CFA Fundamentals - Chapter 2 Economics

Question 1

Law of Supply

Answer 1

When the selling price does not provide revenues sufficient to cover all costs and provide a profit, the item is not supplied.

This leads us to the law of supply, which states that as the price of a product moves higher, more of that product will be supplied. The higher price will make it more attractive for producers to produce and deliver more of the product.

Question 2

Law of Demand

Substitutes

Elasticity

Complements

Answer 2

The law of demand states that consumers will buy more of a good as the price of that good declines.

Demand will be a function of how many potential buyers there are for a product, as well as whether there are other products that could serve the same purpose.

The selling price will usually affect demand, but not always.

Substitutes

1. The demand for soft drinks would probably change if the price changed very much. If the price went up, consumers would shift to other brands of soft drinks, or possibly to juice or water. If the price declined, consumers would likely purchase more.
2. However, demand for a good like milk would be less subject to changes in price. Increases in price may not affect demand much because there are no good substitutes for milk.
3. Similarly, a decrease in price might not create more demand for milk.

Elasticity

1. Above difference in sensitivity of demand to price changes is called elasticity.
2. Elasticity = % Change in Quantity / % Change in Price
3. Inelastic goods are often described as necessities, while elastic goods are considered luxury items.
4. The elasticity of a good will be labelled as perfectly elastic, relatively elastic, unit elastic, relatively inelastic, or perfectly inelastic.

Complements

1. With complements, an increase in demand for one product leads to an increase in demand for another.

Question 3

Equilibrium

Answer 3

From our discussions of supply and demand, we can see that the interaction of these two economic conditions sets prices. Neither supply nor demand alone is sufficient. Regardless of whether a product is expensive or cheap to produce, if no market exists (no demand for the product), it won’t sell at any price. If a strong market exists for the product, it will sell. However, profits depend on the price received. That price, in turn, depends on the number of buyers relative to the number of sellers (i.e., the demand relative to the supply).

Question 4

Equilibrium and Pressure of Supply and Demand

Answer 4

Without resorting to too much economic jargon to explain equilibrium, let’s just leave it as meaning equal forces. In our example, the demand and supply for gold are equal.

Suppliers are willing to provide the amount of gold that consumers are willing to purchase (i.e., the upward pressure on price caused by demand and the downward pressure on price caused by supply are perfectly balanced). Prices are stable because there is no pressure to push them higher or lower.

Question 5

Distortions to Equilibrium

Answer 5

1. Price Controls
2. Price Ceiling
3. Price Floor

Question 6

Price Ceiling

Answer 6

A maximum price is a price ceiling

For example, when rents begin to rise rapidly in a city—perhaps due to rising incomes or a change in tastes—renters may press political leaders to pass rent control laws, a price ceiling that usually works by stating that rents can be raised by only a certain maximum percentage each year.

Let’s expand this example by thinking about a hypothetical town. Rent was fairly stable. But then, the town was featured on a top-ten-places-to-live article in a popular magazine. Eventually, rent control laws were passed.

In the beginning, before the article was published, the equilibrium, corresponding to an equilibrium price of $500 and an equilibrium quantity of 15,000 units of rental housing. In the new market, at the new equilibrium, the price of a rental unit rose to $600 and the equilibrium quantity increased to 17,000 units.

RENT CONTROL

1. Price $400
   
   1. Original Quantity Supplied = 12,000 units
   2. Original Quantity Demanded = 18,000 units
   3. New Quantity Demanded = 23,000 units
2. Price $500
   
   1. Original Quantity Supplied = 15,000 units
   2. Original Quantity Demanded = 15,000 units
   3. New Quantity Demanded = 19,000 units
3. Price $600
   
   1. Original Quantity Supplied = 17,000 units
   2. Original Quantity Demanded = 13,000 units
   3. New Quantity Demanded = 17,000 units
4. Price $700
   
   1. Original Quantity Supplied = 19,000 units
   2. Original Quantity Demanded = 11,000 units
   3. New Quantity Demanded = 15,000 units
5. Price $800
   
   1. Original Quantity Supplied = 20,000 units
   2. Original Quantity Demanded = 10,000 units
   3. New Quantity Demanded = 14,000 units

Now, let’s suppose that a bunch of residents were pretty unhappy with paying a 20% increase in their rent. They pressured local politicians to pass a rent control law to keep the price at the original equilibrium of $500 for a typical apartment.

In the demand and supply model above, the horizontal line at the price of $500 shows the legally fixed maximum price set by the rent control law. However, the underlying forces that shifted the demand curve to the right are still there. At the fixed maximum price of $500, the quantity supplied remains at the same 15,000 rental units, but the quantity demanded is 19,000 rental units. In other words, the quantity demanded exceeds the quantity supplied, so there is a shortage of rental housing.

Price ceilings are enacted in an attempt to keep prices low for those who demand the product—be it housing, prescription drugs, or auto insurance. But when the market price is not allowed to rise to the equilibrium level, quantity demanded exceeds quantity supplied, and thus a shortage occurs.

Those who manage to purchase the product at the lower price given by the price ceiling will benefit, but sellers of the product will suffer, along with those who are not able to purchase the product at all. Quality is also likely to deteriorate.

Question 7

Price Floor and Price Supports

Answer 7

A price floor is the lowest legal price that can be paid in a market for goods and services, labor, or financial capital. Perhaps the best-known example of a price floor is the minimum wage, which is based on the normative view that someone working full time ought to be able to afford a basic standard of living. The federal minimum wage at the end of 2014 was $7.25 per hour, which yields an income for a single person slightly higher than the poverty line. As the cost of living rises over time, Congress periodically raises the federal minimum wage.

Price floors are sometimes called price supports because they support a price by preventing it from falling below a certain level. Around the world, many countries have passed laws to create agricultural price supports. Farm prices, and thus farm incomes, fluctuate—sometimes widely. So even if, on average, farm incomes are adequate, some years they can be quite low. The purpose of price supports is to prevent these swings.

• The most common way price supports work is that the government enters the market and buys up the product, adding to demand to keep prices higher than they otherwise would be.

In the absence of government intervention, the price of wheat would adjust so that the quantity supplied would equal the quantity demanded at the equilibrium points, however policies to keep prices high for farmers keep the price above what would have been the market equilibrium level. The result is a quantity supplied in excess of the quantity demanded. When quantity supplied exceeds quantity demanded, a surplus exists.

Question 8

What is the effect of a price ceiling on the quantity demanded of the product? What is the effect of a price ceiling on the quantity supplied? Why exactly does a price ceiling cause a shortage?

Answer 8

A price ceiling—which is below the equilibrium price—will cause the quantity demanded to rise and the quantity supplied to fall. This is why a price ceiling creates a shortage.

Question 9

Does a price ceiling change the equilibrium price?

Answer 9

A price ceiling is just a legal restriction. Equilibrium is an economic condition. People may or may not obey the price ceiling—the actual price may be at or above the price ceiling—but the price ceiling does not change the equilibrium price.

Question 10

What would be the impact of imposing a price floor below the equilibrium price?

Answer 10

A price ceiling is a legal maximum price, but a price floor is a legal minimum price and, consequently, it would leave room for the price to rise to its equilibrium level. In other words, a price floor below equilibrium will not be binding and will have no effect.

Question 11

So, consider minimum wage case…

Answer 11

If the government increments the minimum wage above the equilibrium, that would result in lower quantity demanded but higher quantity supplied (by saying quantity of course I mean the labor force). What do you think this would mean? Well some people would enjoy their increased wages, but, due to the contraction in quantity demanded brought about by the increased minimum wages, SOME ACTUALLY WOULD LOSE THEIR JOB.

Now approach this problem from the demand (of labor) side. Visualize employers who are now forced to pay more wages to their employees. Obviously, this would indicate decrease in their revenues! Well if the problem further develops and the revenue fails to cover up the increased wages, employers would probably consider firing some of their employees. This would result in decreased production and consequently more decreased revenue, which are not any beneficial to the producer!

Question 12

Black Market

Answer 12

Sometimes, artificial pricing for a good will give rise to a black market that operates outside legal channels. Items that are illegal or heavily taxed often develop black markets, as do items with controlled prices set artificially high or low.

Illegal drugs are traded in a black market, and there are black markets for copyrighted materials such as music and software. Because black markets operate outside the law, the risks are higher for buyers and sellers alike. Buyers must be wary of poor quality goods, and sellers face criminal prosecution if they are caught. Also, because there are no legal remedies, any disputes between buyer and seller must be settled in other ways, often involving violence. A black market sacrifices economic efficiency and rewards the parties willing and able to use the most force to support their position.

Question 13

Effect of Taxes

Answer 13

Equilibrium prices are also distorted by taxes. Taxes that are imposed on a good can affect both the buyer and the seller

Question 14

Tax incidence

Answer 14

Tax incidence measures how the tax actually paid is allocated between buyers and sellers.

Buyers will probably pay a higher price for a good that is taxed, and sellers will probably receive less from selling the good.

