PRINCIPLES OF ECONOMICS
Kunsoo Paul Choi, PhD
A primary emphasis in the study of economics is decision making with limited available resources, including time, money, and information. Individuals, households, firms, and governments make various decisions in everyday life. They want to make the best decisions to maximize their satisfaction (or happiness). Let’s suppose you have $200 (limited available resource) to spend (economic activity). You may buy a book or books that you want to read; you may dine out with your family; you may go to baseball game with your brothers; or you may play golf with your friends. Which decision that you make will give you the best satisfaction?
You will be introduced to various fields or areas of economics, different schools of economic thought over time, and important economic concepts that include scarcity, opportunity cost, demand and supply, price determination in a market, different market structures, gross domestic product, unemployment and inflation, macroeconomic policies, and globalization and issues in the global economy.
1. Scope
Economics is the study of an economy. The word “economy” is a compound word of house (or household) and management (or law). So, the etymological meaning of an economy is management of a household. A smaller unit of a household is an individual’s household, and a larger unit of a household is a country. Economics is a field of social sciences and covers various fields that include microeconomics and applied microeconomics, macroeconomics and applied macroeconomics, global economics, and econometrics.
1.1. Microeconomics and Applied Microeconomics
Microeconomics (Greek μικρός, micros, small) is the study of decision making by individuals (or households) and by firms to maximize their satisfaction (or happiness) for individuals and their profit for firms. Microeconomics deals with consumer behavior and producer behavior, demand and supply, price and output/quantity determination in a market where buyers and sellers gather, and market structures which consist of perfect competition, monopolistic competition, oligopoly, and monopoly. When your monthly budget is $3,000, how do you want to assign your money to different areas of spending such as food, clothes, car and health insurance, transportation, and leisure to be most satisfied? This is an example of decision making as a consumer. When you open a small local pizza store with $200,000, how many (full-time and part-time) employees do you want to hire and how many pizzas per day are you going to produce to maximize profit? This is an example of decision making as a producer.
Applied microeconomics involves the use of microeconomic tools such as individual decision making as a buyer/consumer or a producer/seller, an individual demand and supply in various markets, industries, or areas. Those markets, industries, or areas and issues include the labor market, financial markets, the health care market or industry, issues in urban areas, and environmental or ecological issues. Thus, applied microeconomics is more advanced and specific study of various microeconomic areas or topics.
Labor economics examines the labor market, the labor demand and supply, the employers-employees relationship, determination of wages and employment including union-management bargaining.
Industrial organization studies different markets and industries, market interactions of consumers/buyers and firms/sellers, market power and its sources, firms’ pricing strategies, regulatory policy for industries, and antitrust issues.
Urban economics deals with market forces in the development of cities, urban land use and housing, local government and its finance, and general urban issues such as education, crime, and transportation.
Heath economics studies demand for and supply of health care services and insurance, a market structure in the health care sector, health innovation, and the government’s health policy.
Environmental economics is the study of environmental and ecological issues such as externalities, greenhouse gas, global warming, pollution/emissions, and environmental policies or regulations that include command and control, and cap and trade.
Managerial economics is the study of contemporary business problems and managerial decision making that includes price and production decision-making for profit maximization, investment decision-making for a new project, strategic decision-making in various business situations, and decision-making with risks and uncertainty.
Behavioral economics is the study of individuals’ decision-making behavior based on not only economic aspects but also psychological aspects. Traditional economics assumes that individuals are rational, however, behavioral economics sees that individuals may not be rational, and their decisions/choices are not always made based on human rationality but on psychological factors.
1.2. Macroeconomics and Applied Macroeconomics
Macroeconomics (Greek μακρός, macros-, big) is the study of decision making by a country as a whole to improve the economic conditions for its residents. Macroeconomics deals with gross domestic product (GDP), aggregate demand (AD) and aggregate supply (AS), macroeconomic issues including unemployment and inflation, the federal government’s fiscal policy and the Federal Reserve’s monetary policy. A primary goal or intention of macroeconomic decision making is for the people in a country to be better off, although it may be abused or misused by politicians or a political party. Macroeconomic policy makers aim to attain long-term economic goals with stable economic growth, stabilization of the price level and maximum employment or low unemployment, whereas politicians look for short-term economic performance with high growth of GDP and/or economic expansion for their voters to be reelected. When the economy suffers from high inflation, the Federal Reserve’s policy makers want to lower the inflation rate by raising the interest rate by 0.5-1.0% or more, although it may negatively affect the unemployment rate and GDP for the long-run stable and robust economic growth. However, some politicians may oppose the Federal Reserve’s policy makers’ decision as it may negatively affect their voters’ economic conditions in the short run.
Applied macroeconomics includes money and banking, financial economics, business cycles and economic growth, and economic development. Like applied microeconomics, applied macroeconomics is more advanced and specific study of various macroeconomic areas or topics.
Money and banking economics is the study of the function of financial institutions and financial markets, the roles of the Federal Reserve System, commercial banks and other financial intermediaries, and the effect of the markets for financial assets have in raising funds and determining security prices.
Financial economics deals with both microeconomic aspects and macroeconomic aspects. Its topics include the economic behavior of households and firms in the world of finance and the kinds of financial decisions they make, household saving and investment decisions, risk and risk-management decisions, the capital asset pricing model and alternative models, financial structure of a firm, and financial institutions and the conduct of monetary policy.
Business cycles and economic growth economics is the study of economic fluctuations and their impact on consumers and firms, different explanations for business cycles, monetary and fiscal policy for stabilizing economic fluctuations, and effects of public/national debt, investment, employment, and trade policy on economic growth.
Economic development is the study of macroeconomic issues/problems of developing countries, including economic growth and development, poverty and inequality, other domestic and global issues that are related to economic development, and various paradigms and theories of economic development.
1.3. Global Economics
Global economics is the study of the global environment of firms with particular emphasis on economic variables such as GDP, inflation, interest rates, and exchange rates. Topics in global economics include international trade, international finance, regional issues in the global economy, and governments’ macroeconomic issues in the context of the global economy. When we consider only the domestic macroeconomic data and output, excluding exports and imports, the economy we examine is called the closed economy; when we include international trade – exports and imports – and other economic activities in our study, the economy is called the open economy. Global economics, separate from macroeconomics, has been gaining its importance as countries have been more interdependent to each other, and thus one country’s economic issue or problem does not stay within the country anymore but impact other countries’ economies.
1.4. Econometrics
Econometrics is the study of probability distribution, estimation and hypothesis testing, single and multiple regression analysis, and forecasting analysis, using time series data, cross-section data, and/or panel data, which is the combination of time series data and cross-section data. An example of time series data is the U.S. unemployment rate during 1970-2020. An example of cross-section data is earnings of different races such as White Americans, Black Americans, Hispanic Americans, and Asian Americans, or earnings of different sexes. An example of panel data is earnings of different races during 1980-2020 or the unemployment rates of different races during 1980-2020. Panel data may be obtained from the Current Population Survey (CPS), a monthly survey sponsored by the Bureau of Labor Statistics and conducted by the U.S. Census Bureau or some other sources.[1]
From the very beginning of the human history, there were economic activities. People made decisions to manage their limited resources for themselves, their households, and their businesses. Prior to the beginning of modern economics in the eighteenth century, the dominant form of economic system or practice was referred to as mercantilism. In mercantilism the government encouraged exports but discouraged imports using tariffs to collect or purchase more gold for the nation or the government to be more powerful. The basic idea of mercantilism was that a nation’s wealth and power would be granted by accumulation of gold or silver.
Along with the Industrial Revolution that emerged in the early eighteenth century, modern economics was initiated by Adam Smith (1723-1790) and his well-known book, the Wealth of Nations (1776). Smith advocated free markets where price and quantity are determined, and free trade and its gains, unlike mercantilism’s protectionism with the emphasis of exports. According to Smith, the value (that is, the price) of a good is determined by the amount of labor that is spent for its production (the labor theory of value). Jean-Baptiste Say (1767-1832), a French economist, emphasized the supply (or production) side in the economy; his view was simplified and interpreted by John Maynard Keynes in his book, The General Theory, Interest and Money (1936) as, “Supply creates its own demand,” meaning that all the goods that are produced will be demanded or consumed. According to this theory, the economy is almost always at full employment. Keynes, a founder of Keynesianism, emphasized the demand (or consumption) side in the economy. The expression, coined by Keynes, is now widely known as Say’s Law, although Say himself never wrote it down.
Early classical economists were mainly concerned with areas of microeconomics such as markets and/or industries. Classical economists assumed that a market is free and competitive, the price and the quantity/output of a good are determined in the market, without any government intervention, by so-called “the invisible hand.” The economic system of classical economics is capitalism and is based on the market economy. In capitalism, private ownership or property right is granted. The role of government is minimal.
2.2. Marxian Economics
Karl Marx (1818-1883) in his well-known book, Das Kapital (Capital: A Critique of Political Economy, Volume 1 in 1867, Volume 2 in 1885 and Volume 3 in 1894[2]), criticized classical economists’ capitalism. Marx claimed that in capitalism workers (the proletariat) cannot get their full value of labor, unlike Adam Smith’s labor theory of value, as the worker’s labor is exploited by employers, capitalists (the bourgeoisie). Employers take surplus value, the unpaid portion of labor. According to Marx, price and quantity should be determined not by the market but by the central authority, the government that controls all economic activities of its people, including markets. His economic system is socialism based on the command economy or the centrally planned economy. In socialism, all property is owned by the central authority. However, his ultimate economic system is communism, the highest level of socialism. In Marxian economics, communism or the communist system is an economic system in which there is neither state nor class, which emphasizes common ownership. All property is owned by all farmers and workers. However, common ownership means that no one owns anything individually. Opponents of socialism and communism criticized that workers under these systems may not have incentives to work hard as there is no private ownership or property right granted.
