Fourth, changes in foreign currency exchange rates can also impact aggregate
demand
If the dollar depreciates against foreign currencies, imports become more
expensive and American exports become cheaper for foreigners
This change leads to an increase in exports and a decrease in imports, which
in turn shifts aggregate demand to the right
When a currency depreciates, it becomes less valuable relative to another
If the dollar appreciates against foreign currencies, imports become less
expensive and American exports become more expensive for foreigners
This change leads to a decrease in exports and an increase in imports, which
shifts aggregate demand to the left
When a currency appreciates, it becomes more valuable relative to another
For additional information on exchange rates, see the section on International
Trade and Development below
Fifth, changes in expectations concerning the price level can also shift aggregate
demand
If consumers expect price levels to increase (inflation) in the future, they will buy
more goods now, thus shifting aggregate demand to the right
If consumers expect price levels to decrease (deflation) in the future, they will
wait to buy some goods, which will shift aggregate demand to the left
Sixth, the government can directly impact aggregate demand through its own
spending
By increasing or decreasing government spending, the government directly

changes one of the elements of aggregate demand, shifting the curve by itself
Government influence over aggregate demand is the foundation of Keynesian
economics (see Fiscal Policy below)
Remember that a shift in the aggregate demand curve represents a change in the
level of output demanded at all price levels
A change in the price level itself, however, only causes a movement along the
aggregate demand curve
Aggregate supply
Aggregate supply (AS) represents the potential supply of all goods at any given price
level
Short-run aggregate supply
Short-run aggregate supply (SRAS) represents the potential supply of all goods at
any given price level in the short-run (not in the long-run) 78
Long-run aggregate supply is different and will be discussed in the next section
Prior to Keynes, economists thought that aggregate supply determined national income
This theory is known as supply-side economics
Supply-side economics attempts to increase overall welfare by boosting supply-
side factors, which, in turn, will increase the overall supply of goods
An increase in aggregate supply leads to lower price levels and higher total
output
Jean-Baptiste Say developed a theory called Say’s law 79
Say’s law states 80 that supply creates its own demand: demand will increase
to match increased supply
In other words, a good is demanded simply because it is supplied
Supply-side economics has many variations (both free-market and state-centered)
and was vigorously attacked by Keynes
Keynes reversed the relationship, postulating that increasing aggregate demand will
signal firms to increase production, which will cause an increase aggregate supply
Short-run aggregate supply can be graphed like market supply
The curve is upward-sloping
A direct relationship exists between the level of output and the price level
As the price level increases, suppliers across the economy increase production
Shifts in the short-run aggregate supply curve can occur for four reasons
First, improvements to or changes in the labor force can shift the curve
If labor increases in quality or size, aggregate supply will shift to the right
(outward)
If labor decreases in quality or size, aggregate supply will shift to the left (inward)
Changes in work hours or work habits across the labor force can also influence
the aggregate supply curve
Second, technological progress can shift the curve to the right
If technology improves, then the productivity of all factors of production will
increase, which will increase total output at all price levels
Third, government taxes and subsidies can result in a shift
78
When economists (or USAD, for that matter) say “aggregate supply,” they are generally referring to short-run
aggregate supply.
79
Say’s Law is testable. Remember it! – Zac
80
I fought long and hard to resist the urge to use the word “says” here instead. – Dean
If the state increases taxes on suppliers throughout the economy, then total
output will decrease at all price levels, shifting the curve to the left
If the state provides subsidies or other transfers to firms throughout the
economy, then total output will increase at all price levels, shifting the curve to
the right
Fourth, expectations of inflation can cause a shift
If firms expect inflation, the curve will shift to the left as firms try to save money
now to meet higher costs later
Remember that changes in price level lead only to movements along the short-run
aggregate supply curve, not shifts in the curve itself
The short-run aggregate supply curve splits into three regions when we factor in other
considerations (see graph below)
The first region is called the Keynesian region
It is the leftmost portion of the curve
At this segment of the curve, the economy is operating on very low production
levels
In fact, the economy is probably experiencing a recession
Unemployment is likely very high, and society probably isn’t using resources
very efficiently
As a result, increasing output will not cause any inflation
Rather, production will simply become more efficient as unemployment
drops and resources are utilized
Consequently, this region of the graph is horizontal
Eventually, an economy in this region will regain its health and move back toward
higher levels of production
When this change occurs, the economy moves out of the Keynesian region
and into the intermediate region
The intermediate region is the link between the Keynesian and classical regions
(which will be discussed momentarily)
When we discuss short-run aggregate supply, we are generally referring to the
intermediate region
It resembles the regular supply curve: it is upward sloping (but not vertical)
An economy in this region is normal and healthy
Increases in output lead to increases in price level (inflation)
If an economy increases production drastically, it will eventually move out of the
intermediate region and into the classical region
The classical region is the third and rightmost segment of the curve
Here, we encounter the production limits (or “capacity constraints”) of an
economy
Production is already so high that firms are longer be able to increase output
because all factors of production in the economy are being utilized
As a result, the curve is vertical, or perfectly inelastic
As much as firms might want to respond to changes in the price level, they
are unable to do so
At this level of output, the economy is actually employed above full
employment 81
The economy can only maintain this “overheated” state temporarily, if at all
81
As will be discussed later, full employment is NOT 100% employment. It is actually closer to 96% employment.
Eventually, it will move back toward a lower level of production (and into the
intermediate region again)
Short-Run Aggregate Supply
Price Level
Classical
Intermediate
Keynesian
Level of Output Capacity

Constraints
Long-run aggregate supply

Long-run aggregate supply (LRAS) behaves slightly differently
The long-run aggregate supply curve is determined by the availability and
productivity of the factors of production
In the long run, supply is independent of the price level
As a result, the long-run aggregate supply curve as a whole is perfectly inelastic, or
vertical
Changes in the aggregate supply curve can only come in shifts resulting from changes
in the productivity of the factors of production
The output level of the long-run aggregate supply curve is at the point of full
employment
If the LRAS curve passes through the intersection of the SRAS curve and the
aggregate demand curve, the economy is in “long-run equilibrium” (see graph
below)
If the LRAS curve does not pass through this point, the economy is either
experiencing inflation or recession
A recession is when the production level of long-run aggregate supply is
greater than the current level of production
The economy’s production potential is not being realized
According to classical economic theory, prices will fall, consumption and
production will increase, and the economy will move back to long-run
equilibrium
Inflation occurs when the production level of long-run aggregate supply is
less than the current level of production
Factors are being over-utilized and the economy is “overheated”
According to classical economic theory, prices will rise, consumption and
production will drop, and the economy will move back to long-run
equilibrium
An Economy in Long-Run Equilibrium
LRAS
Price Level
SRAS
AD
Level of Output
Full Employment Capacity
Output Constraints
National Income
Introduction
National income is the total income of all agents in an economy in a given period
Measurements of national income effectively mirror aggregate demand
National income should include all consumption expenditures
A variety of methods and means are used to measure and examine national income
The one on which we will focus is Gross Domestic Product or GDP
GDP
GDP is the value of all final goods and services produced within an economy in a year
GDP is typically calculated by summing total outputs of all goods at market prices
GDP only includes the values of final goods and services
Final goods are goods which are consumed and not used to produce anything else
Two examples are a new box of tissues and this Power Guide82,83
Intermediate goods are goods which are used to produce other goods
Adding intermediate goods to GDP would result in double-counting
The value of intermediate goods should be reflected in the final market value of
final goods
The value of the engine of a new Ford Mustang is included in the price of the
car
Only the car (and not the engine) would be counted in GDP
By definition, GDP includes only those goods produced within the borders of a given
economy
Goods produced in the United States by foreign firms are factored into the United
States’ GDP
Goods produced outside the United States by US-based firms are NOT factored
into the GDP of the United States
82
Please remember that the two are not substitutes. – Dean
83
Nor are they complements. Unless, of course, you have a cold while you’re reading this. Or if economics just brings
you to tears. – Lawrence
Gross National Product (GNP) includes all final goods produced by United
States nationals (individuals and firms) wherever they are in the world
It excludes all foreign individuals and firms (even if they are in the United States)
For example, a McDonalds Big Mac sold in Tokyo is included in the United States’
GNP
It is NOT included in the United States’ GDP
It is, however, included in Japan’s GDP
Most economists prefer to use GDP rather than GNP
GDP is measured at market value
Market value is the current price of a good
Calculating GDP thus involves summing the prices of all final goods sold in the
United States within a year
GDP measures the size of an economy and not necessarily its health or the welfare of
the people in that country
For example, Indonesia has a GDP of $827.4 billion 84 while Ireland has a GDP of
$126.4 billion
Based upon this alone, one would expect Indonesia to be a much nicer place to
live than Ireland
However, Indonesia also has over 60 times as many people as Ireland
The wealth of Indonesia is divided among many more people than the wealth
of Ireland
Thus, to get a truer picture of national well-being, per capita GDP should be
examined
Per capita GDP is equal to GDP divided by the population of the given region
“Per capita” basically means “per person”
In the above example, Indonesia has a per capita GDP of approximately $3500 while
Ireland’s is approximately $31,900
Some economists think that per capita GDP is itself a poor measure of national well-
being
Per capita GDP ignores other factors (such as health, environmental factors,
education, the distribution of income, and even happiness)
Alternative measures of national well-being have been developed, such as the
United Nations’ Human Development Index (HDI)
This index is represented by a number between zero and one
Nations with higher numbers have a higher level of well-being
Other economists point out that nearly all alternative measures are closely
correlated with per capita GDP measurements
Alternative measurements also are difficult to accurately measure
For example, how does one measure the happiness of a person? 85
GDP figures are often calculated by various agencies within national governments
In the United States, GDP is calculated by the Bureau of Economic Analysis, which is
part of the Department of Commerce
The Bureau reports GDP figures quarterly (every three months)
As of 2006, the GDP of the United States was $13.13 trillion (the highest in the world)
According to the CIA’s World Factbook, the per capita GDP of the United States was
$44,000 in 2006
84
All data is from 2004 at Purchasing Power Parity (PPP), unless otherwise noted.
85
A fine question. Bhutan, a small South Asian country, has been trying to answer it since 1972, when the nation
started measuring its growth in Gross National Happiness (GNH) rather in than GDP. – Patrick
This per capita GDP was the ninth highest in the world
The US is below Luxembourg, Bermuda, Jersey, Equatorial Guinea, the United
Arab Emirates, Norway, Guernsey, and Ireland (in order from first to eighth)
Measuring GDP
GDP can be measured in several different ways
The most frequently used approach for calculating GDP is the expenditures
approach
Using expenditures approach, one sums all expenditures in an economy within a
year
The expenditures approach breaks down expenditures into four categories
Consumption expenditures (C) include the values of all purchases of goods
designed for consumption
These goods, by definition, must be final goods
Additionally, used goods do not count
They were already counted when they were purchased as new
Further, the purchase of stocks and bonds does not count in GDP because
no goods or services are involved
These transactions are purely financial
Investment expenditures (I) include the values of all investment spending
Interestingly enough, buying a home is considered investment, not
consumption
Similarly, construction work is also considered investment
Government expenditures (G) include the values of all government
purchases
Net exports (NX) include the values of all exports minus the values of all
imports
Essentially, the expenditure approach is calculated in the same fashion as
aggregate demand: GDP = C + I + G + NX
GDP is sometimes expressed as “Y”
In the United States in 2003, consumption accounted for about 70% of GDP,
government spending 20%, investment 15%, and net exports -5%
Government spending varies widely among economies
Economies with greater state intervention have far higher government shares
of GDP
Even with the explosion of world trade in the past half-century, trade (net
exports) still accounts for a relatively tiny portion of GDP
Investment spending is spending on either capital goods or inventories
Capital goods are capital equipment, such as new machines, factories, or other
items (PCs, cash registers, etc.)
In other words, capital goods are used to turn inputs into outputs
Inventories include goods which are produced but not consumed in the
measured time period
For example, if Steve’s Steel Company produces 1000 tons of steel in 2003
but only sells 800 tons, the 200 tons left over are factored into GDP as
investment spending
These 200 tons add to Steve’s inventories
When inventories are later used up, they are SUBTRACTED from GDP in
the year they are used
If the 200 tons of steel are then sold and used in 2004, the value of the
that steel in current prices is subtracted from the 2004 GDP
This subtraction ensures that inventories are not double-counted

Investment spending can either be planned or unplanned
Planned investment spending is what firms intend to invest in a given year
In other words, it’s how much they intend to spend on capital and how much
they intend to add to inventories
Unplanned investment spending 86 is investment spending which the firm
does not initially intend to make
Unplanned investment spending nearly always takes the form of unexpected
inventories
Let’s assume that Steve’s Steel Company produces 1000 tons of steel in 2003
and plans to sell 800 tons but only sells 700
Steve has planned investment equaling the value of the 200 tons of steel it
intended to add to inventories
Steve also had unplanned investment equaling the value of the 100 tons of
steel which he was unable to sell
Planned investment spending plus unplanned investment spending equals total
investment spending
Government spending generally focuses on public goods
Examples of government spending include infrastructure (such as highways) and
government services (public healthcare or law enforcement)
Governments can directly impact GDP by changing its own spending
This practice is known as fiscal policy (see p. 112)
Governments also allocate significant amounts of money for transfer
payments which are NOT factored into GDP
Transfer payments are payments not in exchange for goods or services
They are made from the government to individuals
Examples include unemployment insurance, Social Security, and welfare
payments
Transfer payments do not produce or provide anything
They simply move money around and, thus, are not factored into GDP
An alternative way of calculating GDP is the national income approach
Using the income approach, one adds together all payments for factors of
production and then subtracts certain items to find national income
National income includes several components:
Wages (and salaries)
Profits of private firms
Interest payments to those who have loaned money
Rents 87 to those who have rented or otherwise loaned certain goods or
resources
Rent is the smallest component of the income approach
Also, indirect taxes (such as sales taxes) and subsidies (government price-
supports for goods) are eliminated
Taxes are added back in, and subsidies are subtracted
The income approach is also known as national income accounting
When depreciation of capital is factored into the income approach, Net
Domestic Product (NDP) is the result
From year to year, capital breaks down or wears out
86
This sounds like a euphemism. It’s not product that we failed to sell, it’s “unplanned investment spending.” – Patrick
87
Note that these first four components are essentially the same as the payments for the four factors of production.
This “wear and tear” is known as depreciation

In other words, depreciation is the consumption of fixed capital
Depreciation takes value out of the economy
Depreciated capital must be replaced
Subtracting depreciation of capital from GDP yields NDP
Following is a summary of the various calculations associated with the national
income approach
GDP – depreciation = NDP
NDP – indirect business taxes = national income (NI)
NI – Social Security tax + transfer payments – retained earnings = personal
income (PI 88 )
Retained earnings include all the money that corporations make but do not
distribute as profit
PI – income taxes = disposable income (DI)
Disposable income is the amount of money that consumers actually have
available to spend
It is disposable income that determines consumers’ level of consumption
A final method for calculating GDP is with the value-added approach
Using the value-added approach, one calculates GDP by adding the value-added to a
good at each stage of its production
As a good is produced, it passes through multiple steps
The value-added approach analyzes each step in the production process and then
factors in the value-added at each step to calculate total value
Value-added is the price at which a good sells minus the cost of the goods (or
resources) used to make it
Value-added presumably represents the value a firm or individual adds to a
given good in one step along the production process
Real and nominal GDP 89
Nominal GDP is GDP valued at current prices
Nominal GDP is linked to, and heavily influenced by, the changing value of money
If the value of money decreases (inflation), prices will increase
The result is an increase nominal GDP
This increase only reflects an increase in prices, not an increase in total level
of output
If prices increase enough, actual output can drop and nominal GDP remain the same
Real GDP is GDP adjusted to account for changes in prices
Real GDP eliminates a problem associated with nominal GDP
Changes in the price level do not distort our perception of total output
Nominal GDP can be adjusted to real terms in two ways
A base year can be chosen, and all prices converted to the prices in that base
year
Indexing prices to a base year makes them constant
A GDP deflator (or GDP price deflator) can also be calculated to measure
changes in the price level relative to changes in GDP from year to year
A GDP deflator allows nominal GDP to be converted to real GDP based on
changes in the price level
88
Not pi the number, and not pie the baked good. PI as in personal income. – Lawrence
89
Nominal always means before adjusting for inflation, and real always means after doing so. USAD loves these terms.
So know them. – Patrick
Both methods convert nominal prices into prices that are “constant”
Constant prices do not change with inflation
They stay the same (remain constant) from year to year (starting from a base
year)
Use the formula below to covert GDP figures with the GDP deflator
Deflator1 GDP1
=
Deflator0 GDP0
Limitations of GDP
GDP, no matter how it is calculated, misses a substantial amount of activity
GDP does not include activities which are not priced in markets
Examples include cleaning your house, cooking your own gourmet meal, or building
your own computer from spare parts
While certain goods used in these activities are factored into GDP, the value-added
by personal labor is not included
Not counting personal activities in GDP can misrepresent total economic output
In developing economies, much of the labor force is involved in subsistence
agriculture – people produce for their own needs
Even though subsistence agriculture results in usable output, it is not counted
because it is not sold in markets
The result is a gross misrepresentation of economic activity
GDP also leaves out the resale of existing goods (used goods)
Buying a used car is not factored into GDP because no new value was added to the
economy
The sale of your rare, mint-condition Transformer figures still in the box on eBay is
also not counted in GDP as this is not a “new” good, even if the value of that
Transformer did appreciate substantially 90
For example, the Jetfire figure would have cost you about $15 in 1985, but will
now set you back around $160, the last time I checked 91
GDP also leaves out activities which take place outside formal, legal markets
The illegal sale of goods, or simply the sale of illegal goods, is not factored into GDP
because these sales take place in black markets
The sale of narcotics in the United States, for example, is not factored into GDP,
though one could (presumably) argue that this reflects value-added activity
Additionally, activities outside of formal markets are left out simply because they are
outside of channels which can be monitored by the state
For example, if Generous George pays his son, Diligent Dave, $15 for mowing
the lawn, it’s unlikely that Dave would report this to the government as income92
This payment, therefore, is not included in GDP
In some countries, large amounts of economic activity take place in black markets
As a result, total economic activity in those countries is undercounted
The Gini coefficient and the Lorenz curve93
The Gini coefficient and Lorenz curve are used together to show the wealth
distribution of a given country
The Gini coefficient can range anywhere from zero to one
90
Probably even more now that the movie has come out. – Dean
91
A point of clarification: Joe is the Transformer geek. Not me. Thanks. – Dean
92
Tax-evading hooligan. – Patrick
93
These topics will only be tested on a very basic level, if at all. The discussion of them in this guide, therefore, will be
very brief and simple.
A Gini coefficient of one means that one individual has 100% of the total wealth
of that country
A Gini coefficient of zero means that wealth is distributed entirely equally in that
country
Every individual has the same amount of wealth
The Lorenz curve is the graphical representation of the Gini coefficient
The Circular Flow Model

Overview
The circular flow model shows the relationships between different sectors of the
economy
The circular flow model, at its most basic level, has two main components
Households provide resources which are used to make goods (factors of
production) and purchase goods in the market
Firms (also referred to as the business sector) consume resources to produce
goods and sell these to households in the market
The circular flow model also has two basic markets, both of which are governed by the
forces of supply and demand
The market in which firms buy factors of production from households is called the
factor market
The market in which households buy final goods and services from firms is called the
product market
The circular flow model illustrates how households and firms are mutually dependent
upon one another
The household and business sectors essentially equal consumption and investment
spending, respectively, in aggregate demand
Complicating the model
The addition of other actors in the circular flow model reflects the different
components of GDP and aggregate demand
The government can be added to the circular flow model to include the impacts of
government spending on economic activity
The government taxes firms and households to support government spending,
creating a leakage
A leakage is when resources “leak” out of (exit) the circular flow model
The government provides transfer payments or subsidies to households and firms,
creating an injection
An injection is when resources are “injected” into (enter) the circular flow
model
When leakages and injections balance each other out, the government plays little
role in the circular flow of resources
When leakages and injections are unbalanced, government spending can influence
the circular flow
If the government injects more money than it takes in, it can stimulate the
economy
If the government collects more money than it gives out, it will act as a brake on
the economy, slowing it down
Foreign households and firms enter the domestic circular flow model when exports and
imports are included
Exports are an injection
Foreigners inject financial resources into the economy in exchange for goods and
services
Imports are a leakage
Foreigners extract financial resources from the economy as payment for goods
and services
Households and firms also interact with financial intermediaries
Households save money in financial intermediaries and receive small payments of
interest in return
Savings count as a leakage
Firms borrow money from financial intermediaries for investment purposes
For the privilege of borrowing, firms make large payments of interest to the
financial intermediaries
Firms’ investment is counted as an injection
In the illustration below, arrowheads show the direction of the flow of money
The Circular Flow Model
Factor Markets
Exports
Financial
Intermediaries
Households Firms
Government
Imports
Product Markets
Economic Growth
Overview
Economic growth is an increase in real GDP
Essentially, an economy grows when it is able to produce more
Growth can be seen as an increase in total output or as the outward expansion of the
PPF of an economy
An increase in nominal GDP does not necessarily mean that an economy has grown
If prices are increasing (inflation), then nominal GDP can increase without real GDP
ever increasing
If prices are decreasing (deflation), then nominal GDP can decrease even if real GDP
actually increases
Economic growth is measured by changes in real GDP
To obtain accurate measurements, nominal GDP must be converted to real GDP
The business cycle
The economy alternates between periods of growth and decline, as indicated by the
business cycle
The business cycle represents the cyclical fluctuations in total output, or real GDP,
that most economies experience
Though the business cycle features periods of growth and decline, the general trend of
the entire cycle is upwards
On average, the economy grows over time
Expansion (or upturn) occurs when the economy shows an increase in real GDP
Expansion is only recorded when growth has persisted for at least two consecutive
quarters (six months)
Expansion continues until the economy reaches a peak
A downturn occurs after the economy has peaked
Real GDP declines
A recession occurs when the economy experiences a persistent downturn
Recessions are recorded when a downturn has persisted for at least two
consecutive quarters (six months)
If a recession lasts for three quarters (nine months) or more, it is known as a
depression
Because of the negative connotation associated with this word, however, it is
rarely used
Recessions continue until the economy reaches a trough, after which the economy
begins to expand again
The National Bureau of Economic Research defines a recession as “a significant
decline in economic activity spread across the economy, lasting more than a few
months, normally visible in real GDP, real income, employment, industrial
production, and wholesale-retail sales” 94
The Business Cycle

Peak
Real Expansion
Output
Downturn Trough
Time
Most governments work to moderate the business cycle through policy

Peaks are dampened to prevent inflation and to ease future downturns
Troughs are dampened to reduce social problems (such as unemployment)
Below is a brief history of the major events in the U.S. economy
The longest economic decline in United States history resulted from the Panic of
1873
The economy reached a trough in 1879
This downturn was sparked by events in the international economy, namely the
collapse of the Vienna Stock Exchange
The world economy was in a state of decline from 1873 to 1896
The Great Depression began with the collapse of the New York Stock Exchange in
1929
The United States’ economy reached a trough in 1933
A second recession took place in 1937, ending in 1938
An OPEC embargo resulted in oil shocks which contributed to a recession from
1973 to 1975
94
NBER, http://www.nber.org/cycles.html.
The longest expansion in US history took place from 1991 to 2001

The most recent recession in the US economy occurred following the bursting of
the “dot-com” bubble, from the first quarter of 2001 to the fourth quarter of 2001 95
Other than the 1990s, most expansions in US history have resulted from, or
coincided with, wars 96
Tracking economic growth
Economic growth can be tracked in a variety of ways besides monitoring real GDP
Leading economic indicators give us a glimpse of real-time changes in the economy
Examples include current housing construction, changes in firm orders for
resources, and stock prices
All of these can be monitored in real-time as events are happening, allowing for
quick insight into economic change
Such indicators are sometimes faulty because they can be affected by short-term
swings that have little impact on the long-run growth of the economy
Leading indicators give us a general idea of the future status of our economy
Concurrent economic indicators give us a sense of general economic activity
Examples include employment, producer output, and net exports
These indicators take a bit more time to compile than leading indicators but still are
available fairly quickly
Concurrent indicators tell us how our economy is doing right now
Lagging economic indicators provide a more in-depth analysis of economic
development
Examples include factor costs (such as unit labor costs) and even GDP itself
These indicators take a great amount of time to put together but provide the most
accurate look at economic activity
Lagging economic indicators help us see how our economy has performed in the
recent past
Other tracking methods
A variety of other methods are also used to track growth in the United States
The Department of Commerce publishes the Index of Leading Economic
Indicators to track 12 economic indicators that measure growth and development
The Index of Consumer Confidence is a survey of 5000 households that tracks
confidence in the economy
This index can reflect the future economic decisions of households and, thus,
prospects for growth
Efficiency criteria: Pareto and Kaldor-Hicks
Pareto efficiency is the first criterion for determining whether or not an economy is
performing efficiently
An economy has achieved Pareto efficiency if no one person’s welfare could be
improved without detracting from the welfare of another
Pareto efficiency usually requires that the given economy is using all the resources at its
disposal
If some resources are idle, firms or individuals can utilize them to produce more
without taking away what is available to others
Pareto efficiency is determined using the pre-existing income distribution in an economy
95
For those who don’t remember this, the late ‘90s saw a huge expansion in the Internet. Companies sprang up left
and right offering every service imaginable in an effort to capitalize on the Internet’s new profitability. In 2001,
however, thousands of Internet businesses (“dot-com” business) went bankrupt, and the bubble burst.
96
Leading to the controversial belief of some that the US economy relies on wars for growth.
Kaldor-Hicks efficiency is the second criterion for determining efficiency