Question 15

The statutory incidence of a tax

Answer 15

The statutory incidence of a tax identifies the party responsible for paying the tax. This may or not be the party who bears the true economic burden of the tax.

Question 16

Example of Tax Incidence

For example, assume that the government imposes a 2% tax on house paint to help cover the negative environmental impact of disposing of old paint. The producer of paint would like to pass the entire tax along to consumers by raising the price of paint by 2%.

Answer 16

It is quite possible, however, that raising all prices by 2% would reduce demand for paint. Consumers might seek substitutes, such as stains, or they might postpone painting jobs. Consumer resistance to higher prices may allow the producer to raise prices by only 1%. In this case, the tax burden would be borne equally by producers and consumers. Consumers would pay 1% more for paint, and producers would receive 1% less. A gallon of paint that cost $10.00 before the imposition of the tax would now sell for $10.10. If a producer made a profit of $1.00 on each gallon, the profit would be reduced by $0.10 to $0.90 per gallon.

Question 17

Elasticity of Demand

Answer 17

In economics, elasticity refers to the responsiveness of the demand or supply of a product when the price changes.

Elasticity = % change in supply or demand / % change in price.

For elastic demand,

1. when the price of a product increases the demand goes down.
2. Elastic products are usually luxury items that individuals feel they can do without.
3. An example would be forms of entertainment such as going to the movies or attending a sports event.
4. A change in prices can have a significant impact on consumer trends as well as economic profits.
5. For companies and businesses, an increase in demand will increase profit and revenue, while a decrease in demand will result in lower profit and revenue.

For inelastic demand

1. For inelastic demand, the overall supply and demand of a product is not substantially impacted by an increase in price.
2. Products that are usually inelastic consist of necessities like food, water, housing, and gasoline. Whether or not a product is elastic or inelastic is directly related to consumer needs and preferences. If demand is perfectly inelastic, then the same amount of the product will be purchased regardless of the price.

An elastic demand curve shows that an increase in the supply or demand of a product is significantly impacted by a change in the price. An inelastic demand curve shows that an increase in the price of a product does not substantially change the supply or demand of the product.

Inelastic Demand: For inelastic demand, when there is an outward shift in supply and prices fall, there is no substantial change in the quantity demanded.

Elastic Demand: For elastic demand, when there is an outward shift in supply, prices fall which causes a large increase in quantity demanded.

Question 18

What doe the Tax Incidence depend on?

Answer 18

The tax incidence will depend on how sensitive supply and demand are to changes in price. The sensitivity of supply and demand to changes in price is called elasticity, which is discussed in the microeconomics section. The more elastic the demand (or supply) is, the more sensitive quantity demanded (supplied) will be to changes in price.

Question 19

GDP

How does it measure?

Answer 19

is the most commonly used measure of economic performance. It is the total market value of all domestically produced final goods and services during a given year. GDP is designed to measure the market value of production that flows through the economy

Measure?

1. GDP includes only goods and services purchased by their final or ultimate users, so GDP measures final production. Intermediate stages of production are not included. For example, the price of flour sold to a baker is not included in GDP. Value added during the intermediate steps (i.e., harvesting, milling, and baking) are all included in the final selling price of the baked goods sold by the baker.
2. GDP counts only the goods and services produced within the country’s borders during the year, whether by citizens or foreigners. Therefore, goods produced at a factory in the United States and sold in the United States would be included in GDP, regardless of whether the factory was owned by a U.S. company or a Japanese company. Sales of used or secondhand goods are excluded, but sales commissions charged on the sale of used products are included.
3. GDP excludes financial transactions and transfer payments since they do not represent current production. For example, stock and bond sales along with welfare and social security payments are excluded.
4. Household goods and services: domestic chores such as cleaning, washing the car, or gardening are not captured in GDP unless someone is paid to do them. This may distort historical GDP comparisons if, for example, over time more households employ outsiders to perform these tasks.
5. Black market activities: these goods and services sold in illegal markets are not captured in GDP
6. Quality of Life:GDP does not reflect productivity or the quality of goods produced and sold. A computer produced in 1980 and sold for $5,000 counts the same in GDP as a computer produced in 2005 and sold for $5,000, despite the fact that the 2005 computer was considerably more powerful. GDP also does not reflect that the 1980 computer may have taken 50 hours to assemble, while the 2005 computer may have taken only 6 hours.
7. Pollution—GDP does not adjust output for any damaging side effects, such • as air or water pollution. Cleaning up pollution will add to GDP as it occurs, but there is no adjustment to current GDP for creating the problem in the first place.

Question 20

Expenditure Approach vs Income Approach

Answer 20

GDP may be measured using either the expenditure approach or the income approach. Both approaches yield the same results because aggregate expenditures must equal aggregate income

Question 21

The expenditure approach

Answer 21

The expenditure approach considers total spending on all final goods and services produced during the year. The expenditure approach is a demand-based concept measured by summing the following expenditure items:

1. Personal Consumption - This represents household purchases for consumption and represents the largest component of GDP. Over two-thirds of GDP is accounted for by personal consumption. This category of expenditures includes durable goods, nondurable goods, and services.
   
   1. Examples of consumer durable goods: include automobiles, books, household goods (home appliances, consumer electronics, furniture, tools, etc.), sports equipment, jewelry, medical equipment, firearms, and toys. Nondurable goods or soft goods (consumables) are the opposite of durable goods.
   2. Examples of nondurable goods include fast-moving consumer goods such as cosmetics and cleaning products, food, condiments, fuel, beer, cigarettes and tobacco, medication, office supplies, packaging and containers, paper and paper products, personal products, rubber, plastics, textiles, clothing, and footwear.
2. Gross Private Investment (expenditures of business) - This is an important component of GDP because it provides an indicator of the future productive capacity of the economy. Fixed investment (investment in capital goods) is a key component of future economic growth. GDP includes replacement purchases plus net additions to the stock of capital assets plus investments in inventories. Inventory investments are the changes in the stock of unsold goods held by a business during the period.
3. Government consumption and gross investment. Purchases of goods and services by federal, state, and local governments are included in GDP. Transfer payments are excluded. Hence, not all government spending is included in GDP.
   
   1. For the purpose of calculating gross domestic product (GDP), government spending does not include transfer payments, which are the reallocation of money from one party to another rather than expenditure on newly produced goods and services.
4. Net exports of goods and services. Since we only want to measure domestic production, net exports are calculated as total exports (domestically produced goods and services purchased by consumers outside the country) minus total imports (foreign-produced goods and services purchased by domestic consumers).

Question 22

The income approach is a supply (i.e., production) oriented approach and measures GDP by summing the following components:

Answer 22

The sum of the first five items (employee compensation, proprietors’ income, rents, corporate profits, and interest income) equals national income. National income includes income earned by domestic citizens abroad as well as what they earn in their home country.

Question 23

Nominal GDP vs. Real GDP

Answer 23

Gross Domestic Product measured at current prices is called nominal GDP

When we discuss economic growth, however, we want to measure the increase in actual production, or real GDP. Thus, we have to adjust nominal GDP for inflation

Question 24

GDP Deflator

Answer 24

The GDP deflator is a price index that corresponds to the price change exhibited by all final goods and services produced. The GDP deflator is useful for measuring economy-wide inflation.

Nominal GDP x (GDP Delfator base year)/(GDP Deflator Current Period) = Real GDP

Question 25

Inflation

Answer 25

Inflation is the continuing rise in the general level of prices of goods and services. The purchasing power of the monetary unit, such as the (American) dollar, declines when inflation is present.

It is easier to think of inflation as the artificial increase in prices due to excess demand, usually caused when there is too much money present in the economy.

This excess spending usually increases demand for luxury goods such as cars, electronic equipment, and housing. The increased demand for those items increases their prices. Meanwhile, the rest of us are sitting around wondering why in the world prices are going up. There hasn’t been an increase in the overall output of the economy. No more goods and services are being supplied that can absorb the excess spending. The result is an increased demand for a relatively constant supply.

The point is that whenever we see more money in the system than the system justifies on the basis of its productive output, the result is inflation
(i.e., a general rise in the level of prices in the economy caused by excess demand for goods and services). Whenever the level of spending in the economy is not due to economic reasons such as increased productivity (increased output from increased effort), the result is “artificial” demand. In other words, if wage increases are not due to economic reasons (e.g., increased efficiency, better or more work), the money added to the system causes “unearned” increased demand. Let’s look at a very simple example.

Question 26

Inflation Example:

• Bob is a carpenter who works rather slowly and is not all that dependable, but when the rest of the carpenters on the job get a raise, Bob also gets one.

Answer 26

Is Bob getting a raise because he deserves it? Has his work improved? Does he do more in a given day that would justify the increase in his wages? Whether or not Bob deserves the raise, his spending will increase, causing increased demand. This is the “artificial” demand referred to previously. Whether real or artificial, increased demand causes prices to rise.

