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PRINCIPLES OF

ECONOMICS:
BUSINESS, BANKING, FINANCE,
AND YOUR EVERYDAY LIFE
COURSE GUIDE

Professor Peter Navarro


UNIVERSITY OF CALIFORNIA, IRVINE
PAUL MERAGE SCHOOL OF BUSINESS

Principles of Economics:
Business, Banking, Finance, and
Your Everyday Life
Professor Peter Navarro
University of California, Irvine
Paul Merage School of Business

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Recorded Books, LLC. All rights reserved.

Principles of Economics:
Business, Banking, Finance, and Your Everyday Life
Professor Peter Navarro


Executive Producer
John J. Alexander

Executive Editor
Donna F. Carnahan

RECORDING
Producer - David Markowitz
Director - Matthew Cavnar
This course was directed and edited by Richard Stanley.

COURSE GUIDE
Editors - James Gallagher
Design - Edward White

Lecture content 2005 by Peter Navarro


Course guide 2005 by Recorded Books, LLC

72005 by Recorded Books, LLC


Cover image: Clipart.com
#UT063 ISBN: 978-1-4193-3933-2
All beliefs and opinions expressed in this audio/video program and accompanying course guide
are those of the author and not of Recorded Books, LLC, or its employees.

Course Syllabus
Principles of Economics:
Business, Banking, Finance, and Your Everyday Life

About Your Professor ......................................................................................................4


Introduction ......................................................................................................................5
Lecture 1

Introduction to Macro- and Microeconomics ............................................6

Lecture 2

The Business Cycle and the Warring Schools


of Macroeconomics ..................................................................................8

Lecture 3

Fiscal Policy and Budget Deficits: The Good, Bad, and Ugly................14

Lecture 4

Monetary Policy: Its All About Money, Credit, and Banking..................22

Lecture 5

Unemployment and Inflation: Enter the Dragons...................................28

Lecture 6

International Trade and Protectionism: Where Did


Our Jobs Go?.........................................................................................34

Lecture 7

The International Monetary System, Exchange Rates,


and Trade Deficits ..................................................................................40

Lecture 8

Supply, Demand, and Equilibrium: How Prices Are Set


in Our Markets........................................................................................45

Lecture 9

Understanding Consumer Behavior: The Essential Elements...............49

Lecture 10

Producer Behavior and an Introduction to Perfect Competition ............54

Lecture 11

Market Structure, Conduct, and Performance: Why


Monopolists Do What They Do ..............................................................61

Lecture 12

Why the Government Intervenes in Our Markets and


Lives: The Economists Critique.............................................................66

Lecture 13

Government Taxation from the Cradle to the Grave:


The Big Issues .......................................................................................70

Lecture 14

Land, Labor, and Capital: How Our Rents, Wages, and


Interest Rates Are Set............................................................................76

Course Materials............................................................................................................80

About Your Professor


Peter Navarro

Photo courtesy of Professor Peter Navarro

Peter Navarro is a business professor at the


Paul Merage School of Business at the
University of California, Irvine. He holds a
Ph.D. in economics from Harvard University
and is the author of the best-selling investment book If Its Raining in Brazil, Buy
Starbucks. His latest book is The Well-Timed
Strategy: Managing the Business Cycle for
Competitive Advantage, which illustrates how
a knowledge of macroeconomics can be
used to improve executive decision-making.
Professor Navarros articles have appeared in a wide range of publications,
from the Harvard Business Review, Sloan Management Review, and Wall
Street Journal to the Los Angeles Times, New York Times, and Washington
Post. He has made frequent guest appearances on major financial news stations, including Bloomberg Television, CNBC, and CNN.
Professor Navarros weekly stock market newsletter, the Big Picture
Investor, is distributed to several thousand readers and available free of
charge at www.peternavarro.com.
You will get the most out of this course if you have the following book:
Economics: Principles, Problems, and Policies, 16th edition, by Campbell R.
McConnell and Stanley L. Brue (New York: McGraw-Hill, 2005).
You will find it useful for the lectures on macroeconomics to also have a
copy of If Its Raining in Brazil, Buy Starbucks, New York: McGraw-Hill, 2004,
which provides an excellent overview of the various economic indicators used
to forecast the business cycle. It also illustrates how to use macroeconomics
in a stock market investing context.
Acknowledgment
My deep thanks to Pedro Sottile for his yeoman work as my long-time
research associate. Id also like to profusely thank my technical whiz kid
Richard Stanley for his wonderful sound editing work in the early stages of
recording this project.

Introduction
This course introduces both macroeconomics and microeconomics.
Macroeconomics focuses on the big economic picturespecifically, how the
overall national and global economies perform. It is a subject that focuses on
big problems like unemployment and inflation and the dire threats that large
budget deficits and trade deficits can pose for economic well-being.
At a business and professional level, macroeconomics can help to answer
questions such as the following: How much should I manufacture this month?
How much inventory should I maintain? Should I invest in new plant and
equipment? Expand into foreign markets? Or downsize my firm?
At a personal level, macroeconomics can also help to answer equally important questions: Should I switch jobsor ask for a raise? Should I buy a
house now or wait until next year? Should I get a variable or fixed-rate mortgage? And what about my investments for retirement?
In contrast, microeconomics deals with the behavior of individual markets
and the businesses, consumers, investors, and workers who make up the
macroeconomy. Microeconomics focuses on issues such as how prices are
set, how wages are determined, how rents are set, and why the government
is sometimes forced to regulate industries that are too monopolistic, that pollute too much, or that may conceal vital information.
At a business level, microeconomics can help to answer the following questions: How can my firm minimize its costs and increase its profits? What
prices should I charge for my products? How should I respond to an aggressive strategic move by one of my competitors?
At a personal level, microeconomics is equally practical. It can help to
answer questions such as the following: Will I really be better off financially if
I quit my job now and go back for an MBA degree? What kind of career
should I be preparing myself for? What about that new refrigerator or automobile I want to buyshould I get the new, energy-efficient one with the higher
price tag or settle for the cheaper model?
Most broadly, microeconomics can help you to understand why the government is so involved in our economic lives. It can do so by answering questions such as the following: Why does the government regulate prices in
industries like electricity and gas, but not in others? Why are there laws
requiring seat belts and motorcycle helmets? Why do we have a Federal
Environmental Protection Agency and thousands of rules about workplace
safety? And why does the government provide some goods and let the free
market provide others?
My hope is that you will not only enjoy this course immensely, but you will
also find it helpful in those areas of economics that affect both your personal
and professional life.
Good luck!
~Peter Navarro
www.peternavarro.com

Lecture 1:
Introduction to Macro- and Microeconomics
LECTURE OBJECTIVES
1. Introduce some of the big problems in macroeconomics
and microeconomics.
2. Illustrate quite specifically how macroeconomics and microeconomics affect you in your personal and professional life.
3. Show how to incorporate an understanding of economics into
your daily decision making.
4. Outline the course and its contents.

Introduction to
Macroeconomics and
Microeconomics
Economics can be
a difficult subject
at times, but it is
also one of the
most interesting
and readily
applicable subjects that you can
ever learn.
We distinguish between the two main branches of economics: macroeconomics and microeconomics.

LECTURE ONE

Macroeconomics is a subject
that focuses on big problems
like unemployment and inflation and the dire threats that
large budget deficits and
trade deficits can pose for
our economic well-being.
Microeconomics deals with
the behavior of individual
markets and the businesses,
consumers, investors, and
workers that make up the
macro economy.

Clipart.com

rt.co

lipa

FOR GREATER UNDERSTANDING

Questions
1. Why do we call economics the dismal science?
2. Which branch of economics is more importantmacroeconomics
or microeconomics?
3. What kind of questions can macroeconomics help you to answer from a
personal and professional perspective?

Websites to Visit
1. Website for the National Bureau of Economic Research www.nber.org
2. Information on macroeconomics events and studies www.dismal.com

Lecture 2:
The Business Cycle and the
Warring Schools of Macroeconomics
LECTURE OBJECTIVES
1. Learn about the business cycle and how its movements from
recession to expansion and back to recession are measured.
2. Explore the reasons why recessions and expansions happen in
the business cycle.
3. Explore the so-called warring schools of macroeconomics and
examine their very different views of why the economy may suffer problems and what should be done to solve those problems.
4. Show how these warring schools relate to very real political figures that have shaped our lives.

The Business
Cycle
(See Figure 2.1)

1. All movements
in the business
cycle are measured by the
rate of growth of
the real gross
domestic product (GDP). A
nations nominal
GDP measures
its economic output; the real GDP is the nominal GDP adjusted
for inflation.

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2. The movements of the GDP define the business cycle, which charts the
recurrent moves from an expansionary phase and some inevitable peak
when business activity reaches a maximum, to a recessionary phase and
some inevitable trough brought on by a downturn in total output, to a
recovery or upturn in which the economy expands toward full employment. Note that each of these phases of the cycle oscillates around a
growth trend line.
3. There are three main explanations for business-cycle volatility.
LECTURE TWO

4. The first explanation for business-cycle volatility centers on random,


external shocks to the economic system. These so-called exogenous
shocks include both negative, recession-inducing events as well as positive, expansionary-enhancing productivity shocks.
5. In the second explanation, the economy is typically viewed as inherently
stable. Yet it can be thrown off course by policy errors and miscalcula8

Peter Navarro

Figure 2.1
The Business Cycle

tions or, in the worst case, by Machiavellian politicians using the powers
of incumbency to enhance their re-election fortunes.
6. The third major explanation of business-cycle movements relies on a
much more complex and systemic view of the economy. It is characterized by the co-movements of many variables.
7. The task for macroeconomists trying to use fiscal and monetary policies
to better manage the business cycle is to understand this process in all
its richness.
Warring Schools of Macroeconomics:
1. The five major warring schools range from classical economics and
Keynesianism to monetarism, supply-side economics, and new
classical economics.
Classical Economics
2. History begins with classical economics, which dates back to the late
1700s. The classical economists believed that the problems of recession
and unemployment were a natural part of the business cycle, that these
problems were self-correcting, and, most importantly, that there was no
need for the government to intervene in the free market to correct them.
3. This approach actually seemed to workuntil the Great Depression of
the 1930s.

Keynesianism
4. British economist John Maynard Keynes flatly rejected the classical
notion of a self-correcting economy. Instead, Keynes believed that the
global economy would not naturally rebound but simply stagnate or,
even worse, fall into a death spiral. In his view, the only way to get the
economy moving again was to prime the economic pump with increased
government expenditures.
In the United States, Franklin Delano Roosevelts Keynesian New
Deal public works programs in the 1930s, together with the 1940s
Keynesian boom of World War II expenditures, lifted the American
economy out of the Great Depression and up to unparalleled heights
just as Keynes predicted.
Pure Keynesianism reached its zenith with the much-heralded Kennedy
Tax Cut of 1964, which would make the 1960s one of the most prosperous decades in America as business boomed.
5. The aggressive fiscal stimulus after World War II laid the foundation for
the emergence of a new macroeconomic problem that Keynesian economics would be totally incapable of solving: stagflationsimultaneous
high inflation and high unemployment.

Line at a Soup Kitchen


In February 1931,
unemployed men lined
up outside a soup kitchen
opened in Chicago by
Al Capone.

Clipart.com

6. The Keynesian dilemma was that using expansionary policies to reduce


unemployment simply created more inflation, while using contractionary
policies to curb inflation only deepened the recession.

LECTURE TWO

The stagflation problem had it roots in President Lyndon Johnsons


stubbornness. In the late 1960s, Johnson increased expenditures on
the Vietnam War but refused to cut spending on his Great Society social
welfare programs.

10

Monetarism & Supply-side Economics


7. Professor Milton Friedmans monetarists challenged what had become
the Keynesian orthodoxy. Friedman argued that the problems of both
inflation and recession may be traced to one thingthe rate of growth of
the money supply. From this monetarist perspective, stagflation is the
inevitable result of activist fiscal and monetary policies that try to push
the economy beyond its so-called natural rate of unemployment
defined as the lowest level of unemployment that can be attained without
upward pressure on inflation.
8. The conservative school of supply-side economics entered the stage
after the monetarists bitter medicine to correct stagflation. Specifically,
supply-siders believed that people would actually work much harder and
invest much more if they were allowed to keep more of the fruits of their
labor. In such a scenario, the supply-siders promised that by cutting
taxes and thereby spurring rapid growth, the loss in tax revenues from a
tax cut would be more than offset by the increase in tax revenues from
increased economic growth.
In the 1980 U.S. presidential election, Ronald Reagan ran on a supplyside platform that promised to simultaneously cut taxes, increase government tax revenues, and accelerate the rate of economic growth
without inducing inflation. Unfortunately, that didnt happen: while the
economy boomed, so too did Americas budget and trade deficit.
In the Bush White House, Ronald Reagans supply-side advisors had
been supplanted not by Keynesians, but rather by a new breed of
macroeconomic thinkersthe so-called new classicals.
New Classical Economics
9. The new classical school is rooted in the classical economic tradition.
New classical economics is based on the controversial theory of rational
expectations, which maintains that if you form your expectations rationally, you will take into account all available information. The idea behind
rational expectations is that activist fiscal and monetary policies might be
able to fool people for a while; however, after a while, people will learn
from their experiences, and then you cant fool them at all. The central
policy implication of this idea is, of course, profound: rational expectations render activist fiscal and monetary policies completely ineffective,
so they should be abandoned.
10. Economically, critics of rational expectations say that most people are
not as sophisticated in their economic thinking as the theory requires,
and therefore adjustments will not take place with anywhere near the
speed they are supposed to.
11. However, this criticism should not detract from the central point of rational
expectations, namely, that peoples behavior may partially, or perhaps
completely, counteract the goals of activist fiscal and monetary policies.

11

It is important not just because of the strong influence it has had on


recent macroeconomic theory but also because new classical economists played a pivotal role during the 1992 defeat of the first George
Bush by Bill Clinton. Bush took the new classical advice, the economy
limped into the 1992 presidential election, and, like Richard Nixon in
1960, Bush lost to a Democrat promising to get the economy moving
again. The irony, of course, is that Bushs fiscally conservative new classical response set the stage for the Clinton boomthe longest expansion in U.S. history.

