University of New Haven WK 2 Market Failure & Economic Inequality Discussion Paper

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jubfgung

Economics

University of New Haven

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Discussion board posts should be no more than 1000, and no less than 900 words

Discussion Board #1 Question:

Part A

Based on our recent in-class discussion on market failures, present and discuss your understanding of the five (5) Market Failures:

  • Monopoly Power
  • Spillover or Externalities
  • Public Goods
  • Inadequate Information
  • Economic Inequality.

Part B

Discuss and present the different corrections for all five (5) Market Failures.

Part C

Consider the Market Failure of Economic Inequality and the argument presented by one of America’s most world-renowned and leading economists, Joseph Stiglitz, that too much economic inequality can be dangerous of the American economy and society. Present your understanding of his work.

In order to help you respond to this question, please refer to the readings: The Price of Inequality: How Today’s Divided Society Endangers Our Future by Joseph Stiglitz, Chapter 1 (attached), and the NY Times Article, Separate and Unequal by Thomas Edsall (link below), as well as the lecture slides, and textbook readings.

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Contemporary Economics The eighth edition of Contemporary Economics continues to offer a clear, concise presentation of basic microand macroeconomic theory. Emphasizing how the discipline of economics connects to the world, the book takes a friendly and accessible tone, illustrating theory with applications. This new edition comes with updated applications and data to reflect the changing world events since the previous edition was published. This handbook uses real-world, globally relevant case studies that make the subject easy to understand. New and updated topics include: • Energy and oil • Economic sanctions on Russia and Iran • The Eurozone Crisis • The Trans-Pacific Partnership • China and the world currency market Including a Companion Website complete with instructor’s manual, lecture slides and test bank, as well as an online study guide and multiple-choice questions for students, Contemporary Economics is suitable for both economics students and non-majors studying economics and economic issues at the introductory level. Robert Carbaugh is Professor of Economics at Central Washington University, USA. 2 Contemporary Economics An Applications Approach Eighth Edition Robert Carbaugh 3 Eighth edition published 2017 by Routledge 711 Third Avenue, New York, NY 10017 and by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Routledge is an imprint of the Taylor & Francis Group, an informa business © 2017 Robert Carbaugh The right of Robert Carbaugh to be identified as author of this work has been asserted by him in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. First edition published by South-Western 2000 Seventh edition published by Routledge 2015 British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Names: Carbaugh, Robert J., 1946- author. Title: Contemporary economics : an applications approach / Robert Carbaugh. Description: 8th edition. | Abingdon, Oxon ; New York, NY : Routledge, [2016] Identifiers: LCCN 2016005286| ISBN 9781138652170 (hardback) | ISBN 9781138652194 (pbk.) | ISBN 9781315624433 (ebook) Subjects: LCSH: Economics. | United States—Economic conditions. Classification: LCC HB171 .C277 2016 | DDC 330—dc23 LC record available at http://lccn.loc.gov/2016005286 ISBN: 978-1-138-65217-0 (hbk) ISBN: 978-1-138-65219-4 (pbk) ISBN: 978-1-315-62443-3 (ebk) Typeset in Bembo Std by Swales & Willis Ltd, Exeter, Devon, UK 4 Contents List of Figures List of Tables Preface Acknowledgments PART 1 Introduction CHAPTER 1 Scarcity and Choice What is Economics? Microeconomics Macroeconomics The Economic Way of Thinking Every Choice Has a Cost People Make Better Choices by Thinking at the Margin Rational Self-Interest Economic Models Positive versus Normative Economics Scarcity Scarcity and Opportunity Cost The Opportunity Cost of Attending College Opportunity Costs and Choices The Production Possibilities Curve and Opportunity Cost Economic Inefficiency The Law of Increasing Opportunity Cost Economic Growth Economic Decline Innovation, Economic Growth, and the American Economy Economic Growth: Trade-Offs between Current and Future Consumption Production Possibilities Applications Opportunity Cost of National Security Economic Sanctions against Iran 5 Russian Aggression against Ukraine Brings Sanctions Chapter Summary Key Terms and Concepts Study Questions and Problems Exploring Further 1.1: A Primer on Tables and Graphs Movements along the Study Time–Grade Line Slope of the Study Time–Grade Line Shifts in the Study Time–Grade Line PART 2 The Microeconomy CHAPTER 2 Market Transactions: Demand and Supply Analysis Markets Demand The Demand Curve and the Law of Demand What Explains the Law of Demand? Changes in Demand: Demand Shifters Demand Theory Applications GM Offers Deep Discounts to Bolster Volt Sales Yankees Slash Prices of Top Tickets to Fill Seats at New Park Supply The Supply Curve and the Law of Supply Changes in Supply: Supply Shifters Hydraulic Fracturing Squeezes More Oil and Natural Gas from the Ground Demand, Supply, and Equilibrium Shifts in Demand and Supply Contemporary Applications of Demand and Supply Bike Competition Puts the Brakes on Schwinn What Drives Gasoline Prices? Rising Health Care Costs Harm Households Reducing America’s Dependence on Oil Chapter Summary Key Terms and Concepts Study Questions and Problems CHAPTER 3 6 Demand and Supply Applications Price Elasticity of Demand Determinants of Price Elasticity of Demand Availability of Substitutes Proportion of Income Time Price Elasticity of Demand and Total Revenue Cigarette Tax Raised to Increase Government Revenue Colleges Hike Tuition Used to Offset Cutbacks in State Aid to Higher Education Pittsburgh Pirates Underestimate Fan Reaction: Ticket Price Hike Was Wrong U.S. Postal Service Boosts Rates to Increase Revenue Price Ceilings and Price Floors Rent Controls Make Housing More Affordable Should Federal Interest-Rate Ceilings Be Imposed on MasterCard and Visa? U.S. Farmers Reap Subsidies from the Government Chapter Summary Key Terms and Concepts Study Questions and Problems CHAPTER 4 Production and the Costs of Production The Short Run and the Long Run The Production Function Short-Run Production Improvements in Technology and Work Rules Shift Product Curves Upward Short-Run Production Costs Total Fixed, Total Variable, and Total Costs Average Costs Marginal Cost Long-Run Production Costs Economies of Scale Diseconomies of Scale Shifts in Cost Curves Apple’s Global Production Network Dell Downsizes to Slash Costs Costs and Profit 7 Explicit Costs and Implicit Costs Accounting Profit and Economic Profit Chapter Summary Key Terms and Concepts Study Questions and Problems CHAPTER 5 Competition and Monopoly: Virtues and Vices Perfect Competition The Perfectly Competitive Firm as a Price Taker Perfect Competition: Profit Maximization in the Short Run Marginal Revenue Equals Marginal Cost Rule Profit Maximization Perfect Competition: Long-Run Adjustments and Economic Efficiency Will iTunes Store Start Singing the Blues? Monopoly Barriers to Entry Legal Barriers Control over Essential Inputs Economies of Scale Cable Television: Why Rates Are So High De Beers: The “Gift of Love” Profit Maximization for a Monopoly Price and Marginal Revenue Maximizing Profits Continuing Monopoly Profits The Case Against Monopoly Universal Service and the Postal Monopoly Reducing Monopoly Power: Generic Drugs Compete Against Brand-Name Drugs Is Google a Monopoly? Should It Be Broken Up? Chapter Summary Key Terms and Concepts Study Questions and Problems Exploring Further 5.1: Loss Minimization and the Shut-Down Rule CHAPTER 6 Imperfect Competition 8 Concentration Ratios Monopolistic Competition Profit Maximization in the Short Run The Long Run: Normal Profit and Excess Capacity Despite Competition from Starbucks, Many Independent Coffeehouses Survive Advertising Price Discrimination Oligopoly Oligopolistic Rivalry Rivalry in the Soft Drink Industry Rivalry in the Photographic Equipment Industry Game Theory and Oligopoly Behavior Competitive Oligopoly and Low Prices Cooperative Behavior and Cheating Airbus and Boeing Compete for Supremacy in the Jetliner Industry Collusion and Cartels Mergers and Oligopoly Chapter Summary Key Terms and Concepts Study Questions and Problems CHAPTER 7 Labor Markets Labor Market Equilibrium Do Minimum Wage Laws Help Workers? Are Workers Better Off with Labor Unions? Increasing Union Wages What Gives a Union Strength? Indiana and Michigan Adopt Right-to-Work Laws Caterpillar Bulldozes Canadian Locomotive Workers Did Restrictive Work Rules Cream Twinkies and Ding Dongs? Outsourcing: Threat or Opportunity for U.S. Workers? What Prevents U.S. Jobs from Being Outsourced Abroad? Effects of Outsourcing Will Jobs Move Back to the United States? Immigration Laws and American Workers 9 Chapter Summary Key Terms and Concepts Study Questions and Problems Exploring Further 7.1: A Firm’s Hiring Decision CHAPTER 8 Government and Markets Market Failure Monopoly Power Antitrust Policy Is Microsoft a Monopoly? Economic Regulation and Deregulation Public Utility Regulation Peak-Load Pricing: Buying Power by the Hour Spillover Effects Spillover Costs Cap and Trade: Trading Emission Certificates Spillover Benefits Should the United States Shift More Energy Subsidies to Renewable Power? Should Government Subsidize Professional Sports? Social Regulation Do Corporate Fuel Economy Standards Promote Fuel Conservation? Public Goods Inadequate Information Economic Inequality Chapter Summary Key Terms and Concepts Study Questions and Problems PART 3 The Macroeconomy CHAPTER 9 The Mixed Economy of the United States Households as Income Receivers: Income Inequality Sources of Income Inequality Trends in Income Inequality Households as Spenders 10 The Business Sector Government in the Mixed Economy Social Insurance: Social Security, Medicare, and Unemployment Compensation Should Social Security Be Privatized? Government Finance Taxation Principles: Benefits Received versus Ability to Pay Progressive, Regressive, and Proportional Taxes The U.S. Tax Structure Federal Personal Income Tax Federal Corporate Income Tax Social Security Tax Sales, Excise, and Property Taxes Overall U.S. Tax System Is the U.S. Tax System Fair? Should the U.S. Tax System Be Reformed? Flat-Rate Income Tax Value-Added Tax National Sales Tax Corporate Income Tax Chapter Summary Key Terms and Concepts Study Questions and Problems C H A P T E R 10 Gross Domestic Product and Economic Growth Measuring an Economy’s Output Gross Domestic Product GDP Is the Market Value Of All Final Goods and Services Produced Within a Country In a Given Year The Components of GDP A Formula for GDP What GDP Does Not Measure Real GDP versus Nominal GDP 11 Long-Run Economic Growth The Rate of Economic Growth What Determines Economic Growth Natural Resources Physical Capital Human Capital Productivity The Significance of Technological Innovation The Role of Government Theories of Economic Growth Is Growth Desirable? Chapter Summary Key Terms and Concepts Study Questions and Problems C H A P T E R 11 The Business Cycle, Unemployment, and Inflation The Business Cycle Phases of the Business Cycle Theories of the Business Cycle The Great Recession: 2007–2009 Bursting of Housing Bubble Triggers Recession Unemployment Measuring Unemployment Three Kinds of Unemployment Mitigating the Costs of Unemployment What Is Full Employment? Inflexible Labor Markets Cost Jobs Productivity, Real Wages, and Jobs Inflation Measuring Inflation: The Consumer Price Index Who Benefits from and Who is Hurt By Inflation? Inflation and the Purchasing Power of Income Redistribution of Wealth from Lenders to Borrowers Inflation and Real Interest Rates Inflation and Taxpayers 12 Effects of Severe Inflation Causes of Inflation Chapter Summary Key Terms and Concepts Study Questions and Problems C H A P T E R 12 Macroeconomic Instability: Aggregate Demand and Aggregate Supply The Stability of the Macroeconomy The Classical View The Great Depression The Keynesian View Aggregate Demand and Aggregate Supply Aggregate Demand Movements along the Aggregate Demand Curve Shifts in the Aggregate Demand Curve The Multiplier Effect Aggregate Supply Movements along the Aggregate Supply Curve Shifts in the Aggregate Supply Curve The Origins of Recession Decreases in Aggregate Demand Decreases in Aggregate Supply The Origins of Inflation Revisited Demand-Pull Inflation Cost-Push Inflation Productivity Growth Dampens Inflation Chapter Summary Key Terms and Concepts Study Questions and Problems Exploring Further 12.1: The Nature and Operation of the Multiplier Effect Calculating the Value of the Multiplier Graphical Illustration of the Multiplier Effect C H A P T E R 13 Fiscal Policy and the Federal Budget Fiscal Policy 13 Fiscal Policy and Aggregate Demand: Short-Run Effects Combating Recession Combating Inflation Automatic Stabilizers Effects of Fiscal Policy in the Long Run Fiscal Policy in Action Problems of Fiscal Policy Timing Lags Crowding-Out Effect Offsetting State and Local Fiscal Policies When Is Fiscal Policy Useful? The Federal Deficit and Federal Debt Sales and Ownership of Federal Debt U.S. Fiscal Policy: Does the Federal Debt Cheat Future Generations? Should the Federal Budget Be Balanced At All Times? Annually Balanced Budget Cyclically Balanced Budget Functional Finance Chapter Summary Key Terms and Concepts Study Questions and Problems Exploring Further 13.1: Fiscal Policy and the Multiplier C H A P T E R 14 Money and the Banking System The Meaning of Money Medium of Exchange Unit of Account Store of Value Are Credit Cards Money? Shopping for a Credit Card: Why Are Rates So High? The U.S. Money Supply Coins Paper Money Checking Accounts Special Types of Checks 14 Check Processing and Collection Holds on Checking Accounts What Backs the Money Supply? Measuring the Money Supply: The M1 Money Supply How Your Money Grows Over Time: Compound Interest The Business of Banking A Bank’s Balance Sheet The Reserve Requirement The Process of Money Creation The Federal Deposit Insurance Corporation Chapter Summary Key Terms and Concepts Study Questions and Problems C H A P T E R 15 The Federal Reserve and Monetary Policy The Federal Reserve System Structure of the Federal Reserve System The Independence of the Fed The Functions of the Federal Reserve System Monetary Policy Open Market Operations The Discount Rate The Reserve Requirement Term Auction Facility Shifting Aggregate Demand Expansionary Policy Restrictive Policy The Federal Reserve and Economic Stabilization The Great Recession of 2007–2009 2001 Attack on America Monetary Policy: Advantages and Disadvantages Advantages of Monetary Policy Disadvantages of Monetary Policy Discretion or Rules: Fixed Money Rule or Inflation Targeting Should Congress Reduce the Independence of the Federal Reserve? 