There is a seemingly logical argument in support of Bob receiving a raise along with his productive and dependable coworkers. If Bob doesn’t get a raise, his “real” income declines. Due to the inflation already in the economy, the dollars Bob earns are worth slightly less each week. After a while, without a raise, this constant erosion of his buying power will reduce Bob’s ability to pay his living expenses.

Does this mean that inflation causes inflation? No. When raises are only sufficient to cover inflation, there is no new demand. Bob is only able to buy the amount of goods and services he could before the raise. Only if Bob’s raise exceeds the current rate of inflation (the current rise in prices) does it cause increased demand.

N
ow, even if it is more than the current rate of inflation, Bob’s raise doesn’t necessarily have to cause inflation. If Bob has become more productive or if he does more or better work in a given day, his raise is due to increased productivity. He has increased his input to the system, thus justifying the extra money. He has not only increased his demand, he has also added more value (goods and/or services) to the economy. His work is “worth” more. We don’t see more money “chasing” the

Question 27

Inflation is measured and tracked using the Consumer Price Index (CPI)

Answer 27

The CPI is a basket of consumer goods** and **services, the total price of which is recorded across time. Changes in the CPI (sometimes referred to as changes in the price level) indicate the amount of inflation (or deflation) in the economy. As the CPI increases over time, an increased price level of goods and services signals positive inflation in the economy.

Inflation =((CPIT) / (CPIT-1)) - 1

Assuming

• CPI_12/31/04 = 185.5
• CPI_3/31/05 = 187.3

Inflation for the first quarter of 2005:

• inflation = (187.3 / 185.5) -1 = .0097 = .97%

Question 28

There is a very important difference between anticipated inflation and unanticipated inflation.

Answer 28

When most economic decision makers expect a given level of inflation, they can plan accordingly. When inflation is unanticipated, however, the potential effects on economic activity are much worse.

Question 29

Unemployment

Three Types?

Answer 29

The U.S. civilian workforce is the total number of people over 16 years of age who are either employed or unemployed. Notice the distinction between the total population over 16 and those who are either employed or unemployed. To be considered unemployed an individual must be actively seeking employment or waiting to go back to work after a layoff.

These individuals would include children living at home, students, and retirees. Also missing from unemployment data are those classified as discouraged workers. An individual is classified as discouraged if he or she is unemployed but has given up trying to find work.

Three Types:

1. Frictional Unemployment
2. Structural Unemployment
3. Cyclical Unemployment

Question 30

Frictional Unemployment

Answer 30

Frictional unemployment is the result of employers not being aware of qualified workers and workers not being aware of available jobs. In other words, frictional unemployment exists because the location of the jobs and the workers has not been conveyed to interested parties, so they don’t connect (lack of communication). The implication is that with proper information and willingness to relocate, this form of unemployment is avoidable.

Question 31

Structural Unemployment

Answer 31

When the structural characteristics of the economy change, the result is structural unemployment. For a variety of reasons, economic conditions often shift such that jobs are lost in one sector, while new jobs are created in another sector. It becomes difficult for those seeking employment to find jobs because they are not qualified.

A historical example was the shift in the early 20th century United States from an agrarian society to an industrial society. Millions of farm workers were unemployed because they did not have the skills to work in factories. Technological advances, such as the increased use of computers, often lead to situations where workers have to acquire new skills or training. Until such training is widely available, unemployment will increase. Under these circumstances, employers also find it difficult to find qualified workers because they need people with different skills.

Question 32

Cyclical Unemplyoment

Answer 32

The third type of unemployment, cyclical unemployment, which derives its name from the business cycle, is due to decreases in the aggregate demand for goods and services. During such periods, firms produce less output and need fewer employees. Employees are typically laid off and return to their positions when the economy improves.

Question 33

Natural Rate of Unemployment

Answer 33

In the United States full employment is thought to be around 95%. This means that at full employment, approximately 5% of the U.S. labor force will be unemployed. Related to full employment is the concept of a natural rate of unemployment, which is the long-run average unemployment rate caused by structural and frictional factors

Question 34

Shift in Demand Curve

Answer 34

O
ne interesting characteristic of the aggregate demand curve is that it represents the quantity demanded of a good at all price levels, given the current level of wealth (income) in the economy. For example, the number of $25.00 steak dinners you are willing to purchase will depend to some degree on how much money you have.

In other words, a general increase in wealth will cause an increased demand for goods and services at every price level, and the AD curve will shift to the right.

By “shift to the right,” we simply mean that the entire curve will move to the right, maintaining the same downward slope, indicating that at every price consumers will demand (consume) more.

Question 35

When an economy experiences a shock, there are naturally occurring self-correcting forces that tend to “push” the economy back toward equilibrium. Three mechanisms that are responsible for self-correcting the economy after a shock are:

Answer 35

1. Consumption Demand
2. Real Interest Rates
3. Resource Prices

Question 36

Consumption Demand

Answer 36

Consumption demand. Demand is relatively stable over the business cycle.

Not too hot, not too cold.

During periods of economic expansion, the incomes of many households increase significantly. However, households tend to save a larger proportion of their income instead of spending it all. This helps avoid a strong increase in demand that would aggravate the inflationary pressures. During recessions, households save less or even dip into their savings. Thus, demand will not decline as much as the decline in income suggests. Both situations tend to stabilize the economy.

Question 37

Real Interest Rates

The cost of money is?

Expansionary Monetary Policy vs. Restrictive Monetary Policy

Answer 37

Real interest rates. Changes in real interest rates help to stabilize aggregate demand and reduce economic fluctuations.

During periods of economic expansion, real interest rates rise due to increased demand for borrowed funds.

The higher real interest rates reduce consumer borrowing and capital spending by businesses. During recessions, real interest rates decline, encouraging consumers to borrow for purchases and businesses to raise capital for investment projects.

The cost of money is the interest rate

Question 38

Resource Prices

Answer 38

Resource prices. Changes in real resource prices will also dampen economic fluctuations. When the economy is operating at greater than full employment capacity, prices of resources increase and discourage continued expenditures. For example, when housing starts and new construction activity is high, the prices of lumber and other building materials tend to increase. Conversely, when the economy is operating at less than full capacity, the costs of resources fall, encouraging increased spending by businesses.

Question 39

Fiscal policy

Answer 39

Fiscal policy refers to the government’s use of taxation and spending policies to achieve various macroeconomic goals. Taxation affects disposable income. To stimulate the economy, the government can reduce taxes, which increases disposable income, thus increasing expenditures (demand) in the private sector. Alternatively, increasing taxes reduces disposable income and private sector spending.

Question 40

Expansionary fiscal policy vs. Restrictive fiscal policy

Answer 40

Expansionary fiscal policy attempts to stimulate the economy by either reducing taxes or increasing expenditures.

Restrictive fiscal policy attempts to restrain (i.e., slow) the economy by increasing taxes or reducing government expenditures.

Question 41

Open Market Operations

Answer 41

The U.S. Federal Reserve (The Fed) can change the supply of money in the economy by buying and selling U.S. Treasury securities in open market operations. To reduce the supply of money in circulation, the Fed can sell Treasury securities from its inventory. The money used to purchase these securities is no longer in circulation. The resulting reduction in the money supply causes interest rates to rise. Consequently, companies and individuals who need to borrow money may have to postpone expansion plans or large purchases until interest rates decline.

If the economy is weak and unemployment is high, the Fed can buy Treasury securities, effectively increasing the money supply. This will cause interest rates to fall, and hopefully the companies that put expansion plans on hold and the individuals who decided to delay their large purchases can go ahead with their plans. This increases expenditures in the private sector and helps the economy
move back to full employment

Question 42

Discount Rate

Answer 42

Another way the Fed can control the money supply is by changing the discount rate, the rate the Fed charges banks in need of short-term funds. By increasing the discount rate, the Fed effectively makes money more expensive. The increase in the discount rate ultimately affects all other interest rates, so we see an economy-wide increase in rates. Since money is now more expensive, we again have a situation where some borrowers may have to postpone their plans. There is less money in the economy, money is now more expensive, and the economy slows.

To stimulate the economy, the Fed can lower the discount rate, causing the general level of interest rates to decline.

Question 43

Marginal Propensity to Consume (MPC)

Answer 43

As your income increases, you consume some of the increase and save some of the increase. The proportion of each additional dollar of income spent on personal consumption is called the marginal propensity to consume (MPC).

Question 44

Marginal Propensity to Consume (MPC) and MPC Expenditure

Think for a moment about this increase in income. Assume you receive an additional, unexpected $1,000 payment. You consume some of it ($1,000 × MPC) and save the rest. What happens to the amount you spent?

Answer 44

It represents someone else’s additional income ($1,000 × MPC). They will spend some [($1,000 × MPC) × MPC] and save the rest. This process continues indefinitely. You can see that the original $1,000 of income expands or multiplies into more than $1,000 of total income for the economy.

Question 45

MPC Expenditure Multiplier Equation

Answer 45

M = 1 / (1 - MPC)

Therefore, if investment spending increases by $1,000, aggregate spending will increase by M × $1,000.