An economy has achieved Kaldor-Hicks efficiency if it is getting the maximum possible
value out of its resources
In other words, those who are harmed by the use of resources will demand a certain
amount of compensation
If the economy is Kaldor-Hicks efficient, those who benefit from the use of these
resources are willing to compensate those who are harmed by the same amount
This principle forms the theoretical foundation of cost-benefit analysis
Employment
The labor force
The labor force of a given economy includes all members of the population who are
employed or actively looking for work
Only adults (ages 16 and over) who are not incarcerated (in jail) can count as part of the
labor force
The percent of the eligible population of an economy which is in the labor force is
known as the labor force participation rate (also sometimes, activity rate)
One is only counted as participating in the labor force if one is either employed or
actively looking for work
Discouraged workers are persons not in the labor force who want to work but
who have given up looking for a job because they believe there aren’t any available 97
Discouraged workers are not counted as part of the labor force
These workers are also called marginally attached workers
In a time of greater prosperity, they would probably be actively seeking a job
or working
They are barely “attached” to the economy and the prospect of having a job
Housewives, retired persons, children, those serving in the armed forces, and other
individuals not looking for work are not counted as part of the labor force
In the United States, the current participation rate is 67% 98
A critical factor impacting the participation rate is the number of women in the
workforce
The entry of more women into the workforce over the last half-century has
significantly increased the participation rate in the US
Unemployment
The employment rate is the number of persons employed divided by the labor force
As of May 2005, the employment rate for the United States was 94.9%
Also as of May 2005, the total number of persons employed was 141.5 million
people
The unemployment rate is the number of persons unemployed (but still in the labor
force) divided by the labor force
As of May 2005, the unemployment rate for the United States was 5.1%
Again as of May 2005, 99 the total number of unemployed persons in the United
States was 7.6 million people
The number of unemployed persons in a given economy is equal to the number
of people in the labor force minus the number of people who are employed
97
Definition from the Bureau of Labor Statistics.
98
According to USAD.
99
This was a big month for statistics. – Patrick
Adding the employment rate and the unemployment rate should always yield 100%
In fact, another way of defining the labor force is the total number of people
employed and unemployed
An individual who is neither employed nor unemployed is not part of the labor
force
Types of unemployment
Unemployment is generally categorized in four ways
Structural unemployment is unemployment which results from changes in the goods
that consumers demand or changes in technology
For workers experiencing structural unemployment, the rest of the economy may
be in perfect health while they are out of work
There are simply not enough jobs in a specific market for the number of
workers who want jobs
Structural unemployment is ultimately due to a mismatch between the skills a
worker possesses and the skills demanded by the market
Structural employment can also be the result of being in the wrong place at the right
time
Let’s assume that new jobs are being created in Los Angeles, California, but not
in Helena, Montana
If Unemployed Ursula were in L.A., she would probably be employed
Since she’s stuck in Helena, though, she’s structurally unemployed
Structural unemployment can only be reduced by retraining workers for new jobs or
by relocating workers to areas of the economy where jobs are being created
For example an unemployed steelworker in Ohio would have a job if he could
learn how to code software or if he could move to Texas
Three laws of note have been passed to combat structural employment by training
structurally unemployed workers with new skills
These three laws are the Manpower Training and Development Act
(1962), the Comprehensive Employment and Training Act (1973), and
the Job Training Partnership Act (1982)
Cyclical unemployment is unemployment which results from changes in the business
cycle
If the economy is in recession, unemployment should be above normal
If the economy is growing, then unemployment should be lower than normal
Cyclical unemployment is the most serious type of unemployment because it
indicates a problem in the economy
Frictional unemployment is unemployment which results from looking for work
Frictional unemployment results from the time-lag between when a worker is fired
or quits his or her job and when he or she find a new job
Job searching, applying and interviewing for jobs, and relocation are among the
reasons for frictional unemployment
Frictional unemployment can never be eliminated because some time lag will always
exist between leaving one job and finding another
Time lags can be reduced, though, by ensuring that a dynamic and flexible labor
market exists so that new jobs are readily available
Seasonal unemployment is unemployment resulting from jobs that fluctuate with the
seasons
When seasons change, seasonal jobs become redundant and workers lose their jobs
temporarily
Seasonal unemployment will always exist
There will forever be little demand for Santa Clauses in July and for ice cream
salesmen in January (at least if you live in Michigan) 100
A classic example is the unemployment of lifeguards during winter
Seasonal employment can be dealt with through worker training to ensure that
workers have skill-sets that allow for year-round employment
For example, we could train all the Santa Clauses to be ice cream salesmen
during the summer to ensure that they are working year-round
Seasonal unemployment is the least serious type of unemployment because it occurs
regularly and is somewhat inevitable
Natural unemployment
For all economies, a natural rate of unemployment is said to exist
The natural rate of unemployment is the unemployment rate which exists in an
economy at full employment
Unemployment can never drop below its natural rate (at least, not for long)
When unemployment drops below its natural rate, firms are competing fiercely for
workers
To attract new workers, firms will have to increase wages (or other benefits),
which increase labor costs
As labor costs increase, the price of goods will also increase, resulting in
increasing inflation
The natural rate of unemployment can thus be described as the level of
unemployment that corresponds to no inflation
Even when the economy is at full employment, some types of unemployment are
inevitable
Frictional unemployment will always be present to some degree as workers
switch jobs
Frictional unemployment is the main component of natural unemployment
Structural unemployment is also a component of natural unemployment
Seasonal and cyclical unemployment should be negligible in a perfectly healthy
economy
The natural rate of unemployment for any economy is the overall unemployment rate
minus cyclical and seasonal unemployment
To recap, an economy at full employment has only natural unemployment
The natural rate of unemployment is often described as the sustainable rate of
unemployment, since any lower levels would result in inflation
Lower levels of unemployment (high levels of employment) would make the labor
market fiercely competitive, driving up wages and costs
The result would be inflation
The relationship between unemployment and inflation is described by the Phillips
Curve, which shows the two to be inversely related
As unemployment decreases, inflation increases
The short-run Philips Curve expresses this relationship
The long-run Philips curve, however is vertical
It shows that, in the long run, the natural rate of unemployment is more or less
constant and independent of inflation (changes in the price level)
Previously, the natural rate of unemployment for developed economies was believed to
be between 5.5 and 6%
100
I live in SoCal. Not only can I eat ice cream in January, I can go surfing too! – Zac
The long period of economic growth in the United States from 1991 to 2001 when
unemployment repeatedly fell below 5.5% but inflation remained stable, called this
conclusion into question
Economists now recognize that the natural rate of unemployment for any economy
can vary significantly depending upon a variety of technological and demographic
factors
The Philips Curve
Long-Run Philips
Inflation Curve
Short-Run Philips
Curve
Natural Rate of Unemployment

Unemployment
Money
The characteristics of money
Money is an object or thing which is accepted as payment for goods and to settle debts
Money should have five qualities to be useful for exchange
Money should be acceptable to most, if not all, parties of potential transactions
It should be durable and, thus, able to be used in multiple transactions
It should be portable and, therefore, easy to carry and use on an everyday basis
Money should be adequately divisible
There should be different bills, coins, etc. of different amounts
For example, eight quarters are considered equal to two one dollar bills
Money should be scarce enough that it is not worthless
Conversely, it should also be widespread enough that transactions can always be
completed using money
Money replaces barter as a means of acquiring goods
Barter is the trade of goods for other goods
Remember, barter is inefficient because it requires a double coincidence of wants
Barter also inhibits the division of labor
Because bartering is so cumbersome, individuals will attempt to become more
self-sufficient to avoid having to trade
The functions of money
Money has three distinct functions
As a medium of exchange, money replaces barter as a means of acquiring goods
One exchanges money for goods
As a unit of account, money helps to establish the value of goods
The pricing of items in monetary terms allows us to compare the relative values
of different goods
This function of money as a standard greatly simplifies economic decisions
Otherwise, it would be extremely difficult to compare goods
If one hammer is worth ten eggs and one shovel is worth five AA
batteries, which is more valuable?
As a store of value, money allows economic worth to be preserved over time

Goods lose value, or depreciate, over time
Money retains its value and can be stored away with the knowledge that it can
later be used to purchase goods with just about the same purchasing power
Note that inflation and deflation undermine money’s ability to serve as a store of
value
Gresham’s law
Thomas Gresham was an advisor to Queen Elizabeth I of England
Gresham’s law examines the relationship between “inferior” and “superior” forms of
money
When “good” and “bad” money are in circulation, “bad” money forces out the
“good” money
People will generally hold on to “good” money and will spend “bad” money to
get rid of it 101
Gresham’s law originated with discussions of debasement
Back in medieval DecaLand, for example, all coins were made of silver
The benevolent King Dan was very careful to ensure that all coins were valuable
and had a high silver content
His successor, the King George the Glutton, wanted to promote his own wealth
and decided to debase the coinage
He instructed the mints to lower the silver content of all new coins so that
more coins could be made from the same amount of silver
This, by the way, is the definition of debasement: lowering the precious
metal content of coins in order to make more of them from the same
amount of the precious metal
Before anyone found out about the lowered silver content, George spent the
large number of silver coins on improvements for his castle
Soon, however, the denizens of DecaLand discovered that George’s coins were
actually debased in value
Naturally, people held onto the “good” coins of King Dan’s era because these
coins had more silver and, thus, were more valuable
Whenever anyone received one of the “bad” King George coins, he or she spent
it as quickly as possible
Eventually, no good coins were in circulation anymore because people only spent
bad coins
In other words, the bad money forced the good money out of circulation
Commodity and fiat money
Money can be based upon either commodities or fiat
Commodity money is money which takes the form of a usable commodity
Money is made from, or is represented by, usable commodities which can either
be used as money or used for their own purposes
The most important examples of commodity money are precious metals,
particularly gold and silver
Commodity money gets its value from what it is made from
Gold coins have value and can be used in exchange because the gold they are
made from is itself valuable
Fiat money is money which gets its value from legal decree
101
For example, I have a small collection of two dollar bills that I’m convinced will be valuable some day. I would much
rather spend two one dollar bills (“bad” money to me) than one two dollar bill (“good” money to me). – Dean
Fiat money has no intrinsic or useful value on its own

Its only use is as money 102
Fiat money is valuable just because the government that prints it promises to
back or support that money
All major economies now use fiat money
The money supply
The money supply is the stock of liquid assets in a given economy which can be
exchanged for goods
Liquidity is how easy it is to transfer, spend, move, or otherwise use an asset, such
as money
The liquidity of a given asset is typically defined as how easily one can convert
that asset into currency
Money can take a variety of forms
Currency is money in the form of paper or coins which is used in everyday
transactions
Currency is the form of money with which we are most familiar
Currency can be made from a particular commodity, backed by a commodity, or
based purely upon fiat
In early America, the government would exchange currency for silver
Currency is the most liquid form of money
Demand deposits consist of money stored in accounts at banks 103
Demand deposits can be withdrawn at any time without prior notice
Typically, demand deposits are checking accounts
Time deposits also consist of money stored in accounts, typically at banks
Time deposits differ from demand deposits in that time deposits cannot just be
withdrawn at any time
Time deposits usually cannot be withdrawn for a predetermined period of
time
Examples of some time deposits include some types of savings accounts and
certificates of deposit (CDs) 104
Money market accounts are another form of deposits that have a variety of
restrictions
Money market accounts typically require a larger initial deposit in exchange for
higher returns on that deposit
Money market accounts usually limit the number of transactions their owners
can make in a given time period (usually a month)
Money markets also require owners to keep larger balances to maintain higher
interest payments on deposits
Other forms of money include traveler’s checks, some types of liabilities, and
Eurodollars
Eurodollars include all dollar accounts held outside of the U.S.
These accounts can be anywhere, not just in Europe
Credit cards and similar devices are NOT considered money
There are several different definitions of the money supply
102
In post-WWI Germany, money was so worthless (due to massive inflation) that people actually started using money
for purposes other than spending. For example, many used bills as kindling for fires. Normally, though, the only use of
money is to spend (not burn) it. – Dean
103
These different types of deposits and accounts are all examples of savings accounts.
104
If you are unfamiliar with CDs, they basically offer you a better interest rate on your money in exchange for your
guarantee that you will not withdraw it for a given period of time.
Definitions of the money supply usually differ from one another based on liquidity
The monetary base is the narrowest possible definition of the money supply,
including only coins and paper currency
These are the most liquid forms of money
It includes all currency held by the general (non-bank) public and that in bank
vaults
M1 is restricted to extremely liquid forms of money but is slightly more inclusive
than the monetary base
It includes currency in the hands of the public, traveler’s checks, demand
deposits, and other deposits against which checks can be written
M2 is a slightly broader definition of the money supply and includes some less liquid
forms of money
M2 includes everything in M1 plus savings accounts, time deposits of under
$100,000, and balances in money market mutual funds
Time deposits under $100,000 are considered “small”105
M2 is less liquid than M1 but includes forms of money which are still useful for
everyday transactions
Many economists consider M2 the best definition of the money supply
M3 is an even broader definition of the money supply which includes substantially
more illiquid forms of money
M3 includes M2 plus “large" time deposits (over $100,000 106 ), balances in
institutional money funds, repurchase liabilities issued by depository institutions,
and Eurodollars held by U.S. residents
M3 includes assets or forms of money which are nowhere near as liquid as the
items included in M1 and M2
M3 and broader definitions capture assets which are more conducive to saving
than to exchange
The Federal Reserve discontinued its use in March 2006
L is the broadest definition of the money supply used in the U.S.
The Federal Reserve officially discontinued its use in 1998
It includes M3 plus commercial papers, deeds, etc.
Broader definitions of money also exist
The United Kingdom, for example, measures five different definitions of money
Continuum of Measurements of the Money Supply

Monetary Base M2 L
Most Liquid M1 M3 Least Liquid
Relating the money supply to total output and prices

The money supply times the number of times money is used, should be equal to the
output in the economy at current prices
The quantity theory of money states that MV = PQ (or sometimes, PT or PY)
This equation is also known as the equation of exchange
105
I’d like a “small” time deposit for college… – Lawrence
106
And I’d like a large one. – Patrick
M is the stock of money or money supply (how much money exists)

M is determined independently of the other variables
In other words, it is an independent variable in the equation
V is the velocity of money, or how often money circulates through the economy
In other words, velocity is how often a dollar bill is spent in a given period
V is considered to have a constant equilibrium value
It varies over time but will always average out to its equilibrium value
Q (or T or Y) is the output of goods and services
Q is said to be given: real output at a given point in time is fixed
Note that P x Q = GDP = M x V
P is the average current price level
P is the dependent variable in the equation
It is influenced by the other three
Since V and Q are fixed, changes in P are directly dependent upon changes in M
The equation basically states that the amount of money spent equals the amount of
money used
It also shows that, given V and Q as constants, increases in M (the money supply) will
result in increases in P (inflation)
Keynes attacked the early neo-classical version of the quantity theory of money, but
it was reborn (in a far more complex form) in the work of the late Milton
Friedman
The ultimate implication of the quantity theory of money is that creating more
money results in inflation
The demand for money
Money is generally valued and demanded for purchases of other goods
People do not generally demand money for money itself
If people valued money itself, they would liquidate their assets (homes, cars, possessions,
etc.) into money rather than holding these assets
Money can, nonetheless, be demanded for a variety of reasons
Money is demanded to make immediate transactions, to be prepared for unexpected
expenditures, and to store wealth
The demand for money directly impacts interest rates
Inflation
General information
Inflation is a sustained rise in the general price level
If an economy is experiencing inflation, the prices of all market goods are increasing
over time
The rate of inflation is the rise in the price level per unit of time
In the United States, most official measurements of inflation are by quarter
A quarter is equal to three months (a quarter of a year)
Inflation decreases the value (purchasing power) of money
Inflation weakens money ability to serve as a “store of value” because it erodes
money’s value over time
As inflation continues, more and more money is needed to buy the same goods
Inflation can occur at varying speeds
“Constant inflation” means that prices are increasing at a constant rate, such as
2% per quarter
Remember that a quarter is three months long
“Disinflation” means that the rate of inflation is slowing down

From the first quarter to the second quarter, for example, inflation could
decrease from 4% to 3%
Disinflation is NOT the same thing as deflation
Deflation is a sustained decline in prices
Basically, the value of money increases as prices decrease
It is usually a result of a drop in the money supply
“Accelerating inflation” means that the rate of inflation is increasing
Acceleration inflation is essentially the opposite of disinflation
From the first quarter to the second quarter, for example, inflation could
increase from 3% to 4%
“Hyperinflation” is a term reserved for extremely high rates of inflation
Inflation above 20% is generally (but not always) considered hyperinflation
This percentage is more of a loose guideline than a concrete rule
The most notable historical example of hyperinflation occurred in Germany after
World War I
In 1920, the price of a one pound loaf of bread cost 1.2 marks
By November 15, 1923, the same loaf of bread cost 80 billion marks 107
The same ideas also apply to deflation
One seldom hears them in this context because deflation is very rare
Types of inflation
Inflation can result from changes in demand, supply, or the money supply
Demand-pull inflation occurs when a sustained rise in aggregate demand results in a
rise in the general price level
As demand grows, firms begin to reach their production capacities
As demand continues to increase, producers are eventually unable to increase
production
Instead, they will raise prices
Increases in the prices of goods results in increases in factor prices, especially wages
When prices rise, workers demand higher wages to maintain their current
standard of living
This process results in a general rise in the price level of the economy
One can say that demand “pulls up” prices
The classic explanation: “demand-pull inflation is caused by too many dollars
chasing too few goods”
Cost-push inflation occurs when an increase in production costs causes a sustained
rise in the general price level
Cost-push inflation results from higher factor costs
Demands from workers for increased wages is one potential cause
Sudden resource shortages can also lead to factor price increases which increase
production costs
Oil embargoes or increases in the price of crude oil can drastically increase
production costs
The increased cost of factors results in a decrease in aggregate supply
The result is higher market prices
In the 1970s, cost-push inflation led to the United States’ famous period of
stagflation
Inflation can also occur if governments produce too much money
107
Seriously. I’m not making this up. – Dean
Expansionary monetary policy by governments results in an increase in the money

supply
Increased amounts of money in the economy results in the same problem as in
demand-pull inflation: too many dollars chasing too few goods
Inflation due to increases in the money supply can result from excessive deficit-
spending by governments or deliberate policy to boost aggregate demand
Except for instances of cost-push inflation which result from outside factors, most types
of inflation can be attributed to a nation trying to “live beyond its means”
Costs and benefits of inflation
Inflation decreases the real income of workers
Wages are unable to sustain the same standard of living as prices increase
Employers actually benefit in times of inflation
The wages they are paying out are not worth as much as they were before
Inflation is a disincentive to save
If prices keep increasing, people will be less willing to save if the rate of inflation is
higher than the returns to their savings (interest)
Inflation leads to price uncertainty for firms, which hurts the ability of firms to plan for
the long-term
The inflation of domestic prices can undermine the competitiveness of a country’s
exports
Inflation results in menu costs
Firms must continually update price information (“change the menu”) to reflect
changing prices
Inflation also creates shoe leather costs
Individuals (or firms) go to banks more often to withdraw deposits because the
money they have in their pockets is suddenly worth less
This consequence is called the “shoe leather” cost because people’s shoes wear
out from walking to the bank so often (figuratively, of course)
Tax payers also suffer from bracket creep, also known as fiscal drag
Let’s say, for example, that Taxpayer Todd works in a factory
If inflation hits the economy, Todd’s wages will probably increase as workers
demand more money to meet higher prices
Todd’s nominal wages, therefore, will increase
His real wages, however, will probably stay the same (if not decrease)
If inflation is bad enough, Todd’s nominal income may increase by enough that he is
bumped into a higher income tax bracket
Because he supposedly makes more money, he now has to pay more taxes even
though his real income hasn’t increased
Since the prices of all goods are increasing, his nominally increased wages really
can’t buy any more goods than before
Todd has experienced bracket creep
The federal government benefits from bracket creep because it receives more
money in the form of income taxes
Inflation hurts lenders (creditors) but helps borrowers (debtors)
Inflation makes money less valuable
Consequently, inflation decreases the real value of a loan over time
The amount the borrower pays back is worth less than it would have been
without inflation
The lender does not get as much real money back as he or she should
Measuring inflation
The Consumer Price Index (CPI) is the method of measuring inflation most often
used by governments
In the US, it is calculated by the Bureau of Labor Statistics
The CPI works by comparing the prices of a given basket of goods between the
current year and a base year
The CPI basket includes the sorts of goods which an average household would
buy on a regular basis
The main component is housing
For the CPI to work, the variety and quantity of individual items in the basket
must be fixed
Changing the make-up of the basket of goods from year to year would make
comparing changes in prices between two or more years impossible because the
comparisons would be between different goods
The CPI is in the base year is always 100
The number represents a percentage
A CPI of 150 would mean that prices are 50% higher than in the base year
A CPI of 90 would mean that prices are 90% of what they were in the base year
In other words, prices have gone down by 10%
To calculate the rate of inflation, find the percent change in two CPI measurements
CPI1 − CPI 0
Inflation = ×100
CPI 0
CPI0 and CPI1 represent the CPIs for the base year and current year, respectively
The CPI is calculated by the Bureau of Labor Statistics, which also determines the
make-up of the basket of goods
The market basket is established by surveys of households
The CPI for April 2005 was 194.6, with 1982-1984 serving as the base period
The CPI has some advantages
It captures changes in price for basic consumer goods, which form one of the
largest (and most important) parts of aggregate demand
Given CPIs, the inflation rate is relatively easy to calculate
The CPI also has some shortcomings
Over time, changing consumer demands, technology, or other factors may
render the fixed basket used for the CPI inaccurate or irrelevant
For example, VCRs were a significant consumer good ten years ago but are
not so important today due to the emergence of DVD players
The CPI does not account for the substitution effect
If one good in the basket becomes too expensive, consumer may switch to a
substitute good
The fixed nature of the CPI does not account for this possibility
The CPI does not account for changes in quality
While the price of cars is certainly more today than it was 15 years ago, part
of this increase is due to the use of more expensive (improved) technology
CPI can also be used to convert the dollars of one year into dollars of another year
CPI1
$0 × = $1
CPI 0
CPI0 and CPI1 are the CPIs of the earlier and later years, respectively
$0 and $1 are the equivalent dollar amounts of the earlier and later years,
respectively
Let’s assume the CPI in 1980 is 100 and the CPI in 2006 is 204
$20 in 1980 would be worth $40.80 in 2006: 20 x (204/100) = 40.80
An alternative to the CPI is the GDP deflator
The GDP deflator is a broad price index used to correct for price increases in
nominal GDP
The GDP deflator allows us to convert nominal GDP to real GDP
Nominal GDP Nominal GDP
Real GDP = so GDP Deflator =
GDP Deflator Real GDP
A GDP deflator of one indicates that there is no inflation
A GDP deflator less than one tells us the economy is experiencing deflation
A GDP deflator greater than one tells us that there is currently inflation108
The GDP deflator examines all goods in an economy (which can change widely from
year to year), rather than a select and fixed basket of goods
The GDP deflator has some positive attributes
It is able to adapt to changes in consumer taste and other developments which
result in a change in output
It takes all goods into account, rather than just a small basket of goods
The GDP deflator also has some shortcomings
It is very difficult to accurately calculate
As a result, it is only published once each year
Consequently, it can’t track inflation very quickly
Like CPI, the GDP deflator fails to take changes in quality into account
Though the GDP deflator presents a far more accurate picture of inflation across
the economy than the CPI, it is not suitable for guiding government policy because it
takes too long and is too difficult to calculate
Interest and Interest Rates

Interest rates
Interest rates are essentially the “price” of money
Money Market
Interest Money
Rate Supply
Money
Demand
Quantity of Money
108
The GDP deflator is sometimes multiplied by 100. In this case, a deflator of 100 indicates no inflation or deflation. A
deflator greater than 100 indicates inflation, and a deflator less than 100 indicates deflation.
For reasons which will be discussed later, the money supply curve in the US is
vertical, or perfectly inelastic
In other words, an increase in the interest rate does not result in an increase in
the quantity of money circulating in the economy
The “pure” interest rate is the interest rate which would have to be paid to borrow
money in order to undertake a risk-free enterprise
In reality, the pure interest rate is never really encountered
Interest rates are increased above the pure rate to allow banks and other
entities to earn profits from financial services
Additionally, interest for loans is often adjusted for the risk of projects in order to
cover the potential risk of failure
The market rate of most interest is the prime rate
The prime rate is the interest rate that banks charge to their most credit-worthy
customers
Major banks almost always feature the same prime rate
Some economists believe that interest rates reflect the demand for money
Money (in currency form) acts as a store of value, but it has an opportunity cost in
the form of the rate of return of other potential assets
Deposits and other interest-bearing opportunities are the next-best alternatives to
hoarding money
Speculation and other behaviors ensure that the rates of return (the market interest
rates) on financial assets are about the same
Other economists believe that interest rates are determined by productivity and savings
Productivity refers to the earnings of potential investments
Higher productivity of investments creates a greater demand for money
If economic agents believe they will profit from investments, they are more
likely to want money to make those investments
As a result, the money demand curve (see graph above) shifts to the right,
thus increasing the interest rate
Savings provide the funds for investments
The intersection of curves representing the supply of funds (savings) and the demand
for funds (the productivity of investments) yields the pure rate of interest
According to the loanable funds theory, the supply and demand of loanable funds
determines the interest rate
Loanable funds are the money that one is willing to lend and another is willing to
borrow
According to this theory, when the quantity supplied and quantity demanded of
loanable funds are equal, interest rates remain constant
Supply represents the ability and desire of those with money to lend it
Demand represents the ability and desire of those who need money to borrow
it
As with traditional supply and demand graphs, we use the intersection of the
two curves to find the interest rate (see graph below)
Interest rates change with shifts in either the supply or demand of loanable funds
The reasons for these shifts resemble the causes for shifts in the markets for
regular goods and services
Loanable Funds Market
Interest Supply of Funds

(Savers)
Rate
Demand for Funds

(Borrowers)
Quantity of Loanable Funds

Real interest rates and nominal interest rates
Nominal interest rates are the interest rates one is charged for a loan or which one
receives for a deposit
These rates are the market rates that we see everyday
Nominal interest rates are the rates that actually appear in loan contracts
Nominal interest rates do not take changes in the price level (inflation or deflation)
into account
Real interest rates are nominal interest rates adjusted for inflation
The real interest rate is what debtors actually pay and what creditors actually earn
after inflation is considered
The real interest rate is calculated by subtracting the current rate of inflation from
the nominal interest rate
Real Interest Rate = Nominal Interest Rate – Current Inflation Rate
When written as Nominal Interest Rate = Real Interest Rate + Inflation Rate,
this equation is known as Fisher’s Hypothesis or the Fisher Equation
Due to inflation, real interest rates can even be negative
The result is a negative price of money
For example, Borrower Barry takes out a one-year loan of $100 from Lender
Larry in January 2001
The nominal interest rate is 5%, but the rate of inflation is 10% per year
The real interest rate, therefore, is -5% (5 – 10 = -5)
In January 2002, Barry pays Larry back the $100 plus $5 in nominal interest
Thus, Barry pays Larry $105
This $105, however, is equivalent to only $95.45 in 2001 dollars:
105 x (100/110) = 95.45
Barry has actually made $4.55 on his loan
The Role of the State in the Economy

Public goods and free riders
The state works to provide public goods
Public goods are commodities or services which, if supplied to one person, are available
to other persons at no extra cost
Examples include national defense, paved roads, the police, and environmental
protection
In contrast, the owner/consumer of a private good can prevent others from having
access to that good
In the ideal case, a public good has two features
It is non-rival
One person’s consumption of a public good does not reduce its availability to
anyone else
It is non-excludable
The provider of a public good cannot prevent anyone from using it
A private good, on the other hand, is both rival and excludable
When one person buys a private good, he or she is essentially preventing anyone
else from having it
That person has the legal right to limit others from having access to that good
Non-excludability of public goods causes the free-rider problem
Those who supply public goods cannot limit public-good access to only those who
have paid for them
Those who have not paid for a public good (or paid less than others) can still
enjoy it
Someone who does not pay taxes, for example, can enjoy a federally funded
national park even if he or she does not pay taxes
This illegal immigrant qualifies as a free rider
Public goods are (ideally) provided as a result of public choice
Public goods can be financed through taxes
Alternatively, members of a society can agree to voluntarily provide and pay for the
good
This situation can also give rise to the free-rider problem
Imagine, for example, that Freeloading Felipe lives on a cul-de-sac
For some reason, the cul-de-sac doesn’t have a streetlight, and the street
gets very dark at night
Felipe’s neighbors decide that they should all chip in to buy a streetlight,
rather than waiting forever for the city to pay for it
This streetlight will, of course, benefit all of the residents in the cul-de-
sac equally
Felipe decides, however, that he doesn’t really want the streetlight, so he
refuses to pay for it
The rest of his neighbors go ahead and buy the streetlight anyway
The streetlight is now a public good
Though Felipe had no part in financing it, he can’t be excluded from its
benefits
Felipe is a free rider
The free-rider problem also occurs when one person uses a public good more than
others do
Let’s assume that Lucky Laura just happens to live two blocks away from a fire
station
Unfortunate Una lives several miles away from the station
In the case of a fire to either house, Laura will certainly benefit more from the
fire department than Una will
Thus, Laura (because of her location) can use more of the fire department (a
public good) than Una can
Note that pure public goods are very rare
Public goods can also result in the tragedy of the commons109