15 Chapter Summary Key Terms and Concepts Study Questions and Problems PART 4 The International Economy C H A P T E R 16 International Trade and the Global Economy The United States as an Open Economy The Advantages of Specialization and Trade Comparative Advantage and International Trade Production and Consumption without Specialization and Trade Production and Consumption with Specialization and Trade Comparative Advantage Why is Free Trade Controversial? Limiting Foreign Competition: Tariffs The Regressive Nature of U.S. Tariffs Arguments for Trade Restrictions Job Protection Protection against Cheap Foreign Labor Fairness in Trade: A Level Playing Field Infant Industry National Security Argument Pursuing Trade Liberalization World Trade Organization North American Free Trade Agreement The Trans-Pacific Partnership Chapter Summary Key Terms and Concepts Study Questions and Problems C H A P T E R 17 International Finance The Balance of Payments The Current Account The Capital and Financial Account What Does a Current Account Deficit (Surplus) Mean? 16 The U.S. Balance of Payments Are U.S. Current Account Deficits Bad? Foreign Exchange Market Exchange Rate Determination Long-Run Determinants of Exchange Rates Short-Run Determinants of Exchange Rates Exchange Rate Systems Floating Exchange Rates Fixed Exchange Rates Monetary Integration in Europe: The Euro Chapter Summary Key Terms and Concepts Study Questions and Problems C H A P T E R 18 Economic Systems and Developing Countries Economic Systems and the Fundamental Economic Questions Market Economy Command Economy Mixed Economy Transition Economies Eastern European Countries China India The Economics of Developing Countries Obstacles to Economic Development The Ladder of Economic Development and Trade Conflicts Fair Trade and Coffee Growers Strategies for Economic Growth Assisting the Developing Countries World Bank International Monetary Fund Generalized System of Preferences Chapter Summary Key Terms and Concepts Study Questions and Problems 17 Glossary Index 18 Brief Contents List of Figures List of Tables Preface Acknowledgments PART 1 Introduction 1 PART PART 2 The Microeconomy 2 Market Transactions: Demand and Supply Analysis 3 Demand and Supply Applications 4 Production and the Costs of Production 5 Competition and Monopoly: Virtues and Vices 6 Imperfect Competition 7 Labor Markets 8 Government and Markets 3 The Macroeconomy 9 PART Scarcity and Choice The Mixed Economy of the United States 10 Gross Domestic Product and Economic Growth 11 The Business Cycle, Unemployment, and Inflation 12 Macroeconomic Instability: Aggregate Demand and Aggregate Supply 13 Fiscal Policy and the Federal Budget 14 Money and the Banking System 15 The Federal Reserve and Monetary Policy 4 The International Economy 16 International Trade and the Global Economy 17 International Finance 19 18 Economic Systems and Developing Countries Glossary Index 20 Figures 1.1 Opportunity Cost and Choice 1.2 Production Possibilities Curve 1.3 The Law of Increasing Opportunity Cost 1.4 The Effect of Economic Growth on the Production Possibilities Curve 1.5 Economic Growth in the United States and Japan 1.6 The Opportunity Cost of National Security 1.7 Effects of Economic Sanctions 1.8 Study Time–Grade Relationship in an Economics Issues Class 2.1 The Demand Schedule and Demand Curve for CDs 2.2 An Increase in Demand 2.3 The Supply Schedule and Supply Curve of CDs 2.4 An Increase in Supply 2.5 Equilibrium in the CD Market 2.6 Changes in Demand and Supply: Effects on Price and Quantity 2.7 The Market for Schwinn Bikes 2.8 Increasing Cost of Health Care 3.1 Raising Tuition and Total Tuition Revenue 3.2 Rent Ceilings and Housing Shortages 3.3 Effect of Price Supports for Wheat 4.1 Short-Run Production Function of Denver Block Co. 4.2 Hypothetical Short-Run Cost Schedules for Hewlett-Packard 4.3 Hypothetical Long-Run Average Total Cost Curve for Hewlett-Packard 5.1 Demand and Marginal Revenue of a Perfectly Competitive Firm 5.2 Profit Maximization for a Perfectly Competitive Firm 5.3 Long-Run Adjustments for a Perfectly Competitive Firm 5.4 Economies of Scale and Natural Monopoly 5.5 Profit Maximization for a Monopolist 5.6 Short-Run Cost Conditions Faced by a Perfectly Competitive Firm 5.7 Demand and Cost Conditions Faced by a Monopolist 5.8 Loss Minimization for a Perfectly Competitive Firm 21 6.1 Market Outcomes Under Monopolistic Competition 6.2 The Effect of Advertising on Demand and Average Total Costs 6.3 Game Theory and Oligopoly Behavior 6.4 Short-Run Position of a Monopolistically Competitive Firm 7.1 Market for Apple Pickers 7.2 Effects of a Minimum Wage 7.3 Union Methods of Increasing Wages 7.4 Mt. Pleasant Apple Company’s Demand Schedule for Labor 8.1 Public Utility Regulation of Natural Monopoly 8.2 Correcting for Market Failure: Spillover Costs 8.3 Correcting for Market Failure: Spillover Benefits 9.1 Preparation of the Federal Government’s Annual Budget 9.2 Replacing the Progressive Income Tax with a Flat-Rate Tax 11.1 Historical Business Fluctuations in the United States 11.2 The Business Cycle 11.3 Rigid Wages Can Result in Involuntary Unemployment 12.1 Macroeconomic Equilibrium 12.2 Aggregate Supply Curve 12.3 The Origins of Recession 12.4 The Origins of Inflation 12.5 Productivity Growth Moderates Inflation 12.6 The Multiplier in Action 13.1 Expansionary Fiscal Policy 13.2 Contractionary Fiscal Policy 13.3 Deficits and Surpluses of the U.S. Government under Various Presidents, 1981–2011 13.4 Fiscal Policy and the Multiplier Effect 14.1 The Dollar Bill 14.2 Electronic Codes on a Check 14.3 How the Payments System Works 14.4 The Future Value of $10,000 Compounded Annually at an Interest Rate of 5 Percent 14.5 The Process of Money Creation 15.1 The Twelve Federal Reserve Districts 15.2 Fed Open Market Purchases of Securities Directly from a Commercial Bank 15.3 Effects of Monetary Policy on the Economy 22 15.4 The Fed and the Recession of 2007–2009 15.5 Combined Balance Sheet of All Commercial Banks 15.6 Wisconsin National Bank’s Balance Sheet 16.1 Comparative Advantage and International Trade 16.2 Economic Effects of a Tariff 17.1 Exchange Rate Determination 23 Tables 1.1 Estimated Average Cost of a Year of College, 2014–2015 1.2 Capacity Utilization Rates for Major U.S. Industries, 1972–2014 Average 1.3 Production Possibilities 1.4 Studying Pays Off in an Economics Issues Class 2.1 Impacts of Changes in Both Demand and Supply 2.2 Supply and Demand Schedules of Computers 3.1 Estimated Price Elasticities of Demand 3.2 Dynamic Ticket Pricing of the San Francisco Giants, AT&T Park, September 8, 2015 3.3 Price Elasticity of Demand for Mail Services of the U.S. Postal Service 3.4 Market for Apartments 3.5 Market for Milk 4.1 A Production Function for Chocolate Chip Cookies 4.2 Hypothetical Cost Schedules for HP Printers in the Short Run 4.3 The Cost of Driving in 2015 4.4 Average Total Cost of a Prescription Drug 4.5 Cost of Producing the iPhone 4.6 Productivity Data 4.7 Producing Textbooks 4.8 Hanson Electric Company’s Cost of Production 4.9 Cost Data for the Production of Microscopes 5.1 Demand and Revenue Schedules for De Beers as a Monopolist 5.2 Revenue and Cost Conditions of Johnson Electronics Inc. 5.3 Revenue and Cost Data of Charette Technologies Co. 5.4 Cost Data for a Perfectly Competitive Firm 6.1 Top-Four Concentration Ratios for Selected U.S. Manufacturing Industries, 2012 6.2 U.S. Automobile Market: Market Shares 6.3 Hypothetical Profit-Payoff Matrix for Nike and Reebok 7.1 Selected State Minimum Wage Rates 7.2 Union Membership, 1985–2010 7.3 Labor Data for Youngquist Strawberry Co. 24 7.4 Market for Less-Skilled Labor 8.1 Federal Subsidies for Electric Power by Source 8.2 Hypothetical Demand and Cost Data for New England Power and Light Co. 9.1 Distribution of Income in the United States, 1980–2012 9.2 Disposition of Household Personal Income, 2004–2014 9.3 Government Receipts and Expenditures, Percent of Total 9.4 Total Tax Receipts as a Percent of Gross Domestic Output 9.5 Progressive, Proportional, and Regressive Taxes 9.6 Federal Income Tax Rates for a Single Taxpayer, 2015 9.7 Share of Federal Personal Income Tax Paid by Various Income Groups 9.8 Corporate Income Tax Rates around the World, 2014 9.9 Hypothetical Tax Data 9.10 Hypothetical Sales Tax Data 10.1 Gross Domestic Product, 2014 10.2 Comparisons of Living Standards Throughout the World 10.3 Nominal GDP, Real GDP, and GDP Deflator, 2009–2014 10.4 Annual Rates of Growth in U.S. Labor Productivity and Real Compensation per Hour in the Business Sector, 1960–2014 10.5 Gross Domestic Product Data 10.6 Calculation of Real Gross Domestic Product 11.1 Post-World War II Recessions for the United States 11.2 The Burdens of Unemployment: Unemployment Rates 11.3 Unemployment Rate Adjusted for Part-Time Workers and Discouraged Workers 11.4 The Impact of Inflation on the Real Value of $10,000, 2000–2010 11.5 Consumer Price Index and Rate of Inflation for Selected Years 11.6 The Price of a Big Mac, July 2015 11.7 Nominal and Real Interest Rates, 2000–2014 11.8 Inflation and Real Wages 11.9 Nominal and Real Interest Rates 12.1 Aggregate Demand and Aggregate Supply Data 12.2 The Multiplier Process 13.1 Examples of U.S. Fiscal Policies 13.2 Discretionary Fiscal Policies 13.3 Automatic Stabilizers during the Great Recession of 2007–2009 25 13.4 Federal Debt Held by the Public 13.5 Hypothetical Tax Data for the United States 14.1 How Bank Credit Cards Compare, 2015 14.2 Interest Rates on Household Loans 14.3 The M1 Measure of U.S. Money Supply, 2015 14.4 Consolidated Balance Sheet for All U.S. Commercial Banks, August 2015 (billions of dollars) 14.5 Hypothetical Money Supply Data 14.6 Balance Sheet of the Bank of Ohio 15.1 Required Reserve Ratios of the Fed, 2015 15.2 Using Monetary Policy to Combat a Recession or Inflation 16.1 The Fruits of Global Trade 16.2 Hewlett-Packard Outsources Production of the HP Pavilion 16.3 Comparative Advantages in the Global Economy 16.4 Hourly Compensation Costs for All Employees in Manufacturing, 2013 16.5 Production Possibilities Schedules of Japan and South Korea 16.6 Australia’s Computer Market 17.1 U.S. Balance of Payments: 1980–2014 17.2 Foreign Exchange Quotations 17.3 International Transactions of the United States 17.4 Supply of and Demand for British Pounds 17.5 Dollar/Franc Exchange Values 18.1 Basic Economic and Social Indicators for Selected Nations, 2013 18.2 Average Tariff Rates of Selected Developing Countries and Advanced Countries 26 Preface As a university instructor, I have enthusiastically taught a one-term survey of economics course for more than 30 years to undergraduate students majoring in business, economics, and other disciplines. Most of the students who take my course are still in their teens and have only a modest awareness of economics. They are interested in learning, but they want to know how economics relates to their daily lives. Learning economic theory, by itself, means little to most students. I sometimes hear students ask “What good is theory if it doesn’t help me get a job or increase my income?” To make my survey of economics course come alive for these students, I combine a clear and concise presentation of microeconomic and macroeconomic theory with an abundance of contemporary applications. To illustrate each economic principle, I relate real-world examples taken from current newspapers, magazines, government reports, and economic journals. Also, I show videos to my students that deal with issues such as Social Security reform, subsidies to renewable energies, and the European Monetary Union. To help my students become informed consumers, I discuss topics such as obtaining mortgages with fixed or variable interest rates and assessing the cost of driving an automobile. Indeed, combining real-world applications with an exciting and sometimes humorous presentation of economic theory is the main focus of my course. The positive feedback that I have received indicates that I have developed an approach to teaching that makes economics come alive for students. This pedagogical approach is integrated into my textbook Contemporary Economics: An Applications Approach, 8th edition. The encouragement that I have received during the first seven editions of this text has convinced me that my approach is meeting the needs of a considerable number of students and faculty. It is with pleasure that I have prepared an eighth edition of this textbook. MEETING STUDENTS’ NEEDS A challenge faced by instructors on economics survey courses is that many of their students will go on to take courses in the principles of microeconomics and the principles of macroeconomics. To be meaningful for these students, the survey of economics course must provide an introduction to microeconomics and macroeconomics without duplicating the principles courses. A strength of Contemporary Economics is that it addresses such a need. By combining a relatively small number of theoretical tools with an abundance of contemporary applications, my textbook is not an abbreviation of a principles textbook. Rather, it is a distinct survey of economics for economics majors who wish to take an