Peter Navarro

The Warring Schools of Macroeconomics

LECTURE TWO

Issue

Mainstream
macroeconomics
(Keynesian based)

Monetarism

Rational
expectations

Supply-side
economics

View of the
private economy

Potentially unstable

Stable in long run


at natural rate of
unemployment

Stable in long run


at natural rate of
unemployment

May stagnate
without proper
work, saving,
and investment
incentives

Cause of the
observed instability of the
private economy

Investment plans
unequal to saving
plans

Inappropriate
monetary policy

Unanticipated AD
and AS shocks in
the short tun

Changes in AS

Appropriate
macro policies

Active fiscal and


monetary policy

Monetary rule

Monetary rule

Policies to
increase AS

How changes in
the money supply
affect the
economy

By changing the
interest rate, which
changes investment and real GDP

By directly
changing AD,
which changes
GDP

No effect on
output because
price-level changes
are anticipated

By influencing
investment and
thus AS

View of the
velocity of money

Unstable

Stable

No consensus

No consensus

How fiscal policy


affects the
economy

Changes AD
via the multiplier
process

No effect unless
money supply
changes

No effect on output,
because pricelevel changes
are anticipated

Affects GDP and


price level via
changes in AS

View of cost-push
inflation

Possible (wagepush, AS shock)

Impossible in the
long run in the
absence of
excessive money
supply growth

Impossible in the
long run in the
absence of
excessive money
supply growth

Possible (taxtransfer disincentives, higher


costs due to
regulation)

12

FOR GREATER UNDERSTANDING

Questions
1. What is the difference between nominal GDP and real GDP?
2. State the phases of the business cycle.
3. Who determines whether the economy is in a recession or an expansion?
4. What are the five warring schools of macroeconomics?
5. Which of the warring schools of economics is the best school to follow?
6. On what issues do the warring schools of macroeconomics converge?
7. Explain the Keynesian view of the Great Depression.
8. For the Monetarists, why does the endorsement of a monetary rule make
the most sense?
9. Explain the new classical view of a self-correcting economy.
10. Why do the supply-side tax cuts differ from those of the Keynesians?
11. Were the tax cuts implemented by George W. Bush in the United States
Keynesian tax cuts or supply-side tax cuts?

Websites to Visit
1. Choose the appropriate link to review the history of the U.S. business
cycle; pinpoint where the business cycle might be currently
www.nber.org
2. The History of Economic Thought website is the most detailed website
about schools of economic theory; select Schools of Thought and learn
more about schools of macroeconomics not covered in this lecture
http://cepa.newschool.edu/het
3. Go to the Catalogue Resources tab and select Schools of Economic
Thought from the Detailed Search option; the site contains summaries and
links devoted to many economists and schools of economic theory
www.econport.org

Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapter 19. Economics:
Principles, Problems, and Policies. 16th ed. New York: McGraw-Hill, 2005.
Navarro, Peter. Introduction, and Chapters 1 and 12. If Its Raining in Brazil,
Buy Starbucks. New York: McGraw-Hill, 2001.
Snowdon, Brian, Howard Vane, and Peter Wynarczyk. A Modern Guide to
Macroeconomics: An Introduction to Competing Schools of Thought.
Cheltenham, UK: Edward Elgar Publishers, 1995.
13

Lecture 3:
Fiscal Policy and Budget Deficits:
The Good, Bad, and Ugly
LECTURE OBJECTIVES
1. Illustrate the basic Keynesian model and show how the application of the model gave birth to fiscal policy.
2. Learn about fiscal policy, which involves the use of government
expenditures or tax changes to expand or contract an economy.
3. Understand why fiscal policy is one of the most potent tools that
governments have to stimulate or contract an economy.
Fiscal Policy:
Historical Perspective

2. The irony is that in their attempt


to save more, many individual
households actually saved less
because their incomes plummeted as the economy weakened.
This result is known as the paradox of thrift, and it can be an
important contributor to recessionary events.

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1. In October 1929, the U.S. stock


market crashed and sent the
business community into a panic.
Reacting to the crash, businesses
cut back sharply on investment
and production. At the same time,
frightened consumers cut back
dramatically on consumption
while attempting to save more as
a response to the crisis.

Panicked investors on Wall Street, October 24, 1929.

3. Because of this depressed consumption and investment and everexpanding layoffs, the economy continued its downward spiral. Eventually, unemployment reached a staggering 25 percent of the workforce.

LECTURE THREE

4. For President Herbert Hoover, a follower of the classical school of economics, the answer was to wait. Eventually, prices would fall and people
would start buying more, wages would fall and businesses would start
hiring again, and, through this so-called price adjustment mechanism,
the economy would bounce right backor, as Hoover himself put it,
prosperity is just around the corner.
5. Contrary to this view, and as the U.S. economy and economies around
the world sunk further into this Depressionary morass, British economist

14

Lord John Maynard Keynes and his socalled income adjustment mechanism
showed that when an economy sinks
into a recession, peoples incomes fall.
This fall in income causes them to
spend less and save less while businesses respond by investing and producing less. This reduction in consumption, savings, investment, and
output, in turn, drives the economy
deeper into recession rather than back
to full employment.
6. In this scenario, Keynes believed that
the only way out of a severe depression was to prime the economic
pump with increased government
spending. This was precisely the idea
behind fiscal policy.

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Herbert Hoover

7. Once Herbert Hoover was replaced by


Franklin Delano Roosevelt, the government did indeed start to spend
first on FDRs so-called New Deal public works projects and then far
more dramatically on defense expenditures for World War II. Together,
these twin stimuli triggered increased consumption and investment, and
the economy roared back to full employment.
Basic Keynesian Model
1. The most important assumption underlying the basic Keynesian model is
that prices are fixed. Keynes himself didnt believe this, of course. But
Keynes did believe that when the economy is in the recessionary range,
prices and wages are sufficiently inflexible so that income would adjust
much faster than prices.
2. One of the important insights of this Keynesian model relates to the concepts of leakages and injections.
3. In this Keynesian model, the economy will be in equilibrium at a point
where aggregate expenditures are equal to aggregate production.
However, if, at that point, the economy is not producing at full capacity,
there is a so-called recessionary gap that must be filled by increased
government spending or some other stimulus to demand like a tax cut.
(See Figure 3.1)

4. In the famous Keynesian equation, aggregate expenditures equal consumption plus investment plus government expenditures plus net exports.
5. The most important thing to understand about aggregate expenditures in
the Keynesian model is that people dont spend every dollar they earn.
Rather, they have a so-called marginal propensity to consume (MPC),
which measures the fraction of every additional dollar that a person
will spend.

15

Peter Navarro

Figure 3.1
The Keynesian Model

Consumption
1. The largest component of aggregate expenditures is consumption,
accounting for almost 70 percent of total aggregate expenditures in the
U.S. economy. Consumption occurs in three categories: durable goods,
non-durable goods, and services.
2. Keynes explained consumption expenditures by defining two distinct
components: autonomous and induced consumption.
3. First, Keynes posited that there is a level of consumption called
autonomous consumption that will occur even if a persons income falls
to zero, regardless of changes in ones income.
4. Second, Keynes said that there is a level of induced consumption
that depends on the individuals disposable income, where disposable
income is simply the amount of money you have left after paying taxes
to the government.

LECTURE THREE

5. Keynes further described this consumption behavior in terms of a persons MPC, which is simply the extra amount that people consume when
they receive an extra dollar of disposable income.
Example: some people may only spend seventy-five cents of every dollar
of their disposable income and save twenty-five cents. In this case, the
MPC is 3/4.
Investment
1. Investment expenditures include the purchases of homes, investment in
business plant and equipment, and additions to a companys inventory.
16

Investment in plant and equipment is by far the biggest category,


averaging a full 70 percent of total investment annually, while total
investment expenditures account for roughly 15 percent of total
aggregate expenditures.
2. In the Keynesian model, investment expenditures are assumed to occur
independently of the level of income.
3. To Keynes, the two important determinants of investments are the sensitivity of investment to changes in the interest rate and the expectations,
or business confidence, that businesses have regarding potential sales
and profits.
4. Note, however, that while Keynes believed the interest rate was important in determining investment, he did not believe that falling interest
rates and increased investment would necessarily lead to a full-employment equilibrium like the classical economists did. This is because
Keynes believed that investment was in large part driven by the expectations that businesses had regarding potential sales and profits. Keynes
referred to these expectations as animal spirits and basically said that if
businesses believed the economy was about to go bad, it could become
a self-fulfilling prophecy.
Government Spending
1. Government spending includes purchases of goods like tanks or roadbuilding equipment as well as the services of judges and public school
teachers. Such government expenditures account for almost 20 percent
of total aggregate expenditures in the United States.
2. In the Keynesian model, increased or decreased government expenditures, together with tax cuts or tax increases, serve as the primary tools
of fiscal policy that are used to counterbalance changes in investment
and consumption spending.
3. Specifically, expansionary fiscal policy involves increased government expenditures, tax cuts, or some combination of the two to
stimulate a recessionary economy and close a recessionary gap. In contrast, contractionary fiscal policy involves reduced government expenditures, tax hikes, or some combination of the two to cool down an overheated economy.
Net Exports
1. Net exports equals the value of
exports minus the value of imports.
Exports create domestic production,
income, and employment for
an economy, so we add
exports to aggregate
expenditures. However,
when we purchase
imports from a foreign
country, no such produc Digital Stock

17

tion, income, or employment is created,


so imports must be subtracted from
aggregate expenditures.
2. While net exports are an important part of
a global, or open, economy, they were
not central to the development of the
Keynesian multiplier model. Therefore, we
assume a closed economy in which
there is no international trade and drop
net exports from the model.
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Keynesian Multipliers
1. The Keynesian expenditure multiplier is the number by which a change in
aggregate expenditures must be multiplied to determine the resulting
change in total output. This multiplier is always greater than one.
2. In the Keynesian model, it can be shown mathematically that the
Keynesian multiplier is simply the reciprocal of one minus the MPC.
Hence, the higher the MPC, the bigger the multiplier.
Example: Suppose that the MPC is 0.5. Then the multiplier is 2, or 1
divided by 1 minus 0.5. If the MPC is 0.75, the multiplier is 4, or 1 divided
by 1 minus 0.75.
3. The Keynesian tax multiplier is simply the regular expenditure multiplier
times the MPC.
Expansionary Fiscal Policy: Numerical Example
1. Lets assume that
the full employment output of the
economy is $900
billion, but the
economy is stuck
at a recessionary
output of $800 billion. In other
words, weve got a
recessionary gap
of $100 billion to
fill so that people
wont be out of
workas illustrated in Figure 3.2.
LECTURE THREE

2. If the marginal
propensity to consume is 0.8, we

Figure 3.2
A Recessionary Gap

18

Peter Navarro

calculate a multiplier of 5. So if the government wants to close that $100


billion recessionary gap, all it needs to do is increase spending by $20
billion dollarsbecause an expenditure multiplier of 5 times the $20 billion dollar spending hike equals $100 billion.
3. Alternatively, lets suppose we prefer to cut taxes. In our example, it
means we dont cut taxes by $20 billion dollars, but by $25 billion dollarsor $5 billion more than we needed to increase government expenditures to achieve the same result. We arrive at this total by first multiplying the expenditure multiplier of 5 times the MPC, yielding a tax multiplier of 4. Then, 4 times the $25 billion tax cut yields the desired $100
billion expansion.
4. The reason for the difference is that a dollars worth of tax cuts actually
has slightly less of an expansionary effect than a dollars increase in government expenditures. With a tax cut, consumers will not increase their
expenditures by the full amount of the tax cut. Instead, they will save a
portion of that tax cut based on their marginal propensity to consume.
Contractionary Fiscal Policy: Example
To close an inflationary gap, we can cut government expenditures,
raise taxes, or use a combination of the two fiscal policies to cool
inflationary pressures.
Budget Deficits
1. Indeed, there are many problems with this mechanistic Keynesian view;
and there may be no problem bigger than the budget deficits that expansionary fiscal policies can give rise to.
2. In thinking about problems associated with chronic budget deficits and a
soaring national debt, economists establish a benchmark by comparing
the debt to the size of the nations GDP. Accordingly, comparing the debt
to the GDP gives us a measure of a nations ability to produce and therefore its ability to pay off its debt.
Even though the United States has the largest public debt in absolute
terms, on a debt-to-GDP basis, it doesnt fare anywhere nearly as badly
as many other nations.
3. One crucial feature that is concerned with the problem of chronic budget
deficits is related to
the distinction between
the so-called structural
deficit and the
cyclical deficit.
4. The structural deficit is
that part of the actual
budget deficit that
would exist even if the
economy were at full
employment. The
structural part of the

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19

budget is thought of as active and is determined by discretionary


fiscal policies.
5. In contrast, the cyclical deficit is that part of the actual budget deficit
attributable to a recessionary economy. It results primarily from the
shortfall of tax revenues that arises when the economys resources
are underutilized.
6. The distinction is important because it helps policymakers distinguish
between long-term changes in the budget caused by discretionary policies versus short run changes caused by the business cycle.
Budget Deficit Financing
1. We have to recognize that the kind of problems the deficit and debt may
cause is in large part determined by how the deficit is financed. In theory,
there are three major ways the government can finance a deficit: raising
taxes, borrowing money, or printing money.
2. In practice, however, raising taxes is politically unpopular. This means
that the government has to resort to one of two other means to finance
the deficit: borrowing money or printing money.
3. With the Borrow Money option, the U.S. Treasury sells IOUs in the form
of bonds or Treasury bills directly to the private capital markets and uses
the proceeds of the sales to finance the deficit. In this case, the Federal
Reserve is out of the loop.
4. Note that the U.S. Treasury is competing directly in the capital markets
with private corporations, which may also be seeking to sell bonds and
stocks in order to raise capital to invest in new plant and equipment. In
order to compete for these scarce investment dollars, the Treasury typically must raise the interest rate it is offering in order to attract enough
funds. In this case, deficit spending by the government is said to crowd
out private investment.
5. The crowding out effect is one of the most important concepts in macroeconomics, because it places clear and obvious limits on the use of
expansionary fiscal policies to stimulate an economy.
6. At least in theory, its possible to avoid crowding out altogether with the
Print Money option. With this option, the Federal Reserve is said to
accommodate the Treasurys expansionary fiscal policy.
7. In particular, the Fed simply buys the Treasurys securities itself rather
than letting these securities be sold in the open capital markets. To pay
for these deficit-financing Treasury securities, the Federal Reserve simply
prints new money.
LECTURE THREE

8. The problem with this option is that the increase in the money supply can
cause inflationan undesirable result in and of itself. Moreover, if such
inflation drives interest rates up and private investment downas it is
likely to dothe end result of the Print Money option may be a crowding
out effect as well.

20

FOR GREATER UNDERSTANDING

Questions

1. What is the most important assumption underlying the Keynesian model?


2. What are the aggregate expenditures?
3. State the difference between autonomous consumption and induced consumption in the Keynesian model.
4. Define the Keynesian expenditure multiplier. How is it calculated?
5. Who sets the fiscal policy?
6. Is it more favored to increase government spending or cut taxes to eliminate recessionary gaps?
7. What is the difference between structural and cyclical budget deficits?
8. Explain the crowding out effect.

Websites to Visit
1. Democrats usually recommend increasing government spending during
recessions and raising taxes to fight demand-pull inflation. Republicans
generally favor tax cuts during recessions and cuts in government spending to fight demand-pull inflation. To learn more about fiscal policy, check
out these websites:
The Progressive Policy Institute www.ppionline.org
(go to the Economic and Fiscal Policy link)
The Cato Institute www.cato.org
(go to Research Areas and click on Budget and Taxes)
2. Choose Browse the FY Budget, then select Historical Tables and
check Federal Debt to get a grasp of the historical evolution of the U.S.
public debt in terms of its level, as a percentage of the GDP, and by holders www.gpo.gov/usbudget
3. Website of the Bureau of the Public DepartmentU.S. Department of the
Treasury; use the site to identify the different kinds of U.S. Treasury securities being offered on a regular basis by the Treasury to finance part of
the government expenditures www.publicdebt.treas.gov

Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapters 9, 10, and 12.
Economics: Principles, Problems, and Policies. 16th ed. New York:
McGraw-Hill, 2005.
Navarro, Peter. Chapters 13, 16, and 17. If Its Raining in Brazil, Buy
Starbucks. New York: McGraw-Hill, 2001.
The Wall Street Journal editorial page provides insight into the conservative
approach to fiscal policy.
21

Lecture 4:
Monetary Policy: Its All About
Money, Credit, and Banking
LECTURE OBJECTIVES
1. Describe our money and banking system and explain how the
Federal Reserve, the nations central bank, creates money.
2. Show how the Federal Reserve conducts active monetary policy.
3. Compare the Keynesian vs. Monetarist approach to active monetary policy.