2.3. Austrian School of Economics/Marginalism
The Austrian school of economics was initiated by Carl Menger (1840-1921). Austrian economists emphasized subjective motivation and valuation, the importance of utility – satisfaction or happiness – and marginal utility to consumers. Carl Menger, William Stanley Jevons (1835-1882), a British economist, and Leon Walras (1834-1910), a French economist, who are called marginal revolutionists (marginalism), independently proposed that the value or the price of a good or a service is not based on the amount of labor spent for its production (Adam Smith’s and other classical economists’ value theory of labor) but is based on marginal utility, an incremental satisfaction or happiness, that is, how much consumers are satisfied with additional or incremental spending of the good or the service. Marginal utility is a consumer’s subjective valuation of the good based on his/her satisfaction on incremental spending or purchasing of the good (the marginal utility theory or the subjective theory of value). Marginal utility attained its importance as it became a fundamental concept to explain consumer behavior in the market, and the value determination of different items. It could also resolve the paradox of water-diamond, which Adam Smith proposed but failed to explain with his value theory of labor. We will examine this paradox further in depth below in Section 4.6.
In the twentieth century, Austrian school economists spread to other countries, Ludwig von Mises (1881-1973) to the United States and Friedrich A. Hayek (1899-1992) to the United Kingdom. Mises extended Carl Menger’s marginal utility theory to money, stating that money is valuable or useful for its marginal utility as a medium of exchange. Like classical economists, Hayek advocated free markets where people – buyers and sellers – collect and use information or data about a good or a service.
2.4. Keynesian Economics
A British economist John Maynard Keynes (1883-1946) was the founder of Keynesian economics with his famous book, The General Theory of Employment, Interest and Money (1936). While classical economists focused more on microeconomic aspects, including markets, Keynesians were concerned more about macroeconomic aspects, including macroeconomic issues such as unemployment and inflation, and government policies. Unlike classical economists, Keynesians claimed that prices and wages are inflexible or rigid and that the economy is usually less than full employment. They did not think that the economy has a self-regulating or self-correcting ability. When the economy is in a difficulty situation such as a recession, Keynesians claimed that the government should actively intervene in the economy to make the economy return to (close to) full employment. Such a government intervention in the economy by increasing government spending or lowering taxes is called fiscal policy. In this situation, the Federal Reserve, the central bank in the United States and a politically independent institution from the federal government, may also intervene in the economy by increasing money supply or lowering interest rates to make the economy return to (close to) full employment, which is called monetary policy. Keynesians preferred any (fiscal or monetary) policy to no policy. Keynesians’ main concern is the short run, as Keynes stated, “In the long run we are all dead.”[3]
2.5. Monetarism
Monetarism was initiated by Milton Friedman (1912-2006). Monetarists, like classical economists, believed that the economy is inherently stable and thus limited government intervention in markets is preferred. Monetarists, unlike classical economists, stated that the economy may not be always at full employment in the short run. They claimed that monetary policy is effective in the short run as it may make the economy, which deviated from full employment due to an economic difficulty or a recession, return to full employment. But in the long run, monetarists stated that as the economy is at full employment, expansionary monetary policy ends up with an increase in the general price level or inflation without changing the level of full employment. The short run is a period during which prices and wages are relatively inflexible or rigid (Keynesians’ emphasis), whereas the long run is a period during which prices and wages are flexible (classical economists’ emphasis).
Monetarists warned against the abuse of monetary policy as it may cause high inflation. Monetarism gained its reputation during the 1970s, when the U.S. inflation went up to over 12% in 1974 and over 13% in 1979 due to supply shocks caused by the OPEC’s crude oil price hikes. Friedman suggested that a modest and steady increase in the money supply, say, 3% a year, may help attain stable economic growth with a low target inflation rate.
2.6. Supply-Side Economics
Supplied-side economics emerged during the Reagan administration and became known as Reaganomics. Arthur Laffer (1940-) provided a rationale for cutting marginal tax rates and/or corporate tax rates that actually maximizes the government’s tax revenue; the approach is presented in the Laffer curve, depicting the relationship between the tax rate and the government’s tax revenue. As the Laffer curve shows below, when the government lowers the tax rate from the current rate (Tc) to the level at which the government’s tax revenue is maximized (T*), workers have incentives to work more, and firms can produce/supply more goods and services (supply side). However, critics argue that this supply-side theory rarely works in the real world as it is difficult to locate the tax rate (T*) that maximizes the government tax revenue, and the current tax rate is probably already lower than T*, as well.
2.7. Rational Expectations/New-Classical Economics
The rational expectations theory, led by Robert Lucas Jr. (1937-) and Thomas Sargent (1943-), proposed that individuals base their decisions on their rationality, past experiences, information available to them, and their predictions about the effects of present and/or future policy changes. Unlike monetarism which stated that there may be policy effectiveness in the short run but not in the long run, the rational expectations theory claimed, like classical economics, that neither monetary policy nor fiscal policy is effective even in the short run.
Economists use various methods to describe an economic phenomenon, claim or verify their economic theories, test their assumptions or hypotheses, or estimate and forecast economic variables or issues in the future. The methods of economics are various, but we will examine some important methods, including positive economics/analysis versus normative economics/analysis, economic models, and quantitative methods.
3.1. Positive Economics vs Normative Economics
Economists describe or explain various economic situations or issues before they propose some recommendations to policy makers based upon their theories, assumptions, and/or analyses. Positive economics is an analysis limited to objective statements that are verifiable, either descriptive statements or scientific predictions. It describes a fact – what it was, what it is, what it will be – or it is a conditional (If/then) statement: “If A (a conditional clause), then B.” Positive economics can be proven either true or false. A statement, “The current inflation rate is 8.58% as of May 2022,” is an example of positive economics/analysis. Another example of positive economics is “If all other things stay the same, when the price of gas goes up, people’s consumption of gas decreases.”
Normative economics is an analysis based on value judgment about an economic situation or issue. Normative economics or analysis reflects the point of view of the economist doing the analysis. In normative economics, the analysis (or value judgement) of economists will depend on whether they adopt classical economics, Marxism, Keynesianism, monetarism, or other theories as their starting point. Policy makers using the analysis, therefore will tend to adopt the economic theory that fits their policy proposals. Normative economics contains words such as “must,” “should,” “ought to,” “in my opinion,” “I think,” etc. in its statement that reflect a person’s subjective value judgment. A statement, “I think the current inflation rate of 8.58% as of May 2022 is too high and thus, the Federal Reserve should raise the federal funds rate, the benchmark interest rate, to lower it to the 2% target rate,” is an example of normative economics. Depending upon their value judgment regarding the underlying issue(s), economists’ recommendations to resolve the economic issues may be different.
3.2. Economic Models
Economists like to use economic models to conduct their analysis. An economic model is a simplified version of reality used to understand and evaluate the relationships between variables. For example, the demand and supply model is to see how buyers and sellers respond when there is a change in the price of a good in the market, or how the demand curve, which represents buyers’ responsiveness for different prices, shifts when, say, their income goes up. Economists employ a step-by-step procedure of model-building to solve problems by identifying the problem, developing a model, gathering data, and testing whether the data are consistent with the theory. Examples of economic models include the demand and supply in a market, a production possibilities frontier (PPF), aggregate demand (AD) and aggregate supply (AS) in an economy, which are examined below.
One of the most common assumptions economists use in their analysis of economic models is the assumption of ceteris paribus, meaning “all other things remain the same,” thus allowing them to focus on the underlying problem/issue. For example, when economists want to examine the relationship between a change in the price of Coke and a change in consumption (quantity demanded) of Coke, they use this ceteris paribus assumption. That is, they assume all other things – Pepsi’s price and other substitutes’ prices, consumers’ income, etc. remain unchanged – to focus on the relationship between a change in the price of Coke and a change in its consumption (quantity demanded). Even when economists do not explicitly mention this ceteris paribus assumption in their analysis of economic models, they usually implicitly assume that “all other things stay the same.”
3.3. Quantitative Methods
Economists like to analyze economic situations and/or forecast what is going to happen in the short run and/or in the long run. They collect data – time series data, cross-section data, or panel data, which is a combination of time-series data and cross-section data – and select variables to form an equation or group of equations. They conduct hypothesis testing to analyze and interpret a certain economic situation. They forecast what will happen to the economy one year later, or two or more years later. For example, with the past and current data of the U.S. unemployment rate, economists want to estimate how the U.S. unemployment rate will be one year later. Business owners want to predict how much their business will be growing in two years, using their past five-years business data.
4. Microeconomics
4.1. Economic Foundations
This section introduces some basic economic principles, ideas, or concepts which help readers better understand economic theories and models, consumer behavior and producer behavior in the market. Economists assume that people are rational, people respond to incentives, and people’s decision is made at the margin, with given limited resources. As people are rational, when the price of gas goes up, they try to reduce driving time. When people decide to buy a new car, they want to compare prices and financing conditions of different car dealerships. When there is a $3,000 cash rebate with 0% financing from one car dealership, they may decide to buy the car from this dealership due to the incentives of the $3,000 cash rebate and 0% financing. When people make a decision, they compare marginal (that is, incremental or additional) benefit and marginal cost of an activity or an item. Their decision is made when marginal benefit and marginal cost are equal.
