19.1: Measuring Output Using GDP

19.1.1: Defining GDP

Learning Objective

Distinguish between the income and expenditure approaches of assessing GDP

Key Points

• GDP can be measured using the expenditure approach: Y = C + I + G + (X – M).
• GDP can be determined by summing up national income and adjusting for depreciation, taxes, and subsidies.
• GDP can be determined in two ways, both of which, in principle, give the same result.

Key Term

GDP

Gross domestic product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period of time.

Gross domestic product (GDP) is the market value of all final goods and services produced within the national borders of a country for a given period of time. GDP can be determined in multiple ways. The income approach and the expenditure approach highlighted below should yield the same final GDP number .

Expenditure Approach

The expenditure approach attempts to calculate GDP by evaluating the sum of all final good and services purchased in an economy. The components of U.S. GDP identified as “Y” in equation form, include Consumption (C), Investment (I), Government Spending (G) and Net Exports (X – M).

Y = C + I + G + (X − M) is the standard equational (expenditure) representation of GDP.

• “C” (consumption) is normally the largest GDP component in the economy, consisting of private expenditures (household final consumption expenditure) in the economy. Personal expenditures fall under one of the following categories: durable goods, non-durable goods, and services.
• “I” (investment) includes, for instance, business investment in equipment, but does not include exchanges of existing assets. Spending by households (not government) on new houses is also included in Investment. “Investment” in GDP does not mean purchases of financial products. It is important to note that buying financial products is classed as ‘saving,’ as opposed to investment.
• “G” (government spending) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. However, since GDP is a measure of productivity, transfer payments made by the government are not counted because these payment do not reflect a purchase by the government, rather a movement of income. They are captured in “C” when the payments are spent.
• “X” (exports) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations’ consumption, therefore exports are added.
• “M” (imports) represents gross imports. Imports are subtracted since imported goods will be included in the terms “G”, “I”, or “C”, and must be deducted to avoid counting foreign supply as domestic.

Income Approach

The income approach looks at the final income in the country, these include the following categories taken from the U.S. “National Income and Expenditure Accounts”: wages, salaries, and supplementary labor income; corporate profits interest and miscellaneous investment income; farmers’ income; and income from non-farm unincorporated businesses. Two non-income adjustments are made to the sum of these categories to arrive at GDP:

• Indirect taxes minus subsidies are added to get from factor cost to market prices.
• Depreciation (or Capital Consumption Allowance) is added to get from net domestic product to gross domestic product.

19.1.2: Learning from GDP

Learning Objective

Explain how GDP is calculated.

Key Points

• The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces.
• The income approach equates the total output of a nation to the total factor income received by residents or citizens of the nation.
• The expenditure approach is basically an output accounting method. It focuses on finding the total output of a nation by finding the total amount of money spent.

Key Terms

gross national product

The total market value of all the goods and services produced by a nation (citizens of a country, whether living at home or abroad) during a specified period.

gross domestic product

A measure of the economic production of a particular territory in financial capital terms over a specific time period.

There are two commonly used measures of national income and output in economics, these include gross domestic product (GDP) and gross national product (GNP). These measures are focused on counting the total amount of goods and services produced within some “boundary” where the boundary is defined by either geography or citizenship.

Since GDP measures income and output, it can be used to compare two countries. The country with higher GDP is often regarded as wealthier, but, when using GDP to compare countries, it is important to remember to adjust for population.

GDP

GDP limits its focus to the value of goods or services in an actual geographic boundary of a country, where GNP is focused on the value of goods or services specifically attributable to citizens or nationality, regardless of where the production takes place. Over time GDP has become the standard metric used in national income reporting and most national income reporting and country comparisons are conducted using GDP.

GDP can be evaluated by using an output approach, income approach, or expenditure approach.

Output Approach

The output approach focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces. Because of the complication of the multiple stages in the production of a good or service, only the final value of a good or service is included in the total output. This avoids an issue referred to as double counting, where the total value of a good is included several times in national output, by counting it repeatedly in several stages of production.

For example, in meat production, the value of the good from the farm may be $10, then $30 from the butchers, and then $60 from the supermarket. The value that should be included in final national output should be $60, not the sum of all those numbers, $90.

Formula: GDP (gross domestic product) at market price = value of output in an economy in the particular year – intermediate consumption at factor cost = GDP at market price – depreciation + NFIA (net factor income from abroad) – net indirect taxes.

Income Approach

The income approach equates the total output of a nation to the total factor income received by residents or citizens of the nation. The main types of factor income are:

• Employee compensation (cost of fringe benefits, including unemployment, health, and retirement benefits);
• Interest received net of interest paid;
• Rental income (mainly for the use of real estate) net of expenses of landlords;
• Royalties paid for the use of intellectual property and extractable natural resources.

All remaining value added generated by firms is called the residual or profit or business cash flow.

Formula: GDI (gross domestic income, which should equate to gross domestic product) = Compensation of employees + Net interest + Rental & royalty income + Business cash flow

Expenditure Approach

The expenditure approach is basically an output accounting method. It focuses on finding the total output of a nation by finding the total amount of money spent. This is acceptable, because like income, the total value of all goods is equal to the total amount of money spent on goods. The basic formula for domestic output takes all the different areas in which money is spent within the region, and then combines them to find the total output .

Formula: Y = C + I + G + (X – M) ; where: C = household consumption expenditures / personal consumption expenditures, I = gross private domestic investment, G = government consumption and gross investment expenditures, X = gross exports of goods and services, and M = gross imports of goods and services.

19.1.3: The Circular Flow and GDP

Learning Objective

Evaluate the effect of the circular flow on GDP

Key Points

• In the circular flow model, the household sector, provides various factors of production such as labor and capital, to producers who in turn produce goods and services.
• Firms provide consumers with goods and services in exchange for consumer expenditure and “factors of production” from households.
• Investment is equal to savings and is the income not spent but available to both consumers and firms for the purchase of capital investments, such as buildings, factories and homes.
• A portion of income is also allocated to taxes (income is taxed and the remaining is either consumed and or saved); government spending, G, is based on the tax revenue, T.
• The continuous flow of production, income and expenditure is known as circular flow of income; it is circular because it has neither any beginning nor an end.

Key Terms

Factors of production

In economics, factors of production are inputs. They may also refer specifically to the primary factors, which are stocks including land, labor, and capital goods applied to production.

circular flow

A model of market economy that shows the flow of dollars between households and firms.

In economics, the “circular flow” diagram is a simple explanatory tool of how the major elements as defined by the equation Y = Consumption + Investment + Government Spending + (Exports – Imports). interact with one another. Circular flow is basically a continuous loop that for any point and time yields the value “Y” otherwise defined as the sum of final good and services in an economy, or gross domestic product (GDP) .

In the circular flow model, the household sector, provides various factors of production such as labor and capital, to producers who in turn produce goods and services. Firms compensate households for resource utilized and households pay for goods and services purchased from firms. This portion of the circular flow contributes to expenditures on consumption, C and generates income, which is the basis for savings (equal to investment) and government spending (tax revenue generated from income).

Investment, I, is equal to savings and is the income not spent but available to both consumers and firms for the purchase of capital investments, such as buildings, factories and homes. I represents an expenditure on investment capital.

Income generated in the relationship between firms and households is taxed and the remaining is either consumed and or saved. Government spending, G, is based on the tax revenue, T. G can be equal to taxes, less than or more than the tax revenue and represents government expenditure in the economy.

Finally, exports minus imports, X – M, references whether an economy is a net importer or exporter (or potentially trade neutral (X – M = 0)) and the impact of this component on overall GDP. Note that if the country is a net importer the value of X – M will be negative and will have a downward impact to overall GDP; if the country is a net exporter, the opposite will be true.

Circular flow

The continuous flow of production, income and expenditure is known as circular flow of income. It is circular because it has neither any beginning nor an end. The circular flow involves two basic assumptions:

1. In any exchange process, the seller or producer receives what the buyer or consumer spends.

2. Goods and services flow in one direction and money payment flow in the opposite or return direction, causing a circular flow.

19.1.4: GDP Equation in Depth (C+I+G+X)

Learning Objective

Identify the variables that make up GDP

Key Points

• C (consumption) is normally the largest GDP component in the economy, consisting of private (household final consumption expenditure) in the economy.
• I (investment) includes, for instance, business investment in equipment, but does not include exchanges of existing assets.
• G (government spending) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government.
• X (exports) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations’ consumption, therefore exports are added.
• M (imports) represents gross imports.

Key Terms

government spending

Includes all government consumption, investment but excludes transfer payments made by a state.

consumption

In the expenditure approach, the amount of goods and services purchased for consumption by individuals.

export

Any good or commodity, transported from one country to another country in a legitimate fashion, typically for use in trade.

import

To bring (something) in from a foreign country, especially for sale or trade.

investment

A placement of capital in expectation of deriving income or profit from its use.

Gross domestic product (GDP) is defined as the sum of all goods and services that are produced within a nation’s borders over a specific time interval, typically one calendar year.

Components of GDP

GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G) and Net Exports (X – M):

()

Defining the components

Consumption

Consumption (C) is normally the largest GDP component in the economy, consisting of private (household final consumption expenditure) in the economy. These personal expenditures fall under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewelry, gasoline, and medical expenses but does not include the purchase of new housing. Also, it is important to note that goods such as hand-knit sweaters are not counted as part of GDP if they are gifted and not sold. Only expenditure based consumption is counted.

Investment

Investment (I) includes, for instance, business investment in equipment, but does not include exchanges of existing assets. Examples include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. Spending by households (not government) on new houses is also included in Investment. In contrast to common usage, ‘Investment’ in GDP does not mean purchases of financial products. Buying financial products is classified as ‘saving’, as opposed to investment. This avoids double-counting: if one buys shares in a company, and the company uses the money received to buy plant, equipment, etc., the amount will be counted toward GDP when the company spends the money on those things. To count it when one gives it to the company would be to count two times an amount that only corresponds to one group of products. Note that buying bonds or stocks is a swapping of deeds, a transfer of claims on future production, not directly an expenditure on products.

Government Spending

Government spending (G) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits.

Net Exports

Exports (X) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations’ consumption, therefore exports are added.

Imports (M) represents gross imports. Imports are subtracted since imported goods will be included in the terms G, I, or C, and must be deducted to avoid counting foreign supply as domestic.

Sometimes, net exports is simply written as NX, but is the same thing as X-M.

Note that C, G, and I are expenditures on final goods and services; expenditures on intermediate goods and services do not count.

19.1.5: Calculating GDP

Learning Objective

Identify the output approach to calculating GDP

Key Points

• The expenditures approach says GDP= consumption + investment + government expenditure + exports – imports.
• The income approach sums the factor incomes to the factors of production.
• The output approach is also called the “net product” or “value added” approach.

Key Terms

expenditure approach

The total spending on all final goods and services (Consumption goods and services (C) + Gross Investments (I) + Government Purchases (G) + (Exports (X) – Imports (M)) GDP = C + I + G + (X-M).

income approach

GDP based on the income approach is calculated by adding up the factor incomes to the factors of production in the society.

output approach

GDP is calculated using the output approach by summing the value of sales of goods and adjusting (subtracting) for the purchase of intermediate goods to produce the goods sold.

Gross Domestic Product

Gross domestic product is one method of understanding a country’s income and allows for comparison to other countries .

By calculating the value of goods and services produced in a country, GDP provides a useful metric for understanding the economic momentum between the major factors of an economy: consumers, firms, and the government. There are a few methods used for calculating GDP, the most commonly presented are the expenditure and the income approach. Both of these methods calculate GDP by evaluating the final stage of sales (expenditure) or income (income). However, another approach referred to as the “output approach” calculates GDP by evaluating the value of all sales and adjusting for the purchase of intermediate goods (to remove double counting).

Expenditures Approach

The most well known approach to calculating GDP, the expenditures approach is characterized by the following formula:

GDP = C + I + G + (X-M)

where C is the level of consumption of goods and services, I is gross investment, G is government purchases, X is exports, and M is imports.

Income Approach

The income approach adds up the factor incomes to the factors of production in the society. It can be expressed as:

GDP = National Income (NY) + Indirect Business Taxes (IBT) + Capital Consumption Allowance and Depreciation (CCA) + Net Factor Payments to the rest of the world (NFP)

Output Approach

The output approach is also called “net product” or “value added” method. This method consists of three stages:

• Estimating the gross value of domestic output;
• Determining the intermediate consumption, i.e., the cost of material, supplies, and services used to produce final goods or services;
• Deducting intermediate consumption from gross value to obtain the net value of domestic output.

Net value added = Gross value of output – Value of intermediate consumption.

Gross value of output = Value of the total sales of goods and services + Value of changes in the inventories.

The sum of net value added in various economic activities is known as GDP at factor cost. GDP at factor cost plus indirect taxes less subsidies on products is GDP at producer price. GDP at producer price theoretically should be equal to GDP calculated based on the expenditure approach. However, discrepancies do arise because there are instances where the price that a consumer may pay for a good or service is not completely reflected in the amount received by the producer and the tax and subsidy adjustments mentioned above may not adequately adjust for the variation in payment and receipt.

19.1.6: Other Approaches to Calculating GDP

Learning Objective

Explain the income approach to calculating GDP.

Key Points

• The sum of COE, GOS, and GMI is called total factor income; it is the income of all of the factors of production in society. It measures the value of GDP at factor (basic) prices.
• Adding taxes less subsidies on production and imports converts GDP at factor cost (as noted, a net domestic product) to GDP.
• By definition, the income approach to calculating GDP should be equatable to the expenditure approach; however, measurement errors will make the two figures slightly off when reported by national statistical agencies.

Key Terms

expenditure approach

The total spending on all final goods and services (Consumption goods and services (C) + Gross Investments (I) + Government Purchases (G) + (Exports (X) – Imports (M)) GDP = C + I + G + (X-M).

income approach

GDP based on the income approach is calculated by adding up the factor incomes to the factors of production in the society.

depreciation

The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.