Question 46

Classical Economics

1. Before the time of John Maynard Keynes, classical economists stressed….
2. The supply-side approach was spelled out in Say’s Law which suggested….

Answer 46

1. the importance of aggregate supply and paid little attention to demand
2. it was impossible to overproduce relative to total demand because supply (production) creates its own demand.

The idea is that production generates the income necessary to buy things. If producers make too much of one thing and not enough of another, the price of one will decline, and the price of the other will increase.

According to classical economists, markets always adjust quickly to direct the economy toward full employment. When unemployment is high, wages decline, which reduces costs and prices and pushes the economy back to full employment. Meanwhile, interest rates bring savings and investment into balance. The supply side emphasis of classical economics gained popularity with the economic policies of Ronald Reagan.

Question 47

Keynesian Economics

1. If spending decreases due to pessimism on the part of consumers and investors… how do business respond?
2. How does Keynes feel towards resource prices, especially wages…?
3. Keynesian Aggregate Expenditure (AE) Model
4. Keynes Solution?

Answer 47

During the depression of the 1930s, John M. Keynes put forth an economic theory that tried to explain the inability of the economy to regain its long-run output level. His theory emphasized the importance of aggregate demand in determining the overall level of output in the economy.

1. If spending decreases due to pessimism on the part of consumers and investors, business will respond by cutting output.
2. Unlike the classical view, Keynes felt that resource prices, especially wages, were highly inflexible in a downward direction
   
   1. In other words, wages would be slow to decline, and employers would instead be forced to lay off more workers. Hence, in Keynes’ view, the economy would languish for an extended period of time with high unemployment.
3. Keynsian AE Model
   
   1. The Keynesian equilibrium occurs when spending is equal to output. Since extreme downward price rigidity is present, prices do not play a role in the Keynesian aggregate expenditure (AE) model. Hence, if demand is slack, there are no automatic forces capable of assuring full employment. Instability in a Keynesian world is driven from the demand side of the economy.

The main source of economic instability are:

1. Consumer Spending
2. Private Investment
3. Government Expenditures

Solution?

1. Keynes believed that fluctuations in aggregate demand were the main cause of economic disruption. Keynes thought that an active fiscal policy, where the government varied its expenditures depending on economic conditions, could help smooth fluctuations in aggregate demand and thus promote economic stability.

Question 48

Keynsian Cylical Economies

Answer 48

Keynes believed that economies tended to move in cyclical patterns of expansion and contraction. Assume there is an increase in AD (perhaps from higher incomes abroad or an increase in consumer or business optimism). The multiplier magnifies the increased demand. The higher demand leads to income growth. The income growth leads to additional consumption and growing business sales. This leads to declining inventories, so businesses expand their output. Unemployment declines and the economy experiences a boom.

Eventually, the economy reaches full employment, which constrains additional growth. As growth slows, consumers and businesses become less optimistic and cut back on their expenditures. The multiplier magnifies the reduction in expenditures. Business inventories begin to build, so businesses cut back on production, and people are laid off. Some businesses experience bankruptcy.

Keynes thought the primary problem was wide fluctuations in private investment. He also thought that recessions would be long because lower interest rates and falling resource prices are insufficient to offset the decline in incomes and spending.

Question 49

Microeconomics

Answer 49

When we study microeconomics, we study how macroeconomic factors such as aggregate supply and demand, inflation, government actions, et cetera, affect the decisions and, hence, the operations of the individual firm.

We know, for example, that as prices increase, consumers demand less of the good. This would imply that the individual supplier will try to produce at the lowest possible cost in order to sell products at a better price than its competitors.

Question 50

Macroeconomic Factors and Microeconomic Effects

For example, as a supplier of gerbil bedding and gold necklaces, you employ 20 people to process the products and prepare them for shipping or delivery. Ten of these people work on bedding and ten on necklaces. In times of high inflation, increases in your wholesale costs cause you to increase your price to retailers, which causes demand for your products to decline.

Answer 50

macroeconomic factors (variables), such as inflation, are out of your control. With adverse changes, you simply try to maintain operations, absorbing profit reductions and increasing prices as much as you can.

In the macroeconomics section, we discussed aggregate demand and aggregate supply, which are measures of overall economic activity. With microeconomics, we need to analyze demand and supply from the perspective of the individual firm.

The bedding is far more sensitive to inflationary pressures, and the demand for it will almost disappear if its price rises. The result is that 10 people who used to work processing the bedding for delivery are now idle. As owner/manager of the firm, you don’t like to see people unemployed, but you must think of your family and other obligations. You hold on as long as you can, but ultimately you must lay off most of the bedding workers. You reassign the most senior bedding processors to the gold necklace line for as long as possible. Finally, as the effects of inflation begin to show on the demand for gold necklaces, you must lay off the reassigned bedding processors as well as some of the gold processors.

Assume the gerbil bedding is processed in a separate building. You can close down that building to avoid paying for heating and cooling and some maintenance. This reduces much of your utility expenses and allows you to reduce your maintenance costs too. Hopefully, increased inflation and unexpected cost increases are temporary, and you can bring back the people you laid off and reopen your gerbil bedding building and production line.

Question 51

Shifts in Demands vs. Movement Along Demand Curves

Answer 51

The demand curve isolates the impact that price has on the amount of a product purchased. As indicated in panel (a) of Figure 4, a movement along a specific demand curve represents the change in quantity demanded resulting from a change in price.

Demand curve shifts are called changes in demand and are caused by the following:

1. Changes in the levels of consumer income
   
   1. When consumers have more money, they can buy more of everything at a given price, so the aggregate demand curve shifts to the right.
2. Changes in the prices of substitutes and/or complements
   
   1. The price of butter goes up, so consumers buy less butter and more margarine. The demand curve for margarine shifts to the right.
3. Changes in expectations
   
   1. Consumers expect the price of cars to rise next month, so they buy a new car now before the price increases. The demand curve for new autos temporarily shifts to the right.
4. Changes in the size of the market
   
   1. As cities grow and shrink and as international markets open to domestic markets, the change in the number of customers shifts the demand curves of many products.
5. Changes in demographic trends
   
   1. In recent years, the number of people ages 15 to 24 has declined. This change will shift demand curves to the left for such things as jeans and pizza.
6. Changes in the popularity of goods
   
   1. As consumer tastes and preferences change, the demand curves for various products will shift.

Question 52

Price elasticity is the….

Answer 52

percentage change in demand given a percentage change in price and is described as follows:

Ep = % change in quantity demanded / % change in price

Ep = %ΔQ / %ΔP

When elasticity is greater than 1, demand is said to be elastic. When elasticity is less than 1, demand is inelastic.

Question 53

Let assume you have been watching a product for a few months and have been counting the number of the product sold at different prices. You find that when the price increases by 8%, sales decrease by 22%. Calculate the product’s price elasticity of demand.

Answer 53

-.22 / .08 = 2.75

There are two important implications of this calculation:

1. Notice that the elasticity is negative. This means that prices and quantity demanded move in opposite directions. As price increases, demand decreases, and as price decreases, demand increases.
2. The percentage change in quantity demanded is 2.75 times the percentage change in price. The demand for this product is fairly elastic, meaning the demand for the good is strongly affected by its price. There are other goods, for example gasoline for your car, that are much less sensitive to price changes. Another example is food. Since people must eat, the amount consumed might be virtually unaffected by price changes. Note, however, that consumers will begin to substitute lower cost foods for the ones with the greatest increases (e.g., chicken for beef).

Question 54

Income Elasticity of Demand

Answer 54

Generally, as income increases, quantity demanded will also increase. Income elasticity of demand is defined as:

E_I = % change in quantity demanded / % change in income

E_I = %ΔQ / %ΔI

Although you will rarely see a product whose demand increases as its price increases, there are actually different types of reactions to changes in income:

1. Inferior goods have negative income elasticity of demand. Their demand actually goes down as income increases.
   
   1. For example, people may stop riding public buses and start driving their own cars as their income increases.
2. Normal goods have income elasticities that are positive and can be divided into two categories.
   
   1. A necessity has income elasticity less than 1.0.
      
      1. An example might be food.
   2. A luxury good has income elasticity greater than 1.0.
      
      1. An example might be recreation (vacations).

Question 55

Capital

Human Capital

Physical Capital

The value of a firm depends on….

Answer 55

Capital = Any resource that has value because it assists in the production or supply of goods and services

Human Capital = refers to the characteristics of people (e.g., physical strength, intelligence, education, manual dexterity, honesty, and reliability) that make them valuable to a company.

Physical Capital = refers to the nonhuman resources employed by the company (e.g., equipment, buildings, tools, and raw materials).

The value of a firm depends on its ability to fill a need in society (i.e., to provide a necessary function or product). In turn, that ability depends on how well the firm uses capital (i.e., people, equipment, and other resources). When you value a firm, whether currently operating or not, you value that firm as if it is performing at its full potential. That is, you value it as though it is using all of its employed capital in the most efficient and productive manner.