Taxes
Most government activity is funded by taxation
Taxation is one of the most significant government interventions in the economy
A tax is a compulsory charge or levy enacted by the government to raise revenue to
provide (among other things) public goods and services
Taxes take two general forms
Direct taxes are applied directly to individual wealth or income
Indirect taxes are taxes on transactions, especially consumer purchases
Income tax is the most familiar form of direct tax
Income taxes can be levied on the earnings of individual citizens or on the profits of
corporations (corporate profit tax)
A flat income tax is levied at a universal rate on all individuals
For example, everyone pays 10% of their gross annual income
Wealthy Wally, who makes $300,000 each year, pays $30,000 in income tax
Needy Ned, who makes $12,000 each year, pays $1,200 in income tax
The flat tax is also referred to as a proportional tax
A progressive income tax features lower rates for poorer members of society and
higher rates for wealthier members
This type is the income tax system in the US today
Regressive income tax is the opposite of a progressive tax
Rich persons pay a lower percentage of their incomes as tax than poor persons
The most notable example of a regressive tax is the sales tax
The poor spend a larger portion of their income on consumption than the
wealthy do
One benefit of income taxes (especially progressive taxes) is that they can help
redistribute income more equally among the populace
Income taxes have several disadvantages
Income taxes may tax savings twice
Income that is saved is taxed and then taxed again when interest or other
payments are collected on those savings
Income taxes have been said to discourage work
If additional wages earned are taxed, individuals will be less inclined to work
This idea is highly disputed
It was first proposed by Arthur Laffer 110 and is graphically represented in
the Laffer curve (see graph below)
The graph is sometimes presented with the axes switched—tax rate on
the horizontal axis, tax revenue on the vertical axis
If the government sets the income tax rate at 0%, it will collect no revenue
If the government sets the income tax rate at 100%, no one will have any
incentive to work (all wages go to the government)
Consequently, the government will collect no revenue
Some rate between 0% and 100% must exist at which the government
collects a maximum amount of tax revenue
Laffer assumed that this rate is 15%, though he never did any research to
justify this number
109
Although this topic fits here thematically, USAD includes it in microeconomics in the Economics Outline. Refer to
the Microeconomics section (page 61) for more discussion on this topic.
110
I suppose it would be ironic if he were a very serious individual. – Lawrence
This theory was often cited by Ronald Reagan as justification for his tax cuts
It is still praised by supply-side economists
The Laffer Curve
Tax Rate
100%
15%
0%
Tax Revenue
Capital gains taxes are direct taxes levied on the appreciation (increase in value) of
investments
Unlike income taxes, investments do not have to be liquidated into income to be
taxable
A capital gains tax focuses on the increase in value of investments even if they have
not yet matured or been cashed in
In the US, capital gains taxes are treated just like income taxes, with a few
exceptions
Capital losses (which can offset capital gains) are not taxed
Each individual over 55 is allowed to liquidate assets up to $150,000 without
taxes one time
Wealth taxes are direct taxes levied on the net wealth of an individual
Unlike income taxes, wealth taxes focus on all of the assets of an individual, not just
income
Income is generated yearly, but wealth persists
The most common form of wealth tax is property tax, a tax on owned land
Owned land is a form of wealth rather than income: it is not generated yearly
Property taxes are often used by states to help pay for public education
Sales tax is the most basic form of indirect tax
Technically, a sales tax is levied on market transactions, typically as a percentage of
the retail price
In the United States, single-stage sales taxes are levied when consumers purchase a
good 111
In most other countries, value-added taxes are collected at each level of
production and distribution
A value-added tax is levied on the difference between the market price of a good
(intermediate or final) and the cost of its production
Sales taxes can be general, applying to all goods, or levied only on select goods
Many states, for example, exclude clothing and food from the sales tax
An example of a selective sales tax is an excise tax
Excise taxes focus only on specific goods, such as alcohol, gasoline, or cigarettes
111
Note that sales taxes are levied by states and/or municipalities – not all areas have sales taxes.
Excise taxes raise the effective price of specific goods to discourage consumers
from buying and consuming them
An excise tax on alcohol, cigarettes, etc. is also known as a sin tax
Sin taxes are also known as Pigovian taxes
Pigovian taxes aim to discourage behaviors which lead to negative
externalities
Sales taxes can be economically costly, as they increase the price of a good above its
equilibrium price
Corporate profit taxes 112 apply only to corporations
Simply put, a corporate profit tax is a tax on the earnings of a corporation
Additional taxes of note are export/import taxes, estate taxes, gift taxes, and taxes
designated to support specific government programs
These taxes target narrower sections of the economy
The estate tax is also known as the “death tax”
It is a tax on inheritance
In the United States, several taxes are designed to fund specific programs rather
than entering into broader federal spending
The payroll tax is a small tax on employers to support the general
administrative costs of welfare programs, especially Social Security
This tax is taken from workers’ paychecks
Usage taxes are designed to support specific federal services and
infrastructure, such as ports and highways
The burden of a tax is determined by examining the incidence of taxation
The incidence of taxation falls upon the party who actually pays the tax
The incidence of taxation is determined by the elasticity of supply and demand
If the elasticity of supply is greater than the elasticity of demand, it is easier
for the supplier to adjust to the tax
As a result, the incidence of taxation falls on the consumer (demander)
If the elasticity of demand is greater than the elasticity of supply, it is easier
for the consumer to adjust to the tax
The incidence of taxation falls on the supplier
For example, let’s assume the government enacts a 10% tax on cigarettes
The goal of this sin tax would probably be to harm the cigarette industry by
decreasing its sales
However, the demand for cigarettes is very inelastic: addicts will probably buy
just as many cigarettes even if the price increases
Consequently, cigarette sales will probably not decrease very much
Most consumers will simply pay more rather than buying fewer cigarettes
In this situation, the incidence of taxation falls on the consumer
This time, let’s assume the government enacts a 10% tax on Coca-Cola
The demand for Coca-Cola is fairly elastic: most consumers wouldn’t mind
switching to Pepsi if the price of Coke went up
As a result, Coke sales will probably drop drastically as many consumers buy
Pepsi instead
In this case, the producer (Coke) bears the incidence of taxation in the form of
lost revenue
Taxes also result in deadweight losses
112
Otherwise known as corporate income taxes. This term is also mentioned and bolded in microeconomics, but we
bold it again here because we are now discussing it in the context of taxes (rather than in the context of corporations).
A deadweight loss is a loss in social welfare resulting from a policy (in this case,
taxation) which produces no corresponding gain
Deadweight losses represent economic inefficiency because welfare is squandered
In taxation, the deadweight loss comes out of consumer and producer welfare
surpluses
Consider the graph below
Graphically, a tax serves to shift the supply curve 113 to the left, 114 decreasing
equilibrium quantity and increasing equilibrium supply
“Supply” is the original supply curve before the tax
“Supply (with tax)” is the supply curve after the tax
Equilibrium shifts from point F to point E
As you can see in the graph, the tax captures part of both consumer and
producer surplus
The loss in consumer surplus is represented by area ABEF
The loss in producer surplus is represented by area BCDF
The revenue collected by the government (because of the tax) is equal to the
quantity of units sold (Qt) times the price of each unit
Therefore, the revenue collected is equal to area ACDE
Area EDF, however, is lost but not recaptured
It is part of the producer and consumer surplus taken by the tax but not part
of the revenue collected by the government
This loss of welfare is the deadweight loss inflicted by the tax
Deadweight Loss
Supply (with tax)
Supply
Price E
A
F
B
C
D
Demand
Qt
Quantity
113
Actually, it’s irrelevant which curve you shift to the left as long as you know how to find the equilibrium quantity and
price after (it’s a little different with the tax taken into consideration). For our purposes, however, we will shift supply.
114
In this case, the supply curve is actually shifting up (because the tax affects price, and the vertical axis of our supply
and demand graph shows price). But we’ll stick with left/right terminology rather than up/down to avoid confusion.
The following pie chart shows the role of varying taxes in funding the 2000 Federal
Budget 115
Excise Taxes
4%
Social Insurance
Payroll Taxes
34%
Individual Income
Taxes
48%
Corporate Income
Other Taxes
4% 10%
Government regulation of markets and competition
The government also acts to promote and manage competition in the economy
Competition policy generally consists of government measures to protect consumers
and social welfare by stimulating competition and limiting monopoly
The government can promote competition through a variety of methods
It can remove barriers to entry and promote competitive markets
It can target anti-competitive behavior and punish firms that partake in such actions
The state can also regulate mergers and acquisitions among companies
Lastly, it can regulate natural monopolies to protect the public interest
The Commerce Clause of the United States Constitution (Article 1, Section 8) gives
Congress the power to regulate interstate (and international) commerce
The Commerce Clause is now very broadly interpreted
It gives Congress regulatory power over almost everything
Technically, just about anything can somehow impact interstate commerce
Thus, all of these acts are fair game for Congress to regulate 116
Within the United States, other laws have been enacted to promote competition
In 1887, government legislation created the Interstate Commerce Commission
(ICC), the first regulatory commission in US history
Originally, the role of the ICC was to regulate the railroads and protect farmers
from their often abusive business practices
The agency was disbanded in 1995
Perhaps the most significant federal law regulating competition in the United States
is the Sherman Antitrust Act
Passed in 1890, the Sherman Antitrust Act was originally aimed at labor unions,
which are, in fact, a type of monopoly
115
Adapted from http://www.gpoaccess.gov/usbudget/fy00/descriptions.html#c26.
116
The astute student and follower of current events will note that the Supreme Court based its decision on medical
marijuana in June 2005 on the Commerce Clause of the Constitution. The abolition of “separate but equal” institutions
was also based on the Commerce Clause.
The act’s first part outlaws collusive agreements (cartels) which restrain trade or
unfairly reduce competition in the market
The second part of the act makes monopolies illegal
The Clayton Antitrust Act (1914) covers mergers
Mergers which will result in monopolies are prohibited
It forbids a member of the board of directors of one company to serve on the
board of directors of a competing company
In other words, the act outlaws interlocking directorates for competing
companies
It also prohibits tying contracts and bilateral monopolies
A tying contract is an agreement between a buyer and a seller to deal
exclusively with one another
The buyer won’t buy from any other seller, and the seller won’t sell to
any other buyer
A tying contract creates a bilateral monopoly
A bilateral monopoly is a market with only one buyer and one seller
Further, it legislates against harmful price discrimination
“Harmful” price discrimination unfairly reduces market competition
The main bodies in the United States that control competition policy are the
Department of Justice’s Anti-Trust Division and the Federal Trade
Commission (FTC)
The Wheeler-Lea Act (1938) gave the FTC the power to investigate unfair and
deceptive business practices
It also granted the FTC the power to prevent false advertising
For countries in the European Union, competition policy is now controlled by the
European Commission rather than by national governments
Government promotion of equality and income security
The most significant ways in which the government seeks to promote equality and
income security are through welfare and Social Security
Welfare and Social Security (among other programs) are significant examples of
transfer payments
Again, transfer payments are payments of money to individuals from the
government not in exchange for current goods or services
Welfare in the United States was originally rooted in the provision of assistance to the
unemployed during the Great Depression 117 but has expanded significantly since
The most significant welfare program in the United States following initial efforts
during the Depression was the Aid to Families with Dependent Children
(AFDC) program 118
AFDC was launched by the Social Security Act of 1935 and is administered by
the states and the US Department of Health and Human Services
AFDC was primarily aimed at families in need and provided extensive benefits
with few strings attached
Welfare programs in the United States were reformed significantly by Bill Clinton at
the request of Congress during the 1990s
The length of time families could receive benefits was limited
New requirements concerning employment were enacted for those on welfare
117
Most Great Depression aid was part of Franklin Roosevelt’s New Deal programs and reforms.
118
Source: http://www.acf.dhhs.gov/programs/afdc.
In other countries, most notably the social-welfare systems of much of Europe,

benefits are very generous and widespread, with few requirements for those on
welfare
This situation is, however, changing in many countries
Welfare, though necessary in many instances, also acts as a perverse incentive
If welfare is generous enough and lasts as long as it needs to, individuals have no
incentive to find a job
Social Security is a program in the United States aimed largely at providing income
security for the elderly and the disabled
Social Security is basically a minimum public pension for which all workers in the
United States are eligible, with a number of limitations and exceptions
Social Security began with the 1935 Social Security Act
The Federal Insurance Contribution Act (1939) levied a tax on all citizens’
paychecks to finance Social Security, welfare, and Medicare
Social Security is funded through payroll taxes, in which employers and employees
contribute funds to Social Security
Rather than paying to take care of themselves, individuals pay into a general fund
which finances the needs of the current elderly (and disabled)
Systems in which current workers pay for current beneficiaries are known as
PAYGO systems: people “pay as they go” until they retire
For PAYGO-funded public pensions schemes to be successful, workers must
outnumber beneficiaries significantly to keep payroll taxes low
Thus, populations must keep growing and stay demographically young in
order to meet this condition
In many developed countries, demographic shifts are occurring: there are
significantly more elderly people (pension beneficiaries) than ever before
Continuing increases in the population of beneficiaries will result in ever-higher
payroll taxes to keep public pensions such as Social Security “solvent”
A program “has solvency” if it is capable of meeting its present (not to
mention future) commitments
Unemployment insurance and benefits provide income security for workers who
have lost their jobs
Unemployment insurance works to smooth transitions between jobs by temporarily
ensuring the welfare of workers and their dependents
In establishing benefits, governments must make benefits large enough to provide
security to workers but small enough to encourage workers to find new jobs
Additionally, benefits expire: workers can only receive unemployment benefits
for a certain period of time
This time limit encourages them to find a new job as quickly as possible
Unemployment insurance is provided by both the federal and state governments in
the United States
The Federal Unemployment Tax Act (1939) levied a small tax on
employers to support the general administrative costs of the unemployment
compensation system
The tax also finances half the cost of extended unemployment benefits
(discussed below)
States fund their own programs through a variety of means
Unemployment insurance has many forms
Extended unemployment insurance is offered during severe economic
downturns to continue worker benefits after they normally would have expired
Trade Readjustment Allowances (TRAs) are a form of extended

unemployment benefits which are offered to workers who have lost their jobs as
a result of foreign trade
Disaster Unemployment Assistance (DUA) is provided to workers who
have lost their jobs as a result of a disaster 119
Additionally, unique unemployment benefits are extended to veterans and
federal employees (in some instances)
The government’s other roles
The government must provide, interpret, and enforce laws for an economy to function
properly
The state may also sponsor research or other programs which, due to cost, private
individuals would not undertake
The government can also overcome certain collective action problems which would
otherwise hinder normal economic activity
Societal norms and standards constitute one key area in which the government acts
Simple things, such as declaring on which side of the road people should drive,
ensure the proper functioning of an economy
If individuals had to decide such things on their own, life would be more
difficult and inefficient (as well as somewhat dangerous)
The Employment Act (1946) set maximum employment, production, and purchasing
power as official goals of the federal government
It also declared inflation to be a significant national problem which the government
would attempt to fight
Trends in government spending since World War II 120
Government intervention in the economy has increased substantially since the end of
WWII
Just before the war, government spending in the OECD nations (discussed in next
section) averaged 20.7% of each nation’s total GDP
In 1996, these same countries’ governments spent on average 45.9% of GDP
As of 2003, the United States federal government spends approximately 18.72% of GDP
Note that this does not include spending of the state and local governments
In many European countries, government spending accounts for well over 50% of GDP
More on government spending
Government spending in the United States is divided among the states and the federal
government
It includes both mandatory (automatic) and discretionary expenditures
The US federal government is responsible for most government spending in the nation
Federal spending includes several mandatory (automatic) programs whose funding is
earmarked
“Earmarked” means that the money cannot be used for any other purpose
These programs include welfare, Medicare, unemployment compensation, etc.
Non-mandatory (discretionary) federal spending comes from the General Fund
Money from the General Fund can be used to fund anything from national
defense to transportation projects
The General Fund budget for 2005 was $2.57 trillion
119
The official status of “disaster” is designated and announced by the president.
120
The percentages below are more food for thought than items that must be memorized. They have been included to
give you a general sense of the level of government intervention in major economies.
Most federal discretionary spending goes to Social Security, defense, Medicare,

Medicaid, 121 and interest on the national debt
The expenditures of individual state governments make up the remainder of
government spending
Most state revenue is collected from sales and property taxes, but most states now
also collect an income tax
The federal government also gives money to the states
State governments spend their budgets mostly on local services
Most funding goes to education, then to other social services and transportation
Government spending has ballooned lately as a result of the recent recession and the
wars in Afghanistan and Iraq
Note that spending in Afghanistan and Iraq is not a part of the defense budget
Instead, it is from special appropriations outside of the existing budget
As a result, the federal budget in fiscal year 2005 was more than $2.57
trillion
Deficit spending and resulting government debts are financed through government-
issued securities
In the United States, these securities are primarily Treasury bonds which are then
sold to private individuals and the Federal Reserve – see Monetary Policy
These bonds come due after varying lengths of time of up to 30 years
By buying bonds, individuals are essentially purchasing shares of government debt
on the promise that such purchases will be repaid, plus interest
Interest rates on government securities reflect inflation and investor confidence in
the government’s willingness and ability to fight inflation
If investors are confident that the government will keep inflation low, they will
accept lower interest rates
Lower interest rates will lead more people to purchase securities, providing a strong
incentive for the government to gain credibility in fighting inflation
Savers demand higher interest rates if they think inflation will occur: inflation will
undermine the value of their savings
121
It’s important to note that Medicare and Medicaid are, in fact, different programs. Medicare is intended to provide
help for the elderly. Medicaid does the same for the poor and the needy.
The following pie chart sums up government spending of the federal budget in 2000122
National Defense
15% Social Security
22%
Net Interest
11%
Reserve Pending Social

Security Reform Non-Defense
6% Discretionary
17%
Other Means-Tested
Entitlements
6%
Medicaid Medicare
Other Mandatory 6% 11%
Spending
6%
The Benefits and Costs of Government Intervention

The government and externalities 123
The government can play a critical role in reducing or eliminating externalities
Negative externalities, or costs which are not internalized, can be combated through
taxes or fines
The actions of individual agents which result in negative externalities are normally
continued because these costs are passed on to other people (externalized)
The government can intervene in these cases and impose costs on these agents for
such activities
By internalizing external costs, the government can work to reduce (or even
eliminate) negative externalities
Examples include fines for pollution or penalties for over-fishing
Positive externalities, or benefits to society which are not internalized by individual
agents, can be increased through government subsidies
The actions of individual agents which result in welfare gains for society (positive
externalities) are often given up because the agents do not receive all of the benefits
The government can intervene by increasing the benefits for individual agents,
encouraging such beneficial actions
Examples include government funding for research and education or providing tax-
breaks to people who buy fuel-efficient cars
The government and long-term plans
Since governments do not operate in the hopes of making profits, they can take actions
which may result in short-term losses but which have long-term benefits
An example is investment in public infrastructure (such as highways)
122
Adapted from http://www.gpoaccess.gov/usbudget/fy00/descriptions.html#c26.
123
See the Fundamentals section (p. 12) for a more complete discussion of externalities.
Infrastructure is very expensive in the short run but has significant long-run benefits
Highways, for example, were very expensive at first but have allowed many cities
to grow and flourish
The government and non-economic decisions
The government can make decisions based on non-economic grounds
In some instances, non-economic decisions are good
Pollution restrictions, for example, may impose a cost on industries but be beneficial
for the overall welfare of populace
However, decisions of the state can be especially costly when they are determined not
by economics, but by the concerns of special interests groups
On one hand, special interests groups may be able to draw attention to problems
which the market economy has been unable to deal with effectively
Many environmental groups, for example, lobby for environmental protection
laws from the government
These groups often work to promote what they think is the public welfare
On the other hand, special interest groups may also work to further their own
interests at the cost of the rest of society by advocating socially harmful policies
For example, oil lobbyists are extremely influential and may try to decrease
government funding for alternative energy sources
Equity and efficiency: a trade-off
One cost of government intervention may be that overall economic efficiency is
sacrificed in exchange for increased equity (such as income equality)
One may argue, for example, that taxes on lucrative corporations discourage
innovation
State action designed to promote economic growth or similar goals may also result in
sacrificing equity
For example, tax cuts to businesses designed to encourage investment also promote
the wealth of the upper-class owners of these businesses
State action must seek to balance the goals of maintaining equality in society while at the
same time ensuring that economic growth and efficiency continue
Topics of recent policy debates
Healthcare: the state can either provide benefits for people or let individuals take care
of themselves
In the United States, current policy is to assist the needy (Medicaid) and the elderly
(Medicare)
All other individuals are left mostly to themselves
The United States is the only developed nation in which more than half of all
healthcare spending is within the private sector
Almost all other developed countries provide some form of healthcare coverage for
the entire populace
Individuals in the US spend the most amount of money on healthcare in the world:
an average of $5635 per person, totaling 15% of GDP 124
The environment: the state can either actively protect the environment or let the
market decide what level of environmental protection is desirable
Many believe that the state must intervene heavily to protect the environment
This intervention will dramatically increase costs for firms which, in turn, will
increase costs for consumers
Others believe that the market should decide on environmental issues
124
We’re number 1! USA! USA! Oh…wait… – Patrick
If consumers desire greater environmental protection, they will buy products

made in environmentally friendly ways, even if these products are more
expensive
This issue is particularly relevant in developing countries
Many developing countries often prefer to develop as quickly as possible, no
matter how much pollution is generated
Developed countries usually prefer to see stricter environmental standards
Setting prices: the state may also intervene to control prices and wages
Some believe the government should work to provide a “decent” standard of living
for all by controlling wages (through minimum wage laws) and prices of basic
commodities (food, housing, etc.)
Others respond that such governmental price controls will result in shortages of the
very same goods, thus defeating the original goal of welfare improvement
Fiscal Policy
Overview
Fiscal policy is the use of government expenditures (and taxation) to influence the
domestic economy
By spending money, the government can directly impact overall economic activity
Increased government spending results in increased aggregate demand and, thus, higher
GDP
Remember: C + I + G + NX = GDP = AD
C = consumption spending
I = investment spending
G = government spending
NX = net exports = Exports – Imports = X – M
Automatic and discretionary policy
Fiscal policy has both automatic and discretionary components
Automatic elements of fiscal policy concern already-existing taxes and transfers designed
to counteract cyclical changes in the economy
When the economy enters into recession, people will earn less
As a result, they will probably pay less money in taxes
As income decreases, existing federal programs such as welfare and
unemployment benefits, will also compensate for the economic downturn
All of these processes involve automatic increases in government spending which
will serve to counteract the repression
Similarly, if the economy were growing too rapidly, increased individual taxes as
incomes rise would act as a brake on growth
Additionally, federal spending on programs such as welfare will decrease, serving
to further decrease GDP
Counteracting expansion limits inflation
Because automatic policies work to counteract cyclical change, they are known as
automatic stabilizers
Automatic policy also includes several programs called means-tested programs
To qualify for one of these programs, an individual’s income must be below a
certain level
Following are some examples of means-tested programs
Temporary Assistance for Needy Families (TANF)
Earned Income Tax Credit (EITC)
Supplemental Security Income (SSI)

