A fundamental dilemma of any economic system is that of scarcity of resources relative to wants. Decisions are necessary to determine how a given volume of resources is to be allocated to production and how the income derived from production is to be distributed to the various factors - capital, land, labor, and managerial ability- that are responsible for it. Human Wants, if not unlimited, are at least indefinitely expandable. But the commodities and services that can satisfy these wants are not, and neither are the factors of production that can produce the desired goods and services. These productive factors usually have alternative uses; that is, they can be used in the production of a number of different goods and services. The system must allocate limited productive resources, which have alternative uses, to the satisfaction of great and growing human material wants. 
Societies have endless ways of organizing and performing their production and distribution functions. In economic terms the possible range is from laissez-faire capitalism through totalitarian communism. The U.S. economy is not a laissez-faire capitalism but rather a mixed economic system. There are four economic systems: Traditional; Command, Market or Laissez-faire; and, Mixed. 
The collapse of communism was remarkable. This century has been dominated by three "isms" - capitalism, communism, and socialism- although Fascism lasted for a short period of time and ended with the defeat of Germany, Japan, and Italy during W W II. The conflict between capitalism and communism has lasted 75 years from the Bolshevik Revolution to the final collapse of the Soviet Union in 1991. The Cold War is over and the question is Where do we go from here? 

Individualistic Capitalism: It is associated with the writings of Locke and A. Smith. The right to govern rests on the hands of the governed, not the governor. The individual is permitted to pursued his/her own interest; the Invisible Hand. According to Thurow, individualism takes a number of forms: large income differentials, brilliant entrepreneurship, and short profit maximization. The individuals are personally responsible for their own success. 

Communitarian Capitalism: It has a number of connotations, but basically it means deriving satisfaction from being part of a group process opposed to functioning as an individual. The role of the state is greatly expanded and plays a role in stimulating economic growth and providing social welfare programs and public investment. 
German Social Market Capitalism and the WEST EUROPE which includes a elaborate system of social welfare programs ranging from national health insurance to family allowances. Transfer payments represent a higher percentage of total government expenditures and reliance on economic planning of the indicative type are the basis of the system. Codetermination between labor and management with labor sitting in the boards of the companies and German banks are the major shareholders in German companies. State Directed Capitalism exists in Japan and other East Asian countries and there is a far closer relationships between government and business. In Japan, the overwhelming emphasis in on the group and one's responsibility to it. Companies are part of the group of companies (including banks). Employees are loyal to the company, and there is little job switching. There is cooperation between labor and government and companies and government. US Market Capitalism; the government intervention is more regulatory than distributive. 
These three types of capitalism can be compared on the basis of the extent of the government involvement in the economy with respect of government expenditures to GDP and taxes to GDP to the extent to which resources have been diverted from private to public. 
The collapse of command economies, although forecast by some Westerners, was quite sudden. In a period of less than two years, communism collapsed in the Soviet Union and in its Eastern European satellite countries. Political and economic structures that had been regarded as unchangeable have dissolved. Central economic planning was inefficient, and rejection of market prices, wages, and interest rates as indicators of scarcity resulted in the production unrelated to the needs of consumers. The economic performance of the Soviet Union and the Eastern countries were very much overrated by the West, for example its is going to cost about a trillion dollars to convert East Germany into the capitalist system of the West. The conversion of markets to free markets will not be easy, because of the number of environmental and economic problems. The production systems of Eastern Europe and the states that compromised the former Soviet system will have to be completely restructured and modernized since they can not meet the domestic needs and international business standards. The division of labor under the old regimes did not reflect comparative advantage costs and attempts to achieve self-sufficiency led to governmental support of inefficient industries. Not only do production systems and physical infrastructure need to be changed; the human infrastructure also needs to change to overcome inexperience with capitalism and market institutions. 
Social problems are as difficult as the economic problems, if not more so. The republics of the former Soviet Union and former Czechoslovakia are examples. Ethnic and border disputes disrupted trade. The GDP of Russia is $1,780, about one third that of South Korea or Costa Rica and less than Mexico. 
There are several approaches that can be used to convert a centrally planned economy into a market economy. One is called The Big Bang Approach where sweeping reforms are 
implemented immediately. Prices are free from state control to seek market determination and the currency unit is devalued to reach a level of consistency with the international currencies. State subsidies are eliminated, interest rates are allow to rise, and state enterprises are turned loose to compete on their own. Wages are free from state control and determined by the market. This approach creates unemployment and rise in the prices of goods and services. 
The second approach is the Gradual Approach in which the changes will be spaced out over time to prevent economic disruptions such as inflation and unemployment. The problem with this approach is that for example, the market economy can not work with centrally planned economy. 
The rest of the world remains with those countries which are neither developed or former communist bloc countries. They are often called third world countries. They include most of the countries in Latin America, Asia, and Africa and range from dirt poor countries like Ethiopia 
(with a GDP per capita of $120) to newly industrialized countries like South Korea (with a per capita GDP of $5,400). Economic history shows that it is possible for countries to develop rapidly and for others slowly. For example, it took the United Kingdom fifty eight years to double its output per worker but only eleven years to South Korea and ten to China. 
Asia, the World most populous continent, has shown a spectacular rate of economic development over the last four decades. However, most of that growth was confined to the East Asian Rim countries and China. Some of the World's poorest countries are located in Asia, including Bangladesh ($200); China and India ($400). China does not have the religious and ethnic problems that India has and is far more accessible to East Asian markets. Therefore the prognosis of doing business in China is better. 
Africa is the poorest continent of the World. Of forty-five countries in the world with the per capita incomes of $500.00 or less, twenty-eight are located in Africa. Population increases that exceed growth rates compound the problems of most African countries. Falling per capita GDPs in African countries will persist for several reasons, including the existence of unstable governments,, foreign debts, lack of educational skills, agricultural problems, and dependence on minerals and a few other products of export which will affect their terms of trade negatively. 
In the 1900's Argentina, U.S. and Canada were the most prosperous countries in the Western hemisphere but Argentina is no longer the economic force it once was. The rest of Latin America has its share of economic problems one of which is the high level of foreign debt. Raw materials and agriculture remain the main source of comparative advantage. 
Globalism, privatization, and regionalism are the two main currents in the world today. Technological innovation is a driving force in the world economy and has no distinctive nationality. As technology has developed , it has become an increasingly internationally marketable commodity. A globalized market for goods and services has also resulted from rapid technological developments that have greatly diminished the costs of international transportation and communication, and international trade manufacturing products has been boosted by the trend toward convergence in per capita incomes and demand patterns of industrial countries. There also has been a globalization of financial markets in that the pool of savings is worldwide, and financial 
intermediaries know no international boundaries. Finally companies manufacturing a particular product increasingly think in terms of the advantages of international locations rather than purely in terms of domestic production. 
At the same time and as a counter globalization there are trends towards regionalism. Three major economic spheres are in the process of formation. NAFTA which includes the United States, Canada, and Mexico which will provide a common market of around 350 million people and a combined GDP of $6.5 trillion. Outside of Japan, Mexico and Canada are the two most important US trading partners. They are important places for US foreign direct investment. NAFTA will not create a ceding of national sovereignty, nor will there be a common currency. 
 

