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Professor Peter Navarro


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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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: © #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 Lecture 2 Introduction to Macro- and Microeconomics ............................................6 The Business Cycle and the Warring Schools of Macroeconomics ..................................................................................8 Fiscal Policy and Budget Deficits: The Good, Bad, and Ugly................14 Monetary Policy: It's All About Money, Credit, and Banking..................22 Unemployment and Inflation: Enter the Dragons...................................28 International Trade and Protectionism: Where Did Our Jobs Go?.........................................................................................34 The International Monetary System, Exchange Rates, and Trade Deficits ..................................................................................40 Supply, Demand, and Equilibrium: How Prices Are Set in Our Markets........................................................................................45 Understanding Consumer Behavior: The Essential Elements...............49 Producer Behavior and an Introduction to Perfect Competition ............54 Market Structure, Conduct, and Performance: Why Monopolists Do What They Do ..............................................................61 Why the Government Intervenes in Our Markets and Lives: The Economist's Critique.............................................................66 Government Taxation from the Cradle to the Grave: The Big Issues .......................................................................................70 Land, Labor, and Capital: How Our Rents, Wages, and Interest Rates Are Set............................................................................76

Lecture 3 Lecture 4 Lecture 5 Lecture 6

Lecture 7

Lecture 8

Lecture 9 Lecture 10 Lecture 11

Lecture 12

Lecture 13

Lecture 14

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


About Your 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 It's 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 Navarro's 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 Navarro's weekly stock market newsletter, the Big Picture Investor, is distributed to several thousand readers and available free of charge at 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 It's 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. I'd 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.

© Photo courtesy of Professor Peter Navarro



This course introduces both macroeconomics and microeconomics. Macroeconomics focuses on the big economic picture--specifically, 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 jobs--or 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 buy--should 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


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. · 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.









1. Why do we call economics the dismal science? 2. Which branch of economics is more important--macroeconomics 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 -- 2. Information on macroeconomics events and studies --


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 nation's nominal GDP measures its economic output; the real GDP is the nominal GDP adjusted for inflation.


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.


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 work--until 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 Roosevelt's 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: "stagflation"--simultaneous 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.


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. The stagflation problem had it roots in President Lyndon Johnson's stubbornness. In the late 1960s, Johnson increased expenditures on the Vietnam War but refused to cut spending on his Great Society social welfare programs.



Monetarism & Supply-side Economics 7. Professor Milton Friedman's monetarists challenged what had become the Keynesian orthodoxy. Friedman argued that the problems of both inflation and recession may be traced to one thing--the 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 monetarist's 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 didn't happen: while the economy boomed, so too did America's budget and trade deficit. · In the Bush White House, Ronald Reagan's supply-side advisors had been supplanted not by Keynesians, but rather by a new breed of macroeconomic thinkers--the 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 can't 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 people's behavior may partially, or perhaps completely, counteract the goals of activist fiscal and monetary policies.


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 Bush's fiscally conservative new classical response set the stage for the Clinton boom--the longest expansion in U.S. history.

© Peter Navarro

The Warring Schools of Macroeconomics

Mainstream macroeconomics (Keynesian based)

Potentially unstable


View of the private economy


Stable in long run at natural rate of unemployment

Rational expectations

Stable in long run at natural rate of unemployment

Supply-side economics

May stagnate without proper work, saving, and investment incentives Changes in AS

Cause of the observed instability of the private economy Appropriate macro policies How changes in the money supply affect the economy View of the velocity of money How fiscal policy affects the economy

Investment plans unequal to saving plans

Inappropriate monetary policy

Unanticipated AD and AS shocks in the short tun

Active fiscal and monetary policy By changing the interest rate, which changes investment and real GDP Unstable

Monetary rule

Monetary rule

Policies to increase AS By influencing investment and thus AS

By directly changing AD, which changes GDP Stable

No effect on output because price-level changes are anticipated No consensus

No consensus

Changes AD via the multiplier process

No effect unless money supply changes

No effect on output, because pricelevel changes are anticipated Impossible in the long run in the absence of excessive money supply growth

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

Possible (taxtransfer disincentives, higher costs due to regulation)




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 -- 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 -- 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 --

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 It's 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 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. 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.