introductory course before moving on to more rigorous courses in the principles of microeconomics and macroeconomics and for non-majors who wish to take only one course in this field. Contemporary Economics is written mainly for students at 4-year colleges and universities as well as for students at community colleges. However, this textbook will also be highly attractive to high schools offering 27 an introductory course in economics. DISTINGUISHING FEATURES The distinguishing features of my textbook include clear and concise presentation of economic theory, global coverage in every chapter, integration of contemporary issues throughout theoretical presentations, and the inclusion of consumer economics topics. Presentation of Theory Presenting economic theory in a clear and easy-to-understand manner is the foundation of this textbook. Students can easily relate to the economic theories because they are presented in terms of realistic examples chosen to appeal to students of all backgrounds and abilities. For example, demand and supply analysis is presented in terms of the market for compact discs, the costs of production in terms of computer printers, perfect competition in terms of the Puget Sound Fishing Co., monopoly in terms of De Beers (the diamond monopoly), and oligopoly in terms of Boeing and Airbus. These contemporary examples are reinforced by additional real-world examples that come from publications such as The Wall Street Journal, Business Week, and The New York Times. For example, Chapter 5 discusses why cable television rates are so high. The discussion combines theoretical topics such as barriers to entry, natural monopoly, and potential competition in the pricing of cable television. Because they are familiar with cable television, students can easily identify with its pricing implications. Students who have read my textbook have commented not only that the presentation is clear and easy to understand, but also that they could remember the specific examples illustrating the theories throughout the textbook. Moreover, all diagrams throughout my textbook use numbers (for example, 10 CDs at a price of $10) on their axes to make the examples familiar and obvious to the student. Many other textbooks use letters on their axes (for example, OA units of product X at a price of OY), which students tend to find remote from their daily lives. Finally, my textbook emphasizes only the economic models that are essential to an introductory understanding of economics: production possibilities analysis, demand and supply for particular markets, production and the costs of production, perfect competition and monopoly, and aggregate demand and supply. Global Content No survey of economics textbooks can ignore discussion of the global economy. Contemporary Economics addresses this issue using a two-pronged approach. First, I globalize each chapter so that students will not think of the U.S. economy in isolated terms as they read this textbook. For example, Chapter 7 discusses whether the outsourcing of jobs by U.S. companies is a threat or an opportunity for American workers. This topic has been publicized in the news media and is familiar to students. Here, they will learn how the U.S. labor market is linked to labor markets in other countries such as 28 India and China. I also introduce a global component by including separate chapters on international trade, finance, and development. Chapter 16, International Trade and the Global Economy, discusses the principle of comparative advantage and the effects of free trade and protectionism. Chapter 17, International Finance, provides an introduction to the U.S. balance of payments, the foreign exchange market, and the factors that cause fluctuations in the dollar’s exchange value. Chapter 18, Economic Systems and Developing Countries, discusses alternative economic systems and the role of developing countries in the global economy. Real-World Applications Contemporary Economics: An Applications Approach lives up to its name by emphasizing applications and policy questions as often as possible. I have written this textbook for the student who is taking economics for the first time, and I stress the material that students should and do find interesting about the study of our economy. Therefore, I have devoted much attention to applications and policy questions that students hear about in the news and bring from their own lives. For example, Chapter 9 discusses the future of the U.S. social security system. Students learn how its payas-you-go system of social security can be threatened when the number of workers paying taxes into the system falls relative to the number of beneficiaries. Of particular interest is whether Americans should be allowed to place a portion of their payroll taxes in personal retirement accounts. Not only are my applications current, but also they show a concern for the diversity among students. As often as possible, I have used examples that are familiar to students: iPod, Google, Microsoft, Delta Airlines, and the like. In particular, here are a few of the many real-world applications that are included in the 8th edition: • Economic Sanctions, Iran, and Russia, Chapter 1 • Hydraulic Fracturing Fosters Oil Production, Chapter 2 • What Drives Gasoline Prices? Chapter 2 • Dynamic Baseball Ticket Pricing, Chapter 3 • U.S. Postal Service Boosts Rates to Increase Revenue, Chapter 3 • Colleges Hike Tuition to Offset Cutbacks to Higher Education, Chapter 3 • Apple’s Global Production Network, Chapter 4 • Higher Wages in China Hamper Competitiveness, Chapter 4 • Do Patents Encourage Innovation? Chapter 5 • Google as a Monopoly, Chapter 5 • Vaughan-Bassett Furniture Survives in a Global Economy, Chapter 6 • Indiana and Michigan Adopt Right-to-Work Laws, Chapter 7 29 • Cap and Trade: Trading Emissions Certificates, Chapter 8 • Renewable Energy and Subsidies, Chapter 8 • Has Income Inequality Gone Too Far? Chapter 9 • Is the U.S. Tax System Fair? Chapter 9 • Does the Penny Make Sense? Chapter 14 • Do Policymakers Have Enough Ammo for the Next Recession? Chapter 15 • Quantitative Easing and the Federal Reserve, Chapter 15 • Should We Give Shoe Tariffs the Boot? Chapter 16 • Mexico Stews Over Tariff Dispute, Chapter 16 • The Trans-Pacific Partnership, Chapter 16 • Is China’s Currency Manipulation the Problem? Chapter 17 • Monetary Integration in Europe: The Euro, Chapter 17 • Market Capitalism Versus State Capitalism: Which Works Better? Chapter 18 Consumer Economics Applications To help students become informed consumers, Contemporary Economics includes applications in consumer economics. Examples include calculating compound interest, identifying electronic codes on a personal check, shopping for a credit card, and holds placed on checking accounts. I have incorporated these topics into my survey of economics class, and my students find them interesting and beneficial to their lives. For example, Chapter 4 discusses the costs of driving an automobile. Students learn about the fixed costs and variable costs of driving and how to calculate the cost of driving on a per-mile basis. These concepts provide a nice transition to the costs of production which are discussed later in the chapter. SUPPLEMENTARY MATERIALS To help students master the tools of economic analysis, Koushik Ghosh of Central Washington University has prepared an excellent online Study Guide. Each chapter provides a summary of important points and learning objectives, matching review questions, multiple-choice questions, true-false questions, and application exercises. To assist instructors in the teaching of this textbook, Margaret Brooks of Bridgewater State University and I have written an online Instructor’s Manual with test bank. Part I contains learning objectives, lecture hints and ideas, discussion starters, and brief answers to end-of-chapter study questions and problems. Part II contains a comprehensive test bank with multiple-choice, true-false, and essay questions. 30 31 Acknowledgments This textbook could not have been written and published without the assistance of many individuals. I am pleased to acknowledge those who provided helpful suggestions and often detailed reviews: John Olienyk, Colorado State University John Adams, Texas A&M International University Bruce Pietrykowski, University of Michigan–Dearborn Tesa Stegner, Idaho State University Clifford Hawley, West Virginia University Rolando Santos, Lakeland Community College Karin Steffens, Northern Michigan University Pam Whalley, Western Washington University Margaret Landman, Bridgewater State University Barry Kotlove, Edmonds Community College R. Edward Chatterton, Lock Haven University Dea Ochs, Jesuit College Prep, Dallas, Texas Z. Edward O’Relley, North Dakota State University Laurence Malone, Hartwick College Vicki Rostedt, University of Akron Kishore Kulkami, Metropolitan State College David Hammes, University of Hawaii at Hilo Gary Galles, Pepperdine University Bruce Billings, University of Arizona Barry Goodwin, North Carolina State University Wike Walden, North Carolina State University Joseph Samprone, Georgia College and State University Robert Grafstein, University of Georgia Mark Healy, William Rainey Harper College Vani Kotcherlakota, University of Nebraska 32 Donald A. Coffin, Indiana University, Northwest Naga Pulikonda, Indiana University, Kokomo F. P. Biggs, Principia College Ken Harrison, The Richard Stockton College of New Jersey Donald Bumpass, Sam Houston State College Sandra Peart, Baldwin-Wallace College Michael Rosen, Milwaukee Area Technical College Nicholas Karatjas, Indiana University of Pennsylvania Ernest Diedrich, St. John’s University Arthur Janssen, Emporia State University Ralph Gray, De Pauw University Maria V. Gamba-Riedel, The University of Findlay Anthony Patrick O’Brien, Lehigh University Charles W. Smith, Lincoln Land Community College Paul Comoli, University of Kansas Walton Padelford, Union University David Gillette, Truman State University Laurence J. Malone, Hartwick College Chris Phillips, Somerset Community College I would also like to thank my colleagues at Central Washington University—Shirley Hood, Koushik Ghosh, Peter Gray, David Hedrick, Peter Saunders, Toni Sipic, and Chad Wassell—for their advice and help while I was preparing the manuscript. It has been a pleasure to work with the staff at Routledge: Taylor & Francis Group who orchestrated the production of this book—Emily Kindleysides, Elanor Best, Alaina Christensen, and Mary Dalton. Finally, I am grateful to my students, who commented on the manuscript. I would appreciate any comments, corrections, or suggestions that faculty or students wish to make, so that I can continue to improve this textbook in the years ahead. Please contact me! Thank you for permitting this text to evolve to the eighth edition. Bob Carbaugh Department of Economics Central Washington University 33 400 East University Way Ellensburg, Washington 98926 34 PART 1 Introduction 35 CHAPTER 1 Scarcity and Choice Chapter objectives After reading this chapter, you should be able to: 1. Discuss the nature of economics and the economic way of thinking. 2. Explain how the concept of scarcity relates to the concept of opportunity cost. 3. Identify the causes of economic growth and decline. 4. Identify the opportunity cost of national security. 5. Describe the purpose and effects of economic sanctions. economics I IN CONTEXT n the years following World War II, the United States sacrificed in order to equip itself with a national defense that could meet the threat posed by the Soviet Union. Trillions of dollars were spent to produce jet aircraft, tanks, missiles, submarines, and other defense goods. Indeed, the resources of the United States were scarce. The production of more defense goods meant that fewer resources were available for libraries, schools, golf courses, and other civilian goods. Put simply, the United States sacrificed civilian goods to produce more military goods. Each time the United States developed a new military system, the former Soviet Union would develop a more costly system of its own. Were it not for scarce resources, the Soviets could have produced more civilian goods and more military goods. Because of scarcity, however, the Soviets had to produce fewer civilian goods to fulfill the everyday needs of the people. Moreover, the Soviet Union was less efficient at producing goods than the United States and other countries. Civilian goods were thus in short supply and of poor quality in the Soviet Union, which led to bitter complaints among the people. In 1992, the Soviet Union collapsed under the pressure of its disenchanted citizens. Suddenly, the world appeared to be a calmer and more secure place to live. That tranquility, however, ended dramatically when terrorists attacked the United States on September 11, 2001, prompting the U.S. military to invade Afghanistan and Iraq. To improve national security, the United States once again increased its expenditures on military goods. However, the production of more military goods meant that fewer resources would be available for the production of civilian goods, such as 36 police and fire protection, hospitals, and highways. The question of how an economy should use its scarce resources is a main focus of public debate for all societies. In this chapter, we will examine the economic choices that must be made in every society because of scarcity. WHAT IS ECONOMICS? Economics means different things to different people. To some it means making money in stocks, bonds, and real estate. To others it means understanding how to own and operate a business. To the president of the United States, it may mean developing a new federal budget or formulating plans to reform the welfare system. Although all of these matters are part of economics, the subject has broader dimensions. Economics is first and foremost the study of choice under conditions of scarcity. Both individually and as a society, we attempt to choose wisely. We are forced to do so because human and property resources are limited, and it takes resources to produce cell phones, computers, automobiles, CD players, and other goods and services that we desire. Obtaining the greatest value from resources is the goal of economic choice. At a personal level, we have limited income to spend on the many items we want. For example, we might forgo purchasing a Toyota RAV4 in order to have funds to pay tuition at University of Wisconsin. Businesses also face alternatives. Should a company use its scarce funds to replace its photocopiers instead of buying new computers? Moreover, the government has to make choices. Should tax dollars be used to purchase additional tanks and missiles, or should these dollars be used to finance the construction of a new highway system? The field of economics is quite broad. Its reach extends from personal concerns—why does a pound of butter cost more than a pound of margarine?