• Your mental estimate of the value of the sandwich and ice cream shop depends on the collective potential value of all the capital it employed (i.e., the location, the building, the equipment, the people, the supplies, and the money). If the shop went out of business, it is a good indication that management was not using its capital in the most efficient and productive manner.

Question 56

Fixed Costs vs. Variable Costs

Short Run vs. Long Run

Answer 56

Fixed Costs

1. Fixed costs are incurred through the passage of time and are independent of production output. They occur each period regardless of whether your firm is actually producing anything. Rent is a good example of a fixed cost. Assume you are leasing (renting) your building and equipment. It doesn’t matter if you ever turn the equipment on to produce your product, you must still pay the rent. When you begin production, the amount of rent you pay does not increase or decrease, so it is independent of production.

Variable Costs

1. Variable costs are associated with production, not the passage of time. Variable costs include the direct labor and material costs incurred in assembling the final product. Consider the production line you use to assemble gold necklaces and prepare them for shipping. There is a station where the chain is measured and cut. The 20-inch pieces then go to another station, where clasps are attached. At the last station, the necklaces are packaged for shipping, and then moved to the shipping area.
2. Now consider the individual costs that are incurred in assembling one necklace: the cost of the material (gold chain), the cost of the clasps, the wages paid to the individuals at each station, the packaging material, and the shipping costs. All of these costs are related directly to the production of the gold necklaces, not the passage of time. They clearly are variable, not fixed, costs of production—if you produce no gold necklaces, none of these costs is incurred.

Short Run vs. Long Run

1. Classifying costs as fixed depends on the time frame. In the short run, there is nothing that can be done to alter the classification of fixed costs. Fixed costs, such as rent and mortgage payments, cannot be changed in the short run. Given a long enough time period, however, fixed costs can change. For instance, we can pay off or refinance our mortgage, or we can negotiate a different rent. Thus, we refer to the period of time necessary for us to change our fixed costs as the long run. In the long run, all costs are variable.
   
   1. ​Given enough time, even fixed costs can change (are variable). With enough time, you can negotiate a different lease, change the amount of equipment you are using, or even change the number of managers you employ. Also, fixed costs are only fixed over a range of output. If your existing equipment can produce a limited number of units of output, to attain higher levels of output you will have to add more equipment, and you might even have to add another manager.

Question 57

Classification of Costs

1. Average Fixed Costs
2. Average Variable Cost
3. Average Total Cost
4. Marginal Cost

Answer 57

1. Average Fixed Costs
   
   1. Average fixed costs is total fixed costs divided by the number of units produced (output), so in the short run it declines as output increases
2. Average Variable Cost
   
   1. Equals the total variable cost divided by the number of units produced (output). We will see that variable cost per unit can increase or decrease as output changes.
3. Average Total Cost
   
   1. equals the total variable cost divided by the number of units produced (output). We will see that variable cost per unit can increase or decrease as output changes.
4. Marginal Cost
   
   1. is the cost of producing one additional unit of output. When you see the word “marginal” in economics, think of the word “next.” A firm’s marginal cost, therefore, is the total (additional) cost associated with producing the next unit of output

Question 58

Profit Maximization Rule

Answer 58

A firm should produce up to the point where marginal costs equal marginal revenues. That is, it should produce up to the quantity at which the revenue received from producing the next unit of production equals the costs to produce that unit.

Marginal Cost is the increase in cost by producing one more unit of the good.

Marginal Revenue is the change in total revenue as a result of changing the rate of sales by one unit. Marginal Revenue is also the slope of Total Revenue.

Profit = Total Revenue – Total Costs

Therefore, profit maximization occurs at the most significant gap or the biggest difference between the total revenue and the total cost.

The MC = MR rule is quite versatile so that firms can apply the rule to many other decisions.

For example, you can apply it to hours of operation. You decide to stay open as long as the added revenue from the additional hour exceeds the cost of remaining open another hour.

Or it can be applied to advertising. You should increase the number of times you run your TV commercial as long as the added revenue from running it one more time outweighs the added cost of running it one more time.

Question 59

The law of diminishing returns

Answer 59

T
he law of diminishing returns states that as more and more resources (e.g., labor) are devoted to the production process, they increase output, but at a decreasing rate. For example, assume you have an acre of corn that needs to be harvested, and you have started by yourself. The addition of a second and third worker is highly beneficial. That is, adding a second worker doubles output and adding a third worker increases output by an additional 40%. But if you already have 300 workers in the field, the increase in harvesting capacity of adding a 301st worker is not near the increase that was achieved when the second worker was added. The 301st worker will want to be paid just as much as everyone else, but his production will be very low. The result is that you have increased your costs by a greater percentage than you have increased your output.

Question 60

Total Cost is equal to…

Answer 60

Total Cost = Variable Cost + Fixed Cost

Question 61

Variable Cost Per Unit

Answer 61

The VC curve is at first upward-sloping and concave because at very low levels of output, variable costs per unit produced are high. Think of this as representing an inability to negotiate low input prices when purchasing small quantities or having too many workers in relation to the quantity produced. As production increases, you will reach a level of output where you can start to negotiate input prices (buy in bulk) and utilize workers more efficiently, so the VC per unit actually declines.

In Figure 5, fixed costs are represented by a horizontal line because they are assumed constant with respect to output. Remember, they are a function of time, not production. The total cost curve is simply the addition of fixed costs to the variable cost curve at every point, so the total cost curve looks identical to the variable cost curve, only shifted upward.

Question 62

Supply Curve

Answer 62

Other things held constant, the supply curve summarizes the willingness of producers to offer a product at a given price. The change in the quantity supplied as price changes represents movements along the supply curve. This is illustrated in panel (a) of Figure 6.

Some factors may cause producers to change the quantity they are willing to supply at all price levels simultaneously. These changes will shift the aggregate supply curve as shown in panel (b) of Figure 6.

The following are some of the reasons for a shift in the supply curve:

Changes in Resource Prices

• Higher costs in the resource markets will reduce supply (shift the supply curve left) and increase price in the product markets based on these resources.

Changes in technology

• The discovery of new, lower-cost production techniques will reduce the costs of production and increase supply in the product markets.

Natural disasters and political disruptions

• Natural disasters and changing political conditions can also alter (shift) supply.

Question 63

Purely Competitive Market

Answer 63

In a purely competitive market, there is intense competition, and prices are determined through an equilibrium process. The theory of pure competition assumes the following market and participant characteristics:

1. All the firms in the market produce a homogeneous product. This simply means that the products produced by the firms in the market are more or less identical. As an example, the corn from one farmer is about the same as the corn from another farmer.
2. There are a large number of independent firms. This means the firms do not collude in any way; they have to compete for your business (i.e., there is no oligopoly).
3. Each seller is small relative to the total market. In other words, no seller controls a large enough portion of the market to manipulate the market in any way (i.e., there is no oligopoly or monopoly).
4. There are no barriers to entry or exit. It is easy for a new competitor to enter the market (or leave) (i.e., the market is not too expensive to enter or regulated too heavily). You can probably think of industries that are somewhat difficult or impossible to enter because of high capital requirements or regulations (e.g., auto manufacturing or public utilities).

Question 64

Price Takers

Answer 64

Competitors in a purely competitive market are price takers, meaning they have no control over the price they receive for their output. Their product is identical to that of their competitors, and they have no advantage in terms of size or pricing power. Since each produces a small amount of output relative to the total market output, each faces a horizontal (perfectly elastic) demand curve. This means they can sell all of their output at the prevailing market price. If they try to set their price higher than the market price, however, they sell nothing! And why would they sell lower?

Question 65

Perfectly Elastic Demand

Answer 65

Notice that the demand curve for the individual competitor is different from the aggregate demand curve for the entire market. The demand curve that represents the entire market is downward-sloping, indicating that demand changes as price changes. As price increases, consumers as a whole demand less. As price decreases, consumers as a whole demand more. The amount demand changes with a given price change is determined by the elasticity of demand for the product, and the demand curve will generally have a negative slope (it will be downward-sloping). The individual competitor, on the other hand, faces a perfectly elastic (flat) demand curve, as in the preceding, because demand for that competitor’s output goes to zero if he tries to raise his price.

Question 66

How does the individual firm in a purely competitive market determine the amount it will produce and sell

Answer 66

An individual firm will continue to expand production (output) until marginal revenue (MR) equals marginal cost (MC). (MR is the revenue obtained from selling one more unit of output, and MC is the additional cost of producing the last unit of output.)

If the producer goes beyond that amount, the price received will not cover expenses. If he produces less, he is not maximizing profits because the marginal costs of producing units is less than the price that will be received.

This production level should make intuitive sense. The firm will produce as many units as it can produce and sell for a profit. If producing another unit will cost more than the unit can be sold for, it makes no sense to produce that unit. The problem with applying this model in the real world is that it is often difficult to know the exact marginal cost of each single unit.

Question 67

What is the shape of the marginal revenue curve in a pure competition with a constant market price?

