PSU IVY Fundamentals of Economics

Fundamentals of Economics
Brian T. Kench,Ph.D.
University of Tampa
Fifth Edition
Copyright 2011
Ivy Software
TABLE OF CONTENTS
TABLE OF CONTENTS
PAGE
Chapter One - Comparative Advantage and the Benefits of Trade..............1

Chapter Two - Demand & Supply..............................................................15
Chapter Three - The Costs of Production and Profit Maximization...........43
Chapter Four - Economic Performance Metrics.........................................60
Chapter Five - Money & Banking..............................................................75
Chapter Six - Aggregate Demand & Aggregate Supply.............................87
Glossary....................................................................................................102
Charts & Graphs.......................................................................................110
CHAPTER ONE
Comparative Advantage and the Benefits of Trade
Central to the globalization debate is the issue of the extent to which the United States
should compel the application of U.S. laws and regulatory standards to activities in
other countries. Most foreign governments resist these demands both because they are
intrusions on the sovereign policies the countries have adopted with regard to regulation,
and because to adopt American standards dramatically reduces a countrys comparative
advantage to the detriment of its workers hoping to improve their lives (emphasis added).
George L. Priest, Wall Street Journal, A10, 6/18/04
1. Introduction
The concepts of opportunity cost and comparative advantage are two of the most important
concepts in all of economics. The opportunity cost of any life activity is the cost of what you give
up to partake in that activity. For example, the opportunity cost of reading this book might be not
watching your childs baseball game. Among a comparison of individuals, businesses or countries,
the one who has the lowest opportunity cost of an activity has a comparative advantage in that
activity. Economists have long used these concepts to prove the mutual advantage of individuals,
businesses or countries specializing in things with which they have a comparative advantage and
trading for the rest. As the quote above reveals, these concepts are mechanisms that assist informed
and educated debates on current public policy.
The following key concepts will be covered in this chapter: the four factors of production,
opportunity cost, production possibilities frontier, increasing opportunity cost, absolute advantage
and comparative advantage.
2. Factors of Production
All the productive resources of the earth may be put in one of the following four categories:
land, labor, capital, and entrepreneurial ability. These four categories are collectively called the
factors of production. The factors of production encompass all the possible productive resources
used to produce goods and services. Moreover, the factors of production are all scarce economic
resources because they are limited in supply.
The category of land includes all the gifts of nature so called natural resources that are
used to produce goods and services. The category of labor includes work time and work effort
that people devote to producing goods and services. The category of capital includes all tools,
instruments, machines, buildings, and other constructions that have been produced in the past that
businesses now use to produce goods and services. Finally, the category of entrepreneurial ability
includes all human resources that organize the other factors of production. Entrepreneurs come up
with new ideas about what and how to produce, make business decisions, and bear the risks that
arise from these decisions.
Because the factors of production are limited in supply, they must be allocated among
members of human society. The price mechanism is one way, among several, that human society
chooses to allocate scarce resources.
The market price of each factor of production has been assigned a unique name by
economists. Rent is the unit price one pays for the use of land. Wage is the unit price one pays for
the services of labor. Interest is the unit price one pays for the use of capital. Profit is the income
earned (or lost) by an entrepreneur for running a business.
3. Opportunity Cost and the Production Possibilities Frontier
The most fundamental principle in economics is opportunity cost. The opportunity cost of
something is what you give up to get it. For example, you are currently using your time to earn a
graduate degree; your opportunity cost of getting a graduate degree is missing time with friends
and family. In this section, the principle of opportunity cost is demonstrated by a production
possibilities frontier. A production possibilities frontier is a model of an economy that shows how
much the economy can produce using all of its factors of production efficiently.
Figure 1-1
Production Possibilities Frontier
The economy in figure 1-1 produces only two goods: eggs and wine. The data in figure 1.1
are the industrial output from one week of work. Each of the following is illustrated in the figure:
If all the factors of production are employed to produce eggs, the economy is able to
produce 82 eggs in a week.
One the other hand, if all the factors of production are employed to produce wine, the
economy is able to produce 10 bottles of wine per week.
If all factors of production are fully and efficiently used, then the economy would be
operating somewhere on the production possibilities frontier.
Points A, B, C, D, E and F each represent bundles of goods that lie on the economys
production possibilities frontier.
When an economy does not fully use its factors of production, then it ends up at a location
inside the production possibilities frontier. If the economy ends up at the output bundle located
at point G, the economy has not fully and efficiently used its factors of production. Lastly, this
economy does not have enough factors of production to produce bundle H or any bundle beyond
its production possibilities frontier.
3.1 Example 1
Suppose the economy in figure 1-1 produces at point B 80 eggs and one bottle of wine.
If the economy chooses to move from point B to point C and produce another three bottles of
wine, it can now only produce 70 eggs. Therefore the opportunity cost of another three bottles of
wine equals 10 eggs (80 eggs 70 eggs). In other words, the economy is giving up the production
of 10 eggs in order to produce another three bottles of wine.
3.2 Example 2
If the economy in figure 1-1 chooses to move from point C to point D and produce
another three bottles of wine, it may now only produce 50 eggs. The opportunity cost of producing
another three bottles of wine is 20 eggs (70 eggs 50 eggs). Again, the economy is giving up the
production of 20 eggs in order to produce another three bottles of wine.
3.3 Example 3
Lastly, if the economy in figure 1-1 chooses to move from point D to point F and
produce another three bottles of wine, it has zero factors of production left for the production of
eggs and can produce zero eggs. The opportunity cost of producing another three bottles of wine
is 50 eggs (50 eggs 0 eggs).
3.4 Increasing Opportunity Cost
As we increase the production of wine at a constant increment (i.e., by three bottles), the
opportunity cost of wine production increases. This is known as the law of increasing opportunity
cost; it is reflected in the bowed-out shape of the production possibilities frontier in figure 1-1. As
more and more of an economys factors of production are employed in the production of wine, the
economy must sacrifice the production of eggs at an increasing rate.
Economic agents always start by using their best factors of production. Therefore, an
economy experiences increasing opportunity cost as they increase one goods production. In the
case of wine production, wine producers use their best fertilizer and their best machines to produce
the first bottles of wine. The factors of production that are well-suited for wine production happen
to be the worst factors of production for the production of eggs. Thus, the opportunity cost of the
first bottle of wine, in terms of eggs, is small. But as we increase our demand for bottles of wine,
the economy must substitute out factors of production that are better suited for egg production and
use them to produce wine. The sacrifice in terms of eggs increases as additional bottles of wine are
produced.
4. Absolute Advantage versus Comparative Advantage

To have an absolute advantage in something means that one has the lowest absolute
production cost relative to those with whom they are compared. To have a comparative advantage
in something means that one has the lowest opportunity cost relative to those with whom they are
compared.
David Ricardo first did the simple mathematics to demonstrate the concept of comparative
advantage and the mutual advantage of trade in his 1817 book, The Principles of Political Economy
and Taxation. Ricardos demonstration is one of the most important in all of economics and it is
used as the root explanation for why
one dines at a restaurant rather than cooking a meal at home;

one hires a landscaper to mow their lawn rather than mowing it for oneself;
Audi contracts with Bose Corporation to manufacture the sound system for its
automobiles rather than making the sound systems internally;
grocery stores in Boston, Massachusetts purchase oranges from Citrus Hills, Florida
rather than growing them in Boston; and
Sykes Corporation hires call centers in Bangalore, India, paying Indian employees
$2,100/year to answer consumer phone calls, rather than hiring employees in Tampa,
Florida for a much higher wage year.
To help you get a better grasp of Ricardos analysis consider the following two examples.
5. Example 1: Elizabeth and Kyle
5.1 Self-Sufficiency
A self-sufficient individual makes everything that he needs in life from the factors of
production with which he is endowed. Consider the following example in which Elizabeth and
Kyle each make wine and clothing: suppose that both Elizabeth and Kyle work a forty hour week
and both of them fully and efficiently use their endowed factors of production. Also assume that the
there is a constant opportunity cost between the production of a unit of wine and the production
of a unit of clothing. Because opportunity costs are constant and not increasing in this example,
the production possibilities frontiers are linear and not bowed outward. This is done to simplify
our discussion.
5.2 Elizabeths Production Possibilities Frontier

First consider Elizabeth. In forty hours, Elizabeth may produce 20 pieces of clothing or
160 bottles of wine or any other combination that lies between these extremes on her production
possibilities frontier (PPF) in figure 1-2. If Elizabeth chooses to spend twenty hours making clothing
and twenty hours making wine, then she would produce 10 pieces of clothing and 80 bottles of
wine. This bundle is located a point A in Elizabeths clothing and wine production possibilities
frontier for a forty-hour-work week.
Figure 1-2
Elizabeths Production Possibilities Frontier
Assume that Elizabeth fully and efficiently uses her factors of production. Therefore, she
will produce a bundle of wine and clothing that is on the production possibility frontier and will not
produce a bundle that is below the production possibilities frontier. Further, because she always
produces somewhere on the production possibilities frontier, we can use figure 1-2 to determine
Elizabeths opportunity cost of producing a bottle of wine and her opportunity cost of producing a
unit of clothing.
Suppose that Elizabeth produces 80 bottles of wine and 10 units of clothing, which is depicted
with point A. If Elizabeth changed her mind and decided that she wanted to produce 20 units
of clothing, how many bottles of wine could she produce? The answer is zero. Elizabeth needs
forty hours (all that she has) to produce 20 units of clothing, which leaves her no time to devote to
the production of bottles of wine in that week. The opportunity cost of making another 10 units of
clothing (from 10 units to 20 units) is 80 bottles of wine.
Using some simple math and the assumption of constant opportunity costs we can reduce and
figure out the opportunity cost of one unit of clothing. If 10 units of clothing have an opportunity
cost of 80 bottles of wine, then one unit of clothing has an opportunity cost of eight bottles of
wine for Elizabeth. By using algebra and solving for one bottle of wine, we can also prove that the
opportunity cost of one bottle of wine is one-eighth of a unit of clothing for Elizabeth.
In economic terms this means that if Elizabeth decides to produce one additional bottle of
wine, she will use up the factors of production that would have been used to produce one-eighth
of a unit of clothing. If she decides to produce one additional unit of clothing, she will use up the
factors of production that would have been used to produce eight bottles of wine.
5.3 Kyles Production Possibilities Frontier
Now consider Kyle. In forty hours, Kyle may produce 16 pieces of clothing and zero
bottles of wine, four bottles of wine and zero pieces of clothing, or any other combination that lies
between these extremes on his production possibilities frontier (PPF) in figure 1-3. If Kyle chooses
to spend twenty hours making clothing and twenty hours making wine, then he would produce eight
pieces of clothing and two bottles of wine. This bundle is located at point A in Kyles clothing
and wine production possibilities frontier for a forty-hour-work week.
Figure 1-3
Kyles Production Possibilities Frontier
Assume that Kyle fully and efficiently uses his factors of production. Therefore, he will
produce a bundle of wine and clothing that lies on the production possibility frontier, and will not
produce a bundle that is below the production possibilities frontier. Further, because he always
produces somewhere on the production possibilities frontier, we can use figure 1-3 to determine
Kyles opportunity cost of producing a bottle of wine and his opportunity cost of producing a unit
of clothing.
Suppose that Kyle produces two bottles of wine and eight units of clothing, which is depicted
at point A. If Kyle changes his mind and decides that he wants to produce 16 units of clothing,
how many bottles of wine could he produce? The answer is zero. Kyle needs forty hours (all that
he has) to produce 16 units of clothing, which leaves him with no time to make bottles of wine in
that week. The opportunity cost of making another eight units of clothing (from eight units to 16
units), is two bottles of wine.
Using some simple math and the assumption of constant opportunity costs, we can reduce and
figure out the opportunity cost of one unit of clothing. If eight units of clothing have an opportunity
cost of two bottles of wine, then one unit of clothing has an opportunity cost of one-fourth of a
bottle of wine for Kyle. By using algebra and solving for one bottle of wine, we can show that the
opportunity cost of one bottle of wine is four units of clothing for Kyle.
In economic terms this means that if he wants to produce one unit of clothing, he must
sacrifice the resources needed to produce one-fourth of a bottle of wine. And if Kyle wants to
produce one bottle of wine, then he must sacrifice the resources needed to produce four units of
clothing.
5.4 Absolute Advantage and Comparative Advantage
Does Elizabeth or Kyle have an absolute advantage in the production of wine? Elizabeth
can produce more wine over the course of forty hours relative to Kyle (160 bottles for Elizabeth
versus four bottles for Kyle). Therefore, Elizabeth has an absolute advantage in the production of
wine.
Does Elizabeth or Kyle have an absolute advantage in the production of clothing? Elizabeth
can produce more clothing over the course of forty hours relative to Kyle (20 units of clothing for
Elizabeth versus 16 units of clothing for Kyle). Therefore, Elizabeth has an absolute advantage in
the production of clothing, too.
Although it is clear that Elizabeth is better at producing wine and clothing relative to Kyle,
the concept of absolute advantage tells us nothing about whether or not Elizabeth or Kyle might
benefit from specializing in the production of one of the two goods and trading for the other. And
let us not be shy here, trading in this context is fully analogous to outsourcing in contemporary
business language. The concept that can help inform Elizabeth and Kyle about the benefits of trade
is the concept of comparative advantage.
The concept of comparative advantage states that when comparing producers, the one with
the lowest opportunity cost in the production of some good or service has a comparative advantage
in the production of that good or service. In our problem, who has a comparative advantage in the
production of a bottle of wine? Who has a comparative advantage in the production of clothing?
First, lets look at the production of wine. Elizabeths opportunity cost of producing one
bottle of wine is one-eighth of a unit of clothing and Kyles opportunity cost of producing one
bottle of wine was four units of clothing. Therefore, Elizabeth has a comparative advantage in the
production of wine because she has to give up less clothing (one-eighth of a unit versus four units
of clothing) to make one bottle of wine.
What about clothing? Elizabeths opportunity cost of producing one unit of clothing is eight
bottles of wine and Kyles opportunity cost of producing one unit of clothing is one-fourth of a
bottle of wine. Therefore, Kyle has a comparative advantage in the production of clothing because
he has to give up less wine (one-fourth of a bottle versus eight bottles of wine) to make one unit of
clothing.
5.5 Trade
An individual or a business should specialize in the production of a good or service in which
they have a comparative advantage. Below we will prove why this is always the correct thing to
do. In our current problem, we have discovered that Elizabeth has a comparative advantage in the
production of wine and Kyle has a comparative advantage in the production of clothing. With this
information, we may conclude that Elizabeth should specialize in the production of wine and trade
for clothing and Kyle should specialize in the production of clothing and trade for wine.
Suppose Elizabeth and Kyle sit down and negotiate the following trade. Elizabeth proposes
that she will produce all 160 bottles of wine and zero units of clothing and sell 32 bottles of wine
to Kyle in exchange for 8 units of clothing. Kyle, who decides to produce 16 units of clothing and
zero bottles of wine, agrees to accept the proposed trade.
Do both Elizabeth and Kyle benefit from this proposed trade? The answer is unambiguously:
yes. In figure 1-4 bundle B illustrates the bundle that Elizabeth ends up with after the trade with
Kyle. This demonstrates that Elizabeth is better off as a result of trading with Kyle because she is
beyond her self-sufficient production possibilities frontier. That is to say, without trading, Elizabeth
could not have bundle B, and this is the proof that we have been searching for. Elizabeth clearly
benefits from specializing in wine and trading with Kyle for units of clothing.
Figure 1-4
Elizabeths After Trade PPF
In figure 1-5 bundle B illustrates the bundle that Kyle ends up with after the trade with
Elizabeth. This demonstrates that Kyle is better off as a result of trading with Elizabeth because he
is beyond his self-sufficient production possibilities frontier. That is to say, without trading, Kyle
could not have bundle B. That, again, is proof that Kyle benefits from specializing in clothing
and trading with Elizabeth for bottles of wine.
Figure 1-5
Kyles After Trade PPF
5.6 The Range of Possible Trading Terms

Both Elizabeth and Kyle become better off when Elizabeth sells Kyle 32 bottles of wine in
exchange for eight units of clothing. Can we figure out all the transactions between Elizabeth and
Kyle that would make them better off? Again, the answer is yes.
The terms of the trade discussed above are 32 bottles of wine for eight units of clothing,
which reduces to four bottles of wine for each unit of clothing. Elizabeth found this to be a good
deal because her opportunity cost of making one unit of clothing is eight bottles of wine. Because
she is able to buy a unit of clothing from Kyle for four bottles of wine, Elizabeth uses more of
her factors of production to produce wine and thus moves beyond her self-sufficient production
possibilities frontier. Therefore, any trade in which a unit of clothing costs less than eight bottles
of wine (Elizabeths opportunity cost of producing a unit of clothing) will benefit Elizabeth. Thus,
the maximum price Elizabeth would be willing to pay for a unit of clothing from Kyle is a smidgen
less than eight bottles of wine.
10
What is the smallest number of bottles of wine that Kyle will accept in exchange for one
unit of clothing? Kyle would be willing to accept a smidgen more than his opportunity cost of
producing a unit of clothing, which is one-fourth of a bottle of wine. Surely, Kyle would prefer 7.9
bottles of wine for one unit of clothing, but he would be willing to accept a smidgen more than his
opportunity cost of producing one unit of clothing.
Therefore, the range of possible terms of trade for one unit of clothing is a smidgen more
than one-fourth of a bottle of wine up to eight bottles of wine. Any trade that occurs within this
pricing range will unambiguously make both Elizabeth and Kyle better off. The actual price that is
negotiated, however, depends on the bargaining power of the parties involved.
What about the range of prices for a bottle of wine? Elizabeth specializes in the production
of wine and she will accept from Kyle anything that is greater than one-eighth of a unit of clothing
(her opportunity cost of producing a bottle of wine). Furthermore, Kyle is willing to pay an amount
that is less than his opportunity cost of producing a bottle of wine, which equals four units of
clothing. The range of possible prices for one bottle of wine is a smidgen more than one-eighth of
a unit of clothing up to four units of clothing. Any trade that occurs within this pricing range will
unambiguously make both Elizabeth and Kyle better off.
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6. Example 2: Cape Cod and Nantucket