Medicaid
Food Stamps
Discretionary elements are deliberate government programs enacted to fight an
economic downturn or to prevent too rapid growth and accompanying inflation
These are the policies of most interest because they require governments to
respond to cyclical changes in the economy
Most discussions of fiscal policy center upon discretionary fiscal policy
The purpose of discretionary policy
Discretionary fiscal policy can either address a downturn or an out-of-control upturn in
the economy
Both types of discretionary policy aim to reduce output gaps
An output gap is the difference between the current level of activity in the economy
and the sustainable (full employment) level of activity in the economy
When current economic activity is below the sustainable level of activity, a
deflationary (or recessionary) gap exists
When current economic activity is above the sustainable level of activity, an
inflationary gap exists
Sustainable activity/output is also referred to as potential activity/output
To calculate output gaps, subtract actual output from sustainable output
Output Gap = Sustainable Output – Actual Output
Deflationary gaps are positive while inflationary gaps are negative
Though this may seem counterintuitive, deflationary gaps are positive
because actual output is less than sustainable output
Similarly, inflationary gaps are negative because actual output exceeds
sustainable output
Gaps are almost never calculated in monetary terms, but rather as percentages
For example, an inflationary gap could be 3% of sustainable output
Output gaps must be taken with a grain of salt, however, as it is impossible to
determine the exact potential output of an economy
Graphically, an output gap is the distance between an economy’s short-run
equilibrium and its long-run equilibrium
Short-run equilibrium exists at the intersection of short-run aggregate supply and
aggregate demand
Long-run equilibrium exists at the intersection of long-run aggregate supply and
aggregate demand
Fiscal policy designed to address a downturn (reduce a deflationary/recessionary gap) is
known as expansionary policy
Expansionary policy seeks to boost economic growth and to reduce or eliminate a
recession
When the government is conducting expansionary policy, it will increase federal
spending and/or decrease taxes
Expansionary policy seeks to spark demand by putting more money in the hands of
private individuals and firms
Income tax cuts increase individuals’ disposable income
Increasing government spending channels money toward private firms
Fiscal policy designed to “rein in” an economy which is expanding too fast (reduce an
inflationary gap) is known as contractionary policy
Contractionary policy aims to reduce economic growth to sustainable levels, mostly
to avoid inflation and a potentially dramatic downturn in the future
When conducting contractionary policy, the government will decrease spending

and/or raise taxes
Contractionary policy seeks to deflate an economy by reducing growth
Keynes
Much of modern fiscal policy originates with the ideas of John Maynard Keynes, the
British economist mentioned in the first section
His most important work is the General Theory of Employment, Interest, and Money
Keynes’ work stressed that a pure capitalist economy cannot maintain full employment
and sustained economic growth on its own
Instead, it requires government intervention
The focus of Keynes’ work (and most Keynesian policy) was on unemployment
Many of his contemporaries argued that cutting wages during periods of high
unemployment would bring an economy out of recession by reducing the price of
goods
Keynes disagreed: he believed that cutting wages would cut workers’ incomes and,
as a result, reduce aggregate demand, worsening the recession
In Keynes’ model, the government should intervene during periods of high
unemployment to increase aggregate demand by increasing spending
Keynes also introduced the idea of sticky wages 125
Classical economists believe that markets are frictionless
In other words, firms and consumers will quickly respond to imbalances in an
economy in order to restore it to equilibrium
Keynes pointed out that, in fact, wages are “sticky” in the downward direction
Workers are reluctant to accept pay cuts, which can prevent aggregate supply
from effectively responding to a change in the market
Multipliers: how fiscal policy works
Fiscal policy actually has a greater impact on the economy than the pure change in
government spending and taxation
The impact of fiscal policy is determined by two factors: the marginal propensity to
consume (MPC) and the marginal propensity to save (MPS)
If Worker Willy receives a $1 raise, the amount of that dollar that he spends is his
marginal propensity to consume
The amount that he doesn’t spend (saves) is his marginal propensity to save
In other words, an individual’s marginal propensity to consume is how much of each
additional dollar in income he or she will spend
The marginal propensity to save is how much he or she will not spend (save)
These two statistics are written as decimals and always fall between zero and one
They must always add up to one since all money received must be either spent
or saved
MPC + MPS = 1
If the government changes spending, the amount that spending influences the economy
is determined by the spending multiplier
1 1
Multiplier = =
1− MPC MPS
The total impact on GDP is equal to the change in spending times the multiplier
If the government changes taxes, the amount this change influences the economy is
determined by the tax multiplier
125
Also known as “rigid” or “inflexible” wages.
− MPC
Tax multiplier =
MPS
The total impact on GDP is equal to the change in tax revenue times the multiplier
The impact on GDP is opposite the change in taxation
An increase in taxes will decrease consumption and GDP
A decrease in taxes will increase consumption and GDP
This inverse relationship is why the tax multiplier has a negative sign in front
of it
In order to finance an increase in government spending, the government sometimes
raises taxes by the same monetary amount as the increase in spending
The resulting impact on the economy is determined by the balanced budget
multiplier
The balanced budget multiplier is always equal to one
Balanced Budget Multiplier = Spending Multiplier + Tax Multiplier
1 − MPC 1− MPC MPS
Balanced Budget Multiplier = +( )= = =1
MPS MPS MPS MPS
Multiply the change in spending (or in taxes, since the changes should be equal)
by the balanced budget multiplier to determine the effect on GDP
Limitations of fiscal policy
Fiscal policy has numerous limitations
To fight a deflationary gap, the government must increase spending and/or decrease tax
revenues
Fiscal policy is most needed at the same time that the government will take in less
money due to the economic downturn
Expansionary fiscal policy almost always results in large government deficits during
periods of recession
The national debt is the total amount of money owed by the government
Government deficits consist of shortfalls in on-going budgets
The national debt is essentially the sum of all deficits and surpluses in a nation’s
history
Running deficits and increasing the size of government debt can increase interest
rates, which will result in less private investment as loans become more expensive
This decrease in investment counteracts (to some degree) the government’s
expansionary policy
This phenomenon is known as crowding out
Crowding out occurs whenever fiscal policy produces side-effects which
reduce the overall impact of the government’s actions
Many supply-side economists cite crowding out as an argument against the
Keynesian approach to manipulating aggregate demand through government
spending
Deficits create a future fiscal burden by adding to a debt which will eventually have
to be paid off
If the recession is brought about by a decrease in aggregate supply, fiscal policy can
fuel inflation by increasing factor prices
Sudden decreases in supply are due to external events called supply shocks
Supply shocks impact nearly all producers in a given economy
An example of a supply shock is a sudden increase in the price of crude oil
A huge percentage of firms use oil as an input in their production

processes
This inflation can reduce consumption (incomes are worth less), which decreases
GDP and aggregate demand
This situation is another example of crowding out
Fiscal policy requires legislative action, as government spending is often controlled by
legislatures
In the US, spending, appropriations, and budgetary decisions are made by Congress
Congressional action can be very slow and, thus, incapable of responding to sudden
changes in the economy
Fiscal policy, however, has a quick effect once implemented
Announcements of a certain policy action often have as much of an effect as the
policy itself
For example, an announcement of a tax cut to take effect in the future often
leads people to start spending more now, as if they had already received the
tax cut
Fiscal policy is very broad and may result in the government taking improper action
If the state thinks that the economy is overheated (when in fact it is not), increasing
taxes or reducing spending may end up causing a recession rather than gradually
reducing an unsustainable expansion
Similarly, if the state misjudges a downturn, improper policies may result in a longer
or more pronounced downturn
Monetary Policy
Overview
Monetary policy is intervention in the economy through changes in the supply of
money
By either restricting or increasing the supply of money in the economy, the state can
impact a variety of economic activities
Monetary policy can be inflationary (increasing the amount of money) or
deflationary (decreasing the amount of money)
A larger money supply leads to lower interest rates in the market
Since more money is circulating in the economy, borrowers don’t have to
compete as much for loans
Loaners lower interest rate to attract borrowers
Lower interest rates encourage investment spending by firms and borrowing
by individuals (leading to more consumption)
The result is a shift of the aggregate demand curve to the right
Inflationary monetary policy is also described as “loose” or “expansionary”
A smaller money supply causes interest rates in the market to increase
Since there is less money going around, borrowers must compete more if they
want to take out a loan
This competition allows loaners to raise interest rates to extract more profit
Higher interest rates discourage investment spending by firms and borrowing
by individuals
The result is a shift of the aggregate demand curve to the left
Deflationary monetary policy is also described as “tight” or “contractionary”
In addition to changing the supply of money, monetary policy also affects (or operates
through) specific interest rates and exchange rates
Monetary policy can have three goals

The first is price stability: ensuring that inflation is kept in check at a constant, low
rate
The second is full employment: ensuring that all resources in the economy
(particularly and especially labor) are being utilized
The third is economic growth: sparking the economy to expand
Note that these goals cannot all be achieved at the same time
Inflationary monetary policy can bring about full employment and spark growth,
but only at the cost of inflation (sacrificing price stability)
Central banks
Monetary policy is most often conducted by a nation’s central bank
Central banks are “bankers’ banks”: lenders of last resort which are responsible for
exercising control over the credit and banking system
Central banks are also responsible for a number of other tasks
These tasks include controlling banknotes, accepting deposits from and making loans
to private banks, acting as the government’s bank, and exchanging money with other
central banks
Central banks play a pivotal role in the economy because the rate of interest charged on
short-term loans to commercial banks forms the basis of all other interest rates in an
economy
These loans are a last resort when banks cannot cover their liabilities
They are known as “repo” or “overnight” loans
“Repo” is short for “repurchase agreements”
Central banks can either be independent of the government or controlled as a policy
instrument of the government
Independent central banks are generally seen as more credible fighters of inflation
and better executors of monetary policy as they do not face political pressures
They can, however, be criticized as unaccountable and undemocratic
Government-controlled central banks are more responsive to public (and political)
demands for full employment and growth
Consequently, though, they have a poor record of fighting inflation and may base
policy not on economic goals but on political goals
Many central banks are now independent
The most notable examples of such banks are the Federal Reserve of the US, the
Bank of Japan, and the European Central Bank of the European Union
This last bank is based on the Bundesbank, Germany’s independent central
bank prior to the introduction of the euro
The Bank of England, the United Kingdom’s central bank and the oldest central
bank in the world, became independent in 1998
The Federal Reserve
The Federal Reserve (Fed for short) is the central bank of the United States
The Federal Reserve Act of 1913 created the Federal Reserve System as the central
bank of the United States 126
Unlike many other central banks, the Federal Reserve System is, in many ways,
decentralized
The Federal Reserve system consists of 12 districts, each with its own bank
Each district is identified by a number and the location of that district’s bank
126
Before the establishment of the Federal Reserve, the US relied on the Bank of the United States and later on a
loosely organized system of national banks established by the National Banking Act (1863).
The districts are headquartered in Boston, New York, Philadelphia, Cleveland,

Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San
Francisco
Missouri is the only state with two Federal Reserve branches (in St. Louis
and in Kansas City)
Within their regions, district banks have several roles
They act as lenders of last resort
They supervise banking practice and management
Each Federal Reserve bank provides services (most notably check clearing) to
other banks in the area
They also implement monetary policy as dictated by the Federal Reserve
Board
Districts are also responsible for producing currency
A quick look at a dollar bill will show a letter inside the seal to the left of
Washington’s portrait – this letter corresponds to the regional bank which
issued the currency
There are 12 letters (A through L), one for each of the 12 districts of the
Federal Reserve System
25 smaller branch banks also operate in the various districts
District and branch banks are supervised and controlled by the Federal Reserve
Board in Washington, DC
The Fed’s Board of Governors consists of seven governors who each serve a 14-
year term
One term expires every 2 years
These governors are appointed by the president and confirmed by the Senate
The chairman of the Board of Governors is the effective head of the Federal
Reserve System and is appointed every four years
The current chairman is Ben Bernanke
Prior to Bernanke, Alan Greenspan served as chairman for four terms
Monetary policy is chiefly exercised by the Federal Open Market Committee
(FOMC)
The FOMC trades (buys and sells) government securities on the open market
(discussed in more detail below)
The FOMC consists of twelve members: the seven members of Federal Reserve’s
Board of Governors, the president of the New York District Bank, and the
presidents of four other district banks
Each of these 12 members has the right to vote on FOMC issues and decisions
Day-to-day operations in accordance with FOMC policy are conducted by the New
York District Bank
One final committee worth noting is the Federal Advisory Council
This council has no policy-making role
Instead, it serves as a forum for communication between commercial bankers and
the Fed
The council consists of one commercial banker representing each district in the
Federal Reserve System
Meetings occur once every quarter and provide a means for private bankers to
officially communicate with the Board of Governors
Not all US banks are members of the Federal Reserve System
Although the Federal Reserve is independent, it operates within or under goals defined
by legislation
Most central banks are charged with achieving either full employment or price
stability
The Employment Act of 1946 established achieving full employment as a prerogative
of the federal government, but not the Federal Reserve
The more extensive Full Employment and Balanced Growth Act of 1978
nominally extended full employment as a goal to be achieved by the Federal Reserve
In practice, however, it only demanded that the FOMC testify before Congress
twice a year on monetary policy
It also set the natural rate of unemployment at 4%
The act deemed any rate above 4% unacceptable, meaning that the
government will intervene if the rate is above 4%
This act was nicknamed the Humphrey-Hawkins Act after its chief sponsors
More recently, the Mack-Saxton Bill (introduced in 1995 and again in 1997) would
have made long-term price stability the primary goal of the Federal Reserve
Ultimately, the Federal Reserve does not have a specific operational goal but,
instead, has great leeway
Other central banks, notably the European Central Bank, have very strict
operational criteria concerning price stability
The European Central Bank works to keep year-to-year inflation below 2%
The Fed’s three tools of monetary policy
The Federal Reserve uses three policy tools to conduct monetary policy
Open-market operations are the primary, day-to-day means through which the
Federal Reserve, through the FOMC, conducts monetary policy
Open-market operations are the buying and selling of government securities
(treasury bonds)
To increase the money supply, the FOMC buys bonds from bondholders
Buying bonds takes securities out of the economy and injects money into it
To reduce the money supply, the FOMC sells bonds
Selling bonds takes money out of the economy and replaces it with securities127
Adjustments to the discount rate and the federal funds rate by the Board of
Governors are the next most-utilized ways of conducting monetary policy
The discount rate is the rate of interest which the Fed charges commercial banks for
loans
Commercial banks will seek loans to meet cash shortfalls or to maintain reserve
requirements
As the lender of last resort, the Federal Reserve acts as the bank for commercial
banks
Commercial banks will only use the Fed as a last-resort source of short-term
credit
Lowering the discount rate encourages commercial banks to make more loans
because borrowing from the Fed in case of a shortfall will be less costly
Increasing the discount rate increases the cost of borrowing from the Fed, which
will discourage commercial banks from making as many loans
The more banks loan, the more money is injected into the economy
Raising the discount rate decreases the money supply
Lowering the discount rate increases the money supply
Additionally, the discount rate directly influences the interest rates banks charge
to their customers, most notably the prime rate
127
A nice mnemonic for you: Buy Bonds = Bigger Bucks, and Sell Bonds = Smaller Bucks. – Lawrence
Again, the prime rate is the interest rate a bank charges to its best customers
If the Fed lowers its discount rate, firms will often lower their prime rates
Lower interest rates encourage individuals and firms to borrow more
money, further expanding the money supply
Higher interest rates discourage individuals and firms from borrowing,
thereby decreasing the money supply even more
The Fed exercises direct control over the discount rate and can effectively set
the rate as it wishes
Commercial banks, can, however, seek other sources of credit
The federal funds rate is the overnight rate of interest charged on loans between
banks (“repo” loans)
As with the discount rate, banks will loan more at a lower rate and less at a
higher rate
More loans means more money in the economy
Unlike the discount rate, the Fed does not directly set the federal funds rate
Instead, it can only influence it through market operations
Buying and selling government securities impacts the interest rate as well
as directly influencing how much money is in the economy
Monetary policy through adjusting interest rates is, like fiscal policy, subject to
crowding out
Increasing the money supply lowers the interest rate
This decrease encourages more individuals and firms to take out loans
The consequential increase in the demand for loans and funds serves eventually
to increase the interest rate
This increase in the interest rate discourages individuals and firms from taking
out loans
This interest rate increase is, however, less than the initial decrease
The crowding out in this case is minor in comparison to the overall impact of
the monetary policy
The final way the Fed can conduct monetary policy is by changing the reserve
requirement
The reserve requirement (also known as the reserve ratio) is the percentage of
deposits which a bank must have on hand at any given time
When banks loan money, the money is taken from deposits given to them by
customers
If all deposits are loaned out depositors will be unable to withdraw their money
when they want to do so
Additionally, if banks run out of deposits, banks can collapse and savers may lose
their money
This situation happened to many during the Great Depression
Ensuring that banks always have a certain amount of money on hand means that
depositors will always be able to withdraw their deposits
Making reserve requirements legally binding means that banks will always have to
meet these requirements
If reserves dip below the required amount, banks have to borrow money
from other banks or from the Fed to restore reserves to the required levels
This process is one way that changes in the discount and federal funds rates
affect money supply
The impact of changes in the reserve ratio on the money supply can be measured
through the money multiplier (MM)
The money multiplier is the inverse of the reserve requirement (RR) 128
1
MM =
RR
For example, if the reserve requirement is 20% of total deposits, then the money
multiplier will be 5: 1 / .2 = 5
To calculate the impact of a new deposit in a bank on the money supply, multiply
the amount of the deposit by the money multiplier
If the reserve ratio is 20% and someone deposits $1 million in a bank, the net
result will be a $5 million increase in the money supply:
$1 million x 5 = $5 million
Theoretically, the bank will loan out $800,000 (80%) of the initial $1
million deposit
Eventually, this $800,000 will all be re-deposited, either by the borrower
or by others (such as firms that receive the money as payment for goods)
Of this $800,000 that is re-deposited, 80% ($640,000) will be loaned out
again
The cycle continues on and on
Eventually, the total impact on the money supply will be an increase in $5
million
If the reserve ratio is decreased, banks have to keep less money on hand
Consequently, they can loan out more funds, increasing the money supply
If the reserve ratio is increased, banks have to keep more money on hand
As a result, they can’t loan out as much money, and the money supply decreases
Unlike open-market operations and changes in interest rates, changes in the reserve
requirement are initiated by the Federal Reserve’s Board of Governors, not the
FOMC
The reserve requirement is not often utilized as a monetary policy tool because
it alters the banking system, which can often create difficulties for banks
The reserve requirement is enabled by fractional reserve banking
In a system of fractional reserve banking, banks keep only a fraction of their
deposits
Depositors still own the money they have deposited in the bank, but banks can
loan this money to borrowers
These loans essentially create additional money, increasing the money supply
Changes in the reserve requirement accelerate or hinder this activity
128
Math experts may notice that the money multiplier formula is an application of the sum of an infinite series.
MONETARY POLICY
How Does It How Often Is This
Policy Tool Who Acts? What Happens?
Work? Tool Utilized?
Injects or removes
Open-Market The Fed buys and
FOMC money from the Daily
Operations sells US securities
economy
The Fed changes the

Changes the cost of
interest rate for loans
Discount Rate Board of Governors
from the Fed to
borrowing from the Rarely 129
Fed
member banks
The Fed changes Changes the cost of

Approximately once
Federal Funds Rate Board of Governors bank-to-bank lending loans between all
per quarter
rates banks
The Fed changes the Changes the amount

Reserve
Board of Governors reserve requirements of reserves banks Very rarely
Requirements for banks must maintain
It’s extremely important to note that the Fed does NOT change the money supply by
actually creating new currency (printing new bills and minting new coins)
The creation of new currency requires special Congressional legislation
Instead, the Fed changes the effective supply of money through the above measures
The graph below illustrates how monetary policy functions
All of the monetary policy tools serve to increase or decrease the effective money
supply
When the Fed uses one of these tools, the money supply curve shifts to the left or
right if the tool is contractionary or expansionary, respectively
A change in the interest rate through monetary policy in turn influences the amount
of investment in an economy
Expansionary monetary policy leads to lower interest rates, which is encouraging
for investment 130
Remember that investment is a component of aggregate demand and GDP
Expansionary monetary policy, therefore, works to increase GDP through
increases in investment
Contractionary monetary policy, on the contrary, decreases GDP through
decreases in investment
129
Interestingly enough, the Fed has been changing the discount rate monthly ever since 2000. Before then, the rate
changed much less often—about once or twice a year, if at all.
130
If this concept doesn’t make sense, think about car commercials—dealerships are always trying to entice consumers
with promises of low interest rates. Yes, this example relates to consumption, but the concept is the same.
Monetary Policy Investment Rates

Interest Money Interest
Rate Supply Rate
Investment
Money Demand
Demand
Quantity of Money Quantity of Investment
Stagflation
Monetary policy is now the dominant way in which the US manages the economy
Keynesian policies remained the basic tool for the United States to manage the
economy until the stagflation period of the 1970s
Sharp increases in oil costs and debts from the Vietnam War resulted in a sluggish
economy
Traditional Keynesian policies recommended boosting aggregate demand through
government intervention
The government attempted such policies but only ended up increasing interest
rates substantially as the government ran ever-higher deficits
Efforts also resulted in high inflation
Inflation led workers to demand pay increases to maintain their standard of living
Wage increases only led to further inflation as factor prices for goods increased
The result was stagflation: simultaneous stagnation (little growth) and inflation
Stagflation defied the fundamental concept behind the Philips curve: a trade-off
exists between inflation and unemployment
An economy should experience one or the other (in varying degrees), not a
lot of both at the same time
The long-run Phillips curve was suggested to account for stagflation
Stagflation would be equivalent to a rightward shift in the Philips curve:
higher unemployment at all levels of inflation
Since then, monetary policy and monetarism (see below) have become more prominent
Monetarists
Monetarists believe that reducing inflation should be the first priority of the
government
They propose that growth will follow price stability
Monetarists posit that any change in aggregate demand created by the government
will ultimately result in higher inflation
The money supply should only grow with increases in real output
Increases above growth in real output will only result in inflation
Monetarists place great emphasis on the quantity theory of money (MV = PQ)
In addition to maintaining price stability, monetarism emphasizes that supply-side
measures are the only path to true economic growth
Like monetarists, supply-side economics rejects government intervention and
Keynesian stabilization policy
They also believe that these measures only increase prices (not real output) in
the long run
Supply-side economics instead emphasizes increasing the real output of the economy
It advocates tax cuts and subsidies to businesses to increase aggregate supply
Increases in aggregate supply lead to lower price levels and higher output
simultaneously
President Ronald Reagan advocated supply-side economics and tax-cuts for
corporations
He hoped that the resulting increases in corporate spending would cause the
benefits of these tax-cuts to “trickle down” to the middle classes
As a result, Reagan’s economic policies were nicknamed trickle-down
economics and Reaganomics
Real output can be increased in the long run by ensuring that all factors of
production are used effectively and efficiently
This goal is best achieved by limiting government intervention in markets and
allowing natural market forces to operate
The chief proponent of monetarism is Milton Friedman
Advantages and disadvantages of monetary policy
Monetary policy, like fiscal policy, has both advantages and disadvantages
Monetary policy has significant advantages in speed, efficacy, and expertise
Unlike fiscal policy, which requires legislation, monetary policy can be enacted swiftly
to deal with sudden changes in the economy
Once implemented, however, monetary policy takes longer to impact the
economy than fiscal policy
Overall, though, it is still faster
If central banks are independent, they are free of political interference or from
public intervention
They can pursue unpopular, but necessary, programs such as restricting the
money supply
Central banks such as the Federal Reserve are staffed by professionals such as
economists or persons with substantial experience in economics
In other words, monetary policy decisions are made by experts
Monetary policy also has its disadvantages
Central banks, if independent, may be insulated from the needs of the rest of the
economy while pursuing strict monetary policy goals
The lack of accountability for some banks can allow bad bankers to keep their
positions
Bad politicians, on the other hand, can be voted out of office
Increasing the money supply may not necessarily boost the economy
Consumers and producers must ultimately want the increased money for
inflationary policy to take effect
Many economists summarize this difficulty by saying, “You can’t push a
string”
Decreasing the money supply, on the other hand, is more effective
Taking money out of people’s hands ensures that they don’t spend it
INTERNATIONAL TRADE AND GLOBAL

ECONOMIC DEVELOPMENT
This section will focus on trade and development. Trade is 10% of the exam (5 questions) will
principally how economies interact; development (as the focus on trade and development
term implies) concerns how economies progress from pre-
8 questions from the USAD practice
industrial societies to vibrant, more complex, and (usually)
test are on topics from this section
wealthier industrial and post-industrial societies.
Economic Growth and Development

