Академический Документы
Профессиональный Документы
Культура Документы
ECONOMICS:
BUSINESS, BANKING, FINANCE,
AND YOUR EVERYDAY LIFE
COURSE GUIDE
Executive Producer
John J. Alexander
Executive Editor
Donna F. Carnahan
RECORDING
Producer - David Markowitz
Director - Matthew Cavnar
This course was directed and edited by Richard Stanley.
COURSE GUIDE
Editors - James Gallagher
Design - Edward White
Principles of Economics:
Business, Banking, Finance, and Your Everyday Life
Introduction ......................................................................................................................5
Lecture 3 Fiscal Policy and Budget Deficits: The Good, Bad, and Ugly................14
Lecture 4 Monetary Policy: It’s All About Money, Credit, and Banking..................22
Lecture 14 Land, Labor, and Capital: How Our Rents, Wages, and
Interest Rates Are Set............................................................................76
Course Materials............................................................................................................80
3
About Your Professor
Peter Navarro
Peter Navarro is a business professor at the
Paul Merage School of Business at the
University of California, Irvine. He holds a
Ph.D. in economics from Harvard University
© Photo courtesy of Professor Peter Navarro
You will get the most out of this course if you have the following book:
Economics: Principles, Problems, and Policies, 16th edition, by Campbell R.
McConnell and Stanley L. Brue (New York: McGraw-Hill, 2005).
You will find it useful for the lectures on macroeconomics to also have a
copy of If It’s Raining in Brazil, Buy Starbucks, New York: McGraw-Hill, 2004,
which provides an excellent overview of the various economic indicators used
to forecast the business cycle. It also illustrates how to use macroeconomics
in a stock market investing context.
Acknowledgment
My deep thanks to Pedro Sottile for his yeoman work as my long-time
research associate. I’d also like to profusely thank my technical “whiz kid”
Richard Stanley for his wonderful sound editing work in the early stages of
recording this project.
4
Introduction
This course introduces both macroeconomics and microeconomics.
Macroeconomics focuses on the big economic picture—specifically, how the
overall national and global economies perform. It is a subject that focuses on
big problems like unemployment and inflation and the dire threats that large
budget deficits and trade deficits can pose for economic well-being.
At a business and professional level, macroeconomics can help to answer
questions such as the following: How much should I manufacture this month?
How much inventory should I maintain? Should I invest in new plant and
equipment? Expand into foreign markets? Or downsize my firm?
At a personal level, macroeconomics can also help to answer equally impor-
tant questions: Should I switch jobs—or ask for a raise? Should I buy a
house now or wait until next year? Should I get a variable or fixed-rate mort-
gage? And what about my investments for retirement?
In contrast, microeconomics deals with the behavior of individual markets
and the businesses, consumers, investors, and workers who make up the
macroeconomy. Microeconomics focuses on issues such as how prices are
set, how wages are determined, how rents are set, and why the government
is sometimes forced to regulate industries that are too monopolistic, that pol-
lute too much, or that may conceal vital information.
At a business level, microeconomics can help to answer the following ques-
tions: How can my firm minimize its costs and increase its profits? What
prices should I charge for my products? How should I respond to an aggres-
sive strategic move by one of my competitors?
At a personal level, microeconomics is equally practical. It can help to
answer questions such as the following: Will I really be better off financially if
I quit my job now and go back for an MBA degree? What kind of career
should I be preparing myself for? What about that new refrigerator or automo-
bile I want to buy—should I get the new, energy-efficient one with the higher
price tag or settle for the cheaper model?
Most broadly, microeconomics can help you to understand why the govern-
ment is so involved in our economic lives. It can do so by answering ques-
tions such as the following: Why does the government regulate prices in
industries like electricity and gas, but not in others? Why are there laws
requiring seat belts and motorcycle helmets? Why do we have a Federal
Environmental Protection Agency and thousands of rules about workplace
safety? And why does the government provide some goods and let the free
market provide others?
My hope is that you will not only enjoy this course immensely, but you will
also find it helpful in those areas of economics that affect both your personal
and professional life.
Good luck!
~Peter Navarro
www.peternavarro.com
5
Lecture 1:
Introduction to Macro- and Microeconomics
LECTURE OBJECTIVES
Introduction to
Macroeconomics and
Microeconomics
• Economics can be
a difficult subject
at times, but it is
also one of the
most interesting lipa
rt.co
m
©C
and readily
applicable sub-
jects that you can
ever learn.
• We distinguish between the two main branches of economics: macroeco-
nomics and microeconomics.
• Macroeconomics is a subject
that focuses on big problems
like unemployment and infla-
tion and the dire threats that
large budget deficits and
trade deficits can pose for
our economic well-being.
• Microeconomics deals with
the behavior of individual
markets and the businesses,
consumers, investors, and
workers that make up the
macro economy.
LECTURE ONE
© Clipart.com
6
FOR GREATER UNDERSTANDING
Questions
Websites to Visit
7
Lecture 2:
The Business Cycle and the
Warring Schools of Macroeconomics
LECTURE OBJECTIVES
1. Learn about the business cycle and how its movements from
recession to expansion and back to recession are measured.
2. Explore the reasons why recessions and expansions happen in
the business cycle.
3. Explore the so-called “warring schools” of macroeconomics and
examine their very different views of why the economy may suf-
fer problems and what should be done to solve those problems.
4. Show how these warring schools relate to very real political fig-
ures that have shaped our lives.
The Business
Cycle
(See Figure 2.1)
1. All movements
in the business
cycle are mea-
sured by the
rate of growth of
the real gross
domestic prod-
uct (GDP). A
nation’s nominal © Clipart.com
GDP measures
its economic output; the real GDP is the nominal GDP adjusted
for inflation.
2. The movements of the GDP define the business cycle, which charts the
recurrent moves from an expansionary phase and some inevitable “peak”
when business activity reaches a maximum, to a recessionary phase and
some inevitable “trough” brought on by a downturn in total output, to a
“recovery” or upturn in which the economy expands toward full employ-
ment. Note that each of these phases of the cycle oscillates around a
“growth trend” line.
3. There are three main explanations for business-cycle volatility.
4. The first explanation for business-cycle volatility centers on random,
LECTURE TWO
8
© Peter Navarro
Figure 2.1
The Business Cycle
tions or, in the worst case, by Machiavellian politicians using the powers
of incumbency to enhance their re-election fortunes.
6. The third major explanation of business-cycle movements relies on a
much more complex and systemic view of the economy. It is character-
ized by the “co-movements” of many variables.
7. The task for macroeconomists trying to use fiscal and monetary policies
to better manage the business cycle is to understand this process in all
its richness.
Classical Economics
2. History begins with classical economics, which dates back to the late
1700s. The classical economists believed that the problems of recession
and unemployment were a natural part of the business cycle, that these
problems were self-correcting, and, most importantly, that there was no
need for the government to intervene in the free market to correct them.
3. This approach actually seemed to work—until the Great Depression of
the 1930s.
9
Keynesianism
4. British economist John Maynard Keynes flatly rejected the classical
notion of a self-correcting economy. Instead, Keynes believed that the
global economy would not naturally rebound but simply stagnate or,
even worse, fall into a death spiral. In his view, the only way to get the
economy moving again was to prime the economic pump with increased
government expenditures.
• In the United States, Franklin Delano Roosevelt’s Keynesian “New
Deal” public works programs in the 1930s, together with the 1940s
Keynesian boom of World War II expenditures, lifted the American
economy out of the Great Depression and up to unparalleled heights—
just as Keynes predicted.