EyeWire

Money and Its Functions


1. Money has a broad definition. It is anything that can be widely used and
accepted in exchange for other goods and services. In practice, there are
three kinds of money: commodity money such as gold or silver; bank
money such as a checkbook; and paper or fiat money such as dollar bills.
2. An important observation to make about money is that it is the most liquid of assets, meaning that it is the most readily spendable.
LECTURE FOUR

3. Money has three major functions. First, money is a medium of exchange.


Second, money serves as a unit of account or standard of value. Third,
money serves as a store of value. However, it is the last function that
money performs least well: in the presence of inflation, money can rapidly
lose its value.

22

The Interest Rate


1. When we examine how money affects economic activity, we focus on the
impact of the interest rate.
2. Technically, the interest rate is the amount of interest paid per unit of
time expressed as a percentage of the amount borrowed.
3. Interest is the payment made for the use of money, and it is often called
the price of money. Note that there is actually a vast array of interest
ratesshort-term rates and long-term rates, government bond rates and
corporate bond rates, and so onnot just the interest rate.
4. There are three main reasons why interest rates differ across time and
the types of interest-bearing assets: the term or maturity of the loan, the
degree of risk, and liquidity.
The Demand for Money
1. The two major determinants of money demand are known as the transactions demand and the asset demand.
2. The transactions demand for money arises because people and firms
use it as a medium of exchange.
3. In contrast, the asset demand or speculative motive for holding money
arises because people use money as a store of value.
4. Note that while money is an asset, money provides no rate of return or
interest like other assets. Moreover, if either the interest rate or the
expectation of inflation increases, there is an increasing opportunity cost
of holding money that includes the interest or rate of return that could
have been earned by lending or investing the money as well as the loss
in value from holding money during inflation. Therefore, the asset
demand for money must decrease.
The Early Goldsmiths
1. The goldsmiths emerged as the
first commercial bankers. Todays
modern banks function much like
the goldsmith system.
2. In this earlier era, people asked
their goldsmiths to store the gold
they didnt want to carry with
them. The goldsmiths, in turn,
would give the gold depositors a
paper receipt and when a depositor needed to get some gold to
make a purchase, he or she
would use that receipt to redeem
the gold.
Goldsmiths Workshop
by the School of Agnolo Bronzino,
Florence, sixteenth century

Clipart.com

23

3. Three important things happened with these goldsmiths.


4. First, the depositors figured out they could trade their gold receipts for
goods. These receipts functioned, in effect, as the first paper money.
5. Second, the gold depositors soon figured out that they didnt have to
leave their gold with the goldsmith for free. Goldsmiths began to offer
depositors interest on their gold deposits.
6. Finally, the goldsmiths figured out that they could operate under what is
today called a system of fractional reserves. Such a system allowed the
goldsmiths to expand the supply of money over and above the amount of
gold reserves they held in their vaults.
About the Federal Reserve and the Modern Banking System
1. Created in 1913, the Federal Reserve, or The Fed, is the nations
central bank. Through its control of bank reserves, the Fed sets the level
of short-term interest rates and has a major impact on output
and employment.
2. From a global perspective, the Fed is a somewhat peculiar central bank: it
is both decentralized and privately owned. It consists of twelve regional
banks spread across the country, and they are owned by the commercial
banks. While legally these twelve regional banks are private, in reality, the
Fed as a whole behaves as an independent government agency.
3. Its board of governors comprises seven members nominated by the president and confirmed by the Senate to serve overlapping terms of fourteen
years; members of the board are usually bankers or economists.
4. The key policy-making body at the Fed is the Federal Open Market
Committee. This committee consists of twelve people: the seven members of the Feds board of governors plus the president of the New York
Federal Reserve District Bank plus four rotating members from the other
eleven Federal Reserve District Banks.
5. At the pinnacle of the system is the chairman of the board of governors.
Often called the second most powerful individual in America, he acts as
public spokesperson for the Fed and exercises enormous power over
monetary policy.
Fed Functions and the Monetary Policy
1. The Fed can serve as the lender of last resort, so that if a bank needs
money to pay off its depositors, it can always borrow it from the Fed,
which is, in essence, a bankers bank. That may take place when a
bank run occurswhen too many of the banks depositors demand their
money at the same time.
LECTURE FOUR

2. Besides issuing currency and being the lender of last resort, the Fed
has four other functions, including regulating our financial institutions,
providing banking services to the federal government, providing financial
services to the nations banks, and, most importantly, conducting monetary policy.

24

3. In particular, monetary policy involves the use of changes in the money


supply to contract or expand the economy.
4. The Fed manages monetary policy through its Federal Open Market
Committee. The Open Market Committee meets periodically to discuss
monetary policy, and it conducts such monetary policy through the use of
three major policy instruments.
5. The first, and least used, of these instruments is setting the reserve ratio
or the reserve requirement. The Fed can increase the money supply by
lowering the reserve requirement or decrease the money supply by raising the reserve requirement.
A related concept is that of the money-supply multiplier, which is simply
one divided by the banks required reserve ratio. Note that the bigger the
reserve requirement, the smaller the money multiplier and the less
money that is created by a new dollar of demand deposits.
6. The second instrument of monetary policy is the discount rate. The discount rate is the interest rate that the Fed charges banks when they borrow money from the Fed. Lowering the rate makes it cheaper for banks
to borrow money and expand the money supply. In contrast, raising the
discount rate makes it more expensive for banks to borrow from the Fed
and is contractionary.
7. The third, and by far the most important, instrument of monetary policy is
open market operations. Open market operations involve the buying and
selling of government securities to expand or contract the money supply.
In a nutshell, the Fed buys government securities when it wants to
expand the money supply, and it sells government securities when it
wants to contract the money supply. (See Figure 4.1)

Peter Navarro

Figure 4.1: Open Market Operations

25

The Monetary Transmission Mechanism


1. The so-called monetary transmission mechanism refers to the intervention of the Fed and its consequent effect on the aggregate demand.
2. The process begins with the change on reserves through open market
operations and the resulting change in money supply and interest rates.
In the next step, the change in interest rates modifies the level of investment and consumption expenditures. The total effect is to change aggregate expenditures or aggregate demand. Therefore, real GDP and inflation likewise move, thus achieving the desired policy goal of stimulating
or cooling the economy and inflationary pressures.
Keynesianism vs. Monetarism
1. From a purely mechanistic Keynesian point of view, monetary policy is
conducted with less precision than fiscal policy. In the case of monetary
policy, Keynesians argue that the link between the money supply and
shifts in the aggregate expenditure curve is much more complex, relying
on changes in the interest rate and the response of investment, consumption, and net exports.
2. In defining an activist role for monetary policy, Keynesians believe that
monetary policy is most effective as a fine tuning policy instrument
when the economy is near full employment. This is particularly true when
there is an inflationary gap in the economy. In such a case, Keynesians
see the use of contractionary monetary policy as pulling on a string.
3. However, Keynesians also believe that in a severe recession or depression, monetary policy is largely ineffectiveequivalent to pushing on a
string. Thus, in the recessionary and depressionary ranges, Keynesians
believe that expansionary fiscal policy is much more appropriate.
4. But it was the inability of Keynesian economics to cope with stagflation
that set the stage for Professor Milton Friedmans monetarist challenge to
what had become the Keynesian orthodoxy.
5. In contrast to the Keynesian orthodoxy, the Monetarist School doesnt
believe in an activist fiscal and monetary policy at all. According to Milton
Friedman, the father of monetarism, the problems of both inflation and
recession may be traced to one thingthe rate of growth of the money
supply. Inflation happens when the government prints too much money
and recessions happen when it prints too little.
6. More broadly, monetarists like Friedman liken the Federal Reserve to a
bad driver constantly either accelerating too fast or braking too hard on
the money supply.

LECTURE FOUR

7. To fight stagflation and to more broadly prevent the roller coaster ride of
economic booms and busts, the monetarist solution is to set monetary
targets and stick with them.
8. These observations lead us to the major paradox of the Keynesian-monetarist debate, namely, that it is the Keynesian economists, not the monetarists, who support an activist role for monetary policy in fighting recessions and inflation.
26

FOR GREATER UNDERSTANDING

Questions

1. It is sometimes said that war is always good for an economy, but the
Vietnam War caused a number of economic problems. Why? How have
the wars in Iraq affected the economy?
2. What is monetary policy?
3. How has the Internet and the use of credit cards affected the money and
banking system? Do these technologies make it harder or easier for the
Federal Reserve to conduct monetary policy?
4. Has the U.S. Federal Reserve typically done a good job?
5. Name and describe the two sources of money demand.
6. What three characteristics of the modern banking system were also characteristics of the early goldsmiths?
7. What are the three instruments of monetary policy? Which is the most
important? Why?
8. Describe the monetary transmission mechanism.
9. What is the Keynesian view of monetary policy?
10. What is the monetarist view of monetary policy?

Websites to Visit
1. Website of the Federal Reserve: Click on the Monetary Policy link and
then click on Open Market Operations; review the history of the Feds
rate changes, as demonstrated by the changes in the Intended Federal
Funds rate www.federalreserve.gov
2. Read some of the Chairmans speeches under the Testimony and
Speeches link in News and Events www.federalreserve.gov
3. Website of the European Central Bank: Get information on how the EBC is
organized and compare it to the Feds structure www.ecb.int

Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapters 13, 14, and 15.
Economics: Principles, Problems, and Policies. 16th ed. New York:
McGraw-Hill, 2005.
Navarro, Peter. Chapter 4. If Its Raining in Brazil, Buy Starbucks. New York:
McGraw-Hill, 2001.
Woodward, Bob. Maestro: Greenspans Fed and the American Boom. New
York: Simon & Schuster, 2000.

27

Lecture 5:
Unemployment and Inflation:
Enter the Dragons
LECTURE OBJECTIVES
1. Examine more closely three of the most important problems in
macroeconomics: unemployment, inflation, and the combination
of these two problems known as stagflation.
2. Learn about one of the great debates in macroeconomic theory:
the so-called Phillips Curve and its suggested tradeoff
between unemployment and inflation.
3. Compare and contrast the Keynesian and monetarist views
of stagflation.
4. Show the doctrine of supply-side economics as a viable political
alternative to Keynesianism and monetarism.

Unemployment
1. In thinking about the unemployment problem, economists identify
three different kinds: frictional,
cyclical, and structural.
2. Frictional unemployment arises
because of the incessant movement of people between regions
and jobs or through different
stages of their life cycle. It is the
least of the economists worries.
3. Cyclical unemployment occurs
when the economy dips into a
recession, and it is this type of
unemployment that macroeconomists have historically spent
most of their time trying to solve.

LECTURE FIVE

4. Structural unemployment occurs


PhotoDisc
when there is a mismatch
between available jobs and the skills workers have to perform them. It
often results when technological change makes someones job obsolete
or when there is a mismatch between the location of workers and the
location of job openings.
5. In this new century, a different type of structural unemployment has
emerged as more and more jobs have moved offshore. Thats going to
mean the acquisition of a new set of skillsif these victims of outsourcing are to be fully employed.

28

6. The distinction between cyclical, frictional, and structural unemployment


is important because it helps economists diagnose the general health of
the labor market and craft appropriate policy responses.
The Unemployment Rate
1. The unemployment rate is the number of unemployed divided by the
labor force times 100.
In developed countries like the United States, an unemployment rate
between 4 and 6 percent is considered to be healthy, while over the last
100 years in America, this rate has averaged around 5 to 6 percent.
2. Macroeconomists and politicians not only take great interest in the unemployment rate, but they also look carefully at unemployment by race, gender, and age as well as by education.
The Economic Impact of Unemployment
Okuns Law was first identified by economist Arthur Okun. By studying
macroeconomic data, Okun found that for every 2 percent that the gross
domestic product falls in a recession, the unemployment rate rises by about
one percentage point.
Inflation and Stagflation
1. Inflation has often been described as the cruelest tax, because it eats
away at our savings and at our paychecks. But not everyone loses from
inflation: inflation that is actually unanticipated can benefit borrowers at
the expense of lenders.
2. The essence of demand-pull inflation is too much money chasing too
few goods.
3. Cost-push or supply-side inflation occurs when external shocks, such
as rapid increases in raw material prices or wage increases, drive up production costs. Because cost-push inflation quite literally raises the costs
of doing business, it acts as a recessionary force bearing down on the
economy.
4. Cost-push inflation can end up with
stagflationthe double whammy of
both lower output and higher prices.
5. The Keynesian dilemma to fight
stagflation was simply this: using
expansionary policies to reduce
unemployment simply created more
inflation while using contractionary
policies to curb inflation only deepened the recession. That meant that
the traditional Keynesian tools could
solve only half of the stagflation problem at any one timeand only by
making the other half worse.
Clipart.com

29

6. It was this inability of Keynesian economics to cope with stagflation that


set the stage first for Professor Milton Friedmans monetarist challenge to
what had become the Keynesian orthodoxy, and then later for the emergence of supply-side economics.
The Phillips Curve
1. Phillips found that wages tended to rise when unemployment was low,
but fall when unemployment was high. The clear implication of this relationship is that the unemployment rate tends to fall as the economys rate
of growth increases, but the inflation rate also tends to rise. Conversely,
a decrease in economic growth will increase the unemployment rate but
decrease inflation.
2. This Phillips Curve relationship is perfectly consistent with Keynesian
economicsbut it is at a loss to explain the emergence of stagflation;
hence, the Phillips Curve relationship breaks down.
3. According to the monetarists, this disappearance of the Phillips Curve
may best be explained through the concept of the natural rate of unemployment and by distinguishing between a short run and a long run
Phillips Curve. To the monetarists, it was simply impossible to drive
unemployment below the natural or lowest sustainable rate in the longer
run, and this assertion clearly implies that the long run Phillips Curve is
vertical rather than downward sloping.
Policy Implications I: Keynesianism and Monetarism
1. The policy implications of the monetarists natural rate theory strike to the
very heart of Keynesian activism. To the monetarists, the only way to
stop an inflationary spiral is to stop using expansionary Keynesian policies and allow the economy to return to the natural or lowest sustainable
rate of unemployment.
2. Nevertheless, even if we stop the upward spiral of inflation, we still have
significant inflation. This is because a higher core rate of inflation has
been built into the economy. The dilemma is that neither the traditional
Keynesian nor the monetarist approach to wringing this inflation out of
the economy has any political appeal.
3. The traditional Keynesian solution is a so-called incomes policy: Impose
wage and price controls until the inflation dissipates.