Trade and interdependence
Global patterns of growth have shown increasing trade among nations and growing
interdependence
The term globalization is often used to describe increasing trade and international
links
Globalization can be defined in many ways, but it is essentially the spread of
economic activity to multiple nations
Increasing foreign trade and investment are the chief indicators of this dispersion
Globalization is not a new phenomenon
It has existed in one form or another for centuries
Trade networks spanning from the Mediterranean to China existed during the
Roman Empire and brought together vastly different parts of the world
Global interdependence also increased dramatically during the 19th century
While globalization has certainly been increasing since the end of WWII, levels of
international trade and similar measures of globalization were all actually higher
prior to WWI than at present
Globalization can also be expanded to include the free movement of not only goods,
services, and investments, but also of people
Past waves of globalization have featured significant migration, mostly from richer
areas to poorer or less-developed areas
For example, some Western Europeans migrated to Africa, South America,
and South Asia
Current migration patterns indicate movements from poorer areas to richer
areas
For example, Mexicans to the US, Turks to Germany, Bangladeshis to the
United Kingdom, etc.
Overall, fewer people migrate to other countries now than in the past
Globalization is thought to extend economic opportunities to other countries and is
thus considered a boost to development
Global patterns of development have shown increasing gaps between Western Europe,
North America, Japan, and Australia and the rest of the world
In the early 19th century, “rich” and “poor” nations accounted for roughly equal
shares of world GDP
Since the “poor” areas had more people, however, their per capita GDPs were
significantly lower
Currently, wealthier nations account for approximately 80% of world GDP, with
poor nations contributing the remaining 20%
At the same time, poorer nations account for about 80% of global population,
meaning that the income of poorer countries is spread among even more people
Income inequality between nations is increasing
Income inequality on the national level can be measured in a variety of ways
The most common measures of inequality are the Lorenz curve and the Gini
coefficient (discussed in macroeconomics on p. 81)
Many measurements of global inequality analyze average income within a country
and compare different countries’ averages
A more accurate way of comparing income inequality weighs these averages
by population
Patterns of development which have brought about income inequality represent two
trends
Western nations and nations heavily influenced by Western ideas (such as Japan
and Australia) have developed much faster than the rest of the world
Non-western nations have experienced far larger population growth than
Western nations but less development
Global development initially centered on heavy industry and manufacturing but is now
shifting to technology and services
Categorizing nations by income
Developed nations are those with a per capita GDP above $10,000
The developed countries include most nations of western Europe and North
America
Australia, New Zealand, and some countries in East Asia (Japan, South Korea,
and Singapore) are also considered developed
Developed countries also feature a number of other marks of development, such as
long life expectancy, low infant mortality rates, and heavy investment in education
Developed countries produce many highly manufactured goods, such as capital
equipment and high technology goods
Many, though, are also heavily involved in producing commodities, such as
agriculture in the US and France or minerals in Australia and Canada
Most developed countries also feature stabilized populations which are not growing
quickly, if at all
Developing countries are those with a per capita GDP between $3000 and $10,000
Developing countries include most of the rest of the world, including India and
China
These two countries alone account for roughly a third of the world’s population
Some developing countries are comparatively well off, such as Malaysia, Thailand,
most of Latin America, and many of the former communist countries in Europe
These countries are sometimes referred to as “middle income” countries
because their per capita GDPs are closer to $10,000
These countries also feature a number of the other signs of development found
in developed countries, such as good healthcare systems, rising life expectancies,
falling infant mortality rates, and increasing investments in education
Developing countries typically feature large manufacturing industries but lack the
technology or the investment required for more advanced economic activity
Most workers, however, work in agriculture
The developing countries of recent fame are the East Asian Tigers, which include
South Korea, Thailand, Malaysia, and Indonesia131
These countries embarked upon a path of state-directed industrial development
focused on exports
The Tiger economies grew mostly by producing goods for export to the
developed world, often with the help of foreign corporations who brought
investment and technology with them
Since the Asian Financial Crisis, the development strategies of the Tiger
economies have been heavily criticized
Nevertheless, the Tiger economies were (and in some cases still are) among
the fastest-growing in the world
These countries are, in many cases, better off now than they were prior to
the period of growth
Less-developed countries (LDCs) are those with a per capita GDP below $3000
LDCs include states that have experienced intense and debilitating conflict (such as
Congo and Somalia), that have suffered from severe disasters (Bangladesh), or which
have simply not grown
LDCs are concentrated in sub-Saharan Africa and South Asia but also include
countries such as Haiti, Laos, Kosovo, 132 and Moldova
They typically feature little, if any, industry
Most economic activity is either subsistence agriculture or black market activity
LDCs score very poorly on other indicators of development
They suffer from poor public health and little investment in education
Poverty in LDCs
There is no single reason why LDCs are extremely poor
LDCs often feature quickly growing populations with low life expectancy
The result is a very young population
Limited resources are spread over increasing numbers of individuals
LDCs feature few industrial or manufacturing jobs
Instead, they rely largely on subsistence agriculture
This dependence on agriculture makes LDCs’ economies highly susceptible to
environmental shocks, such as natural disasters and droughts
If an LDC’s agriculture is disrupted by a severe disaster, the nation may not be able
to recover, resulting in further economic decline
While many might lament that trade exploits workers in LDCs, trade also provides
steady, non-agricultural jobs, which are needed in developing countries
LDCs either have populations without the skills to work in export-oriented factories
or have significant internal barriers or disincentives to foreign investment
Such barriers include predatory governments, civil wars, ethnic conflict, etc.
LDCs suffer from severe brain-drain
Individuals in LDCs that acquire higher levels of education abroad are reluctant to
return to their home country due to low wages and poor quality of life
Skilled and educated workers leave their home country in search of opportunities in
more developed economies
131
Vietnam, the Philippines, Hong Kong, Singapore, and even China are also sometimes referred to as Tigers.
132
Provided, of course, that one considers Kosovo to be an independent nation. The Kosovars certainly did when I
visited. – Daniel
The emigration of skilled and educated workers leaves LDCs with diminishing
amounts of human capital and deprives them of potential political and economic
leaders and innovators
Limitations of per capita GDP
Though per capita GDP is a good guide to development, it is limited in truly gauging the
actual quality of life in a country
Using per capita GDP as a measure of development results in the same problems
inherent in using GDP as a way of determining the welfare of a given economy
GDP does not take into account goods which are not traded on the legal market
In many developing countries and LDCs, many people are involved in subsistence
agriculture
The products of subsistence agriculture are consumed directly by the farmer
and his or her family rather than sold
The output of subsistence agriculture, since it is not sold, is not factored into
GDP
Thus, the true output (and by extension, well-being) of these countries is
under-counted and misrepresented
GDP calculations do not factor in unofficial transactions
Many LDCs and some developing countries feature extensive black markets
The purpose of these black markets is often to avoid government regulations
or price controls
Other times, black markets exist simply because there are no formal markets
GDP calculations do not factor these exchanges into account and, thus, leave
some aspects of welfare out of final GDP figures
GDP can under-represent other measures of well-being in developing countries
Although other indicators of development such as education and health are often
highly correlated with GDP, there are sometimes wide discrepancies between
the two
In many former communist countries, for example, extensive social welfare
networks and education systems still exist, even as incomes have decreased
with the collapse of the state
Per capita GDP does not take these other factors into account
Calculating GDP itself can be problematic in many developing countries and LDCs
GDP calculations require accurate, detailed statistics and measurements of the
economy, which many poorer nations are simply unable to compile
GDP is difficult to calculate and is subject to revision even in the developed world
Japan, for example, generally revises its GDP figures multiple times over many
years
Arriving at accurate measurements in poor societies with large informal markets or
in places suffering from conflict, disasters, or other hardships is even harder
Poorer countries lack the technical and bureaucratic resources required to
calculate GDP
Development and international agencies
To help promote economic development, a number of international organizations lend
advice, expertise, or even funds to poorer countries
Two of the most important international organizations that promote economic
development are the World Bank and the International Monetary Fund (IMF)
Both the World Bank and the IMF have their origins in the Bretton Woods
Conference
Bretton Woods is a town in New Hampshire
In July 1944, the United Nations Monetary and Finance Conference was held to
discuss post-war international payments among both the Allied and (then) enemy
countries
44 countries attended the Conference
It ultimately dealt with the issue of exchange rates (discussed below) and structuring
international payments to avoid the problems that led to the Great Depression
As a result of the Bretton Woods Conference, two organizations emerged
The first was the International Bank for Reconstruction and
Development (IBRD), which eventually evolved into the World Bank
The second was the International Monetary Fund (IMF)
A third organization, the International Trade Organization, was proposed but
ultimately not created
The principles behind the organization were ultimately expressed in the
General Agreement on Tariffs and Trade (GATT)
The World Bank is the title assigned to what is officially known as the International Bank
for Reconstruction and Development and several other organizations
Following the Bretton Woods Conference, the IBRD was established in 1945 and
became an agency of the United Nations in 1947
The IBRD’s headquarters are located in Washington, DC
Its initial purpose was to raise and allocate funds for the reconstruction of Europe
following World War II
Eventually, the World Bank’s purpose shifted to providing low-cost loans for
development where private capital is unavailable
With time, the IBRD was connected to the International Development Association
(IDA), the International Finance Corporation, and the Multilateral Investment
Guarantee Agency to form what is officially known as the World Bank Group
The Bank funds its activities through both member contributions and the sale of
bonds
Each member state of the World Bank is required to contribute funds to the
bank in accordance with that state’s share of world trade
Previously, countries were obliged to make 20% of their contributions in gold
Now, that figure stands at 4.4%
The Bank also acts like a private bank to raise funds: it sells bonds covering its
debt on world markets
The World Bank makes loans either directly to the governments of countries or to
other parties (with the government acting as the guarantor)
World Bank loans are directed by the IBRD
In 2004, the Bank loaned $11 billion to higher-income developing countries
Loans from the World Bank through the IBRD are at a cheaper rate than loans
from commercial banks
They typically feature a 15 to 20 year window (with a three to five year grace
period) before countries are obliged to begin repaying the loan’s principal
The World Bank, through the IDA, also makes direct grants to certain countries to
assist development projects
Grants are generally reserved for lower-income countries (such as LDCs)
because these countries can generally borrow only at high interest rates due to
the high risk involved
In 2004, the Bank, through the IDA, granted $9 billion for 158 projects in 62
low-income countries
IDA funding for grants comes primarily from contributions made by 40 rich
countries every four years
The Bank, through its private activities, also helps fund the grants
More recently, the World Bank group has expanded its operations to include
technical advice and expertise in managing economies
It handles special development problems (such as AIDS) and promotes good
governance
The World Bank currently has 184 members
The current head of the World Bank Group is former ambassador to Indonesia and
former US Deputy Secretary of State Robert Zoellick
The International Monetary Fund (IMF) was established following the Bretton Woods
Conference and became operational in 1945
The IMF became a specialized agency of the United Nations in 1947
The primary purpose of the IMF is to pursue the following goals
To encourage international monetary cooperation, particularly with respect to
exchange rates
To assist member countries in correcting or avoiding balance of payments
difficulties
To encourage global development and the expansion of world trade
The initial goal of the IMF was to manage the exchange rates of its member
countries
The IMF oversaw the Bretton Woods System of managed exchange rates
The currency exchange rates between countries were fixed, with all rates
ultimately tied to convertibility to the dollar
The dollar itself was tied to fixed convertibility to gold
The IMF also sought to end all restrictions of foreign exchange and currency
convertibility
Most significantly, the IMF acted as a lender of last resort for countries
experiencing balance of payment difficulties so they could maintain their fixed
exchange rates and prevent foreign exchange instability
In 1971, the US took the dollar off of the gold standard
In 1972, it devalued the dollar relative to all other currencies, effectively ending
the Bretton Woods System of managed exchange rates
Initially, the IMF focused on correcting balance of payments problems in wealthier
countries, such as the United Kingdom, France, and even the United States
In the 1970s, the IMF shifted its focus from these countries to developing ones
In the 1970s, many developing countries borrowed funds from commercial
banks to finance development projects or other schemes
Following the oil shocks and other economic setbacks, developing countries
found themselves with massive debts to foreign lenders they couldn’t pay
The IMF, working closely with the IBRD, provided loans at a significantly
lower cost to developing countries to cover commercial debts
In exchange for such loans, the IMF required countries to adopt a number of
macroeconomic policies to stabilize their economies and to ensure
repayment of loans
For example, it required countries to run a budget surplus prior to
allocating funds for debt servicing
IMF loans are conditional upon countries accepting these policy
recommendations and implementing them
Subsequently, many criticize the IMF as too controlling
The IMF is funded and governed by its member countries

Control over the IMF is decided by contributions: countries that contribute
more money to the IMF have higher voting weights
This system is similar to the division of control in a corporation based on
stockholders’ shares of ownership
The US contributes the most money, so it has the greatest say in the IMF’s
activities
How much each member nation has to contribute to the IMF is determined by a
number of economic indicators, such as national income, monetary reserves, and
the ratio of exports to national income
Like the World Bank, the IMF has expanded its operations to include technical
assistance
One reason for this change is to assist in the implementation of conditions
imposed upon borrowing countries
The IMF also takes great interest in non-monetary development problems such
as corruption and health crises
The IMF currently has 184 member countries, with total funding at $327 billion
In addition to the World Bank and IMF, a number of other international institutions
exist to provide developmental assistance
The United Nations has multiple agencies with this purpose
Globally oriented agencies include the UN Conference on Trade and
Development and the UN Development Program
A variety of regional agencies operated by the UN also exist, such as the
Economic Commission for Europe and the Economic Commission for Africa
UN agencies generally do not provide funding on their own
Instead, they work to coordinate and manage aid while providing technical
assistance
Multiple regional organizations also exist to foster development
The European Bank for Reconstruction and Development, initially
designed to distribute Marshall Plan 133 aid, now focuses on providing low-interest
loans for development projects in Central and Eastern Europe
The Inter-American Development Bank also provides low-cost loans for
development projects, but in the Western Hemisphere (primarily Central and
South America and the Caribbean)
Individual countries also create bodies to direct aid and provide technical assistance
The US provides aid through the United States Agency for International
Development (USAID)
In addition, the United States has recently created the Millennium Challenge
Account
This organization provides aid to countries which have achieved good
governance and significantly reduced corruption
Other states (or quasi-states) also have their own organizations, such as the EU’s
EuropeAid and the United Kingdom’s Department for International
Development
133
The Marshall Plan was a US-funded program to help rebuild Europe after WWII. The Plan also aimed to contain the
spread of Soviet ideas and communism in Europe.
International Trade
Imports and exports
Exports are goods produced within a country and then sent abroad
The U.S., for example, exports Ford Mustangs to Germany
Imports are goods produced outside a country and then purchased by agents in that
country
The U.S., for example, imports VW Beetles from Germany
A trade deficit occurs when the value of imports exceeds that of exports in a given
country
A trade surplus occurs when the value of exports exceeds that of imports
Canada is the United States’ chief trading partner
Free trade
Free trade exists when there are no non-natural barriers to international trade
Pure free trade is historically rare
Natural barriers to trade include geography, distance, and language differences
Artificial (non-natural) barriers to trade include all regulations, laws, or other
obstructions enacted by states to reduce, manage, or eliminate trade
Types of non-natural barriers to trade
Various artificial barriers to trade currently exist
Tariffs are taxes placed upon imported goods
Ad valorem tariffs are based upon a certain percentage of value
For example, the government could impose a tariff on all imported cars equal to
2.5% of each car’s value
Since ad valorem taxes are based on a percentage, they are not made obsolete
by inflation
Ad valorem is Latin for “according to value”
Specific tariffs are based upon the number of goods imported
For example, the U.S. could levy a tariff of $5 for every stereo imported
Specific tariffs, however, do not account for quality differences
Some stereos will inevitably cost more than others
An equal tax on all stereos, regardless of their different values, can be unfair
Specific tariffs, therefore, are best suited for homogenous items, such as
apples or oranges
Another disadvantage of specific tariffs is that they can become obsolete with
inflation
Tariffs restrict trade by raising the price of imported goods relative to domestically
produced goods
The goal of a tariff is often to stimulate consumption of domestic goods over
foreign goods
Such domestic tariffs cause the domestic consumer to suffer losses
Making the foreign good more expensive than the domestic good coaxes
consumers into purchasing the domestic good instead
This domestic good, however, is often more expensive than the foreign
good would be without the tariff
The result is that the consumer must pay a higher price
Quotas restrict the quantity of a good which can be imported
Absolute quotas restrict the number of goods which can be imported into a country
or imported from a specific source
For example, the U.S. could impose a quota stipulating that Germany could only
import 20,000 VW Beetles each year to America
Tariff-rate quotas allow for a specified number of goods to be imported at a lower

tariff rate
All goods thereafter face a higher tariff rate
Since quotas generally do not depend upon price, they can be far more effective in
restraining trade
The goods impacted are never allowed into the country in the first place
Compared to tariffs, quotas are relatively easy to implement
Most quotas are absolute quotas
Embargoes are restrictions on exports to a specific country with the intention of
punishing that country
In the 1970s, for example, OPEC put an embargo on oil to the US, which created a
shortage
Embargoes are often used to achieve political ends
Import licenses allow only certain firms (or countries) to operate or sell in a given
nation
In order to sell or produce in such a nation, a firm must acquire an import license
To restrict trade, a nation may either make the price of licenses prohibitively high or
reduce the number of licenses available so only a few firms can operate
Non-tariff barriers to trade (NTBT) include a number of product standards and
regulations enacted by a nation
Health and safety regulations are a non-natural barrier to trade
Strict standards will cause some nations to be unable to meet inspection and
health/safety requirements, effectively banning them from competing
Environmental or labor regulations concern the methods used to produce goods
Non-tariff barriers can be enacted for a variety of legitimate reasons
In some cases, legitimate social goals can be accompanied by protectionist interests
Under these circumstances, harsh standards are imposed as a means of
restricting trade
Adam Smith
One of the first theories of foreign trade was Adam Smith’s idea of gains from exchange
In Smith’s thought, people (and nations) should specialize in producing a certain good
and then exchange with others to meet all of their needs
Production in only one good is more efficient
The result is a decrease in the price of goods and an increase in overall welfare
as cheaper goods are exchanged
People can get more of them by exchanging than they could by producing the
goods by themselves
The good each economic agent should specialize in is the good in which it has an
absolute advantage
Whoever can produce the most of a good with the same quantity of resources
holds an absolute advantage in the production of that good
In Smith’s conception of trade, however, those who could not produce goods as
efficiently as others are excluded from trade
David Ricardo 134
David Ricardo’s expansion of trade theory to include comparative advantage showed
that even individuals or states without an absolute advantage should engage in trade
In Smith’s system, gains from exchange can only be realized when two agents have
different efficiencies
134
No relation to Ricky Ricardo. – Lawrence
If one country is better at producing everything than the other, there is no need to
trade because the more efficient country would not gain from the exchange
Ricardo demonstrated that trade can still be mutually beneficial even if one party is
better at producing everything than another by highlighting comparative advantage
Comparative advantage focuses on the relative prices (or costs) of goods within a
country
The relative price of a good is the price of that good in terms of other goods
forgone
In other words, a good’s relative price is its opportunity cost expressed in terms
of another good
For any country (or person, etc.), a variety of goods can be produced at any one
time
To produce one particular good, another must be given up (opportunity
cost)
For all persons, parties, or nations, there will be at least one good that each can
produce at a lower relative price than all others
In other words, each agent produces one good with a lower opportunity cost
than all other agents
According to Ricardo, each agent should specialize in the good for which it has a
comparative advantage, regardless of absolute advantage
Persons or countries should then exchange goods with others to meet their needs
Absolute advantage is substantially different from comparative advantage
An agent has an absolute advantage in something if it can produce the good more
efficiently than all other agents
Absolute advantage implies that some countries or persons might be unable to
produce anything more efficiently than others
These persons or countries would be unable to participate in trade
The genius of comparative advantage is that even someone who is absolutely dreadful in
producing everything must produce one thing less dreadfully than all others
An economic agent should specialize in producing that one thing that it does best
(comparatively) and then trade
If relative prices among all goods in two potential trading partners are the same, there
are no gains from trade and they shouldn’t trade
Shortcomings of comparative advantage
Ricardo’s model of comparative advantage, while explaining why international trade
should occur, does not explain how patterns of trade develop
One peculiar feature of international trade is that most trade is intra-industry135
The United States, for example, trades cars to Europe in exchange for other cars
The model of comparative advantage explains the benefits of trading different
goods
Intra-industry trade seems to fly in the face of the model
Instead of focusing on comparative advantage, economists have explained intra-
industry trade in terms of economies of scale
For certain goods, production becomes most efficient when markets are
large
International trade allows firms to operate in markets far larger than
domestic markets
135
Unlike “inter-,” which means “between,” “intra-” means “within.”
The model of comparative advantage also does little to explain why some countries
might be better at producing some goods than others
The Swedish economists Eli Heckscher and Bertil Ohlin focused on the factor
endowments of countries as a way of explaining comparative advantages
A nation’s factor endowment is the availability of the various factors of
production to that nation
It explains what countries will be most efficient in producing certain goods
Countries which have abundant labor but not a lot of capital should focus on
producing labor-intensive goods while importing capital-intensive goods
For example, they should produce corn and import cars
Similarly, capital-rich economies with scarce land should produce capital-intensive
goods and trade them for resources or food
For example, they should produce computers and trade for wheat
Protectionist critiques of Ricardo’s theory
Protectionism advocates prioritizing and protecting the domestic economy at the
expense of foreign trade
Protectionists criticize the theory of comparative advantage for several reasons, all
of which are summarized below
Protectionist policy entails tariffs and other taxes on imports to encourage
consumption of domestic goods instead
Comparative advantage can cause one nation to become dependent on others to fulfill
its needs
If trade is disrupted for any reason (such as war), the nation will not be able to
survive on its own
Specialization can lead to unemployment
Those who produce goods for which the nation does not have a comparative
advantage will be unemployed when the nation stops producing that good altogether
For example, if Italy has a comparative advantage in wine and trades with the US,
all American winemakers will be unemployed if the US stops wine production
New domestic businesses and industries can be driven out of business by foreign
competition
These new (“infant”) businesses should be protected from foreign firms
This argument is called the infant industry argument
National security should also be prioritized over efficiency
For example, the US should not rely on another country to produce its missiles,
even if that country has a comparative advantage
An example: comparative advantage in action
Let’s assume we’re looking at two goods (erasers and watches) and three nations
(France, Sweden, and Italy)
Sweden has its own production possibilities
If Sweden devotes all its resources to watches, it can produce 100 watches
If it devotes all its resources to erasers instead, it can produce 50 erasers
The relative price of one eraser, therefore, is two watches
The relative price of one watch is half an eraser
France has different production possibilities
If France produces only watches, it can produce 25 watches
If it produces only erasers, it can produce 75 erasers
The relative price of one watch is three erasers
The relative price of one eraser is one third of a watch
Italy has yet another set of production possibilities
If Italy makes only watches, it can produce 15 of them

If it makes only erasers, it can produce three
The relative price of one eraser is five watches
The relative price of one watch if one fifth of an eraser
First, let’s look at the situation through the eyes of Adam Smith and absolute advantage
Sweden has an absolute advantage in the production of watches
France has an absolute advantage in the production of erasers
Sweden should specialize in watches, France should specialize in erasers, and the
two should trade
Neither France nor Sweden should trade with Italy because Italy does not have an
absolute advantage in either good
Now let’s look at Ricardo’s perspective and comparative advantage
Because France has the lowest relative price for erasers (one third of a watch),
France has a comparative advantage in erasers
Similarly, Italy has the lowest relative price for watches (one fifth of an eraser), so it
has a comparative advantage in watches
France should specialize in erasers, Italy should specialize in watches, and the two
should trade
The price of each watch should be between one fifth of an eraser and three
erasers
This price would be between the relative price each nation would pay if it
produced the goods on its own
The price of each eraser should be between one third of a watch and five
watches
Again, this price is between the relative prices of the two nations
With the above prices, each nation benefits from trade
Neither should trade with Sweden because Sweden does not have a comparative
advantage in either good
There must be some other good, however, for which Sweden has a comparative
advantage
Sweden should specialize in this one good (whatever it is) and trade for
others
Dumping
Dumping occurs when a foreign firm sells a good or service domestically at a price
that is below average total cost
For example, Ford could sell Mustangs to Germany at a price below the average
total cost of producing Mustangs
While dumping may not seem serious, it can drive out domestic businesses
Afterward, the dumping company is free to raise prices as high as it likes136
Using our above example, Ford’s intention could be to drive BMW, Volkswagen, and
other German car companies out of business 137
After Ford has achieved this goal, it can raise the price of Mustangs in Germany
as high as it likes
Ford’s dumping practices would be described as “predatory”
Predatory means that the dumping is intentional and malicious
Dumping is illegal under the international trade rules of the World Trade Organization
(discussed below)
136
This practice is analogous to what WalMart does locally. – Dean
137
Quite the Herculean task if I may say so myself. – Lawrence
The solution to dumping is a tariff on the dumped goods

This tariff is called an anti-dumping duty
It raises the price of the good above average total cost
The result is a transfer of welfare from the foreign company to the domestic
government
The good is more expensive domestically, so it will not be as dangerous to
domestic businesses
The government also gets to collect extra revenue
The German government, for example, could levy a tariff on imported Mustangs
This tariff would make Mustangs more expensive, encouraging consumers to buy
cars from BMW, Mercedes-Benz, and other domestic companies instead 138
International Currency Flows and Exchange Rates

Exchange rates
The exchange rate is the rate at which one currency is traded for another
Exchange rates are determined purely by supply and demand when trade and foreign
exchange are free
If more of a currency is demanded, the price of that currency in terms of other
currencies will increase, or appreciate
If less of a currency is demanded internationally, its price in terms of other
currencies will decrease, or depreciate
Prices of currencies are quoted in terms of other currencies
For example, the price of one dollar is 0.7234 euros 139
Exchange rates are necessary because foreign trade would be impossible without them
Foreign buyers and sellers will (generally) only accept payment for their goods and
services in domestic currencies
In Japan, for example, Toyota will only sell cars in exchange for yen
To purchase foreign goods and services, people in the US must exchange dollars for
the foreign currency
The price of the foreign currency is determined by the supply and demand for
dollars and for the other currency
In reality, persons in Japan want to purchase US goods (or financial assets) while
persons in the US want to purchase Japanese items
The interaction of the two results in a flow of goods, services, and currencies
between the two countries
If a given country runs out of foreign currency and cannot exchange its currency for
others, it will be unable to import any goods or services or pay off debts
denominated in foreign currencies
This situation is only applicable when exchange rates are managed (discussed
below)
Types of exchange rates
Exchange rates can be managed or can be governed purely by market forces
When governments do not intervene in foreign exchange markets, exchange rates are
said to be floating or free
Floating exchange rates are governed only by the supply and demand for
currencies
138
As if they needed the encouragement. – Dean
139
As of July 18, 2007.
When unmanaged, exchange rates can fluctuate wildly

Foreign exchange speculators can also undermine a free-floating currency,
potentially leading to economic crises
Speculators buy a currency when its value is low and sell when its value increases
Massive speculation in a currency can disrupt market forces
Floating exchange rates are also known as flexible exchange rates
When governments intervene in foreign exchange markets, currencies can either be
pegged or managed
Pegged currencies are fixed to a certain value
For example, one dollar will always exchange for a certain number of euros or a
certain weight of gold
Hard pegs are immobile
Prices will remain fixed regardless of changes
Soft pegs allow for some fluctuation in exchange rates
A rate is allowed to move within a narrow range in response to market
forces
Managed exchange rates do not feature set targets but do involve heavy
government interference in foreign exchange markets
A country with a managed exchange rate will not establish a peg but will instead
work to keep its currency from fluctuating too wildly
The primary goal of managed currencies is often to avoid appreciations
Any government interference in foreign exchange rates requires governments to
interact with foreign buyers and sellers of currency
Since these buyers and sellers are foreign, governments cannot normally just
impose exchange rates
Governments have to buy or sell assets priced in their own or other currencies
to manage exchange rates
This activity requires large reserves of foreign money
If China wants to keep its currency pegged at a certain level, for example, it has
to intervene in markets and buy dollar-denominated assets to manipulate the
supply and demand for dollars 140
If a country runs out of foreign currency to purchase foreign assets, it will be
unable to manage its own currency any longer
The result is a sudden move toward a floating exchange rate which can be
very disruptive, as it was in Argentina
Impact of exchange rates on trade
Since foreign goods and services can only be bought by trading currencies, the prices of
the involved currencies will significantly impact trade
As a currency appreciates 141 in value, that country’s exports will become more
expensive to foreigners while imports will become cheaper
If the value of the dollar goes up, for example, wine from France will be cheaper for
us to buy
In France, however, American goods will be more expensive
As a currency depreciates in value, that country’s exports will become cheaper while
imports will become more expensive
If the value of the dollar goes down, for example, Chinese televisions will be more
expensive for us to buy
140
China actually did this for a long time. Until the summer of 2005, each yuan was worth exactly $8.28.
141
Remember that “to appreciate” means to increase in value; “to depreciate” means to decrease in value.
In China, however, American goods will be cheaper

Most governments would rather have their currency depreciate than appreciate
Currency depreciation acts as a boost to exports while slowing imports, thus
increasing GDP and domestic employment
Countries which have to borrow in foreign currencies (such as dollars) are hurt by
depreciation
Their currencies become less valuable relative to dollars or other currencies, making
it harder for them to pay off their debts
The dollar
The United States’ dollar (USD) is currently the world’s most dominant currency
Most goods and services (including commodities) are priced in dollars in international
markets given the size and dominance of the American economy
Most countries maintain foreign exchange reserves dominated by dollars
East Asian countries in particular have reserves in dollars
For East Asian countries to maintain their currency pegs, they have to
manipulate demand for the dollar by buying and selling US assets
Aside from the dollar, there are other significant currencies
The second most-important currency in the world is the euro, which is also the
most important currency in most of Europe
The Japanese yen is another important currency in world markets, especially in Asia
Other currencies of note include the British pound sterling, the Swiss franc, and the
Chinese yuan 142
Balance of payments
There are several account balances that are often mentioned when discussing a nation’s
international trade
The balance of payments is the net total of all money and assets going in and out of a
nation
Assets coming in are counted as positive
Assets leaving are counted as negative
The accounts below are specific parts of the balance of payments
The current account includes all short-term payments
It includes payments for goods and services
The balance of trade includes the exchange of goods (but not services)
It includes physical imports and exports
The balance of services includes the exchange of services (but not goods)
It accounts for intangibles rather than physical goods
The United States’ current account balance is negative: more goes out than comes in
The capital account encompasses all long-term payments
It includes capital inflow, capital outflow, and financial assets (such as stocks and
bonds)
The United States’ capital account balance is positive: more comes in than goes out
Terms of trade index
The terms of trade index can also describe the state of a nation’s international trade
Average Export Price Index
Terms of trade index = ×100
Average Import Price Index
If the index is greater than 100, exports are expensive and imports are cheap
142
Five yuan (about 60 cents) buys you a delicious beef noodle soup. Two Yuan gets you Nance and Joyce Yuan,
authors of the Music Fundamentals Power Guide. – Dan and Dean
This situation will probably result in a trade deficit

Domestic consumers will probably buy more imports and firms will be
unable to sell as many exports
If the index is less than 100, imports are expensive and exports are cheap
This situation will probably lead to a trade surplus
Domestic consumers will probably buy fewer imports, and firms will be able
to sell more exports
Trade in the United States

Exports
The United States is the world’s second-largest exporter of goods and services
In 2004, the US exported slightly over $800 billion worth of goods and services,
accounting for 9% of world exports, second only to Germany
Chief exports of the US include intellectual property (from software to popular music),
agricultural products, industrial supplies, and capital equipment
Imports
The US is also the world’s largest importer of goods and services
The US imported approximately $1.5 trillion worth of goods and services in 2004
Chief imports include primary commodities (such as oil) as well as consumer goods
America’s main sources of imports are Canada, China, Mexico, Japan, and Germany (in
that order, from most to least)
Trade deficit
The resulting balance of trade has created a large trade deficit
Even though the United States is one of the world’s largest exporters, it still imports
more than it sells abroad
The United States’ trade deficit has increased steadily since the 1970s
One reason for this trend is the growth of foreign economies, particularly the
emergence of strong export sectors in East Asia and (especially) China
More recently, America’s trade deficit reflects the continuing strength of American
demand for goods and services while much of the rest of the world (particularly
Japan and the EU) is still sluggish
The United States is simply the biggest and most viable buyer of exported goods
Some view the growth in the trade deficit as a sign of a weak United States economy
as we rely more and more upon foreigners to satisfy domestic needs
Others think that the trade deficit is a sign of strength
Domestic demand is so strong that domestic companies alone cannot keep up
with the immense American appetite for goods
In addition to an increasing trade deficit, the United States’ current account deficit has
also increased substantially
The current account is a much broader measure of international activity: it includes
the flow of investments
Normally, richer nations run current account surpluses while poorer nations run
deficits
In a current account surplus, citizens save more, and savings are exported as
investments
In a current account deficit, citizens save less, and richer nations fund capital
investment in that country
In the United States, other countries have fueled the current account deficit by
purchasing American equities (such as stocks), as well as private and public debt
The purchase of public debt in the form of American Treasury bills is one way
that some nations, such as China, have maintained their fixed exchange rates
with the US
International Organizations and Trade Disputes

