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Chapter 1 A BRIEF ECONOMIC HISTORY OF THE UNITED STATES Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objectives After this chapter you should be able to: 1. 2. 3. 4. 5. 6. 7. Summarize America’s economic development in the 19th century. Describe the effect of the Great Depression on our economy and evaluate the New Deal measures to bring about recovery. Discuss the impact of World War II on our economy. List and discuss the major recessions we have had since World War II. Summarize the economic highlights of each decade since the 1950s. Differentiate the “new economy” from the “old economy.” Assess America’s place in history. 1-2 Interesting Times: Economic Misfortunes • Starting in late 2007, the U.S. experienced the: • • • • worst economic downturn since the Great Depression of the 1930s. bursting of the housing bubble (sudden drop in prices). financial crisis requiring over $2 trillion in loans by the Federal Reserve and the U.S. Treasury. subprime mortgage crisis, threatening some 7 million American families with foreclosure. 1-3 The U.S. as a Study in Contrasts in the Last 30 Years. • Wealth • Poverty • Expanding technologies • Dying industries • Won the Cold War • Losing the trade war • 22 million+ new jobs • Fewer Americans during the 1990s • Baby boomers better off than previous generations working in early 2010 than 10 years earlier • Today’s generation is generally worse off than parents 1-4 Strengths of the U.S. Economy • U.S. is still by far the world’s largest economy. • U.S. still has one of the world’s highest standards of living (per person average). 1-5 Ongoing Weaknesses of the U.S. Economy • The federal budget deficit is at a record high, and • • • • was growing even before the crisis started in 2007. The U.S. trade deficit is at a record high (imports greater than exports). The federal government is borrowing nearly $2 billion a day to finance the budget & trade deficits. Social Security & Medicare expenditures are rising drastically. The real hourly wage (after inflation) of the average worker is lower today than it was in 1973. 1-6 Questions for Thought and Discussion • How have the historical features of our economy impacted your personal life or the lives of your family members? • Are you worried about finding a job in your field when you graduate? Is that affecting decisions you are making about your college education? • Who do you think is more likely to be unemployed in today’s economy: a college graduate or someone who only completed high school or less? • Do you think the U.S. will continue to be the world’s largest economy through your lifetime? 1-7 How Did We Get Where We Are? • The American Economy in the 19th Century    Agricultural development Development of transnational railroad network The emergence of industrial capitalism • The American Economy in the 20th and early 21st centuries     Industrial development and the rise of manufacturing Depression and boom Rise of service sector and information technologies Global dominance and the challenges of a global economy 1-8 Agricultural Development • At the start of the American Revolution, America had an almost limitless supply of land.    Nine out of ten Americans lived on a farm. One hundred years later, fewer than one in two lived on a farm. Today, fewer than two in one hundred are able to feed us and export huge surpluses to the rest of the world. • The abundance of land was the most influential factor in U.S. economic development in the 19th century because labor was scarce relative to land.    It brought millions of immigrants to the U.S. It encouraged large families. It encouraged rapid technological development. 1-9 Economic Conflicts Leading to the Civil War • Fight over tariffs:    Northern manufacturing industries benefited from high tariffs (taxes on imports) to protect new industries from competition with British. For Southerners, prices for manufacturing goods were higher than they would have been without the cost of tariffs. Southern plantation economy traded cotton and other agricultural products to the British. • Conflicts over extending slavery in territories:    Southern cotton production based upon slavery was threatened by Northern public opinion. Manufacturing used mostly “free labor,” especially recent immigrants. Mostly, there were self-sufficient family farms in North and West. 1-10 Expansion of North and West After Civil War • Railroad networks led to greater economic integration of the country (except South), facilitating mass production and mass consumption. o From 1850–1890, the U.S. increased miles of railroad track from 10,000 to 164,000. o The government investment in infrastructure sparked economic growth. • Age of Industrial Capitalists emerged. o Steel (Carnegie), chemical (DuPont), farm equipment (McCormick), oil (Rockefeller), and meat packing (Swift) o Rise of “trusts” and monopolies o First federal anti-trust legislation o First wave of unionization as free labor to improve factory working conditions and wages 1-11 The American Economy in the early 20th Century • America was primarily an industrial economy.    Fewer than 4 of 10 people lived on farms, yet technology meant U.S. had farm surpluses, encouraging labor to leave farms for factories. The U.S. was among the world leaders in production of steel, coal, steamships, textiles, apparel, chemicals, and agricultural machinery. Transition from private electric generators to centralized, utility-based power production made manufacturing cheaper. • America’s trade balance was positive (exports greater than imports.)   America exported most of her agricultural surpluses. America began to export manufactured goods. 1-12 The U.S. Economy in Booms and Busts 1-13 Questions for Thought and Discussion • What were the pros and cons of instituting protective tariffs for U.S. industry during the early stages of U.S. manufacturing?  Were they a net positive or net negative factor in the nation’s economic development? • Why do you think the placement of railroad networks largely bypassed the southern states?  Would alternative placement of networks have been beneficial for the country? • How do mass production techniques, like the moving assembly line, enable mass consumption by the middle class? 1-14 The U.S. Emergence as the World’s Leading Industrial Power at the end of World War I (1918) • The U.S. emerged as the world’s leading industrial power at the end of WWI because it possessed physical and human resources such as:      An undamaged infrastructure and workforce because of late entry into war that took place in Europe. A large agricultural surplus emerging from a productive and relatively efficient agricultural sector. The technological know-how necessary to develop cutting edge industries such as the automobile and airplane industries. Large and growing population due to 19th century immigration. The world’s first universal public education system. A large pool of entrepreneurial talent. 