Gross domestic product provides a measure of the productivity of an economy specific to the national borders of a country . It can be measured a few different ways and the most commonly used metric is the expenditure approach; however, the second most commonly used measure is the income approach. The income approach unlike the expenditure approach, which sums the spending on final goods and services across economic agents (consumers, businesses and the government), evaluates GDP from the perspective of the final income to economic participants. GDP calculated in this manner is sometimes referenced as “Gross Domestic Income” (GDI).

This method measures GDP by adding incomes that firms pay households for factors of production they hire- wages for labor, interest for capital, rent for land, and profits for entrepreneurship. The U.S. “National Income and Expenditure Accounts” divide incomes into five categories:

• Wages, salaries, and supplementary labor income
• Corporate profits
• Interest and miscellaneous investment income
• Farmers’ income
• Income from non-farm unincorporated businesses

Two adjustments must be made to get the GDP: Indirect taxes minus subsidies are added to get from factor cost to market prices. Depreciation (or Capital Consumption Allowance) is added to get from net domestic product to gross domestic product.

Income Approach Formula

GDP = compensation of employees + gross operating surplus + gross mixed income + taxes less subsidies on production and imports. Alternatively, this can be expressed as:

GDP = COE + GOS + GMI + T_{P & M} – S_{P & M}

• Compensation of employees (COE) measures the total remuneration to employees for work done.
• Gross operating surplus (GOS) is the surplus due to owners of incorporated businesses.
• Gross mixed income (GMI) is the same measure as GOS, but for unincorporated businesses. This often includes most small businesses.
• T_{P & M} is taxes on production and imports.
• S_P&M is subsidies on production and imports.

The sum of COE, GOS, and GMI is called total factor income; it is the income of all of the factors of production in society. It measures the value of GDP at factor (basic) prices. The difference between basic prices and final prices (those used in the expenditure calculation) is the total taxes and subsidies that the government has levied or paid on that production. So, adding taxes less subsidies on production and imports converts GDP at factor cost (as noted, a net domestic product) to GDP.

By definition, the income approach to calculating GDP should be equatable to the expenditure approach (Y = C + I+ G + (X – M)). In practice, however, measurement errors will make the two figures slightly off when reported by national statistical agencies.

19.1.7: Evaluating GDP as a Measure of the Economy

Learning Objective

Assess the uses and limitations of GDP as a measure of the economy

Key Points

• The sensitivities related to social welfare has continued the argument specific to the use of GDP as a economic growth or progress metric.
• A country with wide disparities in income could appear to be economically stronger, strictly using GDP, than a country where the income disparities were significantly lower (standard of living).
• Therefore, GDP has a tremendous big-picture value but policymakers would be better served using other metrics in combination with the aggregate measure if and when social welfare is being addressed.

Key Terms

qualitative

Based on descriptions or distinctions rather than on some quantity.

welfare

Health, safety, happiness and prosperity; well-being in any respect.

quantitative

Of a measurement based on some number rather than on some quality.

Gross domestic product (GDP) due to its relative ease of calculation and definition, has become a standard metric in the discussion of economic welfare, growth and prosperity. However, the value of GDP as a measure of the quality of life for a given country may be quite poor given that the metric only provides the total value of production for a specific time interval and provides no insight with respect to the source of growth or the beneficiaries of growth. Therefore, growth could be misinterpreted by looking at GDP values in isolation.

Limitations of GDP

Simon Kuznets, the economist who developed the first comprehensive set of measures of national income, stated in his first report to the US Congress in 1934, in a section titled “Uses and Abuses of National Income Measurements”:

“Economic welfare cannot be adequately measured unless the personal distribution of income is known. And no income measurement undertakes to estimate the reverse side of income, that is, the intensity and unpleasantness of effort going into the earning of income. The welfare of a nation can, therefore, scarcely be inferred from a measurement of national income. “

Following on his caution with respect to economic extrapolations from GDP, in 1962, Kuznets stated: “Distinctions must be kept in mind between quantity and quality of growth, between costs and returns, and between the short and long run. Goals for more growth should specify more growth of what and for what. “

The sensitivities related to social welfare has continued the argument specific to the use of GDP as a economic growth or progress metric.

Austrian School economist Frank Shostak has noted: “The GDP framework cannot tell us whether final goods and services that were produced during a particular period of time are a reflection of real wealth expansion, or a reflection of capital consumption. For instance, if a government embarks on the building of a pyramid, which adds absolutely nothing to the well-being of individuals, the GDP framework will regard this as economic growth. In reality, however, the building of the pyramid will divert real funding from wealth-generating activities, thereby stifling the production of wealth. “

GDP as an Evaluation Metric

Although GDP provides a single quantitative metric by which comparisons can be made across countries, the aggregation of elements that create the single value of GDP provide limitations in evaluating a country and its economic agents. Given the calculation of the metric, a country with wide disparities in income could appear to be economically stronger than a country where the income disparities were significantly lower (standard of living). However, a qualitative assessment would likely value the latter country compared to the former on a welfare or quality of life basis .

Therefore, GDP has a tremendous big-picture value but policymakers would be better served using other metrics in combination with the aggregate measure if and when social welfare is being addressed.

18.1: Key Topics in Macroeconomics

18.1.1: Defining Macroeconomics

Learning Objective

Define Macroeconomics.

Key Points

• Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions.
• Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, government spending and international trade.
• Though macroeconomics encompasses a variety of concepts and variables, but there are three central topics for macroeconomic research on the national level: output, unemployment, and inflation.

Key Terms

microeconomics

That field that deals with the small-scale activities such as that of the individual or company.

Macroeconomics

The study of the entire economy in terms of the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the general behavior of prices.

Economics is comprised of many specializations; however, the two broad sub-groupings for economics are microeconomics and macroeconomics.

Macroeconomics

Macroeconomics is a branch of economics that focuses on the behavior and decision-making of an economy as a whole . In this manner it differs from the field of microeconomics, which evaluates the motivations of and relationships between individual economic agents.

Indicators

Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions and develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, government spending, and international trade. These variables taken as a whole comprise a grouping of variables that are referred to as economic indicators. These indicators, which are classified as leading, lagging and coincident relative to their predictive capability, in combination with one another provide economists with a directional attribution for the economy.

Macroeconomic Study

While macroeconomics is a broad field of study, there are two areas of research that are especially well publicized in the media: the evaluation of the business cycle and the growth rate of the economy. As a result, macroeconomics tends to be widely cited in discussions related to government intervention in economic expansion and contraction, as well as, with respect to the evaluation of economic policy.

Though macroeconomics encompasses a variety of concepts and variables, but there are three central topics for macroeconomic research on a national level: output, unemployment, and inflation. Outside of macroeconomic theory, these topics are also extremely important to all economic agents including workers, consumers, and producers.

18.1.2: The Importance of Aggregate Decisions about Consumption versus Saving and Investment

Learning Objective

Explain the relationship between consumption, savings, and investment.

Key Points

• Aggregate demand is downward sloping as a result of three consumption sensitivities: wealth effect, interest rate effect and foreign exchange effect.
• Spending is related to income: Income – Spending = Net Savings.
• For the economy as a whole, aggregate savings is equal to investment, which is usually in the form of borrowed funds available as a result of savings.

Key Term

aggregate demand

The the total demand for final goods and services in the economy at a given time and price level.

There are three choices that market actors can make with their money. They can consume it by spending it on goods and services. For example, buying a movie ticket is spending money on consumption. They can also invest money by lending it to a company or project with the hope of getting back more money in the future. Finally, they can save it by putting it in a bank account (or keeping cash under the bed). Savings is essentially deferred consumption or investment; it is intended for use in the future.

In order to understand the effects of aggregate decisions of consumption, savings, and investment, we must look at aggregate demand (AD). AD is the total demand for final goods and services in the economy at a given time and price level. It specifies the amounts of goods and services that will be purchased at all possible price levels and is the demand for the gross domestic product of a country.

Components of Aggregate Demand

It is often cited that the aggregate demand curve is downward sloping because at lower price levels a greater quantity is demanded. While this is correct at the microeconomic, single good level, at the aggregate level this is incorrect. The aggregate demand curve is downward sloping but in variation with microeconomics, this is as a result of three distinct effects: the wealth effect, the interest rate effect and the exchange-rate effect.

Basically individuals will consume or purchase more when they feel wealthier or have access to inexpensive funding.

The wealth effect is specifically related to the value of assets; market participants will adjust consumption in-line with their perception of the appreciation or depreciation of held assets (a home; equity investments, etc.). The interest rate effect has to do with access to inexpensive funding, which provides an incentive to increase current period expenditures; while the exchange-rate effect has to do with expenditure decisions related to imports or foreign related expenditures, as the exchange rate is perceived to be favorable to the domestic currency, expenditures on foreign items or imports will increase.

Consumption, Savings, and Investment

Aggregate demand met by the market is spending, be it on consumption, investment, or other categories.

Spending is related to income:

Income – Spending = Net Savings

Rearranging:

Spending = Income – Net Savings = Income + Net Increase in Debt

In words: what you spend is what you earn, plus what you borrow: if you spend $110 and earned $100, then you must have net borrowed $10; conversely if you spend $90 and earn $100, then you have net savings of $10, or have reduced debt by $10, for net change in debt of –$10.

For the economy as a whole, aggregate savings is greater than or equal to investment, which is usually in the form of borrowed funds available as a result of savings. Through investment spending, savings influences aggregate demand.

Furthermore, since consumption and investment are components of GDP but saving is not, increased savings indirectly reduces GDP .

18.1.3: The Role of the Financial System

Learning Objective

Explain the importance of the financial system

Key Points

• An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy.
• Markets work by placing many interested buyers and sellers, including households, firms, and government agencies, in one “place,” thus making it easier for them to find each other.
• Healthy financial systems are associated with the accelerated development of an economy.

Key Terms

entrepreneurship

The art or science of innovation and risk-taking for profit in business.

investment

A placement of capital in expectation of deriving income or profit from its use.

saving

the act of storing for future use

Financial System

A financial market or system is a market in which people and entities can trade financial securities, commodities, and other fungible items . Securities include stocks and bonds, and commodities include precious metals or agricultural goods.

There are both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded). Markets work by placing many interested buyers and sellers, including households, firms, and government agencies, in one place, thus making it easier for them to find each other.

An economy that relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy, in contrast either to a command economy or to a non-market economy such as a gift economy.

Role of the Financial System

Financial markets are associated with the accelerated growth of an economy. A financial market helps to achieve the following non-comprehensive list of goals:

• Saving mobilization: Obtaining funds from the savers or surplus units such as household individuals, business firms, public sector units, central government, state governments, etc. is an important role played by financial markets. Borrowers (e.g. bond issuers) are connected with lenders (e.g. bond buyers) in financial markets.
• Investment: Financial markets play a crucial role in arranging to invest funds. Both firms and individuals can invest in companies through financial markets (e.g. by buying stock).
• National Growth: An important role played by financial market is that, they contribute to a nation’s growth by ensuring unfettered flow of surplus funds to deficit units. In other words, financial markets help shift money from industry to industry or firm to firm based on the supply and demand for their products.
• Entrepreneurship growth: Financial markets allow entrepreneurs (and established firms) to access the funds needed to invest in projects or companies.

18.1.4: The Business Cycle: Definition and Phases

Learning Objective

Identify features of the economic business cycle

Key Points

• Business cycles are identified as having four distinct phases: expansion, peak, contraction, and trough.
• Business cycle fluctuations occur around a long-term growth trend and are usually measured by considering the growth rate of real gross domestic product.
• In the United States, it is generally accepted that the National Bureau of Economic Research (NBER) is the final arbiter of the dates of the peaks and troughs of the business cycle.

Key Terms

contraction

A period of economic decline or negative growth.

peak

The highest value reached by some quantity in a time period.

trough

The lowest turning point of a business cycle

expansion

The act or process of expanding.

The Business Cycle

The term “business cycle” (or economic cycle or boom-bust cycle) refers to economy-wide fluctuations in production, trade, and general economic activity. From a conceptual perspective, the business cycle is the upward and downward movements of levels of GDP (gross domestic product) and refers to the period of expansions and contractions in the level of economic activities (business fluctuations) around a long-term growth trend .

Business Cycle Phases

Business cycles are identified as having four distinct phases: expansion, peak, contraction, and trough.

An expansion is characterized by increasing employment, economic growth, and upward pressure on prices. A peak is realized when the economy is producing at its maximum allowable output, employment is at or above full employment, and inflationary pressures on prices are evident. Following a peak an economy, typically enters into a correction which is characterized by a contraction, growth slows, employment declines (unemployment increases), and pricing pressures subside. The slowing ceases at the trough and at this point the economy has hit a bottom from which the next phase of expansion and contraction will emerge.

Business Cycle Fluctuations

Business cycle fluctuations occur around a long-term growth trend and are usually measured by considering the growth rate of real gross domestic product.

In the United States, it is generally accepted that the National Bureau of Economic Research (NBER) is the final arbiter of the dates of the peaks and troughs of the business cycle. An expansion is the period from a trough to a peak, and a recession as the period from a peak to a trough. The NBER identifies a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production. ” This is significantly different from the commonly cited definition of a recession being signaled by two consecutive quarters of decline in real GDP.

18.1.5: Recessions

Learning Objective

Explain the connection between a recession and other macroeconomic variables

Key Points

• Macroeconomic indicators such as GDP (Gross Domestic Product), employment, investment spending, capacity utilization, household income, business profits, and inflation fall, while bankruptcies and the unemployment rate rise.
• Most mainstream economists believe that recessions are caused by inadequate aggregate demand in the economy, and favor the use of expansionary macroeconomic policy during recessions.
• Strategies favored for moving an economy out of a recession vary depending on which economic school the policymakers follow.

Key Term

recession

A period of reduced economic activity

In economics, a recession is a business cycle contraction; a general slowdown in economic activity. Macroeconomic indicators such as GDP (Gross Domestic Product), employment, investment spending, capacity utilization, household income, business profits, and inflation fall, while bankruptcies and the unemployment rate rise. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various events, such as a financial crisis, an external trade shock, an adverse supply shock, or the bursting of an economic bubble .