Table 1-1 contains the labor hours required to produce one lobster dinner or one crab dinner
on Cape Cod and Nantucket. Again, for simplicity, assume that opportunity costs are constant and
that each location has the same set of scarce resources.
Table 1-1
Labor Hours to Produce Dinners
Cape Cod
Nantucket
Number of labor hours needed Number of labor hours

to make one lobster dinner needed to make one crab
per worker
dinner per worker
3
9
2
4
6.1 Absolute Advantage in the Production of a Lobster Dinner and a Crab Dinner
In this example, the location that can produce one unit of a good in the fewest hours of
labor has an absolute advantage in that good. Cape Cod can produce one lobster dinner in three
hours while it takes Nantucket two hours to produce a lobster dinner. Therefore, Nantucket has
an absolute advantage over Cape Cod in the production of a lobster dinner because it can make a
lobster dinner in the fewest hours.
Nantucket also has an absolute advantage over Cape Cod in the production of a crab dinner
because it can produce 1 crab dinner in fewer hours relative to Cape Cod. It takes Nantucket four
hours to produce a crab dinner, while Cape Cod produces a crab dinner in nine hours.
6.2 The opportunity Cost of Producing one Lobster Dinner on Cape Cod and Nantucket
Cape Cod has the capability to produce one lobster dinner in three hours or one crab dinner
in nine hours. This implies that in the time that it takes to make one lobster dinner on Cape Cod,
one-third of a crab dinner can be produced. If Cape Cod chooses to use its time and resources
to produce one lobster dinner, then it is also choosing to not produce one-third of a crab dinner.
Therefore, the opportunity cost of one lobster dinner is one-third of a crab dinner on Cape Cod.
Nantucket has the capability to produce one lobster dinner in two hours or one crab dinner in
four hours. This implies that in the time it takes to make one lobster dinner on Nantucket, one-half
of a crab dinner can be produced. If Nantucket chooses to use its time and resources to produce
one lobster dinner, then it is also choosing to not produce one-half of a crab dinner. Therefore, the
opportunity cost of one lobster dinner is one-half of a crab dinner on Nantucket.
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6.3 The Opportunity Cost of Producing one Crab Dinner on Cape Cod and Nantucket
Cape Cod has the capability to produce one crab dinner in nine hours or one lobster dinner
in three hours. This implies that in the time it takes to make one crab dinner on Cape Cod, three
lobster dinners can be produced. If Cape Cod chooses to use its time and resources to produce one
crab dinner, then it is also choosing to not produce three lobster dinners. Therefore, the opportunity
cost of one crab dinner is three lobster dinners on Cape Cod.
Nantucket has the capability to produce one crab dinner in four hours or one lobster dinner
in two hours. This implies that in the time it takes to make one crab dinner on Nantucket, two
lobster dinners can be produced. If Nantucket chooses to use its time and resources to produce one
crab dinner, then it is also choosing to not produce two lobster dinners. Therefore, the opportunity
cost of one crab dinner is two lobster dinners on Nantucket.
6.4 Comparative Advantage in the Production of a Lobster Dinner and a Crab Dinner
A location has a comparative advantage in the production of a good or service if its
opportunity cost is lower relative to the location with which it is compared. In this example, Cape
Cod has a comparative advantage in the production of lobster dinners because the opportunity
cost of producing a lobster dinner on Cape Cod is lower than that of Nantucket. Precisely, the
opportunity cost of producing one lobster dinner is one-third of a crab dinner on Cape Cod and
one-half of a crab dinner on Nantucket.
On the other hand, Nantucket has a comparative advantage in the production of a crab
dinner because its opportunity cost of producing a crab dinner is lower than that of Cape Cod. The
opportunity cost of producing one crab dinner is two lobster dinners on Nantucket, while on Cape
Cod the opportunity cost of producing one crab dinner is three lobster dinners.
6.5 Who Should Specialize in What?
Because Cape Cod has a comparative advantage in the production of a lobster dinner, it
should specialize in that task. Likewise, because Nantucket has a comparative advantage in the
production of a crab dinner, it should specialize in producing crab dinners.
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6.6 The Range of Possible Prices for a Lobster Dinner and a Crab Dinner
Because Cape Cod has a comparative advantage in the production of a lobster dinner, it
will specialize in the production of that good. Cape Cod will benefit from trading with Nantucket
whenever they receive more than one-third of a crab dinner for a lobster dinner. Again, this is true
because one-third of a crab dinner is the opportunity cost of producing one lobster dinner on Cape
Cod.
Nantucket, too, will benefit by purchasing lobster dinners from Cape Cod, so long as the
price they pay is lower then its opportunity cost of producing a lobster dinner. Recall, that the
opportunity cost of producing a lobster dinner on Nantucket is one-half of a crab dinner.
Therefore, the range of possible prices for one lobster dinner is a smidgen larger than onethird of a crab dinner (Cape Cods opportunity cost of making a lobster dinner) up to a smidgen
less than one-half of a crab dinner (Nantuckets opportunity cost of making a lobster dinner). Any
trade that occurs within this pricing range will unambiguously make both Cape Cod and Nantucket
better off because they will move to a location beyond their self-sufficient production possibilities
frontier.
Nantucket has a comparative advantage in the production of a crab dinner, and it will
specialize in the production of that good. Nantucket will benefit from trade with Cape Cod whenever
it receives more than two lobster dinners for each crab dinner. Again, this is true because two
lobster dinners is the opportunity cost of producing a crab dinner on Nantucket.
Here, too, Cape Cod, benefits by purchasing crab dinners from Nantucket, so long as the
price paid is lower then its opportunity cost of producing a crab dinner. Again, the opportunity cost
of producing one crab dinner on Cape Cod is three lobster dinners.
Therefore, the range of possible prices for one crab dinner is a smidgen more than two
lobster dinners (Nantuckets opportunity cost of making a crab dinner) up a bit less than three lobster
dinners (Cape Cods opportunity cost of making a crab dinner). Any trade that occurs within this
pricing range will unambiguously make both Nantucket and Cape Cod better off because they will
move to a location beyond their self-sufficient production possibilities frontier.
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CHAPTER TWO
Demand & Supply
1. Introduction
This chapter introduces the model of demand and supply. Economists use the model of
demand and supply to analyze how buyers and sellers interact in the marketplace. It shows how
market prices are determined and it demonstrates how many units of a good or service will be
bought and sold. Examples of markets include EBay.com, the New York Stock Exchange, the
restaurant market, the gasoline market, and furniture market. Markets are everywhere.
The following key concepts will be covered in this chapter: a demand schedule, a demand
curve, a demand function, the law of demand, the market demand curve, the market demand schedule,
the price elasticity of demand, the cross price elasticity of demand, the income elasticity of demand,
a supply schedule, a supply curve, a supply function, the law of supply, the market supply curve, the
market supply schedule, the elasticity of supply, and comparative-static analysis.
2. The Theory of Demand
2.1 Sarahs Demand Schedule
Every market has both buyers and sellers. We
begin our analysis on the buyers side of the market.
Consider Sarah who is one consumer in the
market for wine. The way in which Sarah responds
to changes in the price of wine is shown in Sarahs
Demand Schedule, located in table 2-1. For example,
if the price of wine is $50 per bottle, Sarah is willing to
buy 70 bottles. However, if the price of wine increases
to $80 per bottle, Sarah reduces the amount that she is
willing to buy to 40 bottles. All consumers behave in
a similar way. Whenever a goods price increases and
nothing else in the world changes, people respond by
demanding fewer units of that good.
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Table 2-1
Sarahs Demand Schedule
Price
Quantity
Demanded
100
90
80
70
60
50
40
30
20
10
20
30
40
50
60
70
80
90
100
110
2.2 Sarahs Demand Curve

Sarahs demand curve is a picture of the way she responds to changing prices of wine.
Plotting the price and quantity demanded data from Sarahs demand schedule enables us to trace
out a downward sloping line. Figure 2-1 offers two points of reference. Firstly, when the price is
$100 per bottle, Sarah is willing to purchase 20 bottles of wine. Secondly, when the price drops to
$20 per bottle, then Sarah increases the amount of wine that she is willing to purchase to 100 bottles
of wine.
The graph of Sarahs demand for wine contains a lot of information. So lets take the
picture apart piece by piece. The first thing to notice is that the vertical axis is labeled price ($)
and the horizontal axis is labeled quantity/time. The vertical axiss label tells everyone that wine
is priced in dollar terms. The horizontal axiss label provides us with two pieces of information.
The first is the unit of measurement; in the graph of Sarahs demand, a bottle of wine is the unit of
measurement. Alternative units of measurement might be cases of wine or thousands of cases of
wine. The second piece of information on the horizontal axis is the time frame. An individuals
demand curve changes with the passage of time. Certainly, you do not demand the same products
that you did when you were a small child. So consider each graph of a demand curve similar to
a digital picture that captures a moment in time. The time stamp therefore informs the viewer
when the picture was taken or in our case when the demand curve existed.
It is also important to recognize that price($) is the independent variable on the graph,
while quantity is the dependent variable. If you recall your mathematics courses, you have every
right to be scratching your head; because in economics we always place the independent variable
price on the vertical axis, not the horizontal axis. Likewise, we place the dependent variable quantity
on the horizontal axis. Having knowledge of this difference may eliminate potential confusion.
Figure 2-1
Sarahs Demand Curve
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2.3 Sarahs Demand Function

Sarahs quantity demanded of wine depends on independent variables other than the price
of wine. Some of the more influential variables are the prices of complementary goods and the
prices of substitute goods.
Complementary goods. Because Sarah likes to eat Gouda cheese and wheat crackers
as she drinks wine, she considers them complementary goods to wine. Thus, Sarah
considers the price of Gouda cheese and the price of wheat crackers when she decides
how many bottles of wine she is willing to buy at any given price.
Substitute goods. Sarah enjoys drinking wine, Tanqueray gin, and other fine liquors and
she considers these beverages substitutes for one another. Thus, Sarah considers the price
of Tanqueray gin and the price of other fine liquors when she decides how many bottles
of wine she is willing to buy at any given price.
Another factor affecting Sarahs demand for wine is her income.
If wine is a normal good, then positive changes in income will induce Sarah to purchase
more bottles of wine at any given price.
If wine is an inferior good for Sarah, then positive changes in income will induce Sarah
to purchase fewer bottles of wine at any given price.
Does Sarah enjoy drinking wine? Obviously this matters, too. Economists lump measures
of satisfaction, enjoyment, pleasure, etc. into the category tastes and preferences.
For example, after Sarah discovers that she enjoys a particular vineyard and vintage of
wine, she reveals through her market behavior that she is now willing to purchase more
bottles of this wine at any given price.
If she drinks a different brand of wine and finds it horribly bad, then she will reveal that
she is willing to buy fewer bottles of that wine at any given price.
One other important category is Sarahs expectations of the future. Suppose that Sarah
unexpectedly discovers that her favorite wine and vintage is soon to run-out. Because of this new
information, Sarah reveals that she is now willing to buy more bottles at any given price. An
example of this behavior occured when hurricanes Katrina and Rita blew ashore in the U.S. in
2005. Buyers hoarded gasoline - that is, they bought more gasoline at every given price relative to
before the storms developed - because they expected gasoline shortages after the storms.
17
All of these variables may be succinctly expressed in the following general equation, where
ff signifies a general function:
f
Q demanded
= f (Pwine ;Pcomplement ,Psubstitute ,I,T & P, E)
wine
Sarahs quantity demanded of wine is a number, say 15 bottles, and it is the dependent
variable which depends on many independent variables. The quantity demanded depends, foremost,
on the market price of a bottle of wine (Pwine). The price of wine is an independent variable because
it is determined by the wine market. The other independent variables that affect Sarahs quantity
demanded of wine are the price of complements (Pcomplement), the price of substitutes (Psubstitute), income
(I), tastes and preferences (T & P), and expectations of the future (E).
2.4 The Law of Demand
Unlike Sarahs quantity demanded of wine, which is a number, her demand for wine is a
set of numbers. It is a relationship that reveals how many bottles of wine she demands at each and
every price of wine.
Consider this question: What is Sarahs quantity demanded of wine when the price is $90
per bottle? In order to get a simple answer to this question we have to make an assumption: the
ceteris paribus assumption. Ceteris paribus is a Latin phrase that means other things equal. For
our purposes, when the ceteris paribus assumption is imposed, every independant variable except
the price of wine is held constant.
The ceteris paribus assumption is analogous to taking a digital picture of the marketplace,
whereby you stop the market in both time and space. Once all motion stops, we may more easily
analyze the marketplace. In particular, we can discover how many bottles of wine Sarah will
demand when the price is $9.
If the price of wine decreases, then ceteris paribus the quantity demanded of wine will
increase. The reverse is also true. If the price of wine increases, then ceteris paribus the quantity
demanded of wine will decrease. This negative relationship between the price of wine and the
quantity demanded always holds true it is called the law of demand.
18
2.5 Shifts of the Demand Curve

The demand curve shifts only when there is a change in one of the independent variables
held fixed under the ceteris paribus assumption. Therefore, the demand curve shifts only when a
second proverbial digital photo of the marketplace is taken. Something other than the price of wine
has to be different in some way for the demand curve for wine to shift. There are no exceptions to
this rule.
Moreover, a demand curve shifts only to the south-west or to the north-east. For example,
if the price of Gouda cheese, a complement to wine, increases, then Sarah is willing to buy fewer
bottles of wine at any given price. Because of the increase in the price of Gouda cheese, Sarahs
demand curve for wine shifts to the south-west. This is so because Sarah likes wine and cheese
together and the more expensive cheese is, the fewer blocks of cheese and bottles of wine she will
buy.
2.6 The Market Demand Schedule & the Market Demand Curve
Assume the market demand for wine is made up of two buyers Sarah and John. Table
2-2 contains both individuals demand schedule and the market demand schedule. To calculate a
market demand schedule, sum up how many bottles of wine Sarah and John are willing to purchase
at every market price. For example, if the market price of wine is $30 per bottle, Sarah is willing
to purchase 90 bottles of wine and John is willing to purchase 100 bottles of wine. Therefore, if the
market price is $30, the market is willing to purchase 190 bottles of wine.
Table 2-2
Individual and Market Demand The Market Demand:
Sarahs Demand
Schedule
Price
Quantity
Demanded
100
90
80
70
60
50
40
30
20
10
20
30
40
50
60
70
80
90
100
110
Sarah & Johns

Demand Schedules
Johns Demand
Schedule
Price
Quantity
Demanded
Price
Quantity
Demanded
100
90
80
70
60
50
40
30
20
10
5
15
30
45
60
70
80
100
120
140
100
90
80
70
60
50
40
30
20
10
25
45
70
95
120
140
160
190
220
250
19
The market demand function (below) contains one additional independent variable: the
number of buyers in the market. As the number of buyers in the market increases, ceteris
paribus, the market demand curve shifts to the north-east. And if the number of buyers in the
market decreases, ceteris paribus, the market demand curve shifts to the south-west.
Q demanded = f (Pwine ;Pcomplement ,Psubstitute ,I,T & P, E,# of Buyers)

wine
The horizontal summation of Sarah and Johns demand curves yields the market demand
curve and it is depicted in figure 2-2.
Figure 2-2
Market Demand Curve
Market Demand Curve
20
2.7 The Price Elasticity of Demand

The law of demand tells us that if the price of wine increases, ceteris paribus, the quantity
supplied of wine will decrease. But by how much does it decrease? The price elasticity of demand
helps us answer this question. The price elasticity of demand is a measure of the relationship
between a percentage change in the market price of product and a consequential percentage change
in the quantity demanded of a product.
The following mid-point formula is what economists use to calculate the price elasticity
of demand.
new quantity - initial quantity

new quantity + initial quantity
*100
2
EQWine,, PWine =
new price - initial price
*100
new price + initial price

2
Let us look at the numerator and denominator of this price elasticity of demand formula. The
numerator contains the formula to calculate a percentage change in the quantity demanded of wine.
And the denominator contains the formula to calculate a percentage change in the price of the
wine. (Note: All other independent variables remain constant under the ceteris paribus assumption.)
Dividing the percentage change in quantity demanded of wine by the percentage change in price of
a wine, gives us the price elasticity of demand for wine over the specified price range.
21
Suppose the price of wine increases from $50 to $60 a bottle. Referencing Sarahs demand
schedule data in table 2-2, we will calculate her price elasticity of demand over this price range
using the mid-point method. To begin the analysis, we will calculate the percentage change in the
price as follows.
percentage change in price =
*100

2
Inserting our specific market prices for wine yields:

$60 - $50
*100 = 18.18%
$60 + $50
2
This result informs us that the price of wine has changed by 18.18 percent.
Because of the law of demand, we know that if the price of a bottle of wine increases, ceteris
paribus, the quantity of wine demanded will decrease. At a price of $50 per bottle, Sarahs quantity
demanded is 70 bottles. When the price of wine increases from $50 to $60, Sarahs quantity
demanded decreases to 60 bottles of wine. Using this information and the formula below, we will
calculate the percentage change in Sarahs quantity demanded.
percentage change in quantity demanded =
*100
Inserting our initial quantity demanded and new quantity demanded yields:
60 - 70
*100 = 15.38%
60 + 70
2
This result informs us that Sarahs quantity demanded has decreased by 15.38 percent.
22
Putting the whole story together gets us to our price elasticity of demand calculation:
60 - 70
*100
*100
60 + 70
EQWine,,PWine =
-15.38 -.846
18.18
*100
$60 - $50
$60 + $50
*100
Sarahs price elasticity of demand over this price range is -.846. This number is the price
elasticity of demand coefficient. You should be asking yourself: what does the coefficient -.846
mean? Economists generally approach this number with the following language. A one-percent
change in the price of wine, ceteris paribus, causes a -.846 change in the quantity demanded of
wine. The negative in the front of .846 tells us that there exists a negative relationship between
changes in price and changes in the quantity demanded this, of course, confirms the law of
demand.
In fact, for all price elasticity of demand calculations you will get a negative number. The
negative relationship is because of the law of demand. Because the price elasticity of demand
coefficient is always negative, economists typically use the absolute value of this coefficient when
they are communicating such information.
23
Here is a second question you should be asking yourself: does the size of the number matter?
In this case, size does matter. Consider the following three categories that economists use to analyze
a price elasticity of demand calculation.
The first price elasticity of demand category is a coefficient with an absolute value of less
than one. If the price elasticity of demand has an absolute value of less than one, then the demand
curve is inelastic around the prices analyzed. In this category, a one-percent price change generates
a less than one-percent change in the quantity demanded. When the demand curve is inelastic,
consumers do not radically change their quantity demanded when the market price changes. For
example, consumers of insulin (a product that diabetics need to live) do no change their consumption
of insulin when the price of insulin changes. Insulin consumers are not responsive to price changes
because there are few substitute goods available.
The second price elasticity of demand category is a coefficient with an absolute value of
greater than one. If the price elasticity of demand has an absolute value of greater than one,
then the demand curve is elastic around the prices analyzed. In this category, a one-percent price
change generates a greater than one-percent change in the quantity demanded. When the demand
curve is elastic, consumers significantly change their quantity demanded when the market price
changes. For example, a study has proven that when the price of a Honda Civic increases by onepercent, consumers decrease their quantity demanded by four-percent. Honda Civic consumers are
responsive to price changes because there are a lot of other cars available.
The last price elasticity of demand category is a coefficient with an absolute value of one. If
the price elasticity of demand has an absolute value of precisely one, then the demand curve is unit
elastic or of unitary elasticity around the prices analyzed. Here, a one-percent change in price
generates an equal one-percent change in the quantity demanded.
2.8 The Cross Price Elasticity of Demand
Economists use the cross price elasticity coefficient to observe whether two goods are
related; and if they are related, whether the goods are complements or substitutes. For example,
if the price of Gouda cheese increases, Sarahs demand for wine shifts to the south-west, ceteris
paribus, because Sarah considers wine and cheese complements. However, until now we have not
been able to express by how much her demand for wine changes. Economists use a cross price
elasticity of demand calculation to assist in this task.
Consider the following two cross price elasticity examples. First, suppose the demand
schedule in table 2-1 assumes that the price of Gouda cheese is $6.50 per pound. When the market
price of wine is $50 per bottle, Sarah demands 70 bottles of wine. If the price of Gouda cheese
increases to $8.50 per pound, then ceteris paribus at a price $50 per bottle of wine Sarahs quantity
demanded of wine decreases to 60 bottles.
24
Using the midpoint method, the cross price elasticity of the demand for wine with regard to
the price of Gouda cheese is calculated as follows:
new quantity good 1 - initial quantity good 1

new quantity good 1 + initial quantity good 1
*100
EQGood 1,, PGood 2 =
new price good 2 - initial price good 2

new price good 2 + initial price good 2
*100
Inserting our data yields:
60 bottles - 70 bottles
60 bottles + 70 bottles
*100
2
EQWine 1,,PGouda =
= -15.38 = -.577
26.67
$8.50 pound - $6.50 pound

$8.50 pound + $6.50 pound
*100
2
In this example, the coefficient of the cross price elasticity is a negative number. Therefore,
wine and Gouda cheese are complements. More precisely, if the price of Gouda cheese increases
by one-percent, then Sarah will decrease her quantity demanded of wine by .577 percent.
Second, suppose the demand schedule in table 2-1 assumes that the price of Tanqueray gin is
$29 per gallon. If the market price of wine is $50 per bottle, Sarah demands 70 bottles of wine. If
the price of Tanqueray gin increases to $35 per gallon, then ceteris paribus when wine is $50 per
bottle Sarahs quantity demanded of wine increases to 75 bottles.
25
Using the midpoint method, the cross price elasticity between the demand for wine with
respect to the price of Tanqueray gin is calculated as follows:
75 bottles - 70 bottles
75 bottles + 70 bottles
*100
2
EQWine ,,PTanqueray =
$35 gallon - $29 gallon

$35 gallon + $29 gallon
6.90
18.75
= .368
*100
In this case, the coefficient of the cross price elasticity is a positive number. Therefore,
wine and Tanqueray gin are substitutes. More precisely, if the price of Tanqueray gin increases by
one-percent, then Sarah will increase her quantity demanded of wine by .368 percent.
2.9 The Income Elasticity of Demand
Another useful elasticity calculation relates income and quantity demanded. The income
elasticity of demand is a measure of the relationship between a percentage change in income and
a consequential percentage change in the quantity demanded of a product. As with the cross price
elasticity of demand, the sign of the income elasticity of demand provides useful information about
the good under analysis. If the income elasticity of demand coefficient is positive, then the good
under analysis is a normal good. In this case, a one-percent increase in income causes a positive
percentage change in the quantity demanded of the good. Examples of normal goods include new
luxury automobiles, brand name clothing, and meals at nice restaurants. As income increases, one
increases their consumption of normal goods.
If the income elasticity of demand coefficient is negative, then the good under analysis is
an inferior good. Here, a one-percent increase in income causes a negative percentage change in
the quantity demanded of the good. Examples of inferior goods are bus rides, McDonalds meals,
and old beat-up automobiles. As income increases, one purchases fewer inferior goods.
Consider the following example. Suppose Sarah has an income of $60,000 per year. Sarahs
demand for wine is represented by the demand schedule in table 2-1. At a market price of wine is
$50, Sarahs demands 70 bottles of wine. Now suppose that Sarahs income increases to $100,000
a year, ceteris paribus. At a market price of $50 a bottle, Sarah now demands 95 bottles of wine.
26
Using the midpoint method, we may calculate the income elasticity of demand using the
following formula:

*100
2
EQWine,,Income =
new income - initial income
*100
new income + initial income