• Pure Keynesianism reached its zenith with the much-heralded Kennedy
Tax Cut of 1964, which would make the 1960s one of the most prosper-
ous decades in America as business boomed.
5. The aggressive fiscal stimulus after World War II laid the foundation for
the emergence of a new macroeconomic problem that Keynesian eco-
nomics would be totally incapable of solving: “stagflation”—simultaneous
high inflation and high unemployment.
© Clipart.com
welfare programs.
10
Monetarism & Supply-side Economics
7. Professor Milton Friedman’s monetarists challenged what had become
the Keynesian orthodoxy. Friedman argued that the problems of both
inflation and recession may be traced to one thing—the rate of growth of
the money supply. From this monetarist perspective, stagflation is the
inevitable result of activist fiscal and monetary policies that try to push
the economy beyond its so-called “natural rate” of unemployment—
defined as the lowest level of unemployment that can be attained without
upward pressure on inflation.
8. The conservative school of supply-side economics entered the stage
after the monetarist’s bitter medicine to correct stagflation. Specifically,
supply-siders believed that people would actually work much harder and
invest much more if they were allowed to keep more of the fruits of their
labor. In such a scenario, the supply-siders promised that by cutting
taxes and thereby spurring rapid growth, the loss in tax revenues from a
tax cut would be more than offset by the increase in tax revenues from
increased economic growth.
• In the 1980 U.S. presidential election, Ronald Reagan ran on a supply-
side platform that promised to simultaneously cut taxes, increase gov-
ernment tax revenues, and accelerate the rate of economic growth
without inducing inflation. Unfortunately, that didn’t happen: while the
economy boomed, so too did America’s budget and trade deficit.
• In the Bush White House, Ronald Reagan’s supply-side advisors had
been supplanted not by Keynesians, but rather by a new breed of
macroeconomic thinkers—the so-called “new classicals.”
11
It is important not just because of the strong influence it has had on
recent macroeconomic theory but also because new classical econo-
mists played a pivotal role during the 1992 defeat of the first George
Bush by Bill Clinton. Bush took the new classical advice, the economy
limped into the 1992 presidential election, and, like Richard Nixon in
1960, Bush lost to a Democrat promising to get the economy moving
again. The irony, of course, is that Bush’s fiscally conservative new clas-
sical response set the stage for the Clinton boom—the longest expan-
sion in U.S. history.
© Peter Navarro
Mainstream
macroeconomics Rational Supply-side
Issue (Keynesian based) Monetarism expectations economics
View of the Potentially unstable Stable in long run Stable in long run May stagnate
private economy at natural rate of at natural rate of without proper
unemployment unemployment work, saving,
and investment
incentives
How fiscal policy Changes AD No effect unless No effect on output, Affects GDP and
affects the via the multiplier money supply because price- price level via
economy process changes level changes changes in AS
are anticipated
LECTURE TWO
View of cost-push Possible (wage- Impossible in the Impossible in the Possible (tax-
inflation push, AS shock) long run in the long run in the transfer dis-
absence of absence of incentives, higher
excessive money excessive money costs due to
supply growth supply growth regulation)
12
FOR GREATER UNDERSTANDING
Questions
Websites to Visit
1. Choose the appropriate link to review the history of the U.S. business
cycle; pinpoint where the business cycle might be currently —
www.nber.org
2. The History of Economic Thought website is the most detailed website
about schools of economic theory; select “Schools of Thought” and learn
more about schools of macroeconomics not covered in this lecture —
http://cepa.newschool.edu/het
3. Go to the Catalogue Resources tab and select “Schools of Economic
Thought” from the Detailed Search option; the site contains summaries and
links devoted to many economists and schools of economic theory —
www.econport.org
Suggested Reading
13
Lecture 3:
Fiscal Policy and Budget Deficits:
The Good, Bad, and Ugly
LECTURE OBJECTIVES
1. Illustrate the basic Keynesian model and show how the applica-
tion of the model gave birth to fiscal policy.
2. Learn about fiscal policy, which involves the use of government
expenditures or tax changes to expand or contract an economy.
3. Understand why fiscal policy is one of the most potent tools that
governments have to stimulate or contract an economy.
Fiscal Policy:
Historical Perspective
1. In October 1929, the U.S. stock
market crashed and sent the
business community into a panic.
Reacting to the crash, businesses
cut back sharply on investment
and production. At the same time,
frightened consumers cut back
dramatically on consumption—
while attempting to save more as
a response to the crisis.
2. The irony is that in their attempt
to save more, many individual
households actually saved less
because their incomes plummet-
ed as the economy weakened.
© Clipart.com
the economy would bounce right back—or, as Hoover himself put it,
“prosperity is just around the corner.”
5. Contrary to this view, and as the U.S. economy and economies around
the world sunk further into this Depressionary morass, British economist
14
Lord John Maynard Keynes and his so-
called “income adjustment mechanism”
showed that when an economy sinks
into a recession, people’s incomes fall.
This fall in income causes them to
spend less and save less while busi-
nesses respond by investing and pro-
ducing less. This reduction in con-
sumption, savings, investment, and
output, in turn, drives the economy
deeper into recession rather than back
to full employment.
6. In this scenario, Keynes believed that
the only way out of a severe depres-
sion was to “prime the economic
pump” with increased government
spending. This was precisely the idea
behind fiscal policy. © Clipart.com
Herbert Hoover
7. Once Herbert Hoover was replaced by
Franklin Delano Roosevelt, the government did indeed start to spend
—first on FDR’s so-called New Deal public works projects and then far
more dramatically on defense expenditures for World War II. Together,
these twin stimuli triggered increased consumption and investment, and
the economy roared back to full employment.
15
Figure 3.1
© Peter Navarro
The Keynesian Model
Consumption
1. The largest component of aggregate expenditures is consumption,
accounting for almost 70 percent of total aggregate expenditures in the
U.S. economy. Consumption occurs in three categories: durable goods,
non-durable goods, and services.
2. Keynes explained consumption expenditures by defining two distinct
components: autonomous and induced consumption.
3. First, Keynes posited that there is a level of consumption called
“autonomous consumption” that will occur even if a person’s income falls
to zero, regardless of changes in one’s income.
4. Second, Keynes said that there is a level of “induced consumption”
that depends on the individual’s disposable income, where disposable
income is simply the amount of money you have left after paying taxes
to the government.
5. Keynes further described this consumption behavior in terms of a per-
son’s MPC, which is simply the extra amount that people consume when
they receive an extra dollar of disposable income.
Example: some people may only spend seventy-five cents of every dollar
LECTURE THREE
of their disposable income and save twenty-five cents. In this case, the
MPC is 3/4.
Investment
1. Investment expenditures include the purchases of homes, investment in
business plant and equipment, and additions to a company’s inventory.
16
Investment in plant and equipment is by far the biggest category,
averaging a full 70 percent of total investment annually, while total
investment expenditures account for roughly 15 percent of total
aggregate expenditures.
2. In the Keynesian model, investment expenditures are assumed to occur
independently of the level of income.
3. To Keynes, the two important determinants of investments are the sensi-
tivity of investment to changes in the interest rate and the “expectations,”
or business confidence, that businesses have regarding potential sales
and profits.