LECTURE FIVE

4. Monetarists believe that the only way to wring inflation and inflationary
expectations out of the economy is to have the actual inflation rate below
the expected inflation rate. To achieve this, the actual unemployment rate
must be above the natural rate of unemployment, and that means only
one thing: inducing a recession.
Policy Implications II: Supply-side Economics
1. The conservative school of supply-side economics entered the stage
after the monetarists bitter medicine to correct stagflation. Specifically,
supply-siders believed that people would actually work much harder and

30

invest much more if they were allowed to keep more of the fruits of their
labor. In such a scenario, the supply-siders promised that by cutting
taxes and thereby spurring rapid growth, the loss in tax revenues from a
tax cut would be more than offset by the increase in tax revenues from
increased economic growth.
2. Unlike the Keynesians, supply-siders did not agree that such a tax cut
would necessarily cause inflation. The end result would be to increase
the amount of goods and services our economy could actually produce
by pushing out the economys supply curvehence, supply-side economics. Moreover, the price level falls even as real output and employment is rising.
3. The so-called Laffer Curve relates the marginal tax rate, as measured
on a vertical axis to total tax revenues, as measured on the horizontal
axis. It is backward bending; above a certain marginal tax rate, an
increase in the tax rate will actually cause overall tax revenues to fall.
Note also that for a supply-side tax cut to actually increase tax revenues,
the existing tax rate before the tax cut must be above msay at a rate
associated with point n on the curve. (See Figure 5.1)
4. In the 1980 U.S. presidential election, Ronald Reagan ran on a supplyside platform that promised to simultaneously cut taxes, increase government tax revenues, and accelerate the rate of economic growth without
inducing inflation. Unfortunately, that didnt happen: while the economy
boomed, so too did Americas budget and trade deficit.

Peter Navarro

Figure 5.1: The Laffer Curve

31

Policy Implications III: New Classical Economics


1. The so-called twin deficits deeply concerned Reagans successor
George Bush, particularly after the budget deficit jumped over $200 billion at the midpoint of his term in 1990 and the economy began to slide
into recession.
2. However, in the Bush White House, Ronald Reagans supply-side advisors had been supplanted not by Keynesians, but rather by a new breed
of macroeconomic thinkersthe so-called new classical economists.

LECTURE FIVE

3. These new classical economists urged President Bush not to engage in


any Keynesian stimulus, and the rest is history. Bush lost to Bill Clinton,
largely because of the sluggish economy. However, Bushs fiscal policy
restraint also helped to set up the United States for its longest economic
expansion in history.

32

FOR GREATER UNDERSTANDING

Questions

1. Why is the distinction among cyclical, frictional, and structural unemployment important?
2. Explain Okuns Law.
3. Which is worse, inflation or unemployment? Why?
4. What relationship does the Phillips Curve purport to illustrate?
5. Inflation and stagflation were defined in this lecture, but there is also
deflation. What is it?
6. Is it possible that the United States could experience another cycle of
stagflation and double-digit interest rates as in the 1970s? Or was that just
an unusual event?
7. Do countries such as Brazil, China, and India suffer from the same inflationary pressures as developed countries like the United States and Germany?
8. Is the natural rate of unemployment constant? Why or why not?

Websites to Visit
1. The Bureau of Labor Statistics: On the right-hand side of the screen, youll
find information about Employment & Unemployment; check current
unemployment rates by following the link State and Local Unemployment
Rates www.bls.gov
2. On the left-hand side of the screen, find the Consumer Price Index (CPI)
and the Producer Price Index (PPI), two of the most followed and watched
inflation indicators; click the respective links and explore how they are
measured and differ www.bls.gov
3. The Federal Reserves website: Click on the Monetary Policy link and go
to Reports to find the Monetary Policy Report to the Congress; follow
the link and review the latest testimony: look for insights about the labor
market and prices found in Section 2 of the report
www.federalreserve.gov

Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapters 8 and 16.
Economics: Principles, Problems, and Policies. 16th ed. New York:
McGraw-Hill, 2005.
Navarro, Peter. Chapter 15. If Its Raining in Brazil, Buy Starbucks. New
York: McGraw-Hill, 2001.
Solow, Robert, and John B. Taylor. Inflation, Unemployment, and Monetary
Policy. Cambridge, MA: The MIT Press, 1999.

33

Lecture 6:
International Trade and Protectionism:
Where Did Our Jobs Go?
LECTURE OBJECTIVES
1. Examine the economic principles governing international trade
and demonstrate the gains from trade.
2. Explore some of the many political pressures that can arise
among countries over large deficits and lead to the so-called
protectionism and trade barriers.
3. Learn some basic balance of payments accounting.
4. Examine important multilateral trade agreements, such as those
embodied in the World Trade Organization.
Absolute Advantage vs.
Comparative Advantage
(See Figure 6.1)
1. The idea of absolute advantage as a basis for trade was
first set forth by Adam Smith in
the 1700s. Smith said that a
country that can produce a
Clipart.com
good at a lower cost than
another country will have an absolute advantage in the production of that
good.
2. At first glance, the principle of absolute advantage appears to make
sense. Nonetheless, it has a significant implication, and one that is badly
flawed. The more subtle understanding of why this happens is embodied
in the theory of comparative advantage.
3. The theory of comparative advantage was first set forth in 1817 by the
English economist David Ricardo. This principle holds that each country
will benefit if it specializes in the production and export of those goods
that it can produce at a relatively lower cost than other countries.
Conversely, each country will benefit if it imports those goods that it produces at relatively higher cost.
4. Note that this simple principle of comparative advantagealthough one
more subtle than the principle of absolute advantageprovides the
unshakable basis for international trade.

LECTURE SIX

5. The theory of comparative advantage is one of the fundamental principles of economics; and nations that disregard the lessons of comparative
advantage and try to hide behind protectionist trade barriers will pay a
heavy price in terms of their living standards and economic growth.

34

Peter Navarro

Figure 6.1: Comparative Advantage Example

35

Tariffs and Quotas


1. A tariff is simply a tax on imports that is collected by the government.
When a tariff is imposed, domestic producers and the government win.
However, the big loser is the consumer, and the broader economy loses
as well. Together with the reduction in consumer welfare, this creates an
efficiency loss that economists often refer to as a dead weight loss.
2. A quota is an explicit quantity limit on imports. The only real difference
between a tariff and a quota is that with a quota there are no revenues
paid to the government.
3. From a political standpoint, it is a bit easier for a country to impose quotas than tariffs because there is less harm to the foreign producersand
therefore less political pressure on a foreign government to retaliate with
tariffs or quotas of its own.
4. Many nations also use so-called non-tariff barriers (NTBs). NTBs, which
include quotas, also consist of formal restrictions or regulations that make
it difficult for countries to sell their goods in foreign markets.
Arguments in Support of Protectionism
1. For starters, there is the national defense or military self-sufficiency argument. This is not an economic argument, but rather a political and strategic one. Unfortunately, there is no objective criterion for weighing the
worth of an increase in national security relative to a decrease in economic efficiency accompanying the reallocation of resources toward
strategic industries.
2. A second argument for protectionism is to save jobs. This is an argument
that often becomes politically fashionable when a country enters a recession. One problem with this argument has to do with the fallacy of composition. The use of tariffs and quotas to achieve domestic full employment are termed beggar thy neighbor policies.
3. Closely related is the dumping argument. Dumping occurs when foreign
producers sell their exports at a price less than the cost of production.
Because dumping is a legitimate concern, it is prohibited under international trade law; nevertheless, dumping still goes on.
4. The fourth argument for protectionism is called the terms of trade or optimal tariff argument. The idea here is to impose a tariff that will shift the
terms of trade in a countrys favor and against foreign countries.

LECTURE SIX

5. Finally, a favorite argument in support of protectionism in developing


countries is the so-called infant industry argument. The idea here is that
temporarily shielding young domestic firms from the severe competition
of more mature and more efficient foreign firms will give infant industries
a chance to develop and become efficient producers. Historical evidence
suggests that this argument must be weighed cautiously.

36

GATT Treaty
1. The General Agreement on Tariffs and Trade Treaty, or so-called GATT
Treaty, was established at the end of World War II. At the beginning of
1995, it became the World Trade Organization (WTO).
2. Every few years, representatives of the major industrialized countries
meet together for a round of trade talks aimed at reducing both tariffs and
NTBs. At least thus far, with every round of the WTO, trade barriers have
fallen further around the globe.
Balance of Payments
1. An open economy is simply one that engages in international trade. A
useful measure of such openness is something economists call the
trade share, which is simply the ratio of a countrys exports or imports
to its GDP.
2. The current account consists of three major items: the merchandise trade
balance, fees for services, and net investment income.
3. The merchandise trade balance reflects trade in commodities such as
food and fuels and manufactured goods, and is by far the biggest item.
When the United States is running a trade deficit, it is this merchandise
trade balance to which journalists often are referring to.
4. Fees for services include shipping, financial services, and foreign travel.
While this fees category is much smaller than the merchandise trade balance, it has grown in recent years as the United States has shifted from
a manufacturing economy to a more service-oriented economy.
5. The third item in the current account is investment income. Historically,
this category has run a small surplus for the United States. However,
as foreigners have continued to accumulate more and more U.S.
assets, this category has started to run in the red, further exacerbating
the trade deficit.
6. Finally, the fourth item in the current account is unilateral transfers. This
category represents other kinds of payments that are not in return for
goods and services.
7. The trade identity equation refers to an important accounting relationship
between the current account and the capital account. If a country such as
the United States runs a trade deficit in its current account, it must balance that deficit with in-flows into its capital account.
(See Figure 6.2)
8. One part of the capital account shows official-reserve changes. When
all countries have purely market-determined exchange rates, the category equals zero. However, when countries intervene in foreign exchange
markets, it shows up in the balance of payments as changes in official
reserves.
9. Of far greater consequence are the capital out-flows and in-flows, which
track the purchases of real assets like hotels, factories, and golf courses
and financial assets such as stocks and bonds.

37

Trade Deficits and Budget Deficits


1. To many observers, Americas chronic trade deficits are every bit as dangerous as its chronic budget deficits. These trade deficit hawks warn
that America is being forced to sell off its land and its factoriesand its
futureto finance these deficits.
2. Others, however, see the trade deficits simply as an opportunity to buy
inexpensive foreign goods and enjoy a higher standard of living than
Americans could otherwise achieve. These trade deficit doves argue
that if foreign countries are foolish enough to sell us cheap goods, we
should be wise enough to buy and enjoy them and not try to erect protectionist trade barriers.

U.S. BALANCE OF PAYMENTS

Credit

Debit

Net Credits
or Debits

Current Account
a. Merchandise Trade Balance
U.S. Goods Exports
U.S. Goods Imports

612

-191

b. Fees for Services


U.S. Exports of Services
U.S. Imports of Services

237

-803
80
-157

Balance on Goods and Services


c. Net Investment Income
Income earned by U.S.
Investors holding foreign assets
Income earned by foreigners
holding U.S. assets

-111
3
206
-203

d. Unilateral Transfers

-40

Balance on the Current Account

-148

Capital Account
a. Foreign purchases of assets
in the U.S.

517

b. U.S. purchases of assets abroad


Balance on Foreign/U.S. Purchases

Balance on Capital Account

Sum of Current and


Capital Accounts

LECTURE SIX

-148

-0Figure 6.2
Balance of Payments

38

141

Peter Navarro

c. Official reserves

-376

FOR GREATER UNDERSTANDING

Questions
1. Compare the theories of absolute advantage and comparative advantage.
2. What is the difference between a tariff and a quota?
3. From a political standpoint, why are quotas often preferred to tariffs?
4. Write down the five major arguments in support of protectionism and give
an example for each one.
5. According to most economists, the WTO is a good thing. Yet every time
the WTO countries meet, there are large-scale demonstrations. Why?
6. How does a country like the United States, whose workers earn high
wages and whose businesses must contend with strong environmental
protection regulations, ever compete against developing nations like
Mexico, China, or Brazil, which have large, low-paid workforces and few, if
any, environmental regulations?
7. What about countries like China and the Philippines, which copy new
technologies and software without paying the appropriate royalties? How
does the world trading system deal with that?
8. In an age of terrorism, is the free trade of goods really in the worlds interest if terrorists can obtain any of the new technologies they want?

Websites to Visit
1. Read more about balance of payments by visiting the IMF website: use
the search engine to find Balance of Payments and International
Investment Position Statistics www.imf.org
2. The Bureau of Economic Analysis: Click on Balance of Payments under
the International link and check the latest news release of the United
States current account deficit www.bea.gov/beahome.html
3. Spend some time browsing the WTO; you can also download the
Understanding the WTO brochure for future reference
http://www.wto.org

Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapters 6 and 37.
Economics: Principles, Problems, and Policies. 16th ed. New York:
McGraw-Hill, 2005.

39

Lecture 7:
The International Monetary System,
Exchange Rates, and Trade Deficits
LECTURE OBJECTIVES
1. Describe how exchange rates work and how the international
monetary system is structured.
2. Learn the important link between the budget and trade deficits.
3. Understand why it is increasingly important for the nations of
the world to coordinate their fiscal and monetary policies in a
global economy.

Exchange Rates
1. An exchange rate is simply the rate at
which one nations currency can be traded
for another nations currency.
2. Note that exchange rates can fluctuate
rather markedly. Three basic reasons
explain fluctuations among
exchange rates.
3. The first has to do with the different rates
of growth across countries. For example,
if the U.S. GDP is growing faster than the
Japanese GDP, the U.S. dollar will depreciate relative to the Japanese.
4. Exchange rates can also fluctuate with a
change in relative interest rates. For example, when U.S. interest rates rise relative to
British interest rates, the dollar will appreciate relative to the
British pound.

PhotoDisc

5. The third reason why exchange rates shift is because of different rates of
inflation. For example, if the rate of inflation in Canada is higher than in
Europe, the Canadian dollar will depreciate relative to the Euro.
Economists call this the law of one price.
6. A floating exchange rate system is one in which the exchange rates of
currencies like the pound and the dollar are allowed to float freely and be
determined by market forces.
LECTURE SEVEN

7. Not all countries in the international monetary system allow their


exchange rates to be determined in such a flexible or floating
exchange rate system. In fact, some countries use what is called a fixed
exchange rate system in which governments determine the rates at
which currencies are exchanged and then make the necessary adjustments in their economies to ensure that these rates continue.
40

The Gold Standard


1. Between 1867 and 1933, except for the period around World War I, most
of the nations of the world were on the gold standard. Under this fixedexchange-rate system, the currency issued by each country had to either
be gold or redeemable in gold. Once a country agreed to be on the gold
standard, its currency was convertible into a fixed amount of gold.
2. With these fixed exchange rates, if a nation ran a trade deficit, it would
be required to use its gold reserves to buy currency to prevent the value
of the currency from falling. In contrast, if a nation ran a trade surplus, it
would accumulate gold.
3. The gold standard was so popular because of the gold specie flow mechanism. This monetary adjustment mechanism was first described by
Scottish philosopher and economist David Hume in 1752. The net effect
of this gold specie flow trade adjustment is that a balance-of-payments
equilibrium is restored among countries. (See Figure 7.1)
4. The worlds fixed-exchange-rate system based on the gold standard
worked reasonably well at stabilizing the currency markets right up until
World War I. However, with the advent of the war, many nations had to
temporarily abandon the gold standard to finance their war efforts. This
led to differing rates of inflation in different countries, which distort the relative value of currencies.
5. With the collapse of the gold standard in the 1930s, countries desperate
to create jobs in a depressionary global economy engaged in so-called
competitive devaluations. However, these competitive devaluations acted
like a beggar thy neighbor trade policy. These economic pressures, in
turn, contributed to growing political pressures that eventually led to
World War II.