1-15 The Roaring Twenties to the Great Depression • After a brief depression in 1920, the U.S. economy went through a period of almost unparalleled expansion.     Between 1921 and 1929 national output rose by 50%. Number of cars on the road tripled from less than 8 million in 1919 to nearly 27 million in 1929. Stock market began to soar, with stocks purchased on margin by putting down a fraction of the cost. Most Americans thought prosperity would last forever. • Economic theory emphasized limited government role in economic growth. • The stock market crashed in 1929—the “Great Depression” had arrived. 1-16 The Great Depression • Why was The Great Depression “great?”      Automobile market saturated. One car for nearly every household and most were less than six years old. Tire industry, textiles, and residential construction also overbuilt. Stock market crash made consumers wary. Federal reserve cut money supply causing deflation. Nothing done about bank failures under Hoover administration. • The economy hit bottom in March of 1933.    National output was one-third what it was in 1929. Official unemployment was 25%. 16 million Americans were out of work. • The population was less than ½ its present size. 1-17 Recovery and Hope • A lot of credit goes to Franklin D. Roosevelt’s “New Deal” administration for the 1933–1937 expansion:       Banks were reopened. The Securities and Exchange Commission (SEC) came into being in 1934. The Federal Deposit Insurance Commission (FDIC) was set up in 1934. An unemployment insurance benefit program was started . The Social Security System was started in 1935 (this was the most significant reform). Temporary job creation programs were established. • Keynesian Economics influential: government should spend money or cut taxes to create demand for good and services. 1-18 Recovery Stalled • Recession of 1937–1938 was reignited by actions of the Fed and the Roosevelt Administration. • The Federal Reserve greatly tightened credit.  This reduced the money supply. • The Roosevelt administration suddenly got the urge to balance the budget.    Government spending was sharply reduced and taxes were raised. This would have made sense during an economic boom, but not when the unemployment rate was 12%. This caused • Industrial production to fall by 30%. • Five million more people to be put out of work. 1-19 Questions for Thought and Discussion • What led the U.S. to go from boom to bust? What made The Great Depression worse than a typical economic downturn? • How did Roosevelt try to restart the economy? Was his strategy successful? Compare Roosevelt’s efforts with responses to the recent “Great Recession”. • What caused the Recession of 1937–1938? What lessons might this hold for today’s economy? 1-20 What Finally Brought the U.S. Out of the Great Depression? • In April 1938, the Federal Reserve and the Roosevelt Administration reversed course. • War broke out in Europe.    America mobilized in 1940–1941 and then entered the war on December 7, 1941. Massive federal government spending was needed to prepare for and fight World War II. This was deficit spending (borrowed money). In other words, the federal budget ran a deficit. 1-21 The 1940s: World War II and Peacetime Prosperity • WWII required a total national effort.   It consumed nearly half of the nation’s output. It mobilized 12 million men and women. • The unemployment rate fell below 2%. • 1939–1944      Output of goods and services doubled. Government spending rose more than 400% (mainly for defense). The economy grew 10–11% a year. The government instituted wage and price controls and issued ration coupons for meat, butter, gasoline, and other staples. Businesses and workers strove to produce goods of the highest quality possible, believing it a prerequisite to win the war. 1-22 The U.S. Emerges as a Superpower • The country that emerged from WWII was very different from what it had been four years earlier.   Inflation was now the number one economic problem. The U.S. accounted for ½ of the world’s manufacturing output, with just 7% of the world’s population. • The Cold War replaced the actual war.    U.S. and the Soviet Union were the only superpowers left. The U.S. expended 6% of national output on defense. The Soviet Union expended at least 18% of national output on defense, which contributed to its collapse in 1990. The U.S. spent tens of billions of dollars to prop up the economies of Western Europe and Japan, and hundreds of billions more for their defense as allies against the Soviet Union. 1-23 How Did Prosperity Return? • Twelve million men and several hundred thousand women returned to civilian lives. It was feared that unemployment would return.   Congress passed the G.I. Bill of Rights (1944). • The Bill of Rights provided loans for home mortgages, business, and education. The Veterans Administration (V.A.) offered affordable mortgages: • Suburbanization of America    A housing shortage arose, the only place to build was outside cities. This required roads and cars. The federal government subsidized an interstate highway network along with state freeways, state highways, roads, and local streets. Government investment spurred private sector. 1-24 1950s: The Boom Years • Construction and automobile industry prospered.   They supplied America’s pent up demand. The U.S. also became the world’s leading exporter of cars. • Birth rates and advent of television fueled demand for consumer goods and services. • Korean War stimulated economic growth. • The Eisenhower administration:    ended the Korean War and inflation. made no attempt to undo the legacies of the New Deal. made permanent the role of the federal government as a major economic player. 1-25 Questions for Thought and Discussion • How did WWII impact the American economy?  Why was the war followed by inflation? Is war a good solution for an economic crisis? • What contributed to suburbanization?  What were the impacts of suburbanization on the U.S. economy? 1-26 The Soaring Sixties: The Years of Kennedy and Johnson • The country was in recession when Kennedy was elected.    He was assassinated and replaced by Johnson in 1963. Johnson enacted a tax cut that was planned by Kennedy. The tax cut and the spending on the Vietnam war ended the recession. • The federal budget deficit and money supply grew.   Inflation began and lasted until the mid-1980s. Johnson created three entitlement programs: Medicare, Medicaid, and the Food Stamp Program that would have profound fiscal impact. • The service sector grew in the public sector with the expansion of health care and education. 1-27 The Sagging Seventies: the Stagflation Decade • The decade began with the problems of inflation and ending the Vietnam war.  Nixon became President in 1968; Ford became President when Nixon resigned in 1974. • The U.S. experienced stagflation starting in 1973:    Economic stagnation + inflation = stagflation Why? OPEC (Organization of Petroleum Exporting Countries) quadrupled its oil prices. Wage and price controls were initiated. • Carter became President in 1979.    