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. 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 back--or, 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




Lord John Maynard Keynes and his socalled "income adjustment mechanism" showed that when an economy sinks into a recession, people's 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.

Herbert Hoover


7. Once Herbert Hoover was replaced by Franklin Delano Roosevelt, the government did indeed start to spend --first on FDR's 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 didn't 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 don't 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.


© 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 person's income falls to zero, regardless of changes in one's income. 4. Second, Keynes said that there is a level of "induced consumption" that depends on the individual's disposable income, where disposable income is simply the amount of money you have left after paying taxes to the government. 5. Keynes further described this consumption behavior in terms of a person's 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 company's 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


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.


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. Let's 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, we've got a recessionary gap of $100 billion to fill so that people won't be out of work--as illustrated in Figure 3.2.


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

Figure 3.2 A Recessionary Gap

© 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 dollars--because an expenditure multiplier of 5 times the $20 billion dollar spending hike equals $100 billion. 3. Alternatively, let's suppose we prefer to cut taxes. In our example, it means we don't cut taxes by $20 billion dollars, but by $25 billion dollars--or $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 dollar's worth of tax cuts actually has slightly less of an expansionary effect than a dollar's 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 nation's GDP. Accordingly, comparing the debt to the GDP gives us a measure of a nation's 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 doesn't 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



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 economy's 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, it's possible to avoid crowding out altogether with the "Print Money" option. With this option, the Federal Reserve is said to "accommodate" the Treasury's expansionary fiscal policy. 7. In particular, the Fed simply buys the Treasury's 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.


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




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 -- (go to the "Economic and Fiscal Policy" link) The Cato Institute -- (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 -- 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 --

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 It's 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: It's All About Money, Credit, and Banking LECTURE OBJECTIVES 1. Describe our money and banking system and explain how the Federal Reserve, the nation's 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.


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.


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 rates--short-term rates and long-term rates, government bond rates and corporate bond rates, and so on--not 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. Today's modern banks function much like the goldsmith system. 2. In this earlier era, people asked their goldsmiths to store the gold they didn't 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.

Goldsmith's Workshop by the School of Agnolo Bronzino, Florence, sixteenth century



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 didn't 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 nation's 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 Fed's 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 "banker's bank." That may take place when a bank run occurs--when too many of the bank's depositors demand their money at the same time.


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 nation's banks, and, most importantly, conducting monetary policy.


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 bank's 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


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 ineffective--equivalent 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 Friedman's monetarist challenge to what had become the Keynesian orthodoxy. 5. In contrast to the Keynesian orthodoxy, the Monetarist School doesn't 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 thing--the 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. 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




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 Fed's rate changes, as demonstrated by the changes in the "Intended Federal Funds rate" -- 2. Read some of the Chairman's speeches under the "Testimony and Speeches" link in "News and Events" -- 3. Website of the European Central Bank: Get information on how the EBC is organized and compare it to the Fed's structure --

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 It's Raining in Brazil, Buy Starbucks. New York: McGraw-Hill, 2001. Woodward, Bob. Maestro: Greenspan's Fed and the American Boom. New York: Simon & Schuster, 2000.


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. 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 someone's 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. That's going to mean the acquisition of a new set of skills--if these victims of outsourcing are to be fully employed.


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 Okun's 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 "stagflation"--the 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 time--and only by making the other half worse.



6. It was this inability of Keynesian economics to cope with stagflation that set the stage first for Professor Milton Friedman's 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 economy's 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 economics--but 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. 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


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 economy's supply curve--hence, 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 m--say 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 didn't happen: while the economy boomed, so too did America's budget and trade deficit.

© Peter Navarro

Figure 5.1: The Laffer Curve


Policy Implications III: New Classical Economics 1. The so-called "twin deficits" deeply concerned Reagan's 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 Reagan's supply-side advisors had been supplanted not by Keynesians, but rather by a new breed of macroeconomic thinkers--the so-called "new classical" economists. 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, Bush's fiscal policy restraint also helped to set up the United States for its longest economic expansion in history.





1. Why is the distinction among cyclical, frictional, and structural unemployment important? 2. Explain Okun's 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, you'll find information about "Employment & Unemployment"; check current unemployment rates by following the link "State and Local Unemployment Rates" -- 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 -- 3. The Federal Reserve's 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 --

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 It's 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.