Attributes of Recession

A recession has many attributes that can occur simultaneously, these include declines in component measures (economic indicators) of economic activity (GDP) such as consumption, investment, government spending, and net export activity. These indicators in turn, reflect underlying drivers such as employment levels and skills, household savings rates, corporate investment decisions, interest rates, demographics, and government policies.

Causes of Recession

Under ideal conditions, a country’s economy should have the household sector as net savers and the corporate sector as net borrowers, with the government budget nearly balanced and net exports near zero. When these relationships become imbalanced, recession can develop within a country or create pressure for recession in another country. Policy responses are often designed to drive the economy back towards this ideal state of balance.

Most mainstream economists believe that recessions are caused by inadequate aggregate demand in the economy, and favor the use of expansionary macroeconomic policy during recessions.

Policy Responses to Recession

Strategies favored for moving an economy out of a recession vary depending on which economic school the policymakers follow. Monetarists would favor the use of expansionary monetary policy, while Keynesian economists may advocate increased government spending to spark economic growth. Supply-side economists may suggest tax cuts to promote business capital investment. When interest rates reach the boundary of an interest rate of zero percent (zero interest-rate policy) conventional monetary policy can no longer be used and government must use other measures to stimulate recovery.

A severe (GDP down by 10%) or prolonged (three or four years) recession is referred to as an economic depression, although some argue that their causes and cures can be different. As an informal shorthand, economists sometimes refer to different recession shapes, such as V-shaped, U-shaped, L-shaped, and W-shaped recessions.

18.1.6: Managing the Business Cycle

Learning Objective

Identify how changes in monetary and fiscal policy can manage the business cycle, and why that is desirable

Key Points

• If the economy needs to be slowed, enacted policies are referred to as being contractionary and if the economy needs to be stimulated the policy prescription is expansionary.
• Central banks use monetary policy measures to facilitate consistent economic growth, while the government uses fiscal policy.
• The government policy measures are referred to as fiscal policy.

Key Terms

fiscal policy

Government policy that attempts to influence the direction of the economy through changes in government spending or taxes.

monetary policy

The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.

The business cycle is comprised of the upward and downward movement in the level of Gross Domestic Product (GDP) over time . These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or recession).

Policy Responses

When the economy is not at a steady state and instead is at a point of either overheating (growing to fast) or slowing, the government and monetary authorities have policy mechanisms, fiscal and monetary, respectively, at their disposal to help move the economy back to a steady state growth trajectory. If the economy needs to be slowed, these policies are referred to as contractionary and if the economy needs to be stimulated the policy prescription is expansionary.

Expansionary Policy

Expansionary fiscal policy involves government spending exceeding tax revenue, and is usually undertaken during recessions. Fiscal authorities will increase government spending in order to revive the economy.

Expansionary monetary policy relies on the central bank increasing availability of loanable funds through three mechanisms: open market operations, discount rate, and the reserve ratio. As the supply of loanable funds increases, the interest rate is expected to decrease and thereby increase the desire to borrow funds for consumption and investment purposes.

Contractionary Policy

Contractionary fiscal policy is opposite of the action taken in an expansionary purpose, and occurs when government spending is lower than tax revenue.

Similarly, contractionary monetary policy is the opposite of expansionary monetary policy and occurs when the supply of loanable funds is limited, to reduce the access and availability to relatively inexpensive credit.

18.1.7: Long Run Growth

Learning Objective

Explain the impact of consistent long-run growth on an economy.

Key Points

• Growth is usually calculated in real terms, meaning that it is inflation-adjusted to eliminate the distorting effect of inflation on the price of goods produced.
• Policymakers strive for continued and consistent growth.
• The large impact of a relatively small growth rate over a long period of time is due to the power of compounding.
• A small difference in economic growth rates between countries can result in very different standards of living for their populations if this small difference continues for many years.

Key Term

economic growth

The increase of the economic output of a country.

Long run growth is the increase in the market value of the goods and services produced by an economy over time. It is conventionally measured as the percentage of increase in real gross domestic product, or real GDP. Growth is usually calculated in real terms: it is inflation-adjusted to eliminate the distorting effect of inflation on the price of goods produced. In economics, economic growth or economic growth theory typically refers to growth of potential output, which is production at full employment.

Policymakers strive for steady, continued, and consistent growth because it is predictable and manageable for both policymakers and market participants. Over long periods of time even small rates of growth, like a 2% annual increase, have large effects. For example, the United Kingdom experienced a 1.97% average annual increase in its inflation-adjusted GDP between 1830 and 2008. In 1830, the GDP was £41,373 million. It grew to £1,330,088 million by 2008 (in 2005 pounds). A growth rate that averaged 1.97% over 178 years resulted in a 32-fold increase in GDP by 2008 .

The Power of Compounding

The large impact of a relatively small growth rate over a long period of time is due to the power of compounding. A growth rate of 2.5% per annum leads to a doubling of the GDP within 29 years, while a growth rate of 8% per annum (an average exceeded by China between 2000 and 2010) leads to a doubling of GDP within 10 years. Therefore, a small difference in economic growth rates between countries can result in very different standards of living for their populations if this small difference continues for many years.

Note: an easy way to approximate the doubling time of a number with a constant growth rate is to use the Rule of 72. Divide 72 by the percentage annual growth rate to get a rough estimate of the number of years until the number doubles. For example, at a 10%, divide 72 by 10 to get a doubling time of 7.2 years. The actual doubling time is 7.27 years, so the rule of 72 is a good rough approximation.

17.1: Defining and Measuring Inequality, Mobility, and Poverty

17.1.1: Defining and Measuring Poverty

Learning Objective

Describe poverty and the poverty line

Key Points

• The United Nations defines poverty as the inability to obtain choices and opportunities.
• A poverty line pertains to the idea of generating an amount of income that is appropriate to ensure a minimum standard of living for an individual. Someone below a nationally set poverty line lacks the purchasing power to fulfill their needs and capture opportunities.
• In observing poverty over time, the rates of poverty alongside the advances in economic production, demonstrate the value in technological and economic progress.
• Poverty is generally divided into absolute or relative poverty, with absolute concepts referring to a standard consistent over time and geographic location and relative pertaining to social benchmarks.

Key Terms

purchasing power

The amount of goods and services that can be bought with a unit of currency or by consumers.

Poverty line

The threshold of poverty, below which one’s income does not cover necessities.

Poverty is framed from a material or capital possessions perspective, and is loosely defined as lacking a certain amount to fulfill basic standards of living. Absolute poverty is poverty to the extent of which an individual is deprived of the ability to fulfill basic human needs (i.e. water, shelter, food, education, etc.). The United Nations defines poverty as the inability to obtain choices and opportunities. The existence of poverty is one of the greatest challenges faced by the modern world, both in developing and developed nations (see ). Addressing poverty is best approached through the science of understanding monetary exchanges and the creation of wealth, and thus it is useful to employ an economic perspective when discussing and providing solutions to global poverty.

The Poverty Line

When conceptually approaching the idea of a poverty line, it is useful to frame it within the context of generating an amount of income that is appropriate to ensure a reasonable standard of living for an individual. Someone below a nationally set poverty line lacks the purchasing power to fulfill their needs and capture opportunities. The United States, for example, has most recently (2012) set the poverty line at $23,050 (annually) with a total of 16% of the population falling under this level (according to the U.S. Census Bureau). Internationally, the World Bank defines extreme poverty as living on less than $1 per day (adjusted for purchasing power).

In observing poverty over time, the rates of poverty alongside the advances in economic production, demonstrates the value in technological and economic progress. The industrial revolution, the modernization (and thus increased efficiency) of agriculture, mass production in factories, technological innovation and a wide range of factors that have driven production and economies upwards have contributed to an increased standard of living. Economically, while the distribution of wealth heavily has tended to benefit the wealthy, there has been great value derived in technological progress in regards to minimizing poverty.

Measuring Poverty

Varying approaches have been developed to measure poverty levels, with a particular focus on creating standardized tools to capture a global context. Poverty is generally divided into absolute or relative poverty, with absolute concepts referring to a standard that is consistent over time and geographic location. An example of absolute poverty is the number of people without access to clean drinking water, or the number of people eating less food than the body requires for survival. Absolute poverty levels, as discussed above, essentially underline the ability for an individual to survive with autonomy. Relative poverty is an approach based more upon a benchmark, that is to say the upper echelon of society versus the poor. Income distribution measures lend insight into relative poverty levels.

One interesting perspective is the Multidimensional Poverty Index (MPI). This index was created in 2010 by the Oxford Poverty & Human Development Initiative alongside the United Nations Development Programme. It leverages a variety of dimensions and applies it to the number of people and the overall intensity across the poor to create a model to capture the extent of the poverty in the region. This dimensions include health, child mortality, nutrition, standard of living, electricity, sanitation, water, shelter (via the floor), cooking fuel and assets owned.

17.1.2: Defining and Measuring Income Inequality

Learning Objective

Apply indices of income inequality to measure global economic inequality

Key Points

• In pursuing an objective and comparable lens in which to measure income inequality, a variety of methods have been created.
• One of the most commonly used income inequality metric is the Gini Index, which uses a straightforward 0-1 scale to illustrate deviance from perfect income equality.
• The 20:20 Ratio and the Palma Ratio (40:10) use percentile ratios of the richest groups and poorest groups to create scales of income inequality severity.
• The Theil Index takes a slightly different approach than the rest, identifying entropy within the system. Entropy, in this case, means the amount of noise or deviance from par, which is expressed as a scale (0 – 1); 0 indicates perfect equality, and 1 indicates perfect inequality.
• Often touted as the simplest measurement to calculate, the Hoover Index derives the overall amount of income in a system and divides it by the population to create the perfect proportion of distribution in the system.

Key Term

entropy

A measure of the amount of information and noise present in a signal.

Income inequality utilizes the dispersion of capital to identify the way in which economic inequality is defined among a group of individuals in a given economy. Simply put, economics measures income levels and purchasing power across a society to identify averages and distributions to identify the extent of inequalities. Historically this problem was limited to the scope of differences of income and assets between people, creating separate social classes. However, as economists expand their understanding of markets, it has become increasingly clear that there is a relationship between income inequality and the potential for long-term sustainable economic growth. As a result, a wide array of income inequality scales and metrics have been generated in order to identify challenges.

Inequality Metrics

In pursuing an objective and comparable lens in which to measure income inequality, a variety of methods have been created. Models, ratios and indices include:

• Gini Index: One of the most commonly used income inequality metric is the Gini Index, which uses a straightforward 0-1 scale to illustrate deviance from perfect equality of income. A 1 on this scale is essentially socialism, or the perfect distribution of capital/goods. The derivation of the Gini ratio is found via Lorenz curves, or more specifically, the ratio of two areas in a Lorenz curve diagram. The downside to this method is that it does not specifically capture where the inequality occurs, simply the degree of severity in the income gap. This demonstrates the Gini ratio across the globe, with some interesting implications for advanced economies like the U.S.
• 20:20 Ratio:This name indicates the method; the top 20% and the bottom 20% of earners are used to derive a ratio. While this is a simple method of identifying how rich the rich are (and how poor the poor are), it unfortunately only captures these outliers (obscuring the middle 60%).
• Palma Ratio: Quite similar to the 20:20 ratio, the Palma ratio underlines the ratio between the richest 10% and the poorest 40% (dividing the former by the latter). The share of the overall economy occupied by these two groups demonstrates substantial variance from economy to economy, and serves as a strong method to identify how drastic the inequity is.
• Theil Index:The Theil Index takes a slightly different approach than the rest, identifying entropy within the system. Entropy in this context is different than that which is found in thermodynamics, primarily meaning the amount of noise or deviance from par. In this case, 0 indicates perfect equality, and 1 indicates perfect inequality. When there is perfect equality, maximum entropy occurs because earners cannot be distinguished by their incomes. The gaps between two entropies is called redundancy, which acts as a negative entropy measure in the system. Redundancy in some individuals implies scarcity of resources for others. Comparing these gaps and inequality levels (high entropy or high redundancy) is the basic premise behind the Theil Index.
• Hoover Index: Often touted as the simplest measurement to calculate, the Hoover Index derives the overall amount of income in a system and divides it by the population to create the perfect proportion of distribution in the system. In a perfectly equal economy this would equate to income levels, and the deviance from this (on a percentile scale) is representative of the inequality in the system.

To simplify the information above, the basic concept behind measuring inequality is identifying an ideal and tracking any deviance from that ideal (which would be deemed the inequality of a given system). Minimizing this inequality is the sign of a mature and advanced society with high standards of living across the board, while substantial income gaps are indicative of a developing or struggling economy. Some powerful economies, like the United States and China, demonstrate high inequality despite high economic power while others, like Switzerland or Norway, demonstrate high equality despite lower economic output. This is a critical consideration in economic policy (from a political perspective). Minimizing inequality is a central step towards an advanced society.

17.1.3: Defining and Measuring Economic Mobility

Learning Objective

Distinguish between types of economic mobility

Key Points

• This concept of economic mobility is often considered in conjunction with “social mobility,” which is the capacity for an individual to change station within a society.
• Economic mobility can be perceived via a number of approaches, but is best summarized as inter-generational, intra-generational, absolute, or relative.
• Closely related to the concept of economic mobility is that of socio-economic mobility, referring to the ability to move vertically from one social or economic class to another. This is called “vertical” mobility.
• Economists studying economic mobility have identified a number of factors that play an integral role in enabling (or blocking) participants in an economic system from achieving mobility, such as gender, race and education.

Key Terms

glass ceiling

An unwritten, uncodified barrier to further promotion or progression for a member of a specific demographic group.

Economic mobility

The ability of an individual or family to improve their income, and social status, in an individual lifetime or between generations.

Economic mobility is a measurement of how capable a participant in a system can improve (or reduce) their economic status (generally measured in monetary income). This concept of economic mobility is often considered in conjunction with ‘social mobility’, which is the capacity for an individual to change station within a society.