Inflation rose to double digit levels Iranian revolution in 1979 In October 1979, the Federal Reserve (Fed) stopped the growth of the money supply to fight inflation but ended up deepening the recession. 1-28 The 1980s: the Age of Reagan • By January 1980, the country was in recession.   The inflation rate was 18%. The nation’s productivity growth was at 1%, one third the postwar rate. • A new approach to economic policy was Supply-Side theory.   Consumers would have more incentive to work and more of their own money to spend. Businesses would invest more and produce more. • Did Supply-Side work?     Unemployment reached nearly 11% in 1982. Inflation had been brought under control by Fed policies. Unemployment rates began falling but seemed to stick around 6%. Deficits were a problem: $79 billion in 1981 and $290 billion in 1992. 1-29 The 1980s: the Age of Reagan (continued) • George H. W. Bush (Reagan’s vice president) won the election of 1988 with a pledge not to raise taxes.     Two years later, he agreed to a major tax increase. This was supposedly to reduce the deficit, but the deficit continued to rise. A recession began in early 1992 and ended in late 1992. Bush failed in his bid for reelection. 1-30 Questions for Thought and Discussion • What led to the stagflation of the seventies?  What eventually pulled our economy out of recession? • How does Supply-Side economics differ from Keynesian economics?  Did Supply-Side economics work? 1-31 Case Study: State of American Agriculture • American agriculture has increased its productivity tremendously over the past 200 years. In 1820, one farmer could feed 4.5 people. Today, one farmer can feed 500 people. • Despite heavy subsidization, the family farm has disappeared. • Big agribusiness dominates the field and European and American governments spend billions of dollars subsidizing agriculture to compete against one another, leading to the overproduction of food while millions still go hungry. 1-32 The “New Economy” of the Nineties • Clinton took office in 1993 as recession was ending. • “New economy” was marked by low inflation, low unemployment, and rapidly growing productivity.     Growth was sparked by major technological changes. The Federal Government experienced small surpluses by end of Clinton presidency. The stock market soared, especially technology-related stocks (“dot-com” bubble). This was one of the most prosperous decades ever. • The 120 months of economic expansion, an all time record, ended in March 2001. • Just as in the 1920s, it seemed as though the prosperity would never end. 1-33 The American Economy at the End of the 20th Century • The U.S. economy has become increasingly integrated with the global economy. • This has resulted in:     an exodus of jobs making shoes, electronics, toys, and clothing to developing countries. service work like writing software code and processing credit card receipts shifting to low-wage countries. white collar jobs moving offshore. routine service and engineering tasks going to India, China, and Russia. • Educated workers are paid a fraction of what their American counterparts earn. • These factors contributed to the next economic downturn. 1-34 The New Millennium • George W. Bush assumed presidency in 2001. • 2001 was not a good year for America.      In March 2001 the 10-year economic expansion ended as a recession started. The stock market started going down as the dot-com bubble burst. Unemployment began to creep up. 9/11 occurred. Unbridled optimism gave way to uncertainty. • War in Afghanistan was immediately followed by the War in Iraq in 2003.  Federal budget deficit skyrocketed. • The recovery has been partly fueled by rising home values and growth of financial sector. 1-35 Economics in Action: America’s Place in History • U.S. has been the world’s leading industrial power, largest economy, largest consumer market, and largest military power. Will this dominance continue? • Are there lessons from history that can guide U.S. decision makers on how to manage the economy through its present challenges? 1-36 Chapter 2 RESOURCE UTILIZATION Chapter 2 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objectives After this chapter you should be able to: 1. 2. 3. 4. 5. 6. 7. 8. 9. Define economics. Identify the central fact of economics and explain how it related to the economic problem. Name the four economic resources and explain how they are used by the entrepreneur. Explain and apply the concept of opportunity cost. Describe and distinguish among the concepts of full employment, full production, and underemployment. Describe the concept of the production possibilities curve and how it is used. Identify and explain the three concepts upon which the law of increasing costs is based. Define and explain productive efficiency. Identify and explain the factors which enable an economy to grow. 2-2 Economics Defined • Economics studies the efficient allocation of the scarce means of production toward the satisfaction of human wants. o o Efficiency, as a goal, emphasizes the need to maximize our material output; given the amount of resources. Means of production includes our resources and our technological ability to use them to produce output. • • o Resources are the things used to produce goods and services. These resources are scarce (limited). Satisfaction of human wants is the purpose of an economy. • • • Economists assume people know their wants. Definition does not distinguish between wants and needs. Goods and services fulfill our material wants. 2-3 The Central Fact of Economics: SCARCITY • This definition assumes that scarcity is the fundamental economic problem: o There are never enough resources to produce all of the goods and services that people want. • Why is there an economic problem? o The means of production (resources) are limited. o Economists assume that human wants are unlimited. • An economy is a system for organizing the allocation of resources to produce and distribute the goods and services that satisfy human wants. o The more efficient the economy is, the more wants we can satisfy. 2-4 Four Economic Resources • There are four categories of economic resources: o Land - natural resources o Labor - work o Capital - produced goods used to produce other goods and services o Entrepreneurial ability - effort to organize the production process • In a market economy, each of these resources is exchanged in markets for a type of income. o We sell our resources to earn income to purchase goods and services to satisfy our wants. 2-5 Land Earns Rents • Land (a broader meaning than our normal understanding of the word). o Land includes natural resources like timber, oil, coal, iron ore, soil, water, as well as the ground in which these resources are found. • How is land used in an economy? o o Extraction of minerals (mining) and farming (agriculture) It provides the site for factories, office buildings, shopping centers, homes, etc. • Owners of land receive rent. o o Economic rent is money received from something that is given by nature, rather than produced by human effort. Rent is earned by establishing ownership over resources. 