—to issues of national and global importance—will an economic slump in Asia cause the U.S. economy to decline? The field of economics is generally divided into two categories—microeconomics and macroeconomics. Microeconomics Microeconomics is the branch of economics that focuses on the choices made by households and firms and the effects those choices have on particular markets. We can use microeconomics to understand how markets work, to make personal or managerial decisions, and to analyze the impact of government policies. Consider these microeconomic questions: • How would a higher tax on cigarettes affect consumption by teenagers? • Why do convenience stores often close after several years? • How would a ban on immigrant workers from Mexico affect U.S. apple growers? • Should I put my savings in a bank account or invest them in the stock market? • Will an increase in the federal minimum wage help the working poor? 37 Macroeconomics The other branch of economics is macroeconomics. Macroeconomics is concerned with the overall performance of the economy. Macroeconomics does not focus on the activities of individual households, firms, or markets; instead, it focuses on the behavior of the economy itself. It deals especially with the determination of total output, the level of employment, and the price level. We study macroeconomics to learn how the overall economy works and to understand the controversies concerning economic policies. Among the macroeconomic topics that we will examine are the following: • Why do some economies grow more rapidly than others? • What causes unemployment and inflation? • Should the government adopt policies to increase savings and investment? • Should the government limit the outsourcing of American jobs to foreign nations? • How does a decrease in interest rates affect the economy? These two branches—microeconomics and macroeconomics—converge to form the field of modern economics. THE ECONOMIC WAY OF THINKING The practice of economics often calls for an analysis of complex problems. Although economists may differ in their ideological views, they have developed an “economic way of thinking.” This methodology is based on several principles. Every Choice Has a Cost Because human and property resources are scarce, individuals and societies must choose how best to use them. Making prudent choices requires trading off one thing for another. At the core of economics is the notion that “there is no such thing as a free lunch.” A friend may buy your lunch, making it “free” to you, but there still is a cost to someone and, ultimately, to society. This notion expresses the fundamental principle of economics: Every choice involves a cost. The cost of any choice is the value of the best opportunity that is forgone in making it. For example, you can choose to remain in college or quit college. If you quit, you may find a job at Burger King and earn enough money to buy some Levi’s jeans, rent some videos, go golfing and skiing, and hang out with your friends. If you remain in college, you will not currently be able to afford all of these things now. However, your education will enable you to find a better job later, and then you will be able to afford these and many other items. People Make Better Choices by Thinking at the Margin Economists maintain that people make better choices by thinking “at the margin.” Making a choice at the 38 margin means deciding to do a little more or a little less of an activity. As a student, you can allocate the next hour to sleeping or studying. In making this decision, you compare the benefit of extra study time to the cost of forgone sleep. As an example of thinking at the margin, consider how United Airlines decides how much to charge passengers who fly standby. Assume that flying a 300-seat jetliner from Seattle to New York costs the airline $90,000. Therefore, the average cost (per seat) is $300 ($90,000 / 300 = $300). You might conclude that United Airlines should always charge at least $300 per ticket. However, the airline can increase its profits by thinking at the margin. Suppose that a jetliner is going to take off with one empty seat. A standby passenger is waiting at the gate and he is willing to pay $200 to fly from Seattle to New York. Should United Airlines sell him a ticket at this price? Yes, because the cost of flying one more passenger is negligible. Although the average cost of flying a passenger is $300, the marginal (extra) cost is only the cost of a can of Sprite, a bag of pretzels, and a chicken sandwich. As long as United Airlines earns revenues that are more than the marginal cost, the addition an extra passenger is profitable. Rational Self-Interest Economics is founded on the assumption of rational self-interest. This means that people act as if they are motivated by self-interest and respond predictably to opportunities for gain. In other words, people try to make the best of any situation. Often, making the best of a situation involves maximizing the value of some quantity. As a student, getting high grades may be an incentive to study hard because they may help you obtain a job interview with a particular employer or get accepted into a prestigious graduate school. Throughout this text, we will assume that economic incentives underlie the rational decisions that people make. We will assume that a firm’s owners want to maximize profit in order to improve their well-being. Also, we will assume that households seek to maximize their satisfaction from consuming goods and services. Because income is limited and goods have prices, we cannot buy all the things we would like to have. Therefore, we should choose an attainable combination of goods that will maximize our satisfaction. Of course, self-interest does not always imply increasing one’s wealth as measured in dollars and cents or one’s satisfaction from goods consumed. In addition to economic motivations, people also have goals pertaining to friendship, love, altruism, creativity, and the like. Economic Models Like other sciences, economics uses models. In chemistry, you may have seen a model of an atom—a device with blue, green, and red balls that represent neutrons, electrons, and protons. Architects construct cardboard models of skyscrapers before they are built. Economic models are not built with plastic or cardboard, but rather with words, diagrams, and mathematical equations. Economic models, or theories, are simplified representations of the real world that we use to help us understand, explain, and predict economic phenomena in the real world. Economic models explain inflation, unemployment, wage rates, exchange rates, and more. For example, an economic model might tell us how the quantity of compact discs (CDs) that consumers purchase will change if the sellers raise the price. Other 39 models explain how changes in interest rates in the economy affect investment spending by business. Throughout this textbook, we will use economic models to help us understand contemporary economic issues. Positive versus Normative Economics It is important to realize that economics is not always free of value judgments. In thinking about economic questions, we must distinguish questions of fact from questions of fairness. Positive economics describes the facts of the economy—it deals with the way in which the economy works. Positive economics considers such questions as, why do computer scientists earn more than janitors? What is the economic effect of reducing taxes? Does free trade result in job losses for less-skilled workers? Although these questions are difficult to answer, they can be addressed by economic analysis and empirical evidence. Normative economics involves value judgments that cannot be tested empirically. Ethical standards and norms of fairness underlie normative economics. For example, should the United States penalize India for violating U.S. patent and copyright laws? Should welfare payments be reduced in order to encourage the unemployed to find income-producing jobs? Should all Americans have equal access to health care? Because these questions involve value judgments instead of facts, there are no right or wrong answers. Both positive and normative economics are important and will be considered throughout this textbook. Why do economists often appear to give conflicting advice to policymakers? Because economists do not fully understand how the economy operates, they often disagree about actual cause-and-effect relationships. Moreover, economists may have different value judgments, and thus different normative views, about the goals that economic policies should attempt to accomplish. The first part of this chapter has given us an overview of economics and the economic way of thinking. We will now examine the economic problem of scarcity. SCARCITY Whether you are taking just one economics course or majoring in economics, the most important topic you will learn about is scarcity. Scarcity means that there are not enough, nor can there ever be enough, goods and services to satisfy the wants and needs of everyone. Consider your own situation. Can you afford the school that you would most prefer to attend or the car that you would most like to own? Do you have sufficient financial resources for all the clothes, computers, concerts, and sporting events that you want? Societies also face a scarcity problem. Money devoted to national defense, for example, is not available for education or food stamps. The source of the scarcity problem is that people have limited resources to satisfy their unlimited material wants. Resources, or factors of production, are inputs used in the production of goods and services that we want, such as CD players and textbooks. The total quantity of resources that an economy has at any one time determines how much output the economy can produce. The factors of production are classified as follows: 1. Land. Land refers to all natural resources—such as raw materials, land, minerals, forests, water, and 40 climate—used in the productive process. 2. Labor. This resource includes all physical and mental efforts that people make available for production. The services of professional baseball players, accountants, teachers, and autoworkers all fall under the heading of labor. 3. Capital. Capital, or investment goods, refers to goods that are used to produce other goods and services. This includes such things as machinery, tools, computers, computer software, buildings, and roads. Notice that economists do not consider money to be capital because it is not directly used in production. 4. Entrepreneurship. This factor of production is a special type of labor. An entrepreneur is a person who organizes, manages, and assembles the other factors of production to produce goods and services. Entrepreneurs seek profit by undertaking risky activities such as starting a new business, creating a new product, or inventing a new way of accomplishing something. Bill Gates (founder of Microsoft Corp.), Levi Strauss (founder of Levi Strauss Co.), and Henry Ford (founder of Ford Motor Co.) are examples of highly successful entrepreneurs. These factors of production have a common characteristic: They are in limited supply. Quantities of mineral deposits, capital equipment, arable land, and labor (time) are available only in finite amounts. Because of the scarcity of resources and the limitation this scarcity imposes on productive activity, output will be limited. Limited resources conflict with unlimited wants. Human wants are said to be unlimited because no matter how much people have, they always want more of something. Because not all wants can be fulfilled, individuals must choose which ones to fulfill with limited available resources. In a world of scarcity, every want that is fulfilled results in one or more other wants remaining unfulfilled. SCARCITY AND OPPORTUNITY COST The reality of scarcity forces us to make choices that involve giving up one opportunity in order to do or use something else. For example, the cost of going to a Chicago Bulls’ basketball game includes the value of what is sacrificed to attend. Economists use the term opportunity cost to denote the value of the best alternative that is sacrificed. Part of the cost of attending a Bulls’ game is the price of the ticket. This price represents the other goods and services you could have purchased with that money instead. In addition, there is the most valuable alternative use of the time devoted to watching the game. Perhaps you could have used this time to study for an upcoming economics exam. Thus, the opportunity cost of attending the game equals the ticket price plus the difference in your test score that the additional study time would have yielded. Let us consider several applications of opportunity cost. economics IN ACTION Frederick Smith: Entrepreneur 41 Frederick Smith, founder of FedEx, is one of America’s most successful entrepreneurs. He comes from a family tradition based on transportation. His grandfather was a steamboat captain, and his father established a regional bus company that turned into a cornerstone of the Greyhound Bus system. Learning to fly as a teenager, Smith worked weekends as a charter pilot while pursuing an economics degree at Yale University in the 1960s. While flying faculty and other passengers around, Smith had an idea that resulted in a radical change