Scarcity means that we do not have sufficient resources, including time and money, to satisfy our every desire. Scarcity is a problem of everyone – not only poor people but also the richest people. When Elon Musk, the CEO of Tesla, wanted to buy Twitter, he encountered a scarcity issue of money. He had to sell a significant amount of his Tesla stock and raised or borrowed funds from some other people. Scarcity is a fundamental economic problem in a world with limited resources and thus is a starting point of the study of economics. Resources are limited whereas human wants are unlimited. As resources are scarce, a society or economy tries to make best use of all available resources and economic decision makers try to overcome resource scarcity. Because of scarcity, people need to make choices among different options. Economics is the study of how people - a household, a firm, a government, etc. – make various choices or decisions using limited resources to satisfy unlimited wants. The problem of scarcity and choice are basic economic problems faced by every society. Any economy or society has three fundamental questions to answer: What do we produce? How do we produce? For whom do we produce?
Resources are inputs or factors that are used to produce goods or services. Entrepreneurship organizes resources – land, labor, and capital – to produce goods and services. An individual who organizes the production of a good or service, taking a risk, is called an entrepreneur. Examples of entrepreneurs are numerous, including Sam Walton, Dave Thomas, Bill Gates, Steve Jobs, Jeff Bezos, Mark Zuckerberg, and Elon Musk. Land is any natural resource that is provided by nature to produce goods and services. Labor is the mental and physical capacity of workers to produce goods and services. Capital is a man-made good used to produce other goods and services. Financial capital is the money used to purchase capital. People’s knowledge and skills that are acquired by education and/or training are called human capital.
An opportunity cost is the best alternative that you should sacrifice to choose your best item/activity. When there are more than two options, the opportunity cost is the second best one or the best alternative; other options (that is, the second-best alternative, the third-best alternative, …) that you do not choose are not called an opportunity cost. As a high school graduate, LeBron James had some options to choose – go directly to NBA to play basketball there; go to a college to play basketball and pursue a college degree; or he may do something else, he may travel around the world or do business. LeBron decided to play basketball in the NBA, signing a three-year contract worth almost $13 million, with an option for a fourth year at $5.8 million. If his second- best option or the best alternative was ‘go to college to play basketball in the NCAA and attend college,’ this sacrifice of college education is his opportunity cost to choose to play basketball in NBA. Had he decided to attend college instead, LeBron would have incurred an opportunity cost of at least $18.8 million in forgone income to earn a four-year college degree. The concept of an opportunity cost is very important and widely used in economics - not only in microeconomics but also in macroeconomics, especially in international trade.
Marginal analysis is an examination of additions and subtractions from a current situation. In marginal analysis, you compare the marginal benefit and the marginal cost for decision making. Marginal benefit (MB) is additional or incremental benefit, the benefit connected with consuming an additional unit of a good whereas marginal cost (MC) is additional or incremental cost, the cost connected with consuming an additional unit of a good. When MB is larger than MC, you will continue to increase the item until MB = MC at which the optimal decision is made. For example, when a city authority decides to reduce air pollution, the decision makers may need to find out what percentage of air pollution is the optimum level, considering their budget constraint. If air pollution level is reduced to zero, it will be a very pleasant breathing condition, but it is too costly. As the air pollution level goes down, the MB will increase with a diminishing rate. People feel a significant difference when the air pollution rate goes down from 70% to 60% but may not feel much difference when it goes down from 20% to 10%. On the other hand, as the air pollution level goes down, the MC will increase with an accelerating rate as it needs more advanced technology. So, the optimal decision for air pollution reduction is made where MB = MC, 30% of the level of air pollution in Figure 9.2. When MB is larger than MC, then the city authority will continue to reduce the level of air pollution until MB is equal to MC.
4.2. Production Possibilities Frontier and Opportunity Cost
An economy determines what to produce, how to produce, and for whom to produce goods and services. A production possibilities frontier (PPF) model presents a simplified version of production of a good or a service in the economy with available limited resources such as labor and capital. The PPF model assumes that the economy produces only two goods, utilizing all available resources fully, although the economy produces more than thousands of goods and services in the real world. The PPF is the locus of the attainable and efficient combinations of production of the two goods, say, food and clothes. Assumptions for the PPF model are that resources are fixed; resources are fully employed; and technology is unchanged in the short run. All the points or combinations of two products are maximum output levels with given resources and technology. As Figure 3A shows, the economy may decide to produce only food (150 units per day), or only clothes (100 units per day), or both food and clothes (80 units of food and 80 units of clothes, or 100 units of food and 70 units of clothes). Any combination between food and clothes production is efficient, utilizing all available resources fully. If any production combination point is inside the PPF, Point A in Figure 3A, the economy does not fully utilize all available resources. When the human resource is not fully utilized, the economy experiences inefficiency. That is, there are some people who involuntarily unemployed. The production combination point, which is beyond the PPF, Point U in Figure 3A, is said to be an unattainable point with the current available resources. However, when the economy improves its technology or productivity, and/or when there is an increase in resources in the long run, the PPF can be shifted outward, from PPF1 to PPF2 in Figure 3B, to attain the "currently unattainable" production combination. The outward shift of the PPF is called Economic growth.
The law of increasing opportunity cost is the principle that the opportunity cost increases as production of one output expands. The lack of interchangeability between workers is the cause of increasing opportunity costs and the bowed-out shape of the PPF. The constant opportunity cost is the case when the PPF is a downward-sloped line with perfect interchangeability between workers.
Demand is a curve or a schedule, representing buyers’ choice making behavior in a market. The law of demand is an inverse or a negative relationship between the price of a good and the quantity demanded. That is, when the price of a good goes up, the quantity demanded (or consumption) of the good will decrease, and vice versa. The distinction between a change in quantity demanded and a change in demand is important. A change in quantity demanded, a movement along the demand curve, is caused by its own price change (which is called the law of demand) whereas a change in demand, a shift of the demand curve, is caused by a change in non-price determinants, including a change in the number of buyers, buyers’ income, tastes/preferences, prices of related goods (complementary goods or substitute goods), expected future price, etc. As Figure 4 A shows, when the price of gas goes up from $4 per gallon to $5 per gallon, consumers reduce their consumption of gas from 200 gallons to 150 gallons per day, which is called a decrease in quantity demanded, upward movement along the demand curve. When consumers’ average income goes up, their consumption of gas may increase. Although the gas price went up to $5 per gallon, their consumption increases from 150 gallons per day to 250 gallons per day, which is called an increase in demand, that is, a shift of the demand curve to the right, as we can see in Figure 4B.
Supply is a curve or a schedule, representing sellers’ choice making behavior in a market. The law of supply is a positive relationship between the price of a good and the quantity supplied. The distinction between a change in quantity supplied and a change in supply is also important. A change in quantity supplied, a movement along the supply curve, is caused by its own price change (which is called the law of supply) whereas a change in supply, a shift of the supply curve, is caused by a change in non-price determinants, including a change in the number of sellers, technology, factor prices, taxes or subsidies.
As Figure 5A demonstrates, when the price of gas goes up from $4 per gallon to $5 per gallon, producers want to increase quantity to make more money from 200 gallons to 300 gallons per day, which is called an increase in quantity supplied, upward movement along the supply curve. When more countries can produce crude oil, their consumption of gas may increase. Although the gas price went up to $5 per gallon, the supply curve shifts to the right as Figure 5B illustrates, which is called a change in supply. With the new supply schedule, producers increase the quantity from 300 gallons to 500 gallons per day at the price of $5 per gallon, and from 200 gallons to 350 gallons per day at the price of $4 per gallon.
A market is a place where buyers and sellers interact with each other to buy and sell goods and services. The price and the quantity are determined at the point where the demand curve and the supply curve intersect. At this point, the quantity demanded (Qd) and the quantity supplied (Qs) are the same (Qd = Qs). A shortage is a market situation when the quantity demanded is larger than the quantity supplied (Qd > Qs) whereas a surplus is a market situation when the quantity supplied is larger than the quantity demanded (Qd < Qs).
4.4. Government Price Controls
The government may intervene in the market with a good intention to protect consumers/buyers (price ceiling) or producers/sellers (price floor). A price ceiling is a government-imposed price control that requires the price to be lower than the market equilibrium price, for example, a rent control in a metropolitan area or the price of a prescribed medicine. The rental price for an apartment in Manhattan, New York, is very expensive. Without a price ceiling, to get an average one-bedroom apartment, you need to pay more than $3,000 per month. So, let’s suppose that the New York city government intervenes in the market and sets the monthly rental price at $2,000 for a one-bedroom apartment. When the government sets a price lower than the market price, the quantity of the good demanded exceeds the quantity supplied at the ceiling price. As the quantity demanded is larger than the quantity supplied, there is a shortage of the good and a black market may appear. A black market is a market in which a good is traded at prices above the government-imposed ceiling price. The market with a price ceiling is inefficient as the total surplus or economic surplus, which is the sum of consumer surplus and producer surplus, is smaller than the total surplus in a free, competitive market. Consumer surplus is the difference between the maximum price buyers would be willing to pay and the actual price they pay. Producer surplus is the difference between the lowest price sellers would be willing to charge and the actual price they receive.