2-6 Labor Earns Wages. • Labor: o is work and time for which one is paid. o involves human effort. • Income received for one’s labor is called wages and/or salaries o o About two-thirds of the total resource cost is the cost of labor. Unpaid labor (housework, volunteer work) can also contribute to the satisfaction of human wants. 2-7 Capital Earns Interest. • Capital: o o o “human-made” goods used to produce other goods or services. includes office buildings, stores, and factories (physical plant), equipment, and software. This is a different use of the term capital than when it means the money a business uses to buy plant and equipment. • The income owners of capital receive what is called interest. o The purchase of new capital equipment is often funded through loans, so the lender earns interest from its productivity. 2-8 Entrepreneur Ability Earns Profits. • The entrepreneur: o o o o sets up a business. assembles the needed resources. risks his/her own (or borrowed) money. is central to the American economy. • An entrepreneur earns a profit (or a loss) depending upon his or her ability to run a business. • There are over 30 million businesses in the U.S., most are owned by entrepreneurs. o The vast majority work for themselves or have one or two employees. 2-9 Questions for Thought and Discussion • Why are the means of production scarce? • The text has a quote by F.V. Meyer that says “Economics is the science of greed.” What does he mean? Do you agree or disagree with the quote? • Which is the only category of resources that cannot be increased over time? • What is the difference between an entrepreneur and an inventor? 2-10 Our Economic Problem Revisited • Our economic problem is that we have limited resources available to satisfy relatively unlimited wants. • There are NOT enough resources to produce everything that everyone wants. • Therefore, CHOICES must be made! • The wood used to build a table cannot be used to make paper. • The time a nurse spends filling out forms cannot be used in patient care. 2-11 Opportunity Cost: A Fundamental Concept in Economics • Opportunity cost is the foregone value of the next best alternative. o The value of things we give up (our second-best choice). • People weigh the costs and benefits of various options, including opportunity costs. o Economists assume that we choose the option we find more valuable. • In the economic world, “both” is not an admissible answer to a choice of “which one.” 2-12 Choosing the Highest Valued Alternative • Because time is linear, we must make choices. Here are your options: o o o o • spend time on social networking site. play video games. go to movies with friends. study economics. Whichever option is chosen, you will miss the value of the other options. o o o If you go to the movie with friends, the direct cost is the movie ticket and any transportation costs. The opportunity cost is the value of the alternatives use of your time (for example, the benefit of the improvement in your grade from studying). Opportunity cost may or may not have a dollar value. But you implicitly place a value when you make a decision. 2-13 You inherit $40,000. Two choices: Buy your dream car or go to college. Suppose you bought the car (paid $40,000): What was the value of the foregone option? College graduate (lifetime earnings) $1,300,000 High School graduate (lifetime earnings) $800,000 Opportunity Cost $500,000 2-14 Businesses and Government Face Also Opportunity Costs. • A large corporation has to choose between using profits to pay shareholder dividends (boosting stock value) or to purchase additional capital equipment (which might increase profits at a later date). • A small store has to choose which items get more shelf space and which get less shelf space. • Governments have to choose how much to spend on education, military, food inspections, environmental protection, medical research, etc. • Some local governments are not paving local roads so they do not have to raise taxes on residents. 2-15 Questions for Thought and Discussion • Do Bill Gates and other wealthy persons face scarcity? Do they have to weigh opportunity costs? • The direct costs of the wars in Iraq and Afghanistan have been approximately $150 per year. What are some of the opportunity cost of the wars in Iraq and Afghanistan? • What are the opportunity costs of raising taxes to fund government programs? What are the opportunity costs of lowering taxes? 2-16 Full Employment and Full Production • Full employment is when a society’s human resources are being used with maximum efficiency. o o Generally, a 4 – 6% unemployment rate is considered full employment. There will always be a small percentage of the labor force who are between jobs. • Full Production is when a society’s resources are being allocated in the most efficient manner possible. o o Full production can include physical resources (land and capital) and human resources (labor and entrepreneurial ability). Generally, a 85–90% capacity utilization rate is considered full production of a nation’s capital. 2-17 Underemployment of Resources • Underemployment of resources lowers the productive output of the nation as a whole. o o o o It is an economic problem, not just a personal problem. Unemployment and low capacity utilization mean that society is not allocating its resources efficiently in order to maximize output. An unemployment rate greater than 5% is considered underemployment of our labor resources. A capacity utilization rate less than 85% is considered underemployment of our capital resources. • Underemployment of resources occurs during recessions. 2-18 Employment Discrimination Causes Underemployment of Society’s Resources. • Employment discrimination excludes members of particular groups from particular jobs. o o Society loses out when people are kept from being fully productive. Discrimination has diminished but has not been eliminated entirely. • Example: African Americans were kept out of major league baseball until 1947. o o Great baseball players like Satchel Paige played in the separate Negro Leagues. Society lost generations of contributions to records in Major League Baseball. 2-19 The Production Possibilities Curve • The Production Possibilities Curve represents our economy at: o o full employment. full production. • Productive efficiency occurs only when we are operating on the production possibilities curve. o Productivity efficiency means that the output of one good cannot be attained with out reducing the output of some other good. • Guns versus Butter example focuses on government’s choice between military spending or spending on social programs. o Remember: businesses and consumers face trade-offs too! 2-20 The Production Possibilities Curve • Points A, B, C, D, E, and F are efficient with full employment and full production. • Points X, Y, and Z are points where economy is producing below efficiency since either capital is being under utilized or the workforce is underemployed. You can produce more guns without sacrificing butter, or vice versa. • Any point above the production possibility curve, such as W, is not achievable. 