Peter Navarro

Figure 7.1: Gold Specie Flow Mechanism

41

Bretton Woods
1. The harsh lessons of the 1930s
gave birth to a new international
monetary system. The new system
featured a modified fixed exchange
rate system called a partially fixed or
adjustable peg system. This system
replaced the gold standard with a
U.S. dollar standard, and the U.S.
dollar was designated as the worlds
key currency.

Clipart.com

U.S. Delegates to the Bretton Woods Conference,


July 22, 1944

2. Note, however, that Bretton Woods


also provided for a cooperative mechanism in which the exchange rates
were only partially fixed. These new partially fixed rates could be periodically adjusted to reflect changes in currency values in a process known
as adjusting the peg.

3. In August of 1971, a reluctant Nixon Administration abandoned the dollar


standard and the Bretton Woods system collapsed. No longer would dollars be redeemable for gold at $35 an ounce, and in the wake of that
abandonment, the dollars value fell precipitously.
The Current Exchange Rate System
1. The world has moved to a hybrid system known as the managed float,
which has four major features.
2. First, a few countries like the United States have a primarily flexible or
floating exchange rate. In this approach, markets determine the currencys value, and there is very little intervention.
3. Second, other major countries such as Canada, Japan, and, more
recently, Britain have managed-but-flexible exchange rates. Under this
system, a country will buy or sell its currency to reduce the day-to-day
volatility of currency fluctuations. A country may also engage in systematic intervention to move its currency toward what it believes to be a
more appropriate level.

LECTURE SEVEN

4. Third, some countries join together in a currency bloc in order to stabilize


exchange rates among themselves while allowing their currencies to
move flexibly relative to those of the rest of the world. The most important
of these blocs is the European Monetary System, which has adopted that
single currency we call the Euro.
5. Fourth, many countries use a variation on the old fixed-exchange-rate
system by pegging their currencies to a major currency such as the dollar
or to a basket of currencies. Sometimes, this peg is allowed to glide
smoothly upward or downward in a system known as a gliding or crawling peg. Other times it is tightly fixed.
U.S. Trade Deficits
1. The first contributor to explain the trade deficits may be traced to the
large, chronic budget deficits that the United States began to run in the
42

1980s. The need for the government to finance these budget deficits
drove up interest rates. This strengthened the dollar as foreigners had to
first buy dollars in order to buy U.S. bonds, thus resulting in a stronger
dollar that made exports more expensive and imports cheaper, and sent
the trade deficit spiraling upward.
2. A declining savings rate in the United States has also been a major contributing factor to the trade deficit problem. As the U.S. savings rate has
fallen, the investment rate has remained fairly stable or even increased.
This has been possible because foreign investment has filled the savings-investment gap. In this sense, the U.S. capital surplus may not only
result from the trade deficit but also help to cause it.
3. A third reason is that the U.S. economy has grown at a faster pace than
either Europe or Japan, as well as many of its major trading partners.
This growth in U.S. income has boosted import consumption even as
recessions or stagnation in countries like Japan and Canada has
depressed their purchases of U.S. exports.
4. Perhaps what is most interesting about these three major causes of the
U.S. trade deficit is that they are all driven in some degree by arguably
irresponsible U.S. domestic fiscal and monetary policies.
Active Policies and the Global Economy

2. For example, Americas domestic and contractionary fiscal policy can not
only lead to a contraction in the American economy but also function as a
contractionary fiscal policy
for Europe as well.
Economists refer to this
chain of causality as the
multiplier link. (See
Figure 7.2: The Multiplier Link
Figure 7.2)

Peter Navarro

1. The conduct of domestic fiscal and monetary policies in a global economy can affect not only the domestic countrys trade balance, but also significantly affect the rates of growth and unemployment in the domestic
countrys trading partners. Any imbalances in either capital or trade flows
in one country will affect all trading partners.

Peter Navarro

3. Moreover, in its attempt to fight domestic inflation by raising U.S. interest


rates, the Federal Reserve of the United States may well increase the
chance that Europe will experience a recession. Economists refer to this
chain of events as the monetary link. Unlike with fiscal policy and the
multiplier link, the overall impact of monetary policy and the monetary link
on domestic GDP is ambiguous and depends on the particular situation.
(See Figure 7.3)

Figure 7.3: The Monetary Link

43

FOR GREATER UNDERSTANDING

Questions
1. Explain the three major reasons why exchange rates change.
2. Is it better for a country like the United States to have a weak or a
strong currency?
3. Explain the gold specie flow mechanism.
4. When and why did Bretton Woods collapse?
5. What are the three major causes of the chronic trade deficits of the
United States?
6. Explain some of the difficulties of coordinating macroeconomic policies
among countries.
7. When are trade wars most likely to happen?
8. Will the world eventually move to one currency?

Websites to Visit
1. The United Statess trade deficit has its own governmental commission;
browse the Reports section for the final report of the U.S. trade deficit;
compare the Democrats and Republicans diagnoses of the causes and
consequences of the chronic trade deficits and their recommendations for
future action http://govinfo.library.unt.edu/tdrc
2. Click on Market Data, select Currencies, and examine exchange rates
by clicking on Benchmark Currency Rates and World Currencies
www.bloomberg.com
3. Information about the Euro www.europa.eu.int/euro/entry.html

Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapter 38. Economics:
Principles, Problems, and Policies. 16th ed. New York: McGraw-Hill, 2005.

LECTURE SEVEN

Navarro, Peter. Chapter 18. If Its Raining in Brazil, Buy Starbucks. New
York: McGraw-Hill, 2001.

44

Lecture 8:
Supply, Demand, and Equilibrium:
How Prices Are Set in Our Markets
LECTURE OBJECTIVES
1. Illustrate how important microeconomics can be in your personal
and professional life.
2. Introduce the supply and demand curves and explain how the forces
of supply and demand lead to an equilibrium in the market and set
market prices.
3. Show how market price reaches its competitive equilibrium at precisely where the demand and supply curves crosswhere the forces
of demand and supply are just in balance.
4. Introduce the notion of artificial price controls into the free market.
5. Show the advantages of the free market in determining prices
and quantities.

Introduction to Microeconomics
1. The study of microeconomics
deals with the behavior of individual markets and the businesses,
consumers, investors, and workers that make up the macro economy. Microeconomics can help to
answer questions at a professional and personal level. Most broadly, microeconomics can also help
you to come to understand why
the government is so involved in
our economic lives.
2. Three basic facets of economic
and political life must be
addressed by any economy:
scarcity, efficiency, and equity.

Recorded Books, LLC/Ed White

3. The concept of scarcity is related to that of economics goods (that is,


goods that are scarce or limited in supply). While goods are limited,
wants are seemingly limitless. This undeniable fact prompts an economy
to choose among different potential bundles of goods (the what), select
from different techniques of production (the how), and decide in the end
who will consume the goods (the for whom).
4. Efficiency denotes the most effective use of a societys resources in satisfying peoples wants and needs. Allocating resources efficiently is all
the more complicated because in pursuing efficiency, there is almost
always a thorny tradeoff between what is efficient from an economic point
45

of view and what may be viewed as fair or equitable from a social and
political point of view.
5. In fact, grappling with the tradeoff between efficiency and equity is one of
the most difficult tasks of economists and the political and business leaders they serve. In a similar vein, we see that almost any time the government tries to raise taxes to redistribute income from the rich to the poor
through mechanisms like food stamps or Medicare, those taxes tend to
interfere with the efficiency of the free market.
Supply and Demand and Equilibrium
(See Figure 8.1)
1. The implication of a downward-sloping demand curve is that the lower
the price, ceteris paribus (Latin for other things constant), the more
units a consumer will demand. And the higher the price, again holding
other things constant, the less the consumer will demand. This is called
the Law of Demand.
2. The quantity demanded of a good tends to fall as its price rises because
of the substitution effect and the income effect.
3. The demand curve can shift outwards, indicating higher demandor
inwards, indicating lower demand. These demand shifts can occur
because of shift factors, such as changes in the average income of consumers, prices of substitute goods, and consumer tastes.

LECTURE EIGHT

4. The supply curve slopes up. The so-called Law of Supply says that the
lower the price, holding other things constant, the fewer firms will produce, and the higher the price, holding other things constant, the more
firms will produce.

Peter Navarro

Figure 8.1: The Computer Market (Supply and Demand)

46

5. The location and slope of the supply curve depends on the firms ability
to produceto transform the so-called factors of production like raw
materials and labor and capital into consumable goods. However, supply
also depends on the individuals decisions to supply the factors of production to begin with.
6. The supply curve is influenced by shift factors such as technology, input
prices, and government policies.
7. Finally, the demand and supply curves naturally cross at the point where
we are likely to find the market equilibriumwhich tells us how much of
the good is sold in the market and at what price.
8. In supply and demand analysis, equilibrium means that the upward pressure on price is exactly offset by the downward pressure on price. The
equilibrium price is the price toward which the invisible hand drives the
market and is reached at the point where demand and supply are in balance and the market clearsat the intersection of supply and demand.
9. A surplus in the market is an excess of quantity supplied over quantity
demanded. A shortage is an excess of quantity demanded over
quantity supplied.
Price Controls
1. Price support programs set the so-called price floors: if the market price
fell below the floor, the government would make up the difference to the
subsidized by buying up any surplus. In this case, the price floor works to
prop up price above the free market equilibriumand thereby helps the
subsidized, albeit at the expense of consumers.
2. The so-called price ceilings may be instituted by the government. In such
a case, the market price might be well above the price ceiling and at this
price ceiling, consumers will demand far more than the market is willing
to supply.
The Free Market Mechanism
1. First, because it is the market determining the equilibrium prices and quantities of all inputs and outputs, it is the free marketnot the government
that is allocating or rationing out the scarce goods
of society among the possible uses.
2. Second, it is the market and its many price signals
that determine just what goods are produced. For
example, high oil prices stimulate oil production,
whereas low food prices drive resources out
of agriculture.
3. Third, the market can also answer the question: For
whom are goods produced? This is because it is the
power of the purse that dictates the distribution of
income and consumption.
PhotoDisc

47

FOR GREATER UNDERSTANDING

Questions
1. How can microeconomics help you at a business and professional level?
2. How can microeconomics help you at a personal level?
3. How is microeconomics distinguished from macroeconomics?
4. Several examples were given of how an understanding of microeconomics
could help you as an investor. Could you provide another one?
5. An improvement in technology can have a positive impact on a market
by shifting the supply curve outward and lowering prices that consumers
have to pay. What is the broader effect of such technology shocks on
the economy?
6. Summarize the various reasons why the government might intervene in the
private marketplace.
7. President Roosevelt established price supports during the Great
Depression for wheat and corn and other agricultural products. Did it make
sense to raise the price of food during this time when people were having
such a hard time making ends meet?

Websites to Visit
1. The website of Professor Gary Becker, the 1992 Nobel Laureate in
Economics: Click on the Business Week Articles tab and read the articles
related to regulation and family from the archive
http://home.uchicago.edu/~gbecker
2. The Federal Trade Commission (FTC); choose For Consumers and For
Business options to get a flavor of how microeconomics is embedded in
your daily personal and professional life www.ftc.gov
3. The Foundation of Economic Education: a research organization that promotes free markets and limited government intervention www.fee.org

LECTURE EIGHT

Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapters 1, 2, 3, and 3W
(Web). Economics: Principles, Problems, and Policies. 16th ed. New York:
McGraw-Hill, 2005.

48

Lecture 9:
Understanding Consumer Behavior:
The Essential Elements
LECTURE OBJECTIVES
1. Learn about the intricacies of consumer behavior.
2. Introduce important new concepts such as cardinal versus ordinal
utility, diminishing marginal utility, and demand price elasticity.
3. Understand the nature of the demand curve in economicsparticularly why the demand curve slopes downward and has an
inverse relationship to price.

Consumer Choice and Utility Theory


1. Using the theory of self-interest,
economists explain that consumer
choice boils down to three factors:
the pleasure people get from consuming a good, the price they have
to pay for it, and the income or budget available to them to exercise
their choices.
2. In order to measure pleasure, economists have settled for what is called
an ordinal measure of utility, which
ranks the desirability of goods relative to one another.

PhotoDisc

3. It is nonetheless very convenient to


assume that economists can, in fact,
actually use numbers to measure
utility. The cardinal measure of utility
and the related notion of util are
used to build demand curves.
4. Two very important principles in economics are those of total utility and
marginal utility.
5. Total utility is defined as the satisfaction we get from consuming something, while marginal utility is defined as the incremental or additional utility you get from consuming the next unit of a good. Indeed, one of the
most important laws in economics is that while total utility increases with
consumption, it does so at a decreasing rate or that there is a diminishing
marginal utility.
The Equimarginal Principle and Utility Maximization
1. We assume that consumers maximize utility subject to a budget or
income constraint. Hence, consumers have a certain amount of income
49

to spend and, subject to their budget constraint and given a menu of


prices, they choose a market basket of goods that provides them with the
greatest utility or satisfaction.
2. Consumers do maximize their utility by following the utility-maximizing
rule or equimarginal principle. A consumer with a fixed income facing
market prices will achieve maximum satisfaction when the marginal utility
of the last dollar spent on each good is exactly the same as the marginal
utility of the last dollar spent on any other good.
3. Moreover, the equimarginal principle perfectly explains why demand
curves slope downward. Suppose that at the equilibrium point, we hold
the marginal utility per dollar constant for two goods. Then, further suppose that the price of good x increases. Then, the marginal utility per dollar of good x must fall below the same ratio for good z, implying a downward sloping demand curve. This is because as the price of good x rises,
quantity demanded falls.

Unit of
Product
First

Big Mac
Big Mac price = $2
Marginal
Marginal utility
utility,
per dollar
utils
(MU/price)

10

10

24

12

Second

20

10

Third

18

Fourth

16

Fifth

12

Sixth

Seventh

Potential choice

LECTURE NINE

Dove Bar
Dove Bar price = $1
Marginal
Marginal utility
utility,
per dollar
utils
(MU/price)

Marginal utility
per dollar

Purchase decision

Income remaining

First Big Mac


First Dove Bar

12
10

First Big Mac for $2

$8 = $10$2

First Dove Bar


Second Big Mac

10
10

First Dove Bar for $1


and second Big Mac for $2

$5 = $8$3

Second Dove Bar


Third Big Mac

8
9

Third Big Mac for $2

$3 = $5$2

Second Dove Bar


Fourth Big Mac

8
8

Second Dove Bar for $1


and fourth Big Mac for $2

$0 = $3$3

Table 9.1: Example: Elasticity of Demand

The Price Elasticity of Demand


(See Figure 9.1 and Table 9.2)
1. The price elasticity of demand measures how much consumers will
increase or decrease their quantity demanded in response to a price
50

Peter Navarro

Figure 9.1: Elasticity of Demand

change. A big change in quantity demanded when the price changes


means demand is elastic and a small change in quantity demanded when
the price changes means demand is price inelastic.
2. A relatively
flat demand
curve for the
price-elastic
good would
be observed.
This shows
that a small
change in
price leads to
a big change
in quantity
demanded.
3. A relatively
steep demand
curve for the
price-inelastic
good is
expected to
be observed.
Even with a
big change in
price, the
quantity
demanded
doesnt
change much.