2
Inserting our data yields:
95 - 70
95 + 70
*100
2
EQWine ,,Income =
$100,000- $60,000
$100,000 + $60,000
30.30
50
= .606
*100
2
Wine is a normal good for Sarah. A one-percent increase in income causes Sarah to increase
her quantity demanded of wine by .606 percent.
27
3. Supply
3.1 The Supply Schedule
Table 2-3
Big Reds Supply Schedule
Big Reds Vineyard is one supplier in the

market for wine. Big Reds supply schedule in table
2-3 describes how Big Red changes the amount of
wine that it is willing to sell when the price of wine
changes. For example, if the price of wine is $50
per bottle, Big Red is willing to sell 50 bottles of
wine. However, if the price of wine increases to $80
per bottle, then Big Red increases the amount that
they are willing to sell to 80 bottles of wine. All
businesses behave in a similar manner. Whenever a
goods price increases and nothing else in the world
changes, business people will respond by supplying
more units of that good.
3.2 Big Reds Supply Curve
Price
Quantity
Supplied
100
90
80
70
60
50
40
30
20
10
100
90
80
70
60
50
40
30
20
10
A supply curve is a picture of the way in which Big Red responds to changing market prices
of wine. By plotting the price and quantity supplied data from Big Reds supply schedule, we trace
out a positively sloped line. Figure 2-3 provides you with two points of reference. First, when the
price of wine is $20 per bottle, Big Red is willing to produce 20 bottles of wine. Second, when the
price increases to $90 per bottle of wine, then Big Red increases the amount of wine that they are
willing to produce to 90 bottles of wine.
Figure 2-3
Big Reds Supply Curve
Supply
28
3.3 An Individual Supply Function

Big Reds quantity supplied of wine is a dependent variable that depends on numerous independent variables in addition to the market price of wine. Some of these independent variables
include the price of capital equipment (PCapital), the price of land (PLand), the price of labor (PLabor), the price of other inputs into the production process (P1 Pn), the technology (TECH) used
by the organization, and the expectations (E) that the organization has with respect to the market.
All of these variables may be succinctly expressed in the following general equation, where g
signifies a general function.
Q Supplied
= g(PWine ;P1 ,...,PLabor ,PCapital ,PLand ,...,Pn ,TECH, E)
wine
3.4 The Law of Supply
Big Red Vineyards quantity supplied of wine at a particular price is a number. Big Red
Vineyards supply of wine is a set of numbers that reveals how many bottles of wine Big Red
Vineyard is willing to sell at any price of wine. As we did on the demand side of the market, we
have to invoke the ceteris paribus assumption if we want a simple answer to the question: How
many bottles of wine will Big Red Vineyard
ard off
offer to sell when the price of wine is $20 per bottle?
Upon imposing the ceteris paribus assumption, all action in the marketplace stops. In other
words, all independent variables other than the price of wine remain constant. If the price of wine
increases, then ceteris paribus the quantity supplied of wine will increase. The reverse is also true.
If the price of wine decreases, then ceteris paribus the quantity supplied of wine will decrease. This
positive relationship between price and quantity is called the law of supply.
The supply curve moves only when an the independent variable other than the price of wine
changes. Supply curves move only to the north-west or to the south-east because of a change
in an independent variable. For example, if the price of land, the price of capital, or the price of
a production input increases, then Big Red is willing to sell fewer bottles of wine at each price
because marginal production costs have increased.
3.5 The Market Supply Curve
Assume the market supply of wine is made up of two businesses: Big Red Vineyard and
Burgundy Vineyard. Table 2-4 contains a supply schedule for each vineyard and the market
supply schedule. To calculate a market supply schedule, we sum up the number of bottles of wine
that all vineyards in the market are willing to produce at every price of wine. For example, if the
market price of wine is $50 per bottle, Big Red Vineyard is willing to sell 50 bottles of wine and
Burgundy Vineyard is willing to sell 90 bottles of wine. Therefore, if the market price is $50, the
quantity supplied to the market is 140 bottles of wine.
29
Table 2-4
Individual and Market Supply
Big Reds Supply
Schedule
Burgundys Supply
Schedule
Price
Quantity
Demanded
100
90
80
70
60
50
40
30
20
10
100
90
80
70
60
50
40
30
20
10
The Market Supply:

Big Red & Burgundys
Supply Schedules
Price
Quantity
Demanded
Price
Quantity
Demanded
100
90
80
70
60
50
40
30
20
10
120
115
110
105
100
90
75
60
45
0
100
90
80
70
60
50
40
30
20
10
220
205
190
175
160
140
115
90
65
10
The market supply function (below) now contains one additional independent variable:
the number of sellers in the market. As the number of sellers in the market increases, ceteris
paribus, the market supply curve shifts to the south-east. And if the number of sellers in the market
decreases, ceteris paribus, the market supply curve shifts to the north-west.
QSupplied= g(PWine ;P1 ,...,PLabor ,PCapital ,PLand ,...,Pn ,TECH, E,# of Sellers)
wine
The horizontal summation of Big Red and Burgundys supply curves, which yields the market
supply curve, is depicted in figure 2-4.
Figure 2-4
Market Supply Curve
Market Supply Curve
30
3.6 The Supply Elasticity

The law of supply tells us that if the price of wine increases, ceteris paribus, then the quantity
demanded of wine will increase. But by how much does it increase? The price elasticity of supply
helps us answer this question. The price elasticity of supply is a measure of the relationship
between a percentage change in the market price of a product and a consequential percentage
change in the quantity supplied of a product.
The following mid-point formula is what economists use to calculate the price elasticity of
supply.
*100
2
eQWine,,PWine =
*100

2
The numerator contains the formula to calculate a percentage change in the quantity supplied
of wine. The denominator contains the formula for calculating a percentage change in the price
of the wine. Dividing the percentage change in quantity supplied of wine by the percentage change
in price of a wine, gives us the price elasticity of supply for wine over the specified price range.
Suppose the price of wine increases from $50 to $60 a bottle and as a result the quantity
that Burgundy is willing supply to the market increases from 90 bottles to 100 bottles. Using the
mid-point formula, we will now calculate Burgundys elasticity of supply over the $50 to $60 price
range.
100 - 90
100 + 90
*100
eQWine,,PWine =
10.53 .579
18.18
$60 - $50
$60 + $50
31
*100
The coefficient of the supply elasticity is .579 for Burgundy Vineyard over the $50 to $60
price range. This coefficient tells us that if the price of wine increases by one-percent over this range,
ceteris paribus, Burgundy Vineyard will increase their quantity supplied of wine by .579 percent.
Because .579 is positive, the coefficient confirms our story that there exists a positive relationship
between changes in price and changes in the quantity supplied this, of course, confirms the law
of supply.
4. Market Equilibrium
Figure 2-5 brings together the market demand curve for wine from figure 2-2 and the market
supply curve for wine from figure 2-3. The market demand curve crosses the market supply curve
at only one point, denoted point A in figure 2-5. Point A represents a market price of $50 and
a market quantity of 140 bottles of wine. Only at this equilibrium price of $50 is the quantity that
sellers are willing to sell at equal to the quantity that buyers are willing to buy. Point A is called
the market equilibrium point.
Figure 2-5
Market Demand and Market Supply
Market
Supply Curve
Market Demand Curve
5. Comparative-Static Analysis
Comparative-static analysis compares two market equilibrium (static) points, one equilibrium
point before and the other after a change in an independent variable other than the price of the good
being analyzed. For all comparative-static problems, perform the following three steps when an
independent variable does change:
1. Determine whether the demand curve or the supply curve will be affected.
2. Determine the direction in which the affected curve will shift. Recall that demand curves
shift either to the north-east or the south-west and supply curves shift to either the south-east or the
north-west.
3. Compare the equilibrium price and equilibrium quantity before and after the change. Price
and quantity may increase, decrease, remain unchanged, or be ambiguous because all three (an
increase, a decrease, or no change) options are possible.
32
5.1 A Shift in Demand

5.1.1 An Increase in the Price of a Substitute
Consider the effect of an increase in the price of Tanqueray gin, a substitute good in the
wine market. Recall that the price of this good is an independent variable in the market demand
function for wine and it has been held constant under the ceteris paribus assumption. Because the
price of this independent variable has changed, the demand curve for wine in figure 2-6 must shift.
In this case, the market demand curve for wine shifts to the north-east. The equilibrium price of
wine increases from P1 to P2 and the quantity demanded in the wine market increases from Q1 to
Q2.
Figure 2-6
Shifts in the Market Demand for Wine
5.1.2 An Increase in the Price of a Complement
Consider the effect of an increase in the price of Gouda cheese, a complement good in the
wine market. The price of this good is an independent variable in the market demand function for
wine and it has been held constant under the ceteris paribus assumption. Because the price of this
independent variable has changed, the demand curve for wine in figure 2-7 must shift. In this case,
the market demand curve for wine shifts to the south-west. The equilibrium price of wine decreases
from P1 to P2 and the quantity demanded in the wine market decreases from Q1 to Q2.
Figure 2-7
S1
Price($)
P1
P2
D1
D2
Q2
Q1
Quantity (bottles)/Time
33
5.1.3 A Decrease in Income for a Normal Good

Consider the effect of a decrease in income in the economy, and assume that wine is a normal
good. Section 2.3 defines a normal good. Income is an independent variable in the market demand
function for wine and it has been held constant under the ceteris paribus assumption. Because
income has changed, the demand curve for wine in figure 2-8 must shift. In this case, the market
demand curve for wine shifts to the south-west. The equilibrium price of wine decreases from P1
to P2 and the quantity demanded in the wine market decreases from Q1 to Q2.
Figure 2-8
S1
Price($)
P1
P2
D1
D2
Q1
Q2
Quantity (bottles)/Time
5.1.4 A Decrease in Income for an Inferior Good

Consider the effect of a decrease in the income in the economy, and assume now that wine
is an inferior good. Section 2.3 defines an inferior good. Income is an independent variable
in the market demand function for wine and it has been held constant under the ceteris paribus
assumption. Because income has changed, the demand curve for wine in figure 2-9 must shift. In
this case, the market demand curve for wine shifts to the north-east. The equilibrium price of wine
increases from P1 to P2 and the quantity demanded in the wine market increases from Q1 to Q2.
Figure 2-9
34
5.2 A Shift in Supply

5.2.1 An Increase in the Price of Labor
An economic boom can create a relative shortage of workers in the labor market, which causes
the price of labor to increase. The price of labor is an independent variable in the market supply
function for wine and it has been held constant under the ceteris paribus assumption. Because
the price of labor has increased, the supply curve for wine in figure 2-10 must shift. In this case,
the market supply curve for wine shifts to the north-west. This signals that it is more expensive
to produce each unit of wine. Because of this shift, the equilibrium price of wine increases from
P1 to P2 and the quantity demanded in the wine market decreases from Q2 to Q1. This change in
the market signals that it is more expensive to produce each unit of wine. And, at any given price,
vineyards are now willing to sell fewer bottles of wine relative to before the increase in the price of
labor.
Figure 2-10
Shifts in the Market Supply of Wine
35
5.2.2 A Decrease in the Price of Capital (the Interest Rate)

The U.S. economy observed decreases in the federal funds rate (set by the Federal Reserve
Bank) between 2001 and 2003, which enabled commercial banks to lower the interest rate that they
charge for short term and long term loans. The interest rate that banks charge their customers is
the economic price of borrowing money it is the price of capital.
The price of capital is an independent variable in the market supply function for wine and
it has been held constant under the ceteris paribus assumption. Because the price of capital has
decreased, the supply curve for wine in figure 2-11 must shift. In this case, the market supply
curve for wine shifts to the south-east. This signals that it is less expensive to produce each unit of
wine. Because of this shift, the equilibrium price of wine decreases from P1 to P2 and the quantity
demanded in the wine market increases from Q1 to Q2. This change in the market is a signal that it
is less expensive to produce each unit of wine. And, at any given price, vineyards are now willing
to sell more bottles of wine relative to before the decrease in the price of capital.
Figure 2-11
Shifts in Market Supply of Wine
36
5.3 A Shift in Demand and a Shift in Supply

5.3.1 An Decrease in the Price of a Complement and a Decrease in the Price of Labor
Now suppose that multiple changes occur in the wine marketplace. Firstly, there is a decrease
in the price of wheat crackers, a good that buyers consider a complement to wine. Because this
is an independent variable in the market demand function for wine, it has been held constant under
the ceteris paribus assumption. Now that the price of this independent variable has decreased,
the demand curve for wine in figure 2-12 must shift to the north-east. This signals that people are
willing to purchase more wine at any given price.
Secondly, the price of labor decreases because of an exogenous macroeconomic shock to
the labor market. Again, the price of labor is an independent variable in market supply function for
wine and it has been held constant under the ceteris paribus assumption. Because the price of labor
has decreased, the supply curve for wine in figure 2-12 must shift to the south-east. This signals
that it is less expensive to produce each unit of wine. The net result of these two effects causes the
quantity demanded to unambiguously increase from Q1 to Q2.
However, the net effect on the equilibrium price of wine is ambiguous. In figure 2-12,
the equilibrium price has increased from P1 to P2. However, if 1) the demand curve had shifted
half the distance or 2) the supply curve shifted twice the distance, the equilibrium price would
have decreased. Moreover, it is possible for the equilibrium price of wine to have remained
unchanged.
Figure 2-12
Shifts in the Market Supply and the Market Demand for Wine
37
5.3.2 An Increase in the Number of Buyers and an Increase in the Price of Land
Successful expenditures on advertising can have the effect of creating new buyers of wine.
The number of buyers is an independent variable in the market demand function for wine, which
has been held constant under the ceteris paribus assumption. With an increase in the number of
buyers, the demand curve for wine in figure 2-13 will shift to the north-east. This signals that more
people are willing to purchase wine at any given price.
Second, suppose that there is a simultaneous increase in the price of land because all vineyard
owners try to marginally increase their production capacity. The price of land is an independent
variable in market supply function for wine and it has been held constant under the ceteris paribus
assumption. Because the price of land has increased, the market supply curve for wine in figure
2-13 will shift to the north-west. The net result of these two effects causes the price of wine to
increase from P1 to P2.
However, the net effect on the equilibrium price is ambiguous. In figure 2-13, the equilibrium
quantity has not changed. However, for example, if 1) the demand curve had shifted twice the
distance or 2) the supply curve shifted half the distance, the equilibrium quantity would have
increased. Moreover, it is possible for the equilibrium quantity to have decreased if the demand
shifted half the distance or supply curve shifted twice the distance shown in Figure 2-13. Thus,
in this case, we would need additional information about the magnitude of the shifts for us to
determine the actual affect on the equilibrium quantity of wine.
Figure 2-13
Shifts in the Market Supply and Market Demand for Wine
38
5.4 Price Controls

5.4.1 A Binding Price Ceiling
A price ceiling is a government imposed and legally enforced maximum market price.
Governments implement such policies with noble intentions. For example, government enforced
rent controls impose a maximum price for apartments, with the intention of increasing the number
of affordable apartments for lower income tenants. Nevertheless, the collective group of renters
and the market as a whole are never better off because of government imposed price ceilings in
a market. Moreover, history has demonstrated that low income families have fewer apartments
available to them when rent controls are in place.
Consider the wine market in figure 2-14. Before the price ceiling is imposed, the equilibrium
price is $50 and the equilibrium quantity is Q2. Now suppose the government imposes a price
ceiling of $30 in the wine market. This means that $30 is the maximum price that any seller may
charge for a bottle of wine.
Figure 2-14
A Binding Price Ceiling in the Wine Market
The $30 price ceiling is binding because the market price changes as a result of the
government policy. At a price ceiling of $30, the quantity demanded is Q3 and the quantity
supplied at the price ceiling is Q1. Because of the price ceiling, the quantity demanded
exceeds the quantity supplied. There is a shortage of bottles of wine at the price ceiling.
The actual quantity sold in the market, however, equals Q1. Therefore, the price ceiling
has actually reduced the number of bottles of wine bought and sold in the market by Q2-Q1. It is
because of this, that we say that in the aggregate buyers and sellers are worse as a result of the $30
price ceiling.
Suppose, instead, the government imposed a price ceiling of $60 per bottle of wine. In
this case, the maximum price that any seller may charge for a bottle of wine is $60. Because
the equilibrium price is $50, the price ceiling is non-binding. The fact that the government
has declared that the price of wine cannot increase beyond $60 has no effect on this wine
market. The actual market price of wine remains in equilibrium at $50 per bottle. At the
equilibrium price of $50, the quantity demand and the quantity supplied is Q2. Thus, a nonbinding price ceiling has absolutely no effect on the equilibrium price or equilibrium quantity.
39
5.4.2 A Binding Price Floor

A price floor is a government imposed and legally enforced minimum market price.
Governments have implemented price floors with noble intentions, too. For example, the intention
of creating a living-wage for low income workers is a reason why policy-makers enact minimum
wage legislation. Nevertheless, low-income workers, as a group, are never better off with a
minimum wage. Some workers that are willing to work at a price below the minimum wage are no
longer offered a job after the minimum wage is imposed.
Consider the wine market in figure 2-15. Before the price floor is imposed, the equilibrium
price is $50 and the equilibrium quantity is Q2. Now suppose the government imposes a price floor
of $70 in the wine market. This means that $70 is the minimum price that any seller may accept for
bottle of wine.
Figure 2-15
A Binding Price Floor in the Wine Market
The $70 price floor is binding because the market price changes as a result of the government
policy. At a price floor of $70, the quantity demanded is Q1 and the quantity supplied at the price
ceiling is Q3. Because of the price floor, the quantity supplied exceeds the quantity demanded.
There is a surplus of wine being produced at the price floor.
The actual quantity sold in the market, however, equals Q1. Therefore, the price floor has
actually reduced the number of bottles of wine sold in the market by Q2-Q1. It is because of this,
that we say that both the buyers and the sellers are worse off as a result of the $70 price ceiling.
Collectively, the buyers buy fewer bottles of wine and the sellers sell fewer bottles of wine relative
to the volume of transactions before the price floor existed.
Suppose, instead, the government imposes a price floor of $30 per bottle of wine. In this case,
the minimum price that any seller may charge for a bottle of wine is $30. Because the equilibrium
price is $50, the price floor is non-binding. The fact that the government has declared that
price of wine cannot decrease below $30 has no effect on the wine market. The actual market price
remains in equilibrium at $50 per bottle. At the equilibrium price of $50, the quantity demanded
and the quantity supplied equals Q2. Thus, a non-binding price floor has absolutely no effect on the
equilibrium price or equilibrium quantity.
40
5.5 Per-Unit Taxes

5.5.1 A Tax on Buyers
Suppose the government passes a law that requires buyers to pay a $20 tax on every bottle
of wine that they buy in the wine market. The buyers have to pay the sellers for a bottle of wine
and now buyers have to pay an additional $20 per bottle of wine to the government. The new
tax is a change in an independent variable that has been held constant (at zero) under the ceteris
paribus assumption. A new $20 per bottle tax makes buying wine less attractive at any given price.
Therefore, the demand curve will shift to the south-west. Figure 2-16 demonstrates the $20 vertical
difference between the old and new demand curves.
The equilibrium price before the $20 per bottle tax on the buyers is $40 and the equilibrium
quantity is 100 bottles. After the tax is imposed the equilibrium price is $29 and the equilibrium
quantity is 60 bottles.
Figure 2-16
A Tax on Buyers in the Wine Market
Notice that the buyers carry the legal responsibility of the tax they must send $20 per
bottle to the government. However, the economic burden of the tax is shared between the buyers
and the sellers. Because of the $20 per bottle tax on the buyers, the sellers now receive $11 ($40$29) less per bottle sold. Therefore, the sellers have an economic burden of this tax equal to $11
per bottle (out of the $20 tax per bottle). Clearly, the sellers are made worse off because of this tax
on the buyers, they sell 40 fewer bottles of wine and they receive $11 fewer dollars per bottle.
Although the buyers now only pay the sellers $29 per bottle of wine, they also must
send the government a tax of $20 per bottle. Thus, buyers pay a total of $49 ($29+$20) per
bottle of wine. This is an increase of $9 ($49-$40) per bottle of wine. The buyers economic
burden of the $20 tax is $9 per bottle. Buyers are made worse off as a result of this tax
because the total price of wine increases by $9 and they purchase 40 fewer bottles of wine.
In summary, both buyers and sellers are made worse off because of a $20 per unit tax on
buyers because taxes change prices and discourage market activity that otherwise would have
occurred
occurred.
41
5.5.2 A Tax on Sellers