2-21 Production Possibilities Curve Hypothetical Production Schedule Point Units of Butter Units of Guns A 15 0 B 14 1 C 12 2 D 9 3 E 5 4 F 0 5 This Production Possibilities Curve shows the range of possible combinations of guns and butter extending from 15 units of butter and no guns at point A to 5 units of guns and no butter at point F 2-22 Production Possibilities Curve Hypothetical Production Schedule Point Units of Butter Units of Guns A 15 0 B 14 1 C 12 2 D 9 3 E 5 4 F 0 5 Had to give up 1 unit of butter • • When you are on the curve, to get more of one thing you have to give up some of the other thing. The opportunity cost of gaining 1 unit of guns was 1 unit of butter 2-23 Law of Increasing Costs • As we shift from butter to guns, we have to give up increasing units of butter for each additional unit of guns. • Law of Increasing Cost: As the output of one good expands, the opportunity cost of producing additional units of this good increases. • You give up fewer units of butter to get 1 unit of guns up top. From A to B you give up 1 unit of butter to get 1 unit of guns. • You give up more units of butter to get 1 unit of guns at the bottom. From E to F you have to give up 5 units of butter. 2-24 Questions for Thought and Discussion • Explain how unemployment and discrimination are problems for society as a whole, not just those individuals who experience it. Give an example that was not mentioned in your text. • Explain how the concept of opportunity costs is illustrated on the Production Possibilities Curve. • In the Law of Increasing Costs, are we talking about direct costs or opportunity costs increasing as we produce more of one good or service? 2-25 Economic Growth • Economic growth enables a society to produce more guns AND more butter – or whatever goods and services are allocated resources. • What causes economic growth? o More or better trained labor • More or improved plant and equipment (capital) • Technological change (new fertilizer, shift from typewriter to computer) • Economic growth can be illustrated by a new Production Possibilities Curve. o The curve moves to up and to the right 2-26 Economic Growth Illustrated PPC PPC after economic growth PPC after more growth 2-27 Investing in Future Growth Look! The axes have new labels! • • Note that investment in capital equipment today can lead to economic growth in the future. Choosing Point B in Year 1 gives us greater production possibilities in the future than choosing Point A. 2-28 Questions for Thought and Discussion • Given limited resources, is growth always good? o Why do most mainstream economists embrace growth? • Is our economy in a period of full employment and full production? What are the implications for you when you look for a job after college? • Choose a trade-off between any two goods or services and illustrate it on a Production Possibilities Curve. Try to explain how the Law of Increasing Costs would operate as you move along the curve. • Does the PPC move out in a recession year? 2-29 Chapter 3 THE MIXED ECONOMY Chapter 3 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objectives After this chapter you should be able to: 1. 2. 3. 4. 5. 6. 7. 8. 9. List and explain the three questions of economics. Explain the concepts of the profit motive, the price mechanism, competition, and capital. Analyze the circular flow model. Describe and illustrate market failure and externalities. Describe and explain government failure. Discuss the economic role of capital and its importance. Define and describe the “isms”: capitalism, fascism, communism, and socialism. Summarize and explain the decline and fall of the communist system. Discuss the economic transformation of China. 3-2 The Three Questions of Economics • Because scarcity is the central economic problem, an economy cannot produce everything for everybody. • Every economic system therefore must provide mechanisms to answer these three questions: o o o What shall we produce? How shall these goods be produced? For whom shall these goods be produced? • These are questions about how to allocate scarce resources. o o The first two questions involve production. The third question is about distribution. 3-3 How Capitalism Answers the Three Economic Questions • What to produce? o The private sector is guided as if by an “invisible hand,” a metaphor for the way markets operate. o This does not include central planning! Government does not decide (except for public goods and services). • How to produce? o Competition among sellers leads to efficiency. • For whom? o Most goods and services are distributed based upon the ability to pay. o Those who can afford, purchase the goods and services that they value. 3-4 What the U.S. Economy Produces Has Changed Over Time 3-5 The Invisible Hand • Adam Smith coined this term. o The invisible hand is a metaphor for an economic guidance system that leads to desirable economic outcomes. • o Desirable outcomes are defined as efficient production to maximize production (on the Production Possibilities Curve). The invisible hand is made possible by people pursuing their own self-interest. • Businesses pursue profits and consumers pursue satisfaction of their wants. • The price mechanism guides the invisible hand. o o Prices send signals to producers and consumers. When consumers want a product, the price goes up, providing the incentive to businesses to increase production. 3-6 Competition • Competition forces firms to be as efficient as possible. They can charge the lowest possible prices to get people to buy their goods and services. o This process answers the question, “How to produce?” • To have competition, you need many firms in a particular industry. o You need enough so that no one firm is large enough to have any influence over price. • When sectors of American industry are not very competitive the price system doesn’t work well. o o The invisible hand becomes less active and more ineffective. The forces of supply and demand are distorted. 3-7 The U.S. is a Mixed Economy • The United States: o has an imperfectly functioning price system. o functions in a less than competitive economy. o is guided by a not too vigorous invisible hand. • Rather than a pure form of capitalism, we use governments as well as markets to allocate resources. 3-8 Trust • Capitalism is based on trust. o o o Lenders expect borrowers to pay back loans. Buyers and sellers expect contracts to be honored. Workers expect to be paid by employers. • If we do not trust that these agreements will be honored, the economy will not function. • Self-interest can lead economic actors to behave in a trustworthy manner, so they can continue to do business. • The legal system reinforces trust by providing consequences for dishonest behavior. 