A price floor is a government-imposed price control that requires the price to be higher than the market equilibrium price. Examples include the minimum wage in the labor market and farm products price. When the government sets a price higher than the market price, the quantity of the good or factor supplied exceeds the quantity of the good or factor at the floor price. As the quantity supplied is larger than the quantity demanded, there is a surplus of the good or the factor. The market with a price floor is inefficient as the total surplus or economic surplus is smaller than the total surplus in a free, competitive market.
Economists introduced a concept of elasticity to examine how consumers respond to a change in the price of good, a change in their income, and a change in other good’s price, respectively.
The price elasticity of demand (Ep) is consumers’ responsiveness or sensitivity in terms of quantity demanded when there is a change in the price of a good. When the price of gas goes up, people’s consumption of gas (quantity demanded for gas) may not change much as they need gas to commute to work. In this example, the price elasticity of demand for gas is inelastic, and gas is called a necessity. When the price of an iPad goes up, people may not buy it now or buy a cheaper alternative. They (not all people, though) are much sensitive to a change in an iPad price. Then, the price elasticity of demand for an iPad is elastic, and an iPad is called a luxury. In economics, whether a certain good is a necessity or a luxury does not depend on its price but its price elasticity of demand.
The cross elasticity of demand (Exy) is consumers’ responsiveness in terms of quantity demanded of a good when there is a change in the price of another good. When the price of Coke goes up, people’s consumption (demand) of Pepsi may go up, ceteris paribus. In this case, the cross elasticity of demand is positive, and Coke and Pepsi are called substitutes. When the price of coffee goes up, people’s consumption (demand) for coffee mate may go down, ceteris paribus. In this example, the cross elasticity of demand is negative, and coffee and coffee mate are called complements.
The income elasticity of demand (EM) is consumers’ responsiveness in terms of quantity demanded when there is a change in their income. Let’s suppose that your income goes up, and you increase your consumption (quantity demanded) of beef. Then, the income elasticity of demand for beef is positive, and beef is called a normal good. When you reduce consumption (quantity demanded) of chicken although your income goes up, then the income elasticity of demand for chicken is negative. And chicken is called an inferior good.
Utility is the satisfaction (happiness or pleasure), that people get from consuming a good or a service. Total utility is the amount of satisfaction received from all the units of a good or a service consumed. Consumers make one choice over another depending on their marginal utility. Marginal utility is the change in total utility from one additional unit of a good or a service consumed. The concept of marginal utility was also discussed in Section 2.3.
The law of diminishing marginal utility is the principle that the extra satisfaction of a good or service declines as people consume more in a given period. For example, when you eat food at an all-you-can-eat restaurant, the first dish will give you a highest incremental satisfaction (marginal utility) as you were very hungry. The second dish that you take will give some additional satisfaction, but it is smaller than the incremental satisfaction that you get from the first dish. The third dish will obviously give you less additional satisfaction than the subjectively quantified satisfactions that you get from the first dish and the second dish. Total utility is summation of marginal utility that you can obtain from each unit of consumption (eating, buying, watching, etc.). So, although marginal utility is diminishing as you increase consumption of a certain item, total utility will be increasing with a diminishing increasing rate as long as marginal utility is positive. Then, as you experience negative marginal utility, that is, discomfort or displeasure, total utility will start to decrease, as we can see in Figure 7.
The income effect is the change in quantity demanded of a good or service caused by a change in real income (purchasing power). The income effect shows that as prices decline, your real income increases, increasing your buying power, so you buy more units, ceteris paribus. The substitution effect is the change in quantity demanded of a good or service caused by the change in its price relative to substitutes. Suppose the price of potatoes falls and the price of beef remains unchanged; you will buy more potatoes within the given budget, because it is relatively cheaper than beef.
|
The Social Science Mindset: The Paradox of Diamond-Water Why are diamonds much more expensive than water? The paradox of diamond-water or the paradox of value raises a question of how a good’s price is determined. This diamond-water paradox was initially presented by Adam Smith in his book, The Wealth of Nations: “The things which have the greatest value in use have frequently little or no value in exchange; on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarcely anything; scarcely anything can be had in exchange for it. A diamond, on the contrary, has scarcely any use-value; but a very great quantity of other goods may frequently be had in exchange for it.” Adam Smith tries to resolve this paradox, using his labor theory of value. Diamonds are more expensive than water because a larger amount of labor is spent on the production of diamonds than water. However, his explanation was not satisfactory for the question why diamonds are more expensive than water. Some economists try to resolve this diamond-water paradox, using the concept of scarcity. Diamonds are much scarcer than water which can be found almost everywhere in the world. But scarcity itself is not sufficient to explain this paradox as not all scarce items are expensive. Carl Menger and other marginal revolutionists find more persuasive explanation for this paradox, using the concept of marginal utility. Utility is the satisfaction (or happiness) that consumers value subjectively from consumption or purchase of a certain good. Marginal utility is an incremental or additional satisfaction that consumers value subjectively from one more unit of consumption or purchase of the item. Water provides the greater total utility than diamonds as it is plentiful in the world and is consumed by all people, but its marginal utility is much lower than diamonds. The marginal utility of water is very high when you are very thirsty, but then the marginal utility of water drops abruptly once your thirst is satisfied. The marginal utility from each additional unit of the good diminishes as consumption or purchase increases. On the other hand, the marginal utility of diamond stays high (as a matter of fact, your marginal utility from diamonds may not diminish - the more or larger diamond, the more you are satisfied). Money, jewelry, and some valuable paintings are those items whose marginal utility does not go down - the more, the better. Water follows the law of diminishing marginal utility whereas diamonds do not follow it. But what about the marginal utility of water in a desert where you can rarely find an oasis and you have a long way to go, say for 30 more days? Which one between water and diamonds has higher marginal utility, and which one is more expensive in value during the time period of your journey in the desert? |
4.7. Production and Costs
The primary motivation for business decisions is profit maximization. As Figure 8 shows, a firm’s profit maximization can be attained when the difference between total revenue (TR = price x quantity) and total cost (TC = average cost per unit x quantity) is the largest or when marginal revenue (MR = the slope of TR, an additional or incremental revenue when there is an increase in one more unit of a good in production) is equal to marginal cost (MC = the slope of TC, an additional or incremental cost when there is an increase in one more unit of a good in production). In economics, a “marginal” concept is more important than an “average” concept as economic decisions are made at the margin. That is, a firm’s production decision is also made at the margin (MR = MC), where it can maximize profit.
Economic costs include explicit costs and implicit costs whereas accounting costs consist of only explicit costs. Explicit costs are payments to non-owners of a firm for their resources, and implicit costs are the opportunity costs of using resources owned by the firm/owners. When a firm uses its own resources, such as the owner’s labor, land, building, or savings, the firm gives up the opportunity of earning a return on its resources. When you quit your attorney job to start a new business, your annual earnings of $100,000 is an implicit cost. Economic profit is total revenue minus explicit and implicit costs whereas accounting profit is total revenue minus explicit costs. When economic profit is zero, accounting profit is still positive, which is called normal profit. Normal profit is the minimum profit necessary to keep a firm in operation. A firm that earns normal profit earns total revenue that is equal to its total opportunity cost.
A fixed input is any resource for which the quantity cannot change during the period under consideration (i.e., the short run). A variable input is any resource for which the quantity can change during the period under consideration (i.e., the short run). The short run is a period during which there is at least one fixed input whereas the long run is a period during which all inputs are variable.
A production function is the relationship between the maximum amounts of outputs a firm can produce and various quantities of inputs. Marginal product (MP) is the change in total output produced by adding one unit of a variable input, with all other inputs used held constant. The law of diminishing returns is the principle that beyond some point the marginal product decreases as additional units of a variable resources are added to a fixed factor in the short run.
Total cost (TC) is the sum of total fixed cost (TFC) and total variable cost (TVC) at each level of output (TC = TFC + TVC). Examples of fixed costs are regularly paying full-time workers’ salaries, rent or lease costs, machines and other equipment expenses. Examples of variable costs are irregularly paying part-time workers’ hourly wages, office supplies expenses, transaction fees, commissions, and utility fees. Average total cost (ATC) is total cost (TC) divided by the quantity of output produced, also is called per-unit cost. Marginal cost (MC) is the change in total cost when one unit of output is produced.
The long-run average cost (LRAC) is the curve that traces the lowest cost per unit at which a firm can produce any level of output when the firm can build any desired plant size. Economies of scale are a situation in which the LRAC declines as the firm increases output. Constant returns to scale are a situation in which the long-run average cost curve does not change as the firm increases output. Diseconomies of scale are a situation in which the long-run average cost curve rises as the firm increases output due to expansion of production lines, purchase of new machines, or inefficient management and operations.
4.8. Market Structures
Depending upon the number of sellers in a market, market structures are classified as perfect competition, monopolistic competition, oligopoly, and monopoly, depending upon the number of firms, the similarity or difference of the products, the degree of barriers to entry and exit in a market or an industry.
Perfect competition is characterized by many small firms, homogeneous products, very easy or free entry and exit. We can rarely find a good example of perfect competition in the real world, but the agricultural products market may be considered as a close example of perfect competition. Numerous small firms cannot influence the market price and they take the price that is determined in the market (price-takers). Homogeneous (identical or same) products mean that buyers cannot distinguish one from others. When the product is homogeneous, buyers will go to another seller when one seller increases the price. In perfect competition a new firm can freely enter the market and an existing firm exits the market without any barrier. The market price is determined by the demand curve and the supply curve in the market. An individual firm’s demand curve is a horizontal line at the market price (P = MR = AR), which is different from the downward sloped market demand curve. Marginal revenue (MR) is the change in total revenue from the sale of one additional unit of output (ΔTR/ΔQ), where delta (Δ) means “a change.” Average revenue (AR) is total revenue (TR) divided by quantity (Q).