4. Note, however, that while Keynes believed the interest rate was impor-
tant in determining investment, he did not believe that falling interest
rates and increased investment would necessarily lead to a full-employ-
ment equilibrium like the classical economists did. This is because
Keynes believed that investment was in large part driven by the expecta-
tions that businesses had regarding potential sales and profits. Keynes
referred to these expectations as “animal spirits” and basically said that if
businesses believed the economy was about to go bad, it could become
a self-fulfilling prophecy.
Government Spending
1. Government spending includes purchases of goods like tanks or road-
building equipment as well as the services of judges and public school
teachers. Such government expenditures account for almost 20 percent
of total aggregate expenditures in the United States.
2. In the Keynesian model, increased or decreased government expendi-
tures, together with tax cuts or tax increases, serve as the primary tools
of fiscal policy that are used to counterbalance changes in investment
and consumption spending.
3. Specifically, expansionary fiscal policy involves increased govern-
ment expenditures, tax cuts, or some combination of the two to
stimulate a recessionary economy and close a recessionary gap. In con-
trast, contractionary fiscal policy involves reduced government expendi-
tures, tax hikes, or some combination of the two to cool down an over-
heated economy.
Net Exports
1. Net exports equals the value of
exports minus the value of imports.
Exports create domestic production,
income, and employment for
an economy, so we add
exports to aggregate
expenditures. However,
when we purchase
imports from a foreign
country, no such produc-
© Digital Stock
17
tion, income, or employment is created,
so imports must be subtracted from
aggregate expenditures.
2. While net exports are an important part of
a global, or “open,” economy, they were
not central to the development of the
Keynesian multiplier model. Therefore, we
assume a “closed economy” in which
there is no international trade and drop
net exports from the model.
© Clipart.com
Keynesian Multipliers
1. The Keynesian expenditure multiplier is the number by which a change in
aggregate expenditures must be multiplied to determine the resulting
change in total output. This multiplier is always greater than one.
2. In the Keynesian model, it can be shown mathematically that the
Keynesian multiplier is simply the reciprocal of one minus the MPC.
Hence, the higher the MPC, the bigger the multiplier.
Example: Suppose that the MPC is 0.5. Then the multiplier is 2, or 1
divided by 1 minus 0.5. If the MPC is 0.75, the multiplier is 4, or 1 divided
by 1 minus 0.75.
3. The Keynesian tax multiplier is simply the regular expenditure multiplier
times the MPC.
propensity to con-
sume is 0.8, we
Figure 3.2
A Recessionary Gap © Peter Navarro
18
calculate a multiplier of 5. So if the government wants to close that $100
billion recessionary gap, all it needs to do is increase spending by $20
billion dollars—because an expenditure multiplier of 5 times the $20 bil-
lion dollar spending hike equals $100 billion.
3. Alternatively, let’s suppose we prefer to cut taxes. In our example, it
means we don’t cut taxes by $20 billion dollars, but by $25 billion dol-
lars—or $5 billion more than we needed to increase government expen-
ditures to achieve the same result. We arrive at this total by first multi-
plying the expenditure multiplier of 5 times the MPC, yielding a tax multi-
plier of 4. Then, 4 times the $25 billion tax cut yields the desired $100
billion expansion.
4. The reason for the difference is that a dollar’s worth of tax cuts actually
has slightly less of an expansionary effect than a dollar’s increase in gov-
ernment expenditures. With a tax cut, consumers will not increase their
expenditures by the full amount of the tax cut. Instead, they will save a
portion of that tax cut based on their marginal propensity to consume.
Budget Deficits
1. Indeed, there are many problems with this mechanistic Keynesian view;
and there may be no problem bigger than the budget deficits that expan-
sionary fiscal policies can give rise to.
2. In thinking about problems associated with chronic budget deficits and a
soaring national debt, economists establish a benchmark by comparing
the debt to the size of the nation’s GDP. Accordingly, comparing the debt
to the GDP gives us a measure of a nation’s ability to produce and there-
fore its ability to pay off its debt.
Even though the United States has the largest public debt in absolute
terms, on a debt-to-GDP basis, it doesn’t fare anywhere nearly as badly
as many other nations.
3. One crucial feature that is concerned with the problem of chronic budget
deficits is related to
the distinction between
the so-called structural
deficit and the
cyclical deficit.
4. The structural deficit is
that part of the actual
budget deficit that
would exist even if the
economy were at full
employment. The
structural part of the © Clipart.com
19
budget is thought of as “active” and is determined by discretionary
fiscal policies.
5. In contrast, the cyclical deficit is that part of the actual budget deficit
attributable to a recessionary economy. It results primarily from the
shortfall of tax revenues that arises when the economy’s resources
are underutilized.
6. The distinction is important because it helps policymakers distinguish
between long-term changes in the budget caused by discretionary poli-
cies versus short run changes caused by the business cycle.
20
FOR GREATER UNDERSTANDING
Questions
Websites to Visit
Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapters 9, 10, and 12.
Economics: Principles, Problems, and Policies. 16th ed. New York:
McGraw-Hill, 2005.
Navarro, Peter. Chapters 13, 16, and 17. If It’s Raining in Brazil, Buy
Starbucks. New York: McGraw-Hill, 2001.
The Wall Street Journal editorial page provides insight into the conservative
approach to fiscal policy.
21
Lecture 4:
Monetary Policy: It’s All About
Money, Credit, and Banking
LECTURE OBJECTIVES
1. Describe our money and banking system and explain how the
Federal Reserve, the nation’s central bank, creates money.
2. Show how the Federal Reserve conducts active monetary policy.
3. Compare the Keynesian vs. Monetarist approach to active mone-
tary policy.
© EyeWire
22
The Interest Rate
1. When we examine how money affects economic activity, we focus on the
impact of the interest rate.
2. Technically, the interest rate is the amount of interest paid per unit of
time expressed as a percentage of the amount borrowed.
3. Interest is the payment made for the use of money, and it is often called
the “price of money.” Note that there is actually a vast array of interest
rates—short-term rates and long-term rates, government bond rates and
corporate bond rates, and so on—not just “the” interest rate.
4. There are three main reasons why interest rates differ across time and
the types of interest-bearing assets: the term or maturity of the loan, the
degree of risk, and liquidity.
Goldsmith’s Workshop
by the School of Agnolo Bronzino,
Florence, sixteenth century © Clipart.com
23
3. Three important things happened with these goldsmiths.
4. First, the depositors figured out they could trade their gold receipts for
goods. These receipts functioned, in effect, as the first paper money.
5. Second, the gold depositors soon figured out that they didn’t have to
leave their gold with the goldsmith for free. Goldsmiths began to offer
depositors interest on their gold deposits.
6. Finally, the goldsmiths figured out that they could operate under what is
today called a system of “fractional reserves.” Such a system allowed the
goldsmiths to expand the supply of money over and above the amount of
gold reserves they held in their vaults.
24
3. In particular, monetary policy involves the use of changes in the money
supply to contract or expand the economy.
4. The Fed manages monetary policy through its Federal Open Market
Committee. The Open Market Committee meets periodically to discuss
monetary policy, and it conducts such monetary policy through the use of
three major policy instruments.
5. The first, and least used, of these instruments is setting the reserve ratio
or the reserve requirement. The Fed can increase the money supply by
lowering the reserve requirement or decrease the money supply by rais-
ing the reserve requirement.
A related concept is that of the money-supply multiplier, which is simply
one divided by the bank’s required reserve ratio. Note that the bigger the
reserve requirement, the smaller the money multiplier and the less
money that is created by a new dollar of demand deposits.