Price Elasticities for a


Variety of Products
Product or Service

Elasticity of Demand

Housing

.01

Electricity (household)

.13

Bread

.15

Telephone Service

.26

Medical Care

.31

Eggs

.32

Legal Services

.37

Automobile Repair

.40

Clothing

.49

Milk

.63

Household Appliances

.63

Movies

.87

Beer

.90

Shoes

.91

Motor Vehicles

1.14

China, Glassware, etc.

1.54

Restaurant Meals

2.27

Lamb and Mutton

2.65
Peter Navarro

Table 9.2: Price Elasticities

51

4. The concept of the price elasticity of demand has tremendous application


in the pricing and marketing strategies of both businesses and government agencies. It also helps us to better understand many aspects of
public policy. The demand elasticity helps both businesses and government agencies think about how to price their products and services.
Determinants of Price Elasticity of Demand
1. On the one hand, necessities like housing, electricity, and bread are very
price inelastic. On the other hand, goods that tend more toward being
luxuries, such as restaurant meals and glassware, are price elastic.
2. Besides whether a good might be considered a luxury or a necessity,
other important factors that determine the price elasticity are the number
of substitutes for a good, how you define a good, the proportion of
income, and time.
3. Economists define complement goods as those that are consumed jointly
to satisfy consumers wants and needs. If the demand of one complement product goes up, the demand for the other one goes up as well.
4. In contrast, substitute goods refer to the case where an increase in
the price of one good determines the decrease in the demand for the
other good.
5. Economists measure the degree of a products substitutability or complementariness by estimating so-called cross-price elasticity.
The Income Elasticity of Demand
1. As for the equally interesting distinction between so-called normal goods
and inferior goods, these relate to the income elasticity of demand.
2. The idea of a normal good is that people will buy more of it as their
incomes increase. Houses, luxury cars, and steak fit neatly into
that category.

PhotoDisc

LECTURE NINE

3. In contrast, rental units, mass transit, and potatoes are inferior goods
because people will buy less of these goods as their income risesas
they switch to owning their own
homes, buying
cars, and eating
better quality food,
like steak.

52

FOR GREATER UNDERSTANDING

Questions
1. Consumer choice boils down to what three things?
2. Explain the law of diminishing marginal utility.
3. State the utility-maximizing rule or the equimarginal principle.
4. What are the four major determinants of price elasticity of demand?
5. Why dont most new cars sell at their sticker price?
6. Why do many farmers go bankrupt when crops are plentiful?
7. If the government imposes a sales tax on a product that is highly elastic,
what will happen to total tax revenues?
8. This idea of elasticity seems like a really powerful one. Why do so many
business executives keep making the same mistake of trying to raise
prices in a recession to boost revenues when they are selling products
with elastic demands?
9. Some material introduced in this lecture is technical, and it was mentioned
that college students in economics have to learn about the mathematics of
all of this. Am I missing anything by skipping the mathematics?
10. Henry Ford only wanted to sell black Model Ts, but if you go into a grocery store today, you can buy fifty different kinds of plain old cereal
dressed up in sugar or chocolate or colors or shapes. Is there any such
thing as too much consumer choice?

Websites to Visit
1. To see how price elasticity works, click on Microeconomic Principles and
then choose Elasticity Measures and experiment with the applet included
in the page www.digitaleconomist.com
2. Not all economists adhere to the notion of the utility theory as it is
assumed by mainstream microeconomics; check the National Science
Foundation website and use the search engine included in the webpage;
type utility theory and you will find a brief article questioning utility theory
www.nsf.gov

Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapters 20 and 21.
Economics: Principles, Problems, and Policies. 16th ed. New York:
McGraw-Hill, 2005.

53

Lecture 10:
Producer Behavior and
an Introduction to Perfect Competition
LECTURE OBJECTIVES
1. Understand the theory of production and analyze how firms produce and offer goods for sale.
2. Recognize the difference between short-run and long-run costs,
marginal cost, and the law of diminishing returns, economies of
scale, and the shapes of various cost curves.
3. Introduce the Structure-Conduct-Performance paradigm and the
four forms of market structure.
Production Function
The production function
specifies the maximum
output that can be produced with a given quantity of inputs for a given
state of engineering and
technical knowledge.
Short vs. Long Run
1. The short run is the period
in which firms can adjust
production only by changing variable factors, such as materials and
labor, but cannot change fixed factors, such as capital.

Clipart.com

2. The long run is a period sufficiently long enough so that all factors in the
production function, including capital, can be adjusted.
3. The distinction between the short and long run is important in production
theory because each period has its own kind of cost analysis.
Short Run Cost Analysis
(See Table 10.1)
1. The firms fixed costs, sometimes called overhead, are those costs that
do not change with the level of output. Examples of fixed costs include
rent, interest on the bonds, insurance premiums, and the salaries of
top management.

LECTURE TEN

2. Variable costs are those costs that change with the level of output. For
example, when you increase production to meet demand, you have to
pay for more raw materials and fuel. You also have to pay more in wages
to cover the increased overtime and additional workers.
3. The total cost is simply variable costs plus fixed costs.
4. Marginal cost is the additional cost incurred in producing one extra unit of
output. It is arguably the most important kind of cost.
54

Short Run Cost Analysis


1

Output

Fixed
costs
(FC)

Variable
costs
(VC)

Total
costs
(TC)

50

50

100

5
6
Marginal costs
Average
(MC)
fixed costs
(change in
(AFC)
total costs)
FC/Output
12.50

7
Average variable
fixed costs
(AVC)
VC/Output

8
Average
costs (ATC)
(ATC)
AFC+AVC

12.50

25.00

10
5

50

60

110

10.00

12.00

22.00

10

50

100

150

5.00

10.00

15.00

11

50

106

156

4.54

9.64

14.18

17

50

150

200

2.94

8.82

11.76

18

50

157

207

2.78

8.72

11.50

21

50

182

232

2.38

8.67

11.05

23

50

200

250

24

50

210

260

2.17

8.70

10.87

2.08

8.75

10.83

10
28

50

250

300

1.79

8.93

10.72

29

50

265

315

1.72

9.14

10.86

32

50

350

400

1.56

10.94

12.50

Peter Navarro

15

Table 10.1: Short Run Cost Analysis

5. The Law of Diminishing Returns states that if one factor of production is


increased while the others remain constant, the overall returns will relatively decrease after a certain point.
Average Fixed Cost, Average Variable Cost, and Average Total Cost
(See Figure 10.1)

Peter Navarro

1. First, the average fixed cost (AFC) curve slopes downward and
approaches zero on the horizontal axis, while the average variable cost
(AVC) curve
approaches the
average total
cost (ATC)
curve. The average fixed cost
(AFC) curve
must approach
zero, because as
a firms output
increases, it
spreads its fixed
costs over a
larger number
of units, so average fixed costs
Figure 10.1: AFC, AVC, and ATC Curves
55

must fall. Similarly, the AVC curve must approach the ATC curve as
output increases.
2. The marginal cost (MC) curve intersects both the AVC and AC curves at
their minimums. If the marginal cost is greater than average total cost,
then the average total cost must be rising, and vice versa. Thus, it must
be that only when marginal cost equals average total cost that the ATC is
at its lowest point. This is a very critical relationship. It means that a firm
searching for the lowest average cost of production should look for the
level of output at which marginal cost equals average cost.
Long Run Cost Analysis
(See Figure 10.2)
1. The long run average cost curve is the envelope of the short run average
cost curves. For example, for any given plant scale, capital inputs are
fixed in the short run and there is a point on the average total curve
where average cost is minimized. Now, if you build a bigger plant, output
will increase, and there will be another short run ATC curve created. And
each point on this bumpy planning curve shows the least unit cost obtainable for any output when the firm has had time to make all desired
changes in plant size.

LECTURE TEN

2. The reason for


the U-shape of
the long run
average cost
curve is not
the law of
diminishing
returns.
Instead, the
explanation
lies in understanding one
of the most
important concepts in economics, known
Peter Navarro
as economies
Figure 10.2: The Long-Run Average Cost Curve
of scale:
economies of
scale are said to exist when the per-unit output cost of all inputs
decreases as output increases. As to why such economies of scale may
exist, they may be traced to such factors as increased labor and managerial specialization and more efficient capital use. Finally, economies
of scale are not necessarily present in all industries.

56

Shapes of the Curves


(See Figure 10.3)
1. The first graph on the top left shows the broad U-shaped curve we
observed earlier.
2. The second graph on the top shows a narrow and steep U-shape, which
indicates that economies of scale are exhausted quickly, so that minimum unit costs will be encountered at a relatively low output. The typical
profile of an industry characterized by this kind of V-shaped curve is
numerous sellers and healthy competition.
3. The third graph, bottom left, shows a flat segment, characteristic of constant returns to scale. Rather than a smooth U-shape, there is a long flat
spot in the middle of the curve over which unit costs do not vary with
size. It has important implications for business executives contemplating
strategic decisions such as mergers and acquisitions.
4. In the fourth graph, bottom right, we have whats called increasing returns
to scale over the relevant range of output. With a natural monopoly, unit
costs steadily fall as plant size increases over a large range. In particular,
the natural monopoly shape of the curve means that over time, bigger
producers will drive out smaller producers until there is only one producer
leftthe infamous monopolist.

Peter Navarro

Figure 10.3: The Long-Run ATC (Shapes)

Market Failure
1. The result of the so-called market failure is that price will be set too high
and output too low for market efficiency, and government regulation may
be warranted. Thats why economists often argue that natural monopolies
like railroads, electricity, and gas distribution should be regulated.
57

2. Minimum efficient scale is defined as the smallest level of output that a


firm can minimize long-run average costs. This important concept can
give rise to another type of industry structure known as oligopoly, which
is characterized by a small number of large sellers. Examples include
automobiles, aluminum, steel, and cigarettes.
The Structure-Conduct-Performance Paradigm
(See Figure 10.4)

2. Market
conduct
embodies
the various
pricing and
marketing
tactics and
strategies
of businesses. Such
conduct
includes not
only at what
level a firm
or industry
sets its price
and output,
but also
whether that
firm or
industry
engages in
various
kinds of
Figure 10.4: Structure, Conduct, Performance
nonprice
competition through product differentiation and advertising.
3. The different types of market conduct in turn drive market performance
where performance is measured by yardsticks such as allocative and
productive efficiency. These yardsticks can tell us how wellor poorly
a societys resources are being used.

LECTURE TEN

4. Market structure refers to how many firms are in an industry, whether the
firms are big or small, what the firms cost structures look like, and how
market share is divided among the firms. The four major types of market
structure include perfect competition, monopolistic competition, oligopoly,
and monopoly.

58

Peter Navarro

1. The central concept driving this paradigm is that industry structure


determines market conduct, and market conduct, in turn, determines
market performance.

The Four Forms of Market Structure


(See Figure 10.5)
From a practical
point of view,
the most important feature of
each form of
market structure is the
degree of pricing and market
power that each
form of market
structure gives
to the participants in
that market.
Perfect
Competition

Peter Navarro

Figure 10.5: Market Structure Forms


1. Perfect competition is the market structure by which economists measure all other market structures.
Beginning in the 1700s with the father of economics, Adam Smith, many
economists have shown that the invisible hand of the perfectly competitive market is the best form of market structure.

2. The most important requirement of perfect competition is numerous buyers and sellers. When this assumption is met, any one firms output is
miniscule compared to the market output. This condition is important
because it is one of the primary reasons why perfectly competitive firms
are price takers rather than price makers in the market.
3. A second important assumption of perfect competition is that of a
homogenous product where each firms output is indistinguishable from
any other firms output. The homogeneous product assumption means
that every firm in the industry is selling exactly the same product, so that
the only thing that firms can compete on is price, and not on other things
such as product design and product quality.
4. A third important assumption is that of free entry and exit. In order for this
free entry condition to hold, there must be no barriers to entry.
5. Given a market structure of perfect competition, we can expect prices to
be set to a firms marginal cost of production (that is, P=MC). Moreover,
this pricing scheme will be economically efficient, because the market is
allocating resources efficiently and consumers will receive the most output at the best price.

59

FOR GREATER UNDERSTANDING

Questions
1. What does the production function specify?
2. Define the short run. Define the long run.
3. What is the difference between fixed versus variable costs?
4. Explain the law of diminishing returns.
5. How can a knowledge of the supply side of the market help me in my personal life?
6. Why do economists and politicians make such a big deal about the free
market if there are few industries that are perfectly competitive?
7. The big buzz word in business today is strategy. Do economists and the
lessons in this lecture have anything to say about just what good strategy is?
8. What does industry structure refer to? What are the major types of industry structures?
9. What is the central concept driving the structure-conductperformance paradigm?
10. What is the relationship between the industry market price and the firms
marginal revenue in a perfectly competitive industry?

Websites to Visit
1. Browse Companies for Americas largest private companies; can you
identify in which market structure the Top Ten companies are most likely to
be included? www.forbes.com/lists
2. Search for car rentals; now choose any travel Web company (not a car
rental company) and search for prices for a weekend trip to any city near
you; can you find any substantial difference in prices? How about product
differentiation? www.google.com

LECTURE TEN

Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapters 22 and 23.
Economics: Principles, Problems, and Policies. 16th ed. New York:
McGraw-Hill, 2005.

60

Lecture 11:
Market Structure, Conduct, and Performance:
Why Monopolists Do What They Do
LECTURE OBJECTIVES
1. Resume the discussion about the four different types of market
structure: perfect competition, monopoly, oligopoly, and monopolistic competition.
2. Learn about the various strategies and tactics that business
executives use to make big profits in the market placeoften at
the expense of consumers.
3. Focus on the differences between monopolistic competition and
oligopoly, and monopolistic competition and perfect competition.
Monopoly
1. In a monopoly, there is only one seller in
the market selling a product, and that
monopolist sells a product for which
there are no close substitutes. In such a
case, the monopolist is a price maker and
wields this power by controlling the quantity
supplied in the market.

Cl

co

rt.

ipa

2. The monopolist sets price equal to its marginal revenue, where marginal
revenue is the amount of revenue obtained by selling the last unit.
Marginal revenue is higher than marginal cost, and their difference is the
monopolists profits. The result is that consumers pay a lot more for a lot
less in a monopolized marketwhile the monopolist earns profits well
above that of the perfect competitor. Therefore, the government typically
regulates monopolies and sets the prices that monopolists can charge.
3. Perfect competition and monopoly are actually more the exceptions,
rather than the rule, in most global economies. Indeed, most industries
fall somewhere between these two extremes and can be classified by
one of the two other forms of market structuremonopolistic competition
and oligopoly.