When firms make more than a normal profit (a positive economic profit), new firms enter the market or the industry; as supply increases, a downward pressure is put on prices. When firms make less than a normal profit (negative economic profit), some existing firms leave the market or the industry; as supply decreases, an upward pressure is put on prices. In the short run, a profit-maximizing firm produces the product at MR = MC. As a perfectly competitive firm’s MR is equal to price (MR= P), its profit maximization is expressed as P = MR = MC. In the long run, a perfectly competitive firm’s economic profit goes to zero but still makes a normal profit (or an accounting profit).
Monopolistic competition is characterized by many small sellers, heterogeneous (differentiated) products, and very low barriers to entry and exit. Most markets or industries in the real business world belong to monopolistic competition, including the retail industry and the fast-food industry. As there are many firms, each firm’s influence in the market is small. As monopolistically competitive firms determine their own prices with differentiated products, they are price-setters/makers, like firms in oligopoly and monopoly. There are very low barriers to entry, but entry is not quite as easy as in a perfectly competitive market because monopolistically competitive firms sell differentiated products. Nonprice competition is that a firm competes with other firms using reputation, better quality, better service, location, advertising, etc. other than prices. Product differentiation gives a monopolistically competitive firm some control over its price. For a monopolistically competitive firm whose product is differentiated, advertising may be an effective way to attractive more buyers. A monopolistically competitive firm decides its price and quantity at MR = MC, which is called profit maximization condition. This profit maximization condition is common for all imperfectly competitive firms (P > MR = MC). In the long run, a monopolistically competitive firm’s economic profit, like that of a perfectly competitive firm, goes to zero because of very low barriers to entry but still makes a normal profit.
Oligopoly is characterized by a few large sellers, homogeneous or differentiated products, and very high barriers to entry. Examples of oligopoly include the aluminum industry, the steel industry, the breakfast cereal industry, and the wireless industry. As there are a few large firms with high concentration ratios or market shares, each large firm’s influence in the market is significant. A condition of oligopoly in which an action by one firm may cause a reaction from other firms. Oligopoly firms may produce homogeneous (identical) or heterogeneous (different) products. Homogeneous product industries include the steel and aluminum industries whereas heterogeneous product industries include automobile, breakfast cereals, and cell phone (carriers and production) industries. There are different oligopoly models that explain oligopoly firms’ behavior, including nonprice competition, price leadership, cartel or collusion, and game theory. Like in monopolistic competition, firms in oligopoly compete with other firms using advertising or development of new products. The price leadership model is a pricing strategy in which a dominant firm sets the price and other firms follow. The cartel model presents the firms’ group or collusion behavior in determining their price and/or output. A cartel is illegal in the United States but may be permitted internationally outside of the United States, for example, the Organization of Petroleum Exporting Countries (OPEC).
Monopoly is characterized by a single seller, a single product, and blocked entry to the market. A local single utility company at many towns in the United States is an example of monopoly. There is only one seller in the market with many buyers. There are no close substitutes for the monopolist’s product. Barriers that prevent new firms from entering the market include ownership of a vital material, government-imposed barriers (patents, property rights, licenses), and economies of scale. A natural monopoly is a situation in which the long-run average cost of production declines throughout the entire market, which is called economies of scale.
4.9. Poverty and Income Inequality
Poverty has been a long-discussed issue in human history. Even a developed country like the United States contains a significant portion of its people who live an economically marginal life. Poverty can be determined in absolute terms or relative terms. Poverty in absolute terms is a dollar figure that represents some level of income per year required to purchase some minimum amount of goods and services to meet basic needs. Poverty in relative terms is a level of income that places a person or family in the lowest, say, 20 percent of all persons or families receiving income. The poverty line is the level of income below which a person or a family is considered poor. It is based on the cost of a minimal diet multiplied by three because low-income families spend about one-third income on food. According to the Office of the Assistant Secretary for Planning and Evaluation (ASPE), the 2021 poverty guidelines are $12,880 for one person, $17,420 for two persons, $21,960 for three persons, and $26,500 for four persons in family/household.[4] According to the U.S. Census Bureau, as of 2020, 37.2 million people are in poverty and the poverty rate is 11.4% of the U.S. population, as Figure 9.9 shows.
The government provides numerous programs to reduce the poverty rate such as cash assistance and in-kind transfers programs. Cash assistance or transfer programs include Social Security (OASDHI), earned income tax credit (EITC), unemployment compensation, etc. In-kind transfers are government payments in the form of goods and services that include Medicare, Medicaid, Supplemental Nutrition Assistant Program (SNAP), Special Supplemental Nutrition Program for women, infants and children (WIC), and housing assistance.
Income inequality exists in every society or country due to the differences in education, gender, race, region, and/or other factors. Income inequality may impact a society in several different areas, including the economy, education, crime and other environments, and health and life expectancy, etc. Income inequality caused by race and/or gender difference, although the workers have similar levels of education and skills, may be called discrimination in earnings against female workers and/or colored workers.
The Lorenz curve in Figure 10 shows the unequal distribution of households’ income. The Gini coefficient or index, a measure of inequality of income distribution, using the Lorenz curve, ranges from 0 (perfect equality, meaning everyone receives an equal share), to 1 (perfect inequality, meaning only one recipient or group of recipients receives all the income). According to the Organization for Economic Co-operation and Development (OECD) report, income inequality has been increasing in most OECD countries during the past 30 years (OECD, 2014).[5] The Gini coefficient was 0.29 in OECD countries in the middle of 1980s but went up to 0.32 in 2011/2012 (OECD, 2014). The Gini coefficient for the United States was 0.403 in 1980 and 0.468 in 2011, which were higher than the other OECD countries. In 2020, the top 5% of all income earners (over $274,000) made 23% of all income received, and the top quintile (20%) of income earners (over $141,0000) made 52.2% of all income received.[6]
Unlike microeconomics which is more interested in an individual’s decision-making behavior as a consumer/buyer or as a producer/seller in the market to attain maximum satisfaction or happiness with the given resources and budget constraints, macroeconomics pays more attention to a country’s economy and issues such as unemployment and inflation, and policies to resolve those issues, for its people to be better off. Topics in macroeconomics include gross domestic product, unemployment and inflation, functions of money and the banking system, and the federal government’s fiscal policy and the Federal Reserve’s monetary policy.
5.1. Gross Domestic Product (GDP)
Economists seek to evaluate the health of the country’s economy by reviewing its people’s quantity of life and their quality of life and by checking economic issues such as the unemployment rate and the inflation rate. The quantity of life refers to economic growth that is measured by gross domestic product (GDP) or GDP per capita. The quality of life refers to economic welfare, which cannot be measured by GDP, a country’s quantified economic activity. Examples of economic welfare include health and life expectancy, people’s level of education, crime rates, level of pollution, and leisure and happiness. When the country’s economy is healthy, its people will be satisfied with their quality of life as well as their quantity of life, maintaining a low unemployment rate and a low inflation rate.
Gross domestic product (GDP) is defined as the value of final goods and services that are produced within a country’s territory during a certain period, usually a year. GDP was designed to measure economic growth (the quantity of life) but not economic welfare (the quality of life). GDP does not include intermediate goods and services, second-hand transactions, financial transactions, miscellaneous household activities.
GDP can be measured using the expenditure approach and the income approach. According to the expenditure approach, which is the official measure of GDP in the United States by the Bureau of Economic Analysis, GDP is the sum of consumption expenditures (C) + investment expenditures (I) + government expenditures (G) + net exports (NX), where net exports are exports (X) minus imports (M). According to the income approach, GDP is the sum of wages/salaries income + rent income + profit income + interest income + indirect taxes + depreciation.
As GDP does not properly measure economic welfare, some economists suggested alternative measures such as the Genuine Progress Indicator (GPI), the Measure of Economic Welfare (MEW), Gross National Happiness (GNH).
A business cycle is fluctuations of real GDP over time and consists of four phases – expansion (including recovery at the beginning), peak, contraction/recession, and trough. An expansion is the (uphill) phase of the business cycle during which real GDP increases after the trough phase, and the beginning of the expansion phase is called a recovery. A peak is the phase when real GDP reaches its maximum after the expansion phase. A contraction or a recession is the (downhill) phase during which real GDP declines after the peak phase. A recession in macroeconomics is a decline in country’s real GDP for two consecutive quarters. A depression is a severe or long-lasting recession. A trough is the phase when real GDP reaches its minimum/bottom after the contraction/recession phase.
5.2. Aggregate Demand and Aggregate Supply
An individual’s consumption schedule at different prices in the market is expressed as (an individual’s) demand. When we add all consumers’ consumption schedules at different prices in the market, it is called market demand. In the same manner, when we add all different sectors’ demand or spending in various markets, we can obtain aggregate demand in the nation’s economy. Aggregate demand (AD) is the quantity demanded of all goods and services at different price levels by households (consumption), firms (investment), governments (government spending), and the foreign sector (exports – imports), ceteris paribus. Thus, like GDP according to the expenditure approach, the quantity for aggregate demand is the sum of the real consumption expenditures (C), investment (I), government expenditures on goods and services (G), and exports (X) minus imports (M): Y = C + I + G + NX. As in the case of an individual demand curve, a movement along the AD curve is caused by a change in the price level. When the price level goes down, the quantity of real GDP demanded increases and thus the AD curve is downward sloped. The price level refers to the price index such as the consumer price index (CPI) or the personal consumption expenditures price index (PCEPI). Shifts of the AD curve is caused by non-price determinants, including monetary policy (changes in the money supply or interest rates) and/or fiscal policy (changes in government spending and/or taxes); expectations about the future; and the state of the world economy.