Types of Economic Mobility

Economic mobility can be perceived via a number of approaches, but is best summarized in the following four:

• Intergenerational:Intergenerational mobility pertains to a person’s capacity to alter their station relative to the economic status of their parents or grandparents, essentially the flexibility within a society to allow individuals to grow regardless of their initial station. Contrary to concepts of mobility in America, 42% of individuals in born into the bottom income bracket remain there. An interesting chart, measuring intergenerational income elasticity, can be found in .
• Intragenerational:Intragenerational mobility is defined by an individual’s upwards and downwards movement throughout their lifetime (both relative to their working career and their peers). This type of mobility is shorter term than intergenerational in regards to the way in which it is confined to the lifetime of that individual specifically.
• Absolute:Similar to intergenerational mobility, absolute mobility looks at how widespread economic growth improves (or reduces) an individual or a family’s income over a generational time frame. Put simply, it answers the following question: How likely is a person to exceed their parents income at a given age?
• Relative:Relative mobility, as the name implies, measures the mobility and economic growth of a particular person within the context of the system in which they work.

Closely related to the concept of economic mobility is that of socioeconomic mobility, which refers to the ability to move vertically from one social or economic class to another. This is called “vertical” mobility, which overlaps substantially with the categories discussed above.

Economists studying economic mobility have identified a number of factors that play an integral role in enabling (or blocking) participants in an economic system from achieving mobility. Some of the more well-known issues include:

• Gender: Gender is quite often a limiting factor in economic mobility, with concepts like the “glass ceiling” underlining the difficulty encountered by women in achieving high-earning status. While women have made great strides in some countries, many global economies still struggle to incorporate women into the workplace with equity.
• Race/Ethnicity: In the United States in particular there is huge inequity between Caucasian workers and that of other backgrounds (African American, Hispanic, etc.). Approaching this social tie with income inequity has taken a great deal of political reform over the years, and has much left to accomplish in terms of enabling movement across economic levels.This could in many ways be coupled with immigration, or the concept of being different socially or ethnically from a group that has historically achieved high income levels.
• Education: Access to equitable and affordable education in all places worldwide is a substantial domestic and global challenge in enabling the next generation for success. Access to the best education is highly correlated with access to the best professional opportunities, and thus the expansion and funding of effective public education lies at the center of enabling economic mobility.

17.1.4: Measurement Problems

Learning Objective

Describe issues with measuring poverty and income inequality globally

Key Points

• The most popular measurement of income inequality is the Gini ratio, which leverages a simple scale of 0-1 to derive deviance from a given perfect equality point. The primary drawback to this approach is that it measures relative poverty (as opposed to absolute poverty).
• The poverty line is a useful absolute measurement, but suffers from having no global standard set (for comparative value), having limited nuance to measure deviations from the poverty line, and failing to incorporate intangible societal assets such as health care.
• One interesting risk in measuring poverty is the concept of voluntary poverty, or the active pursuit of living at the absolute bare minimum.
• Overall, while measuring inequality is a necessary and useful economic perspective, there are inherent statistical drawbacks in mathematically approaching complex societal issues.

Key Terms

Poverty line

The threshold of poverty, below which one’s income does not cover necessities.

Gini Index

A measure of income distribution.

As with any statistical modeling and measuring approach, there is a great deal of complexity to capture within a finite algorithmic structure, making the accuracy and efficacy of many poverty and inequality measurements less than ideal. Inequality, poverty and economic mobility in particular have a number of measurement challenges.

Gini Index

The most popular measurement of income inequality is the Gini index, which leverages a simple scale of 0-1 to derive deviance from a given perfect equality point. If a system demonstrates a Gini index of 0, the implication is that income differences among any individuals in the population will be essentially zero, while a measurement of 1 is complete income disparity. The primary drawback to this approach is that it measures relative poverty (as opposed to absolute poverty). This criticism spans across most poverty measurement systems (Thiel entropy, the 20:20 ratio, and the Palma ratio to name a few), and ultimately implies that much of what is measured as inequality does not take into account absolute gains.

For example, if an economy were to grow by 20% over 10 years, it is perfectly possible (and indeed quite likely) that the upper 20% will capture 50% gains while the bottom 20% will only capture 10% gains. That bottom 10% (assuming inflation has been accounted for) will be gaining wealth and purchasing power in absolute terms despite the fact that the Gini index will be much worse. The Gini index still has important implications about relative inequality in this circumstance, but it neglects to point out positive gains.

Criticisms of the Poverty Line

Taking into account the problems with the Gini ratio, a concept like the poverty line does an effective job in offsetting this variability. A poverty line is the determination of a specific income level in which it is considered the absolute minimum amount of capital required for an individual or family to live (and have all necessities) over the course of one year.

While there is great absolute value in utilizing a poverty line to determining the percentage of people still surviving on less than is considered the bare minimum, there are also drawbacks to this method as well. Looking at the , one can see that measuring the percentages of individuals under the poverty line from country to country demonstrates what appears to be a graphic for comparison. However, due to the fact that poverty lines are different in different countries (because there is no standard way in which to enforce setting and measuring the poverty line) it is not relative. As a result, there is high absolute value for each country but minimal comparative value between countries. Another prospective drawback of this method is that the poverty threshold only measures when an individual is above or below it, and not the extent to which each individual deviates. Finally, it is also important to consider less quantitative components that affect the standard of living (for example, education quality, roads, access to public transportation, access to healthcare, etc.), and thus country to country comparisons are somewhat reduced in value.

Voluntary Poverty

One interesting risk in measuring poverty is the concept of voluntary poverty, or the active pursuit of living at the absolute bare minimum. This is done as a result of lifestyle choice or religion, and is counted into poverty and inequality levels despite the fact that the individual being counted has actively pursued this place in society. While this is a somewhat unusual circumstance, it shifts the measurement of poverty in some regions (particularly those with a high population of certain beliefs or religions) higher than would be expected.

16.1: Introduction to Taxes

16.1.1: What Taxes Do

Learning Objective

Explain the role of taxation with respect to consumer and firm behavior

Key Points

• Taxes allow the government to perform and provide services that would not evolve naturally through a free market mechanism, for example, public parks.
• Taxes are the primary source of revenue for most governments.
• Governments also use taxes to establish income equity and modify consumption decisions.

Key Terms

sales tax

A local or state tax imposed as a percentage of the selling price of goods or services payable by the customer. The tax is not recognized as the seller’s earnings; the seller only collects the tax and transmits the same to local or state authorities.

income tax

A tax levied on earned and unearned income, net of allowed deductions.

progressive tax

A tax by which the rate increases as the taxable base amount increases.

regressive tax

A tax imposed in such a manner that the rate decreases as the amount subject to taxation increases.

Taxes are the primary source of revenue for most governments. They are simply defined as a charge or fee on income or commerce. Taxes are most readily understood from the perspective of income taxes or sales tax, although there are many other types of taxes levied on both individuals and firms.

Necessarily, taxes raise the price of purchasing the good or resource for firms and consumers. As a result, the quantity demanded and supplied reacts according to the supply and demand curves.

Tax Authority

In the United States, Congress has the power to tax as stated in The United States Constitution, Article 1, Section 8, Clause 1: “The Congress shall have the Power to lay and collect Taxes, Duties, Imposts, and Excises to pay the Debts and provide for the common Defense and general Welfare of the United States. ” This power was reinforced in the Sixteenth Amendment to the Constitution: “The Congress shall have the power to lay and collect taxes on income, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

It is important to note that Congress has delegated to the Internal Revenue Service (IRS) the responsibility of administering the tax laws, known as the Internal Revenue Code (the Code). Congress enacts these tax laws, and the IRS enforces them. Individual states also have the power to tax as do smaller government entities such as towns, cities, counties, and municipalities.

Purpose of Taxation

On a general level, tax collections provide a revenue source to support the outlays or primary activities of a government including but not limited to public buildings, military, national parks, and public welfare in the form of transfer payments. Taxes allow the government to perform and provide services that would not evolve naturally through a free market mechanism, for example, public parks. However, governments also use taxes to establish income equity and modify consumption decisions .

Sources of Tax Revenue: Income Taxation

Governments use different kinds of taxes and vary the tax rates. This is done to distribute the tax burden among individuals or classes of the population involved in taxable activities, such as business, or to redistribute resources between individuals or classes in the population. This type of taxation is referred to as progressive taxation because the tax liability increases in proportion to income.

Sources of Tax Revenue: Sales Taxes

Sales taxes are borne by the consumer when s/he purchases certain goods. It is an ad valorem tax: the charged value is based on the value of what is being sold. This is in contrast to an excise tax, where the charged value is based on the number of items being sold.

Sales tax is a form of regressive taxation; the liability is based on the percentage of income consumed, which is higher for low income earners. As a result, individuals earning a relatively lower income will pay a higher proportion of income in the form of sales tax, defining the regressive nature of the tax. Though a general revenue source, sales taxes are also used to modify behavior. For example taxes on cigarettes are meant to dissuade purchase due to the inherent health implications of smoking.

16.1.2: How Taxes Impact Efficiency: Deadweight Losses

Learning Objective

Discuss how taxes create deadweight loss

Key Points

• Causes of deadweight loss can include actions that prevent the market from achieving an equilibrium clearing condition and include taxes.
• Deadweight loss can generally be referenced as a loss of surplus to either the consumer, producer, or both.
• Harberger’s triangle refers to the deadweight loss associated with government intervention in a perfect market.

Key Terms

Pareto optimal

Describing a situation in which the profit of one party cannot be increased without reducing the profit of another.

deadweight loss

A loss of economic efficiency that can occur when an equilibrium is not Pareto optimal.

Deadweight Loss

In economics, a deadweight loss (also known as excess burden or allocative inefficiency) is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal (resource allocation where it is impossible to make any one individual better off without making at least one individual worse off). Causes of deadweight loss can include actions that prevent the market from achieving an equilibrium clearing condition (where supply and demand are equal) and include taxes or subsidies and binding price ceilings or floors (including minimum wages). Deadweight loss can generally be referenced as a loss of surplus to either the consumer, producer, or both.

Harberger’s Triangle, Taxes, and Deadweight Loss

Harberger’s triangle, generally attributed to Arnold Harberger, refers to the deadweight loss (as measured on a supply and demand graph) associated with government intervention in a perfect market . This can happen through price floors, caps, taxes, tariffs, or quotas. In the case of a tax on the supplier of a good, the supply curve will shift inward in proportion to the tax and resulting in a non-market clearing level of supply. As a result, the price of the good increases and the quantity available decreases .

The area represented by the Harberger’s triangle results from the intersection of the supply and demand curves above market equilibrium resulting in a reduction in consumer surplus and producer surplus relative to their value before the imposition of the tax. The loss of the surplus, not recouped by tax revenues, is deadweight loss.

Some economists have argued that these triangles do not have a huge impact on the economy, whereas others maintain that they can seriously affect long term economic trends by pivoting the trend downwards, causing a magnification of losses in the long run.

15.1: Sources of Inefficiency

15.1.1: Asymmetric Information: Adverse Selection and Moral Hazard

Learning Objective

Examine the concept of adverse selection in the context of imperfect information

Key Points

• Adverse selection is a term used in economics that refers to a process in which undesired results occur when buyers and sellers have access to different/imperfect information, also known as asymmetric information.
• Asymmetric information causes an imbalance of power.
• A moral hazard is a situation where a party will take risks because the cost that could incur will not be felt by the party taking the risk.
• A lack of equal information causes economic imbalances that result in adverse selection and moral hazards. All of these economic weaknesses have the potential to lead to market failure.

Key Terms

adverse selection

The process by which the price and quantity of goods or services in a given market is altered due to one party having information that the other party cannot have at reasonable cost.

moral hazard

A situation where there is a tendency to take undue risks because the costs are not borne by the party taking the risk.

Asymmetric Information

Asymmetric information means that one party has more or better information than the other when making decisions and transactions. The imperfect information causes an imbalance of power. For example, when you are trying to negotiate your salary, you will not know the maximum your employer is willing to pay and your employer will not know the minimum you will be willing to accept.

Accurate information is essential for sound economic decisions. When a market experiences an imbalance it can lead to market failure.

Adverse Selection

Adverse selection is a term used in economics that refers to a process in which undesired results occur when buyers and sellers have access to different/imperfect information. The uneven knowledge causes the price and quantity of goods or services in a market to shift. This results in “bad” products or services being selected. For example, if a bank set one price for all of its checking account customers it runs the risk of being adversely affected by its low-balance and high activity customers. The individual price would generate a low profit for the bank.

Moral Hazards and Market Failure

In addition to adverse selection, moral hazards are also a result of asymmetric information. A moral hazard is a situation where a party will take risks because the cost that could incur will not be felt by the party taking the risk . A moral hazard can occur when the actions of one party may change to the detriment of another after a financial transaction. In relation to asymmetric information, moral hazard may occur if one party is insulated from risk and has more information about its actions and intentions than the party paying for the negative consequences of the risk. For example, moral hazards occur in employment relationships involving employees and management. When a firm cannot observe all of the actions of employees and managers there is the chance that careless and selfish decision making will occur.

Asymmetric information starts the downward economic spiral for a firm. A lack of equal information causes economic imbalances that result in adverse selection and moral hazards. All of these economic weaknesses have the potential to lead to market failure. A market failure is any scenario where an individual or firm’s pursuit of pure self interest leads to inefficient results.

15.1.2: Principle-Agent Problem

Learning Objective

Explain the Principal-Agent Problem

Key Points

• A business contract creates a straightforward connection between agent performance and profitability.
• In business relationships, the principal will use performance evaluations to ensure that the agent is fulfilling the necessary duties.
• Incentive structures are used in business relationship in order to bridge the gap between best interests of the principal and the agent.

Key Terms

subjective

Formed, as in opinions, based upon a person’s feelings or intuition, not upon observation or reasoning; coming more from within the observer than from observations of the external environment.