6. The second instrument of monetary policy is the discount rate. The dis-
count rate is the interest rate that the Fed charges banks when they bor-
row money from the Fed. Lowering the rate makes it cheaper for banks
to borrow money and expand the money supply. In contrast, raising the
discount rate makes it more expensive for banks to borrow from the Fed
and is contractionary.
7. The third, and by far the most important, instrument of monetary policy is
open market operations. Open market operations involve the buying and
selling of government securities to expand or contract the money supply.
In a nutshell, the Fed buys government securities when it wants to
expand the money supply, and it sells government securities when it
wants to contract the money supply. (See Figure 4.1)
© Peter Navarro
25
The Monetary Transmission Mechanism
1. The so-called monetary transmission mechanism refers to the interven-
tion of the Fed and its consequent effect on the aggregate demand.
2. The process begins with the change on reserves through open market
operations and the resulting change in money supply and interest rates.
In the next step, the change in interest rates modifies the level of invest-
ment and consumption expenditures. The total effect is to change aggre-
gate expenditures or aggregate demand. Therefore, real GDP and infla-
tion likewise move, thus achieving the desired policy goal of stimulating
or cooling the economy and inflationary pressures.
26
FOR GREATER UNDERSTANDING
Questions
1. It is sometimes said that war is always good for an economy, but the
Vietnam War caused a number of economic problems. Why? How have
the wars in Iraq affected the economy?
2. What is monetary policy?
3. How has the Internet and the use of credit cards affected the money and
banking system? Do these technologies make it harder or easier for the
Federal Reserve to conduct monetary policy?
4. Has the U.S. Federal Reserve typically done a good job?
5. Name and describe the two sources of money demand.
6. What three characteristics of the modern banking system were also char-
acteristics of the early goldsmiths?
7. What are the three instruments of monetary policy? Which is the most
important? Why?
8. Describe the monetary transmission mechanism.
9. What is the Keynesian view of monetary policy?
10. What is the monetarist view of monetary policy?
Websites to Visit
1. Website of the Federal Reserve: Click on the “Monetary Policy” link and
then click on “Open Market Operations”; review the history of the Fed’s
rate changes, as demonstrated by the changes in the “Intended Federal
Funds rate” — www.federalreserve.gov
2. Read some of the Chairman’s speeches under the “Testimony and
Speeches” link in “News and Events” — www.federalreserve.gov
3. Website of the European Central Bank: Get information on how the EBC is
organized and compare it to the Fed’s structure — www.ecb.int
Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapters 13, 14, and 15.
Economics: Principles, Problems, and Policies. 16th ed. New York:
McGraw-Hill, 2005.
Navarro, Peter. Chapter 4. If It’s Raining in Brazil, Buy Starbucks. New York:
McGraw-Hill, 2001.
Woodward, Bob. Maestro: Greenspan’s Fed and the American Boom. New
York: Simon & Schuster, 2000.
27
Lecture 5:
Unemployment and Inflation:
Enter the Dragons
LECTURE OBJECTIVES
Unemployment
1. In thinking about the unemploy-
ment problem, economists identify
three different kinds: frictional,
cyclical, and structural.
2. Frictional unemployment arises
because of the incessant move-
ment of people between regions
and jobs or through different
stages of their “life cycle.” It is the
least of the economists’ worries.
3. Cyclical unemployment occurs
when the economy dips into a
recession, and it is this type of
unemployment that macroecono-
mists have historically spent
most of their time trying to solve.
4. Structural unemployment occurs
when there is a mismatch © PhotoDisc
between available jobs and the skills workers have to perform them. It
often results when technological change makes someone’s job obsolete
or when there is a mismatch between the location of workers and the
location of job openings.
LECTURE FIVE
28
6. The distinction between cyclical, frictional, and structural unemployment
is important because it helps economists diagnose the general health of
the labor market and craft appropriate policy responses.
29
6. It was this inability of Keynesian economics to cope with stagflation that
set the stage first for Professor Milton Friedman’s monetarist challenge to
what had become the Keynesian orthodoxy, and then later for the emer-
gence of supply-side economics.
30
invest much more if they were allowed to keep more of the fruits of their
labor. In such a scenario, the supply-siders promised that by cutting
taxes and thereby spurring rapid growth, the loss in tax revenues from a
tax cut would be more than offset by the increase in tax revenues from
increased economic growth.
2. Unlike the Keynesians, supply-siders did not agree that such a tax cut
would necessarily cause inflation. The end result would be to increase
the amount of goods and services our economy could actually produce
by pushing out the economy’s supply curve—hence, supply-side eco-
nomics. Moreover, the price level falls even as real output and employ-
ment is rising.
3. The so-called “Laffer Curve” relates the marginal tax rate, as measured
on a vertical axis to total tax revenues, as measured on the horizontal
axis. It is backward bending; above a certain marginal tax rate, an
increase in the tax rate will actually cause overall tax revenues to fall.
Note also that for a supply-side tax cut to actually increase tax revenues,
the existing tax rate before the tax cut must be above m—say at a rate
associated with point n on the curve. (See Figure 5.1)
4. In the 1980 U.S. presidential election, Ronald Reagan ran on a supply-
side platform that promised to simultaneously cut taxes, increase govern-
ment tax revenues, and accelerate the rate of economic growth without
inducing inflation. Unfortunately, that didn’t happen: while the economy
boomed, so too did America’s budget and trade deficit.
© Peter Navarro
31
Policy Implications III: New Classical Economics
1. The so-called “twin deficits” deeply concerned Reagan’s successor
George Bush, particularly after the budget deficit jumped over $200 bil-
lion at the midpoint of his term in 1990 and the economy began to slide
into recession.
2. However, in the Bush White House, Ronald Reagan’s supply-side advi-
sors had been supplanted not by Keynesians, but rather by a new breed
of macroeconomic thinkers—the so-called “new classical” economists.
3. These new classical economists urged President Bush not to engage in
any Keynesian stimulus, and the rest is history. Bush lost to Bill Clinton,
largely because of the sluggish economy. However, Bush’s fiscal policy
restraint also helped to set up the United States for its longest economic
expansion in history.
LECTURE FIVE
32
FOR GREATER UNDERSTANDING
Questions
1. Why is the distinction among cyclical, frictional, and structural unemploy-
ment important?
2. Explain Okun’s Law.
3. Which is worse, inflation or unemployment? Why?
4. What relationship does the Phillips Curve purport to illustrate?
5. Inflation and stagflation were defined in this lecture, but there is also
“deflation.” What is it?
6. Is it possible that the United States could experience another cycle of
stagflation and double-digit interest rates as in the 1970s? Or was that just
an unusual event?
7. Do countries such as Brazil, China, and India suffer from the same inflation-
ary pressures as developed countries like the United States and Germany?
8. Is the natural rate of unemployment constant? Why or why not?
Websites to Visit
1. The Bureau of Labor Statistics: On the right-hand side of the screen, you’ll
find information about “Employment & Unemployment”; check current
unemployment rates by following the link “State and Local Unemployment
Rates” — www.bls.gov
2. On the left-hand side of the screen, find the Consumer Price Index (CPI)
and the Producer Price Index (PPI), two of the most followed and watched
inflation indicators; click the respective links and explore how they are
measured and differ — www.bls.gov
3. The Federal Reserve’s website: Click on the “Monetary Policy” link and go
to “Reports” to find the “Monetary Policy Report to the Congress”; follow
the link and review the latest testimony: look for insights about the labor
market and prices found in Section 2 of the report —
www.federalreserve.gov
Suggested Reading
33
Lecture 6:
International Trade and Protectionism:
Where Did Our Jobs Go?