Suppose the government passes a law that requires sellers to pay a $20 tax on every bottle
of wine that they sell in the wine market. Because the sellers have to pay the government $20 per
bottle of wine, the wine business becomes less profitable. Thus, the new tax will affect the market
supply curve. The new tax is a change in an independent variable that has been held constant (at
zero) under the ceteris paribus assumption. The $20 per bottle tax will cause the supply curve to
shift to the north-west. Figure 2-17 demonstrates the $20 vertical difference between the old and
new supply curves.
The equilibrium price before the $20 per bottle tax on the sellers is $40 and the equilibrium
quantity is 100 bottles. After the tax is imposed the equilibrium price is $49 and the equilibrium
quantity is 60 bottles.
Figure 2-17
A Tax on Sellers in the Wine Market
In this case, the sellers carry the legal responsibility of the tax they must send $20 per
bottle to the government. However, the economic burden of the tax is shared. The sellers now
receive $49 from the buyers, of which they get to keep $29 ($49-$20) per bottle and they send the
tax due of $20 per bottle to the government. The sellers have an economic burden of $11 ($40-$29)
per bottle (out of the $20 tax per bottle). The sellers are made worse off because of this tax; they
sell 40 fewer bottles of wine and they get to keep $11 fewer dollars per bottle.
After the $20 tax on sellers is imposed, the buyers pay $49 per bottle of wine. This is an
increase of $9 ($49-$40) per bottle of wine. Thus, the buyers economic burden of the tax is $9
($49-$40) per bottle (out of the $20 tax per bottle).
In summary, the economic burden of a $20 per bottle tax on buyers or a $20 per bottle tax on
sellers is equivalent. Buyers and sellers are made worse off because of the $20 per unit tax. In both
a tax on buyers and a tax on sellers, equilibrium quantity decreases by 40 bottles, the price paid by
the buyers increases by $9 per bottle, and the price that sellers keep decreases by $11 per bottle.
42
CHAPTER THREE
The Costs of Production and Profit Maximization

1. Introduction
The objective of every private business owner is to maximize her or his profits. This chapter
defines costs of production concepts and presents the basic elements of the profit maximization
model. These tools have proven to help business owners and their managerial agents in achieving
the goal of profit maximization.
Concepts covered in this chapter include: fixed costs, variable costs, sunk costs, the short
run, the long run, total cost, average fixed cost, average variable cost, average total cost, marginal
cost, total revenue, marginal revenue, perfect competition, monopoly, the profit maximizing rule,
the shut down rule, economies of scale, diseconomies of scale, constant economies of scale, joint
cost, and economies of scope.
2. The Costs of Production
To make a logical decision on how to maximize the profits of a business, we need to first
categorize its various costs of production. The first separation of the data is to place costs into fixed
and variable columns. Costs that do not vary with increases in the quantity produced are called
fixed costs. Costs that do vary with increases in the quantity produced are called variable costs.
Consider Crepe Myrtle Incorporated, an agricultural business whose production expenses
are listed in table 3-1. This business produces its product (trees) in 100 unit increments.
Table 3-1
Crepe Myrtle Production Expenses
Production Rent
Wages
Supplies
Tools
Total Cost
0
$400
$300
$0
$200
$900
100
$400
$549
$50
$300
$1,299
200
$400
$846
$100
$400
$1,746
300
$400
$1,226
$150
$500
$2,276
400
$400
$1,707
$200
$600
$2,907
500
$400
$2,303
$250
$700
$3,653
600
$400
$3,025
$300
$800
$4,525
700
$400
$3,880
$350
$900
$5,530
800
$400
$4,872
$400
$1,000
$6,672
900
$400
$6,006
$450
$1,100
$7,956
43
The trick to determining what is a fixed cost is to ask the following question: what expenses
must be paid even if production equals zero? Referencing table 3-1, the $400 rent payment must
be paid regardless of Crepe Myrtle Incorporateds decision to produce even a single unit. At this
zero production rate, the business must also pay $300 in wages and $200 in tool expenses. The
$300 in wages is frequently observed as a salaried employee, a person who is paid an annual fixed
fee. The $200 tool expense is for a tool bought before production started and therefore it is a fixed
cost. Moreover, in this example, the $200 tool is a unique piece of machinery that Crepe Myrtle
Incorporated had specifically made for their production process. The tool is useless to anyone else
and therefore its cost can never be recovered this type of expense is called a sunk cost. The
remaining tool expenses are variable costs that depend on the rate of production. Altogether then,
the fixed expenses total $900 ($400 rent + $300 wages + $200 tools). Because fixed expenses are
fixed, Crepe Myrtle Incorporateds fixed costs equal $900 at every production rate .
Variable costs do not exist at a unit production of zero. However, variable costs begin
to accumulate when unit production starts. For example, variable costs equal $399 when Crepe
Myrtle Incorporated produces 100 units. The business must pay an additional $249 in wages, $50
in supplies, and $100 in tool expenses when production increases to 100 units. It is important
to remember, that these new variable costs are in addition to the fixed cost payment of $900 that
Crepe Myrtle Incorporated must pay. The total cost of production when Crepe Myrtle Incorporated
produces 100 units equals $1,299 ($900 + $399).
Variable costs equal $846 when Crepe Myrtle Incorporated produces 200 units. In this case,
the business pays $546 in wages above and beyond the $300 paid to its salaried workers, $100 in
supply costs, and $200 in variable tool expenses. A total cost of $1,746 is calculated by adding
together the fixed costs and the variable costs of producing 200 units. Table 3-2 lists the fixed,
variable, and total costs for all production rates.
Table 3-2
Costs of Production
Production
0
100
200
300
400
500
600
700
800
900
Fixed Cost (FC)

$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
Variable Cost (VC)

$0
$399
$846
$1,376
$2,007
$2,753
$3,625
$4,630
$5,772
$7,056
44
Total Cost (TC)

$900
$1,299
$1,746
$2,276
$2,907
$3,653
$4,525
$5,530
$6,672
$7,956
In economic terms, the short run is a time horizon within which a business is unable to
adjust at least one input. In other words, in the short run there exists some fixed cost. Therefore,
if you observe a fixed cost, then the business is in the short run. The concept of the short run,
however, has no easy calendar measure that is constant across all businesses. For example, it might
be a single day for one business and three years for another. In the present example, Crepe Myrtle
Incorporated is in the short run because it has $900 in fixed costs.
On the other hand, the long run is a time horizon long enough for the seller to adjust all
inputs. Thus, if you observe a business with no fixed costs, then it is in a long run state. Clearly,
the long run is a tough standard to meet.
We now want to convert our short run production cost data into four new categories. These
categories will enable us to visualize the production cost constraint of this business in a way that
will be useful in ultimately determining the quantity that maximizes the profit of Crepe Myrtle
Incorporated. The four new cost categories are: average fixed cost, average variable cost, average
total cost, and marginal cost.
Average fixed cost equals fixed cost divided by the quantity produced. For example, Crepe
Myrtle Incorporated has a fixed cost of $900 and when they produce a quantity of 100 units, their
average fixed cost is $900/100 or $9.00 per unit. Average variable cost equals the variable cost
divided by the quantity produced. The average variable cost equals $399/100 or $3.99 per unit
when 100 units are produced at Crepe Myrtle Incorporated. Average total cost equals the total
cost divided by the quantity produced or the sum of average fixed cost plus average variable cost.
The average total cost equals $1299/100 or $12.99 per unit when 100 units are produced. Table 3-3
contains all the average cost data for each quantity produced.
Marginal cost is equal to the change in the total cost that arises from an extra unit of
production. It is calculated by taking the change in total cost and dividing it by the change in the
quantity produced. For example, the change in total cost between zero and 100 units equals $399
($1,299-$900). The change in the quantity produced between zero units and 100 units equals 100
units. The marginal cost of each of the first 100 units is $3.99 ($399/100).
$1,299 - $900
$399
=
= $3.99
100 - 0
100
One more demonstration will be useful. The change in total cost between a quantity produced
of 100 units and 200 units equals $447 ($1,746-$1,299) and the change in the quantity produced is
again 100 units. The marginal cost of each of the units between 100 and 200 equals $4.47.
$1,746 - $1,299 $447
=
= $4.47
200 - 100
100
45
The remaining marginal cost calculations for Crepe Myrtle Incorporated are in table 3-3. A
summary of cost concepts is in table 3-4.
Table 3-3
Average and Marginal Costs of Production
Production
0
100
200
300
400
500
600
700
800
900
Average Fixed Average

Cost (AFC)
Variable Cost
(AVC)
--$9.00
$3.99
$4.50
$4.23
$3.00
$4.59
$2.25
$5.02
$1.80
$5.51
$1.50
$6.04
$1.29
$6.61
$1.125
$7.215
$1.00
$7.84
Average Total
Cost (ATC)
-$12.99
$8.73
$7.59
$7.27
$7.31
$7.54
$7.90
$8.34
$8.84
Marginal Cost
(MC)
-$3.99
$4.47
$5.30
$6.31
$7.46
$8.72
$10.05
$11.42
$12.84
Table 3-4
Cost Concepts
Type of Cost
sunk cost
Initials
SC
fixed cost
FC
variable cost
VC
total cost
average fixed
cost
average
variable cost
average total
cost
TC
AFC
Definition
a cost that has already been committed and
cannot be recovered
costs that do not vary with changes in the quantity produced
costs that do vary with changes in the quantity
produced
the sum of fixed costs and variable costs
fixed cost divided by quantity
AVC
variable cost divided by quantity
ATC
total cost divided by quantity
marginal cost
MC
the increase in total cost that arises from an extra unit of production, calculated by taking the
change in total cost and dividing by the change
in the quantity produced
46
Formula
TC = VC + FC
FC
AFC =
Q
AVC = VC
Q
ATC = TC
Q
MC = DTC
DQ
Figure 3-1 shows the average fixed cost curve, the average variable cost curve, the average
total cost curve, and the marginal cost curve for Crepe Myrtle Incorporated. The average fixed cost
curve declines as output increases because the $900 in fixed cost is being spread over a successively
larger quantity of output. The marginal cost curve crosses the average variable cost curve and
the average total cost curve at their lowest points. Whenever marginal cost is higher than average
variable cost or average total cost, the average variable cost or average total cost must increase.
Whenever marginal cost is lower than average variable cost or average total cost, then the average
variable cost or average total cost must decrease. And finally, whenever the marginal cost curve
crosses the average variable or total cost curve, then the values are equal.
Figure 3-1 also contains the capital letters A through E. The vertical distance between
the letters represents the various costs at a quantity of 300 units. The distance between A and B
represents the average fixed cost at 300 units, which is $3.00. The distance between A and C equals
the average variable cost of producing 300 units. The distance between A and E equals the average
total cost of producing 300 units. Notice that the distance between A and B plus the distance
between A and C equals the distance between A and E. This is true because average fixed cost plus
average variable cost equals average total cost. Because of this fact of arithmetic, it is also true
that the distance between A and B equals the distance between C and E; both distances are equal
to the average fixed cost of producing 300 units. Lastly, the distance between A and D equals the
marginal cost of producing the 300th unit.
Figure 3-1
Cost Curves for Crepe Myrtle Incorporated
C
B
47
3. The Profit Maximizing Decision

The last few pages have organized Crepe Myrtle Incorporateds expense statement into
categories that economists find helpful in the ultimate task of discovering where the business
maximizes its profits. The next step is to analyze the revenue constraint of the business. In the
first case below, we assume that Crepe Myrtle Incorporated is one of many perfectly competitive
businesses in the Crepe Myrtle tree industry. In the second case, we assume that Crepe Myrtle
Incorporated is a monopoly.
3.1 Application: Profit maximizing in a Perfectly Competitive Industry
There are three characteristics of a perfectly competitive industry:
there are many buyers and sellers,

the good is homogeneous (e.g., trees or peas), and
all who want to enter the industry are free to do so and any business may exit at a
time of their choosing.
These conditions that define a perfectly competitive industry imply that no business may
influence the market price of the product that they sell. It is because of this that businesses operating
in perfectly competitive industries are said to be price takers.1
In a perfectly competitive industry, market prices are determined by the interaction of the
market demand and market supply curves. Consider the case where the Crepe Myrtle tree market
price equals $10.05 per unit. Because Crepe Myrtle Incorporated is one of many businesses in the
Crepe Myrtle Market, it must charge $10.05 per unit. To set any higher price would devastate the
business because zero units would be sold. Customers would simply purchase their Crepe Myrtle
trees from other businesses that are charging the lower market price of $10.05.
Total revenue and marginal revenue data for Crepe Myrtle Incorporated when the market
price is $10.05 per unit are in table 3-5. Total revenue is calculated by multiplying price and
quantity. For example, if quantity is 300 units, then total revenue equals $3,015.
_______________________
1
Perfect competition does not occur frequently in the real world. Competition in many industries is so
fierce that the model of perfect competition is of enormous help in predicting the behavior of the firms in
these industries. Farming, fishing, grocery retailing, plumbing, and dry cleaning are all good examples of
industries that are highly competitive.
48
Marginal Revenue is the change in total revenue generated from an additional unit sold.
It is calculated by taking the change in total revenue divided by the change in quantity sold. In a
perfectly competitive market, the price is determined by the market and it remains constant when
the quantity sold changes. So the change in total revenue resulting from a one-unit increase in the
quantity sold equals the market price. For example, the marginal revenue for each unit sold between
200 and 300 units is $10.05.
$3,015 - $2,010
$1,005 = $10.05
=
300 - 200
100
This is calculated by dividing the $1,005 change in total revenue between 200 and 300 units by the
100 unit change in quantity sold.
Table 3-5
Demand Schedule, Total Revenue, & Marginal Revenue for Crepe Myrtle Incorporated
Production
0
100
200
300
400
500
600
700
800
900
Market Price
$10.05
$10.05
$10.05
$10.05
$10.05
$10.05
$10.05
$10.05
$10.05
$10.05
Total Revenue
(TR)
$0
$1,005
$2,010
$3,015
$4,020
$5,025
$6,030
$7,035
$8,040
$9,045
49
Marginal Revenue
(MR)
-$10.05
$10.05
$10.05
$10.05
$10.05
$10.05
$10.05
$10.05
$10.05
In the pursuit of maximizing profits, business owners are constrained in two fundamental
ways. Firstly, the competency of its employees and the market prices of inputs into the production
process dictate the costs of producing output, i.e., competencies and input prices determine the data
in table 3-2 and table 3-3. Secondly, the price that a perfectly competitive business can charge is
determined by the market, and not the business owner.
Given these two constraints the business owners key task is to make two decisions.
The first decision is to determine the profit maximizing quantity to produce.
In the short run, the second decision is to decide whether to produce or to shut down the
business for a short period of time.
In the long run, the second decision is to decide whether to produce or to exit the industry,
forever.
Lets walk through an example. Consider Crepe Myrtle Incorporateds marginal cost data
from table 3-2 and the marginal revenue data from table 3-5, both of which are graphed in figure
3-2.
50
Figure 3-2
Marginal Revenue and Marginal Cost
For the first decision, the business owner analyzes the marginal revenue and marginal cost
data of the business to determine the profit maximizing quantity to produce. Because there are fixed
costs in this example, we are in the short run. Therefore, the second decision for the business is to
figure out if it is in their interest to stay open or to shut down. Table 3-6 contains all of the relevant
data that Crepe Myrtle Incorporated needs to make its stay-open or shut-down decision.
From figure 3-2, we can observe that the profit maximizing quantity for Crepe Myrtle
Incorporated is not less than 700 units. For each unit between 1 and 699, the additional revenue
from another unit sold (i.e., marginal revenue) is greater than the additional cost associated with
producing another unit (i.e., marginal cost). Thus, for all units in the range 1 to 699 it makes
economic sense to continue selling Crepe Myrtle trees because marginal profits are gained over this
range. In addition, for all units greater than 700 units, the additional revenue from selling another
unit is less than the additional cost associated with producing another unit. Therefore, it does not
make economic sense to produce unit 701 and beyond because each unit in this range would cost
more than the business receives in revenue, on the margin.
51
The incentive to increase profits over the 1-699 range and the fear of losing profits over the
701+ range leads us to our optimal profit maximizing quantity: 700 units. The additional revenue
received by selling the 700th unit is $10.05 and the additional cost incurred because of producing
the 700th unit is $10.05. At the 700th unit marginal revenue equals marginal cost.1 This result is
summarized in what economists call the profit maximizing rule. The profit maximizing rule
states that a business maximizes profits when it produces where the marginal revenue from selling
another unit equals the marginal cost of producing an additional unit.
Using Crepe Myrtle Incorporateds marginal revenue and marginal cost data and the profit
maximizing rule, weve concluded that 700 units is the optimal quantity to produce. At that quantity,
table 3-6 reports that total revenue equals $7,035 and total cost equals $5,530. In the short run, the
business is making a positive economic profit and it should stay open and produce 700 units.
Table 3-6
Crepe Myrtle Incorporateds Revenue and Cost Data
Production
0
100
200
300
400
500
600
700
800
900
Marginal
Revenue
(MR)
-$10.05
$10.05
$10.05
$10.05
$10.05
$10.05
$10.05
$10.05
$10.05
Marginal
Cost
(MC)
-$3.99
$4.47
$5.30
$6.31
$7.46
$8.72
$10.05
$11.42
$12.84
Total Revenue
(TR)
Total Cost
(TC)
Profit
(p)
$0
$1,005
$2,010
$3,015
$4,020
$5,025
$6,030
$7,035
$8,040
$9,045
$900
$1,299
$1,746
$2,276
$2,907
$3,653
$4,525
$5,530
$6,672
$7,956
-$900
-$294
$264
$739
$1,113
$1,372
$1,505
$1,505
$1,368
$1,089
Suppose something happens in the Crepe Myrtle market and the market price drops to
$5.30 per Crepe Myrtle tree. How should Crepe Myrtle Incorporated respond to this change in
economic events?
First, they must find there new profit maximizing quantity. Second, they must make another
shut-down or stay-open decision. Table 3-7 contains the new revenue data for a market price of
$5.30 in addition to the previous cost of production data, which has not changed.
___________________
1
The business is actually indifferent at this point, but for analytical ease we adopt a policy of: if indifferent,
produce it.
52
Table 3-7
Production Price
0
100
200
300
400
500
600
700
800
900
$5.30
$5.30
$5.30
$5.30
$5.30
$5.30
$5.30
$5.30
$5.30
$5.30
Total
Total Marginal Marginal Average Average Profit
Revenue Cost Revenue Cost Variable Total
(p)
(TR)
(TC)
(MR)
(MC)
Cost
Cost
(AVC) (ATC)
$0
$900 -----$900
$530
$1,299 $5.30
$3.99
$3.99 $12.99 -$769
$1,060 $1,746 $5.30
$4.47
$4.23
$8.73 -$686
$1,590 $2,276 $5.30
$5.30
$4.59
$7.59 -$686
$2,120 $2,907 $5.30
$6.31
$5.02
$7.27 -$787
$2,650 $3,653 $5.30
$7.46
$5.51
$7.31 -$1,003
$3,180 $4,525 $5.30
$8.72
$6.04
$7.54 -$1,345
$3,710 $5,530 $5.30
$10.05
$6.61
$7.90 -$1,820
$4,240 $6,672 $5.30
$11.42 $7.215 $8.34 -$2,432
$4,770 $7,956 $5.30
$12.84
$7.84
$8.84 -$3,186
According to the data in table 3-7 and the profit maximizing rule, Crepe Myrtle Incorporateds
profit maximizing quantity is 300 units. The sale of 300 units will generate a loss of $686. Because
of this result, should the business stay open or should it shut down? Without hesitation, Crepe
Myrtle Incorporated should stay open.
This result might seem strange. Why stay open when the business is making a loss? The
answer is simple. Shutting down when the market price is $5.30 per unit will place the business in
a worse economic position. If the business shuts down, they collect no revenue and still must pay
their fixed costs rent, tools, and salaried wages totaling $900. By staying open and selling 300
units, the market price collected per unit fully covers average variable cost, which equals $4.59,
and it contributes 71 cents per unit toward the payment of fixed costs. Simply put: Crepe Myrtle
Incorporated loses less by staying open and selling 300 units.
Does it ever make sense to shut down? Yes, when the losses from operating are greater than
the fixed costs. The decision process is succinctly summarized in what economists call the short
run shut-down rule. A business should shut down if production at the profit maximizing quantity
(where MR=MC) generates total revenues that are less than variable costs, in all other cases the
business should stay open. If a business does decide to shut down it is usually only for a short
period of time, e.g., for the winter season when market prices are low.
53
When prices remain low for very long periods of time, then the business moves into a long
run decision mode. In the long run, there are no fixed costs. A business must decide to stay open or
exit the industry in the long run. The long run exit decision states that a business should exit the
industry if production at the profit maximizing quantity (where MR=MC) generates total revenues
that are less than total cost, otherwise stay open.
3.2 Application: Profit Maximizing and a Monopolistic Industry
Three characteristics define a monopolistic industry. In this type of industry:
there are many buyers and only one seller,