A producer’s supply or production schedule at different prices in the market is expressed as (a producer’s) supply. When we add all producers’ supply or production schedules at different prices in the market, it is called market supply. In the same manner, when we add all different sectors’ supply or production in various markets, we can obtain aggregate supply in the nation’s economy. Aggregate supply (AS) is the relationship between the quantity of real GDP supplied and the price level, ceteris paribus. Classical economists claimed that the economy is almost always at full employment, and that prices and wages are flexible. So, their AS curve is vertical at full employment with price flexibility. On the other hand, Keynesian economists asserted that the economy is rarely at full employment, and that prices and wages are inflexible or rigid due to multi-year (three to four year) contracts. So, Keynesian AS curve is horizontal, showing price inflexibility. Economists tried to make a consensus between classical economists and Keynesian economists, stating that when the economy is away from full employment or potential GDP, the AS curve is closer to horizontal; when the economy is at full employment or potential GDP, the AS curve is vertical; and when the economy approaches to full employment or potential GDP, the AS curve is upward sloping, as Figure 12 illustrates. They state further that the AS curve is flatter or upward sloping in the short run, which is called the short-run aggregate supply (SRAS) curve, but that the AS curve is vertical in the long run, which is called the long-run aggregate supply (LRAS) curve.
A movement along the SRAS curve is caused by a change in the price level (in terms of CPI or PCEPI). Shifts of the SRAS curve are caused by non-price determinants such as workers and firms’ expectation of rising costs or the price level, changes in the labor force, capital stock, or productivity/technology, the expected price change of an important natural resource (such as crude oil price).
Short run is a period during which people do not have sufficient information and thus cannot adjust themselves fully to any change in the federal government or the Fed’s policy change, or the price change. In the short run, prices and wages are inflexible, as Keynesian economists claimed. Long run is a period during which people have sufficient/full information and thus can adjust themselves fully to any change in the federal government or the Fed’s policy, or the price change. In the long run, prices and wages are flexible, as classical economists claimed.
5.3. Unemployment and Inflation
Unemployment and inflation are the two most important macroeconomic issues for the federal government and the Federal Reserve System aim to maintain at low target rates.
Unemployment is the total number of adults (aged 16 years or older) who are willing and able to work and who are actively looking for work but have not found a job. Part-time workers who only work, say, five hours a week are considered employed. People in the labor force are working-age individuals aged 16 years or older who either have jobs (employed) or who are looking and available for jobs (unemployed). Marginally attached workers are people who do not have a job, are available and willing to work, have not made specific efforts to find a job within the previous four weeks, but have looked for work sometime in the recent past. Discouraged workers are marginally attached workers who have not made specific efforts to find a job within the previous four weeks because they were discouraged from previous unsuccessful attempts.
There are typically three different types of unemployment – frictional unemployment, structural unemployment, and cyclical unemployment. Frictional unemployment is unemployment that arises from normal labor turnover from people entering and leaving the labor force and from the ongoing creation and destruction of jobs. Structural unemployment is unemployment that arises when changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs. And cyclical unemployment is unemployment over the business cycle that increases during a recession and decreases during an expansion. The natural rate of unemployment, usually around 4-4.5%, which is allowable unemployment at full employment or potential GDP, consists of frictional unemployment and structural unemployment. That is, full employment does not mean that the unemployment rate is zero, but there are some people who are temporarily unemployed even at full employment to transit from one job to another job, or from one industry to another industry. The natural rate of unemployment, which is equivalent to potential GDP or full employment, is a concept developed by Milton Friedman and Edmund Phelps in the 1960s. The natural rate of unemployment may vary over time.
Inflation is an increase in the general price level of goods and services in the economy. You see that the gas price went up from $4,49 per gallon to $4.99 per gallon, your favorite beef price from $8.99 per pound to $10.99 per pound, along with the increases in other goods’ prices. When there is inflation, the purchasing power of money will decline. Disinflation is a decline in the inflation rate but still positive. During a disinflation period, the inflation rate continuously goes down, for example, from 9%, to 7.5%, 6.2%, 4.3%, and then to 2.5%. Deflation is a decrease in the general price level of goods and services. You may observe deflation during a recession or an economic difficulty, which is usually caused by a significant decrease in people’s consumption or investment. A recent deflation example in the United States can be found during March-October 2009 of the financial crisis when the inflation rate was -0.38% in March, -0.74% in April, -1.28% in May, -1.43% in June, -2.10% in July, -1.48% in August, -1.29% in September, and -0.18% in October (inflationdata.com).
To measure inflation, some price indexes are used such as the consumer price index (CPI), the GDP chain price index or GDP deflator, the personal consumption expenditure price index (PCEPI). The CPI measures changes in the average prices of consumer goods and services purchased by the typical urban family of four, reported monthly by the Bureau of Labor Statistics (BLS). The GDP price chain index or GDP deflator is calculated as nominal GDP divided by real GDP times 100, reported quarterly, along with GDP, by the Bureau of Economic Analysis (BEA). The PCEPI measures changes in the average prices across all categories within personal consumption expenditures, which is preferred by the Federal Reserve (Fed) in measuring the inflation rate. An annual inflation rate is calculated using one of these price indexes.
The two types
of inflation are demand-pull inflation and cost-push inflation. Demand-pull
inflation is an increase in the general price level as the AD curve shifts
to the right. When there is demand-pull inflation, GDP will increase, and
unemployment will decrease. Cost-push inflation is an increase in the
general price level as the AS curve shifts to the left. When there is cost-push
inflation, GDP will decrease, and unemployment will increase.
|
The Social Science Mindset: Inflation and Government Policy The high inflation during 2021-2022 was caused not only by too much supply of money by the Federal Reserve and three-time stimulus packages by the federal government due to COVID-19 during 2020-2021 (the demand side) but also by the supply-chain issues, the labor shortage in the labor market, the crude-oil price hike to over $100 per barrel, and Russia’s invasion of Ukraine (the supply-side). That is, the recent high inflation is a complicated combination of demand-pull inflation and cost-push inflation. How should the Federal Reserve and/or the federal government respond to high inflation? Classical economists, believing the economy’s self-correcting ability, will advise that the government should not implement any policy but wait. Then, the economy will return to full employment or potential GDP eventually. Keynesians think that contractionary fiscal policy (and monetary policy although it is less effective) will bring down the high inflation rate. Keynesians will propose that the federal government should implement contractionary fiscal policy by raising taxes and/or cutting government spending to decrease aggregate demand (AD) or shift the AD curve to the left. The Fed may implement contractionary monetary policy by reducing the money supply which causes the interest rate to rise. However, Keynesians prefer fiscal policy to monetary policy, believing that monetary policy is less effective or ineffective. Monetarists find the cause of inflation from “too much money chasing too few goods.” Monetarists will recommend that the Fed should reduce the money supply to reduce the inflation rate. The unemployment rate may go up in the short run when the Fed reduces the money supply, but the economy will return to the natural rate of unemployment or full employment as the economy automatically self-corrects. Once the inflation rate goes down to the target rate (around 2%), monetarist will recommend the Fed should maintain a moderate fixed money supply growth rate to stabilize the price level. Supply-side economists see the cause of inflation as a shortage of goods supplied. They will propose that the government should increase aggregate supply (AS) or make the AS curve shift to the right by cutting marginal tax rates and reducing government regulations. If the AS curve shifts to the right, both the inflation rate and the unemployment rate go down. New-classical economists or rational expectations economists may advise, like classical economists, that the government should wait without taking any action, believing the economy’s self-correcting ability (policy ineffectiveness). They state that people act on their expectations of predictable contractionary fiscal and monetary policies. Flexible prices and wages adjust immediately to restore the economy to full employment or potential GDP. Which school of economic thought do you think will resolve the recent high inflation issue? |
5.4. Fiscal Policy
Fiscal policy is implemented by the federal government, which consists of Congress and the office of the U.S. president, using government spending and/or taxes. There are two different kinds of fiscal policy. Discretionary fiscal policy requires a bill (to increase/decrease government spending and/or raise/lower taxes) to be passed in Congress and be signed by the U.S. president; on the other hand, non-discretionary fiscal policy or automatic stabilizers do not require Congressional approval once the law is made. Discretionary fiscal policy uses changes in government spending and/or taxes to shift the AD curve to stabilize the economy, whose bill is discussed and passed in Congress and is signed by the president. Expansionary fiscal policy is implemented to fight a recession by increasing government spending and/or cutting taxes. Contractionary or tightening fiscal policy is implemented to fight inflation by decreasing government spending and/or raising taxes. Automatic stabilizers are mechanisms that change government spending or taxes, without any vote in Congress, including transfer payments, unemployment compensation, and the federal progressive income tax system. The federal government’s stimulus packages and relief funds during the 2008-2009 financial crisis and the 2020-2021 COVID-19 economy are good examples of (expansionary) fiscal policy. By doing so, the government expected that people’s consumption would increase, which would result in an increase in GDP and employment.