in the transportation business. He realized that besides flying people, he often delivered spare parts for firms that could not wait for United Airlines and others to ship essential components to customers. In 1965, Smith formalized his notion of an express delivery service in a term paper written in an economics course. Although lore has it that Smith received a modest grade of “C” for his efforts, he recalls doing better. After serving a tour of duty with the Marines in Vietnam, Smith began to pursue his ambition. With $4 million in backing from his family and $80 million from other investors, he built the Federal Express Corporation (FedEx) from scratch in 1971. Its vow: guaranteed one-day delivery of packages between any two points in the United States. However, FedEx was no overnight success. The firm drummed up only seven packages for its first run. Therefore, Smith hired additional sales staff to boost sales. Yet deficient volume wasn’t the only problem. Until the late 1970s, the U.S. Postal Service was able to use its monopoly power to prevent FedEx from delivering documents. Also, strict airline regulations initially limited FedEx to flying small aircraft instead of larger, more efficient ones. Smith was in such dire need of funds that he traveled to Las Vegas to play the blackjack tables. He sent the $27,000 he won back to FedEx. Smith’s perseverance yielded success. By 1980, Americans had come to rely on FedEx’s promise to deliver packages by the next day. Although FedEx’s success has led to many competitors, it is still the dominant firm of the express delivery market. And all because a college economics major could visualize an opportunity that others could not. Sources: “Frederick Smith: Father of Overnight Delivery Service,” Academy of Achievement, Washington, D.C., February 2005. See also Dean Foust, “No Overnight Success,” Business Week, September 20, 2004, p. 18, and the home page of Federal Express, available at www.fedex.com. The Opportunity Cost of Attending College Another example is the opportunity cost of attending college. It is not simply the dollar amount listed in your college catalog. The money you spend on tuition, fees, textbooks, and supplies is only part of the opportunity cost; the income that you could have earned during the years that you are spending in classes is also part of the opportunity cost. Table 1.1 shows the total estimated, out-of-pocket costs of a year of college for the average student in 2014–2015. For example, the second column of the table shows the cost for an average instate resident at a 42 four-year state college to be $23,410. Of this amount, the student pays $9,139 in tuition and fees, $1,225 in books and supplies, $9,804 for room and board, and $3,242 for personal expenses and transportation. Is the student’s opportunity cost for a year of college $23,410? No. Some of this cost must be incurred regardless of whether the student attends college. For example, you would still have to assume room and board expenses—say, by living in an apartment—even if you did not attend college. This cost would not be eliminated even if you lived at home because your family could be renting your room to someone else. The same reasoning applies to transportation and other expenses, at least the portion that you would have assumed if you were not in college. Suppose that these expenses are the same regardless of whether you attend college. The opportunity cost of attending college thus consists of tuition and fees ($9,139) and books and supplies ($1,225), which total $10,364. In addition, the opportunity cost of a year of college includes the amount of forgone income. Assuming that you earn $15 an hour and reduce your work hours by 30 hours a week during the 32 weeks a year that you are in college, the forgone earnings represent a cost of $14,400 ($15 × 30 hours × 32 weeks) a year. It should be noted that most students will use their education to generate future earnings that will more than offset this sum. Nevertheless, the $14,400 also represents an opportunity cost of attending college. The opportunity cost of a year of college thus includes the payments for tuition and fees ($9,139), payments for books and supplies ($1,225), plus the $14,400 of forgone income. This sum totals $24,764. Notice that this amount is greater than the estimated $23,410 of out-of-pocket costs shown in Table 1.1. Some students find the opportunity cost of attending college to be even higher. Suppose that you are a talented baseball player or tennis player who could play professionally after graduating from high school. The opportunity cost of a year at college could easily exceed $100,000. Tiger Woods, a professional golfer, faced this dilemma after attending Stanford University for two years. Upon winning his third straight U.S. Amateur golf title, he chose to turn pro rather than continue his studies at Stanford. He immediately became a multimillionaire, with contracts worth more than $40 million, from Nike and Titleist in hand. It is no wonder that talented athletes often consider the opportunity cost of their college education to be too high and thus drop out of school to pursue professional sports. Opportunity Costs and Choices Suppose that your student club conducts a fund-raiser, and each club member agrees to spend 8 hours working at a Saturday car wash. A local service station donates its parking area and water, and your club supplies the washcloths and detergent. Club members wave their signs at passing motorists in an attempt to lure business. After washing several vehicles, the members determine that they can wash 10 compact cars or 5 minivans in an hour’s time. In an 8-hour day, then, the club could wash 80 compacts (8 × 10 = 80) or 40 minivans (8 × 5 = 40). Figure 1.1 illustrates the combinations of compacts and minivans that could be washed in an 8-hour day. Devoting the entire day to washing compacts results in 80 washed cars, shown by point A in the figure. 43 Conversely, devoting the entire day to washing minivans results in 40 washed minivans, shown by point E. Let us connect these two combinations with line AE. Other combinations (B, C, D) are attainable on this line. Line AE thus shows all the possible combinations of compacts and minivans that could be washed in a day. Table 1.1 Estimated Average Cost of a Year of College, 2014–2015 Source: Data from Trends in College Pricing: 2014–2015, The College Board, available at www.collegeboard.com. Based on the College Board’s Annual Survey of Colleges. Figure 1.1 Opportunity Cost and Choice In an 8-hour day, a student club can wash many combinations of minivans and compacts. Line AE illustrates these combinations given the assumption that the entire day is devoted to washing the two types of vehicles. The line is downward-sloping, suggesting that there is a tradeoff between the number of compacts and the number of minivans that can be washed. Along line AE, the opportunity cost of each additional washed minivan is 2 compacts that are not washed. Sliding down line AE, we see that there is an opportunity cost for washing minivans. For every 10 minivans that the club washes, it must sacrifice the washing of 20 compacts. This implies that the opportunity cost for each additional washed minivan equals 2 compacts (20 ÷ 10 = 2) that are not washed. Why does this trade-off occur? Given an 8-hour day, as more hours are devoted to the washing of minivans, fewer hours can be devoted to washing compacts. The 8-hour limitation of our Saturday car wash thus forces the club to make choices concerning how much effort should be devoted to washing compacts or minivans. Tabular and graphical relationships are further discussed in “Exploring Further 1.1” at the end of this chapter. CHECK POINT 44 1. What is economics? 2. Differentiate between microeconomics and macroeconomics. 3. Identify the major principles of the economic way of thinking. 4. How does scarcity force an individual to incur opportunity costs? 5. What opportunity cost do you face in attending college? THE PRODUCTION POSSIBILITIES CURVE AND OPPORTUNITY COST Just as scarcity affects the car-wash choices of a student club, it also influences the production choices of a nation. The relationship between the ideas of scarcity and choice that an entire nation faces can be illustrated by a production possibilities curve. A production possibilities curve illustrates graphically the maximum combinations of two goods that an economy can produce, given its available resources and technology. Several assumptions underlie an economy’s production possibilities curve: 1. Fixed resources. The quantities of all resources, or factors of production, are held constant. This means that there are no changes in the economy’s labor, machinery, and the like. Existing resources can only be transferred from the production of one good to the production of another good. 2. Fully employed resources. Everyone who wants a job has one, and all other resources are being used. All resources are producing the maximum output possible. 3. Technology unchanged. The existing technology is held fixed with no new innovations or inventions taking place. The assumptions of fixed resources and fixed technology imply that we are looking at an economy at a specific point in time or over a very short period. Over a relatively long period, it is possible for resources to change and technological advances to occur. Figure 1.2 illustrates a hypothetical economy that has the capacity to produce many combinations of DVD players and computers. If all resources are devoted to computer production, 6 million computers per year can be produced, denoted by point A in the figure. If all resources are devoted to the production of DVD players, 3 million DVD players per year can be produced, denoted by point D. Between the extremes of points A and D are other possible combinations of the two goods, denoted by points B point C. By connecting these points, we can see the economy’s production possibilities curve. The production possibilities curve in Figure 1.2 (a) is downward-sloping because of the problem of scarcity. Resources of land, labor, capital, and entrepreneurship are limited to particular amounts at any one point in time. In a fully employed economy, if more resources are going into the production of DVD players, fewer resources will be left for the production of computers. To produce more DVD players, the cost will be a lower output of computers. The figure thus illustrates a basic truth of economics: All choices have opportunity costs. 45 Economic Inefficiency Because all points along a production possibilities curve depict maximum output with given resources and technology, an economy realizes economic efficiency when it is operating along the curve. What if an economy does not employ all of its resources at their maximum capacity? For example, during economic downturns some workers probably cannot find work, and some plants and equipment may become underutilized. In this situation, the economy fails to realize the output potential of its production possibilities curve, and economic inefficiency occurs. In Figure 1.2 (b), point E shows an inefficient output combination for an economy that realizes unemployed labor or other underutilized resources; only 1 million DVD players and 1 million computers are produced. With full employment, the economy can produce a larger output combination—say, 2 million DVD players and 3 million computers, shown by point C in the figure. Comparing these two points, we see that unemployment results in forgone output equal to 2 million computers and 1 million DVD players. Generalizing, the effect of unemployment is illustrated graphically by a point beneath the production possibilities curve. This point is attainable, but not necessarily desirable. Figure 1.2 Production Possibilities Curve A production possibilities curve graphically depicts the various combinations of two goods that an economy can produce with full employment, fixed resources, and fixed technology. Points inside the production possibilities curve are economically inefficient, while points outside the curve are unattainable given an economy’s existing resources and technology. Even if an economy can fully employ all of its resources at their maximum capacity, certain output combinations cannot be realized. In Figure 1.2 (b), any point outside the economy’s production possibilities curve, say, point F, is unattainable because it lies beyond the economy’s current production capabilities. The economy cannot achieve this output combination with its existing resources and technology. Scarcity restricts an economy to operating at points along or beneath its production possibilities curve. Do economies actually operate along their production possibilities curves? Strictly speaking, no. Economies always experience some degree of unemployment and underproduction which causes them to operate beneath 46 their production possibilities curves. A production possibilities curve can thus be viewed as a yardstick against which an economy’s production performance can be measured. To what extent has the United States been able to utilize its industrial capacity? A measure of such utilization is the capacity utilization rate, which is the ratio of an industry’s production to its capacity. According to this measure, an industry that is operating at full capacity has a 100-percent capacity utilization rate; a rate less than 100 percent implies that at least some plants and equipment are idle. Table 1.2 illustrates capacity utilization rates for major U.S. industries. We see that from 1972 to 2014 all U.S. industries combined operated at an average capacity utilization rate of 80.1 percent. The average capacity utilization rates for the economy’s manufacturing, mining, and utilities sectors during this period equaled 78.5 percent, 87.5 percent, and 85.9 percent, respectively. The table also shows capacity utilization rates for particular U.S. manufacturing industries. Table 1.2 Capacity Utilization Rates for Major U.S. Industries, 1972–2014 Average Source: Federal Reserve Statistical Release G-17, Industrial Production and Capacity