Answer 67

In pure competition with a constant market price, the firm’s marginal revenue is constant and equal to the selling price. In other words, no matter what amount the firm sells, it receives the market price (P) per unit. (This explains why the firm’s MR curve presented in Figure 8 is flat.) The graph indicates increasing marginal costs, as we have already discussed. When the firm’s marginal cost exactly equals its marginal revenue, the firm is at the optimal output level (Q).

Question 68

Price Searcher Markets vs. Price Takers Markets

Answer 68

In a price searcher market, firms enjoy a certain amount of control over the supply of the good. They must search for the optimal price at which they maximize their profits. The reason some firms search for the optimal price rather than accepting the market price is entry barriers. That is, for some reason competitors cannot readily enter the market, so the existing firms experience limited competition.

Question 69

Economies of Scale?

Answer 69

Economies of scale - Sometimes bigger is better. The ability to produce more efficiently (cheaply) based upon volume is known as economies of scale. Large firms are able to spread their fixed costs across a higher volume of products, thus allowing them to sell those products at lower prices. In industries that have high fixed costs, competition will be limited by the fact that any new competitors cannot easily enter the market. New firms would need time to build sales to a level where the fixed costs could be effectively reduced on a per unit basis. The economies of scale are therefore a barrier to entry for new competition.

Consider the automobile industry. There are large fixed costs associated with automobile production: research into the engineering and design, plus the production process itself. In order for auto producers to be profitable, they must be able to spread these high fixed costs across a high number of automobiles produced.

If a plant only produced one vehicle, the price of that vehicle would have to cover all of the high fixed costs. If the plant produced one thousand vehicles, the fixed costs could be allocated across all of them, and the vehicles would be more affordable to consumers.

Question 70

Government licensing and legal barriers

Answer 70

create barriers to entry in certain industries such as television broadcasting, where required government licenses restrict new competition.

Question 71

Patents or exclusive rights or production

Answer 71

are granted to producers of new and innovative products. These encourage research and development because firms with new, innovative products know they will be protected from competition for a while, giving them the opportunity to recover the substantial costs associated with research and development.

Question 72

Resource Control

Answer 72

relates to the single firm that has sole control over a resource essential for entry into an industry, effectively eliminating potential competitors. For example, you don’t see many new, successful diamond mines.

Question 73

Problems associated with markets having high barriers to entry include the following:

Answer 73

Unsatisfied demand

1. Monopolists (discussed in the following) can suppress supply and charge relatively high prices while not meeting the total demand of a population.

Limited consumer options

1. For example, there is typically only one cable television operator in any region. If service is bad, customers can either keep subscribing or not. They don’t have the option of switching operators.

Entry and exit are not properly motivated by profit

1. Since barriers to entry are high, inefficient producers may be able to survive.

Legal protection

1. can allow a monopolist to seek abnormal profits. Spending time and money in search of favors from the government (called rent seeking) can be a waste of valuable resources.

Question 74

Monopoly

Characteristics of Monopoly Markets?

Answer 74

When only one supplier of a product exists, that supplier is said to have a monopoly. Typically, there are very high barriers to entry in monopoly markets.

For instance, assume* you have control over land that holds a vast supply of gold. Next, assume that searching for gold in other parts of the world is extremely expensive because the world’s supply of gold is nearly depleted and any new supplies are extremely deep underground. In a situation such as this, the possibility of new suppliers exploring for gold and being able to compete with you is very low. *You are a monopoly because you effectively control the world’s supply of gold.

Question 75

Profit Maximization for Monopolist

Answer 75

Now let’s make the simplifying assumption that your costs to supply gold are more or less constant, so your profit equals total revenues less some constant cost, where total revenue equals the amount of gold you sell multiplied by its selling price. Your goal, as a monopolist, is to find the combination of price and quantity supplied that maximizes total revenue. Since your costs are more or less constant, your only concern is maximizing the revenues you receive.

This optimal price-quantity combination is at the point where the price increase (resulting from a reduction in the amount of gold you supply) exactly offsets the accompanying reduction in demand (caused by the increase in price). Thus, you have maximized your profit, and you didn’t even consider competition.

Think like macroeconomic demand.

But even if the monopolist can set the price anywhere it wants, does it charge the highest possible price? The answer is no, because the monopolist wants to maximize profits, not price. Monopolists will not make profits if the ATC line is always above the demand curve. For example, if someone held a patent on a machine that could be used just one time to convert a $5 bill into a $10 bill, but the ATC of producing the machine was $6, the monopolist would not make a profit.

Question 76

What is the demand curve of a monopolist vs the demand curve of a firm in a perfectly competitive market?

Answer 76

Monopolist

1. Since the monopolist is the only supplier of the good, the demand curve faced by the monopolist is effectively the demand curve for the whole market. The monopolist, therefore, faces a downward-sloping demand curve. The monopolist can raise or lower prices, but demand will be affected when it does so.

Perfectly Competitive Market

1. We showed previously that the individual firm in a competitive market faces a perfectly elastic (flat) demand curve, meaning the competitive firm must accept the market price.

Question 77

Figure 9 shows the revenue-cost structure facing the monopolist.

Answer 77

Note that, just as with the pure competitor, production will expand until MR = MC at optimal output Q*. To find the price at which it will sell Q* units, you must go to the demand curve. Note that the demand curve itself does not determine the optimal behavior of the monopolist. Just as with the pure competition model, optimal quantity is where MR = MC. For a profit to be ensured, the demand curve must lie above the ATC curve at the optimal quantity point (i.e., P1 – C1 > 0).

Question 78

Oligopoly is a market structure characterized by the following:

Answer 78

• A small number of sellers
• Interdependence among competitors (decisions made by one firm affect the demand, price, and profit of others in the industry).
• Large economies of scale.
• Significant barriers to entry.
• Products may be similar or differentiated.

Question 79

How are Oligopolies different than Monopolies?

What industry is an example of an Ologopoly?

Answer 79

As with a monopoly, producers in an oligopoly market seek that combination of supply and price that maximizes profits. In contrast to a monopolist, oligopolists are highly dependent upon the actions of their rivals when making business decisions.

Price determination in the auto industry is a good example. Automakers tend to play “follow the leader” and announce price increases in close synchronization. They are not working explicitly together, but the actions of one producer have a large impact on the others. The barriers to entry are large. It would take an enormous capital investment to start a new auto company because the large economies of scale that are achieved by the existing firms pose a significant barrier.

Oligopolists recognize that they cannot maximize profits when they are in fierce competition with one another. Hence, they may attempt to form associations or cartels to set prices and output so as to maximize profits.

Although not technically an oligopoly, OPEC is a familiar example of the concept of a cartel. OPEC faces an interesting problem, since they do not control the entire supply of crude oil. Member countries only control a very large portion of it, which they maintain carefully to manipulate prices. However, if they limit supplies too much, prices will rise to the point where potential competitors (drillers in Texas, the Gulf of Mexico, the North Sea, etc.) will be enticed to reopen their drilling and exploration sites.

Question 80

What is the incentive for Oligopolists?

Answer 80

Another interesting aspect of cartels is that each member is better off by secretly increasing its supply (i.e., cheating). Industry profits are maximized when all producers agree to restrict supply (thus mimicking monopoly conditions). This collusive agreement among producers will establish prices at a high level. Once the supply level is agreed to, individual firms will maximize their own profits by increasing their own production and thus increasing their share of the industry profit. For instance, if OPEC agrees on a certain supply from each country, all member countries are bound by that agreement. Once the agreement has been reached, the price of crude oil reacts based on the expected supply. Since each member’s best interests are served by maximizing revenues, each member will want to do so. The way a member nation maximizes revenues is by increasing supply above that specified in the agreement. In other words, what is best for the group is not necessarily best for the individual member, and vice versa. Because each participant has an incentive to cheat, cartels tend not to be sustainable over time.

Such collusive behavior is also limited for the following reasons:

• Number of oligopolists
  
  • When the number of oligopolists is large, effective collusion is less likely.
• Monitoring partners
  
  • Collusion is less attractive when it is difficult to detect and eliminate price cuts. In other words, if cheating is difficult to detect, fewer firms will be willing to enter into collusive agreements.
• Low entry barriers
  
  • New entrants will see the “premium” pricing that is available and enter the market (outside the oligopoly) with more attractive pricing in an attempt to steal market share.
• Unstable demand conditions
  
  • Unstable demand can lead to differing opinions between oligopolists as to how to best serve the industry’s clientele.
• Vigorous antitrust action
  
  • Antitrust actions may increase the cost of collusion.

Question 81

1. Comparative advantage is…
2. For example…
   
   1. Units of Output per Day
      
      1. Country A produces 2 units of food or 4 units of drink
      2. Country B produces 6 units of food or 9 units of drink

Answer 81

Comparative advantage is the ability of one country to produce a good at a lower opportunity cost than its trading partners.

Comparative advantage is the reason there is a differential impact from international trade among industries. Relative cost is the key to having comparative advantage. When trading partners specialize in producing products for which they have comparative advantage, costs are minimized, output is greater, and both trading partners benefit.