LECTURE OBJECTIVES
advantage and try to hide behind protectionist trade barriers will pay a
heavy price in terms of their living standards and economic growth.
34
© Peter Navarro
35
Tariffs and Quotas
1. A tariff is simply a tax on imports that is collected by the government.
When a tariff is imposed, domestic producers and the government win.
However, the big loser is the consumer, and the broader economy loses
as well. Together with the reduction in consumer welfare, this creates an
efficiency loss that economists often refer to as a “dead weight loss.”
2. A quota is an explicit quantity limit on imports. The only real difference
between a tariff and a quota is that with a quota there are no revenues
paid to the government.
3. From a political standpoint, it is a bit easier for a country to impose quo-
tas than tariffs because there is less harm to the foreign producers—and
therefore less political pressure on a foreign government to retaliate with
tariffs or quotas of its own.
4. Many nations also use so-called non-tariff barriers (NTBs). NTBs, which
include quotas, also consist of formal restrictions or regulations that make
it difficult for countries to sell their goods in foreign markets.
36
GATT Treaty
1. The General Agreement on Tariffs and Trade Treaty, or so-called GATT
Treaty, was established at the end of World War II. At the beginning of
1995, it became the World Trade Organization (WTO).
2. Every few years, representatives of the major industrialized countries
meet together for a round of trade talks aimed at reducing both tariffs and
NTBs. At least thus far, with every round of the WTO, trade barriers have
fallen further around the globe.
Balance of Payments
1. An open economy is simply one that engages in international trade. A
useful measure of such openness is something economists call the
“trade share,” which is simply the ratio of a country’s exports or imports
to its GDP.
2. The current account consists of three major items: the merchandise trade
balance, fees for services, and net investment income.
3. The merchandise trade balance reflects trade in commodities such as
food and fuels and manufactured goods, and is by far the biggest item.
When the United States is running a “trade deficit,” it is this merchandise
trade balance to which journalists often are referring to.
4. Fees for services include shipping, financial services, and foreign travel.
While this fees category is much smaller than the merchandise trade bal-
ance, it has grown in recent years as the United States has shifted from
a manufacturing economy to a more service-oriented economy.
5. The third item in the current account is investment income. Historically,
this category has run a small surplus for the United States. However,
as foreigners have continued to accumulate more and more U.S.
assets, this category has started to run in the red, further exacerbating
the trade deficit.
6. Finally, the fourth item in the current account is unilateral transfers. This
category represents other kinds of payments that are not in return for
goods and services.
7. The trade identity equation refers to an important accounting relationship
between the current account and the capital account. If a country such as
the United States runs a trade deficit in its current account, it must bal-
ance that deficit with in-flows into its capital account.
(See Figure 6.2)
8. One part of the capital account shows “official-reserve changes.” When
all countries have purely market-determined exchange rates, the catego-
ry equals zero. However, when countries intervene in foreign exchange
markets, it shows up in the balance of payments as changes in official
reserves.
9. Of far greater consequence are the capital out-flows and in-flows, which
track the purchases of real assets like hotels, factories, and golf courses
and financial assets such as stocks and bonds.
37
Trade Deficits and Budget Deficits
1. To many observers, America’s chronic trade deficits are every bit as dan-
gerous as its chronic budget deficits. These “trade deficit hawks” warn
that America is being forced to sell off its land and its factories—and its
future—to finance these deficits.
2. Others, however, see the trade deficits simply as an opportunity to buy
inexpensive foreign goods and enjoy a higher standard of living than
Americans could otherwise achieve. These “trade deficit doves” argue
that if foreign countries are foolish enough to sell us cheap goods, we
should be wise enough to buy and enjoy them and not try to erect protec-
tionist trade barriers.
Net Credits
U.S. BALANCE OF PAYMENTS Credit Debit or Debits
Current Account
a. Merchandise Trade Balance -191
U.S. Goods Exports 612
U.S. Goods Imports -803
b. Fees for Services 80
U.S. Exports of Services 237
U.S. Imports of Services -157
Balance on Goods and Services -111
c. Net Investment Income 3
Income earned by U.S. 206
Investors holding foreign assets
Income earned by foreigners -203
holding U.S. assets
d. Unilateral Transfers -40
Balance on the Current Account -148
Capital Account
a. Foreign purchases of assets 517
in the U.S.
b. U.S. purchases of assets abroad -376
Balance on Foreign/U.S. Purchases 141
c. Official reserves 7
Balance on Capital Account -148
Figure 6.2
Balance of Payments
LECTURE SIX
38
FOR GREATER UNDERSTANDING
Questions
Websites to Visit
1. Read more about balance of payments by visiting the IMF website: use
the search engine to find “Balance of Payments and International
Investment Position Statistics” — www.imf.org
2. The Bureau of Economic Analysis: Click on “Balance of Payments” under
the “International” link and check the latest news release of the United
States’ current account deficit — www.bea.gov/beahome.html
3. Spend some time browsing the WTO; you can also download the
“Understanding the WTO” brochure for future reference —
http://www.wto.org
Suggested Reading
39
Lecture 7:
The International Monetary System,
Exchange Rates, and Trade Deficits
LECTURE OBJECTIVES
Exchange Rates
1. An exchange rate is simply the rate at
which one nation’s currency can be traded
for another nation’s currency.
2. Note that exchange rates can fluctuate
rather markedly. Three basic reasons
explain fluctuations among
exchange rates.
3. The first has to do with the different rates
of growth across countries. For example,
if the U.S. GDP is growing faster than the
Japanese GDP, the U.S. dollar will depre-
ciate relative to the Japanese.
4. Exchange rates can also fluctuate with a
change in relative interest rates. For exam- © PhotoDisc
40
The Gold Standard
1. Between 1867 and 1933, except for the period around World War I, most
of the nations of the world were on the gold standard. Under this fixed-
exchange-rate system, the currency issued by each country had to either
be gold or redeemable in gold. Once a country agreed to be on the gold
standard, its currency was convertible into a fixed amount of gold.
2. With these fixed exchange rates, if a nation ran a trade deficit, it would
be required to use its gold reserves to buy currency to prevent the value
of the currency from falling. In contrast, if a nation ran a trade surplus, it
would accumulate gold.
3. The gold standard was so popular because of the gold specie flow mech-
anism. This monetary adjustment mechanism was first described by
Scottish philosopher and economist David Hume in 1752. The net effect
of this gold specie flow trade adjustment is that a balance-of-payments
equilibrium is restored among countries. (See Figure 7.1)
4. The world’s fixed-exchange-rate system based on the gold standard
worked reasonably well at stabilizing the currency markets right up until
World War I. However, with the advent of the war, many nations had to
temporarily abandon the gold standard to finance their war efforts. This
led to differing rates of inflation in different countries, which distort the rel-
ative value of currencies.
5. With the collapse of the gold standard in the 1930s, countries desperate
to create jobs in a depressionary global economy engaged in so-called
competitive devaluations. However, these competitive devaluations acted
like a “beggar thy neighbor” trade policy. These economic pressures, in
turn, contributed to growing political pressures that eventually led to
World War II.