Utilization, available at www.federalreserve.gov. The Law of Increasing Opportunity Cost Figure 1.3 illustrates the production possibilities curve of our hypothetical economy as previously discussed. Notice that the production possibilities curve is bowed outward, or concave. This is because the opportunity cost of DVD players increases as more DVD players are produced. Moving from point A to point B along the curve, the opportunity cost of 1 DVD player is 1 computer; between points B and C, the opportunity cost is 2 computers; and between points C and D, the opportunity cost is 3 computers. These opportunity costs represent what occurs in the real world for most goods: Opportunity costs increase as we produce more of a good. This relationship is known as the law of increasing opportunity cost. But why do opportunity costs generally increase as we produce more of a good? The answer is that resources are not completely adaptable to alternative uses. For example, some workers have skills that are more useful for producing DVD players than other workers have. When a company first starts producing DVD players, it employs workers who are most skilled at the production of DVD players. The most skilled workers are those who can produce DVD players at a lower opportunity cost than others. Yet as the company produces more DVD players, it finds that it has already employed the most skilled workers; thus, going forward, it must employ workers who are less skilled in the production of DVD players. These workers produce DVD players at a high opportunity cost. Whereas two skilled workers could produce a DVD player in a day, as many as five 47 unskilled workers may be required to produce one DVD player in the same amount of time. Thus, as more DVD players are produced, the opportunity cost of producing DVD players increases. ECONOMIC GROWTH At any particular point in time, an economy cannot operate outside its production possibilities curve. Over time, however, it is possible for an economy to expand its output potential. This occurs through economic growth, which refers to the increased productive capabilities of an economy that are made possible by either an increasing resource base or technological advancement. Figure 1.3 The Law of Increasing Opportunity Cost In the real world, most production possibilities curves are bowed outward. This means that, for most goods, the opportunity cost increases as we produce more of them. Increasing opportunity costs occur when resources are not completely adaptable to alternative uses. Economic growth entails an outward shift in an economy’s production possibilities curve so that more of all goods can be produced. Figure 1.4 illustrates the significance of an outward shift in a production possibilities curve. Before the occurrence of economic growth, suppose that an economy can produce 2 million DVD players and 3 million computers, shown by point C along curve PPC0. As a result of growth in the economy’s resource base or technological advancement, the production possibilities curve shifts outward to a higher level, PPC1. Economic growth permits the economy to produce more computers (a movement to point E), more DVD players (a movement to point G), or more of both goods (a movement to point F). Many other previously unattainable combinations also become attainable with economic growth. In short, economic growth allows the economy to produce more of everything! However, growth does not guarantee that the economy will operate at a point along the higher production possibilities curve. The economy might fail to fulfill its expanded possibilities. One way to increase an economy’s production capacity is to gain additional resources. More (or better trained) workers or more (or improved) plants and equipment can increase a nation’s output potential. Worker productivity is also facilitated by investment in infrastructure such as roads, bridges, airports, and utilities. Another way to achieve economic growth is through research and development of new technologies. 48 Technological development allows more output to be produced with the same quantity of resources. A faster photocopier, a more smoothly operating assembly line, or a new-generation computer system are examples of technological advances. Throughout America’s history, agriculture has been a highly productive sector of the economy. In 1870, about 75 percent of Americans were farmers; in 2013, there were about 2 million farmers and agricultural workers, constituting less than 1 percent of the U.S. population. During this period, total farm output expanded greatly. How could a declining number of farmers produce greater output? The answer is improved technology. Whereas farmers once farmed with negligible capital equipment, today they use modern tractors, computers, pesticides, cellular phones, and the like. As a result, more food can be produced by fewer farmers. As farmers left farms, they entered manufacturing and service industries such as computers, automobiles, aircraft, accounting services, and engineering. Technological advances in farming thus made it possible to produce additional goods in other sectors of the economy. The result was an outward shift in the U.S. production possibilities curve. Figure 1.4 The Effect of Economic Growth on the Production Possibilities Curve Economic growth shifts a production possibilities curve outward and makes it possible to produce more of all goods. Prior to growth in production capacity, point C was on PPC0 and points E, F, and G were unattainable. After growth, shown by PPC1, points E, F, and G (and many other previously unattainable combinations) are attainable. ECONOMIC DECLINE Just as an expanding resource base causes an economy’s production possibilities to increase, decreasing resources can likewise reduce an economy’s output potential. During World War II, for example, the production possibilities of Europe and Japan decreased. The war disrupted people’s lives, and many people did not survive the war. Entire factories, roads, bridges, railway networks, electrical utilities, and other types of capital goods were reduced to rubble. The destructive effects of the war caused the production possibilities curves of Europe and Japan to shift inward. The physical devastation of Europe and Japan caused by World War II yielded some paradoxical effects for 49 these war-devastated economies. Because a large share of their stock of capital goods was destroyed by the war, these nations had to rebuild their industries from scratch. They did so with the most up-to-date factories and equipment. The result was a substantial increase in labor productivity, which allowed these economies to realize production possibilities exceeding those that had existed before the war. Conversely, nations that had been spared the devastation of the war had their prewar technologies in place and grew slower than those whose stock of capital goods was destroyed and replaced with more modern technology. For example, the United States was the most powerful steel-producing nation in the world immediately following World War II. The U.S. steel industry came out of the war intact, accounting for nearly half of the world’s steel output. Moreover, U.S. firms produced more steel than all of Europe combined and almost 20 times as much as Japan! During the 1950s and 1960s, however, the absence of foreign competition caused U.S. steel companies to become complacent. Instead of investing in new plants, they manufactured steel in outmoded plants using obsolete technologies and paid wages almost twice the average of all other U.S. manufacturing sectors. In contrast, Japan and Europe replaced the steel factories that had been devastated by the war with modern plants which used the most efficient equipment. By the 1970s, the productivity of Japanese and European steel companies was increasing relative to the productivity of U.S. companies and the competitiveness of U.S. companies dwindled. The threat of foreign competition forced U.S. steel companies to shut down many obsolete factories in the 1980s and replace them with modern plants and equipment. Natural disasters can also reduce an economy’s output potential. For example, in 2005 the states of Alabama, Louisiana, and Mississippi were struck by two major hurricanes (Katrina and Rita) which damaged the productive capacity of the U.S. economy. These hurricanes passed through offshore areas where oil and natural gas platforms are concentrated and then struck onshore areas where petroleum is refined and natural gas is processed. In addition to the tragic loss of life and massive destruction of personal property that they caused, the hurricanes damaged energy equipment and structures; about 28 percent of total U.S. production was shut down. Most of this output loss was the result of the destruction of oil and natural gas operations.1 Innovation, Economic Growth, and the American Economy As we have seen, the ability of an economy to grow rests on its resource base and technological advancement. Innovation is crucial for improving technologies that result in economic growth. Is the United States maintaining its innovation edge? The next time that you are at an electronics store, take a close look at an iPhone. You will find that it was designed by Apple Inc. in California and assembled in China. Similar to Apple, the United States has often seen other industries locating abroad in the past, such as wind turbines and smart phones, which were born in the United States. Moreover, when abandoning an industry, the United States may also lose technologies that can promote the development of future industries. Consider the Amazon Kindle. In 2007, Amazon introduced the Kindle electronic reader, a device that allows users to download and read textbooks, magazines, and other digital media on a portable computer screen. Amazon first released the Kindle in November 2007, for $399 and it was sold out in five and one half hours. By 2013, the Kindle sold for less than $130 as competition from other producers intensified. 50 To produce the electronic ink for the Kindle, Amazon initially partnered with E-Ink Co., an American producer. However, it turned out that E-Ink could not produce the screens due to unforeseen problems and Amazon had to find another partner. Although Amazon’s search initially began in the United States, it was unsuccessful because American firms did not have the capability to produce the Kindle screen. Eventually, Amazon linked with Prime View, a Chinese company, to produce the screen. Within a short period of time, Prime View acquired E-Ink and moved ink production from the United States to China. Even though the Kindle’s key innovation was initially invented in the United States, most of the Kindle production took place in China. economics IN ACTION Adam Smith: Father of Modern Economics Adam Smith (1723–1790) was a Scottish philosopher and is widely cited as the father of modern economics. He is the author of The Wealth of Nations, which is considered the first modern work of economics. Born in a small fishing village near Edinburgh, Scotland, Smith was the only child of the village’s customs officer. He studied philosophy at the University of Glasgow and Oxford University. After graduating, Smith became a professor at the University of Glasgow. He was lured away from his professorship by a wealthy Scottish duke who gave him a pension of £300 per year (ten times the average income of his day) to devote to the writing of The Wealth of Nations. This book was published in 1776 at the height of the Industrial Revolution when new technologies were applied to the manufacturing of iron, textiles, and agriculture. In his later life, Smith took a tutoring position allowing him to travel throughout Europe where he met other intellectual leaders of the day. The Wealth of Nations considers why some nations are wealthy and others are poor. Smith’s answer to this question emphasized the importance of free markets and the division of labor. He believed that the free market is guided to produce the right amount and variety of goods by an “invisible hand.” According to Smith, in a free market each participant will try to maximize self-interest. The interaction of market participants, leading to the exchange of goods and services, provides for each participant better than when simply producing for themselves. He further said that in a free market, no government regulation of any type would be needed to ensure that the mutually beneficial exchange of goods and services took place, since this “invisible hand” would guide market participants to trade in the most mutually beneficial manner. Smith also maintained that the division of labor and specialization would result in a large increase in labor productivity. An example he used was the making of pins. He noted that one worker using hand tools might make only 20 pins per day. However, if 10 workers divided up the 18 steps required to make a pin, they could together make 48,000 pins in one day: One worker draws out the wire, another straightens it, a 51 third cuts it, and so on. However, a large market is needed to support the division of labor. A factory employing 10 workers would need to sell more than 15 million pins a year to remain in operation. The Wealth of Nations was a precursor to the modern study of economics. It provided a strong intellectual rationale for free trade and capitalism, greatly influencing the writings of later economists. Sources: James Buchan, The Authentic Adam Smith: His Life and Ideas (New York, NY: W.W. Norton and Company, 2006); and Mark Skousen, The Making of Modern Economics (Armonk, NY: M.E. Sharpe, 2001). Some analysts note that as firms exit the United States, the country loses its innovation edge. They emphasize how manufacturing is a vital driver of research and development that fosters inventions which promote economic growth. The United States cannot sustain the level of economic growth it needs without a strong manufacturing sector. To promote stronger manufacturing, the United States needs investmentfriendly government policies, according to these analysts. However, others disagree. They maintain that from the perspective of America’s competitiveness, all of the essential technological activities still take place in America. They also note that international trade promotes evolution in a country’s industries over time. For example, the production of televisions initially began in the United States. But as technologies became standardized, television production shifted to other countries, such as Japan, with lower wages. This resulted in manufacturing costs and prices tumbling, to the benefit of consumers. Yet the question remains: how about the livelihood of Americans that formerly produced televisions? Indeed, the world economy is dynamic and producers who have prospered have been the ones who can modify their business models to match or surpass their competitors. ECONOMIC GROWTH: TRADE-OFFS BETWEEN CURRENT AND FUTURE CONSUMPTION The production possibilities curve and economic growth can be used to investigate the trade-off between current and future consumption. This trade-off can be illustrated for nations producing consumer goods and capital goods. Consumer goods are goods such as food, electricity, and clothing that are available for immediate use by households. They do not contribute to future production in the economy. Capital goods, such as factories and machines, are used to produce other goods and services in the future. Instead of being consumed today, capital goods are a source of an economy’s economic growth potential. A nation that sacrifices current consumption in order to invest in capital goods is forward-looking. Rather than getting instant satisfaction from the production of capital goods, the nation increases its capacity to produce consumer goods in the future. This is similar to students attending college. Students devote time to study that could have been spent working, earning income, and therefore engaging in a higher level of consumption. Most students decide to postpone consumption because they expect education to increase their productivity and income, allowing greater consumption in the future. 