the good is heterogeneous (e.g., Microsoft Office is different from other software
applications), and
barriers to entering the market exist (e.g., patents are barriers that make it illegal
for someone to produce a product without permission of the patent owner).
In a monopolistic industry, because there is only one seller of a product the business owner
actually goes through a process of setting the price of its product, a task that competitive firms are
unable to do. Thus monopolistic firms are called price setters.
Assume Crepe Myrtle Incorporated is now a monopoly. The business faces the entire
market demand for its product because it is now the only business that sells Crepe Myrtle trees.
Consider the market demand data listed in table 3-8 (the first two columns show the market demand
schedule). If the business produces 100 units, it can sell them at $16.02 each. If it produces 200
units, then it must lower the price to $14.93 in order to sell all 200 units. If it produces 300 units,
then it must lower the price to $13.88 in order to sell all 300 units. And so on. The two columns
reveal a downward sloping demand curve, which is shown in figure 3-3.
Total revenue and marginal revenue for Crepe Myrtle Incorporated is in table 3-8. Total
revenue is calculated by multiplying price and quantity. For example, if the quantity is 300 units,
then total revenue equals $4,164 ($13.88 x 300).
Marginal Revenue is the change in total revenue from an additional unit sold. It is calculated
by taking the change in total revenue divided by the change in quantity sold. For example, the
marginal revenue for each unit sold between 200 and 300 units is $11.78. This is calculated by
dividing $1,178, the change in total revenue between 200 and 300 units, by 100, the change in
quantity sold between 200 and 300 units. The marginal revenue schedule is listed in table 3.8 and
graphed in figure 3-3.
54
The task of a monopoly is to maximize profit given two constraints. The first constraint
is described in the expense data and cost curves of section 2. The second constraint is the market
demand. Given these two constraints the business must make three decisions. The first decision
is to determine the profit maximizing quantity to produce. The second decision is to decide what
price to charge. Because this is the short run, the third decision is to decide whether to produce or
to shut down the business for a short period of time.
According to the data in table 3-8 and the profit maximizing rule, Crepe Myrtle Incorporateds
first decision is to produce at its profit maximizing quantity of 500 units (because that is where
marginal revenue equals marginal cost). The second decision is to set as high a price as it can,
and still sell 500 units. The only market price that satisfies this condition is $11.74 (denoted PM).
So $11.74 is the market price that Crepe Myrtle Incorporated sets. To set a price that is any higher
would lead customers to buy something less than 500 units, which would result in the business
NOT maximizing its profits.
At a price of $11.74 per unit, the sale of 500 units will generate a profit of $2,217. Because
profits are positive, the business decides to stay open. It is important to remember, however, that
the stay open or shut down decision, in the short run, and the stay open or exit decision, in the long
run, still apply to monopolistic businesses.
Table 3-8
Production Price
0
100
200
300
400
500
600
700
800
900
$17.11
$16.02
$14.93
$13.88
$12.81
$11.74
$10.65
$9.56
$8.47
$7.38
Total
Total Marginal Marginal Average Average Profit
Revenue Cost Revenue Cost Variable Total
(p)
(TR)
(TC)
(MR)
(MC)
Cost
Cost
(AVC) (ATC)
$0
$900
-----$900
$1,602 $1,299 $16.02
$3.99
$3.99 $12.99 $303
$2,986 $1,746 $13.84
$4.47
$4.23
$8.73 $1,240
$4,164 $2,276 $11.78
$5.30
$4.59
$7.59 $1,888
$5,124 $2,907 $9.60
$6.31
$5.02
$7.27 $2,217
$5,870 $3,653 $7.46
$7.46
$5.51
$7.31 $2,217
$6,390 $4,525 $5.20
$8.72
$6.04
$7.54 $1,865
$6,692 $5,530 $3.02
$10.05 $6.61
$7.90 $1,162
$6,776 $6,672 $0.84
$11.42 $7.215 $8.34 $104
$6,642 $7,956 -$1.34
$12.84 $7.84
$8.84 -$1,314
55
Figure 3-3
4. Scale and Scope Economies

The costs of production depend on the scale of production. The production of information
technology, for example, requires an enormous amount of time and effort to write the software code.
All of the coding expenses (labor, equipment, and materials) occur before a single unit is sold in the
market place usually this amounts to a very large fixed cost. The marginal cost of reproducing an
additional unit of information technology (i.e., another copy) is very inexpensive. Think of the cost
of burning a copy of your favorite music CD and you will observe the cost of making an additional
copy of information technology.
Information technology such as Microsofts operating system, an Ivy Software CD, a
pharmaceutical pill, and even newspapers are all products that have economies of scale. Such
products have large fixed costs and relatively low marginal costs. Therefore, as production of these
products increases, average total cost decreases.
56
Consider the expense statement of the John Sykes Printing Press detailed in table 3-9.
The business has $4450 in fixed costs ($3,500 for labor, $800 for the printing press, and $150 for
electric power). The labor costs are fixed, in this example, because all the news is reported and the
paper is assembled before a single paper is printed and sold. Table 3-10 contains all of the data
which are reorganized into the categories of fixed cost, variable cost, average fixed cost, average
variable cost, average total cost, and marginal cost.
The John Sykes Printing Press has economies of scale because as output increases, average
total cost decreases. In this example marginal cost and average variable cost are both $1.70 per unit
at every scale of production listed. The gains from scale are made by spreading a large fixed cost
over an increasingly larger quantity, while at the same time marginal costs remain constant.
The market demand and the market structure are two additional factors that will ultimately
determine the quantity that the John Sykes Printing Press will produce. If the market demand is
relatively large, then it is in the businesss profit maximizing interest to produce at a large scale
where average total costs are lowest.
Table 3-9
The Cost of Production for John Sykes Printing Press
Daily Production
(thousands)
0
1
2
3
4
5
6
7
8
9
Labor
Printing Press Ink and Paper Electric Power Total
$3,500
$3,500
$3,500
$3,500
$3,500
$3,500
$3,500
$3,500
$3,500
$3,500
$800
$1,300
$1,800
$2,300
$2,800
$3,300
$3,800
$4,300
$4,800
$5,300
$0
$1,100
$2,200
$3,300
$4,400
$5,500
$6,600
$7,700
$8,800
$9,900
57
$150
$250
$350
$450
$550
$650
$750
$850
$950
$1050
$4,450
$6,150
$7,850
$9,550
$11,250
$12,950
$14,650
$16,350
$18,050
$19,750
Table 3-10
Total, Average, & Marginal Costs of Production
Daily
Production
(thousands)
0
1
2
3
4
5
6
7
8
9
Fixed
Cost
Variable Total
Cost
Cost
Marginal AFC
Cost
AVC
ATC
$4,450
$4,450
$4,450
$4,450
$4,450
$4,450
$4,450
$4,450
$4,450
$4,450
$0
$1,700
$3,400
$5,100
$6,800
$8,500
$10,200
$11,900
$13,600
$15,300
-$1.70
$1.70
$1.70
$1.70
$1.70
$1.70
$1.70
$1.70
$1.70
-$1.70
$1.70
$1.70
$1.70
$1.70
$1.70
$1.70
$1.70
$1.70
-$5.95
$3.93
$3.18
$2.81
$2.59
$2.44
$2.34
$2.27
$2.19
$4,450
$6,150
$7,850
$9,550
$11,250
$12,950
$14,650
$16,350
$18,050
$19,750
-$4.25
$2.23
$1.48
$1.11
$0.89
$0.74
$0.64
$0.57
$0.49
Notice the distinction between the example in table 3-10 and the previous example of
Crepe Myrtle Incorporated in table 3-3. In the table 3-3 example, economies of scale exist over
the first 400 units of production. For units 500 to 900 there are diseconomies of scale because as
output increases over this range, average total costs begin to increase. The only other alternative is
constant economies of scale, which is defined by constant average total cost as output increases.
When an organization can produce several products together at less cost than could a group
of single product firms operating independently, then the organization has economies of scope.
Examples of economies of scope abound. For example, America Online (AOL) and Time Warner
merged in 2000 because they believe the combined operation would be better able to take advantage
of the growth of broadband delivery of television and Internet at home than would the two companies
on their own. Thus, economies of scope arise whenever there are significant joint costs, which are
costs that do not change with the scope of production.
58
Consider the Ivy Printing Presss cost of production data listed in table 3-11. If the business
had one facility to produce a morning paper and a second facility to produce an evening paper (or if
two different businesses printed the papers), they would need two printing presses. Their total cost
of running two facilities equals $45,400.
Table 3-11
Ivy Printing Presss Cost of Production Data
Organization
Production Wages
Separate
production
Morning 75,000
Evening 75,000
Total
Combined
Production
150,000
Printing Ink, Paper & Total Cost

Press
Supplies
$7,500
$7,500
$5,500
$5,500
$15,000 $5,500
$9,700
$9,700
$22,700
$22,700
$45,400
$19,400
$39,900
However, if the business combined the production of the morning and the evening paper
under one roof, then they would only need one printing press. The total cost of running a joint
production process equals $39,900. By having only one printing press Ivy Printing Press saves
$5,500. Because the organization has the ability to use this fixed expense jointly (for two different
products), they can capture economies of scope and thereby lower their total cost of production.
59
CHAPTER FOUR
1. Introduction
Economic Performance Metrics
In this chapter, we shift gears from studying the underlying microeconomic foundations of
consumers and businesses to studying the elements of macroeconomic behavior. Macroeconomics
offers a set of tools and concepts that both economists and policy makers use to try to figure out the
overall pulse of the economy.
The following key concepts are covered in this chapter: nominal gross domestic product,
the business cycle, real gross domestic product, transfer payments, the national income identity, the
circular flow, the consumer price index, the producer price index, the inflation rate, the unemployment
rate, discouraged workers, and the types of unemployment.
2. Gross Domestic Product
Figure 4-1 shows U.S. Real GDP per Capita in 2005 prices over the years 1929-2008.
This title has a lot of information, so let us spend some time explaining each of the components of
the title. The initials GDP stand for gross domestic product. The term gross tells the reader that
the data are not adjusted for depreciation. Depreciation is a term that represents the reduction in
market value of economic capital as it slowly wears out and approaches the end of its useful life.
The calculation which adjusts for depreciation is called net domestic product.
Domestic tells us that the data are for output produced and inside the boundaries of the
United States.1 Product equals the market value of final goods and services produced over the
course of a year in the domestic economy. In calculating domestic product, it does not matter that
a business is owned by an individual from a foreign nation. If the good or service is produced
inside the boundaries of a country it is included in that countrys domestic product calculation. For
example, a bottle of Coca-Cola produced in Atlanta, GA and sold in the United States is included
in the United States domestic product.
On the other hand, income from output sold abroad by a business located abroad, but owned
by an American is not included in domestic product. For example, a bottle of Coca-Cola produced
and sold in Bratislava, Slovakia is not included in the United States domestic product.
______________________
1
The alternative concept, national product, would include products made and income generated by foreign
property owned by U.S. citizens, and would exclude products made and income generated by property in the
U.S. that was owned by non-U.S. citizens.
60
Figure 4-1
U.S Real GDP Per Capita 1929-2008
Source: www.bea.gov
Real and 2005 prices inform the reader that the market value of the economic product
calculations are adjusted for changes in the price level i.e., for changes in inflation or deflation.
How do you adjust for changes in the price level? The idea is to take the goods and services
produced in 1929, for example, and price them at year 2005 prices. The value of this calculation
captures what the 1929 bundle would cost in the year 2005. By processing the data in this way for
all years, we may then step back and accurately compare the value of goods and services in 1929
to those of 2008. This is done in Figure 4-1.
The alternative is to calculate nominal GDP which equals the market value of final goods
and services produced at current year prices. Nominal GDP is almost useless at telling us the true
value of final goods and services because it confuses changes in the inflation or deflation with
changes in total production. Suppose that quantity produced in the next year stayed unchanged
but prices doubled. Nominal GDP would double. Suppose that the production doubled but prices
stayed the same. Nominal GDP would double. Nominal GDP does not distinguish between these
two sources of increases in domestic product. But since it is very important that we do distinguish
between the two sources of increases in domestic product, economists use real GDP and reject
nominal GDP.
61
Per capita means that total GDP is divided by the U.S. population. This is done to control
for changes, positive or negative, in the U.S. population.
So that is the breakdown of figure 4-1. Real GDP per capita in 2005 dollars is a measure
of the market value of the average domestic labor force production of final goods and services,
controlling for inflationary and deflationary shifts in the price level.
GDP includes only final goods and services, which are items sold to the end user. A new
home, a coffee frappucino from Starbucks, the cost of your attorneys time to refinance your current
home, and a large pepperoni pizza from your favorite pizza joint are all examples of final goods and
services that are included in the governments calculation of GDP.
Intermediate goods and services are used in the production of final goods and services.
Intermediate goods and services are not included in GDP. For example, Starbucks purchases coffee
beans an intermediate good. The coffee bean transaction is not included in GDP. However, when
Starbucks, in the United States, grinds the beans, adds hot water, and sells you a tall coffee the sale
is recorded as part of U.S. domestic GDP.
A clear observation from figure 4-1 is that the value of what is produced in the U.S. has
increased over time. A conservative reading of the figure reveals that the average American is 5.5
times better off in 2008 with $43,540 in real GDP relative to 1929 with $7,926 in real GDP.
62
Figure 4-2
A Stylized Business Cycle
It is important to note that figure 4-1 has wiggles along with a positive trend. These irregular
wiggles are this countrys business cycles. Figure 4-2 details all phases of a stylized business
cycle. The negative movement from peak to trough is an economic contraction because real GDP
is smaller than the previous period. If a contraction moves below the trend line for two or more
quarters of a year, then it is called a recession. The positive movement from trough to peak is
called an economic expansion (or recovery) because real GDP is larger than the previous period.
63
3. A Simple Calculation of GDP

To get a single measure of the total market value of final goods and services in the domestic
economy, we need to aggregate the quantities of all the goods and services and aggregate it into a
single number. Consider the simple example from the country of Nuts to illustrate the process. In
the country of Nuts, the total production in year 1 is 4 pounds of cashews, 8 pounds of walnuts, 5
pounds of pecans, and 14 pounds of pistachios. The price of each type of nut in year 1 is listed in
table 4-1.
Table 4-1
Year 1 Quantities and Prices
Good
Cashews
Walnuts
Pecans
Pistachios
Quantity
4
8
5
14
Price
$1.50/pound
$0.75/pound
$2.50/pound
$1.25/pound
The total nominal market value of all final production of nuts in the country of Nuts (the
only good produced in this simple economy) in year 1 is equal to:
Nominal GDPyear 1 = (4 pounds of cashews X $1.50/pound) +
(8 pounds of walnuts X $0.75/pound) + (5 pounds of pecans X $2.50/pound) + (14

pounds of pistachios X $1.25/pound) = $42.00
Because of this calculation, the more expensive nuts receive a higher weight relative to the cheaper
nuts. For example, 5 pounds of pecans have a market value of $12.50 and 8 pounds of walnuts have
a market value of $6. Pecans form a larger share of nominal GDP relative to walnuts. This is what
we want. Indeed, economists believe that the amount people are willing to pay for an item is an
indication of the value they receive from the item. So because we are trying to calculate the market
value, we want to multiply quantities by their price.
Suppose that in year two the prices and quantity of nuts produced change to those in table
4-2. The total nominal market value of all final production of nuts in year two is equal to:
Nominal GDPyear 2 = (4 pounds of cashews X $1.00/pound) +
(16 pounds of walnuts X $1.25/pound) +
(5 pounds of pecans X $3.00/pound) +
(14 pounds of pistachios X $1.25/pound) = $56.50
64
Now we will calculate the real GDP in year 1 and year 2, using year 1 as the base year.
Because the base year is year 1, by definition the nominal GDP and the real GDP are the same (this
can occur only in the base year). Therefore, the real GDP in year 1 equals $42.00.
To find the real GDP for year 2, we must value the quantities produced in year 2 using the
prices in the base year, which is year 1. The real GDP in year 2 is equal to:
Real GDPyear 2 = (4 pounds of cashews X $1.50/pound) +
(16 pounds of walnuts X $0.75/pound) +
(5 pounds of pecans X $2.50/pound) +
(14 pounds of pistachios X $1.25/pound) = $48.00
We can now determine how much the country of Nuts has actually grown in terms of the
value of its output of final goods and services. Since real GDP was $42.00 in year 1 and $48.00 in
year 2, the real value of final goods and services has increased by 14.3% between year 1 and year
2.
Table 4-2
Year 2 Quantities and Prices
Good
Cashews
Walnuts
Pecans
pistachios
Quantity
4
16
5
14
65
Price
$1.00/pound
$1.25/pound
$3.00/pound
$1.25/pound
4. The Components of GDP

The U.S. Department of Commerces Bureau of Economic Analysis (BEA) measures U.S.
gross domestic product.1 The BEA builds the aggregate expenditure measure of gross domestic
product from four main components: consumption expenditures, investment expenditures,
government expenditures, and net exports.
Consumption spending (C) is made up of all the final goods and services that are
ultimately bought and used by households, except for newly constructed buildings.
Investment spending (I) is made up of all the final goods and services that become part
of the business or residential capital stock, including newly constructed buildings.
Government spending (G) is made up of all the final goods and services bought by the
government, for example, lumber and raw materials purchased and deployed to Iraq for
the reconstruction effort.
o
o
Transfer payments are NOT included in government spending.

Examples of a transfer payment include a social security payment, a welfare
benefit, and unemployment insurance benefit. Each of these involves a payment
by the government for which no current goods or services are received by the
government.
Net exports (NX) is made up of the difference between exports (E) and imports (I).
o Exports are final goods and services produced in the U.S. and purchased by
foreigners living outside the U.S.
o Imports include all final goods and services produced by foreigners outside the
U.S. and purchased by a member of the domestic population.
Combine the domestic consumption (C), investment (I), and government expenditures (G)
plus net exports (NX) and we arrive at the level of aggregate expenditure. Aggregate expenditure
is a measure of nominal GDP and it is also known as the national income identity. In summary,
National Income Identity = C + I + G + NX = Aggregate Expenditure = Nominal GDP
____________________
1
See the BEAs website at www.bea.gov.
66
Table 4-3 contains the shares of each component of real GDP per capita between 1999 and 2008.
Table 4-3
United States Real GDP Category Shares 1999-2008 Averages
Source: www.bea.gov, personal calculation
Real GDP
Category
Consumption
Investment
Government
Net Exports
Share
Total
69.2
16.5
19.0
-4.7
100
5. The Circular Flow Diagram

Double entry bookkeeping ensures that the expenditure on final goods and services in the
domestic economy equals the total incomes paid for the scarce factors of production used to produce
those final goods and services that is, wages, rent, interest and profit earned from production.
Aggregate income, therefore, equals the sum of income paid for the scarce factors of production
used to produce total final output in the domestic economy. That is,
Aggregate expenditure = GDP = Aggregate Income
Because of the equality between expenditures and income, economists think of economic
activity as a circular flow of purchasing power through the economy. This circular flow metaphor
allows us to confidently predict that changes in one part of the economy will affect the whole,
and how such changes will affect the whole. The circular flow diagram in figure 4-3 captures the
important relationships in the economy.
67
Figure 4-3
The Circular Flow Model
In figure 4-3, the circular flow of income and expenditures occurs as follows: Income flows
from businesses to households as they pay their workers and their owners (e.g., shareholders) for
their labor and their capital, which is used to produce final goods and services. Expenditures then
flow from households to businesses as households buy consumer goods, pay taxes, and save. Taxes
turn into expenditures when the government spends tax revenues on goods and services. Savings
turn into expenditures when the funds are loaned to and then spent by firms making investments to
boost their capital stock.
The cycle depicted in the circular flow diagram confirms that our GDP from section 4, which
measures expenditures on final goods and services in a time period, must also equal the sum of all
income in the same time-period.
6. The Price Level and Inflation
The price level is a composite measure reflecting the prices of all goods and services in the
economy relative to prices in a base year. The consumer price index (CPI) is one measure of the
price level. Another common measure of the price level is the producer price index (PPI), which
measures the prices paid for inputs that are used in the production of final goods and services.
The consumer price index (CPI) measures changes over time in the cost of buying a market
basket of goods and services purchased by a typical family. The CPI is calculated and reported
once a month by the Bureau of Labor Statistics (BLS). When the BLS publishes the CPI, they
report it as a percentage change in consumer prices over the previous month this is alternatively
known as the inflation rate.
68
To calculate the CPI, the BLS designs the market basket so that it closely resembles the
goods and services that consumers are actually buying. Major changes to the market basket are
made by the BLS every five to ten years. Each good or service in the market basket receives a
weight equal to its share in the total expenditure by consumers in the base year.
Table 4-4
Market Basket Prices
Year
2020 (base year)
2021
2022
2023
Price of Starbucks
coffee/12 oz. (tall)
$1.40
$1.45
$1.50
$1.50
Price of basic cable/

month
$35.00
$40.00
$45.00
$50.00
Price of Milk/gallon
$2.00
$2.50
$3.25
$4.25
Consider the market basket in table 4-4 which we will use to calculate the CPI. In the base
year, assume our consumers spend a total of $1,035: suppose consumers buy $511.00 (49.4%) worth
of Starbucks coffee, $420.00 (40.6%) worth of basic cable, and $104.00 (10%) worth of milk. The
consumer price index is calculated as follows, where a goods weight equals its percentage of the
consumers total expenditure.
price of Starbucks coffee today
CPI = price of Starbucks coffee in base year X Starbucks coffee weight +
price of basic cable today