5.5. Money, Interest, and the Banking System
Money is any commodity or token that is generally accepted as a means of payment. Money can be divided up into small parts (divisibility). Money has three primary functions – a medium of exchange, a unit of account, and a store of value. A medium of exchange is an object that is generally accepted in return for goods and services. A unit of account is an agreed-upon measure for stating the prices of goods and services. A store of value is any commodity or token that can be held and exchanged later for goods and services. Deposits are money because they can be converted into currency on demand and used directly to make payments. Credit cards are not money as they do not function as a store of value.
There are two definitions of money or money supply, M1 and M2. M1 consists of currency by individuals and businesses, traveler’s checks, and checkable deposits owned by individuals and businesses. M2 consists of M1 plus savings deposits, small time deposits, money market funds, and other deposits.
Interest is the price (or cost) paid for the use of money. If the price for the use of money becomes cheaper, people want to borrow more money, and vice versa. The (nominal) interest rate is the opportunity cost of holding money foregone on an alternative asset. The demand for money is the inverse relationship between the nominal interest rate and the quantity of money demanded. The supply of money is the positive relationship between the nominal interest rate and the quantity of money supplied. There is an inverse relationship between the price of the bond and the interest rate. If the price of the bond falls, the interest rate rises, and vice versa. The real interest rate is the nominal interest rate minus (expected) inflation rate. When your bank pays you the nominal interest rate of 2% for your one-year certificate deposit (CD) and the (expected) inflation rate is 5%, then the real interest rate for your CD is -3%. That is, you as losing money by 3% by investing your money in a CD with your bank. You would want to find some other place to invest to earn more than 5% that covers the (expected) inflation rate.
The banking system consists of the Federal Reserve and the banks and other financial institutions that accept deposits and that provide the services that enable people and businesses to make and receive payments. Commercial banks are firms that are licensed by the Comptroller of the Currency in the U.S. Treasury (or by a state agency) to accept deposits and make loans. The Federal Reserve System (the Fed) is the central bank of the United States. The Fed’s main task is to regulate the interest rate and quantity of money to achieve low and predictable inflation and sustained economic growth.
5.6. The Federal Reserve and Monetary Policy
The structure of the Federal Reserve System (Fed) includes the Board of Governors, the 12 Federal Reserve Banks, and the Federal Open Market Committee (FOMC). The Board of Governors has 7 members with a 14-year term. The FOMC consists of 12 members including 7 members of the Board of Governors, the president of New York Federal Reserve Bank, and 4 of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. The FOMC meets 8 times a year – every six weeks. In their meetings, the FOMC members review and discuss monetary policy and the target federal funds rate. The federal funds rate is an overnight interest rate that is charged by one commercial bank to another bank when it borrows money to maintain the required reserves.
The Fed’s (conventional) monetary policy tools include open market operations, discount rate, and required reserve ratios. Open market operations are the purchase or sale of government securities – U.S. Treasury bills and bonds – by the New York Fed in the open market. The discount rate is the interest rate at which the Fed lends reserves to commercial banks. A required reserve ratio is the fraction of deposits that the Fed requires banks to hold in reserves and not loan out.
When the economy is in a recession, the FOMC may decide to lower the target federal funds rate and buys government securities in an open market to attain this target federal funds rate, which is an increase in the supply of money. In addition, the Fed may use unconventional expansionary monetary policy tools that include quantitative easing (QE), credit easing, operation twist, etc. Quantitative easing is a monetary policy tool in which the Fed buys private securities such as mortgage-backed securities (MBSs), collateralized-debt obligations (CDOs), or collateralized-mortgage obligations (CMOs). Credit easing is the action in which the Fed buys private securities or makes loans to financial institutions to stimulate their lending. Operation twist is the action in which the Fed buys long-term government securities and sells short-term government securities to lower long-term securities and stimulate borrowing and investment in the short run.
When the economy is in a boom or expanding, the FOMC may decide to raise the target federal funds rate and sell the government securities in an open market to attain its target federal funds rate, which is a decrease in the supply of money. The FOMC may decide to implement tapering (when it was implementing QE), the reversal of QE, which is reducing its purchase of private securities. Then, as the economy is expanding, the FOMC may implement quantitative tightening (QT), an unconventional contractionary monetary policy tool, which is selling private securities and thus shrinking the size of the Fed’s balance sheet. During the 2008-2009 financial crisis and during COVID-19, the Federal Reserve implemented expansionary monetary policy, by lowering the target federal funds rate down to 0-0.25% in December 2008, which lasted for seven years until December 2015, and then again down to 0-0.25% in March 2020, along with QE, when COVID-19 hit the U.S. economy hard to fight unemployment in a recession. During a high inflation period in 2022, the Fed implemented contractionary or tight monetary policy by raising the target federal funds rate to reduce the money supply to fight high inflation.
6. Global Economics
Globalization is a process of people, countries, and governments becoming interdependent and integrated in various areas of the world’s economies, including finances, cultures, societies, languages, and others. An individual countries’ economic, political, military decisions or global circumstances immediately affects other countries immediately due to globalization. Global economics provides an analysis of economic decision making in a global setting. It examines the fundamental questions of economics as they relate to individuals, firms, and governments operating in an open economy. Topics of global economics include international trade, international finance, and regional issues in the global economy.
6.1. International Trade and the Gains from Trade
In the Mercantile period, from the 16th through the end of the 18th centuries, trade was driven by a need to accumulate gold and silver. Mercantilism encouraged exports but discouraged imports. With the emergence of the Industrial Age, classical economists began to approach trade and international commerce from a different viewpoint. In an open economy, a country’s trade with other countries affects its GDP, price levels, interest rates, wages and jobs, and other economic categories. Adam Smith in his book, The Wealth of Nations (1776), suggested a basis of trade, which is known as an absolute advantage. When one country can produce a certain item more than other countries (using the same resources), the country has an absolute advantage in that item. Later, David Ricardo provided a modified framework, known as a comparative advantage, which became the basis of modern views of international trade. When one country can produce a certain item at a lower opportunity cost than other countries, the country has a comparative advantage in that item. In the two countries-two goods model, the opportunity cost, which is also called the marginal rate of transformation (MRT), to increase one more unit of one good is the number of units of the other good that is to be sacrificed/given up. Any small country has a comparative advantage in at least one item, and thus comparative advantage is a driving force that makes countries participate in international trade and attain gains from trade. Comparative advantage for each country in a simple two countries-two goods production-possibilities-frontiers (PPF) model can be obtained by comparing their opportunity costs for additional production of each item. Comparative advantage is a driving force that makes countries participate in international trade and attain the gains from trade.
6.2. Theory of Tariffs and Quotas
Industrialists claim that the government should protect the country’s infant and weak industries by imposing tariffs, quotas, or other restrictions on imported goods whereas most economists are in favor of free trade.
Tariffs are the most frequently used method to discourage imports by imposing taxes on imported items. A tariff may be a set amount ($10 per ton) or a percentage (5% of the value of an imported item). Quotas directly limit the quantity of imports. For example, when the U.S. government imposes a tariff or a quota on an imported good, the domestic production of the good may increase as the price of the imported good goes up. However, consumers should pay higher prices, overall consumption will decrease, and thus their welfare or consumer surplus will be worse off. Overall, U.S. imports will decrease. Also, other countries may retaliate against the U.S., and U.S. exports will decline.
6.3. Trade and Balance of Payments
The balance of payments consists of the current account, the financial account, and the capital account. The current account contains three components – exports and imports of goods and services (the trade balance), income received from abroad and income paid abroad (primary income), and transfers received from abroad and transfers made abroad (secondary income). When exports of goods and services are larger than imports of goods and services, it is called trade surplus; when exports of goods and services are equal to imports of goods and services, it is called trade balance; and when exports of goods and services are smaller than imports of goods and services, it is called trade deficit.
The financial account is the record of all financial transactions between a country and the rest of the world, containing net acquisition of financial assets, net incurrence of financial liabilities, and a net change in financial derivatives. The capital account is the smallest of the three accounts of the balance of payments and consists of capital transfers and the acquisition and disposal of non-produced, non-financial assets, which is usually zero and negligible.
The balance of payments for any country is zero. That is, ignoring the capital account, which is usually zero, when the current account is positive, say, +$350 billion, then the financial account is negative, around -$350 billion. This is because when one country has more money because its exports are larger than its imports, then the country will invest more money to foreign countries than other countries to the country, more capital outflows than inflows. When the current account balance is negative, then the financial account balance is positive, meaning more capital inflows than capital outflows. The sum of the current account balance and the capital account balance is equal to the financial account balance with opposite signs. So, the sum of all three accounts – the current account balance, the financial account balance, and the capital account balance – is zero. If the sum is not zero, the non-zero amount (or measurement errors) is treated as statistical discrepancy to make the balance of payments zero. The balance of payments is reported by the Bureau of Economic Analysis, quarterly.
6.4. Exchange Rates
An exchange rate is the price of one country’s currency in terms of another country’s currency. Appreciation is a situation when a currency becomes more valuable against another currency whereas depreciation is a situation when a currency becomes less valuable against another currency.
There are two different exchange rate systems – fixed or pegged exchange rate systems and flexible or floating exchange rate systems. A fixed exchange rate pegs the home currency to another currency (such as the US dollar) or to a basket of currencies at the official rate of exchange. Advantages of fixed or pegged exchange rates include reduction of uncertainty and currency risk, prevention of currency depreciation and high inflation, and attraction of foreign investment. Disadvantages of fixed or pegged exchange rates include a difficulty or restriction in implementing monetary policy for a domestic macroeconomic issue, requirement of holding large foreign currency to which its currency is pegged, and limitation of adjusting interest rates.