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 © 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 advantage--although one more subtle than the principle of absolute advantage--provides the unshakable basis for international trade. 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.



© Peter Navarro

Figure 6.1: Comparative Advantage Example


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 producers--and 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 country's favor and against foreign countries. 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.



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 country's 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.


Trade Deficits and Budget Deficits 1. To many observers, America's 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 factories--and its future--to 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.

Net Credits or Debits




Current Account

a. Merchandise Trade Balance U.S. Goods Exports U.S. Goods Imports b. Fees for Services U.S. Exports of Services U.S. Imports of Services 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 d. Unilateral Transfers 206 -203 -40 -148 -191 612 -803 80 237 -157 -111 3

Balance on the Current Account

Capital Account

a. Foreign purchases of assets in the U.S. b. U.S. purchases of assets abroad Balance on Foreign/U.S. Purchases c. Official reserves 517 -376 141 7 -148

© Peter Navarro

Balance on Capital Account

Sum of Current and Capital Accounts

Figure 6.2 Balance of Payments






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 world's 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" -- 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 -- 3. Spend some time browsing the WTO; you can also download the "Understanding the WTO" brochure for future reference --

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.


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 nation's currency can be traded for another nation's 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.


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 world's 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


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 world's key currency.


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.

U.S. Delegates to the Bretton Woods Conference, July 22, 1944

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 dollar's 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 currency's 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. 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 1. The conduct of domestic fiscal and monetary policies in a global economy can affect not only the domestic country's trade balance, but also significantly affect the rates of growth and unemployment in the domestic country's trading partners. Any imbalances in either capital or trade flows in one country will affect all trading partners. 2. For example, America's 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) 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


© Peter Navarro

© Peter Navarro



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 States's 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 -- 2. Click on "Market Data," select "Currencies," and examine exchange rates by clicking on "Benchmark Currency Rates" and "World Currencies" -- 3. Information about the Euro --

Suggested Reading

McConnell, Campbell R., and Stanley L. Brue. Chapter 38. Economics: Principles, Problems, and Policies. 16th ed. New York: McGraw-Hill, 2005. Navarro, Peter. Chapter 18. If It's Raining in Brazil, Buy Starbucks. New York: McGraw-Hill, 2001.



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 cross--where 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 society's resources in satisfying people's 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 demand--or 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. 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)


5. The location and slope of the supply curve depends on the firm's ability to produce--to transform the so-called "factors of production" like raw materials and labor and capital into consumable goods. However, supply also depends on the individual's 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 equilibrium--which 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 clears--at 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 equilibrium--and 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 market--not 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.

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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 -- 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 -- 3. The Foundation of Economic Education: a research organization that promotes free markets and limited government intervention --

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.



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 economics--particularly 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. 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

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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.

Dove Bar Dove Bar price = $1 Marginal Marginal utility utility, per dollar utils (MU/price) 10 8 7 6 5 4 3 10 8 7 6 5 4 3 Big Mac Big Mac price = $2 Marginal Marginal utility utility, per dollar utils (MU/price) 24 20 18 16 12 6 4 12 10 9 8 6 3 2

Unit of Product First Second Third Fourth Fifth Sixth Seventh

Potential choice First Big Mac First Dove Bar First Dove Bar Second Big Mac Second Dove Bar Third Big Mac Second Dove Bar Fourth Big Mac LECTURE NINE

Marginal utility per dollar 12 10 10 10 8 9 8 8

Purchase decision First Big Mac for $2 First Dove Bar for $1 and second Big Mac for $2 Third Big Mac for $2 Second Dove Bar for $1 and fourth Big Mac for $2

Income remaining $8 = $10­$2 $5 = $8­$3 $3 = $5­$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 doesn't change much.

Price Elasticities for a Variety of Products

Product or Service Housing Electricity (household) Bread Telephone Service Medical Care Eggs Legal Services Automobile Repair Clothing Milk Household Appliances Movies Beer Shoes Motor Vehicles China, Glassware, etc. Restaurant Meals Lamb and Mutton Elasticity of Demand .01 .13 .15 .26 .31 .32 .37 .40 .49 .63 .63 .87 .90 .91 1.14 1.54 2.27 2.65

© Peter Navarro

Table 9.2: Price Elasticities


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



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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 don't 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 -- 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 --

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.