3-9 Equity & Efficiency • Markets can be efficient, without seeming “fair.” o The threat of poverty provides incentives to work hard which can lead to efficiency. o Too much inequality can be a disincentive to hard work. • Efficiency can be balanced by equity. o Should we tax those with higher incomes and redistribute to the needy? How much and who do we tax? o Should we allocate some goods and services regardless of the ability to pay? Examples include public schools, public housing, & food stamps. 3-10 Questions for Thought and Discussion • Does it make sense that self-interest is enough to create a well-functioning system? o What rules need to be in place to allow the invisible hand to work its magic? • How were the three economic questions answered by hunter-gatherer societies? • Can you think of goods or services that are not allocated according to our ability to pay? What is the reasoning behind these alternative allocation mechanism? o Why aren’t organs for transplant sold to the highest bidder? 3-11 Modeling a Market Economy without Government: Circular Flow Diagram Resources are owned by households, who sell them to business firms for wages & salaries, rent, interest, and profits. 3-12 The Flow of Goods & Services Businesses use these resources to produce goods and services that they sell back to households. Households use the income they received from selling their resources. 3-13 The Circular Flow Model The model has two flows: (1) a flow of money and (2) a flow of resources, goods, and services. 3-14 Economic Role of Government • Government is o Federal o State o Local • Each level of government: o Collects taxes. o Provides services. o Make laws and regulations. • Government alters the outcome of the three questions: o What? How? and For Whom? 3-15 Economic Role of Government • A mixed market system needs government in order to function effectively. • The government should: o Protect property rights. • o o o o Without property rights, the rest will not matter much. Provide the infrastructure for a market to function efficiently. Ensure that competition flourishes. See that information flows freely. Minimize side effects of economic activity such as pollution. • The appropriate size and functions of government depends largely on how well private enterprise does the job of efficiently allocating resources. 3-16 Market Failure • Market failure is when our resources are not allocated efficiently by the private sector using the price mechanism. o o The profit incentives in private markets may yield too many socially undesirable outcomes. The profit incentives in private markets may yield too few socially desirable outcomes. • Types of market failure include: o o Externalities and environmental pollution. Lack of public goods and services • Another cause of market failure is when large firms crowd out competition. • Government intervenes when markets fail. 3-17 Negative Externalities • Negative externalities are external costs. o “External” means affecting a third party who is not the buyer or the seller. o For Example: • • • • You may satisfy your individual want by driving an inefficient vehicle that pollutes. The seller has a profit motive to sell you the car you want. The price you pay for the vehicle and gas will cover the costs of production for the seller and a profit, but not the costs of pollution on other peoples’ health and well-being. The market price is lower than the true social cost. • Government can discourage negative externalities by taxing them or limiting them. 3-18 Two Approaches to Environmental Regulations • Command-and-control regulations o Government limits market choices. • • fuel economy standards for new cars ban on leaded gasoline • Incentive-based regulations o Government influences market choices by making some options more costly. • • taxes on gasoline tradable emissions rights 3-19 Positive Externalities • Positive Externalities are external benefits. • Example: o o o If you pay someone to paint your house, your neighbors will benefit. If you do not paint your house, it will lower your neighbors’ property values. The social value of painting your house may be greater than what you are willing to pay. • Government can encourage positive externalities by subsidies or regulations. o o The federal government subsidizes student loans because society benefits from more college graduates. Local governments may have regulations requiring you to maintain your property. 3-20 Public Goods and Services • Public goods and services are supplied by government because entrepreneurs could not make a profit by selling them. • Characteristics of public goods and services: o Non-excludable: once it exists, everyone can freely benefit from it. • • o There is no way to exclude anyone from consuming the goods even if she/he did not pay for them. Tend to be indivisible or come in large units that cannot be broken into pieces for purchase or sale in the private market. No rivalries: one person’s benefiting does not reduce the amount of it available for others. • Private goods are consumed by an individual. o After I eat my ice cream cone, it cannot be eaten by anyone else! 3-21 Examples of Public Goods and Services • Public goods and services: o o o o o o o o national defense court system police and fire protection construction and maintenance of infrastructure including streets, highways, bridges, and water and sewer mains environmental protection public parks public schools public libraries • A public bus is not a public good: o o Individuals can be excluded if they do not pay. Government provides public transportation because it has positive externalities. 3-22 Government Failure • Government can fail to allocate resources efficiently and to meet desirable social goals. o Sometimes government is slow and bureaucratic or its programs continue even when not meeting objectives. • Examples: o The complex and confusing income tax code that creates inefficient need for professional tax preparers and others to process forms. o The agriculture price support system that was intended to save family farms but most payments go to huge corporate farms. o Despite a “War on Poverty,” 39 million Americans, mostly children, are still in poverty. 3-23 Questions for Thought and Discussion • Give an example of when government might be involved in answering each of the three economic questions: 1. What to produce? 2. How to produce? 3. For whom? • If a factory is polluting and producing its product cheaply, who are the third parties affected by this externality and how are they affected? How might the government approach this problem? • If people are under-purchasing higher education, who are the third parties affected by this positive externality and how are they affected? How might the government approach this problem? • What kinds of regulations affect the market for cigarettes? Why does government regulate this market? 