Recorded Books, LLC/Ed White

61

Monopolistic Competition
The defining characteristics of monopolistic competition are a relatively
large number of sellers; easy entry to, and exit from, the industry; and
product differentiation.
Oligopoly vs. Monopolistic Competition
1. A monopolistically competitive industry is relatively unconcentrated. In
contrast, market concentration and price-making power are relatively high
in an oligopoly.
2. The key concept of market concentration is important because the
level of concentration serves as an indicator of the degree of whats
called strategic interaction that might occur in an industry. Strategic
interaction describes how each firms business strategy depends on its
rivals strategies.
3. In the economics of strategy, the so-called mutual interdependence recognized means that the executives of each firm are more likely to want
to collude when setting prices and quantities. Such collusion or collusive
behavior may be defined as the concerted action by executives in an oligopoly-like situation to restrict output and fix prices.
4. The most important distinction between oligopoly and monopolistic competition relies on the concept of collusion: on the one hand, because
of the small number of firms in an oligopoly, collusion is possible; on the other hand, however, the relatively large number
of firms in a monopolistically competitive industry ensures
that collusion is all but impossible.
Monopolistic Competition vs. Perfect Competition
1. Monopolistic competition resembles perfect competition in three ways: there are numerous buyers and
sellers, entry and exit are easy, and firms are price
takers. The big difference is that with monopolistic
competition, there is product differentiation.

Clipart.com

LECTURE ELEVEN

2. Consumers have reasons other than price to prefer one


product over another because of product differentiation.
In turn, the economic rivalry between firms will typically
take the form less of price competition and more of what
is called non-price competition.

62

3. From the business executives perspective, product differentiation in general and advertising in particular have two
strategic goals in mind. The first goal is to increase consumer demand and thereby shift the firms demand curve
outwards and increase the firms market share. The second
goal is to increase the inelasticity of the demand curve for its
product and thereby increase the pricing power of the firm
and its ability to raise prices to increase its total revenues
and profits.

Oligopoly
Oligopoly exists when a small number of typically large firms dominate an
industry, and the central element of oligopoly is the strategic interactions
that might arise through either explicit or tacit collusion over price and output decisions, as well as decisions about both market entry and exit.
The Sources of Oligopoly
1. As with monopoly, one such source is the presence of economies of
scale in production. But in the case of oligopoly, it is not one firm but
rather several large firms that win the race to achieve their minimum efficient scale and drive everyone else out.
2. Barriers to entry play an important role in creating and sustaining oligopolistic industries. Such barriers to entry do indeed deter entry into an oligopolistic industry and thereby preserve the oligopolistic structure.
Examples of those barriers are the so-called scale-economy barriers to
entry, large capital requirements, and absolute-cost advantages derived
from valuable know-how in production or so-called trade secrets.
3. Market power signifies the degree of control that a firm or a small number
of firms has over the price and production decisions in an industry. A
common measure of market power is the four-firm concentration ratio,
which is simply defined as the percent of total industry output accounted
for by the four largest firms. (See Figure 11.1)

Industry Concentration in America


Product
Instant breakfast
Disposable diapers
Video game players
Cameras and film
Telephones
Car rentals
Telephone service
(long distance)
Batteries
Soft Drinks
Credit cards
Razor blades
Greeting cards
Toothpaste
Automobiles
Beer
Canned tuna
Spaghetti sauce
Aspirin
Records and tapes

Largest Firms

Four-firm
Concentration
Ratio

Carnation, Pillsbury, Dean Foods


Procter & Gamble, Kimberly-Clark, Curity, Romar Tissue Mills
Nintendo, Sega
Eastman Kodak, Polaroid, Bell & Howell, Berkey Photo
Western Electric, General Telephone, United Telecommunications,
Continental Telephone
Hertz, Avis, National, Budget
AT&T, MCI, Sprint
Duracell, Eveready, Ray-O-Vac, Kodak
Coca-Cola, Pepsico, Cadbury Schweppes (7-Up, Dr. Pepper,
A&W), Royal Crown
Visa, Mastercard, American Express
Gillette, Warner-Lambert (Schick, Wilkinson), Bic
Hallmark, American Greetings, Gibson
Procter & Gamble, Colgate-Palmolive, Lever Bros., Beecham
General Motors, Ford, Chrysler, Honda
Anheuser-Busch, Phillip-Morris (Miller), Coors, Strohs
Heinz (Starkist), Unicord (Bumble Bee), Van Camp
Unilever (Ragu), Campbell Soup (Prego), Hunt-Wesson
(Health Choice)
Johnson & Johnson, Bristol-Meyers, American Home Products
Sterling Drug
Time Warner, Sony, Thorn, Matsushita

100
99
98
98
95
94
94
94
93
92
91
91
91
90
90
82
80
78
77

Figure 11.1: Industry Concentration in America

63

Cooperative vs. Non-cooperative Behavior


1. Concentration ratios are important in serving as an indicator of the
degree of strategic interaction and collusive behavior that might occur in
an industry. Moreover, once this mutual interdependence is recognized,
firmsand the business executives that run themhave a choice
between pursuing cooperative versus non-cooperative behavior.
2. On the one hand, business executives act non-cooperatively when they
act on their own without any explicit or implicit agreements with other
firms. Thats the kind of market conduct that typically characterizes
monopolistic competition.
3. On the other hand, business executives operate in a cooperative mode
when they try to minimize competition by explicitly or tacitly colluding on
price and output and other market issues. And thats the kind of behavior
we can fully expect from oligopolists in an industry.
The Cartel Model and Price Leadership
1. If the oligopolists can truly coordinate their activities, the obvious price to
set is the same as that which would be set by a single monopolist, where
marginal revenue equals marginal cost. Therefore, the oligopolists will
jointly maximize their profits, which is why this model is often called the
joint profit maximization or cartel model.
2. In the price leadership model, the policing or enforcement mechanism
used is often punishment by the price leaderusually the biggest or
dominant firm in the industry. A practice evolves where the dominant
firmusually the largest firminitiates a price change and all other firms
more or less automatically follow that price change. If one or more firms
refuse to follow suit, the price leader may choose to back down.
Game Theory

LECTURE ELEVEN

1. The guiding philosophy in


game theory is that you will
choose your own strategy
under the assumption that
your rival is analyzing your
strategy and acting in his
or her own best interest.
Understanding game theory will therefore help you
better understand not just
your own actions, but your
rivals actions.

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2. A Nash Equilibrium in game theorynamed after the Nobel Prize-winning


mathematician John Nashdescribes a situation in which no player can
improve his or her payoff given the other players strategy. The concept
of the Nash Equilibrium often describes a non-cooperative equilibrium. In
the absence of collusion, each party chooses that strategy that is best for
itself, without collusion and without regard for the welfare of society or
any other party.
64

FOR GREATER UNDERSTANDING

Questions
1. Why is the OPEC oil cartel allowed to openly collude on price?
2. Can you summarize the major problems with monopoly, monopolistic
competition, and oligopoly?
3. A lot of examples in the lectures were historical. Do practices like price
fixing still go on?
4. What is a cartel? Are cartels legal in the United States?
5. Explain the three key differences between oligopoly and
monopolistic competition.
6. Define the four-firm concentration ratio. Why are concentration ratios so
important in studying market structure?
7. Discuss the concepts of strategic interaction and mutual interdependence.
8. From the economists point of view, product differentiation in general and
advertising in particular have what two goals?
9. Why are concentration ratios so important in the study of oligopoly?
10. What is the difference between explicit versus tacit collusion? Which one
is illegal in the United States?
11. What is a Nash Equilibrium? Why is this concept important?

Websites to Visit
1. Choose Newsroom, then Reports, and search for documents that contain the word monopoly; you will find many documents, so use the
advanced search option and look for Intel and Microsoft cases: Are these
companies popular in your final search? www.ftc.gov
2. Learn more about oligopolies and real life applications
http://www.oligopolywatch.com

Suggested Reading
Caves, Richard. American Industry: Structure, Conduct, Performance. New
York: Prentice-Hall, 1992.
McConnell, Campbell R., and Stanley L. Brue. Chapters 24, 25, 26, and 32.
Economics: Principles, Problems, and Policies. 16th ed. New York:
McGraw-Hill, 2005.

65

Lecture 12:
Why the Government Intervenes in
Our Markets and Lives: The Economists Critique
LECTURE OBJECTIVES
1. Focus on both how and why the government intervenes in the
private marketplace.
2. Understand why such government intervention has an enormous
effect on our everyday lives.
3. Explore three very important types of market failures, public
goods, externalities, and asymmetric information, and come to
understand the role of government in correcting these types of
market failures.

Private vs. Public Goods


1. Private goods are divisible,
coming in small enough units
to be afforded by individual
buyers. Moreover, a private
good is also rival in consumptionif I consume the good,
you cannot. Finally, a private
good is subject to the exclusion principlethose unable
or unwilling to pay can
be excluded from the
products benefits.

LECTURE TWELVE

2. In contrast, public goods are


indivisible, non-rival in consumption, and the exclusion
from the consumption of a
public good is very difficult
and, with some goods, even
impossible. Hence, this non-excludability makes it difficult for the private
marketplace to supply the good.

PhotoDisc

3. The economic difference between public goods and private goods rests
on technical considerations, not political philosophy. The central question
is whether we have the technical capability to exclude non-payers from
non-rival goods like national defense or flood control (and if that exclusion is economically feasible).
Free Rider Problem
1. Once a public good is provided, a producer cannot possibly exclude nonpayers from receiving its indivisible benefits. This creates a perverse
incentive among potential buyers to want a free ride.
66

2. When the free-rider problem is present, potential buyers will not want to
pay for a good precisely because they can obtain that benefit for free.
Furthermore, these free riders will not even want to reveal their true preferences as to how much they value the good.
3. The result of the free-rider problem is that the perceived demand for the
public good doesnt generate enough revenue to cover the costs of production, even though the collective benefits of the public good may
exceed the economic costs.
Benefit-Cost Analysis
1. The benefit-cost decision rule is simply this: if the benefits from the project exceed its costs, we should build the project. However, if the costs
exceed the benefits, we should not. Note that benefit-cost analysis can
indicate not just whether a public project is worth building, but also help
government choose among the best competing alternatives.
2. Cost-benefit analysis helps shatter the simplistic notion that the best way
to make government more efficient is to always reduce government
spending: efficient government does not necessarily mean minimizing
public spending.
The Theory of Externalities
1. The idea behind externalities is that the production or consumption of a
good may generate spillover effects, or external benefits or costs that
are not accurately reflected in the supply and demand curves of producers and consumers. As a result of these spillover effects, or externalities, the free market may be inefficient and under-supply or over-supply
the good.
2. The externalities problem provides a strong economic rationale for a
good portion of federal, state, and local intervention into the free market
on issues ranging from environmental protection and traffic congestion to
education and public health. This is because in the case of negative
externalities like pollution and congestion, the free market is likely to produce too much of the externality and too much of the good generating
the externality. In contrast, with a positive externality, the market undersupplies the good and generates too few spillover benefits.
The Coase Theorem
1. The Coase Theorem was conceived by University of Chicago
professor and Nobel laureate Ronald
Coase. Coase argued that negative
or positive externalities do not
require government intervention
where (1) property ownership is
clearly defined, (2) the number
of people involved is small,
and (3) bargaining costs
are negligible.
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67

2. The Coase Theorem helps to illustrate that, at least in some situations,


government intervention into the marketplace may not be necessary,
because externalities can be solved through individual bargaining.
3. While the Coase Theorem reminds us that clearly defined property rights
can be a positive factor in remedying externalities, many negative externalities involve large numbers of affected people, high bargaining costs,
and community property such as air and water. Thus, it is appropriate for
the government to intervene.
Tort System and Direct Government Intervention
1. A second approach to internalizing externalities that has some limited
applicability and that relies upon a legal framework of liability laws is
known as the wrongful act or tort system. The idea behind torts is that
the person or corporation that produces the negative externality is legally
liable for any damages caused to other persons.
2. However, as with the Coase Theorem, this tort system has its limitations. For one thing, lawsuits are expensive, time-consuming, and have
uncertain outcomes, while major time delays in the court system are
commonplace. In addition,
there is great uncertainty.
3. Moreover, many negative
externalities do not involve
private property, but rather
property held in common.
This observation leads us to
direct government intervention,
which involves placing limits:
for example, this command
and control approach has
dominated environmental
public policy in the United
States for decades.

PhotoDisc

4. Note there is a second way that this same command and control
result can be achieved: this method involves the use of so-called
Pigouvian taxes and subsidies to tax negative externalities and subsidize positive externalities.
Asymmetric Information
1. The asymmetric information problem can arise particularly when buyers
dont have complete information about a product.
LECTURE TWELVE

2. Two other types of situations can arise associated with asymmetric information. One is called adverse selection, when the problem begins
before the transaction occurs. The other is known as moral hazard, and
the problem doesnt arise until after the transaction is consummated.

68

FOR GREATER UNDERSTANDING

Questions
1. Contrast private versus public goods.
2. Describe the free-rider problem and provide several examples.
3. What is the idea behind externalities?
4. Explain the Coase Theorem and its implications for government intervention into the market.
5. What is the importance of assigning property rights in the
Coase Theorem?
6. How might the Coase Theorem break down?
7. A second approach to internalizing externalities relies upon a legal framework of liability laws. Describe this framework.
8. Why does the government require motorcycle riders to wear helmets in
some states?
9. Why does the United States provide free vaccines to children?
10. Cigarettes are taxed heavily by the government and smoking is banned in
many public places. Is this a moral judgment against smoking?
11. Why cant consumers obtain a detailed map about where different cell
phone companies have the best coverage in their network so they can
make a more informed decision when purchasing a cell phone plan?

Websites to Visit
1. The Coase Theorem is a pillar concept in economics
www.ideachannel.com/Coase.htm.
2. The US Environmental Protection Agency: Choose Browse EPA Topics,
then Economics and go to the recommended pages
http://www.epa.gov

Suggested Reading
Coase, Ronald H. The Firm, the Market, and the Law. Chicago: University of
Chicago Press, 1990.
Dixit, Avinash, and Barry J. Nalebuff. Thinking Strategically. New York: W.W.
Norton & Co., 1993.
McConnell, Campbell R., and Stanley L. Brue. Chapter 30. Economics:
Principles, Problems, and Policies. 16th ed. New York: McGraw-Hill, 2005.