© Peter Navarro
41
Bretton Woods
1. The harsh lessons of the 1930s
gave birth to a new international
monetary system. The new system
featured a modified fixed exchange
rate system called a partially fixed or
adjustable peg system. This system
replaced the gold standard with a
U.S. dollar standard, and the U.S.
dollar was designated as the world’s © Clipart.com
42
1980s. The need for the government to finance these budget deficits
drove up interest rates. This strengthened the dollar as foreigners had to
first buy dollars in order to buy U.S. bonds, thus resulting in a stronger
dollar that made exports more expensive and imports cheaper, and sent
the trade deficit spiraling upward.
2. A declining savings rate in the United States has also been a major con-
tributing factor to the trade deficit problem. As the U.S. savings rate has
fallen, the investment rate has remained fairly stable or even increased.
This has been possible because foreign investment has filled the sav-
ings-investment gap. In this sense, the U.S. capital surplus may not only
result from the trade deficit but also help to cause it.
3. A third reason is that the U.S. economy has grown at a faster pace than
either Europe or Japan, as well as many of its major trading partners.
This growth in U.S. income has boosted import consumption even as
recessions or stagnation in countries like Japan and Canada has
depressed their purchases of U.S. exports.
4. Perhaps what is most interesting about these three major causes of the
U.S. trade deficit is that they are all driven in some degree by arguably
irresponsible U.S. domestic fiscal and monetary policies.
43
FOR GREATER UNDERSTANDING
Questions
Websites to Visit
1. The United States’s trade deficit has its own governmental commission;
browse the “Reports” section for the final report of the U.S. trade deficit;
compare the Democrats’ and Republicans’ diagnoses of the causes and
consequences of the chronic trade deficits and their recommendations for
future action — http://govinfo.library.unt.edu/tdrc
2. Click on “Market Data,” select “Currencies,” and examine exchange rates
by clicking on “Benchmark Currency Rates” and “World Currencies” —
www.bloomberg.com
3. Information about the Euro — www.europa.eu.int/euro/entry.html
Suggested Reading
44
Lecture 8:
Supply, Demand, and Equilibrium:
How Prices Are Set in Our Markets
LECTURE OBJECTIVES
Introduction to Microeconomics
1. The study of microeconomics
deals with the behavior of individ-
ual markets and the businesses,
consumers, investors, and work-
ers that make up the macro econ-
omy. Microeconomics can help to
answer questions at a profession-
al and personal level. Most broad-
ly, microeconomics can also help
you to come to understand why
the government is so involved in
our economic lives.
2. Three basic facets of economic
and political life must be
© Recorded Books, LLC/Ed White
addressed by any economy:
scarcity, efficiency, and equity.
3. The concept of scarcity is related to that of economics goods (that is,
goods that are scarce or limited in supply). While goods are limited,
wants are seemingly limitless. This undeniable fact prompts an economy
to choose among different potential bundles of goods (the “what”), select
from different techniques of production (the “how”), and decide in the end
who will consume the goods (the “for whom”).
4. Efficiency denotes the most effective use of a society’s resources in sat-
isfying people’s wants and needs. Allocating resources efficiently is all
the more complicated because in pursuing efficiency, there is almost
always a thorny tradeoff between what is efficient from an economic point
45
of view and what may be viewed as “fair” or “equitable” from a social and
political point of view.
5. In fact, grappling with the tradeoff between efficiency and equity is one of
the most difficult tasks of economists and the political and business lead-
ers they serve. In a similar vein, we see that almost any time the govern-
ment tries to raise taxes to redistribute income from the rich to the poor
through mechanisms like food stamps or Medicare, those taxes tend to
interfere with the efficiency of the free market.
© Peter Navarro
46
5. The location and slope of the supply curve depends on the firm’s ability
to produce—to transform the so-called “factors of production” like raw
materials and labor and capital into consumable goods. However, supply
also depends on the individual’s decisions to supply the factors of pro-
duction to begin with.
6. The supply curve is influenced by shift factors such as technology, input
prices, and government policies.
7. Finally, the demand and supply curves naturally cross at the point where
we are likely to find the market equilibrium—which tells us how much of
the good is sold in the market and at what price.
8. In supply and demand analysis, equilibrium means that the upward pres-
sure on price is exactly offset by the downward pressure on price. The
equilibrium price is the price toward which the invisible hand drives the
market and is reached at the point where demand and supply are in bal-
ance and the market clears—at the intersection of supply and demand.
9. A surplus in the market is an excess of quantity supplied over quantity
demanded. A shortage is an excess of quantity demanded over
quantity supplied.
Price Controls
1. Price support programs set the so-called “price floors”: if the market price
fell below the floor, the government would make up the difference to the
subsidized by buying up any surplus. In this case, the price floor works to
prop up price above the free market equilibrium—and thereby helps the
subsidized, albeit at the expense of consumers.
2. The so-called “price ceilings” may be instituted by the government. In such
a case, the market price might be well above the price ceiling and at this
price ceiling, consumers will demand far more than the market is willing
to supply.
© PhotoDisc
47
FOR GREATER UNDERSTANDING
Questions
Websites to Visit
Suggested Reading
48
Lecture 9:
Understanding Consumer Behavior:
The Essential Elements
LECTURE OBJECTIVES
49
to spend and, subject to their budget constraint and given a menu of
prices, they choose a market basket of goods that provides them with the
greatest utility or satisfaction.
2. Consumers do maximize their utility by following the utility-maximizing
rule or equimarginal principle. A consumer with a fixed income facing
market prices will achieve maximum satisfaction when the marginal utility
of the last dollar spent on each good is exactly the same as the marginal
utility of the last dollar spent on any other good.
3. Moreover, the equimarginal principle perfectly explains why demand
curves slope downward. Suppose that at the equilibrium point, we hold
the marginal utility per dollar constant for two goods. Then, further sup-
pose that the price of good x increases. Then, the marginal utility per dol-
lar of good x must fall below the same ratio for good z, implying a down-
ward sloping demand curve. This is because as the price of good x rises,
quantity demanded falls.
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
Marginal utility
Potential choice per dollar Purchase decision Income remaining
First Big Mac 12 First Big Mac for $2 $8 = $10–$2
First Dove Bar 10
First Dove Bar 10 First Dove Bar for $1 $5 = $8–$3
Second Big Mac 10 and second Big Mac for $2
Second Dove Bar 8 Third Big Mac for $2 $3 = $5–$2
Third Big Mac 9
Second Dove Bar 8 Second Dove Bar for $1 $0 = $3–$3
Fourth Big Mac 8 and fourth Big Mac for $2
Table 9.1: Example: Elasticity of Demand
LECTURE NINE
© Peter Navarro
51
4. The concept of the price elasticity of demand has tremendous application
in the pricing and marketing strategies of both businesses and govern-
ment agencies. It also helps us to better understand many aspects of
public policy. The demand elasticity helps both businesses and govern-
ment agencies think about how to price their products and services.
© PhotoDisc
52
FOR GREATER UNDERSTANDING
Questions
Websites to Visit
Suggested Reading
53
Lecture 10:
Producer Behavior and
an Introduction to Perfect Competition
LECTURE OBJECTIVES
Production Function
The production function
specifies the maximum
output that can be pro-
duced with a given quanti-
ty of inputs for a given
state of engineering and
technical knowledge.