52 Figure 1.5 illustrates the production possibilities curves for the United States and Japan. The two axes of each production possibilities curve are designated as consumer goods (current goods) and capital goods (goods for the future). Assume that the two nations are identical in every respect except that the U.S. choice along its production possibilities curve strongly favors consumer goods as opposed to capital goods; let this be designated by point A in Figure 1.5(a). Conversely, Japan’s choice along its production possibilities curve strongly favors capital goods and is denoted by point A in Figure 1.5(b). The relatively large accumulation of capital goods allows the Japanese economy to grow faster than the U.S. economy. In Figure 1.5, this is illustrated by Japan’s production possibilities curve, which shifts farther out to the right than the U.S. curve. Over time, Japan’s faster growth rate allows it to produce more consumer goods than the United States. This increase in production, however, requires Japanese households to sacrifice current consumption in exchange for future consumption. PRODUCTION POSSIBILITIES APPLICATIONS The production possibilities concept can be applied to issues pertaining to national security. Let us consider the application of the production possibilities concept to the terrorist attacks of September 11, 2001, and to the economic sanctions levied by the United States against Iran. Figure 1.5 Economic Growth in the United States and Japan The current choice favoring consumer goods, made by the United States in (a), will cause a modest outward shift in the U.S. production possibilities curve. A current choice favoring capital goods, as made by Japan in (b), will lead to a greater outward shift in the Japanese production possibilities curve. The extra goods, made possible by economic growth, thus result in a greater improvement in the standards of living in Japan. Opportunity Cost of National Security The September 11 terrorist attacks resulted in a tragic loss of life for thousands of innocent people. It also jolted America’s golden age of prosperity and the promise it held for global growth, which had existed 53 throughout the 1990s. Because of the threat of terrorism, Americans became increasingly concerned about their safety. Immediately following the terrorist attacks, businesses and governments made greater efforts to improve their security. For example, Quality Carriers Inc., the country’s biggest chemical trucker, rehired the $5,000a-month night-shift security guard it had previously let go at its tanker-truck terminal in Newark, New Jersey. The company also paid two drivers a total of $1,200 to re-park any vehicles loaded with chemicals in plain view and under security lights. For Quality Carriers, achieving extra security required the firm to use more of its resources to protect the company from terrorists, leaving fewer resources available to transport chemicals for its customers. In like manner, security procedures were beefed up at power plants, communication companies, airports, and government buildings following the September 11 attacks. Simply put, providing for national security entails an opportunity cost. When we employ labor, capital, and land for security, we sacrifice other things that we could have produced with them. To demonstrate this point, consider Figure 1.6, which depicts hypothetical production possibilities curves for the United States. The vertical axis denotes the annual production of security goods (for example, metal detectors and X-ray monitors) and the horizontal axis denotes the annual production of goods other than security (for example, televisions and autos) that contribute directly to our standard of living. Because of technological progress and the growth in the nation’s stock of plants and equipment, the nation’s production possibilities curve shifts outward, as shown by the movement from curve PPC0 to curve PPC1. Figure 1.6 The Opportunity Cost of National Security Providing for national security entails an opportunity cost. When we use land, labor, and capital to produce security goods, we sacrifice other things we could have produced with them. Assume that prior to September 11, the United States was located at point E along curve PPC0. Also assume that in a typical year, economic growth would shift the United States from point E on curve PPC0 to point F on curve PPC1. This means that the nation would realize a modest increase in production of security goods, but most of our growth would have been used to produce additional quantities of autos, televisions, and other things we enjoy. Because of the September 11 terrorist attacks, however, we move from point E to point 54 G. Notice that although we produce additional quantities of nonsecurity goods, we do not produce as much of those goods as we would have if the attacks had not occurred. This limits our economic well-being as measured by the quantity of nonsecurity goods available for our consumption. Therefore, providing for national security results in an opportunity cost in terms of other goods that we enjoy. Economic Sanctions against Iran Nations often disagree with each other’s policies regarding military adventures, arms proliferation, support of terrorism and drug trafficking, human rights abuses, and so on. Besides military action, are there other ways to convince a foreign government to modify its policies regarding these issues? One alternative is economic sanctions, which are government-imposed limitations, or complete bans, placed on customary trade or financial relations between nations. The nation initiating the sanctions, the imposing nation, hopes to impair the economic capabilities of the recipient target nation. The goal of economic sanctions is to inspire the people of the target nation to force their government to alter its policies. Let us consider the sanctions imposed by the United States and other countries on Iran. Since 1987, the United States has implemented numerous sanctions against Iran, such as export boycotts, import boycotts, and financial sanctions. These sanctions have been in response to the United States’ viewing Iran as a state sponsor of international terrorism. An objective of the sanctions has been to force Iran to verifiably confine its nuclear program to purely peaceful uses rather than for the development of nuclear weapons that could be used against nations such as Israel. Since 2011, a broad coalition has joined the United States in applying progressively strict sanctions against Iran. Included in the coalition have been the European Union, Australia, Canada, India, Japan, South Korea, and others. Figure 1.7 can be used to illustrate the goal of the U.N. sanctions levied against Iran. The figure shows the hypothetical production possibilities curve of Iran for machines and oil. Prior to the imposition of sanctions, suppose that Iran is able to operate at maximum efficiency, as shown by point A along production possibilities curve PPC0. Under the sanctions program, the imposing nations’ refusal to purchase Iranian oil leads to idle wells, refineries, and workers in Iran. The unused production capacity thus forces Iran to move inside PPC0. If the imposing nations also target productive inputs, thus curtailing equipment sales to Iran, the output potential of Iran would decrease. This is shown by an inward shift of Iran’s production possibilities curve to PPC1. Economic inefficiencies and reduced production possibilities, both of which are caused by economic sanctions, are thus intended to inflict hardship on the people and government of Iran. International sanctions had sizable adverse effects on Iran. The value of Iran’s currency, the rial, has decreased more than 50 percent from 2011 to 2015. Also, Iran has virtually been cut off from the international banking system and was increasingly forced to trade through barter arrangements rather than hard currency exchange. Inflation soared in Iran, many foreign firms have left Iran’s markets, and Iranian firms have laid off workers. Also, the sanctions have reduced Iranian oil exports, which provide most of Iranian government revenues. Figure 1.7 Effects of Economic Sanctions 55 Trade and financial bans placed against a target nation have the effect of forcing the nation to operate inside its production possibilities curve. Economic sanctions can also result in a leftward (inward) shift in the target nation’s production possibilities curve. With the intensity of the sanctions increasing, Iran saw that it was in a vulnerable position. In 2015 Iran negotiators reached an agreement with the United States and its allies. Iran agreed to restrain its enrichment of uranium (the fuel for a bomb), and to reduce its stockpile of low- and medium enriched uranium (from which the weapons-grade material is produced), for a period of 10–15 years. Iran also agreed to United Nations’ inspectors monitoring of all its nuclear facilities. When the agreement was enacted, most of the sanctions would be removed. At the writing of this textbook, it remains to be seen if this agreement will be approved by the governments involved. Russian Aggression against Ukraine Brings Sanctions In response to political unrest stirred up by pro-Russian supporters in Ukraine, in 2014 President Vladimir Putin sent Russian troops into the country. Russian military forces rapidly gained control of the Crimea region in Ukraine. Russian arms and technical assistance were also provided for pro-Russian rebels living in Ukraine. The Ukrainian government immediately protested and declared that Russia’s aggression was illegal and must stop. To show support for the Ukrainian government, the United States, European Union, and other major nations soon enacted a coordinated set of economic sanctions against Russia. The sanctions were intended to convince Putin that his military activities would result in a high cost to Russia, and that they must cease. The sanctions included prohibitions on travel to the United States, Canada, and the European Union by key Russian officials and politicians, the freezing of financial assets of wealthy Russians having holdings in the United States, and restrictions imposed against Russian state-owned banks. Also, bans were placed on the export of technologies needed by Russia’s oil and defense industries. Analysts widely agreed that the West’s sanctions were not sufficiently strong to bring about a collapse in the Russian economy. But they could inflict considerable damage on an already ailing economy which was plagued by a collapse in its currency, the ruble. Hit by the sanctions and falling oil prices, the Russian economy slid into recession in 2015, for the first time 56 since 2009. Most observers felt that Putin underestimated the West’s resolve in levying economic pressure against Russia for its aggression against Ukraine. Although Putin appeared to count on the West’s inability to enact a significant arsenal of sanctions, the sanctions did occur, and the costs were higher than Putin estimated. In February 2015, Russia and Ukraine agreed to a tentative cease-fire accord. It was hoped that this would lead to the government of Ukraine agreeing to more autonomy for the eastern regions of its country; for Russia, it would mean withdrawing forces from Ukraine and returning control to Kiev of the Ukrainian side of the border. At the writing of this text, it was unclear how Russian–Ukrainian relations would unfold. In this chapter, we have examined the economic choices that must be made in every society because of scarcity. The next chapter will consider the role of demand and supply in analyzing market transactions. CHECK POINT 1. How can we use a production possibilities curve to illustrate opportunity cost for a nation? 2. Concerning economic growth, does it make any difference whether an economy devotes more resources to the production of capital goods as opposed to the production of consumer goods? 3. Identify the opportunity cost of nat...
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Running Head: ECONOMIC DISCUSSION POST ON MARKET FAILURES