69

Lecture 13:
Government Taxation from the Cradle to the Grave:
The Big Issues
LECTURE OBJECTIVES
1. Introduce public choice theory, a branch of microeconomics and
political science that examines how the democratic political
process leads to economic choices.
2. Look at the expenditure side of the government equation.
3. Explore several aspects of the principles of taxation, such as the
important differences between progressive, proportional, and
regressive taxes.
4. Introduce one of the most powerful tools in microeconomics,
known as tax incidence analysis.
Public Choice Theory

LECTURE THIRTEEN

1. Discussions about
government intervention into the marketplace have focused
upon whats called a
normative theory of
government. This kind
of normative theory is
one in which economic
arguments for government intervention have
been presented into
the free market so as
to increase benefits
to society.
2. But in dispensing their
PhotoDisc
normative prescriptions, economists are not starry-eyed about the government any more
than they are about the free market. We know that just as there are market failures, there are government failures in which government intervention leads to waste or a redistribution of income, not from the rich to
the poor, but the other way around. These important issues are the
domain of public choice theory.
Revealing Preferences Through Majority Voting
(See Figure 13.1)
1. Many of the decisions about our government are made collectively in the
United States through a process that relies heavily on majority
voting. Although this democratic process generally works well at
70

revealing our
social preferences, it can also
produce both
inefficiencies and
inconsistencies.
2. Majority voting
may produce economically inefficient outcomes,
because it fails to
incorporate the
strength of the
preferences of the
individual voters.
Peter Navarro

Political Logrolling

Figure 13.1: Inefficient No Vote

The trading of
votes to secure favorable outcomes on decisions that would otherwise
be bad ones can turn an inefficient outcome into an efficient one.
This technique is called political logrolling. Note, however, that logrolling can either increase or diminish economic efficiency depending on
the circumstances.
Paradox of Voting
1. The so-called paradox of voting refers to a situation when society may
not be able to rank its preferences consistently through majority voting.
2. Note that the problem in the paradox of voting is not irrational preferences but rather a flawed procedure for determining the preferences.
Hence, under certain circumstances, majority voting fails to make consistent choices that reflect the communitys underlying preferences.
Median Voter Model
(See Figure 13.2)
1. The median voter
model helps
explain the twoparty system of
Republicans and
Democrats in
American politics,
as well as why we
typically elect
candidates representing the
political center.
Peter Navarro

Figure 13.2: Median Voter Model

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2. The median voter is defined as the person holding the exact middle
position on any issue.
3. A two-party system of majority voting such as the one in the United
States moves political outcomes to the political center. It is for this reason
that we often observe political candidates taking very similar positions,
essentially becoming what one political wag once called Tweedledum
and Tweedledee.
Government Expenditures
1. Americans face three levels of government: federal, state, and local.
2. These three levels of government reflect a division of fiscal responsibilities in a system that political scientists refer to as fiscal federalism. But
note that their boundaries are not always clear cut.
3. Under fiscal federalism, the federal government is responsible for activities that concern the entire nation, such as providing for national defense
and conducting foreign affairs, while state and local government provide
public goods to state and local residents.
Principles of Taxation

2. The benefits-received principle or


benefit principle holds that different
individuals should be taxed in proportion to the benefits they receive
from government programs. There are
some public goods financed on this
benefit principle basis, such as gasoline taxes or a bridge toll.

Recorded Books, LLC/Ed White

1. The two main competing philosophies


for organizing a tax system are the
benefits-received principle and the
ability-to-pay principle.

3. While the benefit principle would


appear to have great appeal on the
grounds of fairness, difficulties immediately arise when an accurate and
widespread application is considered.

LECTURE THIRTEEN

4. The ability-to-pay principle of taxation contrasts sharply with the benefit


principle. Ability-to-pay taxation states that the amount of taxes people
pay should relate to their income or wealth. The higher someones wealth
or income, the more taxes that person should pay in both absolute and
relative terms.
5. Usually tax systems organized along the ability-to-pay principle are also
redistributive, meaning that they raise funds from higher-income people
to increase the incomes and consumption of poorer groups.
6. The underlying economic idea behind ability-to-pay is that each additional
dollar of income received by a household will yield smaller and smaller
increments of satisfaction or marginal utility. While this ability-to-pay argu72

ment is appealing, problems of application exist just as they do with the


benefit principle.
Progressive, Proportional, and Regressive Taxes
1. A tax is progressive if its average rate increases as income increases.
Such a tax claims not only a larger absolute amount, but also a larger
fraction or percentage of income as income rises; and a progressive tax
redistributes income from the richer to the poorer.
2. In contrast, a regressive tax has an average rate that declines as income
increases. Such a tax takes a smaller and smaller proportion of income
as income increases and effectively redistributes income from the poorer
to the richer.
3. A tax is proportional, or flat, when its average rate remains the same,
regardless of the size of income.
Personal and Corporate Income Tax
1. While the federal personal income tax in the United States is progressive,
the federal corporate income tax is essentially a flat-rate proportional tax.
2. However, some tax experts argue that at least part of
the tax is passed through, or shifted, to consumers
in the form of higher product prices. To the extent that
this occurs, the tax is regressive.
Payroll Taxes
1. Payroll taxes are levied on wage earnings to pay for
social insurance programs like Social Security,
Medicare, unemployment compensation, and disability
programs. They consist of about 15 percent of all wage
income for incomes, while this tax is split between
employer and employee.
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2. The payroll tax does have some regressive features


because it exempts property income and is higher on low wages than on
high wages.
Sales, Excise, and Property Taxes
1. A sales tax is a general tax on consumption. In contrast, an excise tax is
a tax on selected goods such as alcohol or tobacco or gasoline.

2. Sales and excise taxes are clearly regressive: a sales tax is regressive
because a larger portion of a poor persons income is exposed to the tax
than is true for a rich person.
3. As for property taxes, most economists conclude that property taxes on
buildings are regressive for the same reasons as for sales taxes.
Tax Incidence Analysis
1. The notion of who bears the burden of a tax is the domain of a fascinating branch of microeconomics called tax incidence analysis.
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2. Specifically, the ability of a company to pass on a sales tax to its customers depends on the price elasticity of demand for the product: for
example, a company is able to shift more of the tax burden on to consumers when the price for a product is relatively more inelastic.

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The Efficiency Loss of a Tax


1. The government decides the kind of tax it should impose on any particular good or service, thus affecting both the efficiency of any given tax in
raising revenues without harming the economy as well as equity considerations as to whether or not the tax is fair.
2. There is a deadweight loss in most cases when the government imposes
a tax on either production or consumption. By raising the cost of production to producers or the cost of consumption to consumers, the price of
the product effectively rises and discourages production or consumption
of the good.
Ramsay Tax Rule
1. The Ramsay tax rule provides governments with the guidance they
need to minimize the deadweight loss of any tax they apply.
2. The rule depends on the price elasticity of demand and states that the
government should levy the heaviest taxes on those inputs and outputs
that are most price-inelastic in supply or demand.

LECTURE THIRTEEN

3. In fact, Ramsey taxes may constitute an important way of raising


revenues with a minimum loss of economic efficiency. But note that an
economically efficient tax is not always judged to be a fair tax in the
political arena.

74

FOR GREATER UNDERSTANDING

Questions
1. What does public choice theory examine?
2. The median voter model helps explain why presidential candidates in
America often sound similar by election day. What happens when viable
third-party candidates such as Ross Perot in the 1990s or Ralph Nader in
2004 throw their hats into the ring?
3. Explain the benefits-received principle.
4. Explain the ability-to-pay principle.
5. Explain progressive, proportional, and regressive taxes.
6. Describe the personal income tax, the corporate income tax, payroll and
social insurance taxes, sales and excise taxes, and property taxes.
Comment on the progressivity, proportionality, or regressiveness of each.
7. Every few years, there is talk about a flat tax replacing our current income
tax system. Is this a good idea?
8. What is a poll tax? Is it fair? Why or why not?
9. Whats a value-added tax, and isnt this kind of tax used widely in Europe?

Websites to Visit
1. Internal Revenue Service: Go to 1040 Central and choose Taxpayer
Rights to learn more about your rights as a taxpayer www.irs.gov
2. Visit the European Union in the United States website; select EU Law &
Policy Overviews and look for Value Added Tax; follow this link to learn
more about the European VAT www.eurunion.org

Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapter 31. Economics:
Principles, Problems, and Policies. 16th ed. New York: McGraw-Hill, 2005.

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Lecture 14:
Land, Labor, and Capital:
How Our Rents, Wages, and Interest Rates Are Set
LECTURE OBJECTIVES
1. Examine so-called factor pricing, or how land, labor, and capital are priced in the marketplace.
2. Understand the nature of capital markets and its enormous
application to both personal and professional lives.
3. Explore the net present value (NPV) tool and its application in
investment decisions.

Land and Rent


1. The essential feature of land is that
its quantity is fixed and completely
unresponsive to price.
2. Pure economic rent is the price
paid for the use of land and other
natural resources that are completely fixed in supply.
3. Rent is actually determined in the
market in terms of productivity
and location.

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4. Different acres of land vary greatly in productivity. These productivity differences stem primarily from differences in soil fertility and such climatic
factors as rainfall and temperature and, therefore, are reflected in
resource demand and the associated rents.
5. Location is as important as productivity in explaining differences in land
rent. Business renters will pay more for a unit of land that is strategically
located with respect to materials, labor, and customers than for a unit of
land that is remote from the markets.
Labor Market and Wage Determination

LECTURE FOURTEEN

1. The demand for factors in general and for labor in particular is a derived
demand, implying that factor resources usually do not directly satisfy consumer wants, but indirectly by producing goods and services.
2. The derived nature of resource demand implies that the strength of the
demand for a factor such as labor depends on two things: (1) the productivity of the factor helping to create the product, and (2) the market price
of the product that the factor is helping to produce. In particular, if productivity increases, wages increase. By the same token, if the price of the
product falls, wages fall as well.
3. There are a number of important influences on a workers productivity,
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but the most important are the amount of capital and natural resources
that a person has to work with, the state of the technology, and the quality of the labor itself.
4. The supply of labor might affect wages. The three most important determinants of the labor supply are labor force participation, hours worked,
and the rate of immigration.
5. One of the most dramatic developments in labor force participation over
the last half-century has been the sharp influx of women into the work
force. At the same time, labor force participation by older men has fallen
sharply, particularly for men over 65.
6. One of the most interesting analytical concepts in labor market economics
is associated with the backward-bending curve. The idea behind the backward-bending curve is that the higher the wage, the more people will be
willing to work, but only to a point at which people will actually work less.
The reason is that at higher wages, workers can afford more leisure even
though each extra hour of leisure costs more in wages foregone.
Wage Differentials
1. One reason to explain the often hefty wage differentials observed among
people in different occupations refers to what economists call compensating differentials. Such compensating differentials measure the relative
attractiveness of jobs as well as the degree of risk.
2. A second explanation looks into the differences that people have in both
their mental and physical capabilities.
3. Still a third explanation of wage differentials refers to the different
amounts that people invest in their own human capital, where human
capital refers to the stock of useful and valuable skills and knowledge
that are accumulated by people in the process of their education
and training.
4. Economists refer to the excess of these wages above those of the nextbest available occupation as a pure economic rent or, more precisely, a
quasi-rent.
The Capital Market
1. One of the most important tasks of an economy, business, or household
is to allocate its capital across different possible investments. The analysis of capital markets provides us with a framework for evaluating investments in new capital over time.
2. We distinguish between real capitalthe bricks and mortar and
machinesand financial capitalthe stocks and bonds and other loanable fundsused to finance real capital.
3. There are three major categories of real capital goods. The first is structures such as factories and homes. The second is equipment, including
consumer durable goods, such as automobiles, and producer durable
equipment, such as machine tools and computers. The third category of
capital goods is inventories and includes things like cars in dealers lots.
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Interest Rates
1. The interest rate is the price paid for the use of loanable funds,
where the term loanable funds is used to describe funds that are available for borrowing.
2. In particular, the interest rate is the amount of money that must be paid
for the use of one dollar of loanable funds for a year.
3. Because it is paid in kind, interest is typically stated as a percentage of
the amount of money borrowed rather than as an absolute amount.
The Rate of Return
The rate of return on capital is the additional revenue that a firm can
earn from its employment of new capital. This additional revenue is usually measured as a percentage rate per unit of timethe annual net
return per dollar of invested capital.
Theory of Loanable Funds
1. The theory of loanable funds helps to better understand how the interaction of interest rates and rates of return actually determine investment
decisions in a market economy.
2. Firms will demand loanable funds to invest in new projects so long as the
rate of return on capital is greater than or equal to the interest rate paid
on funds borrowed.
Net Present Value (NPV)
(See Figure 14.1)
1. In most cases, capital investments that are made today and that we pay
for today dont really bear all of their fruits for many years. The net present value (NPV) concept is the tool that allows us to evaluate an investment for which a capital outlay occurs todaysay for a new factory or
piece of machinerybut for which the benefits from that investment
come in the form of a revenue stream over many years.

LECTURE FOURTEEN

2. On the one hand, the net present value rule says that if an investment is
negative, your company should not make the investment. On the other
hand, if the value of an investment in net present value terms is positive,
or zero at the prevailing cost of borrowed funds, the rule says you should
make the investment.

Peter Navarro

Figure 14.1

78

FOR GREATER UNDERSTANDING

Questions

1. What is rent seeking? Provide an example from public policy.


2. How come houses that are run down and beat up sometimes sell for
almost as much as brand new houses in an upscale neighborhood?
3. Explain why the demand for labor and other factors of production is a
derived demand.
4. The derived nature of resource demand implies that the strength of the
demand for a factor such as labor will depend on what two things?
5. What does human capital refer to?
6. A lot of people are getting wage increases, but at the same time they
are seeing their health care benefits cut. What does that say about the
labor market?
7. On a personal level, what kind of question can capital analysis help us
to answer?
8. At a professional level, what kind of questions can capital analysis help
business executives to answer?
9. Suppose the economy had been in a deep recession, but now is moving
toward full employment. What will happen to the interest rate and why?

Websites to Visit
1. Visit the Bureau of Labor Statistics and select Wages, Earnings &
Benefits; you can explore for information on wages, earnings, and benefits
of workers categorized by geographical area, occupation, or industry
www.bls.gov
2. Click on Economic Research and Data and follow Statistics: Releases
and Historical Data; interest rates can be found under Interest Rates;
check for the weekly release of the selected interest rates and follow the
direction rates are currently showing www.federalreserve.gov
3. Select Financial Calculators under Tools and click on the new Net
Present Value Calculator; work on the example presented in this lesson to
see how the acceptance-rejection criteria differ depending on the selected
discount rate www.investopedia.com

Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapters 27, 28, 29, and 35.
Economics: Principles, Problems, and Policies. 16th ed. New York:
McGraw-Hill, 2005.

79

COURSE MATERIALS

Suggested Reading for This Course:


Youll get the most out of this course if you have the following book:
McConnell, Campbell R., and Stanley L. Brue. Economics: Principles,
Problems, and Policies. 16th ed. New York: McGraw-Hill, 2005.
Suggested Readings for Lectures in This Course:
Caves, Richard. American Industry: Structure, Conduct, Performance. New
York: Prentice-Hall, 1992.
Coase, Ronald H. The Firm, the Market, and the Law. Chicago: University of
Chicago Press, 1990.
Dixit, Avinash, and Barry J. Nalebuff. Thinking Strategically. New York: W.W.
Norton & Co., 1993.
Navarro, Peter. If Its Raining in Brazil, Buy Starbucks. New York:
McGraw-Hill, 2001.
Snowdon, Brian, Howard Vane, and Peter Wynarczyk. A Modern Guide to
Macroeconomics: An Introduction to Competing Schools of Thought.
Cheltenham, UK: Edward Elgar Publishers, 1995.
Solow, Robert, and John B. Taylor. Inflation, Unemployment, and Monetary
Policy. Cambridge, MA: The MIT Press, 1999.
Woodward, Bob. Maestro: Greenspans Fed and the American Boom. New
York: Simon & Schuster, 2000.

COURSE MATERIALS

These books are available online through www.modernscholar.com


or by calling Recorded Books at 1-800-636-3399.

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