X basic cable weight +
price of basic cable in base year
price of milk today

price of milk in base year X milk weight .
CPI =
price of Starbucks coffee today

X 49.4 +
$1.40
price of basic cable today

X 40.6 +
$35.00
price of milk today

X 10.0
$2.00
69
In the base year, the CPI, by definition, equals 100. This is clearly demonstrated when 2020 prices
are inserted for todays prices:
CPI2020 =
$1.40
$35.00
$2.00
X(49.4)+
(49.4)+
X(40.6)+
(40.6)+
X(10.0) = 100
$1.40
$35.00
$2.00
In reality, the market basket does not change for as long as a ten year period of time. The
weights assigned to each good only change when the market-basket changes. Therefore, we will
assume that our market basket and weights do not change over the 2020-2023 time period.
The CPI for the years 2021-2023 are:
$1.45
$40.00
$2.50
X(49.4)+
(49.4)+
X(40.6)+
(40.6)+
X(10.0) = 110.1
$1.40
$35.00
$2.00
$1.50
$45.00
$3.25
CPI2022 =
X(49.4)+
(49.4)+
X(40.6)+
(40.6)+
X(10.0) = 121.4
$1.40
$35.00
$2.00
$1.50
$50.00
$4.25
CPI2023 =
X(49.4)+
(49.4)+
X(40.6)+
(40.6)+
X(10.0) = 132.2
$1.40
$35.00
$2.00
CPI2021 =
Changes in the cost of the market basket from one year to the next are commonly referred
to as changes in the cost of living or as the inflation rate. The inflation rate in 2021 is:
Inflation Rate2021 =
CPI2021 - CPI2020
(110.1 - 100)
X 100 =
X 100 = 10.1%
100
CPI2020
The inflation rates for 2022 and 2023 are:

CPI2022 - CPI2021
(121.4 - 110.1)
X 100 =
X 100 = 10.26%
110.1
CPI2021
CPI2023 - CPI2022
(132.2 - 121.4)
X 100 =
X 100 = 8.90%
121.4
CPI2022
70
The federal government reports the CPI every month based on price data collected from
about 23,000 retail and service establishments in 87 urban areas throughout the country.1 The
twelve monthly changes in consumer prices over the course of the year are added up and become
that years inflation rate. When we speak of the inflation rate, we speak of it as a percent per year.
To speak of the inflation rate without a unit of time attached is incomplete. But people do, and we
always assume that, when the period of time is omitted, the inflation rate is being given in percent
per year.
The producer price index (PPI) measures the average change over time in the prices
received by domestic producers. The PPI is also calculated by the BLS. The PPI sample includes
over 25,000 establishments providing approximately 100,000 price quotations per month. Goods
and services included in the PPI are weighted by value-of-shipments data contained in the 1997
economic census. The PPI is calculated in exactly the same way we calculated the CPI, but it
uses producer prices and a fixed production market basket instead of consumer prices and a fixed
consumer market basket. Changes in the cost of the PPI over a period of time offer another measure
of the inflation rate. The rate of change in the cost of the PPI is calculated as follows:
Inflation Ratecurrent period =
PPIcurrent period - PPIprevious period

PPIprevious period
_________________
1
See www.bls.gov for more details.
71
X 100
6. Unemployment
The unemployment rate is a key indicator of economic performance and it is one of the
most widely reported government statistics. Indeed, keeping unemployment low is a frequently
quoted goal of macroeconomic policy makers most notably the President of the United States.
The Bureau of Labor Statistic (BLS) calculates the unemployment rate by conducting
60,000 personal and telephone interviews of households in a nationwide survey called the Current
Population Survey (CPS). The CPS provides a comprehensive body of data on the labor force,
employment, unemployment, and persons not in the labor force. The BLS classifies the people that
it interviews into four categories:
I.
II.
III.
IV.
Those who are employed individuals with some kind of job.

Those who are out of the labor force individuals who do not want a job right
now.
Those who do want a job right now, but who have not been looking for work
because they do not think they could find one they would take.
Those who do want a job right now, have been looking for work, but have not
found a job that they would take.
The labor force is defined as group I plus group IV, those who have a job plus those
looking for jobs:
Labor Force = (Employed) + (Have Been Looking for Work)
The unemployment rate is defined to equal group IV divided by the labor force:
Unemployment Rate =
Have Been Looking for Work

Have Been Looking for Work
=
Labor Force
(Employed) + (Have Been Looking for Work)
For example, if the number of people employed equaled 8 million and the number of people
looking for work equaled 2 million, then the labor force equals 10 million. The unemployment rate
in this example would equal twenty percent (2 million people/10 million people).
72
The official unemployment rate may underestimate the real experience of unemployment.
For example, many people in group III could be classified as discouraged workers. These are
people who have tried to find a job for a long period of time and could not get a job. They are
frustrated and they have simply stopped looking for work. Many of these discouraged workers
may go back to school in an effort to strengthen their job market skills. Notice that when group III
workers decide to renew their job search efforts, they increase the numerator and the denominator
of the unemployment rate. Because of this, you could observe both an increase in the labor force
and an increase in those employed, while seeing no change in the unemployment rate.
Figure 4-4 is a graph of the unemployment rate between 1948 and 2009. The average
unemployment rate over this time period is 5.66%. Generally speaking, the unemployment rate
rises during economic contractions and falls during economic expansions
Figure 4-4
United States Unemployment Rate, 1948-2009
Annual Average, Recessions Marked
Source: www.bls.gov
There are three general categories of unemployment: frictional unemployment, structural

unemployment, and cyclical unemployment. Frictional unemployment occurs because it takes
time for workers to search for the jobs that best suit their tastes and job skills. This type of
unemployment is really a matching problem that usually does not last for a long period of time.
Online job search sites, e.g., www.monster.com, reduce frictional unemployment because they
provide a lot of information at a very low cost.
73
Structural unemployment occurs because the number of jobs available in a labor market
is insufficient to provide jobs for all that want a job. For example, many manufacturing jobs are
being eliminated because computers have replaced work once performed by humans. Thus, despite
increased output in these markets, there are fewer jobs available. Cyclical unemployment is
unemployment that occurs because of declines in the economys aggregate output (GDP) during
economic contractions and recessions.
74
CHAPTER FIVE
Money & Banking
1. Introduction
What is money? Money is any asset that may be used to carry out a transaction between a
buyer and a seller. The most familiar asset is currency, dollar bills and coins, but other examples
of money include bank accounts and money market accounts. This chapter examines the role of
money in the economy.
Key concepts covered in this chapter include: the functions of money, the types of money,
classifications of the money supply, the money creation process, bank reserves, required and desired
reserve deposit ratio, the Federal Reserve, monetary policy, the price level, the value of money, and
money supply and demand.
2. The Functions and Types of Money
The three basic functions of money are a medium of exchange, a store of value, and a unitof-account. Money is a medium of exchange because money makes exchange easier. In a barter
economy, an economy with no money, people spend a lot of time carrying out exchanges. In such
an economy, there must be a double coincidence of wants for exchange to take place. For example,
someone who had a piece of cheese and wanted a glass of wine would have to hunt around for a
bar that was willing to trade a glass of wine for a piece of cheese. But in a monetary economy,
pieces of paper may be used to buy a glass of wine. The bar owner will accept these pieces of paper
because, in turn, he/she believes that others will accept them, and so on. Money, therefore, solves
the transaction cost problem of a barter economy.
Money is also a store of value. People will hold money only if they believe it will continue
to have some value, so money can operate as a medium of exchange only if it serves as a store of
value. For example, using fish as money is a poor choice because its purchasing power literally
deteriorates. Rabbits are also a poor choice because the rapid increase in supply would decrease the
purchasing power of any one rabbit. Any such choice will quickly be replaced by a more durable
asset that is a better store of value. The industry standard, of course, is paper money because it is
generally a good store of value.
75
Lastly, money is a unit-of-account. Money is a convenient and widely recognized measure

for accounting and transactions; it is a yardstick for measuring the value of all goods and services.
In the United States, for example, people negotiate contracts in dollars and post prices in dollars
because it is convenient and because they know that others will understand.
Paper money that has no intrinsic value, e.g., the U.S. dollar, is known as fiat money. Fiat
money is paper money that derives its status as money from the power of the state, or by fiat. It is
money because the government says that it is money, it otherwise has no real value. Fiat money can
be contrasted with commodity money, which exists when some intrinsically valuable good also
serves as money. Gold is an example of commodity money because it has value even if it were not
used as money.
3. Measuring the Money Supply
When people talk of the quantity of money or the money supply, they are usually thinking
about currency bills and coins. Yet, currency is not the only asset that you can use to purchase
goods and services. The Federal Reserve System, the central bank of the United States, classifies
several alternative definitions of money. One of the Federal Reserves definitions of money supply
is called M1, while another is called M2.
The most narrowly defined money supply is M1, which includes currency, travelers checks,
demand deposits, and other checkable deposits. M2 is more expansive. It includes everything in
M1, plus savings deposits, small time deposits, money market mutual funds, and a few other minor
categories.1 Table 5-1 defines the measures of money. Figure 5-1 shows the annual average of M1
and M2 from 1959 to 2009. Ultimately, which definition of money one chooses is largely a matter
of personal preference. The most common definition of money is M1.
__________________
1
There are two other definitions of money, M3 and M4, which we will not cover in this book.
76
Table 5-1
The Types of Money
Type of Money
currency
travelers checks
demand deposits
Definition
the paper bills and coins in the hands of the public
a check issued by a financial institution that functions as cash
but is protected against loss or theft
demand deposits are so named because a depositor with such an
account can write a check to demand those deposits at any time
other checkable
other deposits against which checks may be written
deposits
savings deposits
deposits that earn interest but have no specific maturity date
small time deposits deposits that earn a fixed rate of interest if held for the specified
period, which can range anywhere from several months to
several years, commonly referred to as certificates of deposits
or CDs
money market funds an open-end mutual fund which invests only in money markets.
These funds invest in short term, one day to one year debt
obligations such as Treasury bills, certificates of deposits, and
commercial paper
Figure 5-1
Annual Average of M1 and M2 from 1959-2009
Source: www.federalreserve.gov
77
4. Commercial Banks and the Creation of Money

The money supply consists of more than the value of the currency. The determination of
the actual money supply depends on the behavior of commercial banks and their depositors. The
operating principles that apply to the money creation process in commercial banks, which we will
now review, easily apply to other depository institutions.
Suppose that a group of business people form the Bank of Tampa, a commercial bank with
numerous branches to satisfy their customers needs. For simplicity, assume that people prefer
checkable bank deposits to cash and they keep all of their currency with the commercial banks.
Also, assume that when customers buy a good or service they will write a check on their account.
Thus, no currency will actually circulate in the economy. Checks give the bank permission to
transfer dollars from the account of the person paying by check to the receiver of the check.
The assets of the commercial banking system equal the value of the currency sitting in the
banks vaults, the value of the government bonds held by the bank, and the value of loans issued by
the bank. The liabilities are the deposits of the banks customers, since checking account balances
represent money owed by the banks to the depositors. Bank reserves equal the currency that is
held by banks.
To begin the analysis, suppose that the Federal Reserve purchases $1 million in government
securities from the Bank of Tampa. This transaction is recorded in table 5-2. The sale of government
securities increases the Bank of Tampas reserves by $1 million.
In this example, the Bank of Tampa is the only commercial bank. Therefore, as reported
in table 5-2, bank reserves total $1,000,000. Bank reserves are held by banks in their vaults, rather
than circulated among the public, and thus are not counted as part of the money supply. Therefore,
the money supply equals $0 at this point.
Table 5-2
Balance sheet of the Bank of Tampa
Assets
Liabilities
Government bonds
- $1,000,000 Checkable deposits
Currency (=bank reserves) +$1,000,000
Loans
$0
78
$0
Because the Bank of Tampa earns no interest on the currency obtained from the sale of
government bonds, it will loan out the currency to try to earn a return. Suppose the bank loans out
$1 million to various businesses and individuals. The bank extends the loan by creating a checking
account for the businesses and individuals and immediately deposits the loan proceeds into them.
The transactions are recorded in table 5-3. Note that both assets and liabilities increased by $1
million (Assets: $1 million in loans and Liabilities: $1 million in deposits).
Table 5-3
Assets
Liabilities
Government bonds
-$1,000,000 Checkable deposits +$1,000,000
Loans
+$1,000,000
Checkable deposit balances are counted as money and therefore are part of the money
supply because they may be used in making transactions throughout the economy. In table 5-3, the
Bank of Tampa has $1,000,000 in checkable deposits. Therefore, the money supply in this example
equals $1,000,000. The situation in table 5-3 is unusual because 100 percent of the banks currency
is being held as reserves this is called 100 percent reserve banking.
A banking system in which banks have checkable deposits that exceed actual reserves
is called a fractional-reserve banking system. So, rather than operating at 100 percent reserve
banking, suppose that the Bank of Tampa operates as a fractional reserve banking system. Assume
that the Bank of Tampa is required by the government to keep reserves equal to only 20 percent of
deposits. Assume that it is estimated that 20 percent is enough to meet the random ebb and flow of
customer withdrawals and payments from their individual banks. Therefore, the Bank of Tampa
will issue loans to borrowers for interest for the remaining 80 percent of deposits.
Table 5-4 reports the new balance sheet of the Bank of Tampa. The Bank of Tampa has
loaned out $800,000 (80 percent of its currency) to businesses and individuals. Again, the bank
extends the loans by creating a checking account for the business and individuals and immediately
deposits the loan proceeds into them. The $800,000 in deposits subsequently increases the banks
currency, which is once again $1 million.
Table 5-4
Assets
Liabilities
Government bonds
- $1,000,000 Checkable deposits +$1,800,000
Loans
+$1,800,000
79
The Bank of Tampa has now loaned out $1.8 million, has $1.8 million in checkable deposits,
and has $1 million in reserves. The money supply is measured as the sum of checkable deposits and
currency in circulation. Because all currency is in the banks vault, it does not get counted as part
of the money supply. The money supply is equal to bank deposits or $1,800,000.
The Bank of Tampas target reserve-deposit ratio, bank reserves divided by checkable
deposits, is 20 percent. However, when we calculate its actual reserve-deposit ratio after issuing
loans, we discover that it is actually equal to 55.55 percent ($1 million / $1.8 million). Again,
the Bank of Tampa only needs 20 percent of deposits held in reserve. Twenty percent of its $1.8
million in deposits equals $360,000. Therefore, the bank currently has $640,000 too much in
reserve. Because of this excess, the Bank of Tampa will make another $640,000 worth of loans,
which are, of course, added to checkable deposits and currency. Table 5-5 summarizes the banks
new balance sheet.
Table 5-5
Assets
Liabilities
Government bonds
Loans
+$2,440,000
The money supply now equals $2,440,000. The Bank of Tampa needs 20 percent of its
$2.44 million in deposits or $488,000 held in reserve. Thus, the bank still has too much currency
held in reserve in its vault. More loans will be issued, more funds will be entered into checkable
deposits, and the money supply will continue to expand until the Bank of Tampa is left with only
20 percent in reserves. Table 5-6 reflects the banks balance sheet at the end of this process.
Table 5-6
Assets
Liabilities
Government bonds
Loans
+$5,000,000
The money supply at the end of the process equals $5 million. This means that the
fractional-reserve banking system has created a money supply that is five times larger than the
currency held in the banks vault. In this example, it was the Federal Reserves $1 million purchase
of government securities from the Bank of Tampa that created a money supply equal to $5 million.
Indeed, buying and selling government securities is the Federal Reserves most important tool that
it uses to increase the money supply.
80
Taking the data from this process, we may conclude that the following relationship holds:
bank reserves
= desired reserve deposit ratio
checkable deposits
This states that the banks reserves divided by the total of the banks checkable deposit obligations
equal the banks desired reserve deposits ratio. Inserting the data from table 5-6 yields:
$1,000,000
= .2
$5,000,000
As we stated above, 20 percent of deposits held in reserve exactly equals the percentage of
reserves that the bank chooses to hold. The empirical relation always holds. Therefore, we may
also rearrange the equation to help answer another question. If we know the amount of currency and
it is all held as bank reserves and we know the desired reserve-deposit-ratio, what will checkable
deposits equal? The following equation is written to solve for checkable deposits:
bank reserves
= checkable deposits
desired reserve deposit ratio
Thus, if reserves equal $1 million and the reserve-deposit-ratio is 20 percent, then checkable
deposits equal $5 million. Because checkable deposits equal the money supply in this example, the
money supply is $5 million.
$1,000,000
= $5,000,000
.2
In a different example, suppose bank reserves equal $2 million and the desired reserve
deposit ratio is 10 percent. Using the equation we can determine that bank deposits and thus the
money supply will total $20 million. And if bank reserves equal $2 million and the desired reserve
deposit ratio is 5 percent, then checkable deposits and the money supply will equal $40 million.
81
In summary, the banking systems ability to create money depends on the amount of bank
reserves and the desired reserve deposit ratio. From this example, we have worked through two of
the three ways in which the U.S. Federal Reserve may change the money supply. The first and most
often used way is by purchasing government securities. This tool changes the amount of currency
in circulation, which alters bank reserves. The second way is by changing the desired reservedeposit-ratio. Section 5 discusses the third way in which the Federal Reserve may change the
money supply: by changing the discount rate that the Federal Reserve charges banks for overnight
loans.
5. The Federal Reserve System and Monetary Policy
In some countries, the monetary authority is simply a branch of the government. In the
U.S., the Federal Reserve Bank has some independence from the political system. There are seven
board members on the Federal Reserves Board of Governors. Board members are appointed by
the president and confirmed by the Senate, but the members fourteen year tenure generally means
that the Federal Reserve is not under the control of the current administration.
The Federal Reserve System is made up of the Federal Reserve Board in Washington, D.C.
and 12 regional Federal Reserve Banks located in major cities around the country. Table 5-7 lists all
the regional Federal Reserve banks and their bank letter and number. All Federal Reserve notes are
printed at the Bureau of Engraving and Printing at the Department of Treasury, but they are issued
by the regional Federal Reserve banks. Each note has a letter and a number that tells you where the
note was issued. Take a look at your Federal Reserve notes and see for yourself.
Table 5-7
Federal Reserve Banks
Federal Reserve Bank District
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
Kansas City
Dallas
San Francisco
District Bank Letter

A
B
C
D
E
F
G
H
I
J
K
L
82
District Bank Number

1
2
3
4
5
6
7
8
9
10
11
12
The control of the money supply by the Federal Reserve Bank is known as monetary
policy. The Federal Reserve has three tools at its disposal to alter the money supply: open market
operations, reserve requirement changes, and changes to the Federal Reserves discount rate.
The Banking Acts of 1933 and 1935 centralized power of the Federal Reserve in Washington
D.C., and established the Federal Open Market Committee (FOMC). The FOMC is made up
of 7 members of the Board of Governors and 5 of the 12 regional bank presidents. All 12 regional
bank presidents are present at FOMC meetings, but only 5 vote at any given meeting. Voting rights
rotate among the regional bank presidents, except the New York Federal bank president always
votes.
The FOMC meets about every six weeks in Washington, D.C., in order to discuss the
condition of the economy and consider changes to monetary policy, most important of which is open
market operations. Open market operations are purchases and sales of government securities by
the Federal Reserve in an effort to influence the money supply. When the Federal Reserve decides
to purchase government securities (e.g., Treasury bills), it is choosing to increase the money supply
and when it decides to sell government securities it is choosing to reduce the money supply.
The second monetary policy option is to change the required reserve deposit ratio. As
discussed in section 4, an increase in the required reserve deposit ratio will lead to a decrease in
the money supply and a decrease in the required reserve deposit ratio will lead to an increase in the
money supply.
The third monetary policy tool is the Federal Reserve discount rate, which is the interest
rate on loans that the Federal Reserve charges to other banks. A bank borrows from the Federal
Reserve when it has too few reserves to meet reserve requirements. This might occur because the
bank made too many loans or because it has experienced too many recent withdrawals. When the
Federal Reserve increases the discount rate, it discourages banks from borrowing reserves from
the Federal Reserve. Thus, an increase in the discount rate reduces the quantity of reserves in
the banking system, which in turn reduces the money supply. And a decrease in the discount
rate, encourages borrowing reserves from the Federal Reserve, which in turn increases the money
supply.
83
6. The Value of Money and the Price Level