Objective

Agreed upon by all parties present (or nearly all); based on consensually observed facts.

incentive

Something that motivates, rouses, or encourages.

Principal-Agent Problem

In economics, the principal-agent problem (also known as an agency dilemma) exists when conflicts of interest arise between a principal and an agent in a business setting . Conflicts usually exist when contracts are written due to uncertainty and risk taken on by both parties. The principal hires the agent to perform specific to duties that represent its best interest. The work that is performed can be costly to the agent and not in the principal’s best interest. In short, the work done by the agent doesn’t actually reflect the best interests of the principal. Examples of relationships that can experience the principal-agent problem include:

• Management (agent) and shareholders (principal)
• Politicians (agent) and voters (principal)

The conflict of interest potentially arises in almost any context where one party is being paid by another to do something, whether it is in formal employment or a negotiated deal. The two parties have different interests and asymmetric information. The deviation of the agent from the principals interest is referred to as “agency costs. “

Contract Design

In order to minimize and control economic conflict, principals and agents design and agree on a contract. It serves as a guide and agreement to safeguard the best interests of both parties. The linear model is used to determine incentive compensation in a contract: w = a + b(e + x + gy).

In the linear model w is the wage, a is a constant, e is the unobserved effort, x is the unobserved exogenous effects on outcomes, and y is the observed exogenous effects; while g and a represent the weight given to y, and the base salary.

A business contract creates a straightforward connection between agent performance and profitability. This connection sets the standard for judging the performance of the agent.

Performance Evaluation

In business relationships, the principal will use performance evaluations to ensure that the agent is fulfilling the necessary duties. There are two forms of performance evaluation:

• objective performance evaluation – takes into account how fast a task can be completed. The evaluation compares the performance of an agent by comparing the work completed by peers within the industry.
• subjective performance evaluation – involves the principal directly evaluating the performance of the agent. In this case, the evaluation is based on opinions instead of observations or reasoning. .

Incentive Structures

Incentive structures are used in business relationship in order to bridge the gap between best interests of the principal and the agent.

Principals offer various incentive structures, which are rewards or motivating factors that drive the agent to work in the best interest of the principal and complete tasks efficiently. Incentive structures include price rates/commissions, profit sharing, and efficiency wages.

It is usually in best interest of both parties to work together. For the principal, agent inefficiency results in sub-optimal results and low welfare. For the agent, efficiency is important in order to receive payment for work completed.

15.1.3: Public Choice: Median Voters and Inefficient Voting Outcomes

Learning Objective

Use the Condorcet paradox to evaluate voting systems

Key Points

• A voting system is a method by which voters choose between multiple options, usually in an election or policy referendum.
• The Condorcet paradox is a voting paradox where collective preferences can be cyclical. It is a paradox because the wishes of the majority can conflict with one another.
• The Condorcet method of voting consists of any election method that elects candidate that would win by majority rule in all pairings against the other candidates.
• Most Condorcet voting methods consist of a single round of voting where individuals rank their top choices. In the event of a tie or unclear winner (Condorcet paradox) alternate methods of determining a winner are used including tie breakers, additional rounds of voting, ect.

Key Terms

paradox

A counter-intuitive conclusion or outcome.

public choice theory

The use of modern economic tools to study problems that traditionally are in the province of political science.

voting system

A system used to determine the result of an election based on voters’ preferences.

A voting system is a method by which voters choose between multiple options, usually in an election or policy referendum. The system enforces rules to ensure valid voting, accurate tabulation, and a final result. Common voting systems include majority rule, proportional representation, or plurality voting. The study of voting systems is called voting theory. Voting theory is a subfield of economics.

Public Choice Theory

No matter what voting system is used, the act of voting gives the public the ability to choose a candidate or influence a decision. Obviously, when voting takes place not everyone will agree with the outcome, but everyone has the ability to participate in the process. Public choice is described as “the use of economic tools to deal with traditional problems of political science. ” In microeconomics, public choice analyses collective decision making and studies economic models of political processes including rent-seeking, elections, legislatures, and voting behavior.

Since not every voter participates in an election, not every voter will have full information, and not every voter will vote based on what s/he perceives as the best long-term outcome, voting outcomes may be inefficient. Elections do not necessarily reflect the best long-term outcome, what the active voters thought was best given their criteria at the time.

Condorcet Paradox

The Condorcet paradox is a voting paradox where collective preferences can be cyclical. It is a paradox because the wishes of the majority can conflict with one another. Conflicting majorities are made up of different groups of individuals. For example, the Condorcet paradox can be compared to the game rock/paper/scissors. For each candidate, there can be another that is preferred by some majority. The Condorcet method of voting consists of any election method that elects candidate that would win by majority rule in all pairings against the other candidates. Most Condorcet voting methods consist of a single round of voting where individuals rank their top choices. In the event of a tie or unclear winner (Condorcet paradox) alternate methods of determining a winner are used including tie breakers, additional rounds of voting, etc.

An example of a voting paradox can be seen in a simple voting scenario. There are three candidates including 1, 2, and 3. There are three voters with preferences. Each voter ranks the candidates from most to least favored . If the results are determined and 3 is the winner, it can be argued that another candidate should have won due to the number of preferred votes verse the first choice of each voter. In this case, the requirement of majority rule does not provide a clear winner. According to the Condorcet paradox additional methods would be needed to determine the winner since the voting process is complex and each voter provides preferences instead of only selecting one candidate.

The Condorcet paradox means that there is not a clear winner and ambiguities must be resolved to determine the election results.

15.1.4: Behavioral Economics: Irrational Actions

Learning Objective

Paraphrase the history and characteristics of behavioral economics

Key Points

• Behavioral economics studies the consequences for market prices, returns, and resource allocation. It focuses on the bounds of rationality of economic agents.
• Behavioral economics analyzes behavioral finance, financial models, and the behavioral game theory in order to gain insight into why certain economic decisions are made.
• Three prevalent themes in behavioral economics are heuristics, framing, and market inefficiencies, though there are many more.
• Throughout its history, behavioral economics has analyzed psychology and economic findings to determine how and why economic decisions are made. Areas of focus included fairness, justice, and utility.

Key Terms

behavioral economics

Study of the effects of social, cognitive, and emotional factors on the economic decisions of individuals and institutions and the consequences for market prices, returns, and resource allocation.

heuristic

Relating to general strategies or methods for solving problems.

Behavioral economics is the study of the effects of social, cognitive, and emotional factors on the economic decisions of individuals and institutions. It also studies the consequences for market prices, returns, and resource allocation. Behavioral economics focuses on the bounds of rationality of economic agents.

Characteristics

Behavioral economics has specific characteristics based on what is studied. Areas of focus include:

• Behavioral finance: the intent is to explain why market participants make systematic errors. Errors impact prices and returns which the create market inefficiencies. It also looks at how other participants take advantage of market inefficiencies.
• Financial models: some financial models used in money management incorporate behavioral financial parameters. Examples of areas studied include overreaction and irrational purchasing habits.
• Behavioral game theory: analyzes interactive strategic decisions and behavior using the methods of game theory, experimental economics, and experimental psychology. Studies interactive learning, social preferences, altruism, framing, and fairness.

There are many aspects in behavioral economics, and three of the most prevalent are:

• Heuristics: people make decisions based on approximate rules and not strict logic.
• Framing: using a collection of anecdotes and stereotypes that make up the mental and emotional filters that individuals rely on the understand and respond to events.
• Market inefficiencies: include the study non-rational decision making and incorrect pricing.

Behavioral economics focuses on the study of how and why individuals and institutions make economic decisions .

History

Behavioral economics was born out of the combination of economics and psychology. By 1979, economists used cognitive psychology to explain economic decision making, which included an editing stage and an evaluation stage. The editing stage simplified risky situations using heuristics of choice. The evaluation stage evaluated risky alternatives through the study of dependence, loss aversion, non-linear probability weighting, and sensitivity to gains and losses. Throughout its history, behavioral economics has studied the economic choices of individuals and institutions by analyzing psychology against economic research. The study of behavioral economics shows both the strengths and weaknesses in decision making tendencies and how the decisions impact economic choices.

15.1.5: Government Failure

Learning Objective

Analyze situations in which the government has failed to act in an economically optimal way

Key Points

• Government failure, also known as non-market failure, is the public sector version of market failure.
• Government failures can occur in relation to both supply and demand within a market.
• Economic crowding out occurs when the government expands its borrowing to pay for increased expenditure or tax cuts. The expanded borrowing is in excess of its revenue.
• Inefficient government regulation contributes to market and government failure.

Key Terms

expenditure

Act of expending or paying out.

arbitrage

Taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance; the profit made between price differences.

Government Failure

Government failure, also known as non-market failure, is the public sector version of market failure . The market fails and government intervention causes a more inefficient allocation of goods and resources than would occur without the intervention. It occurs when the market inadequacies are not compared and analyzed against possible interventions before action is taken. Government failure can be described as providing “only limited help in prescribing therapies for government success. “

A government failure is not the failure of the government to enact a solution to a failure, but rather it is a systematic problem that prevents an efficient government solution to the problem. Government failures can occur in relation to both supply and demand within a market. Demand failures are the result of preference/revelation problems and the imbalance of voting and collective behavior. Supply failures are usually the result of principal-agent problems. In this case, the failure occurs in trying to get one party (agent) to work in the best interest of another party (principal).

Economic Crowding Out

There are specific scenarios that are directly associated with government failure. Economic crowding out occurs when the government expands its borrowing to pay for increased expenditure or tax cuts. The expanded borrowing is in excess of its revenue which crowds out private sector investment due to higher interest rates. Government spending also crowds out private spending.

Government Regulation

When analyzing government failure, inefficient regulation contributes to market failure. The are three specific regulatory inefficiencies:

• Regulatory arbitrage occurs when a regulated institution takes advantage of the difference between its real risk and the regulatory position.
• Regulatory capture occurs when regulatory agencies co-opt whether its the members or the entire regulated industry. Mechanisms that allows regulatory capture include rent seeking and rational ignorance.
• Regulatory risk is a risk faced by private sector firms when there is a chance that regulatory changes will negatively affect their business.

Recent evidence has suggested that even when democracies are economically stable, transparency, media freedom, and a larger government all contribute to increased government corruption. Government corruption leads to both market and government failure.

14.1: Demand for Labor

14.1.1: Marginal Product of Labor (Physical)

Learning Objective

Define the marginal product of labor

Key Points

• The marginal product of labor is not always equivalent to the output directly produced by that added unit of labor.
• When production is discrete, we can define the marginal product of labor (MPL) as ΔY/ΔL.
• When production is continuous, the MPL is the first derivative of the production function in terms of L.
• Graphically, the MPL is the slope of the production function.
• The law of diminishing marginal returns ensures that in most industries, the MPL will eventually be decreasing.

Key Terms

returns to scale

A term referring to changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor).

marginal product

The extra output that can be produced by using one more unit of the input.

In economics, the marginal product of labor (MPL) is the change in output that results from employing an added unit of labor. This is not always equivalent to the output directly produced by that added unit of labor; for example, employing an additional cook at a restaurant may make the other cooks more efficient by allowing more specialization of tasks, creating a marginal product that is greater than that produced directly by the new employee. Conversely, hiring an additional worker onto an already crowded factory floor may make the other employees less productive, leading to a marginal product that is lower than the work done by the additional employee.

When production is discrete, we can define the marginal product of labor as ΔY/ΔL where Y is output. If a factory that is initially producing 100 widgets hires another employee and is then able to produce 106 widgets, the MPL is simply six. When production is continuous, the MPL is the first derivative of the production function in terms of L. Graphically, the MPL is the slope of the production function.

gives another example of marginal product of labor. The second column shows total production with different quantities of labor, while the third column shows the increase (or decrease) as labor is added to the production process.

The law of diminishing marginal returns ensures that in most industries, the MPL will eventually be decreasing. The law states that “as units of one input are added (with all other inputs held constant) a point will be reached where the resulting additions to output will begin to decrease; that is marginal product will decline. ” The law of diminishing marginal returns applies regardless of whether the production function exhibits increasing, decreasing or constant returns to scale. The key factor is that the variable input is being changed while all other factors of production are being held constant. Under such circumstances diminishing marginal returns are inevitable at some level of production.

14.1.2: Marginal Product of Labor (Revenue)

Learning Objective

Define the marginal product of labor under the marginal revenue productivity theory of wages

Key Points

• The marginal revenue product of a worker is equal to the product of the marginal product of labor (MP:) and the marginal revenue (MR) of output.
• The marginal revenue productivity theory states that a profit maximizing firm will hire workers up to the point where the marginal revenue product is equal to the wage rate.
• The change in output from hiring one more employee is not limited to that directly attributable to the additional worker.

Key Terms

diminishing marginal returns

The decrease in the per-unit output of a production process as the amount of a single factor of production is increased.

marginal product

The extra output that can be produced by using one more unit of the input.

The marginal revenue product of labor (MRPL) is the change in revenue that results from employing an additional unit of labor, holding all other inputs constant. The marginal revenue product of a worker is equal to the product of the marginal product of labor (MPL) and the marginal revenue (MR) of output, given by MR×MP: = MRPL. This can be used to determine the optimal number of workers to employ at an exogenously determined market wage rate. Theory states that a profit maximizing firm will hire workers up to the point where the marginal revenue product is equal to the wage rate, because it is not efficient for a firm to pay its workers more than it will earn in revenues from their labor.

For example, if a firm can sell t-shirts for $10 each and the wage rate is $20/hour, the firm will continue to hire workers until the marginal product of an additional hour of work is two t-shirts. If the MPL is three t-shirts the first will hire more workers until the MPL reaches two; if the MPL is one t-shirt then the firm will remove workers until the MPL reaches two.

Let TR=Total Revenue; L=Labor; Q=Quantity. Mathematically:

• MRPL= ∆TR/∆L
• MR = ∆TR/∆Q
• MPL = ∆Q/∆L
• MR x MPL = (∆TR/∆Q) x (∆Q/∆L) = ∆TR/∆L

Note that the change in output is not limited to that directly attributable to the additional worker. Assuming that the firm is operating with diminishing marginal returns then the addition of an extra worker reduces the average productivity of every other worker (and every other worker affects the marginal productivity of the additional worker) – in other words, everybody is getting in each other’s way.