International trade before WWI
Prior to World War I, international trade was at the highest levels in world history
The flow of trade between the European nations, their colonies, and the United States
created a truly globalized world
Following WWI, the war debt problems of the European powers led to increasing
protectionism around the world
Countries favored domestic producers to boost employment and economic growth
When the Great Depression hit in 1929, the world reverted to full protectionism,
particularly with the passage of the Smoot-Hawley Act 143 in the United States
This act attempted to ameliorate the economic downturn by placing tariffs on
certain imports, thus boosting the consumption of domestic products
Instead, the act backfired as other nations stopped buying exports from the US
The Depression only worsened as a result
Trade flows essentially disappeared with the Depression and World War II
International trade after WWII
Following the second World War, the major powers (except the Soviet Union) sought
to create a framework for promoting and sustaining international trade
Recognizing that competitive tariffs had essentially derailed the world economy and
worsened the Depression, the post-war powers sought to reduce protectionism
The first proposal to do so, an institutional International Trade Organization, failed
to materialize
In 1947, an agreement was signed in Geneva, Switzerland, creating the General
Agreement on Tariffs and Trade (GATT)
The GATT is not an institutional body like the IMF
It instead establishes codes of conduct for trade relations and multilateral
negotiations to resolve trade disputes
The chief aim of the GATT was the gradual elimination of all tariffs and barriers to
trade
The primary principles of the GATT are reciprocity and non-discrimination
Nations reciprocate in creating trade relations
All nations are treated the same
The GATT moved forward through several rounds of negotiations designed to
further liberalize trade and reduce tariffs
The final GATT round was started in Uruguay in 1986
This round led to the creation of the World Trade Organization (WTO 144 )
The WTO institutionalized the GATT and several other trade agreements
The chief innovation of the WTO was that it added an independent dispute
resolution body to arbitrate trade disputes instead of leaving all disputes to
negotiations
The WTO also incorporated two other agreements which were enacted alongside
the GATT
143
Sometimes referred to as the Hawley-Smoot Act.
144
Pro skater Rodney Mullen supports that. Rock on. – Zac
The first was the General Agreement on Trade in Services, which covered
trade in services such as law and medicine
The second was the agreement on Trade-Related Aspects of Intellectual
Property Rights (TRIPs), which covered issues such as patents and copyrights
The WTO brought all of these agreements under one central body with its dispute
resolution body
Prior to the WTO, GATT agreements had to be have a consensus: all members had
to agree to any new policies or agreements
By introducing the dispute resolution mechanism, the WTO has eliminated the
possibility of a single member holding up trade liberalization
The WTO’s headquarters are in Geneva, Switzerland
Other agreements and organizations
In addition to the GATT/WTO, a number of regional trade agreements and
international economic organizations were enacted in the post-war period
The most significant regional development in the post-war period was the evolution of
the European Union (EU)
The European Union is a fledgling “super-state” which now includes 27 European
nations
The original member states include Germany, France, the Netherlands, Italy,
Belgium, and Luxembourg
The first expansion of the Union included the United Kingdom, Ireland, and
Denmark
Later expansion encompassed Spain, Portugal, Greece, Austria, Finland, and
Sweden
The latest round of expansion (2004) brought in ten countries, mostly former
communist nations: the Czech Republic, Slovakia, Poland, Hungary, Slovenia,
Estonia, Lithuania, Latvia, Malta, and Cyprus
Romania and Bulgaria joined the Union in 2007, bringing total membership to 27
nations
Croatia, Serbia, and Turkey are all either starting or in the midst of negotiations
to join the Union at a future date
The European Union has evolved significantly since its initial founding in 1951
The European Union is the de facto successor to the European Coal and
Steel Community which liberalized trade in coal and steel among the founding
six members
The Union began to take shape as a “super-state” and free trade area with the
signing of the Single European Act in 1986
The final step in creating the current European Union was the signing of the
Maastricht Treaty, which laid out the criteria for political union and the
European Monetary Union (EMU)
The European Union is a customs union
Members are obliged to follow the same policies concerning imports, including
universal tariff rates and trade agreements as negotiated by the Union
The EU is dedicated to the free movement of goods, services, capital, and people
The EU also features its own currency, the euro
The foundations of the euro are in the Maastricht Treaty, which established the
criteria for the EMU
The euro was launched in January 1999 145
145
The actual coins and banknotes were not fully introduced until 2002.
Members of the euro area include all members of the Union except the United
Kingdom, Sweden, and Denmark
The latest 10 entrants to the EU are not yet in the euro area but have pledged
to join as soon as they meet the criteria for doing so
Thus far, the euro has made trade among European nations in the euro area far
easier
It eliminates the hassle of switching currency in each country
In North America, the North American Free Trade Agreement (NAFTA 146 ) is
the primary regional trade agreement covering the United States, Canada, and Mexico
Initially, the US and Canada were pursuing a free trade agreement between
themselves in the late 1980s until Mexico’s president, Carlos Salinas, approached the
US about starting a regional free trade agreement
NAFTA came into force in 1994
Under NAFTA, the US, Canada, and Mexico are obliged to reduce all tariffs, quotas,
and other trade barriers among themselves within the next 15 years
At the insistence of pressure groups primarily in the United States, social and
environmental clauses were added to NAFTA
Unlike the EU, NAFTA is not a super-state, as the three countries involved maintain
significant degrees of sovereignty
NAFTA does possess a dispute resolution panel to arbitrate trade disagreements
among its three members
NAFTA has long been criticized by American workers, who fear that reduced trade
barriers will threaten American jobs
The Association of South East Asian Nations (ASEAN) is an organization
dedicated primarily to economic cooperation
It also aspires to create a regional free trade agreement
Indonesia, Malaysia, the Philippines, Singapore, and Thailand launched ASEAN in
1967
Since its founding, ASEAN has added Vietnam, Myanmar, Laos, and Cambodia to its
membership pool and has worked on forming a special relationship with China
ASEAN’s primary purpose has been coordinating regional industrial developments
More recently, ASEAN has dedicated itself to creating a regional free trade area and
even proposes the introduction of a common currency
ASEAN has a permanent secretariat but lacks many of the institutional features of
NAFTA and (especially) the EU
In West Africa, the Economic Community of West African States (ECOWAS)
has sought to create a customs union and free trade area among its members
ECOWAS includes all of the nations of sub-Saharan west Africa
Nigeria is by far the largest economy in the community
ECOWAS was created by the Treaty of Lagos in 1975 with the aim of forming a
customs union
This goal was later expanded to include the development of a free trade area and
cooperation to improve regional infrastructure
More recently, ECOWAS has sought to create a common currency
The West African Monetary Institute was created in 2001 as a precursor to a
future West African Central Bank
ECOWAS has not been very successful in fostering cooperation among its members,
partially due to the instability of some of them (such as Liberia)
146
An anagram of NAFTA is Fanta. Don’t you want a NAFTA? – Patrick
Mercosur is a customs union of South American countries

Brazil, Argentina, Paraguay, and Uruguay are the four members of Mercosur
Bolivia, Chile, Columbia, Ecuador, and Peru are associate members
Venezuela will become a full member pending ratification by Brazil and Paraguay
Mercosur was launched in 1991 to create a “Southern Common Market,” or
customs union, among its four members
Tariffs on intra-Mercosur trade have been abolished
Its members are obliged to obey common external tariffs, but this requirement has
been relaxed due to economic crises in member states (primarily Argentina)
The G7 147 is not so much an international organization or trade agreement but, rather,
an avenue of communication for the world’s largest and richest economies 148
Members of the G7 include the US, Japan, Germany, the United Kingdom, France,
Italy, and Canada
In 1998, President Clinton formally invited Russia to G7 meetings
Russia has been attending ever since
Consequently, the group is now known as the G8
The primary function of the G8 is to serve as a forum of communication and
cooperation among the world’s most powerful economies
The G8 forum allows countries to coordinate economic policy to achieve common
goals 149
The G8 has no formal structure or institutional mechanism
The Organization of Economic Cooperation and Development (OECD 150 ) is
similar to the G8 but is somewhat more formal and has a much larger membership
The OECD evolved out of the Organization for European Economic Cooperation
At present, the OECD has 30 member states, including non-Western states such as
South Korea and Turkey
The OECD has several general goals
To encourage economic growth and high employment in member countries
To contribute to the economic growth of less-developed member and non-
member states
To push for the expansion of international trade
The OECD has a number of committees and performs a variety of statistical and
analytical functions but has no binding institutional structure
Like the G8, the OECD primarily serves as a forum to encourage economic
cooperation among its members
147
G7 is actually short for “Group of Seven.”
148
I showed up in Calgary once on the eve of a G7 conference. I was coming in for just a day and carrying nothing but a
backpack, which probably made me look like a protester, because I was taken into a special interrogation room by the
Canadian immigration service. – Dan
149
It also allows certain leaders to thank other leaders for thoughtful gifts, such as “lovely sweaters.” – Dean
150
I have OCD, but that’s totally different. – Dean
POWER LISTS151
TERMS – FUNDAMENTAL ECONOMIC CONCEPTS:
Absolute quota Restricts the number of units of a specific good that can be
imported into a country or from a specific source
Accounting cost The monetary cost of an item, production, or any other activity;
also known as out-of-pocket expense and explicit cost
Accounting profit Equals total revenue minus accounting cost
Ad valorem tariff Levied on the value of a good or service; for example, a 2.5% tariff
on the final value of all imported automobiles
Allocative efficiency Goods, services, and resources are allocated to the activities that
society values most
Bargaining cost Type of transaction cost; includes the value of the time and effort
spent to come to an acceptable agreement, draw up a contract, etc.
Barter The direct trade of goods and services for one another; requires a
double coincidence of wants: I must want what you have and you
must want what I have for exchange to take place
Bullion Precious metals, such as gold and silver
Capital One of the four factors of production; includes all resources used
to produce other goods or services; can be divided into both
physical and human forms; does not include money
Capital stock The total pool of capital goods in a nation
Capitalism The economic and political theory in which individual economic
agents own the means of production and economic decisions are
made in free markets
Ceteris paribus “All else held constant”; an important assumption made in many
economic models since so many variables are often involved
Collective action Agents acting together to either coordinate action or to combine
efforts to reach common goals
Command economies Economies in which the government plays a significant role;
decision-making is generally autocratic in nature or confined to
bureaucratic elements which are not responsible to the public for
their decisions; one of the two types of planned economies; for
example, North Korea
Comparative advantage An individual economic agent’s comparative advantage is whatever
good or service it can produce at the lowest relative price (lowest
opportunity cost)
Cost-benefit analysis The simplest decision-making model for economics; one compares
the costs and benefits of a given activity
Creative destruction Competition and innovation result in the elimination of old firms,
practices, goods, etc. over time as they are replaced with newer,
more efficient, firms, practices, or goods
151
My former teammate insists that any term from an economics glossary would make an awesome band name. Go
nuts. But he has dibs on “Opportunity Cost.” – Patrick
Economic cost The sum of accounting (explicit) and opportunity (implicit) costs
Economics The social science of allocating scarce resources among competing
ends
Entrepreneurship One of the four factors of production; is human ingenuity which
seeks out new or more efficient combinations of the other three
factors of production
Explicit cost See accounting cost; compare to opportunity cost
Externality Cost or benefit to an activity that affects a third party; since it is not
faced by the decision-maker, it is not factored into that agent’s
decision-making
Factors of production The factors, or inputs, required to produce any good or service
Fallacy of composition What’s true for the parts may not be true for the whole
Fallacy of division What’s true for the whole may not be true for the parts
Free good A good without an opportunity cost, such as air
Free market economies Economies in which the government has only a very basic role in
private economics; decision-making on economic matters is
completely left to individual economic agents
Human capital Human capabilities such as training, education, and intelligence; can
be improved through education
Implicit cost See opportunity cost; compare to accounting cost
Import license Government license which only allows firms with government
approval to import (or otherwise supply) a specific good or service
in an economy
Incentives Inducements to perform or refrain from a certain activity; in other
words, rewards or punishments for certain actions
Indicative economy A type of planned economy characterized by group decision-making
and goal-oriented planning
Interest (capital) Payment for capital
Invisible hand Postulated by Smith in The Wealth of Nations; refers to the invisible
market forces that guide the market toward equilibrium
Involuntary exchange The forced exchange of goods or services between two agents; can
only take place when one or both agents involved are coerced
Kaldor-Hicks efficiency Achieved in an economy if it is getting the maximum possible value
out of its resources; those who benefit from the use of these
resources are willing to pay just as much as is demanded by those
who are harmed
Labor One of the four factors of production; consists of all human physical
and mental efforts
Laissez faire Literally “Leave [businesses] alone”
Laissez-faire economics An extreme form of free-market economics; the government has
essentially no economic role other than the provision of the most
basic of services and the enforcement of the most limited of laws
Land One of the four factors of production; includes all natural resources
Law of diminishing marginal As individuals consume greater amounts of a single good or service,
utility each additional unit consumed will bring the consumer less utility
Law of one price Goods and services of uniform quality in free markets will have a
single price; every unit of that item will have the same price
Libertarianism An extreme form of capitalism which envisions an extremely limited
government
Long run The period of time over which firms can vary all factors of
production
Marginal Concerning one more unit of something
Marginal analysis A modification of cost-benefit analysis focusing not on all-or-nothing
decisions but on the impacts of incremental changes in behavior on
total costs and benefits
Marginal benefit The benefit gained from the consumption or production of one
additional unit of a good or service
Marginal cost The cost of consuming or producing one additional unit of a good
or service
Market Exists wherever and whenever two or more parties wish to make
an exchange
Market forces The effects of supply and demand on behavior; when a given
decision or the allocation of resources is decided by supply and
demand, it is decided by these
Market systems Markets can be structured in a number of ways depending on who
(or what) answers the three fundamental economic questions
Mercantilism A market system featuring heavy government control and regulation
of the economy and government manipulation of trade to ensure
the steady inward flow of precious metals
Mixed-market economy Economy in which most economic decisions are made in free
markets, but the government plays an active role in such decisions
through spending or regulation; the dominant type of economy
today
Monetary incentive An incentive that involves money
Money An item which is used as a medium of exchange, unit of account,
and store of value that is durable, portable, hard to counterfeit,
easily divisible, and accepted by all parties
Negative externality Costs from an activity which affect a third party not involved in the
activity
Negative incentive An incentive which increases the costs an agent will incur from
acting in a certain way; for example, industrial pollution
Non-monetary incentive An incentive that does not have to do with money
Non-tariff barriers to trade Non-traditional, non-monetary barriers to trade such as health and
(NTBT) safety requirements
Normative economics Strays from what is factually testable by introducing opinions and
preferences; usually marked by statements of what “should be”
Opportunity cost The cost of the next best alternative to a chosen good, service, or
activity; also known as implicit cost
Optimization The process by which we attempt to maximize benefits and
minimize costs
Out-of-pocket expense See accounting cost

Pareto efficiency Achieved in a society if no one person’s welfare could be improved
without detracting from the welfare of another; usually requires
that the economy fully utilize all the resources at its disposal
Physical capital Physical goods or other items which are used for the production of
other goods or services, such as factory machines
Planned economy Economy in which the government plays a significant role in
answering the fundamental economic questions; includes command
and indicative economies
Policing and enforcing cost A type of transaction cost; includes the value of the time, effort, and
money spent to ensure that the other party of an exchange sticks
to agreed terms
Positive economics Economics as science; statements are limited to objective and
observable facts that can be tested and proved to be true or false
Positive externality Benefits from an activity which are received by a third-party
Positive incentive An incentive which increases the benefits an agent will receive from
acting in a certain way
Positive-sum game A situation in which the improvement of any single individual’s
situation does not mean taking something away from someone else;
everyone can benefit without anyone losing out
Primary commodities Another name for raw goods; refers to commodities (or goods)
immediately after they are extracted from land
Production possibilities The possible combinations of two goods or services that an
individual, firm, or society can produce with given factor
endowments and productivity
Production Possibilities See production possibilities frontier
Curve (PPC)
Production Possibilities The graphical representation of the possible combinations of two
Frontier (PPF) goods or services that a given agent can produce; all points on the
curve are equally efficient, all points inside are inefficient, and all
points beyond the curve are impossible without improved factor
endowments or increases in productivity; also known as production
possibilities curve
Productivity The output of goods or services which a given unit of a factor of
production yields
Profit Payment for entrepreneurship; equals total revenue minus total
costs
Public monopolies Monopolies which provide vital services; the monopoly is granted
by the government for the good of the public
Quotas Restrict the quantity of a good or service which can be imported
Raw goods A type of land resource; examples include raw timber or minerals
extracted but not yet refined
Regulation Government intervention in an economy or market
Relative price The price of a good or service in terms of the other goods or
services given up; reflects opportunity costs; critical for determining
the comparative advantage of economic agents, or what they are
best at producing
Rent (traditional) Payment for land; compare to economic rent
Resource endowments Another name for factor endowments, but this term often focuses
purely on land endowments
Scarcity A fundamental problem that exists with all resources because
human desires are endless and resources are limited
Search and information cost Includes the value of all time and effort spent to determine where a
desired good is available, who has the best price, etc.; a type of
transaction cost
Short run The period of time over which firms can only vary a few of the
factors of production (usually labor and resources) while others are
fixed (capital)
Specialization When an individual economic agent focuses on producing a single
good or service to take advantage of increased efficiency; agents will
then satisfy other needs by trading with others
Specific tariffs Fixed monetary tariffs on each unit of a good or service; for
example, a $1.00 tariff on every pair of imported shoes
Sunk costs Costs which have already been paid and cannot be recovered;
rational agents ignore sunk costs in decision-making
Tariff Tax paid on imported goods
Tariff-rate quotas Quotas which allow for a certain number of goods or services to be
imported duty-free or at one tariff rate, with a higher tariff applying
once more goods or services are imported
Trade barrier Any obstruction to trade, including natural and artificial barriers
Trade deficit When a country imports more than it exports
Traditional economy Economy in which the fundamental economic questions are
answered according to tradition
Transaction costs The costs incurred in making an economic exchange; include search
and information, bargaining, and policing and enforcement costs
Utility The satisfaction or pleasure that one receives from consuming a
good or service or performing a certain activity
Voluntary exchange The consensual trade of goods or services between two agents; will
only take place if both parties expect to benefit from the exchange
Wage Payment for labor; generally presented as a rate per hour
Wants Unlimited human desires; they are unlimited because they can never
be completely satisfied
Zero-sum game A situation in which the improvement of any individual’s position
means that someone else has to lose something
TERMS – MICROECONOMICS:
AFL-CIO American Federation of Labor and Congress of Industrial
Organizations; one of the most important labor unions today
Average cost The average per-unit cost of a unit of output; includes both fixed
and variable costs
Barrier to entry A difficulty which makes it harder (or impossible) for a firm to enter
a specific market
Bilateral monopoly A market with one buyer and one seller
Break-even point Level of production at which a firm earns normal profits
Budget line A curve, generally a straight line, representing the combinations of
two goods or services that a consumer can buy with his or her
current income
Cartel A group of firms that colludes to control prices
Closed shop A workplace which only hires union members; outlawed by Taft-
Hartley Act
Common stock Owners of this type of stock are the last in line to receive
dividends, but they have a vote in the company
Competition policy A variety of public policy tools designed to regulate monopolies and
competition within a select market or the economy as a whole
Complementary goods Goods which are consumed together, such as hamburgers and buns;
as the price of a good increases, demand for its complement will
decrease; have a negative cross-price elasticity coefficient
Conglomerate merger When two totally unrelated companies merge
Consumer surplus The surplus utility received by consumers who would have bought a
good or service at a higher price but only have to pay the market
price instead
Contractual savings Financial institutions such as insurance companies and pension funds
institutions which enter into a contract with savers to provide some benefit
(such as insurance coverage or future retirement benefits) and
which invest current funds by loaning them out to borrowers
Contrived scarcity Monopolists can voluntarily lower production to create scarcity and
thus drive up prices
Copyright Grants the exclusive right to reproduce artistic material; lasts the
duration of the creator’s lifetime plus 50 years; can create
monopolies
Corporate profit tax Special tax on the excess profit of a corporation
Corporation Business owned by stockholders
Craft union Union made up of members practicing a single craft or job; also
known as trade union
Cross-price elasticity Examines the effects that a change in price of one good or service
has on the quantity demanded of another good or service
Demand The willingness and ability of consumers to purchase a specific good
or service at any given price
Demand curve The quantity demanded at all prices as presented on a graph;
quantity is on the horizontal axis while price is on the vertical axis;
has a negative slope
Demand schedule A table presenting the quantity demanded at various prices
Depository institutions Financial institutions such as banks which accept deposits from
savers and make loans to borrowers
Depreciation The deterioration of fixed capital over time
Derived demand The demand for any factor of production; determined by the
demand for all possible uses of that factor of production
Direct correlation Describes the relationship between two variables that change in the
same direction: when one goes up, the other goes up, and vice
versa; also known as positive correlation
Discrimination margin The difference between different prices for a firm that practices
price discrimination
Diseconomies of scale Exist when production becomes less efficient as output increases
Dividends Money paid out to stockholders
Division of labor The dividing up of production activities such that an individual is
only responsible for a few (or even one) part of the production
process; allows for specialization and productivity gains as
individuals become better at their specific tasks
Double coincidence of wants A requirement of bartering; two parties must want what the other
has
Due process Legal principle stipulating that the government will not deprive a
citizen of his or her basic legal rights
Economic profits Profits over and above opportunity costs
Economic rent Return to an input over and above its opportunity cost
Economies of scale Exist when production becomes more efficient as output increases
Elastic demand Describes a good for which a change in price results in a
proportionally greater change in quantity demanded; elasticity
coefficient is greater than one; an increase in price leads to a
decrease in total revenue
Elasticity The relationship between two variables, usually expressed as the
proportion of change in one variable to change in another variable
Elasticity coefficient The numeric representation of a curve’s elasticity
Elasticity of demand Measures the responsiveness of quantity demanded to changes in
price; computed by dividing the percentage change in quantity by
the percentage change in price
Elasticity of supply The responsiveness of quantity supplied to changes in price; heavily
dependent on time: in the short run, supply is very inelastic because
firms cannot vary all factors of production in response to price
changes, but in the long run, supply is very elastic because firms can
vary all factors of production to respond to price changes
Equilibrium price See equilibrium price
Equilibrium quantity See equilibrium quantity
Exchange price The price at which goods or services are currently bought and sold;
also known as equilibrium price and market-clearing price
Exchange quantity The quantity exchanged at the market price; also known as
equilibrium quantity
Factor market Market in which factors of production are bought and sold; usually,
households sell factors of production while firms consume them
Federal Deposit Insurance Insures each deposit up to $100,000 at member financial institutions
Corporation
Fixed cost The costs of fixed inputs such as factories; cannot change over the
short run
Horizontal merger When two companies who produce the same product at the same
stage of production merge
Income The flow of money, goods, or services to any economic agent
Income effect One of the two reasons for the downward slope of the demand
curve; occurs because as prices for one good increase, consumers
can buy fewer units of that good with the same amount of money
Income elasticity Measures the change in quantity demanded as a result of a change in
consumer income; if positive, the good is normal; if negative, the
good is inferior
Indifference curve A curve which plots the combinations of two goods or services that
bring the consumer the same amount of utility
Inelastic demand Describes a good for which a change in price results in a
proportionally smaller change in quantity demanded; elasticity
coefficient is less than one; an increase in price leads to an increase
in total revenue
Inferior goods Goods which are demanded less and less as consumer income
increases; for example, shoe repair
Initial public offering (IPO) The price per share of a stock when it first goes on the market
Inverse correlation When two variables are inversely correlated, they vary in opposite
directions: when one goes up, the other goes down; also known as
negative correlation
Kinked demand curve The demand curve for an oligopolist firm; while other firms will
match price decreases, no firm in the market will match a price
increase; thus, demand is elastic above the market price and
inelastic below the market price
Knights of Labor One of the most important early labor unions; established in 1869
Law of demand As the price of a good or service increases, the quantity demanded
of that good or service decreases (and vice versa)
Law of diminishing returns As more of a given factor is employed in an activity, returns (or the
productivity) of that factor will decrease (after a certain point) as it
is combined with fixed amounts of other factors
Law of supply As the price of a good or service increases, the quantity supplied of
that good or service increases
Luxury goods Have the same relationship to price as normal goods, except
consumers will demand more at higher levels of income and almost
none at lower levels of income (the relationship is more extreme)
Marginal product The increase in output gained by adding one more unit of a given
factor of production
Marginal productivity theory Firms will continue hiring more laborers until MRP of labor equals
of wages the wage rate (MR = MC)
Marginal revenue The additional revenue a firm gains by selling one more unit of a
good or service
Marginal revenue product The revenue gained by a firm by selling the output produced by one
(MRP) additional unit of a factor of production; equal to marginal product
times marginal revenue
Market clearing price The price at which the quantity supplied is equal to the quantity
demanded; all supplied goods are demanded (and consumed)
Market equilibrium When the quantity supplied is equal to the quantity demanded
Market-clearing price See exchange price
Merger The union of two or more companies under the same ownership;
one company can buy another or the two can simply combine
Microeconomics The study of individual economic agents and markets
Monopolistic competition A market structure characterized by many firms supplying similar,
but differentiated, products and competing over both price and
non-price factors; there are some barriers to entry because of
product differentiation
Monopoly Firm which does not face competition; a market with only one firm
Monopoly power The degree to which a firm can charge a higher price for its good
than would prevail if the market were perfectly competitive
Monopsony A market with only one consumer
Negative correlation See inverse correlation
Non-excludable A feature of public goods: once a public good is made available, the
provider cannot exclude anyone from having access to it
Non-price competition When firms compete (mainly through advertising) over factors
other than price, such as perceived quality
Non-rival A feature of public goods: one person’s consumption of a public
good does not limit the ability of anyone else to consume it
Normal goods Goods which consumers will consume more of as income increases
and less of as income decreases
Normal profits Profits which exceed accounting costs but which do not exceed
opportunity costs; equal to zero economic profit
Oligopoly A market structure characterized by a few firms supplying
homogenous or differentiated products and engaging mostly in non-
price competition; significant barriers to entry exist, mostly because
of product differentiation and economies of scale
Open shop A workplace where anyone (union or non-union) can work
Organization of Petroleum Collusive oligopoly that works to artificially raise the market price
Exporting Countries (OPEC) of crude oil
P/E ratio Ratio of the price of a share of stock to its earnings; represents the
number of years it will take a shareholder to make back his money
Partnership Business owned by two or more individuals
Patent A legal monopoly granted to a firm to produce a given good or
service in exchange for revealing the product’s exact manufacturing
techniques
Perfect competition A market structure characterized by many small firms supplying

essentially identical products and competing on price alone; no
barriers to entry
Permanent income Income which is sustainable over a long period of time
Picketing Used by union members to draw attention to demands
Planned supply The fact that the supply curve only reflects what firms plan to do,
not what they actually do; due to unforeseen events or other
developments, the quantity firms actually supply of a given good or
service can be significantly different from what they plan to supply
given the current market price
Positive correlation See direct correlation
Preferences Consumer opinions about what is “in style” and what isn’t; reflect
the popularity of a given good; also known as tastes
Preferred stock Owners of this type of stock are paid dividends before owners of
common stock, but they do not have a vote in the company
Price ceiling A maximum price for a good or service imposed by the
government; when set below market equilibrium, a shortage will
result as consumers demand more than producers are willing to
supply
Price competition Firms compete in a market based solely on price
Price discrimination Charging different consumers different prices for the same good;
requires dividing the market up in terms of consumer’s elasticities
and preventing resale
Price floor A minimum price imposed by the government; when set above
market equilibrium, surpluses result as producers supply more than
consumers demand
Price-maker Label for monopolistically competitive firms because product
differentiation allows for some control over price, but not to the
degree of the true monopolist
Price-setter Another name for monopoly firms; a monopolist’s high market
power allows it to manipulate supply to charge the price it wants
Price-taker Label for perfectly competitive firms because they can only take the
market price; these firms have no control over the market price
Principal The price of a bond; paid back after a specified period of time
Principal-agent problem The motivation of agents (managers) to make decisions that benefit
themselves rather than the company and the shareholders (the
principals); a big problem for corporations
Private goods Goods which are privately owned, meaning that owners can
exclude others from enjoying the benefits and use of that good;
both rival and excludable
Producer surplus The surplus that firms which would have been willing to sell their
good at lower prices receive by selling at the market price
Product differentiation When firms make their product appear different from other, similar
products that fulfill the same function; for example, we consider
Nike and Reebok to be very different even though they both make
basketball shoes
Proprietorship Business owned by one individual