The price level and the value of money are directly related. As the overall level of prices
increases, the value of a unit of money decreases. For example, if we observe the price of a soda
increasing from 5 cents to $1.25 over 80 years, it is likely that the satisfaction level has stayed the
same and the money used to purchase a soda has decreased in value because of an increase in the
price level.
The price level and value of money relationship is best illustrated in figure 5-2, which
is a diagram of the demand and supply for money. In the figure, the quantity of money is on the
horizontal axis. The left hand vertical axis shows the value of money 1/P and the right hand axis
shows the inverted price level P.
Figure 5-2
The Money Market
Value of Money
(1/P)
Money Supply
Price Level
(P)
(high) 1
1 (low)
Money Demand
(low)
(low)
Quantity Fixed by
the Federal Reserve
the Federal Reserve
84
(high)
(high)
Quantity of Money / time
The supply of money is determined by the Federal Reserve and the overall banking system,
as discussed in sections 3 and 4 above. Three general policies shift the supply of money curve.1
Firstly, if the Federal Reserve buys government bonds in open market operations, it pays
out dollars and causes the money supply to shift to the right. When it sells government
bonds in open market operations, it takes in dollars and causes the supply of money curve
to shift to the left.
Secondly, if the Federal Reserve decreases the required reserve requirement, the supply
of money will shift to the right. And if the Federal Reserve increases the required reserve
deposit ratio, the supply of money will shift to the left.
Lastly, if the Federal Reserve decreases the discount rate, the supply of money will shift to
the right. When they increase the discount rate, the supply of money will shift to the left.
The demand for money reflects how much wealth people want to hold in liquid form at
any point in time. The most important determinant of how much money people demand is the
price level. Because money is a medium of exchange, they demand it to buy goods and services
throughout their ordinary business of life. Other assets like real estate, stocks, or bonds are not
very liquid and cannot be easily used to buy goods and services. Thus, the higher the price level,
the larger will be the quantity demanded of money (e.g., cash and checking account funds), so that
people can fulfill their transactions for goods and services.
In the long run, the overall level of price adjusts to the level at which the demand for money
equals the supply of money. This is shown in figure 5-2.
At equilibrium the price level or the price of goods measured in money is 2. This number
tells you that one basket of goods and services will cost you $2.
On the other hand, the value of money measured in terms of goods and services is . And
this number tells you that you are able to buy one-half of a basket of goods and services
with $1.
If for some reason the price level was equal to 3, people would demand a quantity of money
that exceeded the quantity supplied by the Federal Reserve. As a result, the price level would
decrease (and the value of money would increase) until equilibrium was again reached. When the
price level is lower than the equilibrium price level, the market will adjust back to equilibrium in
the long run.
___________________
1
We only consider the direct effect of the following policy changes. There are indirect effects that are
ignored here.
85
Monetary policy shifts the supply of money. If the Federal Reserve increases the supply
of money, the price level in the economy increases and the value of money decreases. Recall from
chapter 4, that an increase in the price level from one period to the next is called inflation. In this
case, because the Federal Reserve has increased the supply of money, it caused inflation in the
economy.
Alternatively, if the Federal Reserve decreases the supply of money, the price level in the
economy decreases and the value of money increases. A decrease in the price level from one period
to the next is called deflation.
86
CHAPTER SIX
Aggregate Demand & Aggregate Supply
1. Introduction
In chapters four and five we looked at the determinants of macroeconomic variables in the
long run. In macroeconomics, there are two major differences between the short run and the long
run. Firstly, in the long run we assume that there is a separation of real (adjusted for price level
changes) and nominal (not adjusted for price level changes) variables. This separation of real and
nominal variables is a concept that is formally called the classical dichotomy. Secondly, in the long
run, the money supply affects only nominal variables and not real variables. This is demonstrated in
chapter fives figure 5-2, where a change in the money supply by the Federal Reserve strictly causes
the price level to change, i.e., it causes inflation or deflation, and it has no effect on the real value
people place on goods and services. This second idea is formally called monetary neutrality.
However, when we look at year-to-year changes in the economy, the assumption of monetary
neutrality is no longer appropriate. In this chapter, we will drop the assumption of monetary
neutrality and develop a model of aggregate demand and aggregate supply that deals with short run
economic fluctuations.
In this model, the first variable is real gross domestic product (real GDP) and the second
variable is the overall price level (P) which is measured by the consumer price index or some
other index of prices in the economy.1 Notice, that this short run model reflects a breakdown of
the classical dichotomy because it uses a nominal variable, the price level, and a real variable, real
GDP, at the same time.
Key concepts introduced in this chapter include: classical dichotomy, monetary neutrality,
aggregate demand, the interest rate effect, the wealth effect, the open economy effect, the real
exchange rate, the short run aggregate supply, the profit effect, the misperceptions effect, the menu
costs effect, long run aggregate supply, potential real GDP, the natural rate of unemployment,
inflationary gap, deflationary gap, fiscal policy, automatic stabilizer, and monetary policy.
________________
1
See chapter 4 for definitions of the consumer price index and the producer price index
87
2. Aggregate Demand
The aggregate demand curve reflects the real gross domestic product demanded by all
groups in the economy at any given price level. Recall that nominal GDP is calculated by summing
up consumption spending, investment spending, government purchases, and net exports. And that
real GDP is equal to the nominal GDP adjusted for changes in the price level. That is,
NOMINAL GDP = C + I + G + NX, and
REAL GDP =
NOMINAL GDP
*100
PRICE LEVEL INDEX
It is important to realize that the aggregate demand curve is very different from an
individual market demand curve (individual market demand curves are discussed in chapter two).
The aggregate demand curve is literally an aggregation of all real market activity at each price
level. An economy, therefore, has just one aggregate demand curve. The substitution that takes
place in individual markets because of changes in the prices of independent variables absolutely
does not take place with an aggregate demand curve.
Figure 6-1 illustrates the downward sloping aggregate demand curve (AD). Real GDP is
located on the horizontal axis and price level (P) is on the vertical axis. Suppose the economy moves
from point A to point B on the aggregate demand curve because of a change in some exogenous
factor. In this case, a decrease in the price level causes an increase in the real GDP demanded by
all groups in the economy. On the other hand, suppose the economy moved from point B to point
A. Here an increase in the price level causes a decrease in the real GDP demanded by all groups in
the economy.
Figure 6-1
Aggregate Demand
Price Level
(P)
PA
PB
AD
Real GDPA
Real GDPB
88
Real GDP/time
To understand why the aggregate demand is negatively sloped we need to find out how the
price level affects the quantity of goods and services demanded. The three general explanations
for the negative slope of the aggregate demand curve are: the interest rate effect, real wealth effect,
and the open economy effect.
Firstly, the interest rate effect tells us that a reduction in the price level causes people to
convert cash to interest bearing assets. Interest bearing assets include assets such as bonds and
certificates of deposit. Interest bearing assets are commonly called loanable funds1, and this is the
term well use for our discussion. Figure 6-2 illustrates an increase in the supply of loanable funds
with a south-east shift of the supply of loanable funds curve from S1 to S2. The result of this southeast shift is a decrease in the interest rate and an increase in the quantity demanded of loanable
funds. Because the interest rate is equal to the price of investment goods, a decrease in the interest
rate causes an increase in spending on investment goods (I), which by definition increases REAL
GDP.
Figure 6-2
The Loanable Funds Market
S1
Interest rate
( i)
iA
S2
A
B
iB
D1
LA
LB
Quantity of loanable
funds/time
Secondly, a decrease in the price level makes consumers feel wealthier because each nominal
dollar can purchase more goods and services, relative to before the price level decrease. This is
known as the wealth effect. It also operates in the opposite direction. For example, if the price
level increases, each nominal dollar purchases fewer goods and services, decreasing real wealth.
Subsequently, this causes a decrease in real GDP demanded by all groups in the economy.
_______________________
1
The term loanable funds is a catch-all term that includes all resources available to finance investment
spending and capital accumulation.
89
Thirdly, when the price level falls, it causes the real exchange rate to depreciate. This
is called the open economy effect. The real exchange rate is the rate at which foreign made
goods can be bought or sold for domestic made goods. The depreciation of the real exchange rate
increases the quantity of exports and decreases the quantity of imports and therefore it increases
net exports (NX) or exports minus imports. Because of the increase in net exports, the quantity
demanded of real GDP increases.
The aggregate demand curve may shift to the north-east and to the south-west. Holding the
price level constant, if there is a change in consumption spending, investment spending, government
purchases, or in net exports, then the aggregate demand curve will shift. If we hold the price level
constant and increase any one of the four components of real GDP, then the aggregate demand
curve will shift to the north-east. And if we hold the price level constant and decrease any one of
the four components of real GDP, then the aggregate demand curve will shift to the south-west.
Table 6-1 contains examples of the variables that cause the aggregate demand curve to shift.
Table 6-1
Exogenous Variables that Shift Aggregate Demand
Increases in Aggregate Demand
Decreases in Aggregate Demand
(north-east shift)
(south-west shift)
Consumption (C)
Consumption (C)
lower personal taxes
higher personal taxes
a rise in consumer confidence
a fall in consumer confidence
greater stock market wealth
reduced stock market wealth
Investment (I)
Investment (I)
lower real interest rates
higher real interest rates
optimistic business forecasts
pessimistic business forecasts
lower business taxes
higher business taxes
Government purchases (G)
Government purchases (G)
an increase in government
a decrease in government
purchases
purchases
1
an increase in transfer payments
a decrease in transfer
payments
New Exports (NX)
New Exports (NX)
income increases abroad, which
income decreases abroad,
will likely increase exports
which will likely decrease
exports
_____________
1
See chapter four for a definition of a transfer payment.
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3. Aggregate Supply
The aggregate supply curve reflects the total quantity of goods and services that producers
in the economy are willing and able to produce at any given price level. In the short run, the
aggregate supply curve is upward sloping. In the long run, the aggregate supply curve is a vertical
line located at the economys potential real GDP.
The short run aggregate supply curve is upward sloping because of the profit effect, the
misperception effect, and the menu costs effect. Firstly, consider the profit effect. Salaried workers
frequently sign one year, or multiple year, labor contracts. Because such nominal wage (w) contracts,
do not automatically adjust (by definition) to the ebb and flow of real-time labor market prices, they
are considered sticky in the short run. In an environment with a lot of long term labor contracts, if
the price level (P) increases, employment and production become more profitable because real wage
expenditures (nominal wage/ the price level, or w/P), which are adjusted for changes in the price
level, actually decrease. If businesses observe real wage expenditures decreasing, they are more
likely to increase the production of their goods and services in an effort to increase real profits.
In summary, ceteris paribus, sticky wages in the short run 1) induce firms to increase the
production of goods and services when the price level increases and 2) induce firms to decrease
their production of goods and services when the price level decreases.
Secondly, the misperceptions effect argues that in the short run producers are temporarily
fooled about what is really causing price changes in the markets in which they sell their products.
Because of these misperceptions, producers respond to changes in the price level despite no change
in a products real price, and this response leads to an upward-sloping supply curve.
For example, suppose the owner of a lobster boat business sees the price of lobster increasing.
The owner believes that the real price of lobsters is increasing. That is, the owner believes that the
marketplace is increasing the value it assigns to lobsters. Because of this belief, the owner decides
to gather and sell more lobsters than before. However, if all nominal market prices increase and all
market prices remained constant relative to one another, then the increase in the price of lobsters is
because of inflation and not because the marketplace changed its valuation of lobster. In this case,
the lobster owner was fooled into increasing his lobster production because of a misperception
about the price level.
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Lastly, the menu cost effect argues that because it can be expensive to change menus
and pricing boards and because business owners dont want to constantly tell their customers that
theyve changed their prices, they dont do it often. This implies that when there is a change in
the price level because of a contraction in the economy, for example, producers keep their prices
unchanged. In this case, the real price charged by a producer actually increases, and customers
subsequently demand a smaller quantity because of these higher real prices. This behavior forces
the business to then cut back on production and employment. In the short run, when the price level
decreases and menu changing costs are high, real GDP declines.
At the end of the day, the best way to think about the short run aggregate supply curve is as
a composite of all three effects, because in reality they are all at work out there in the real world.
Figure 6-3 depicts a representative short run aggregate supply curve (SRAS). In the
figure, real GDP is on the horizontal axis and the price level in on the vertical axis. As the
price level increases from price level A (PA) to price level B (PB) real GDP increases from Real
GDPA to Real GDPB because of one or a combination of the three effects mentioned above.
Figure 6-3
Short Run Aggregate Supply
SRAS
Price Level
(P)
PB
PA
Real GDPA
Real GDPB
Real GDP/time
In the long run, every thing in the economy is variable. Prices, wages, interest rates, and
rents all fluctuate with market conditions. The long run provides enough of a time horizon for
producers to figure out whether a market price fluctuation is due to a change in consumer valuation
or a change in the price level. Therefore, in the long run, the aggregate supply curve is at potential
real GDP, which is the economys maximum sustainable output level given the supply of the
factors of production, the state of technology, and formal and informal institutions supporting the
economy.
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Figure 6-4 depicts the long run aggregate supply curve (LRAS). Again, real GDP is on the
horizontal axis and the price level is on the vertical axis. The aggregate supply curve is vertical in
the long-run. The location of the LRAS depends on the economys supply of land, capital, labor, and
entrepreneurial ability and the productivity of these resources, and not the price level.
An important point to emphasize is that unemployment exists when the real GDP is equal
to potential real GDP. The unemployment that exists when the economy is operating at potential
real GDP is called the natural rate of unemployment. This level of unemployment includes
structural and frictional unemployment, but excludes cyclical unemployment.1 The natural rate of
unemployment moves slowly over time but it is currently estimated at between 4 and 5 percent.
Figure 6-4
Long Run Aggregate Supply
Price Level
(P)
LRAS
Potential Real GDP
Real GDP/time
The short run and long run aggregate supply curves shift when there is a change in any
one of the factors of production. If there is a permanent increase in a factor of production, then the
short run aggregate supply curve shifts to the south-east and the long run aggregate supply curve
shifts to the right. And if there is a permanent decrease in a factor of production, then the short run
aggregate supply curve shifts to the north-west and the long run aggregate supply curve shifts to
the left.
__________
1
See chapter 4 for an explanation of structural, frictional, and cyclical unemployment.
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Some other factors exclusively shift the short run aggregate supply curve. For example, a
change in the price of a factor of production will only affect the short run aggregate supply curve if
it does not reflect a permanent change in the supply of that factor of production. For example, figure
6-5 depicts the effect of a decrease in the price of electricity. Businesses that use electricity increase
their production to a new (higher) profit maximizing quantity supplied, at any given price level,
because the price of electricity has decreased. Thus, cheaper input costs cause a south-east shift
of the short run aggregate supply curve from SRAS1 to SRAS2. However, the long run aggregate
supply curve does not shift so long as the capacity to produce electricity has not been increased.
A second type of exogenous change that only affects the short run aggregate supply curve
is a temporary supply shock. Examples include an expected terrorist threat that never materializes
but causes workers to stay home for a period of time; a hurricane that hit, but did not alter the long
run productive capacity of the economy; and a labor union strike. Each of the above would cause
the short run aggregate supply curve to shift to the north-west for a temporary period of time. After
the event and with the passage of time the short run aggregate demand curve would shift back to its
original location, ceteris paribus.
Figure 6-5
Short and Long Run Aggregate Supply
Price Level
(P)
SRAS1
LRAS
SRAS2
Potential Real GDP
94
Real GDP/time
Table 6-2 contains examples of the factors that cause the short run aggregate supply and the
long run aggregate supply curve to shift. Again, these factors shift both the long run and short run
aggregate supply only if the effect is permanent. If the effect is not permanent, then only the short
run aggregate supply curve will shift.
Table 6-2
Exogenous Variables that Shift Aggregate Supply
An increase in Aggregate Supply
(SRAS: south-east shift)
(LRAS: rightward shift)
Lower costs
lower wages
other input prices fall
Government Policy
tax cuts
deregulation
lower trade barriers
Economic growth
improvements in technology
productivity advances
an increase in labor
Favorable weather
A decrease in Aggregate Supply

(SRAS: north-west shift)
(LRAS: leftward shift)
Higher costs
higher wages
other input prices rise
higher oil prices
Government Policy
tax increases
overregulation
higher trade barriers
A decline in labor productivity
Terrorist Attacks
Natural Disasters
Unfavorable weather
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4. Aggregate Demand & Aggregate Supply

In this section we will put aggregate demand, short run aggregate supply, and long run
aggregate supply together in one diagram and then analyze two shocks to the macroeconomic
economy.
Consider the economy depicted in figure 6-6. This economy is in long run equilibrium
at point A, where the price level is PA and aggregate output is equal to potential real GDP. Now
suppose that there is a wave of optimism in the economy because of a boom in the stock market
or because of a feeling that the economy is on the right track. Such an event induces people to
positively alter the consumption and investment plans. The net effect of a wave of optimism is
for people to increase their consumption of goods and services at any given price level. Thus, the
wave of optimism causes AD1 to shift to the north-east to AD2. As a result of the shift in aggregate
demand, the price level increases to PB and aggregate output increases to real GDPB.
Figure 6-6
Shifts in Aggregate Demand and Aggregate Supply
Price Level
(P)
PC
PB
PA
LRAS
SRAS2
C
SRAS1
B
A
AD2
AD1
Potential Real GDPB
Real GDP
Real GDP/time
The difference between potential real GDP and real GDPB in figure 6-6 is called an
inflationary gap. When an economy experiences an inflationary gap such as this, the actual price
level is higher than what workers expected. Workers eventually figure out the actual price level
and realize that their real wage, adjusted for inflation, is lower than they expected and they demand
higher real wages. In the aggregate, businesses react to the increase in labor costs by decreasing
the quantity that they are willing and able to produce at any given price level. This reaction by the
business community causes the short run aggregate supply curve to shift north-west from SRAS1
to SRAS2. At point C, the inflationary gap is eliminated and the economy is back at its sustainable
level of output. However, the price level has increased to PC.
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Now consider figure 6-7, which is an economy in long run equilibrium at point C with a price
level equal to PC and aggregate output equal to potential real GDP. Suppose a wave of pessimism
washes over the economy, lowering consumer confidence and decreasing the quantity of goods and
services that consumers demand at any given price level. As a result, AD1 shifts south-west to AD2.
The short run equilibrium is now at point B, where the price level is PB and aggregate output is at
real GDPB.
The difference between potential real GDP and real GDPB in figure 6-7 is called a deflationary
gap. An economy that is in a deflationary gap experiences an unemployment rate that is higher
than the natural rate of unemployment. This is the case because cyclical unemployment1 is now
added to the natural rate of unemployment.
The economy will eventually self-correct and eliminate a deflationary gap. For example,
because of the higher than natural rates of unemployment, workers are willing to accept lower
wages in an effort to get a job. In the aggregate, businesses experience lower input costs and as
a result they increase their profit maximizing quantity supplied at every given price level. This
is demonstrated in figure 6-7 with a south-east shift of the short run aggregate supply curve from
SRAS1 to SRAS2. Long run equilibrium is again reached at point A. At this point, the price level
equals PA, the recessionary gap is eliminated, and the economy is again operating at potential real
GDP.
Figure 6-7
Shifts in Aggregate Demand and Aggregate Supply
Price Level
(P)
LRAS
SRAS1
C
PC
PB
SRAS2
B
A
PA
AD1
AD2
Real GDPB
Potential
Real GDP
_____________
1
See Chapter 4 for a definition of cyclical unemployment.
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Real GDP/time
5. Fiscal Policy & Short Run Economic Fluctuations

The governments fiscal policy is its plan for managing aggregate demand through
governments power to tax individuals and businesses and its power to spend and transfer the tax
revenues that it collects. Fiscal policy can be used 1) to stimulate aggregate demand when the
economy is in a deflationary gap and 2) to slow the economy down when it is in an unsustainable
inflationary gap.
Suppose the economy is in a deflationary gap. The short run equilibrium point A, in figure
6-8, depicts this scenario because the actual real GDPA is below the economys potential real GDP.
In this case, the government could use fiscal policy to increase aggregate purchases of goods and
services, to increase transfer payments to its citizens, or to decrease taxes, ceteris paribus. Each of
these changes will cause the aggregate demand curve to shift to the north-east from AD1 to AD2. If
the fiscal policy were implemented precisely, then the economy would be in equilibrium at point B,
where output is equal to potential real GDP and the price level is PB.
Figure 6-8
Fiscal Policy and a Deflationary Gap
Price Level
(P)
LRAS
SRAS1
B
PB
PA
AD2
AD1
Real GDPA
Potential
Real GDP
98
Real GDP/time
On the other hand, suppose the economy is in an inflationary gap, which is depicted in
figure 6-9. In this scenario, a fiscal policy that decreases government purchases, decreases transfer
payments, or increases taxes would slow the economy down and cause the aggregate demand curve
to shift to the south-west from AD1 to AD2. Again, if done precisely, fiscal policy of this type would
cool the economy off and bring it back to equilibrium point A, where aggregate quantity demanded
equals potential real GDP and the price level equals PA.
Figure 6-9
Fiscal Policy and an Inflationary Gap
Price Level
(P)
LRAS
SRAS1
B
PB
PA
A
AD1
AD2
Potential
Real GDP
Real GDPB
Real GDP/time
Several caveats are in order. Generally speaking, the government is not able to precisely
estimate how much fiscal policy stimulus the economy needs when it is in deflationary gap. Nor
does the government know how much fiscal policy is needed to cool the economy off when it is in
an inflationary gap. Nevertheless, the direction is clear and a relative magnitude can be estimated
so that fiscal policy can be helpful in both cases.
A more important concern is the lag time associated with much fiscal policy. Tax and
spending changes must pass through the Congress, which takes time. Thus, it is possible that an
economic stimulus will arrive after the economy has already self-corrected. Or a fiscal policy that
is intended to cool off the economy arrives when the economy is slipping into a recession.
Automatic stabilizers exist because they help solve the problem of fiscal policy lags.
Automatic stabilizers automatically stimulate the economy when it enters a deflationary gap and
automatically cools the economy down when it enters an inflationary gap. Automatic stabilizers are
a just-in-time fiscal policy, because they operate without policymakers having to take any deliberate
action. Examples of automatic stabilizers include unemployment insurance, welfare benefits, and
income taxes.
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6. Monetary Policy & Short Run Economic Fluctuations