Because the MRPL is equal to the marginal product of labor times the price of output, any variable that affects either MPL or price will affect the MRPL. For example, changes in technology or the quantity of other inputs will change the marginal product of labor, and changes in the product demand or changes in the price of complements or substitutes will affect the price of output. These will all cause shifts in the MRPL.

14.1.3: Deriving the Labor Demand Curve

Learning Objective

Explain how a company uses marginal revenue product in hiring decisions

Key Points

• The marginal revenue product of labor (MRPL) is the additional amount of revenue a firm can generate by hiring one additional employee. It is found by multiplying the marginal product of labor by the price of output.
• Firms will demand labor until the MRPL equals the wage rate.
• The demand curve for labor can be shifted by shifted by changes in the productivity of labor, the relative price of labor, or the price of the output.
• It will also change as a result of a change in technology, a change in the price of the good being produced, or a change in the number of firms hiring the labor.

Key Terms

marginal revenue product

The change in total revenue earned by a firm that results from employing one more unit of labor.

factor of production

A resource employed to produce goods and services, such as labor, land, and capital.

Firms demand labor and an input to production. The cost of labor to a firm is called the wage rate. This can be thought of as the firm’s marginal cost. The additional revenue generated by hiring one more unit of labor is the marginal revenue product of labor (MRPL). This can be thought of as the marginal benefit.

The marginal revenue product of labor (MRPL) is the additional amount of revenue a firm can generate by hiring one additional employee. It is found by multiplying the marginal product of labor (MPL) – the amount of additional output one additional worker can generate – by the price of output. If an employee of a customer support call center can take eight calls an hour (the MPL) and each call earns the company $3, then the MRPL is $24.

We can use the MRPL curve to determine the quantity of labor a company will hire. Suppose workers are available at an hourly rate of $10. The amount a factor adds to a firm’s total cost per period is the marginal cost of that factor, so in this case the marginal cost of labor is $10. Firms maximize profit when marginal costs equal marginal revenues, and in the labor market this means that firms will hire more employees until the wage rate (marginal cost of labor) equals the MRPL. At a price of $10, the company will hire workers until the last worker hired gives a marginal revenue product of $10 .

Thus, the downward-sloping portion of the marginal revenue product curve shows the number of employees a company will hire at each price (wage), so we can interpret this part of the curve as the firm’s demand for labor. As with other demand curves, the market demand curve for labor is the sum of all firm’s individual demand curves.

Shifting the Demand for Labor

There are three main reasons why the demand curve for labor may shift:

1. Changes to the marginal productivity of labor: Technology, for instance, may increase the marginal productivity of labor, shifting the demand curve to the right. For example, computer technology has increased the productivity (marginal product) of many types of workers. This has led to an increase in the marginal revenue product of labor for these jobs, shifting firms’ demand for labor to the right. This both increases the number of employed workers and increases the wage rate.
2. The prices of other factors of production: The change in the relative price of labor will increase or decrease demand for labor. For example, is capital becomes more expensive relative to labor, the demand for labor will increase as firms seek to substitute labor for capital.
3. The price of the firm’s output: Since the price of the output is a component of MRPL, changes will shift the demand curve for labor. If the price that a firm can charge for its output increases, for example, the MRPL will increase. This is reflected in an outward shift of the demand for labor.

13.1: Prerequisites of Oligopoly

13.1.1: Few Sellers

Learning Objective

Explain how increasing returns to scale will cause a higher prevalence of oligopolies

Key Points

• The existence of oligopoly requires that a few firms are able to gain significant market power, preventing other, smaller competitors from entering the market.
• Increasing returns to scale is a term that describes an industry in which the rate of increase in output is higher than the rate of increase in inputs. In other words, doubling the number of inputs will more than double the amount of output.
• Monopolies and oligopolies often form when an industry has increasing returns to scale at relatively high output levels.

Key Terms

oligopoly

An economic condition in which a small number of sellers exert control over the market of a commodity.

returns to scale

A term referring to changes in output resulting from a proportional change in all inputs (where all inputs increase by a constant factor).

Oligopoly Structure

In an oligopoly market structure, a few large firms dominate the market, and each firm recognizes that every time it takes an action it will provoke a response among the other firms. These actions, in turn, will affect the original firm. Each firm, therefore, recognizes that it is interdependent with the other firms in the industry. This interdependence is unique to the oligopoly market structure; in perfect and monopolistic competition, we assume that each firm is small enough that the rest of the market will ignore its actions.

Increasing Returns to Scale

The existence of oligopoly requires that a few firms are able to gain significant market power, preventing other, smaller competitors from entering the market. One source of this power is increasing returns to scale. Increasing returns to scale is a term that describes an industry in which the rate of increase in output is higher than the rate of increase in inputs. In other words, doubling the number of inputs will more than double the amount of output. Increasing returns to scale implies that larger firms will face lower average costs than smaller firms because they are able to take advantage of added efficiency at higher levels of production.

Types of Returns to Scale

Most industries exhibit different types of returns to scale in different ranges of output. Typically in competitive markets, there could be increasing returns at relatively low output levels, decreasing returns at relatively high output levels, and constant returns at one output level between those ranges. Monopolies and oligopolies, however, often form when an industry has increasing returns to scale at relatively high output levels. When a few large firms already exist in this type of market, any new competitor will be smaller and therefore have higher average costs of production. This will make it difficult to compete with the already-established firms. Therefore, the oligopoly firms have a built-in defense against new competition.

Take the example of the cell phone industry in the United States. As of the fourth quarter of 2008, Verizon, AT&T, Sprint, and T-Mobile together controlled 89% of the U.S. cell phone market. The cell phone industry has increasing returns to scale: the cost of providing cellular access to 100,000 people is more than half the cost of providing cellular access to 200,000 people. Any new entrant into the cell phone market will either need to pay one of the larger companies for access to its already-existing network, or try to build a network from scratch. Both options result in higher costs, higher prices, and difficulty in competing with the major networks .

13.1.2: Product Differentiation

Learning Objective

Explain the relationship between product differentiation and the existence of an oligopoly

Key Points

• Product differentiation is the process of distinguishing a product or service from others, to make it more attractive to a particular target market.
• The objective of differentiation is to develop a position that potential customers see as unique. This primarily affects performance through reducing competition.
• Many oligopolies make differentiated products: cigarettes, automobiles, computers, ready-to-eat breakfast cereal, and soft drinks.
• Although product differentiation is not required for an oligopoly to form, if a firm can successfully differentiate its products it will gain market power and resist competition more easily.

Key Term

product differentiation

Perceived differences between the product of one firm and that of its rivals so that some customers value it more.

Product differentiation (or simply differentiation) is the process of distinguishing a product or service from others, to make it more attractive to a particular target market. This involves differentiating it from competitors’ products as well as a firm’s own products. In economics, successful product differentiation is inconsistent with the conditions for perfect competition, which include the requirement that the products of competing firms should be perfect substitutes.

Differentiation is due to buyers perceiving a difference; hence, causes of differentiation may be functional aspects of the product or service, how it is distributed and marketed, or who buys it. The major sources of product differentiation are as follows:

• Differences in quality which are usually accompanied by differences in price
• Differences in functional features or design
• Ignorance on the part of buyers regarding the essential characteristics and qualities of goods they are purchasing
• Sales promotion activities of sellers and, in particular, advertising
• Differences in availability (e.g. timing and location).

The objective of differentiation is to develop a position that potential customers see as unique. This primarily affects performance through reducing competition: As the product becomes more differentiated, categorization becomes more difficult and hence draws fewer comparisons with its competition. A successful product differentiation strategy will move a product from competing based primarily on price to competing on non-price factors (such as product characteristics, distribution strategy, or promotional variables).

Product Differentiation and Oligopolies

While some oligopoly industries make standardized products – tools, copper, and steep pipes, for example – others make differentiated products: cars, cigarettes, soda, and cell phone manufacturers. Product differentiation is not necessary for the existence of an oligopoly, but if a firm can successfully engage in product differentiation it can more easily gain market power and dominate at least part of the industry.

For example, the soft drink industry in the US is an oligopoly dominated by the Coca-Cola Company, the Dr. Pepper Snapple Group, and PepsiCo. These companies are able to differentiate their products (e.g. by taste), and are therefore able to gain market power .

13.1.3: Entry Barriers

Learning Objective

Explain the necessity of entry barriers for the existence of an oligopoly

Key Points

• Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices.
• The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy new entrants.
• In industrialized economies, barriers to entry have resulted in oligopolies forming in many sectors, with unprecedented levels of competition fueled by increasing globalization.

Key Terms

incumbent

A firm that is an established player in the market.

research and development

The process of discovering and creating new knowledge about scientific and technological topics in order to develop new products

patent

A declaration issued by a government agency declaring someone the inventor of a new invention and having the privilege of stopping others from making, using, or selling the claimed invention.

One important source of oligopoly power is barriers to entry. Barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry—such as government regulation and patents, or a large, established firm taking advantage of economies of scale—or those an individual faces in trying to gain entrance to a profession—such as education or licensing requirements. Because barriers to entry protect incumbent firms and restrict competition in a market, they can contribute to distortionary prices.

The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy new entrants. For example, microprocessing companies face high research and development costs before possibly making a profit. This means that new firms cannot enter the market whenever existing firms are making a positive economic profit, as is the case in perfect competition. Pharmaceutical manufacturers are one type of company that generally rely on patents, which makes competition irrelevant for a period of time after development: competitors can’t legally begin manufacturing the product until the patent expires.

Additional sources of barriers to entry often result from government regulation favoring existing firms. For example, requirements for licenses and permits may raise the investment needed to enter a market, creating an effective barrier to entry.

In industrialized economies, barriers to entry have resulted in oligopolies forming in many sectors, with unprecedented levels of competition fueled by increasing globalization. For example, there are now only a small number of manufacturers of civil passenger aircraft. Oligopolies have also formed in heavily-regulated markets such as wireless communications: in some areas only two or three providers are licensed to operate .

13.1.4: Price Leadership

Learning Objective

Define price leadership within the context of an oligopoly

Key Points

• Oligopolies are defined by one firm’s interdependence on other firms within the industry. When one firm changes its price or level of output, other firms are directly affected.
• When firms collude, they use restrictive trade practices to voluntarily lower output and raise prices in much the same way as a monopoly, splitting the higher profits that result.
• An alternative to overt collusion is tacit collusion, an unwritten, unspoken understanding through which firms agree to limit their competition.
• One strategy is to follow the price leadership of a particular firm, raising or lowering prices when the leader makes such a change. The price leader may be the largest firm in the industry, or it may be a firm that has been particularly good at assessing changes in demand or cost.

Key Terms

Price leadership

The action taken by a leader in an oligopolistic industry to determine prices for the entire industry.

collude

To act in concert with; to conspire.

Cartel

A group of businesses or nations that collude explicitly to limit competition within an industry or market.

Oligopoly

Oligopolies are defined by one firm’s interdependence on other firms within the industry. When one firm changes its price or level of output, other firms are directly affected. Unlike perfect competition and monopoly, uncertainty about how rival firms interact makes the specification of a single model of oligopoly impossible. Economists often simplify firm behavior into two strategies: firm can compete, in which case the market outcome will resemble that in perfect competition; or they can collude, in which case the market outcome will more closely resemble monopoly. When firms collude, they use restrictive trade practices to voluntarily lower output and raise prices in much the same way as a monopoly, splitting the higher profits that result.

Price Leadership

Firms can collude explicitly, as in the case of cartels, but this type of behavior is illegal in many parts of the world. An alternative to overt collusion is tacit collusion, in which firms have an unspoken understanding that limits their competition. One way in which firms achieve this is price leadership, in which one firm serves as an industry leader and sets prices, while other firms raise and lower their prices to match. For example, the steel, cars, and breakfast cereals industries have all been accused of engaging in tacit collusion..

Tacit collusion can be difficult to identify. The fact that a price change by one firm is follwed by similar price changes among other firms doesn’t necessarily mean that tacit collusion exists. After all, in a perfectly competitive industry, economists expect prices to move together because all firms face similar changes in demand and the cost of inputs.

For example, imagine that a town has three gas stations. Without any way to communicate, all three will lower their prices in an attempt to capture the entire market, stopping only when marginal cost equals marginal revenue. If the firms could cooperate, however, they would be better off if all set the price of gas at $0.20 above marginal cost. Each would have slightly lower sales but would have much higher revenue. Although explicit communication about prices is illegal, the firms might tacitly agree that whenever one station raises its prices, the other two will follow suit. In this way, all three can receive the benefits of oligopoly . The gas station that first raises its prices, and that the other two follow, is called the price leader.

12.1: Monopolistic Competition

12.1.1: Defining Monopolistic Competition

Learning Objective

Evaluate the characteristics and outcomes of markets with imperfect competition

Key Points

• Monopolistic competition is different from a monopoly. A monopoly exists when a person or entity is the exclusive supplier of a good or service in a market.
• Markets that have monopolistic competition are inefficient for two reasons. First, at its optimum output the firm charges a price that exceeds marginal costs. The second source of inefficiency is the fact that these firms operate with excess capacity.
• Monopolistic competitive markets have highly differentiated products; have many firms providing the good or service; firms can freely enter and exits in the long-run; firms can make decisions independently; there is some degree of market power; and buyers and sellers have imperfect information.

Key Terms

monopoly

A market where one company is the sole supplier.

Monopolistic competition

A type of imperfect competition such that one or two producers sell products that are differentiated from one another as goods but not perfect substitutes (such as from branding, quality, or location).

Monopolistic Competition

Monopolistic competition is a type of imperfect competition such that many producers sell products that are differentiated from one another as goods but not perfect substitutes (such as from branding, quality, or location). In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms.

Unlike in perfect competition, firms that are monopolistically competitive maintain spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities .

Monopolistic competition is different from a monopoly. A monopoly exists when a person or entity is the exclusive supplier of a good or service in a market. The demand is inelastic and the market is inefficient.

Monopolistic competitive markets:

• have products that are highly differentiated, meaning that there is a perception that the goods are different for reasons other than price;
• have many firms providing the good or service;
• firms can freely enter and exits in the long-run;
• firms can make decisions independently;
• there is some degree of market power, meaning producers have some control over price; and
• buyers and sellers have imperfect information.

Sources of Market Inefficiency

Markets that have monopolistic competition are inefficient for two reasons. The first source of inefficiency is due to the fact that at its optimum output, the firm charges a price that exceeds marginal costs. The monopolistic competitive firm maximizes profits where marginal revenue equals marginal cost. A monopolistic competitive firm’s demand curve is downward sloping, which means it will charge a price that exceeds marginal costs. The market power possessed by a monopolistic competitive firm means that at its profit maximizing level of production there will be a net loss of consumer and producer surplus.

The second source of inefficiency is the fact that these firms operate with excess capacity. The firm’s profit maximizing output is less than the output associated with minimum average cost. All firms, regardless of the type of market it operates in, will produce to a point where demand or price equals average cost. In a perfectly competitive market, this occurs where the perfectly elastic demand curve equals minimum average cost. In a monopolistic competitive market, the demand curve is downward sloping. In the long run, this leads to excess capacity.

12.1.2: Product Differentiation

Learning Objective

Define product differentiation

Key Points

• Differentiation occurs because buyers perceive a difference between products. Causes of differentiation include functional aspects of the product or service, how it is distributed and marketed, and who buys it.
• Differentiation affects performance primarily by reducing direct competition. As the product becomes more different, categorization becomes more difficult, and the product draws fewer comparisons with its competition.
• There are three types of product differentiation: simple, horizontal, and vertical.

Key Term

product differentiation

Perceived differences between the product of one firm and that of its rivals so that some customers value it more.

One of the defining traits of a monopolistically competitive market is that there is a significant amount of non-price competition. This means that product differentiation is key for any monopolistically competitive firm. Product differentiation is the process of distinguishing a product or service from others to make it more attractive to a target market .

Although research in a niche market may result in changing a product in order to improve differentiation, the changes themselves are not differentiation. Marketing or product differentiation is the process of describing the differences between products or services, or the resulting list of differences; differentiation is not the process of creating the differences between the products. Product differentiation is done in order to demonstrate the unique aspects of a firm’s product and to create a sense of value.

In economics, successful product differentiation is inconsistent with the conditions of perfect competition, which require products of competing firms to be perfect substitutes.

Consumers do not need to know everything about the product for differentiation to work. So long as the consumers perceive that there is a difference in the products, they do not need to know how or why one product might be of higher quality than another. For example, a generic brand of cereal might be exactly the same as a brand name in terms of quality. However, consumers might be willing to pay more for the brand name despite the fact that they cannot identify why the more expensive cereal is of higher “quality. “

There are three types of product differentiation:

• Simple: the products are differentiated based on a variety of characteristics;
• Horizontal: the products are differentiated based on a single characteristic, but consumers are not clear on which product is of higher quality; and
• Vertical: the products are differentiated based on a single characteristic and consumers are clear on which product is of higher quality.

Differentiation occurs because buyers perceive a difference. Drivers of differentiation include functional aspects of the product or service, how it is distributed and marketed, and who buys it. The major sources of product differentiation are as follows:

• Differences in quality, which are usually accompanied by differences in price;
• Differences in functional features or design;
• Ignorance of buyers regarding the essential characteristics and qualities of goods they are purchasing;
• Sales promotion activities of sellers, particularly advertising; and
• Differences in availability (e.g. timing and location).

The objective of differentiation is to develop a position that potential customers see as unique. Differentiation affects performance primarily by reducing direct competition. As the product becomes more different, categorization becomes more difficult, and the product draws fewer comparisons with its competition. A successful product differentiation strategy will move the product from competing on price to competing on non-price factors.

12.1.3: Demand Curve

Learning Objective

Explain how the shape of the demand curve affects the firms that exist in a market with monopolistic competition

Key Points

• The downward slope of a monopolistically competitive demand curve signifies that the firms in this industry have market power.
• Market power allows firms to increase their prices without losing all of their customers.
• The downward slope of the demand curve contributes to the inefficiency of the market, leading to a loss in consumer surplus, deadweight loss, and excess production capacity.

Key Terms

market power

The ability of a firm to profitably raise the market price of a good or service over marginal cost. A firm with total market power can raise prices without losing any customers to competitors.

elastic

Sensitive to changes in price.

The demand curve of a monopolistic competitive market slopes downward. This means that as price decreases, the quantity demanded for that good increases. While this appears to be relatively straightforward, the shape of the demand curve has several important implications for firms in a monopolistic competitive market.

Market Power

The demand curve for an individual firm is downward sloping in monopolistic competition, in contrast to perfect competition where the firm’s individual demand curve is perfectly elastic. This is due to the fact that firms have market power: they can raise prices without losing all of their customers. In this type of market, these firms have a limited ability to dictate the price of its products; a firm is a price setter not a price taker (at least to some degree). The source of the market power is that there are comparatively fewer competitors than in a competitive market, so businesses focus on product differentiation, or differences unrelated to price. By differentiating its products, firms in a monopolistically competitive market ensure that its products are imperfect substitutes for each other. As a result, a business that works on its branding can increase its prices without risking its consumer base.

Inefficiency in the Market

Monopolistically competitive firms maximize their profit when they produce at a level where its marginal costs equals its marginal revenues. Because the individual firm’s demand curve is downward sloping, reflecting market power, the price these firms will charge will exceed their marginal costs. Due to how products are priced in this market, consumer surplus decreases below the pareto optimal levels you would find in a perfectly competitive market, at least in the short run. As a result, the market will suffer deadweight loss. The suppliers in this market will also have excess production capacity.

12.1.4: Short Run Outcome of Monopolistic Competition

Learning Objective

Examine the concept of the short run and how it applies to firms in a monopolistic competition

Key Points

• The “short run” is the time period when one factor of production is fixed in terms of costs, while the other elements of production are variable.
• Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the short-run.
• Also like a monopoly, a monopolastic competitive firm will maximize its profits when its marginal revenues equals its marginal costs.

Key Term

short-run

The conceptual time period in which at least one factor of production is fixed in amount and others are variable in amount.

In terms of production and supply, the “short run” is the time period when one factor of production is fixed in terms of costs while the other elements of production are variable. The most common example of this is the production of a good that requires a factory. If demand spikes, in the short run you will only be able to produce the amount of good that the capacity of the factory allows. This is because it takes a significant amount of time to either build or acquire a new factory. If demand for the good plummets you can cut production in the factory, but will still have to pay the costs of maintaining the factory and the associated rent or debt associated with acquiring the factory. You could sell the factory, but again that would take a significant amount of time. The “short run” is defined by how long it would take to alter that “fixed” aspect of production.

In the short run, a monopolistically competitive market is inefficient. It does not achieve allocative nor productive efficiency. Also, since a monopolistic competitive firm has powers over the market that are similar to a monopoly, its profit maximizing level of production will result in a net loss of consumer and producer surplus, creating deadweight loss.

Setting a Price and Determining Profit

Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the short-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve. The profit the firm makes is the the amount of the good produced multiplied by the difference between the price minus the average cost of producing the good. .

Since monopolistically competitive firms have market power, they will produce less and charge more than a firm would under perfect competition. This causes deadweight loss for society, but, from the producer’s point of view, is desirable because it allows them to earn a profit and increase their producer surplus.

Because of the possibility of large profits in the short-run and relatively low barriers of entry in comparison to perfect markets, markets with monopolistic competition are very attractive to future entrants.

12.1.5: Long Run Outcome of Monopolistic Competition

Learning Objective

Explain the concept of the long run and how it applies to a firms in monopolistic competition

Key Points

• In terms of production and supply, the “long-run” is the time period when all aspects of production are variable and can therefore be adjusted to meet shifts in demand.
• Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the long-run.
• Like a monopoly, a monopolastic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs.
• In the long-run, the demand curve of a firm in a monopolistic competitive market will shift so that it is tangent to the firm’s average total cost curve. As a result, this will make it impossible for the firm to make economic profit; it will only be able to break even.

Key Term

long-run

The conceptual time period in which there are no fixed factors of production.

In terms of production and supply, the “long-run” is the time period when there is no factor that is fixed and all aspects of production are variable and can therefore be adjusted to meet shifts in demand. Given a long enough time period, a firm can take the following actions in response to shifts in demand:

• Enter an industry;
• Exit an industry;
• Increase its capacity to produce more; and
• Decrease its capacity to produce less.

In the long-run, a monopolistically competitive market is inefficient. It achieves neither allocative nor productive efficiency. Also, since a monopolistic competitive firm has power over the market that is similar to a monopoly, its profit maximizing level of production will result in a net loss of consumer and producer surplus.

Setting a Price and Determining Profit

Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the long-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve.

While a monopolistic competitive firm can make a profit in the short-run, the effect of its monopoly-like pricing will cause a decrease in demand in the long-run. This increases the need for firms to differentiate their products, leading to an increase in average total cost. The decrease in demand and increase in cost causes the long run average cost curve to become tangent to the demand curve at the good’s profit maximizing price. This means two things. First, that the firms in a monopolistic competitive market will produce a surplus in the long run. Second, the firm will only be able to break even in the long-run; it will not be able to earn an economic profit .

12.1.6: Monopolistic Competition Compared to Perfect Competition

Learning Objective

Differentiate between monopolistic competition and perfect competition

Key Points

• Perfectly competitive markets have no barriers of entry or exit. Monopolistically competitive markets have a few barriers of entry and exit.
• The two markets are similar in terms of elasticity of demand, a firm’s ability to make profits in the long-run, and how to determine a firm’s profit maximizing quantity condition.
• In a perfectly competitive market, all goods are substitutes. In a monopolistically competitive market, there is a high degree of product differentiation.

Key Term

perfect competition

A type of market with many consumers and producers, all of whom are price takers

Examples

• The classic example of a monopoly is De Beers, who at one point in the 1980s reputably owned 90% of all the diamond supply to major markets. This results in a high degree of price control, as a lack of competitive forces will enable De Beers to essentially set the going price for diamonds (granted the control their distribution).
• A good example of monopolistic competition, on the other hand, would be the Some modern day apps in the app store (this is NOT to say the app stores themselves, which are something of an oligopoly). There are thousands upon thousands of apps, some are free, some are paid, and some have free versions with microtransactions. The key is that demand is highly elastic, and supply is nearly infinite, allowing consumers a great deal of freedom in their purchasing decisions.

Perfect competition and monopolistic competition are two types of economic markets.

Similarities

One of the key similarities that perfectly competitive and monopolistically competitive markets share is elasticity of demand in the long-run. In both circumstances, the consumers are sensitive to price; if price goes up, demand for that product decreases. The two only differ in degree. Firm’s individual demand curves in perfectly competitive markets are perfectly elastic, which means that an incremental increase in price will cause demand for a product to vanish ). Demand curves in monopolistic competition are not perfectly elastic: due to the market power that firms have, they are able to raise prices without losing all of their customers.

Also, in both sets of circumstances the suppliers cannot make a profit in the long-run. Ultimately, firms in both markets will only be able to break even by selling their goods and services.

Both markets are composed of firms seeking to maximize their profits. In both of these markets, profit maximization occurs when a firm produces goods to such a level so that its marginal costs of production equals its marginal revenues.

Differences

One key difference between these two set of economic circumstances is efficiency. A perfectly competitive market is perfectly efficient. This means that the price is Pareto optimal, which means that any shift in the price would benefit one party at the expense of the other. The overall economic surplus, which is the sum of the producer and consumer surpluses, is maximized. The suppliers cannot influence the price of the good or service in question; the market dictates the price. The price of the good or service in a perfectly competitive market is equal to the marginal costs of manufacturing that good or service.

In a monopolistically competitive market the price is higher than the marginal cost of producing the good or service and the suppliers can influence the price, granting them market power. This decreases the consumer surplus, and by extension the market’s economic surplus, and creates deadweight loss.

Another key difference between the two is product differentiation. In a perfectly competitive market products are perfect substitutes for each other. But in monopolistically competitive markets the products are highly differentiated. In fact, firms work hard to emphasize the non-price related differences between their products and their competitors’.

A final difference involves barriers to entry and exit. Perfectly competitive markets have no barriers to entry and exit; a firm can freely enter or leave an industry based on its perception of the market’s profitability. In a monopolistic competitive market there are few barriers to entry and exit, but still more than in a perfectly competitive market.

12.1.7: Efficiency of Monopolistic Competition

Learning Objective

Discuss the effect monopolistic competition has on overall market efficiency

Key Points

• Because a good is always priced higher than its marginal cost, a monopolistically competitive market can never achieve productive or allocative efficiency.
• Suppliers in monopolistically competitive firms will produce below their capacity.
• Because monopolistic firms set prices higher than marginal costs, consumer surplus is significantly less than it would be in a perfectly competitive market. This leads to deadweight loss and an overall decrease in economic surplus.

Key Terms

producer surplus

The amount that producers benefit by selling at a market price that is higher than the lowest price at which they would be willing to sell.

consumer surplus

The difference between the maximum price a consumer is willing to pay and the actual price they do pay.

Monopolistically competitive markets are less efficient than perfectly competitive markets.

Producer and Consumer Surplus

In terms of economic efficiency, firms that are in monopolistically competitive markets behave similarly as monopolistic firms. Both types of firms’ profit maximizing production levels occur when their marginal revenues equals their marginal costs. This quantity is less than what would be produced in a perfectly competitive market. It also means that producers will supply goods below their manufacturing capacity.