Public employee unions Unions consisting of workers in public (government) employment
Public goods Goods which are held by society at large; non-rival and non-
excludable
Quantity demanded The quantity of goods or services that consumers demand at a
specific price; corresponds to a point on the demand curve
Quantity supplied The quantity of goods or services supplied at a specific price;
corresponds to a point on the supply curve
Real wages Wages in terms of real purchasing power (the quantity of goods and
services that one can purchase with the wages); can be calculated
using indexation or a deflator
Retained earnings The amount of money made by a corporation that is not distributed
as dividends; also known as undistributed profit
Right-to-work laws Made legal by Taft-Hartley act; outlaw union shops; can be passed
by states (not passed by federal government)
Shortage Results when more goods or services are demanded than are
supplied; can result from a price ceiling
Shut-down point Equal to the minimum of a firm’s average variable costs; if a firm is
selling its product for less than this amount, it should close or shut
down
Stock Share of ownership in a corporation; two types: preferred and
common
Strike When union members refuse to work; used as a bargaining tool
Subsidy Monetary incentive given by the government to a firm; increase
supply (shift the curve to the right)
Substitute goods A good which can be consumed instead of another without a loss of
satisfaction (utility); a classic example is Pepsi and Coke; as the price
of a good increases, demand for its substitute will increase
Substitution effect One of the two reasons for the downward slope of the demand
curve; occurs because as the price of one good increases,
consumers start to switch to different (but comparable) goods
Supply The quantity of a good or service that a producer is willing and able
to produce at any given price
Supply curve The quantity supplied of a good or service at all prices presented as
a graph; price is on the vertical axis; quantity supplied is on the
horizontal axis; has a positive slope
Supply schedule A table listing the quantity supplied at various prices
Surplus Results when more goods or services are supplied than consumers
demand
Tastes See preferences
Theory of the consumer Another name for the study of demand
Theory of the firm Another name for the study of supply
Trade union See craft union
Tragedy of the commons Since public goods are non-excludable and can be attained at no
cost, agents overuse them, eventually to the point of depletion; an
example is overfishing
Undistributed profit See retained earnings
Union shop A place of employment where the employer can hire union
members or non-members; when hired, however, a non-member
must join the union
Unit-elastic demand Describes the demand for a good if a change in price results in a
proportionately equal change in quantity demanded; a change in
price will not change total revenue
Variable cost The cost of variable inputs in the production process, such as labor;
increases as more units are produced
Vertical merger When two companies who produce at different stages of
production of the same product merge
Yellow-dog contract Agreement signed by an incoming worker in which he or she
pledges not to join a union; outlawed by Norris-La Guardia Act
TERMS – MACROECONOMICS:
Accelerating inflation When the rate of inflation is increasing
Aggregate demand The total demand in the economy at all price levels, which is
reflective of the total expenditures of the economy; total
expenditures can be determined by adding all consumer,
government, and investment spending to net exports; is graphed
much like the market demand curve, except the price level is on the
vertical axis and the total level of output is on the horizontal axis
Aggregate supply (long-run) Perfectly vertical: supply is independent of price level (thus, it is
perfectly inelastic); shifts inward and outward with long-term
changes in technology and productivity
Aggregate supply (short-run) The potential supply of all goods and services at all price levels; is
upward-sloping until capacity constraints, after which the curve is
vertical since producers cannot produce more even if they wanted
to
Antitrust Division, The federal body charged with managing competition policy by
Department of Justice enforcing the US’s antitrust acts
Automatic stabilizers Government policies which work to counteract cyclical changes in
the business cycle; these policies are always in place and perform
their economic function automatically
Balanced budget multiplier Equal to one; used when the government changes taxes by the same
amount as government spending to finance the latter
Base year The price level of this year is the basis for “real” prices
Bond A promissory note or I.O.U.; purchased from a company as an
investment in it
Bracket creep A consequence of inflation: taxpayers move into higher income tax
brackets simply because their nominal (but not real) incomes have
increased; also known as fiscal drag
Bureau of Labor Statistics Compiles a number of economic statistics, including employment

data and the CPI
Business cycle A cycle between periods of growth and periods of decline; includes
expansion, peak, downturn, trough
Capital gains tax A tax levied on returns from investments, such as the sale of stocks
Central banks “Bankers’ banks”; lenders of last resort for private banks; are often
charged with managing the credit and banking systems of a country
Check-off provision Employers automatically deduct union fees from employees’ salaries
and pay the fees directly to the union; outlawed by Taft-Hartley Act
Circular flow model Shows the links between households, firms, the government,
financial institutions, and foreign nationals as money and output flow
through the economy; shows how the different sectors of the
economy are interdependent
Classical region (short-run Vertical, perfectly inelastic region of the short-run aggregate supply
aggregate supply curve) curve; in this region, the economy has reached capacity constraints
on output, and firms are unable to respond to increases in price
level with higher levels of production
Collective bargaining A union negotiates with employers on behalf of every union
member
Collusion When firms work together to set prices abnormally high; illegal in
the U.S.; most prominent example is OPEC
Commodity money Money made from a material which is useful or valuable in itself,
such as gold or silver
Comparative advantage An individual economic agent’s comparative advantage is whatever
good or service it can produce at the lowest relative price (lowest
opportunity cost)
Constant inflation When prices are increasing at a constant rate
Consumer Price Index (CPI) A measurement of inflation which compares the changing price of a
fixed basket of goods over time
Consumer spending Spending of all individuals on final goods and services
Contractionary policy Policy designed to shrink the economy by reducing either federal
spending or the money supply
Corporate income tax See corporate profit tax
Corporate profit tax A tax on the earnings of a corporation; also known as corporate
income tax
Cost-push inflation Increased factor prices result in increased costs for producers;
higher production costs decrease supply (shift it to the left),
resulting in higher prices and inflation
Crowding out Whenever fiscal or monetary policy results in side-effects that
counteract the initial actions; for example, expansionary policy often
has a small contractionary side effect
Currency The actual paper and coins which circulate in an economy
Current economic indicators These provide a sense of general economic activity and include
factors such as employment, producer output, and net exports; take
some time to put together and are not in real time, but are still
determined fairly quickly
Cyclical unemployment Unemployment resulting from changes in the business cycle

Deadweight loss The loss of welfare resulting from increasing the price of a good or
service above its equilibrium value, either through an exercise of
monopoly power or through taxes; eliminates a significant portion
of the consumer and producer surpluses
Debasement Lowering the precious metal content of coins in order to make
more of them from the same amount of the precious metal
Deficit A shortfall in an on-going budget
Deflation A sustained decrease in prices over time
Deflationary gap An output gap in which actual output is less than potential output
Demand deposits A form of money which is stored at banks that can be withdrawn at
any time; examples include most checking accounts; included in M1
Demand-pull inflation The result of increased demand for goods and services when
suppliers are unable to keep up; consumers “bid up” the prices of
goods and services, which creates inflation; also referred to as “too
many dollars chasing too few goods”
Depression A phase of the business cycle; a downturn that lasts three quarters
(nine months) or more
Direct tax Taxes which are applied directly to individual wealth or income
Discount rate The rate of interest the Fed charges private banks for loans;
lowering it usually increases private lending, which increases the
money supply; increasing it usually decreases private lending, which
restricts the money supply
Discouraged worker A persons who could be in the labor force but is no longer actively
seeking employment; also known as marginally attached worker
Discretionary spending Federal spending which can be used for any purpose
Disinflation When the rate of inflation is slowing down
Disposable income Equal to personal income minus income taxes; determines how
much consumers actually consume
Downturn A period of the business cycle when economic activity is decreasing
Earmarked Federal spending which is set aside for a specific purpose
Economic growth A sustained increase in real GDP over time
Economic income Income which includes benefits that are not represented in
monetary terms, such as the benefits of improving one’s own
household (an activity which does not have a market value)
Embargo Restrictions on exports to a specific country with the intention of
punishing that country
Employment rate The percentage of persons in the labor force which have jobs
Equation of exchange See quantity theory of money
Estate tax Tax on inheritance
Eurodollars All dollar accounts held outside the U.S.
Excise tax An indirect sales tax that is levied on specific goods or services,
such as alcohol
Expansion A period of the business cycle when economic activity is increasing;

also known as upturn
Expansionary policy Policy designed to expand the economy through either an increase
in government spending (fiscal policy) or an increase in the money
supply (monetary policy)
Expenditures approach One method of measuring GDP; is the sum of all expenditures in
the economy over a given time period; GDP is calculated by adding
consumer spending, government spending, investment spending, and
net exports
Extended unemployment Offered during severe economic downturns to supplement and
insurance extend existing unemployment benefits
Factor endowment The factors of production available to a nation; has a significant
impact on the production possibilities of that agent
Federal Advisory Council Consists of one commercial banker representing each district in the
Federal Reserve system; is a purely advisory body with no policy-
making power
Federal funds rate The rate private banks charge each other on overnight loans; the
Fed does not have direct control over this rate, but instead aims to
influence it through open-market operations
Federal Open Market Trades government securities, or debt, on the open market as a
Committee (FOMC) way of conducting day-to-day monetary policy; consists of the
Federal Reserve Board plus the President of the New York District
Bank and the presidents of four other district banks
Federal Reserve Established in 1913; is the independent central bank of the US
Federal Reserve Board The governing body of the Federal Reserve; consists of seven
governors appointed by Congress to 14-year terms with one term
expiring every two years
Federal Trade Commission Important government agency that controls competition policy;
(FTC) oversees mergers and works to ensure fair trade
Fiat money Money which is valuable (legal tender) only because a legal authority
says it is valuable; nearly all modern money is fiat money
Final goods/services Goods and services not used to produce other goods and services
Financial institution Acts as an intermediary between savers and borrowers; provides
services to both, reducing the costs of lending and increasing the
benefits of saving
Fiscal drag See bracket creep
Fiscal policy Government actions which are designed to increase or decrease
aggregate demand; is enabled by the government’s ability to directly
impact aggregate demand by increasing or decreasing its spending
Fisher’s Equation See Fisher’s Hypothesis
Fisher’s Hypothesis Nominal Interest Rate = Real Interest Rate + Current Inflation
Rate; also known as Fisher’s Equation
Flat tax A type of tax; all individuals pay the same percent tax; also known
as proportional tax
Fractional reserve banking Banks keep only a fraction of their deposits and loan the rest out
Free-rider problem A result of the non-excludable nature of public goods; those who
haven’t paid for a public good can still enjoy it
Frictional unemployment Unemployment resulting from the time lag between when workers
leave one job and find a new job; exists even in the healthiest and
wealthiest of economies
Full employment All resources in the economy (especially labor) are being fully
utilized; does not, however, correspond to 100% employment
(closer to 96% due to frictional and structural unemployment)
GDP deflator Used to adjust nominal GDP to yield real GDP; a measure of
inflation which takes into account all economic activity
Gini coefficient A number from zero to one that represents a country’s distribution
of wealth; one means that one individual has all wealth; zero means
wealth is distributed equally
Government spending The money spent by the government on final goods and services
Gresham’s Law ”Bad money drives out the good”; relates primarily to commodity
money: as two different kinds of money are introduced into an
economy, people will hoard “good” money and spend “bad” money;
the result is that only “bad” money is present in the economy
Gross Domestic Product The total of all purchases of final goods and services in an economy
(GDP) in one year; can be calculated in multiple ways; focuses on all
activity within a nation, thus including the actions of foreign
nationals and companies in a given country, but not including the
actions of home-country citizens and companies abroad
Human Development Index An indicator published by the United Nations; measures the well-
(HDI) being of nations based upon health and social factors in addition to
economic well-being
Hyperinflation When the rate of inflation is extremely high (generally above 20%);
an example is the inflation that occurred in Germany after WWI
Incidence of taxation The party in a transaction (consumer or producer) which ends up
bearing the burden of a tax; whichever party has a more inelastic
demand will bear most of the burden
Income tax A tax on personal income
Index of Consumer A survey of 5000 households that tracks confidence in the
Confidence economy; reflects the future economic decisions of households
Index of Leading Economic An index of several leading economic indicators published by the US
Indicators Department of Commerce to measure real-time growth and
development
Indirect tax Tax on transactions, especially expenditures; an example is sales tax
Industrial union A union consisting of workers with multiple jobs but in the same
industry
Inflation A general rise in prices over time
Inflationary gap An output gap in which actual output is greater than potential
output; results in inflation
Injection Refers to the introduction of resources into the circular flow
model; examples include investment and exports
Interest (money) The price of (borrowing) money
Interest effect One reason why aggregate demand is downward sloping: as the
price level increases, more people borrow money, which drives up
interest rates; the higher rates discourage investment and
consumption, which leads to a decrease in aggregate demand
Interlocking directorate When someone on the board of directors of one company serves
on the board of directors of another company; outlawed by Clayton
Act for competing companies
Intermediate goods/services Goods and services which are used to produce other goods and
services
Intermediate region (short- Middle region of the short-run aggregate supply region; upward
run aggregate supply curve) sloping; increases in output lead to increases in price level (inflation)
Interstate Commerce Established in 1887 to regulate the railroads and protect farmers;
Commission (ICC) disbanded in 1995
Investment spending Total investment expenditures in the economy, including capital
investments and inventories
Keynesian region (short-run Horizontal, perfectly elastic region of the short-run aggregate supply
aggregate supply curve) curve; in this region, the economy is in a recession, so increases in
output do not lead to increases in price level
L Equal to M3 plus commercial papers, deeds, etc.; its use was
discontinued by the Fed in 1998
Labor force The total number of persons aged 16 and over who are either
working or actively seeking employment (excluding those who are
incarcerated or in the military)
Labor union Organization of workers which provides benefits to members and
acts as a bargaining intermediary for individual workers
Laffer curve Curve that shows the relationship between tax rate and tax
revenue; at 0% and 100% tax rates, revenue is zero; ideal tax rate is
somewhere in between (assumed to be 15%)
Lagging economic indicators Provide an in-depth analysis of economic development and include
measurements such as factor costs and GDP; take a great deal of
time to put together and are usually retrospective in nature
Leading economic indicators Provide a real-time glimpse of economic activity and include things
such as current housing construction and changes in firm orders for
resources; easily tracked and readily available
Leakage When resource escape the circular flow model; include imports and
savings
Liquidity A term which refers to how easy it is to convert a form of money
into something that can be spent immediately (i.e., currency)
Loanable funds The money that one is willing to lend and another is willing to
borrow
Loanable funds theory The supply and demand of loanable funds determines the interest
rate
Long-run equilibrium State of the economy when the long-run aggregate supply curve
passes through the intersection of the short-run aggregate supply
curve and the aggregate demand curve
Lorenz curve The graphical representation of the Gini coefficient; shows the
(in)equality of the income distribution of a nation
M1 A definition of the money supply that includes all currency, demand
deposits, traveler’s checks, and other deposits against which checks
can be written; the most liquid definition of the money supply
M2 Includes all of M1 plus savings accounts, time deposits under
$100,000, and balances in retail money market funds; often
considered the “best” definition of the money supply
M3 Includes everything in M2 plus time deposits over $100,000,
balances in institutional money funds, repurchase liabilities issued by
depository institutions, and Eurodollar accounts; discontinued by
the Fed in March 2006
Macroeconomics The study of entire economies or societies, as well as the global
economy
Marginal propensity to The percentage of every dollar added to income that an individual
consume will spend
Marginal propensity to save The percentage of every dollar added to income that an individual
will not spend (save)
Marginally attached worker See discouraged worker
Means-tested program Provides aid to individuals whose income falls below a certain
minimum level
Medium of exchange Anything which acts as a means of exchanging goods and services;
eliminates the need for barter by providing an intermediary for
exchange that can later be traded for other goods or services; most
common example is money
Menu cost A cost inflicted by inflation; increasing prices means that firms must
continually change the listed prices of goods and services
Monetarists A school of economic thought opposed to Keynes; Milton Friedman
was a primary proponent; focuses on increasing aggregate supply
through supply-side economics as a means of stimulating the
economy and controlling inflation
Monetary base The most restrictive definition of the money supply, limited only to
currency
Monetary policy Management of the economy through the Fed, which changes the
money supply; tools include open market operations, changes in
reserve requirements, and changes in the discount interest rate
Money An item which is used as a medium of exchange, unit of account,
and store of value that is durable, portable, hard to counterfeit,
easily divisible, and accepted by all parties
Money market accounts A form of account which requires larger-than-normal initial deposits
in exchange for higher returns on that deposit; the number of
transactions one can make with this type of account is generally
limited
Money multiplier The inverse of the reserve requirement (1/RR); used to calculate
the change in the money supply that results from a new deposit in a
bank
National debt The total amount of money owed by the government; equal to the
sum of all surpluses and deficits in a nation’s history
National income The total income of all agents in the economy in a given period;
measurements effectively mirror aggregate demand; equal to NDP
minus indirect business taxes
National income approach One method of measuring GDP; add together all payments for the
factors of production (wages, rents, interest, and profits) and
subtract indirect taxes and subsidies
Natural rate of The long-term sustainable rate of unemployment; unemployment
unemployment above or below this level results in recession or inflation,
respectively; equal to about 4%
Net Domestic Product Equal to GDP minus depreciation
(NDP)
Net exports Another term for balance of trade; is a factor of aggregate demand
Nominal GDP GDP in current prices
Nominal interest rate The interest rate that one receives for a deposit or must pay for a
loan
Nominal wages Wages expressed in terms of current price levels (not adjusted for
inflation)
Non-excludable A feature of public goods: once a public good is made available, the
provider cannot exclude anyone from having access to it
Non-rival A feature of public goods: one person’s consumption of a public
good does not limit the ability of anyone else to consume it
Open economy effect See trade effect
Open-market operations The buying and selling of government securities on the open market
by the FOMC to manipulate the money supply; buying securities
increases the money supply; selling securities decreases the money
supply
Output gap The difference between nation’s potential output and actual output;
usually calculated by subtracting actual output from potential output
Participation rate The percentage of the total population that is eligible for the labor
force that is currently in the labor force (employed or actively
seeking employment)
Payroll tax Small tax on employers which is used to fund government programs
such as Social Security and Medicare; paid as a portion of workers’
paychecks
Peak The part of the business cycle at the end of an expansion and just
before a downturn
Per capita GDP GDP divided by the population; yields the level of national income
per person, which is often used as a measurement of economic
development and well-being
Personal income Equal to national income minus Social Security tax, plus transfer
payments, minus retained earnings
Pigovian tax A tax which aims to discourage a behavior which creates a negative
externality; a sin tax is one type of this tax
Planned investment spending The amount that firms plan to invest in a given year; equal to capital
spending plus planned additions to inventories
Price stability A goal often assigned to central banks; refers to maintaining
constant rates of low inflation over time
Prime rate The interest rate banks charge their best customers
Progressive tax A tax which taxes poor individuals at a smaller percentage of
income than rich individuals
Proportional tax See flat tax
Public goods Goods which are held by society at large; non-rival and non-
excludable
Quantity theory of money MV = QP: the amount of money in circulation multiplied by the
velocity of money (how many times a dollar is spent in a year) is
equal to the total output of the economy multiplied by the current
price level; V and Q are generally fixed, so any change in M will
result in a change in P; also known as the equation of exchange
Reaganomics See trickle-down economics
Real GDP GDP expressed in constant prices, which allows for comparisons
over time
Real interest rate The rate of interest which factors in inflation; calculated by
subtracting the current rate of inflation from the nominal interest
rate; can even be a negative number (due to inflation)
Recession A contraction that lasts two quarters (six months) or more
Regressive tax A tax which taxes rich individuals at a smaller percentage of income
than poorer individuals
Reserve ratio See reserve requirements
Reserve requirements The percentage of deposits which banks must keep on hand at any
given time by law; also known as reserve ratio
Sales tax A tax on the purchase of goods and services; can be charged to the
producer or the consumer (or both), but the incidence of taxation
determines who really bears the burden of the tax
Say’s Law “Supply creates its own demand”: an increase in supply will result in
a matching increase in demand to consume the expanded supply; a
pre-Keynes conception of supply-side economics
Seasonal unemployment Unemployment resulting from seasonal changes or from work
which is only available at certain times of year; for example, life
guards are often unemployed in the winter
Shoe-leather costs A cost of inflation; consumers have to go to the bank more often
because their money is worth less; the increased “walking to the
bank” metaphorically wears out consumers’ shoes
Sin tax Excise tax on items such as alcohol, cigarettes, etc.
Spending multiplier 1 1
= ; used to calculate the impact of a change in
MPC -1 MPS
government spending on GDP
Stagflation Occurs whenever economic stagnation and inflation take place at
the same time, such as throughout much of the 1970s
Sticky wages Introduced by Keynes; also known as “rigid” and “inflexible” wages;
workers are reluctant to accept pay cuts, so wages don’t always fall
smoothly in response to changes in the economy
Store of value A function of money: money that is earned today retains its
spending power in the future; inflation undermines this ability
Structural unemployment Unemployment resulting from fundamental changes in the economy,
such as changes in technology or consumer preferences; results
from a mismatch of skills offered and skills desired
Supply shock A sudden, external event that affects all producers; usually results in
a decrease in aggregate supply; an example is a sudden, dramatic
increase in the price of crude oil
Supply-side economics Economic school focusing on changes in supply as the main
determinant of total output; proposes that the best way to promote
overall welfare is to increase aggregate supply
Tax A compulsory charge or levy enacted by a government to raise
revenue; the primary means through which governments fund their
activities
Tax multiplier − MPC
; used to determine impact of a change in taxation on GDP
MPS
Time deposit A form of money stored at banks which can only be retrieved after
a certain length of time; an example is a CD (certificate of deposit)
Total investment spending The sum of planned and unplanned investment spending
Trade effect One reason why aggregate demand is downward sloping: as the
price level of domestic goods and services decreases, domestically-
produced goods become cheaper abroad, increasing exports and
reducing imports, which will increase GDP (output); also known as
open economy effect
Trickle-down economics Nickname for the economic policies of President Ronald Reagan; he
hoped that tax cuts for corporations would “trickle down” to the
middle classes as a result of increased corporate spending; also
known as Reaganomics
Trough The part of the business cycle at the end of a downturn and just
before an expansion
Tying contract Agreement between one buyer and one seller to deal exclusively
with one another; creates a bilateral monopoly
Unemployment insurance Federal and state programs designed to supplement the income of
unemployed workers while they search for new jobs
Unemployment rate The percentage of unemployed persons in the labor force (who, by
definition, are actively searching for a job)
Unit of account A function of money which allows us to compare the value of
different items by looking at their prices
Unplanned investment The amount of a firm’s unforeseen investment, usually in the form
spending of larger or smaller inventories than planned
Upturn See expansion
Usage tax Tax designed to support specific government services
Value-added The price a good sells for (as either a final good or an intermediate
good) minus the costs of the resources used to produce it
Value-added approach One way of measuring GDP; total the value-added to every good
and service at each stage of production
Value-added tax A type of indirect tax which taxes a percentage of the value-added
at every step of the production of a good or service; most
developed countries have a value-added tax
Wealth effect One reason why aggregate demand is downward sloping: as the
price level decreases, the real income of consumers increases, thus
allowing them to purchase more goods and services
Wealth tax A tax on fixed wealth; the most common example is property tax
Welfare Government programs designed to ensure the social well-being of
individual citizens
TERMS – INTERNATIONAL TRADE AND GLOBAL DEVELOPMENT:

Absolute advantage An economic agent’s ability to produce a good or service more
efficiently than another agent
Anti-dumping duty A tariff levied on an imported good to raise its price above its
average total cost, effectively preventing dumping; transfers welfare
from the foreign company to the domestic government
Appreciate To increase in value; often used to describe an increase in value in
one currency relative to foreign currencies
Association of South East An agreement among Southeast Asian nations to eventually create a
Asian Nations (ASEAN) free trade area and a common currency; members include
Indonesia, Malaysia, Thailand, Vietnam, the Philippines, Laos,
Cambodia, Singapore, and Myanmar
Balance of payments Includes the total flow of assets and currency in and out of a nation
Balance of services Includes the value of all services flowing in and out of a nation
Balance of trade The difference between exports and imports, typically presented as
exports minus imports; only includes physical goods
Brain-drain The exit of skilled human capital from less-developed countries in
search of opportunities in more developed economies; deprives
LDCs of potential innovators and leaders
Bretton Woods Conference Took place near the end of the WWII; was a gathering of the Allied
powers to discuss and manage the post-war economic order;
resulted in the International Monetary Fund and the International
Bank for Reconstruction and Development (which later evolved
into the World Bank)
Capital account Includes all long-term payments made in international trade;
includes capital inflow/outflow and long-term investments
Current account Includes all short-term payments made in international trade;
includes goods, services, investment income, and transfers of assets
Department for International A body in the United Kingdom that provides aid and technical
Development assistance to developing nations
Depreciate To decrease in value; often used to describe a decrease in value in

one currency relative to foreign currencies
Developed country Country with a per capita GDP over $10,000
Developing country Country with a per capita GDP between $3000 and $10,000
Dumping When a foreign firm sells a good domestically for a price that is less
than average total cost; described as “predatory” when the intent of
the firm is to drive domestic companies out of business
Economic Community of An agreement among west African nations to work toward creating
West African States a customs union, free trade area, and common currency; I most
(ECOWAS) significant and largest member is Nigeria
Euro The common currency of the European Union
EuropeAid The primary body for coordinating and providing aid from the
European Union
European Bank for Initially designed as a way to distribute Marshall Plan Aid; is now a
Reconstruction and body which provides loans and technical assistance throughout
Development Europe and the former Soviet Union
European Coal and Steel The first stage of what is now the European Union; was a free trade
Community area in coal and steel established among France, Germany, Italy, the
Netherlands, Belgium, and Luxemburg
European Monetary Union Created the euro, the common currency for several members of
(EMU) the European Union: Ireland, France, Germany, the Netherlands,
Belgium, Spain, Portugal, Italy, Luxemburg, Austria, Finland, and
Greece
European Union (EU) Created following the Maastricht Treaty; is a customs union and
free trade area which also features supranational government and a
common currency (the euro)
Export Good or service produced domestically and sold to foreigners
Fixed exchange rate When the government intervenes to establish a specific exchange
rate for domestic currency; also known as pegged exchange rate
Flexible exchange rate See floating exchange rate
Floating exchange rate When exchange rates are set by market forces; also known as
flexible exchange rate
Foreign exchange The trade of currencies on international markets
Free trade When there are no non-natural barriers to international trade
General Agreement on Tariffs Consisted of a series of agreements which resulted in the gradual
and Trade (GATT) lowering of tariffs and other barriers to trade; replaced by the more
institutional World Trade Organization in 1994
Globalization The increase in the flow of goods, services, investment, and people
between countries
Import Good or service produced by foreigners and sold domestically
Infant industry argument A protectionist critique of comparative advantage; argues that we
must protect new (“infant”) industries from foreign competition
while as they develop
Inter-American Development Provides loans and technical assistance to nations in the Western
Bank Hemisphere
International Bank for Initially set up as a means for distributing aid after WWII; is the
Reconstruction and loan-granting arm of the World Bank
Development (IBRD)
International Development A World Bank member institution; specializes in providing grants to
Association (IDA) poor countries
International Monetary Fund A lender of last resort for countries; works to prevent balance of
(IMF) payments difficulties and encourage monetary cooperation between
nations; primarily provides loans and technical assistance; is also a
Bretton Woods institution
Less-developed countries Countries with a per capita GDP under $3000
(LDCs)
Maastricht Treaty Created the European Union and started the process toward
greater European political integration and monetary union
Managed exchange rate The government heavily intervenes to manipulate a currency’s value
but does not have a specific set or fixed value for it
Mercosur A customs union and eventual free trade area among Brazil,
Argentina, Paraguay, and Uruguay, with Chile, Bolivia, Columbia,
Ecuador, and Peru as associate members
Millennium Challenge A new body for aid distribution established by George W. Bush;
Account focuses not only on the need of countries, but also on good
governance
North American Free Trade An agreement among the United States, Mexico, and Canada;
Agreement (NAFTA) designed to eventually eliminate all barriers to trade between these
three countries; is a free trade area only, and does not include a
customs union agreement
Organization for Economic An organization of (mostly) developed countries which provides
Cooperation and technical assistance and allows for some policy coordination among
Development (OECD) member states
Organization of Petroleum Collusive oligopoly that works to artificially raise the market price
Exporting Countries (OPEC) of crude oil
Pegged exchange rate See fixed exchange rate
Protectionism Advocates prioritizing and protecting the domestic economy at the
expensive of foreign trade
Relative price The price of a good or service in terms of the other goods or
services given up; reflects opportunity costs; critical for determining
the comparative advantage of economic agents, or what they are
best at producing
Single European Act 1986; created the single, or common, market for European goods
among the members of what was then known as the European
Community
Terms of trade index Average Export Price Index
× 100 ; if greater than 100, will probably
lead to a trade deficit; if less than 100, will probably lead to a trade
surplus
United States Agency for The primary source of US aid to foreign countries
International Development
(USAID)
World Bank A part of the United Nations that specializes in providing loans and
grants to developing countries and LDCs; one of the Bretton
Woods institutions; includes the IBRD and IDA
World Trade Organization Created in 1994; incorporated the GATT, the General Agreement
(WTO) on Trade in Services, and Trade-Related Aspects of Intellectual
Property Rights agreements; contains a dispute resolution
mechanism which allows the body to mediate trade disputes
between member states
IMPORTANT PEOPLE – ECONOMISTS:

Bernanke, Ben Current chairman of the Federal Reserve
Engels, Friedrich Coauthored The Communist Manifesto with Marx
Fourier, Robert An early utopian socialist; preceded Marx
Friedman, Milton Worked with and significantly modified the Fisher Equation to
defend the argument that expansionary monetary policy will only
result in inflation and not an increase in real output; important
monetarist; responsible for reviving interest in the quantity theory
of money
Greenspan, Alan Chairman of the Federal Reserve before Bernanke
Gresham, Thomas Namesake for Gresham’s law; an advisor to Queen Elizabeth
Heckscher, Eli Studied factor endowment as a way to explain comparative
advantage
Keynes, John Maynard 1883-1946; British economist; wrote General Theory of Employment,
Interest, and Money; founder of Keynesian economics: an active
government manipulates aggregate demand to close output gaps
Laffer, Arthur Developed Laffer curve; his work was cited as support for Reagan’s
tax cuts
Marx, Karl Coauthored The Communist Manifesto with Engels; his work inspired
modern communist thought
More, Thomas Early utopian socialist; preceded Marx
Nozick, Robert Notable libertarian theorist
Ohlin, Bertil Studied factor endowment as a way to explain comparative
advantage
Owen, Robert Early utopian socialist; preceded Marx
Rand, Ayn Notable libertarian theorist
Ricardo, David Authored The Principles of Political Economy and Taxation, which
formed the basis for comparative advantage and modern trade
theory
Say, Jean Baptiste Formulated Say’s law, which is the basis for supply-side economics
Smith, Adam Wrote The Wealth of Nations (1776); his work founded capitalism
and the formal study of economics
Sweezy, Paul Postulated the existence of the “kinked” demand curve

Zoellick, Robert Current head of the World Bank group
IMPORTANT ECONOMIC TEXTS:

The Communist Manifesto Book by Karl Marx and Friedrich Engels; published in 1848; laid the
foundation for communist thought
General Theory of Employment, Written by John Maynard Keynes; discusses the mixed economic
Interest, and Money system
The Wealth of Nations By Adam Smith; founded capitalism and the formal study of
economics; published in 1776; postulates the existence of an
“invisible hand”
LAWS – ANTI-TRUST AND FAIR COMPETITION:

Celler-Kefauver Act 1950; prohibited any type of merger that gave the merging firms
an unfair advantage in the marketplace
Clayton Antitrust Act 1914; prohibited mergers that would result in the creation of
monopolies; also outlaws tying contracts and interlocking
directorates
Robinson-Patnam Act 1956; made certain forms of price discrimination illegal; defined
“harmful discrimination” as discrimination that leads to unfair
competition
Sherman Antitrust Act 1890; designed to outlaw collusion aimed at restricting trade
(cartels); made monopolies illegal
Wheeler-Lea Act 1938; gave power to the FTC to investigate unfair, deceptive
business practices and prevent false advertising
LAWS – UNIONS:
Landrum-Griffith Act 1959; made union leaders more accountable in order to help fight
union corruption
National Labor Relations Act 1935; officially legalized unions
Norris-La Guardia Act 1932; outlawed yellow-dog contracts
Taft-Hartley Act 1947; abolished closed shops; allowed states to pass “right-to-
work” laws; prohibited check-off provisions
Wagner Act 1935; guaranteed unions’ right to collective bargaining
LAWS – EMPLOYMENT AND THE GREAT DEPRESSION:

Comprehensive Employment 1973; aimed at combating structural unemployment by training
and Training Act structurally unemployed workers with new skills
Employment Act 1946; established maximum (full) employment, production, and
purchasing power as official goals of the federal government (but
not of the Fed)
Federal Insurance 1939; levied a tax on all citizens’ paychecks to pay for Social
Contribution Act (FICA) Security, welfare, and Medicare
Federal Unemployment Tax 1939; levied a small tax on employers to support the general
Act administrative costs of the unemployment compensation system;
this tax also covers half of the costs of extended unemployment
benefits
Full Employment and 1978; ostensibly made full employment the official goal of the
Balanced Growth Act Federal Reserve, but in reality only required the FOMC to testify to
Congress twice a year on monetary policy; set 4% as the natural
rate of unemployment; nicknamed the Humphrey-Hawkins Act
Hawley-Smoot Act See Smoot-Hawley Act
Humphrey-Hawkins Act See Full Employment and Balanced Growth Act
Job Training and Partnership 1982; aimed at combating structural unemployment by training
Act structurally unemployed workers with new skills
Manpower Training and 1962; aimed at combating structural unemployment by training
Development Act structurally unemployed workers with new skills
Smoot-Hawley Act Passed at the beginning of the Great Depression (1930); sparked a
series of tariff hikes throughout the world which essentially ground
world trade to a halt, worsening the Depression; sometimes
referred to as the Hawley-Smoot Act
Social Security Act 1935; provided workers who lost their jobs with a weekly
compensation payment; established the Social Security system
LAWS – OTHER:
Commerce Clause A clause in the Constitution (Article I, Section 8) which gives the
US Congress significant jurisdiction over interstate commerce
Federal Reserve Act 1913; created the Federal Reserve System as the central bank of the
US
Mack-Saxton Bill Introduced in 1995 and again in 1997; would have made long-term
price stability the primary goal of the Federal Reserve
FEDERAL PROGRAMS FOR DOMESTIC AID IN THE US:

Aid to Families with Was part of the 1935 Social Security Act and is administered by the
Dependent Children (AFDC) US Department of Health and Human Services; was designed to
help families in need with few strings attached until welfare reform
during the 1990s
Disaster Unemployment Unemployment insurance offered in the wake of a severe natural
Assistance (DUA) disaster
Earned Income Tax Credit An example of a means-tested program
(EITC)
Food Stamps An example of a means-tested program
Medicaid An example of a means-tested program; provides medical assistance
for the needy
Medicare Federal program that provides medical assistance to the elderly

Social Security Initially aimed at providing for the elderly and the disabled; started
with the 1935 Social Security Act; is funded on a PAYGO basis:
current workers pay for current retirees (“pay as you go”)
Supplemental Security Income An example of a means-tested program
Temporary Assistance to An example of a means-tested program
Needy Families (TANF)
Trade Readjustment A form of extended unemployment insurance which is offered to
Allowances (TRAs) workers that have lost their jobs due to foreign trade
POWER EQUATIONS
MICROECONOMICS – ELASTICITY:
Arc/midpoint formula for (change in QD) QD1 − QD0
elasticity of demand
(average QD) (QD1 + QD0 ) ÷ 2
E= =
(change in P) P1 − P0
(average P) (P1 + P0 ) ÷ 2
Cross-price elasticity (% change in QDx )
Ec =
(% change in Py )
General equation % Change in Dependent Variable
Elasticity =
% Change in Independent Variable
Income elasticity (% change in QD)
EI =
(% change in income)
Point formula for elasticity of % change in QD (QD1 − QD0 ) ÷ QD0
demand E= =
% change in P (P1 − P0 ) ÷ P0
MICROECONOMICS – OTHER:
Average cost (Total Fixed Costs + Total Variable Costs)
Average Total Cost =
Total Number of Units Produced
MACROECONOMICS – PRICE LEVELS AND INFLATION:

CPI (to convert currency) CPI1
$0 x = $1
CPI0
CPI (to find inflation) CPI1 − CPI0
Inflation = ×100
CPI0
GDP Deflator (relation to Nominal GDP Nominal GDP
nominal and real GDP) Real GDP = so GDP Deflator =
GDP Deflator Real GDP
GDP Deflator (to convert Deflator1 GDP1
GDP figures) =
Deflator0 GDP0
MACROECONOMICS – FISCAL POLICY:

Balanced budget multiplier Balanced Budget Multiplier = Spending Multiplier + Tax Multiplier
1 − MPC 1 − MPC MPS
Balanced Budget Multiplier = +( )= = =1
MPS MPS MPS MPS
Marginal propensities MPC + MPS = 1

Money multiplier 1
MM =
RR
Spending multiplier 1 1
Multiplier = =
1 − MPC MPS
Tax multiplier − MPC
Tax multiplier =
MPS
INTERNATIONAL TRADE AND GLOBAL DEVELOPMENT:

Terms of trade index Average Export Price Index
Terms of trade index = ×100
POWER TABLES
FACTORS OF PRODUCTION
Factor What Is It? What Is Its Reward? Examples
Land Natural resources Rent Farmland; oil; water
Labor Human resources Wages Physical or mental activity
Goods used to produced Computers; factory

Capital other goods
Interest
machinery
An intelligent businessman
New or improved ways to invents a new, more
Entrepreneurship produce goods and services
Profits
efficient production process
for microchips
COMPARING ECONOMIC SYSTEMS

Who Owns the Who Makes Who Receives the
Who Makes
Type of Economy Means of Economic Benefits of
Political Decisions?
Production? Decisions? Production?
Individual persons Whoever is willing to
Market Economies and firms
Individuals Individuals
pay the most
The state decides

Indicative If democratic,
The state The state how benefits are
Economies individuals
distributed
The state decides

Command
The state The state Dictators, kings, etc. how benefits are
Economies distributed
Primarily whoever is
Primarily individuals
The state and willing to pay, but the
Mixed Economies individuals
with some state Individuals
state will intervene if
action
necessary
Traditional Traditional bodies Traditional Traditional Traditional

Economies (e.g., the village) authorities authorities allocations
FACTORS WHICH SHIFT SUPPLY

Factor Relationship to Supply
Negative/Inverse:
Cost of Inputs
Increase in costs leads to decrease in supply
Positive/Direct:
Technological Progress Increase in technology (technological development) leads to increase in
supply
Positive/Direct:
Number of Suppliers
Increase in number of suppliers leads to increase in supply
Taxes—Negative/Inverse: Increase in taxes leads to decrease in supply

Regulations—Negative/Inverse: Increase in regulations leads to decrease in
Government Regulations supply
Subsidies—Positive/Direct: Increase in subsidies leads to increase in supply
Negative/Inverse: Expectations of lower prices in the future leads to

Expectations of Changes in Price increase in supply now
Prices of Other Goods Produced Negative/Inverse: Increase in the price of another good leads to decrease in
by the Same Firm supply
FACTORS WHICH SHIFT DEMAND

Factor Relationship to Demand Other Notes
Positive/Direct: Increase in number of demanders
Number of Demanders leads to increase in demand
N/A
Use cross-price elasticity formula

Price of Negative/Inverse: Increase in price of
to determine if two goods are
Complementary Good complementary good leads to decrease in demand
complements
Use cross-price elasticity formula

Price of Substitute Positive/Direct: Increase in price of substitute
to determine if two goods are
Good goods leads to increase in demand
complements
Normal goods—Positive/Direct: Increase in

consumer income leads to increase in demand Use income elasticity formula to
Consumer Income determine if a good is normal or
Inferior goods—Negative/Inverse: Increase in inferior
consumer income leads to decrease in demand
Positive/Direct: Increase in popularity leads to

Tastes or Preferences increase in demand
N/A
Depends on which factor the expectation is related

to
Expectations N/A
Example: Expectations of higher price in the future
lead to increase in demand
SHIFTS IN SUPPLY AND DEMAND
Demand Shifts… Supply Shifts… Effect on Price Effect on Quantity
To the right No shift Increase Increase

To the left No shift Decrease Decrease
No shift To the right Decrease Increase
No shift To the left Increase Decrease
To the right To the right ? Unknown Increase
To the right To the left Increase ? Unknown
To the left To the left ? Unknown Decrease
To the left To the right Decrease ? Unknown
ELASTICITY
Relation to Total Graphical
Number Range Name Other Notes
Revenue (TR) Representation
Increase in price
leads to increase in
E=0 Perfectly inelastic TR; decrease in price Perfectly vertical line Purely theoretical
leads to decrease in
TR
Increase in price are necessities and
leads to increase in goods that have few
E<1 Inelastic TR; decrease in price Steep line available substitutes;
leads to decrease in goods are more
TR inelastic in the short
run
Change in price has Line with a slope of 1
E=1 Unit elastic
no effect on TR or -1
Increase in price
are luxuries and
leads to decrease in
goods that have many
E>1 Elastic TR; decrease in price Flat line
available substitutes;
leads to increase in
goods are more
TR
elastic in the long run
Change in price leads Perfectly horizontal
E=∞ Perfectly elastic
to loss of all TR line
Purely theoretical
COMPARING MARKET TYPES

Type of Number of Kind of Barriers to Another Name Special
Market Producers Competition Entry for Firms Characteristics
Monopoly One None No entry possible Price-setter Only one firm
Perfect No barriers Perfectly elastic

A great many Price competition Price-taker
Competition (free entry) demand
Non-price Product
Monopolistic Low barriers
Many competition; price Price-maker differentiation and
Competition competition
(easy entry)
branding
Primarily non- Medium barriers Kinked demand

Oligopoly A few
price competition (difficult entry)
N/A
curve
CALCULATING GDP
Method Process
Add together all payments for the factors of production and subtract distortions;
National Income Method Wages + Profits + Rents + Interest – Subsidies – Indirect Taxes = GDP
Sum the value-added for all goods and services at each stage of production; “value-
Value-Added Method added” is the price a good or service sells for minus the costs of the
goods/services or resources used to produce it
Add up the value of all finals goods and services in an economy;

Expenditures Approach C + I + G + NX = GDP
TYPES OF UNEMPLOYMENT
Type of Unemployment Definition When It Occurs
Unemployment resulting from the
Frictional time lag between when workers leave Always present in the economy
jobs and when they find new jobs
Unemployment resulting from

Always present in the economy, but
structural changes in the economy;
Structural results from a mismatch of skills
can be reduced by retraining
unemployed workers
demanded and skills supplied
Unemployment resulting from Only occurs with a downturn in the

Cyclical changes in the business cycle business cycle
Occurs when seasons change, but can

Unemployment resulting from
Seasonal seasonal changes
be reduced by retraining unemployed
workers
TAXES
Earmarked or
Type of Tax Direct or Indirect What Is Taxed
Discretionary?
An additional income tax
Capital-Gains Tax Direct
on investment returns
Discretionary
Estate tax Direct Inheritance Discretionary
Income Tax Direct Earned income Discretionary
Payroll Tax Direct Income earned from work Earmarked
Discretionary (although
many states earmark
Property, either at a
Property Tax Direct
constant rate or by value
significant portions of
property taxes for
education)
Transactions, either at a
Sales Tax Indirect
constant rate or by value
Discretionary
A flat usage fee charged for

Usage Tax Direct using certain facilities or Earmarked
services
MONETARY POLICY
How Does It How Often Is This
Policy Tool Who Acts? What Happens?
Work? Tool Utilized?
Injects or removes
Open-Market The Fed buys and
FOMC money from the Daily
Operations sells US securities
economy
Changes the cost of

The Fed changes the borrowing from the
interest rate for loans Fed, which can
Discount Rate Board of Governors
from the Fed to encourage or
Rarely
member banks discourage banks to
take out loans
The Fed changes Changes the cost of

Approximately once
Federal Funds Rate Board of Governors bank-to-bank lending loans between all
per quarter
rates banks
The Fed changes the Changes the amount

Reserve
Board of Governors reserve requirement of reserves banks Very rarely
Requirements for banks must maintain
INTERNATIONAL INSTITUTIONS
Institution Purpose Regional or Global? Are Its Actions Binding?
Provides loans and
expertise; serves as an
IMF international lender of last
Global Binding
resort
Provides loans and

World Bank development assistance
Global Binding
Enforces WTO agreements

among member states and
WTO moderates disputes among
Global Binding
states
Free trade zone in North

NAFTA America
Regional Binding
Political and economic

European Union (EU) union in Europe
Regional Binding
Promotes free trade and

Mercosur common tariffs in Latin Regional Technically binding
America

ASEAN common tariffs in Southeast Regional Technically binding
Asia

ECOWAS common tariffs in west Regional Technically binding
Africa
A forum for discussion for

OECD the world’s richer Potentially global Non-binding
economies
A smaller discussion forum

for the world’s richest
G7/G8 economies (G8 also
Technically global Non-binding
includes Russia)
PRACTICE TEST ANALYSIS

The Practice Test Analysis can be downloaded by coaches only. All the analyses are available
together as the 2007-2008 Practice Test Analysis Power Guide. Ask your coach for a copy.
BIBLIOGRAPHY, ACKNOWLEDGEMENT
REFERENCES:
AmosWeb – GLOSS-arama. AmosWeb*LLC. 11 June 2007 <http://www.amosweb.com/cgi-bin/
awb_nav.pl?s=gls>.
“AS, A2 & IB Economics Revision Notes.” tutor2u. tutor2u. 11 June 2007
<http://www.tutor2u.net/economics/revision-notes/index.html>.
Baumol, William J. and Alan S. Blinder. Economics: Principles and Policy. 9th ed. Texas: South-Western
Educational Publishing, 2004.
Dictionary.Com. Lexico Publishing Group, LLC. <http://www.dictionary.com>.
“Economic Theories & Theorists.” Economy Professor. Arts & Sciences Network. 11 June 2007
<www.economyprofessor.com>Error! Hyperlink reference not valid.
Emery, David E. Principles of Economics. Florida: Harcourt, 1985
“Financial Dictionary.” ANZ. Melbourne, Australia. Australia and New Zealand Banking Group, Ltd. 11
June 2007 <http://www.anz.com/edna/dictionary.asp>.
“Notes for Institutions and Markets—Chapter 2.” Finance Professor.com. FinanceProfessor. 6 June 2007
<http://www.financeprofessor.com/fin322/notes/Chapter2-Determinationofinterestrates.htm>.
Samuelson, Paul A. and William D. Nordhaus. Economics. 18th ed. California: McGraw-Hill/Irwin, 2004.
As editor and reviser, I am deeply indebted to Dr. Aksoy, the wonderful economics teacher who taught
me almost everything I know about this subject. Many of the preceding pages have benefited from the
lecture notes I took during his class. This guide in its present form would not have been possible
without him and the inspiration he imparted to my team and to me. Thank you, Dr. Aksoy, for your
knowledge, patience, humor, and, above all, your wisdom.
Also, many thanks to Kevin Leung for his research, tips, constructive comments, and “incessant” emails.
☺
ABOUT THE AUTHOR

A grizzled veteran (or an out-of-touch has-been,
depending upon your perspective), Joe Slowik
competed for two years as an Honors member of
Whitney Young’s Academic Decathlon team in
1998-1999 and 1999-2000, serving as team captain
his second year.
Following graduation, Joe received a B.A. in

philosophy from Michigan State University, and
then his M.A. in the Humanities from the University
of Chicago.
Presently, when not writing materials for DemiDec

in the wee hours of the morning, Joe works as a
marketing analyst for McMaster-Carr in Elmhurst,
Illinois and is planning on either earning an MBA or
a public policy degree in the near future (or both if
he feels sufficiently ambitious).
Vital Stats:
Competed with Whitney Young High School from Chicago, Illinois, at the national
competitions in Anaheim in 1999 and San Antonio in 2000
Though memory now fails him, Joe vividly recalls scoring well above 8000 at most competitions,
and narrowly missing (by around 20 points or so) becoming the third-highest scorer in the
Honors division in San Antonio
Decathlon philosophy: “Someone, somewhere, is reading through Super Quiz one more time
right now… which means you should be doing the same.”
ABOUT THE AUTHOR/EDITOR

Dean Schaffer is fond of caves, but only those that have
enough light for him to study. He first discovered his affection
for secluded spaces in his junior year of high school when he
joined Taft High School’s Academic Decathlon team. Two years
of grueling hours, tired eyes, and yummy snacks later, he and
his team proudly claimed the national title in San Antonio,
Texas.
Although he still spends much of his time in non-Decathlon-

related caves, Dean makes sure never to neglect his religious
principles—he brings a full outfit of pirate regalia and several
cases of Ramen noodles everywhere so he may properly and
frequently venerate the Flying Spaghetti Monster. 152
Although Dean clings to his Monsterism faith pretty strongly, his prayers for better personal
foresight have, as of yet, gone unanswered. In high school, he thought he would become a rock
star. Last summer, he predicted that his forthcoming career at Stanford University would result
in a major in English and a minor in music. One year later, he thinks his plans will more likely
involve a major in American studies (with an emphasis on American music) and a minor in classical
literature and philosophy. If his track record of accuracy continues, Dean will probably be attending
a completely different school with a major in animal husbandry around this time next year.
All personal misconceptions aside, Dean will start his sophomore year at Stanford in the fall, and he
couldn’t be happier to be at the school DemiDec Dan once called the “Disneyland of Academia.”
Dean started his DemiDec career by authoring the Renaissance Music Power Guide in the 2005-
2006 season. Since the summer of 2006, he has had the privilege of serving as DemiDec’s Power
Guide Coordinator, a somewhat ambiguous position which essentially involves Dean slowly
evolving into a series of nonsensical bullets. Square, square, circle. BOLD!
If you have any questions, comments, or predictions on Dean’s future, please send him an email at
dean@demidec.com. He’ll probably read it, but his response will most likely be in bullet form.
Vital Stats:
Competed with Taft High School at the LA regional and California state competitions in
2005; competed at the LA, California, and national competitions in 2006
In 2005, team placed first at regionals and fifth at state with individual scores of 8792 and 8887,
respectively
In 2006, team placed first at regionals, state, and nationals with individual scores of 9121, 8903,
and 8962, respectively
Decathlon philosophy in a phrase: “Get back to work!”
Joined DemiDec in April 2005
152
Visit www.venganza.org if you’re confused.

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© 2007 DEMIDEC RESOURCES

WHAT IS A POWER GUIDE?

AUTHOR’S NOTE ON USAGE

-Dean and Joseph

Civil War Fundamentals

FUNDAMENTAL ECONOMIC CONCEPTS

Scarcity and Wants

The four assumptions of economics 7

Producers must decide to make certain goods over others

The PPF in action: guns and butter

Sunk costs are costs incurred in the past

Since he’s very hungry, the first slice tastes great

Shortages will be discussed in more detail with price ceilings later

Resources are allocated to those activities that society values most

COMPARING ECONOMIC SYSTEMS 28

The state decides

The state decides

Traditional Traditional bodies Traditional Traditional

Incentives and Individual Decision-Making

Exchange and Markets

There are no restrictions placed upon exchanges

Specialization, Interdependence, and Trade

Miscellaneous Basic Economic Concepts35

Ceteris paribus is Latin for “all other things constant” or “equal”

Other times, managers embezzle from their own company

Bonds are rated in safety from AAA to DDD

Supply and Demand 40

Higher prices allow for higher profits at higher levels of production

Supply Schedule for William’s Widgets

Supply is represented visually by the supply curve

The Supply Curve

Several factors can cause a shift in the supply curve

If the price of hotdogs decreases, Hannah will concentrate more on hamburgers

Quantity Supplied Quantity Supplied

Demand Schedule for William’s Widgets

Demand can be represented visually by the demand curve

Quantity Demanded Quantity Demanded

The demand for a good can be either elastic or inelastic

The following equation is called the “arc” or “midpoint" formula

Quantity Demanded Quantity Demanded

Inelastic Unit Elastic Elastic

Price Price Price

Quantity Demanded Quantity Demanded Quantity Demanded

Applies to goods that

Applies to goods that

Change in price leads to Perfectly horizontal

The Consumption Decisions of the Individual

Ian’s Indifference Curves

The result is a downward-sloping line which reveals the different combinations of

Good A Indifference curve

Indifference curves have extreme variants for certain types of goods

The Production Decisions of the Firm

(Total Fixed Costs + Total Variable Costs)

He knows that his average in the class is currently 90%

Price competition is when firms compete based on price alone

Monopoly Oligopoly Monopolistic Competition Perfect Competition

Less competitive More competitive

Examples include patents, copyrights, and similar property protections, all of

An example is the government’s exclusive contract with Halliburton to rebuild Iraq 57

Essentially, monopolistic firms use advertising and marketing to gain market

The Kinked Demand Curve

Non-collusive, unorganized oligopolies face a “kinked” demand curve (see graph