A flexible or floating exchange rate may be determined by the supply curve and the demand curve in the foreign exchange market. When there is an increase in demand for a country’s currency, ceteris paribus, the value of the currency will go up, which is called appreciation. On the other hand, when there is an increase in supply of the country’s currency, ceteris paribus, the value of the currency will decrease, which is called depreciation. Advantages of flexible or floating exchange rates include automatic adjustment of the balance of payments, enhancement of market efficiency, minimum requirement of holding foreign currency, and flexible implementation of monetary policy for a domestic macroeconomic issue. Disadvantages of flexible or floating exchange rates include more volatility, discouragement of foreign investment, uncertainty and risk, and/or currency speculation.
6.5. Contagion Effects in the Global Economy
With faster and wider globalization, a country’s economic problem may spread to neighboring countries and may spread worldwide, when the problem begins in an economically and/or politically powerful country. Global financial or economic crises usually involve an exchange rate or currency crisis, a banking crisis, a debt crisis, or a combination of these three crises.
The 1980s Latin American debt crisis, often called “the lost decade,” started in Mexico in August 1982 and soon spread to almost all Latin American countries, including Brazil, Argentina, Venezuela, and Chile. A primary source of this large debt was the crude oil price shocks during the 1970s by the OPEC (Organization of Petroleum Exporting Countries), which made many Latin American countries experience current account deficits. In addition, international interest rates went up significantly and borrowing money became much more costly. So, Latin American countries, along with many other oil-importing countries in the world, suffered for almost the decade of the 1980s.
The 1997-1998 Asian financial or currency crisis started in Thailand in July 1997 and spread to East Asian countries, including Malaysia, Indonesia, the Philippines, and South Korea. Some other neighboring countries were also affected but not as strong as these countries. Their currencies devalued as foreign investors pull out their money. Many small and large firms were bankrupt, and recessions began and ruined their economies for a while.
The 2007-2009 financial crisis, which is also called the Great Recession, began in the United States due to the housing market collapse with a subprime mortgage problem and widespread business people’s unethical behavior or moral hazard. This financial crisis was aggravated because of a crude oil price hike up to $150 per barrel (a negative supply shock) in the middle of 2008. This U.S. financial crisis soon spread to European countries and other countries as their financial institutions had purchased mortgage-related securities issued by U.S. banks and other financial institutions. Many countries experienced recessions and high unemployment.
Coronavirus disease or COVID-19 originated at Wuhan, a city of China in December 2019 and soon spread all over the world. Millions of people died due to COVID-19 worldwide.[7] The U.S. economy, along with most countries in the world, was hit hard by COVID-19. The U.S. GDP dropped by 33% during the second quarter of 2020 (bea.gov), and the unemployment rate went up to 13.2% in May 2020 (bls.gov). The U.S. stock market, along with other countries’ stock markets, was significantly damaged in a month. From February to March 2020, the Dow Jones Industrial Average (DJIA) dropped by 42%, S&P 500 Index by 32%, and NASDAQ Composite Index by 29%. Many companies in different industries, including airline companies, oil and gas production companies, greatly suffered. As goods and services were not produced normally, it caused supply-chain issues, which lasted long and raised the inflation rate further higher.
As globalization continues to make the world closer, one country’s economic and/or political issue will rarely remain its own problem. So, most countries pay more attention to issues of a single country, a region, or a continent so that they may be able to be better prepared for them.
6.6. Macroeconomic Policy in the Global Economy
In the United States, fiscal policy is implemented by the federal government, using government spending and/or taxes whereas monetary policy is implemented by the Federal Reserve, the central bank, using open market operations, discount rates, and reserve requirement ratios.
When a country is under a floating or flexible exchange rate system like the United States, expansionary monetary policy makes interest rates go down and the value of its currency also decline (depreciation). Thus, as the country’s products prices become relatively cheaper than other countries’ products prices, its exports increase, and imports decrease. So, net exports (exports – imports) will increase and GDP will go up, along with an increase in GDP domestically, via an increase in consumption and/or investment by an increase in money supply. On the other hand, expansionary fiscal policy makes interest rates go up and the value of its currency also go up (appreciation). Thus, as the country’s products prices become relatively more expensive than other countries’ products prices, its exports decrease, and imports increase. So, net exports will decrease, and GDP will go down, although expansionary fiscal policy domestically makes GDP go up via an increase in consumption and/or government spending. That is, expansionary fiscal policy is not effective in an open economy as its decrease in net exports may reduce or cancel out its increase in consumption and/or government spending.
When a country is under a fixed or pegged exchange rate system, expansionary monetary policy does not change the value of currency as the exchange rate is supposed to remain at the fixed rate. On the other hand, expansionary fiscal policy makes the Fed increase the money supply to maintain the fixed exchange rate, as otherwise, the country cannot maintain the fixed rate. Thus, in contrast to the case of the floating or flexible exchange rate system, expansionary fiscal policy under the fixed or pegged exchange rate system increases net exports in international trade, along with an increase in GDP domestically via an increase in consumption and/or government spending. That is, expansionary monetary policy is less effective under a fixed or pegged exchange rate system.
7. Application of Economics
Even if you do not major (or minor) in economics, the study of economics will help you as a consumer, a producer, or a policymaker for the government make better decisions to be most satisfied, given limited available resources. The study of economics will let you better understand how the price and the quantity/output are determined in a market economy, what important macroeconomic issues there are in the economy, how the federal government and the Federal Reserve respond to these issues, what globalization is, why economists advocate free trade, and how a country’s macroeconomic policies affect in connection with the global economy.
By attaining a BA degree in economics, students are prepared for employment as economists, economic/financial analysts of private firms, government, or government-related research institutes such as the Bureau of Labor Statistics, the Bureau of Economic Analysis, or the Federal Reserve Bank, financial advisors/planners of investment banks, and financial services firms. After attaining a BA degree in economics, students may also pursue master’s and doctoral degrees at a graduate school in order to teach at the college level. When students decide to pursue an advanced degree to teach and research at the college level, double majoring in economics and mathematics is strongly recommended as a higher level of the study of economics requires competitive mathematical background.
8. Summary
This chapter examines the scope, methods, and history of economics. Economics as a tool of decision making in everyday life deals with various fields of life that include people’s consumption behavior and firms’ production behavior in the production market, labor supply and demand in the labor market, industrial organizations, energy and environmental activities, health care systems and insurance, financial markets and institutions, and others. Economists like to use simplified economic models to focus on specific issues, analyze, evaluate, and thus resolve the problems.
Modern economics began with Adam Smith and other classical economists in the 18th century. Classical economists’ main concerns were free markets where prices and outputs are determined, and focused on capitalism with the market economy that grants private ownership. Karl Marx, however, claimed that workers are less paid than their value of labor, as employers exploit their labor, taking a portion of their wages as surplus. Marxian economics promotes socialism against capitalism, in which prices and outputs are determined by the central authority instead of the market, with the command economy or centrally planned economy. All property belongs to the central authority. Marxian economics’ ultimate goal, however, is communism, where there is “no state, no class.” In communism, all property belongs to workers and farmers (common ownership), which means no one owns anything. Carl Menger, the founder of the Austrian school of economic thought, Leon Walras and William Stanley Jevons developed the concept of utility. This is a new value theory in which consumers value a good or a service subjectively based on their incremental or additional satisfaction from one more unit of consumption or purchase of the good or the service, which is called marginal utility. Keynes proposed a government’s active role in resolving economic issues. Keynesian economics was a beginning of macroeconomics as classical economics was more concerned with microeconomic aspects, including markets. After Keynesian economics, monetarism, supply-side economics, and the theory of rational expectations followed.
Microeconomics deals with consumer behavior and producer behavior in the market, where prices and quantities are determined by the demand and supply curve, and different market structures. Macroeconomics examines GDP, and macroeconomic issues such as inflation and unemployment, and macroeconomic policies to resolve those macroeconomic issues. Global economics discusses globalization and its issues, international trade and international finance, and government’s macroeconomic policies in the context of the global economy.
The purpose of the study of economics is to better understand our daily economic activity and the country’s domestic economic issues such as inflation and unemployment, and their impact on our daily life. Economics also studies the worldwide economic and political issues and their effects on our country’s economy and us as individuals. Better understanding of our surrounding economic and political issues may help us make good decisions in our daily life, with limited available resources.
End Notes
[1] https://www.census.gov/programs-surveys/cps.html
[2] Volumes II and III were completed from Marx’s notes and published by Friedrich Engels (1820-1895).
[3] Keynes quoted this statement in his earlier work, The Tract on Monetary Reform, in 1923.
[4] Source: https://aspe.hhs.gov/topics/poverty-economic-mobility/poverty-guidelines/prior-hhs-poverty-guidelines-federal-register-references/2021-poverty-guidelines
[5] OECD (2014, December). “Focus on Inequality and Growth.”
Retrieved from https://www.oecd.org/social/Focus-Inequality-and-Growth-2014.pdf
[6] Source: https://inflateyourmind.com/microeconomics/unit-9-microeconomics/section-1-united-states-income-distribution.
[7] Source: https://news.google.com/covid19/map?hl=en-US&mid=%2Fm%2F02j71&gl=US&ceid=US%3Aen