FOR EXAMPLE

• The preceding table indicates that Country A can produce either 2 units of food or 4 units of drink per worker per day. Therefore, Country A must give up 2 units of drink to produce 1 unit of food. Country B can produce 6 units of food or 9 units of drink per worker per day. Country B must give up 1.5 units of drink to produce 1 unit of food. The opportunity cost for producing food is greater for A than B. If B produces 6 units of food and A produces 4 units of drink, and each country can agree on a trading price somewhere between 1.5 to 2.0 units of drink for 1 unit of food, they will both benefit compared to other possible combinations of productions.
• if the trading rate (called the terms of trade) is 1.75 units of drink for one unit of food, then B could produce 6 units of food and trade 2 units of food to A for 2 × 1.75 = 3.5 units of drink. A ends up with 2 units of food and 0.5 units of drink. With no trading, A would have had only 1.75 units of food if enough resources had been diverted to produce 0.5 unit of drink, so its food consumption is increased 17% by specializing and trading.
• B ends up with 4 units of food and 3.5 units of drink. With no trading, B would have had 4 units of food only by diverting resources from drink production that would have limited drink output to 3 units. Thus, both countries are better off. This makes intuitive sense—the most efficient producer of a good should produce that good and trade its output for goods that are more efficiently produced elsewhere.

Question 82

Absolute Advantage?

Answer 82

Absolute advantage describes the situation in which a nation, as the result of its previous experience or natural endowments, can out-produce another nation using the same resources.

A country gains (i.e., realizes expanded consumption possibilities) from international trade when it exports those goods for which it has a comparative advantage and imports those goods for which it does not. For example, suppose we can produce wheat at $2 per bushel. If the production cost is $3 in all other nations, it is to our advantage to produce more wheat and sell it on the world market. Hence, our exports increase and the other nations get cheaper wheat.

Question 83

Impact of Trade Restrictions

Tariff vs. Quota?

Reasons that nations adopt trade restrictions include the following:

Answer 83

A tariff is a tax imposed on imports, while a quota is an import quantity limitation.

Both types of trade barriers artificially distort the costs of goods, potentially eliminating the benefits of comparative advantage.

Reasons that nations adopt trade restrictions include the following:

1. National defense
   
   1. Some industries are highly sensitive to national security, and their products should, therefore, remain in the country.
2. Infant industries
   
   1. These industries should be protected with tariffs or import quotas for a time, while they develop and reduce costs.
3. Anti-dumping
   
   1. Dumping occurs when a foreign firm sells products below cost in an attempt to gain market share by driving out domestic suppliers. The practice is sometimes supported by the foreign government.

Question 84

Tariffs

Answer 84

Tariffs benefit domestic producers of products because the level of imports will be reduced due to an effective increase in the price of importing the good. For example, if the world price of semiconductors is $40, and domestic producers can only profitably sell semiconductors at $45, foreign producers have a comparative advantage. Hence, domestic producers will not be able to compete in their own domestic semiconductor market. However, if the government places a $5 tariff on imported semiconductors, local producers will become competitive with foreign producers in the local market, and local semiconductor production will rise. Tariffs will also benefit the government because the government will collect the $5 tax on all foreign semiconductors sold in the domestic market.

Question 85

Quotas

Answer 85

The bottom line is quotas can be more harmful than tariffs because (1) the government does not receive any funds from the imposition of quotas and (2) the foreign producers receive the revenue transfer (due to higher prices received for all goods sold under the import license).

A quota is a limit (maximum) set on the import of a specific product and has the same effect as a tariff. The supply of imported goods is reduced, and a lower supply means a higher price domestically. With a quota, the government does not directly benefit because an explicit tax is not involved. Rather, the foreign producers who are granted import permits benefit because they are allowed to sell their goods in the domestic market at artificially high prices. Clearly, domestic producers also benefit from quotas because competition from foreign producers is limited.

Question 86

Do trade barriers protect jobs?

Answer 86

Trade restrictions are typically supported by local governments and citizens who believe they protect jobs and help maintain high wage levels. In the long run, however, trade restrictions cannot protect the net number of jobs in a country. The number of jobs protected by import restrictions will be offset by jobs lost in the import/export industry. Import/export firms will be unable to sell the overpriced domestic product abroad or import and sell the lower-priced, restricted foreign-made product.

Question 87

Do trade restrictions create jobs?

Answer 87

Trade restrictions may create jobs in the short run, but not in the long run. First of all, trade restrictions prevent your trading partners from developing the purchasing power needed to buy import goods from you, thus depressing your own export industry. Secondly, the higher price of the protected domestic good dampens domestic aggregate purchasing power, taking sales away from other domestic products. Finally, the jobs that would have been created in the import industry are typically never created.

Question 88

Does trade with low-wage countries depress wage rates in high-wage countries?

Answer 88

The belief that trading with low-wage countries depresses wages is based on a misunderstanding of the law of comparative advantage. A high hourly wage does not necessarily mean high per-unit labor costs. Labor productivity must be considered. The worker’s skill level, the amount of invested capital, and production methods may produce labor costs per unit of output below that found in low-wage countries.

Consider the law of comparative advantage (not absolute advantage). When each country produces goods for which it has a comparative advantage, both countries will benefit. High-wage countries will have an advantage in high-tech manufacturing, and low-wage countries will have an advantage in labor-intensive goods. When both produce the goods in which they have an advantage, total output and the availability of goods increase.

Question 89

Foreign Exchange & Importance of Currency

Answer 89

The second major consideration for international traders is foreign exchange (i.e., exchanging the domestic currency for the foreign currency).

To purchase products from a foreign country, the firm must have the currency of that country. Since foreign trade is so prevalent, there must be an equilibrium “price” for each currency in terms of all other currencies.

Question 90

Exchange Rate?

1. If the Australian dollar (AUD) is trading at 0.60 U.S. dollars ($0.60), each AUD will buy
2. How much AUD will one USD buy?

Answer 90

An exchange rate is a ratio that describes how many units of one currency you can buy with one unit of another currency. Note that an exchange rate is quoted relative to another currency.

1. Each AUD will buy 60 U.S. cents
2. $1 USD = 1/0.6
   
   1. 1.66 AUD per U.S. dollar

Question 91

A U.S. importer has agreed to purchase 200 dozen long-stem roses from a Japanese flower supplier. The latest foreign exchange quote is ¥111.02/$ or $0.009007/¥.

Specify the total dollar price for the roses if they are quoted at ¥650, including all shipping costs.

Answer 91

First, if the roses cost ¥650 per dozen, their total cost in yen is:

1. ¥650 × 200 = ¥130,000

Next, since the U.S. importer must pay in yen, he must exchange dollars for yen. That means we have to find the number of dollars that are equivalent to ¥130,000:

1. ¥130,000 × $0.009007/¥ = $1,170.91

The importer would go to the foreign exchange markets and exchange $1,170.91 for ¥130,000 to pay the Japanese supplier.

Question 92

Who are the participants of the foreign exchange market and what is the general commission?

Answer 92

1. Participants in the foreign exchange (interbank) market are large commercial banks, foreign exchange brokers, major multinational corporate customers, and central banks
2. Most of the trading in the United States goes through foreign exchange brokers, who match buyers and sellers for a small commission (1/32 of 1%).
3. If small amounts of foreign currency are needed, individuals typically deal with their local banks.

Question 93

Spot Market vs. Foward Market

Answer 93

Spot Market

1. The foreign currency spot market is where currencies trade for immediate delivery, although in practice, the settlement date (also called the value date) is set at two working days after the date the transaction is concluded. For example, if a spot deal is concluded on Thursday, the settlement date is Monday.

Forward Market

1. The foreign currency forward market is where contracts are used to buy or sell currencies for future delivery.
2. For example, a forward contract between a bank and a U.S. customer might call for the delivery of a specified amount of a foreign currency on a specified future date in exchange for a specified amount of dollars.
3. The exchange rate is fixed at the time the contract is signed. Forward contracts are generally for 30-, 90-, 180-, or 360-day periods.
4. Why would the firm enter into a forward contract, when if it just waited and exchanged its francs when it received them it would get more U.S. dollars? The answer is that the firm did not know at the agreement date whether the Swiss franc would strengthen, weaken, or remain the same. Since it had no way of knowing the direction of exchange rate movements, if any, the firm was willing to lock in at the forward contract rate (a known price) to avoid the uncertainty associated with waiting (i.e., the exchange rate risk).

Question 94

Assume a U.S. firm must pay a Swiss firm CHF150,000 (CHF is the symbol for Swiss francs) in 90 days.

What benefit will a forward market provide to the U.S. Firm?

Answer 94

The U.S. firm has dollars now but needs Swiss francs in the future. In order to offset the risk that the value of the Swiss franc might change (i.e., the exchange rate between Swiss francs and U.S. dollars), the U.S. firm will buy Swiss francs in the forward market.