3-24 Capital • Capital is the CRUCIAL element in every economic system. o Remember: capital consist of plant, equipment, & software. • Capital is the key to economic development and raising a country’s standard of living. o o Countries who invest in capital have higher rates of economic growth. Capital increases productivity. Example: • o U.S. farmer produces 10 – 20 times as much output as a Nigerian farmer because of the use of tractors, harvesters, and reapers. 3-25 Where does capital come from? • Capital comes from: o cutting consumption o increasing production • Examples: o In industrializing Europe, the low wages and barbaric conditions for factory workers enabled factory owners to invest in better capital. o In Soviet Union, communist government invested in capital and there were few consumer goods available for purchase. o After World War II, Japan and Western Europe focused on capital investments rather than consumption. 3-26 The “Isms” • Capitalism o There is private ownership of most means of production. o The profit motive moves individuals to produce. o The price system guides production. o The government’s role is kept to a minimum. • Most capitalist countries are political democracies, but the two systems do not always co-exist. “The vice of capitalism is that it stands for the unequal sharing of blessings; whereas the virtue of socialism is that it stands for the equal sharing of misery.” —Winston Churchill 3-27 The “Isms” • Communism o o There is no private property. At first, the state owns everything. Government planning committees dictate: • • • o o What is produced. How it is produced. For whom it is produced. Prices no longer send signals about what consumers want. Eventually, the state would “wither” away and workers would make economic decisions collectively. “The theory of the Communists may be summed up in the single sentence: Abolition of private property.” − Karl Marx & Friedrich Engels 3-28 The “Isms” • Fascism o Also called corporatism because corporate and state power are merged. o There is private ownership of the means of production, but strong role for government planning. o Government power is centralized. o Fascism is characterized by a one-party state, militarism, suppression of economic freedom, and intolerance of political opposition. • Fascists have been virulently anti-communist. 3-29 The “Isms” • Socialism o There is government ownership of some means of production but most are privately owned. o There is a substantial degree of government planning and provision of public goods and services. • • Con: High taxes. Pro: Promises cradle to grave security to protect citizens from fluctuations of market economies. • Some European countries are democratic socialist systems. o Soviet Union was sometimes called state socialist instead of communist. 3-30 For Example… • Socialism o You have two cows; the state takes one and gives it to someone else. • Communism o You have two cows; the state takes both of them and gives you milk. • Fascism o You have two cows; the state takes both of them and sells you milk. • Capitalism o You have two cows; you sell one and buy a bull. 3-31 Transformation in China • 1949–1979 o The Chinese economy was dominated by Soviet style central planning. • Late 1970s–early 1980s o Reform began in the industrial sector. • • o State firms were allowed to sell any surplus output. Family-run enterprises were allowed. The government shifted the responsibility of operating huge collective farms to the families who lived on the farms. • • • The families could lease the land for 15 years. Output above the government quota could be sold. Output jumped 60%. 3-32 Transformation in China • China has become a world-class industrial power. o In 2012, China had a $315 billion export surplus to the U.S. • Old communist credo o “From each according to his ability, to each according to his needs.” • New Credo o “More pay for more work; less pay for less work.” • China operates basically as a capitalist economy with a strong state, although it is still defined as Communistic. o Presently, over 2/3 of its population lives in rural areas and the standard of living is still poor. 3-33 Questions for Thought and Discussion • How does capital explain productivity differences between countries? • Contrast Marx’s view of the exploitative capitalist with the mainstream economic view of the economic role of the entrepreneur. • What does “the bridge to nowhere” project tell us about the efficient allocation of scarce resources? Is it an example of market failure or government failure? 3-34 Chapter 4 SUPPLY AND DEMAND Chapter 4 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objectives In this chapter you’ll learn how to: 1. 2. 3. 4. 5. 6. 7. Define and explain demand in a product or service market. Define and explain supply in a product or service market. Determine the equilibrium point in the market for a specific good, given data on supply and demand at different price levels. Explain what causes shifts in demand and supply. Explain how price ceilings cause shortages. Explain how price floors cause surpluses. Apply supply and demand analysis to real-world problems. 4-2 Demand • Demand is the schedule of quantities of a good or service that people are willing and able to buy at different prices. o Sometimes a schedule is also called a table. • Shows how much quantity of a good or service can be sold at different prices. • Illustrates that people pay for goods or services according to how many benefits those goods or services will yield. 4-3 Demand Schedule and Curve Table 1 Price QD $500 1,000 450 3,000 400 7,000 350 12,000 300 19,000 250 30,000 200 45,000 150 57,000 100 67,000 Begin with P = $500 and Q = 1,000 To graph, plot one set of points at a time. 4-4 Supply  Supply is the schedule of quantities of a good or service that people are willing to sell at different prices.  Generally, the higher the price, the more of a good or service individuals are willing to supply. As price increases so does quantity provided.  As the price increases or decreases, producing a good or service becomes more or less attractive to producers at the margin. 4-5 Supply Schedule and Curve Price $500 $450 $400 $350 $300 $250 $200 $150 $100 QS 62,000 59,000 54,000 48,000 40,000 30,000 16,000 7,000 2,000 Begin with P = $100 and Q = 2,000 To graph, plot one set of points at a time. 4-6 Equilibrium  Equilibrium price is the price at which quantity demanded equals quantity supplied or QD = QS.  A surplus occurs when the market price is above equilibrium price.  A shortage occurs when the market price is below equilibrium price. 4-7 A Picture of Equilibrium  Equilibrium occurs at the point where supply crosses demand.  If price were higher than equilibrium, more producers would want to produce goods or services than consumers would want to consume. QS > QD  If the price were lower, more consumers would want to consume goods or services than producers would want to produce. QD > QS 4-8 Shifts in Demand • A change in the price of a good or service causes movement along a given demand curve. o Movement up or down the same curve. • A change in the demand schedule results in a shift of the demand curve to a completely different curve. o If consumer preferences change, that will shift the demand curve either outward or inward depending upon the nature of the change. 