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.


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. 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 2 Fixed costs (FC) 50 50 50 50 50 50 50 50 50 50 50 50 3 Variable costs (VC) 50 60 100 106 150 157 182 200 210 250 265 350 4 Total costs (TC) 100 10 5 10 11 17 18 21 23 24 28 29 32 110 150 6 156 200 7 207 232 250 10 260 300 15 400 1.56 10.94 12.50

© Peter Navarro © Peter Navarro

Output 4

5 6 Marginal costs Average (MC) fixed costs (change in (AFC) total costs) FC/Output 12.50 10.00 5.00 4.54 2.94 2.78 2.38 2.17 2.08 1.79 1.72

7 Average variable fixed costs (AVC) VC/Output 12.50 12.00 10.00 9.64 8.82 8.72 8.67 8.70 8.75 8.93 9.14

8 Average costs (ATC) (ATC) AFC+AVC 25.00 22.00 15.00 14.18 11.76 11.50 11.05 10.87 10.83 10.72 10.86


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) 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 firm's 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. 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.



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 what's 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 left--the 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. That's 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) 1. The central concept driving this paradigm is that industry structure determines market conduct, and market conduct, in turn, determines market performance. 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 well--or poorly --a society's resources are being used. 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.



© Peter Navarro

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

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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 firm's 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 firm's output is indistinguishable from any other firm's 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 firm's "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.




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 firm's marginal revenue in a perfectly competitive industry?

Websites to Visit

1. Browse "Companies" for America's largest private companies; can you identify in which market structure the Top Ten companies are most likely to be included? -- 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? --

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.



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 place--often 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.







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 monopolist's profits. The result is that consumers pay a lot more for a lot less in a monopolized market--while 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 structure--monopolistic competition and oligopoly.

© Recorded Books, LLC/Ed White


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 what's called "strategic interaction" that might occur in an industry. Strategic interaction describes how each firm's 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. 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. 3. From the business executive's 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 firm's demand curve outwards and increase the firm's 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


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

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

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, Stroh's 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 Figure 11.1: Industry Concentration in America


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, firms--and the business executives that run them--have 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. That's 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 that's 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 leader--usually the biggest or dominant firm in the industry. A practice evolves where the "dominant firm"--usually the largest firm--initiates 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 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.



2. A Nash Equilibrium in game theory--named after the Nobel Prize-winning mathematician John Nash--describes a situation in which no player can improve his or her payoff given the other player's 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



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 economist's 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? -- 2. Learn more about oligopolies and real life applications --

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.


Lecture 12: Why the Government Intervenes in Our Markets and Lives: The Economist's 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 consumption--if I consume the good, you cannot. Finally, a private good is subject to the exclusion principle--those unable or unwilling to pay can be excluded from the product's benefits. 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 doesn't 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.



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. 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 don't have complete information about a product.


© PhotoDisc

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 doesn't arise until after the transaction is consummated.




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 can't 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 -- 2. The US Environmental Protection Agency: Choose "Browse EPA Topics," then "Economics" and go to the recommended pages --

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.


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 1. Discussions about government intervention into the marketplace have focused upon what's 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 community's 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


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 1. The two main competing philosophies for organizing a tax system are the benefits-received principle and the ability-to-pay principle. 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.

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. 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 someone's 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


© Recorded Books, LLC/Ed White

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. 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 person's 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. 73


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.


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. 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.





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. What's a value-added tax, and isn't 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 -- 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 --

Suggested Reading

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


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.


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 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 worker's productivity, 76

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 capital--the bricks and mortar and machines--and financial capital--the stocks and bonds and other loanable funds--used 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. 77

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 time--the 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 don't 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 today--say for a new factory or piece of machinery--but for which the benefits from that investment come in the form of a revenue stream over many years. 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




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 -- 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 -- 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 --

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.



Suggested Reading for This Course: You'll 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 It's 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: Greenspan's Fed and the American Boom. New York: Simon & Schuster, 2000. These books are available online through or by calling Recorded Books at 1-800-636-3399.




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