An opposite situation is a U.S. firm that agrees to receive payment of CHF200,000 30 days from now. To offset the risk of changing value, the firm will contract to sell Swiss francs in the forward market.

Question 95

Strengthening of Foreign Currency?

Answer 95

When the value of a currency rises, so that the currency exchanges for more of other currencies, the exchange rate is described as appreciating or “strengthening.”

When the value of a currency falls, so that a currency trades for less of other currencies, the exchange rate is described as depreciating or “weakening.”

1. A U.S. dollar traded for $1.17 Canadian in 1980 (CAD $1.17/$).
2. The U.S. dollar appreciated or strengthened to $1.39 Canadian in 1986
   
   1. The Canadian Dollar depreciated (CAD 1.39/$)
3. depreciated or weakened to $1.15 Canadian in 1991, and then appreciated or strengthened to $1.60 Canadian by early in 2002, fell to roughly $1.20 Canadian in 2009, and then had a sharp spike up and decline in 2009 and 2010.

Question 96

A U.S. firm has entered into a contract in which it will receive CHF100,000 from a Swiss firm in 60 days. Forward contracts on Swiss francs maturing in 60 days specify a rate of CHF1.7530/$.

The current exchange rate is CHF1.7799/$. One way or another, the U.S. firm has to exchange its Swiss francs for U.S. dollars in 60 days.

Part 1: Assume the U.S. firm chooses to take its chances with exchange rates and will simply take the rate of exchange on the date it receives the francs. Compared to the current exchange rate, how much will the U.S. firm gain or lose if, when it receives the francs, the exchange rate is 1.6556 Swiss francs to the dollar?

Answer 96

Part 1

1. At the original exchange rate, assuming no change before the payment date, the U.S. firm would receive $56,182.93 for the CHF100,000:
   
   1. Current Exchange Rate is CHF1.7799/$
   2. If you are exchanging Swiss Franc for Dollar, first notice that if since you get more than 1 CHF for 1 USD, and you have 100,000 of CHF, then the amount of USD you are going to get will result in less than 100,000 CHF.
   3. Inverse Exchange Rate:
      
      1. 1/1.7799 = 0.561829
   4. CHF100,000 × $0.561829/CHF = $56,182.93
2. At the Payment Date, the exchange rate has changed
   
   1. Current Exchange Rate is CHF 1.6556/USD
   2. If you are exchanging Swiss Franc for Dollar, first notice that if since you get more than 1 CHF for 1 USD, and you have 100,000 of CHF, then the amount of USD you are going to get will result in less than 100,000 CHF.
   3. 1/1.6556 = 0.604011

By waiting, the U.S. firm receives more U.S. dollars for its Swiss francs. This is due to the strengthening of the Swiss franc. The Swiss franc strengthened with respect to the dollar, because on the agreement date it took 1.7799 Swiss francs to purchase one dollar, but it only took 1.6556 Swiss francs to purchase a dollar on the payment date.

Another way of looking at this is that the dollar weakened with respect to the Swiss franc over the period. It took $0.561823 (1/1.7799) to purchase one Swiss franc originally, but at the payment date it took $0.604011 (1/1.6556) to purchase one Swiss franc.

Question 97

A U.S. firm has entered into a contract in which it will receive CHF100,000 from a Swiss firm in 60 days. Forward contracts on Swiss francs maturing in 60 days specify a rate of CHF1.7530/$. The current exchange rate is CHF1.7799/$. One way or another, the U.S. firm has to exchange its Swiss francs for U.S. dollars in 60 days.

Part 2: Using the same exchange rates, assume the firm entered into the forward contract to sell Swiss francs at CHF1.7530/$.

Answer 97

Part 2

1. 1/1.7530 = 0.570451
2. With the forward contract, the firm has locked in a rate of exchange. It has agreed to receive $57,045.10 for their CHF100,000 (at CHF1.7530/$):

Question 98

A U.S. firm has entered into a contract in which it will receive CHF100,000 from a Swiss firm in 60 days. Forward contracts on Swiss francs maturing in 60 days specify a rate of CHF1.7530/$. The current exchange rate is CHF1.7799/$. One way or another, the U.S. firm has to exchange its Swiss francs for U.S. dollars in 60 days.

Part 3: Now assume at the time of payment the exchange rate has risen to CHF1.8250/$.

Answer 98

Remember that at the original exchange rate (CHF1.7799/$) and assuming no change before the payment date, the U.S. firm would receive $56,182.93 for its CHF100,000:
CHF100,000 × $0.561829/CHF = $56,182.93
1/1.7799 = 0.561829

At the payment date the exchange rate has changed and the firm actually • receives $54,794.52:
CHF100,000 × $0.547945/CHF = $54,794.52
1/1.8250 = 0.547945

By waiting, the U.S. firm receives less, due to the weakening of the Swiss franc. The Swiss franc weakened with respect to the dollar because on the agreement date it took 1.7799 Swiss francs to purchase one dollar, and it took 1.8250 Swiss francs to purchase a dollar on the payment date.

Another way of looking at this is that the dollar strengthened with respect to the Swiss franc over the period. It took $0.561829 (1/1.7799) to purchase one Swiss franc originally, but at the payment date it took only $0.547945 (1/1.8250) to purchase one Swiss franc.

Question 99

Currency Appreciation or Depreciation?

Answer 99

Supply and Demand

1. Exchange rates are largely a function of supply and demand for currencies
2. If demand for a currency rises relative to the supply, the currency should appreciate in value.
3. If supply increases relative to demand, the currency should depreciate.

Question 100

Three major factors cause a currency to appreciate or depreciate

Answer 100

1. Income growth
2. Inflation Rates
3. Interest Rates

Question 101

Income Growth

Answer 101

Differential income growth among nations will cause nations with the highest income growth to demand more imported goods. Countries experiencing faster growth than its trading partners will have an increase in demand for foreign currencies to pay for the imported goods.

There will be an increase in the supply of the fast growth country’s currency together with more demand for foreign currencies. The result will be that the currency of the faster growth nation will depreciate relative to the currencies of the trading partners.

Question 102

Inflation Rates

Answer 102

Differential inflation rates will reduce demand for the currencies with higher inflation rates. If a country’s inflation rate is higher than its trading partner’s, the demand for the country’s currency will be low, and the currency will depreciate.

Question 103

Interest Rates

Answer 103

Differential interest rates will cause a flow of capital into those countries with the highest available real rates of interest. Therefore, there will be an increased demand for those currencies, and they will appreciate relative to countries whose available real rate of return is low.

Low interest rates spur consumer spending and economic growth, and generally positive influences on currency value. If consumer spending increases to the point where demand exceeds supply, inflation may ensue, which is not necessarily a bad outcome. But low interest rates do not commonly attract foreign investment. Higher interest rates tend to attract foreign investment, which is likely to increase the demand for a country’s currency.

Question 104

Balance of Payments

Answer 104

Balance of payments (BOP) accounting is used to keep track of transactions between a country and its international trading partners. The BOP accounts reflect all payments and liabilities to foreigners and all payments and obligations received from foreigners. The BOP equation is:

• current account + capital account + official reserve account = 0

In order for the balance of payments to sum to zero, changes in the current account must be offset by changes in the capital account. This makes sense when you think about it. Assume that an American buys a bottle of French wine using dollars. The French wine seller now has dollars. Those dollars are no good in France, but they can be used either to buy American goods or to buy American assets. Either way, the dollars have to come back to the United States because they represent U.S. assets. In recent years, the United States has had large merchandise trade deficits, and large current account deficits, meaning that U.S. citizens have bought a lot of foreign goods.

If foreigners bought lots of U.S. goods, the current account deficit could be reduced. Otherwise, those dollars will come back to the United States. through the purchase of U.S. assets, which will create a surplus in the U.S. capital account. In fact, this is just what has happened, and the large proportion of foreign ownership of U.S. stocks and bonds reflects the capital account surplus of recent years.

Question 105

Balance of Payment - Current Account?

Answer 105

current account + capital account + official reserve account = 0

T
he current account measures the exchange of merchandise goods, the exchange of services, the exchange of investment income, and unilateral transfers (gifts to and from other nations). Basically, the current account includes all international transactions for goods and services. If an American buys a pair of shoes made in Italy, the transaction shows up in the current account. If a Japanese citizen hires an American lawyer, that transaction shows up in the current account. When the media reports on the “trade deficit,” it is usually referring to the balance of merchandise trade, which is the goods component (and the largest piece) of the current account. The balance on current account summarizes the balance on goods and services, the exchange of investment income, and unilateral transfers.

Question 106

Balance of Payments - Capital Account?

Answer 106

The capital account measures the flow of funds for debt and equity investment into and out of the country. Instead of goods and services, the capital account includes transactions involving the assets of another country. If an American buys land in Italy, that transaction would be in the capital account. Similarly, if a Japanese investor bought U.S. Treasury securities (or stock in a U.S.-based company), that transaction would be in the capital account.

Question 107

Balance of Payments - Official Reserve Account