4-9 Demand Curve Shifts Outward  When people are willing to buy     more goods or services at every possible price. If preferences or income (ability to pay) increase. If perceived benefits increase, people will pay more. If more people want to fly to visit family at Thanksgiving than at other times, we expect an outward shift in demand for flights. D1 shifts to the right to D2 . 4-10 Demand Curve Shifts Inward  When people are willing to buy fewer goods at every previous price.  If preferences or income (ability to pay) change.  If there is a severe economic downturn and fewer people are taking trips, we would expect an inward shift of the demand curve. 4-11 Questions for Thought and Discussion  What would happen to demand for the various services and products under the following scenarios? Will the curve shift and in which direction? o o o The President of the U.S. expresses concern about mad cow disease and beef. What happens to the demand for hamburgers? The National Institutes of Health releases a study that shows Vitamin D reduces the probability of getting cancer. What happens to demand for Vitamin D? The manufacturers of Frisbees discover a new, less expensive polymer to make Frisbees. What happens to the demand for Frisbees? 4-12 Shifts in Supply  Changes in the cost of factors of production or increases in productivity shift the supply curve.  Changes in technology or the number of sellers shift the supply curve.  Changes in the expectation of the price shift the supply curve. 4-13 Supply Shift Outward (Increase)  Businesses supply more at the same price as before.  Improvements in technology, lower resource costs, or higher factor productivity can result in this sort of shift.  If the price of jet fuel decreases, this would result in an outward shift in the supply curve of airline flights.  S1 shifts to the right to S2. 4-14 Supply Curve Shift Inward (Decrease)  Businesses supply less at the same price as before.  As costs change for businesses, opportunity costs change.  If the cost of jet fuel rises, that would shift the supply curve for airline flights inward to the left.  On the graph, an increase in costs of grapes would lead to a lower supply of bottles of wine. 4-15 Shift in Demand and Equilibrium  If there are shifts in demand or supply, a new equilibrium point will be found. Demand 2 Price (monthly bill) Supply 140  In this instance, a demand- driven 120 increase for the new iPhone pushes price up and the quantity of subscriptions sold up. 100 80 60 Demand 5 10 15 20 25 30 Quantity (Millions of I Phone Subscribers) 4-16 Shift in Supply and Equilibrium  If there are shifts in demand or supply, a new equilibrium point will be found.  In this instance, there is an increase in supply.  What happens to equilibrium price and quantity when supply increases from S1 to S2? 4-17 Questions for Thought and Discussion  Why is equilibrium thought to be efficient?  What happens if price is not at an equilibrium point?  What do prices represent to producers and consumers? 4-18 Governments and the Market  The government may ensure the smooth operation of the markets by protecting property rights, guaranteeing enforcement of legal contracts, and issuing a supply of money that buyers and sellers readily accept.  Governments sometimes change market outcomes by imposing prices floors and price ceilings. This may create shortages or surpluses.  While governmental interference with the market system can have adverse affects, the government does have a substantial supportive role to play in a market economy. 4-19 Price Floors  Sometimes producers believe the     price they are getting for their product is too low. They may lobby the government to impose a price floor above equilibrium. This effective price floor results in a surplus being supplied at the higher price. Suppliers end up supplying more than consumers want to buy. Examples: wheat and corn prices and federal minimum wage How do you think price floors for agricultural commodities would impact the market for these commodities? 4-20 Price Ceilings  Sometimes buyers believe they are paying too much for a good or service.  Buyers may lobby the government to put a price cap on what sellers can charge.  Classic example: rent controlled apartments.  When rent control is in place producers can not charge a price above the ceiling. This is an effective price ceiling because it is set below equilibrium. 4-21 Rent Control: The Institution People Love to Hate  People who live in rent-controlled properties get their apartments at bargain prices.  People looking for apartments will have a harder time finding them and will have to put up with more inconveniences in the housing market because rent control reduces the incentives of business people to provide quality housing options.  Rent control can misallocate a scarce resource (housing) to people who value the resource less than market value.  From a policy standpoint, who is helped or hurt by rent control? Why does local government have this policy in some U.S. cities? 4-22 Application of Supply and Demand: Interest Rate Determination  Interest rates are set by supply     and demand. It is the market for loanable funds. Suppliers are banks, mortgage companies, credit unions, etc. Demanders are homeowners and businesses. On the graph, what is the equilibrium interest rate? How much money is lent/borrowed? 4-23 Application of Supply and Demand: Shifts in Interest Rates What would happen to the interest rate and funds lent/borrowed when supply or demand increases? 4-24 Further Applications of Supply and Demand: Questions for Thought and Discussion  Should parking be free at your school?  Would a parking fee eliminate the shortage?  If the price of gasoline increased to $8 a gallon, would you cut back on your driving?  Explain how prices are a signal to producers about consumer preferences. 4-25 Gasoline Markets and Price: Hurricane Katrina Case Study  On Labor Day weekend of 2005, Hurricane Katrina: o Temporarily shut down off-shore wells in the Gulf of Mexico. o Briefly put 10% of our refineries out of commission. o Caused a sudden drop in oil supply.  The result was: o o o The government took a “hands off” approach. Gasoline prices rose sharply. People could buy all they wanted but at sharply increased prices. 4-26 Questions for Thought and Discussion  How is equilibrium price affected by changes in demand and supply?  If you were a landlord, would you be against rent control?  Do corporations have incentives to lobby the government for price floors or ceilings?  Practical Application: Urban highways are usually congested during morning and evening commuting times. Using supply and demand analysis, what simple step could be taken to greatly reduce congestion? 4-27
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