© Peter Navarro
32 50 350 400 1.56 10.94 12.50
Average Fixed Cost, Average Variable Cost, and Average Total Cost
(See Figure 10.1)
1. First, the average fixed cost (AFC) curve slopes downward and
approaches zero on the horizontal axis, while the average variable cost
(AVC) curve
approaches the
average total
cost (ATC)
curve. The aver-
age fixed cost
(AFC) curve
must approach
zero, because as
a firm’s output
increases, it
spreads its fixed
© Peter Navarro
costs over a
larger number
of units, so aver-
age fixed costs Figure 10.1: AFC, AVC, and ATC Curves
55
must fall. Similarly, the AVC curve must approach the ATC curve as
output increases.
2. The marginal cost (MC) curve intersects both the AVC and AC curves at
their minimums. If the marginal cost is greater than average total cost,
then the average total cost must be rising, and vice versa. Thus, it must
be that only when marginal cost equals average total cost that the ATC is
at its lowest point. This is a very critical relationship. It means that a firm
searching for the lowest average cost of production should look for the
level of output at which marginal cost equals average cost.
56
Shapes of the Curves
(See Figure 10.3)
1. The first graph on the top left shows the broad U-shaped curve we
observed earlier.
2. The second graph on the top shows a narrow and steep U-shape, which
indicates that economies of scale are exhausted quickly, so that mini-
mum unit costs will be encountered at a relatively low output. The typical
profile of an industry characterized by this kind of V-shaped curve is
numerous sellers and healthy competition.
3. The third graph, bottom left, shows a flat segment, characteristic of con-
stant returns to scale. Rather than a smooth U-shape, there is a long flat
spot in the middle of the curve over which unit costs do not vary with
size. It has important implications for business executives contemplating
strategic decisions such as mergers and acquisitions.
4. In the fourth graph, bottom right, we have what’s called increasing returns
to scale over the relevant range of output. With a natural monopoly, unit
costs steadily fall as plant size increases over a large range. In particular,
the natural monopoly shape of the curve means that over time, bigger
producers will drive out smaller producers until there is only one producer
left—the infamous monopolist.
© Peter Navarro
Market Failure
1. The result of the so-called market failure is that price will be set too high
and output too low for market efficiency, and government regulation may
be warranted. That’s why economists often argue that natural monopolies
like railroads, electricity, and gas distribution should be regulated.
57
2. Minimum efficient scale is defined as the smallest level of output that a
firm can minimize long-run average costs. This important concept can
give rise to another type of industry structure known as oligopoly, which
is characterized by a small number of large sellers. Examples include
automobiles, aluminum, steel, and cigarettes.
engages in
various
kinds of Figure 10.4: Structure, Conduct, Performance
nonprice
competition through product differentiation and advertising.
3. The different types of market conduct in turn drive market performance
where performance is measured by yardsticks such as allocative and
productive efficiency. These yardsticks can tell us how well—or poorly
—a society’s resources are being used.
4. Market structure refers to how many firms are in an industry, whether the
firms are big or small, what the firms’ cost structures look like, and how
LECTURE TEN
market share is divided among the firms. The four major types of market
structure include perfect competition, monopolistic competition, oligopoly,
and monopoly.
58
The Four Forms of Market Structure
(See Figure 10.5)
From a practical
point of view,
the most impor-
tant feature of
each form of
market struc-
ture is the
degree of pric-
ing and market
power that each
form of market
structure gives
to the partici-
pants in
that market.
Perfect
Competition © Peter Navarro
59
FOR GREATER UNDERSTANDING
Questions
Websites to Visit
Suggested Reading
60
Lecture 11:
Market Structure, Conduct, and Performance:
Why Monopolists Do What They Do
LECTURE OBJECTIVES
Monopoly
1. In a monopoly, there is only one seller in
the market selling a product, and that
monopolist sells a product for which rt.
co
m
ipa
there are no close substitutes. In such a ©
Cl
61
Monopolistic Competition
The defining characteristics of monopolistic competition are a relatively
large number of sellers; easy entry to, and exit from, the industry; and
product differentiation.
and profits.
62
Oligopoly
Oligopoly exists when a small number of typically large firms dominate an
industry, and the central element of oligopoly is the strategic interactions
that might arise through either explicit or tacit collusion over price and out-
put decisions, as well as decisions about both market entry and exit.
63
Cooperative vs. Non-cooperative Behavior
1. Concentration ratios are important in serving as an indicator of the
degree of strategic interaction and collusive behavior that might occur in
an industry. Moreover, once this mutual interdependence is recognized,
firms—and the business executives that run them—have a choice
between pursuing cooperative versus non-cooperative behavior.
2. On the one hand, business executives act non-cooperatively when they
act on their own without any explicit or implicit agreements with other
firms. That’s the kind of market conduct that typically characterizes
monopolistic competition.
3. On the other hand, business executives operate in a cooperative mode
when they try to minimize competition by explicitly or tacitly colluding on
price and output and other market issues. And that’s the kind of behavior
we can fully expect from oligopolists in an industry.
Game Theory
1. The guiding philosophy in
game theory is that you will
choose your own strategy
under the assumption that
your rival is analyzing your
strategy and acting in his
or her own best interest.
Understanding game theo-
ry will therefore help you
better understand not just
your own actions, but your © Clipart.com
rivals’ actions.
LECTURE ELEVEN
Questions
Websites to Visit
1. Choose “Newsroom,” then “Reports,” and search for documents that con-
tain the word “monopoly”; you will find many documents, so use the
advanced search option and look for Intel and Microsoft cases: Are these
companies “popular” in your final search? — www.ftc.gov
2. Learn more about oligopolies and real life applications —
http://www.oligopolywatch.com
Suggested Reading
65
Lecture 12:
Why the Government Intervenes in
Our Markets and Lives: The Economist’s Critique
LECTURE OBJECTIVES
66
2. When the free-rider problem is present, potential buyers will not want to
pay for a good precisely because they can obtain that benefit for free.
Furthermore, these free riders will not even want to reveal their true pref-
erences as to how much they value the good.
3. The result of the free-rider problem is that the perceived demand for the
public good doesn’t generate enough revenue to cover the costs of pro-
duction, even though the collective benefits of the public good may
exceed the economic costs.
Benefit-Cost Analysis
1. The benefit-cost decision rule is simply this: if the benefits from the pro-
ject exceed its costs, we should build the project. However, if the costs
exceed the benefits, we should not. Note that benefit-cost analysis can
indicate not just whether a public project is worth building, but also help
government choose among the best competing alternatives.
2. Cost-benefit analysis helps shatter the simplistic notion that the best way
to make government more efficient is to always reduce government
spending: efficient government does not necessarily mean minimizing
public spending.
67
2. The Coase Theorem helps to illustrate that, at least in some situations,
government intervention into the marketplace may not be necessary,
because externalities can be solved through individual bargaining.
3. While the Coase Theorem reminds us that clearly defined property rights
can be a positive factor in remedying externalities, many negative exter-
nalities involve large numbers of affected people, high bargaining costs,
and community property such as air and water. Thus, it is appropriate for
the government to intervene.
Asymmetric Information
1. The asymmetric information problem can arise particularly when buyers
don’t have complete information about a product.
2. Two other types of situations can arise associated with asymmetric infor-
LECTURE TWELVE
68
FOR GREATER UNDERSTANDING
Questions
Websites to Visit
Suggested Reading
Coase, Ronald H. The Firm, the Market, and the Law. Chicago: University of
Chicago Press, 1990.
Dixit, Avinash, and Barry J. Nalebuff. Thinking Strategically. New York: W.W.