Economic Discussion Post on Market Failures
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ECONOMIC DISCUSSION POST ON MARKET FAILURES

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Definition of a Market Failure
According to Marciano & Medema (2015), market failure refers to an economic
situation characterized by an inept distribution of products and services within a free market.
Distinct spurs for rational behavior, in market failure, don't prompt rational outcomes for a group.
Alternatively, states, every person makes a precise decision regarding himself or herself. However,
they only prove to be unwise decisions for the entire group. This could be demonstrated as a steadystate equilibrium, where the supplied quantity is not equal to the amount demanded. Generally,
there five market failure sources identified by economists. These sources include monopoly power,
inadequate information, spillover or externalities, and public goods. However, this paper will
mainly focus on helping a learner understand all the five market failures, the different corrections
for those market failures. The paper will also help the learner understand Joseph Stiglitz’s
argument on the market failure of economic inequality.
Discussion and corrections for all the five Market Failures
Monopoly Power
In most cases, monopoly of power happens when a particular company holds a
dominant position (i.e., has over 40% of the market share) within a market (Carbaugh, 2013).
However, such a firm may choose to abuse monopoly power by limiting the output, setting higher
prices, working together with rivals, or conspiring with competitors, thus prompting market failure
due to less choice, issues with suppliers, and deadweight welfare loss. Besides, there is no rival
competitor under such a system, and fewer outputs are sold and more profits earned. It increments
the income inequality. Thus, numerous steps are proposed to help correct it. These methods
include: regulating it by imposing taxes, regulating the monopoly conditions, as in the case of

ECONOMIC DISCUSSION POST ON MARKET FAILURES

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regulated and natural monopolies (i.e., MC pricing), and imposing anti-monopoly policies and
laws to thwart unfair discrimination of prices amongst various consumers.
Spillover or Externalities
Spillover or externalities is another market failure source that happens when a few
production costs or benefits aren't wholly reflected in supply schedules or market demand.
Alternatively stated, it's the benefit or cost imposed on individuals other than the product
consumers or producers (Carbaugh, 2013). Most commonly, a market failure results from a
spillover cost when the production of a few products gives rise to a spillover cost. For instance, if
smelters pollute water or air, and not even the company or its consumers pay for the harms brought
about by the pollution, the pollution turns out to be a spillover cost for the society. Correcting
spillover benefits somehow needs the governme...


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