Monetary policy is any action that changes the supply of money and alters the interest
rate. In the United States, monetary policy is implemented by the Federal Reserve System.
Figure 6-10 depicts a new model of the money market (one that is different from the model
presented in chapter 5) that is helpful in showing the effects of monetary policy changes. In this
model, the interest rate is on the vertical axis and the quantity of money is on the horizontal axis.
The money supply curve (MS) is vertical because it is determined by the Federal Reserve. The
money demand curve (MD) is downward sloping. This is the case because as the interest rate
increases, the opportunity cost of holding money increases and the quantity demanded of money
decreases. Also, as the interest rate decreases, the opportunity cost of holding money decreases and
people choose to increase there quantity demanded of money. The equilibrium interest rate is the
interest rate that balances the quantity demanded and quantity supplied of money.
Figure 6-10
The Money Market
Interest Rate
(i)
MS1
MS2
i1
i2
MD1
Q1
Q2
Quantity of Money/time
Assume that the money market is in equilibrium where the equilibrium interest rate is i1
and the equilibrium quantity of money is Q1. Suppose that the Federal Reserve increases the money
supply from MS1 to MS2 by implementing one or several of its three monetary tools (see chapter 5
for a discussion of monetary tools). An increase in the money supply would cause a decrease in the
interest rate from i1 to i2 and an increase in the equilibrium quantity of money from Q1 to Q2. If the
Federal Reserve subsequently decreased the money supply from MS2 to MS1, then the interest rate
would increase back to i1 and the equilibrium quantity of money would decrease back to Q1.
100
Consider equilibrium point A in figure 6-11, which depicts the economy in a deflationary
gap. In this situation, the Federal Reserve could increase the money supply and reduce the interest
rate. A decrease in the interest rate reduces the cost of borrowing and induces consumption and
investment expenditures by consumers and businesses, which by definition stimulates real GDP
at every price level. If done precisely, aggregate demand will increase from AD1 to AD2 and the
economy will be in equilibrium at point B. In summary, a monetary policy injection by the Federal
Reserve can stimulate an economy and pull it out of a deflationary gap.
Figure 6-11
Monetary Policy and a Deflationary Gap
Price Level
(P)
PB
PA
LRAS
SRAS1
B
A
AD2
AD1
Real GDPA
Potential
Real GDP
Real GDP/time
Alternatively, suppose the economy is at an unsustainable inflationary gap similar to point

B in figure 6-12. In this situation, the Federal Reserve could decrease the money supply and
thereby increase the interest rate. An increase in the interest rate increases the cost of borrowing
and causes a reduction in consumption and investment expenditures by consumers and businesses
at every price level. Therefore, a decrease in the money supply causes the aggregate demand
curve to shift to the south-west from AD1 to AD2 and returns the economy back to its long run
equilibrium.
Figure 6-12
Monetary Policy and an inflationary Gap
Price Level
(P)
LRAS
SRAS1
B
PB
A
PA
AD1
AD2
Potential
Real GDP
Real GDPB
101
Real GDP/time
Glossary
1. the factors of production - The factors of production encompass all the possible productive
resources used to produce goods and services. Labor, capital, land, and entrepreneurial ability are
examples of factors of production.
2. opportunity cost - The opportunity cost of something is what you give up to get it.
3. production possibilities frontier - A production possibilities frontier is a model of a two-good
economy that shows how much the economy can produce using all of its factors of production
efficiently.
4. increasing opportunity cost - As more and more of an economys factors of production are
employed in the production of a good, the economy must sacrifice the production of other goods at
an increasing rate.
5. absolute advantage - To have an absolute advantage in something means that one has the lowest
absolute production cost relative to those with whom they are compared.
6. comparative advantage - To have a comparative advantage in something means that one has
the lowest opportunity cost relative to those with whom they are compared.
Chapter 2
1. a demand schedule - A table showing the relationship between price and the quantity of a good
that buyers are willing to buy.
2. a demand curve - A demand curve is a picture of the way an individual responds to changing
prices of a good.
3. a demand function - A relationship between independent demand variables, such as the price
of good X and the price of a substitute good Y, and the dependent variable, the quantity demanded
of good X.
4. the law of demand - As the price of a good increases, ceteris paribus, the quantity demanded of
the good decreases.
5. the market demand curve - The horizontal summation of individual demand curves yields the
market demand curve.
6. the market demand schedule - The market demand schedule is a table that is calculated by
summing up how many units of a good buyers are willing to purchase at every market price.
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7. the price elasticity of demand - A measure of the relationship between a percentage change in
the market price of product and a consequential percentage change in the quantity demanded of a
product.
8. the cross price elasticity of demand - A measure of the relationship between a percentage
change in the market price of product X and a consequential percentage change in the quantity
demanded of product Y.
9. the income elasticity of demand - A measure of the relationship between a percentage change
in income and a consequential percentage change in the quantity demanded of a product.
10. a supply schedule - A table showing the relationship between price and the quantity of a good
that sellers are willing to produce.
11. a supply curve - A supply curve is a picture of the way in which a producer responds to
changing market prices of a good.
12. a supply function - A relationship between independent supply variables, such as the price of
inputs and technology, and the dependent variable, the quantity supplied of a good.
13. the law of supply - As the price of a good increases, ceteris paribus, the quantity supplied of
the good increases.
14. the market supply curve - The horizontal summation of individual supply curves yields the
market supply curve.
15. the market supply schedule - The market supply schedule is calculated by summing up how
many units of a good sellers are willing to produce at every market price.
16. the elasticity of supply - A measure of the relationship between a percentage change in the
market price of a product and a consequential percentage change in the quantity supplied of a
product.
17. market equilibrium - An economic balance in which no individual would be better off doing
something different; an equality of supply and demand.
18. comparative-static analysis - The process of comparing two market equilibrium (static) points,
one equilibrium point before and the other after a change in an independent variable.
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Chapter 3
1. the short run - The short run is a time horizon within which a business is unable to adjust at
least one input. In other words, in the short run there exists some fixed cost.
2. the long run - The long run is a time horizon long enough for the seller to adjust all inputs.
Thus, if you observe a business with no fixed costs, then it is in a long run state.
3. fixed costs - Costs that do not vary with changes in the quantity produced are called fixed
costs.
4. variable costs - Costs that do vary with changes in the quantity produced are called variable
costs.
5. total costs - The sum of fixed costs and variable costs.
6. average fixed costs - Average fixed cost equals fixed cost divided by the quantity produced.
7. average variable costs - Average variable cost equals the variable cost divided by the quantity
produced.
8. average total costs - Average total cost equals the total cost divided by the quantity produced or
it is the sum of average fixed cost plus average variable cost.
9. marginal costs - Marginal cost is equal to the change in the total cost that arises from an extra
unit of production. It is calculated by taking the change in total cost and dividing it by the change
in the quantity produced.
10. sunk costs - A cost that has already been committed and cannot be recovered.
11. total revenue - Total revenue is calculated by multiplying price and quantity.
12. marginal revenue - Marginal Revenue is the change in total revenue generated from an
additional unit sold. It is calculated by taking the change in total revenue divided by the change in
quantity sold.
13. perfect competition - An industry with many buyers and many sellers. An industry in which
the good is homogeneous. And it is an industry in which all who want to enter the industry are free
to do so and any business may exit at a time of their choosing.
14. monopoly - An industry controlled by a monopolist. A monopolist is a firm that is the
only seller of a good. The good the monopolist sells is heterogeneous. And the market that the
monopolist sells its product in has barriers to entry.
15. the profit maximizing rule - The profit maximizing rule states that a business maximizes
profits when it produces where the marginal revenue from selling another unit equals marginal
cost of producing an additional unit.
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16. the shut down rule - A business should shut down if production at the profit maximizing
quantity (where MR=MC) generates total revenues that are less than variable costs, in all other
cases the business should stay open.
17. economies of scale - A range of production in which average total costs decline as output
increases.
18. diseconomies of scale - A range of output in which average total costs increase as output
increases.
19. constant economies of scale - A range of production where average total costs remain constant
as output increases.
20. joint costs - Costs that do not change with changes in the scope of production.
21. economies of scope - When an organization can produce several products together at less cost
than could a group of single product firms operating independently.
Chapter 4
1. nominal gross domestic product - The market value of final goods and services produced at
current year prices.
2. the business cycle - Fluctuations in economic activity, such as employment and real GDP.
3. real gross domestic product - A measure of the market value of the production of final goods
and services, controlling changes in the price level.
4. transfer payments - Transfer payments are a sum of money that the government gives to certain
individuals as outright grants. Examples of a transfer payment include a social security payment,
a welfare benefit, and unemployment insurance benefit.
5. the national income identity - The accounting concept which states that, in a time period,
aggregate expenditure on wages, interest, rents, and profits is equal to nominal GDP is equal to
consumption spending, investment spending, government spending, and net exports.
6. the circular flow - The cycle depicted in the circular flow diagram graphically depicts the
national income identity.
7. the consumer price index - The consumer price index (CPI) measures changes over time
in the cost of buying a market basket of goods and services purchased by a typical family.
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9. the inflation rate - A percentage change in a price index between two periods.
10. the unemployment rate - The unemployment rate is defined as the percent of people who do
want a job right now, have been looking for work, but have not found a job that they would take
divided by the labor force.
11. the labor force - The sum of people that have a job and those that are actively seeking a job.
12. discouraged workers - People who have tried to find a job for a long period of time and can
not find a job. They are frustrated in their search and have stopped looking for work.
13. the types of unemployment - Frictional unemployment (which occurs because it takes time
for workers to search for the jobs that best suit their tastes and job skills), structural unemployment
(which occurs because the number of jobs available in a labor market is insufficient to provide
jobs for all that want a job), and cyclical unemployment (which occurs because of declines in the
economys aggregate output during economic contractions and recessions).
Chapter 5
1. the functions of money - The three basic functions of money are a medium of exchange, a store
of value, and a unit-of-account. Money is a medium of exchange because money makes exchange
easier. Money is also a store of value. People will hold money only if they believe it will continue
to have some value, so money can operate as a medium of exchange only if it serves as a store of
value. Lastly, money is a unit-of-account. Money is a convenient and widely recognized measure
for accounting and transactions; it is a yardstick for measuring the value of all goods and services.
2. the types of money - Paper money that has no intrinsic value, e.g., the U.S. dollar, is known
as fiat money. Fiat money is paper money that derives its status as money from the power of the
state, or by fiat. It is money because the government says that it is money, it otherwise has no real
value. Fiat money can be contrasted with commodity money, which exists when some intrinsically
valuable good also serves as money. Gold is an example of commodity money because it has value
even if it were not used as money.
3. classifications of the money supply - The most narrowly defined money supply is M1, which
includes currency, travelers checks, demand deposits, and other checkable deposits. M2 is more
expansive. It includes everything in M1, plus savings deposits, small time deposits, money market
mutual funds, and a few other minor categories.
4. the money creation process - A process that describes the amount of money the banking system
creates with each dollar held in reserve.
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5. bank reserves - Deposits that a bank has received but has not loaned out.
6. required reserve deposit ratio - Bank reserves divided by checkable deposits.
7. the Federal Reserve Bank - The central bank of the United States.
8. monetary policy - The setting of the money supply by policymakers at the central bank. The
central bank, e.g., the Federal Reserve Bank in the U.S., has three tools at its disposal to alter the
money supply: open market operations, reserve requirement changes, and changes to the Federal
Reserves discount rate.
9. the price level - A measure of the cost of a typical market basket. Measures of the price level
are the consumer price index and the producer price index. As the overall level of prices increases,
the value of a unit of money decreases.
10. the value of money - The quantity of real goods and services that each nominal unit of money
can purchase.
11. money supply - The quantity of money available in the economy.
12. money demand - A relationship between independent variables such as the interest rate and
the price level and the dependent variable quantity demanded of money. For example, as the price
level increases, ceteris paribus, the quantity demanded of money decreases.
Chapter 6
1. classical dichotomy - In the long run, we assume that there is a separation of real (adjusted for
price level changes) and nominal (not adjusted for price level changes) variables. This separation
of real and nominal variables is a concept that is formally called the classical dichotomy.
2. monetary neutrality - A concept that in the long run, the money supply affects only nominal
variables and not real variables. This is demonstrated in chapter fives figure 5-2, where a change
in the money supply by the Federal Reserve strictly causes the price level to change, i.e., it causes
inflation or deflation, and it has no effect on the real value people place on goods and services.
3. aggregate demand - The aggregate demand curve reflects the real gross domestic product
demanded by all groups in the economy at any given price level.
107
4. the interest rate effect - The interest rate effect tells us that a reduction in the price level causes
people to convert cash to interest bearing assets. An increase in the supply of loanable funds causes
a south-east shift of the supply of loanable funds, which leads to a lower interest rate. Because
the interest rate is equal to the price of investment goods, a decrease in the interest rate causes an
increase in spending on investment goods (I), which by definition increases real GDP
5. the wealth effect - A decrease in the price level makes consumers feel wealthier because each
nominal dollar can purchase more goods and services, relative to before the price level decrease.
This causes an increase in real GDP demanded at every price level.
6. the open economy effect - When the price level falls, it causes the real exchange rate to
depreciate. The real exchange rate is the rate at which foreign made goods can be bought or sold for
domestic made goods. The depreciation of the real exchange rate increases the quantity of exports
and decreases the quantity of imports and therefore it increases net exports (NX) or exports minus
imports. Because of the increase in net exports, the quantity demanded of real GDP increases.
7. the real exchange rate - The real exchange rate is the rate at which foreign made goods can be
bought or sold for domestic made goods.
8. the short run aggregate supply - The aggregate supply curve reflects the total quantity of
goods and services that producers in the economy are willing and able to produce at any given
price level. The short run aggregate supply curve is upward sloping because of the profit effect, the
misperception effect, and the menu costs effect.
9. the profit effect The concept that, ceteris paribus, sticky wages in the short run 1) induce firms
to increase the production of goods and services when the price level increases and 2) induce firms
to decrease their production of goods and services when the price level decreases because it leads
to an increase in real profits.
10. the misperceptions effect - The misperceptions effect argues that in the short run producers
are temporarily fooled about what is really causing price changes in the markets in which they sell
their products. Because of these misperceptions, producers respond to changes in the price level
despite no change in a products real price, and this response leads to an upward-sloping supply
curve.
11. the menu costs effect - The menu cost effect argues that because it can be expensive to change
menus and pricing boards and because business owners dont want to constantly tell their customers
that theyve changed their prices, they dont do it often. This implies that when there is a change
in the price level because of a contraction in the economy, for example, producers keep their prices
unchanged.
108
12. long run aggregate supply - The aggregate supply curve is vertical in the long-run. The
location of the long run aggregate supply curve depends on the economys supply of land, capital,
labor, and entrepreneurial ability and the productivity of these resources, and not the price level.
13. potential real GDP - The economys maximum sustainable output level given the supply of
the factors of production, the state of technology, and formal and informal institutions supporting
the economy.
14. the natural rate of unemployment - The unemployment that exists when the economy is
operating at potential real GDP is called the natural rate of unemployment.
15. inflationary gap - The inflationary gap is the amount by which the equilibrium level of real
GDP exceeds potential real GDP.
16. deflationary gap - The deflationary gap is the amount by which the equilibrium level of real
GDP falls short of potential real GDP.
17. fiscal policy - The governments fiscal policy is its plan for managing aggregate demand
through governments power to tax individuals and businesses and its power to spend and transfer
the tax revenues that it collects.
18. automatic stabilizer - Automatic stabilizers automatically stimulate the economy when it enters
a deflationary gap and automatically cools the economy down when it enters an inflationary gap.
Automatic stabilizers are a just-in-time fiscal policy, because they operate without policymakers
having to take any deliberate action. Examples of automatic stabilizers include unemployment
insurance, welfare benefits, and income taxes.
19. monetary policy - Monetary policy is any action that changes the supply of money. In the
United States, monetary policy is implemented by the Federal Reserve System.
109
Charts & Graphs

Chapter 1
Pretest Question 7
Pretest Questions 9 & 10
110
Exercise 1
Exercise 3
Chapter
apter 2
Exercise 2
Exercise 4
111
Chapter 3
Exercise 1
Exercise 2
112
Exercise 3
Exercise 5
113
Chapter 4
Exercise 1
Exercise 2
Year
2003
2004
2005
Price of wine
per bottle
Price of pizza
per pie
Price of salad
per pound
Price of cheese
per pound
$15.00
$18.00
$16.50
$10.00
$12.00
$12.00
$7.50
$5.25
$6.00
$25.00
$30.00
$30.00
Exercise 3
Year
2003
2004
2005
Price of steel
per ton
$250
$300
$325
Price of copper
per ton
Price of raw paper

per ton
$1,000
$1,200
$1,500
$800
$1,000
$800
114
Price of plastic
per ton
$120
$150
$180
Exercise 4
Chapter 5
Exercise 2
Balance sheet of the Bank of Boston
Government bonds
Currency (=bank reserves)
Loans
115
Chapter 6
Exercise 4
LRAS
Price Level
(P)
PC
PB
SRAS2
C
D
SRAS1
B
PA
AD2
AD1
Real GDPD Potential Real GDPB
Real GDP
Real GDP/time
Exercise 5
LRAS
Price Level
(P)
PC
PB
PA
SRAS2
C
D
SRAS1
B
A
AD2
AD1
Real GDPD Potential Real GDPB
Real GDP
Real GDP/time
116

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Fundamentals of Economics

Chapter One - Comparative Advantage and the Benefits of Trade..............1

4. Absolute Advantage versus Comparative Advantage

one dines at a restaurant rather than cooking a meal at home;

5.2 Elizabeths Production Possibilities Frontier

5.6 The Range of Possible Trading Terms

6. Example 2: Cape Cod and Nantucket

Number of labor hours needed Number of labor hours

2.2 Sarahs Demand Curve

2.3 Sarahs Demand Function

2.5 Shifts of the Demand Curve

Sarah & Johns

Q demanded = f (Pwine ;Pcomplement ,Psubstitute ,I,T & P, E,# of Buyers)

Market Demand Curve

2.7 The Price Elasticity of Demand

new quantity - initial quantity

new price + initial price

percentage change in price =

new price + initial price

Inserting our specific market prices for wine yields:

new quantity + initial quantity

new price - initial price

new price + initial price

new quantity good 1 - initial quantity good 1

EQGood 1,, PGood 2 =

new price good 2 - initial price good 2

Inserting our data yields:

$8.50 pound - $6.50 pound

$35 gallon - $29 gallon

new quantity - initial quantity

new income + initial income

Big Reds Vineyard is one supplier in the

3.3 An Individual Supply Function

The Market Supply:

3.6 The Supply Elasticity

new quantity + initial quantity

new price + initial price

new quantity + initial quantity

new price - initial price

new price + initial price

Market Demand Curve

5.1 A Shift in Demand

5.1.2 An Increase in the Price of a Complement

5.1.3 A Decrease in Income for a Normal Good

5.1.4 A Decrease in Income for an Inferior Good

5.2 A Shift in Supply

5.2.2 A Decrease in the Price of Capital (the Interest Rate)

5.3 A Shift in Demand and a Shift in Supply

5.4 Price Controls

5.4.2 A Binding Price Floor

5.5 Per-Unit Taxes

5.5.2 A Tax on Sellers

The Costs of Production and Profit Maximization

Fixed Cost (FC)

Variable Cost (VC)

Total Cost (TC)

Average Fixed Average

variable cost divided by quantity

total cost divided by quantity

3. The Profit Maximizing Decision

there are many buyers and sellers,

there are many buyers and only one seller,

4. Scale and Scope Economies

Printing Press Ink and Paper Electric Power Total