Norton & Co., 1993.
McConnell, Campbell R., and Stanley L. Brue. Chapter 30. Economics:
Principles, Problems, and Policies. 16th ed. New York: McGraw-Hill, 2005.
69
Lecture 13:
Government Taxation from the Cradle to the Grave:
The Big Issues
LECTURE OBJECTIVES
tions, economists are not starry-eyed about the government any more
than they are about the free market. We know that just as there are mar-
ket failures, there are “government failures” in which government inter-
vention leads to waste or a redistribution of income, not from the rich to
the poor, but the other way around. These important issues are the
domain of public choice theory.
LECTURE THIRTEEN
70
revealing our
social prefer-
ences, it can also
produce both
inefficiencies and
inconsistencies.
2. Majority voting
may produce eco-
nomically ineffi-
cient outcomes,
because it fails to
incorporate the
strength of the
preferences of the
individual voters.
© Peter Navarro
Paradox of Voting
1. The so-called paradox of voting refers to a situation when society may
not be able to rank its preferences consistently through majority voting.
2. Note that the problem in the paradox of voting is not irrational prefer-
ences but rather a flawed procedure for determining the preferences.
Hence, under certain circumstances, majority voting fails to make consis-
tent choices that reflect the community’s underlying preferences.
71
2. The “median voter” is defined as the person holding the exact middle
position on any issue.
3. A two-party system of majority voting such as the one in the United
States moves political outcomes to the political center. It is for this reason
that we often observe political candidates taking very similar positions,
essentially becoming what one political wag once called “Tweedledum
and Tweedledee.”
Government Expenditures
1. Americans face three levels of government: federal, state, and local.
2. These three levels of government reflect a division of fiscal responsibili-
ties in a system that political scientists refer to as fiscal federalism. But
note that their boundaries are not always clear cut.
3. Under fiscal federalism, the federal government is responsible for activi-
ties that concern the entire nation, such as providing for national defense
and conducting foreign affairs, while state and local government provide
public goods to state and local residents.
Principles of Taxation
1. The two main competing philosophies
for organizing a tax system are the
benefits-received principle and the
ability-to-pay principle.
2. The benefits-received principle or
benefit principle holds that different
individuals should be taxed in pro-
portion to the benefits they receive
© Recorded Books, LLC/Ed White
5. Usually tax systems organized along the ability-to-pay principle are also
redistributive, meaning that they raise funds from higher-income people
to increase the incomes and consumption of poorer groups.
6. The underlying economic idea behind ability-to-pay is that each additional
dollar of income received by a household will yield smaller and smaller
increments of satisfaction or marginal utility. While this ability-to-pay argu-
72
ment is appealing, problems of application exist just as they do with the
benefit principle.
Payroll Taxes
1. Payroll taxes are levied on wage earnings to pay for
social insurance programs like Social Security,
Medicare, unemployment compensation, and disability
programs. They consist of about 15 percent of all wage
income for incomes, while this tax is split between
employer and employee.
© Clipart.com
2. The payroll tax does have some regressive features
because it exempts property income and is higher on low wages than on
high wages.
73
2. Specifically, the ability of a company to pass on a sales tax to its cus-
tomers depends on the price elasticity of demand for the product: for
example, a company is able to shift more of the tax burden on to con-
sumers when the price for a product is relatively more inelastic.
© Clipart.com
74
FOR GREATER UNDERSTANDING
Questions
Websites to Visit
Suggested Reading
75
Lecture 14:
Land, Labor, and Capital:
How Our Rents, Wages, and Interest Rates Are Set
LECTURE OBJECTIVES
2. The derived nature of resource demand implies that the strength of the
demand for a factor such as labor depends on two things: (1) the produc-
tivity of the factor helping to create the product, and (2) the market price
of the product that the factor is helping to produce. In particular, if pro-
ductivity increases, wages increase. By the same token, if the price of the
product falls, wages fall as well.
3. There are a number of important influences on a worker’s productivity,
76
but the most important are the amount of capital and natural resources
that a person has to work with, the state of the technology, and the quali-
ty of the labor itself.
4. The supply of labor might affect wages. The three most important deter-
minants of the labor supply are labor force participation, hours worked,
and the rate of immigration.
5. One of the most dramatic developments in labor force participation over
the last half-century has been the sharp influx of women into the work
force. At the same time, labor force participation by older men has fallen
sharply, particularly for men over 65.
6. One of the most interesting analytical concepts in labor market economics
is associated with the backward-bending curve. The idea behind the back-
ward-bending curve is that the higher the wage, the more people will be
willing to work, but only to a point at which people will actually work less.
The reason is that at higher wages, workers can afford more leisure even
though each extra hour of leisure costs more in wages foregone.
Wage Differentials
1. One reason to explain the often hefty wage differentials observed among
people in different occupations refers to what economists call compensat-
ing differentials. Such compensating differentials measure the relative
attractiveness of jobs as well as the degree of risk.
2. A second explanation looks into the differences that people have in both
their mental and physical capabilities.
3. Still a third explanation of wage differentials refers to the different
amounts that people invest in their own human capital, where human
capital refers to the stock of useful and valuable skills and knowledge
that are accumulated by people in the process of their education
and training.
4. Economists refer to the excess of these wages above those of the next-
best available occupation as a pure economic rent or, more precisely, a
quasi-rent.
77
Interest Rates
1. The interest rate is the price paid for the use of loanable funds,
where the term loanable funds is used to describe funds that are avail-
able for borrowing.
2. In particular, the interest rate is the amount of money that must be paid
for the use of one dollar of loanable funds for a year.
3. Because it is paid in kind, interest is typically stated as a percentage of
the amount of money borrowed rather than as an absolute amount.
© Peter Navarro
Figure 14.1
78
Questions
FOR GREATER UNDERSTANDING
Websites to Visit
1. Visit the Bureau of Labor Statistics and select “Wages, Earnings &
Benefits”; you can explore for information on wages, earnings, and benefits
of workers categorized by geographical area, occupation, or industry —
www.bls.gov
2. Click on “Economic Research and Data” and follow “Statistics: Releases
and Historical Data”; interest rates can be found under “Interest Rates”;
check for the weekly release of the selected interest rates and follow the
direction rates are currently showing — www.federalreserve.gov
3. Select “Financial Calculators” under “Tools” and click on the new “Net
Present Value Calculator”; work on the example presented in this lesson to
see how the acceptance-rejection criteria differ depending on the selected
discount rate — www.investopedia.com
Suggested Reading
McConnell, Campbell R., and Stanley L. Brue. Chapters 27, 28, 29, and 35.
Economics: Principles, Problems, and Policies. 16th ed. New York:
McGraw-Hill, 2005.
79
COURSE MATERIALS
You’ll get the most out of this course if you have the following book:
McConnell, Campbell R., and Stanley L. Brue. Economics: Principles,
Problems, and Policies. 16th ed. New York: McGraw-Hill, 2005.
Coase, Ronald H. The Firm, the Market, and the Law. Chicago: University of
Chicago Press, 1990.
Dixit, Avinash, and Barry J. Nalebuff. Thinking Strategically. New York: W.W.
Norton & Co., 1993.
Woodward, Bob. Maestro: Greenspan’s Fed and the American Boom. New
York: Simon & Schuster, 2000.
These books are available online through www.modernscholar.com
or by calling Recorded Books at 1-800-636-3399.
COURSE MATERIALS
80