Firms in a monopolistically competitive market are price setters, meaning they get to unilaterally charge whatever they want for their goods without being influenced by market forces. In these types of markets, the price that will maximize their profit is set where the profit maximizing production level falls on the demand curve.This price exceeds the firm’s marginal costs and is higher than what the firm would charge if the market was perfectly competitive. This means two things:

• Consumers will have to pay a higher price than they would in a perfectly competitive market, leading to a significant decline in consumer surplus; and
• Producers will sell less of their goods than they would have in a perfectly competitive market, which could offset their gains from charging a higher price and could result in a decline in producer surplus.

Regardless of whether there is a decline in producer surplus, the loss in consumer surplus due to monopolistic competition guarantees deadweight loss and an overall loss in economic surplus .

Productive and Allocative Efficiency

Productive efficiency occurs when a market is using all of its resources efficiently. This occurs when a product’s price is set at its marginal cost, which also equals the product’s average total cost. In a monopolistic competitive market, firms always set the price greater than their marginal costs, which means the market can never be productively efficient.

Allocative efficiency occurs when a good is produced at a level that maximizes social welfare. This occurs when a product’s price equals its marginal benefits, which is also equal to the product’s marginal costs. Again, since a good’s price in a monopolistic competitive market always exceeds its marginal cost, the market can never be allocatively efficient.

12.1.8: Advertising and Brand Management in Monopolistic Competition

Learning Objective

Evaluate whether advertising is beneficial or detrimental to consumers

Key Points

• A company’s brand can help promote quality in that company’s products.
• Advertising helps inform consumers about products, which decreases selection costs.
• Costs associated with advertising and branding include higher prices, customers mislead by false advertisements, and negative societal affects such as perpetuating stereotypes and spam.

Key Terms

brand

The reputation of an organization, a product, or a person among some segment of the population.

advertising

Communication with the purpose of influencing potential customers about products and services

One of the characteristics of a monopolistic competitive market is that each firm must differentiate its products. Two ways to do this is through advertising and cultivating a brand. Advertising is a form of communication meant to inform, educate, and influence potential customers about products and services. Advertising is generally used by businesses to cultivate a brand . A brand is a company’s reputation in relation to products or services sold under a specific name or logo.

Benefits of Advertising and Branding

The purpose of the brand is to generate an immediate positive reaction from consumers when they see a product or service being sold under a certain name in order to increase sales. A brand and the associated reputation are built on advertising and consumers’ past experiences with the products associated with that brand.

Reputation among consumers is important to a monopolistically competitive firm because it is arguably the best way to differentiate itself from its competitors. However, for that reputation to be maintained, the firm must ensure that the products associated with the brand name are of the highest quality. This standard of quality must be maintained at all times because it only takes one bad experience to ruin the value of the brand for a segment of consumers. Brands and advertising can thus help guarantee quality products for consumers and society at large.

Advertising is also valuable to society because it helps inform consumers. Markets work best when consumers are well informed, and advertising provides that information. Advertising and brands can help minimize the costs of choosing between different products because of consumers’ familiarity with the firms and their quality.

Finally, advertising allows new firms to enter into a market. Consumers might be hesitant to purchase products with which they are unfamiliar. Advertising can educate and inform those consumers, making them comfortable enough to give those products a try.

Costs of Advertising and Branding

There are some concerns about how advertising can harm consumers and society as well. Some believe that advertising and branding induces customers to spend more on products because of the name associated with them rather than because of rational factors. Further, there is no guarantee that advertisements accurately describe products; they can mislead consumers. Finally, advertising can have negative societal effects such as the perpetuation of negative stereotypes or the nuisance of “spam. “

11.1: Introduction to Monopoly

11.1.1: Defining Monopoly

Learning Objective

Differentiate monopolies and competitive markets

Key Points

• A monopoly market is characterized by the profit maximizer, price maker, high barriers to entry, single seller, and price discrimination.
• Monopoly characteristics include profit maximizer, price maker, high barriers to entry, single seller, and price discrimination.
• Sources of monopoly power include economies of scale, capital requirements, technological superiority, no substitute goods, control of natural resources, legal barriers, and deliberate actions.
• There are a few similarities between a monopoly and competitive market: the cost functions are the same, both minimize cost and maximize profit, the shutdown decisions are the same, and both are assumed to have perfectly competitive market factors.
• Differences between the two market structures including: marginal revenue and price, product differentiation, number of competitors, barriers to entry, elasticity of demand, excess profits, profit maximization, and the supply curve.
• The most significant distinction is that a monopoly has a downward sloping demand instead of the “perceived” perfectly elastic curve of the perfectly competitive market.

Key Terms

monopoly

A market where one company is the sole supplier.

differentiation

The act of distinguishing a product from the others in the market.

A monopoly is a specific type of economic market structure. A monopoly exists when a specific person or enterprise is the only supplier of a particular good. As a result, monopolies are characterized by a lack of competition within the market producing a good or service .

Characteristics of a Monopoly

A monopoly can be recognized by certain characteristics that set it aside from the other market structures:

• Profit maximizer: a monopoly maximizes profits. Due to the lack of competition a firm can charge a set price above what would be charged in a competitive market, thereby maximizing its revenue.
• Price maker: the monopoly decides the price of the good or product being sold. The price is set by determining the quantity in order to demand the price desired by the firm (maximizes revenue).
• High barriers to entry: other sellers are unable to enter the market of the monopoly.
• Single seller: in a monopoly one seller produces all of the output for a good or service. The entire market is served by a single firm. For practical purposes the firm is the same as the industry.
• Price discrimination: in a monopoly the firm can change the price and quantity of the good or service. In an elastic market the firm will sell a high quantity of the good if the price is less. If the price is high, the firm will sell a reduced quantity in an elastic market.

Sources of Monopoly Power

In a monopoly, specific sources generate the individual control of the market. Sources of power include:

• Economies of scale
• Capital requirements
• Technological superiority
• No substitute goods
• Control of natural resources
• Network externalities
• Legal barriers
• Deliberate actions

Monopoly vs. Competitive Market

Monopolies and competitive markets mark the extremes in regards to market structure. There are a few similarities between the two including: the cost functions are the same, both minimize cost and maximize profit, the shutdown decisions are the same, and both are assumed to have perfectly competitive market factors.

However, there are noticeable differences between the two market structures including: marginal revenue and price, product differentiation, number of competitors, barriers to entry, elasticity of demand, excess profits, profit maximization, and the supply curve. The most significant distinction is that a monopoly has a downward sloping demand instead of the “perceived” perfectly elastic curve of the perfectly competitive market.

10.1: Perfect Competition

10.1.1: Definition of Perfect Competition

Learning Objective

Describe degrees of competition in different market structures

Key Points

• The major types of market structure include monopoly, monopolistic competition, oligopoly, and perfect competition.
• Perfect competition is an industry structure in which there are many firms producing homogeneous products. None of the firms are large enough to influence the industry.
• The characteristics of a perfectly competitive market include insignificant contributions from the producers, homogenous products, perfect information about products, no transaction costs, and no long-term economic profits.
• In practice, very few industries can be described as perfectly competitive, though agriculture comes close.

Key Terms

oligopoly

An economic condition in which a small number of sellers exert control over the market of a commodity.

Monopolistic competition

A market structure in which there is a large number of firms, each having a small proportion of the market share and slightly differentiated products.

monopoly

A situation, by legal privilege or other agreement, in which solely one party (company, cartel etc. ) exclusively provides a particular product or service, dominating that market and generally exerting powerful control over it.

Market structure is determined by the number and size distribution of firms in a market, entry conditions, and the extent of product differentiation. The major types of market structure include the following:

• Monopoly: An industry structure where a single firm produces a product for which there are no close substitutes. Monopolists are price makers. Barriers to entry and exit exist, and, in order to ensure profits, a monopoly will attempt to maintain them.
• Monopolistic competition: A market structure in which there is a large number of firms, each having a small portion of the market share and slightly differentiated products. There are close substitutes for the product of any given firm, so competitors have slight control over price. There are relatively insignificant barriers to entry or exit, and success invites new competitors into the industry.
• Oligopoly: An industry structure in which there are a few firms producing products that range from slightly differentiated to highly differentiated. Each firm is large enough to influence the industry. Barriers to entry exist.
• Perfect competition: An industry structure in which there are many firms, none large enough to influence the industry, producing homogeneous products. Firms are price takers. There are no barriers to entry. Agriculture comes close to being perfectly competitive.

Perfect competition leads to the Pareto-efficient allocation of economic resources. Because of this it serves as a natural benchmark against which to contrast other market structures. However, in practice, very few industries can be described as perfectly competitive. Nevertheless, it is used because it provides important insights.

A perfectly competitive market has several important characteristics:

• All producers contribute insignificantly to the market. Their own production levels do not change the supply curve.
• All producers are price takers. They cannot influence the market. If a firm tries to raise its price consumers would buy from a competitor with a lower price instead.
• Products are homogeneous. The characteristics of a good or service do not vary between suppliers.
• Producers enter and exit the market freely.
• Both buyers and sellers have perfect information about the price, utility, quality, and production methods of products.
• There are no transaction costs. Buyers and sellers do not incur costs in making an exchange of goods in a perfectly competitive market.
• Producers earn zero economic profits in the long run.

10.1.2: Conditions of Perfect Competition

Learning Objective

Calculate total revenue, average revenue, and marginal revenue for a firm in a perfectly competitive market

Key Points

• A perfectly competitive market is characterized by many buyers and sellers, undifferentiated products, no transaction costs, no barriers to entry and exit, and perfect information about the price of a good.
• The total revenue for a firm in a perfectly competitive market is the product of price and quantity (TR = P * Q). The average revenue is calculated by dividing total revenue by quantity. Marginal revenue is calculated by dividing the change in total revenue by change in quantity.
• A firm in a competitive market tries to maximize profits. In the short-run, it is possible for a firm’s economic profits to be positive, negative, or zero. Economic profits will be zero in the long-run.
• In the short-run, if a firm has a negative economic profit, it should continue to operate if its price exceeds its average variable cost. It should shut down if its price is below its average variable cost.

Key Term

economic profit

The difference between the total revenue received by the firm from its sales and the total opportunity costs of all the resources used by the firm.

The concept of perfect competition applies when there are many producers and consumers in the market and no single company can influence the pricing. A perfectly competitive market has the following characteristics:

• There are many buyers and sellers in the market.
• Each company makes a similar product.
• Buyers and sellers have access to perfect information about price.
• There are no transaction costs.
• There are no barriers to entry into or exit from the market.

All goods in a perfectly competitive market are considered perfect substitutes, and the demand curve is perfectly elastic for each of the small, individual firms that participate in the market. These firms are price takers–if one firm tries to raise its price, there would be no demand for that firm’s product. Consumers would buy from another firm at a lower price instead.

Firm Revenues

A firm in a competitive market wants to maximize profits just like any other firm. The profit is the difference between a firm’s total revenue and its total cost. For a firm operating in a perfectly competitive market, the revenue is calculated as follows:

• Total Revenue = Price * Quantity
• AR (Average Revenue) = Total Revenue / Quantity
• MR (Marginal Revenue) = Change in Total Revenue / Change in Quantity

The average revenue (AR) is the amount of revenue a firm receives for each unit of output. The marginal revenue (MR) is the change in total revenue from an additional unit of output sold. For all firms in a competitive market, both AR and MR will be equal to the price.

Profit Maximization

In order to maximize profits in a perfectly competitive market, firms set marginal revenue equal to marginal cost (MR=MC). MR is the slope of the revenue curve, which is also equal to the demand curve (D) and price (P). In the short-term, it is possible for economic profits to be positive, zero, or negative . When price is greater than average total cost, the firm is making a profit. When price is less than average total cost, the firm is making a loss in the market.

Over the long-run, if firms in a perfectly competitive market are earning positive economic profits, more firms will enter the market, which will shift the supply curve to the right. As the supply curve shifts to the right, the equilibrium price will go down. As the price goes down, economic profits will decrease until they become zero.

When price is less than average total cost, firms are making a loss. Over the long-run, if firms in a perfectly competitive market are earning negative economic profits, more firms will leave the market, which will shift the supply curve left. As the supply curve shifts left, the price will go up. As the price goes up, economic profits will increase until they become zero.

In sum, in the long-run, companies that are engaged in a perfectly competitive market earn zero economic profits . The long-run equilibrium point for a perfectly competitive market occurs where the demand curve (price) intersects the marginal cost (MC) curve and the minimum point of the average cost (AC) curve.

10.1.3: The Demand Curve in Perfect Competition

Learning Objective

Describe the demand for goods in perfectly competitive markets

Key Points

• In a perfectly competitive market individual firms are price takers. The price is determined by the intersection of the market supply and demand curves.
• The demand curve for an individual firm is different from a market demand curve. The market demand curve slopes downward, while the firm’s demand curve is a horizontal line.
• The firm’s horizontal demand curve indicates a price elasticity of demand that is perfectly elastic.

Key Term

Perfectly elastic

Describes a situation when any increase in the price, no matter how small, will cause demand for a good to drop to zero.

In a perfectly competitive market the market demand curve is a downward sloping line, reflecting the fact that as the price of an ordinary good increases, the quantity demanded of that good decreases. Price is determined by the intersection of market demand and market supply; individual firms do not have any influence on the market price in perfect competition. Once the market price has been determined by market supply and demand forces, individual firms become price takers. Individual firms are forced to charge the equilibrium price of the market or consumers will purchase the product from the numerous other firms in the market charging a lower price (keep in mind the key conditions of perfect competition). The demand curve for an individual firm is thus equal to the equilibrium price of the market .

The demand curve for a firm in a perfectly competitive market varies significantly from that of the entire market.The market demand curve slopes downward, while the perfectly competitive firm’s demand curve is a horizontal line equal to the equilibrium price of the entire market. The horizontal demand curve indicates that the elasticity of demand for the good is perfectly elastic. This means that if any individual firm charged a price slightly above market price, it would not sell any products.

A strategy often used to increase market share is to offer a firm’s product at a lower price than the competitors. In a perfectly competitive market, firms cannot decrease their product price without making a negative profit. Instead, assuming that the firm is a profit-maximizer, it will sell its goods at the market price.