WEB SITES OF INTEREST 

 1. http://www.efr.hw.ac.uk/EDC/edinburghers/ 
 2. http://william-king.www.drexel.edu/top/prin/text/equil/CF1.html 
 3. http://www.usatoday.com/money/economy/ 
 4. http://www.conference-board.org/products/c-consumer.cfm 
 5. http://www.access.gpo.gov/su_docs/budget99/ 
 6. http://www.census.gov/ftp/pub/foreign-trade/www/ 
 7. http://www.whitehouse.gov/ 
 8. http://www.theatlantic.com/unbbound/flashbks/budget/keynesf 
 9. http://www.whitehouse.gov/fsbr/income 
 10. http://www.bog.frb.fed.us/releases/ 
 11. http://www.whitehouse.gov/fsbr/international 
 12. http://www.census.gov/ftp/pub/indicator/www/ustrade 
 13. http://www.nber.org/ 
 14. http//www.ifm.org 
 15. http//www.hoover.org 
 16. http://www.gpo.ucop.edu/cataalog/erp99 
 17. http://stats.bls.gov/cpihome.htm 
 18. http://stats.bls.gov/cpihome.htm 
 19. http://www.dismal.com/ 
 20. http://www.odci.gov/cia/publications/ 
 21. http://www.eco.utexas.edu/joe/ 
 22. http://www.ed.gov/ 
 23. http://www.ars.usda.gov/ 
 24. http://www.csuchico.edu/econ/links/ 
 25. http://www.globalexposure.com/ 
 26. http://www.worldbank.org/http://www.globalexposure.com/ 
 27. http://www.tradeport.org/ 
 28. http://www.helsinki.fi/WebEc/ 
 29. http://www.ita.doc.gov 
 30. http://www.unicc.org/ 
 
 
 

Lecture Notes Ch. 1

I. The Economy and Economics 
A. An economy is the institutional structure through which individuals in a society coordinate their diverse wants and desires. 

B. An economic system is the means by which the economy is organized. 

C. Economics is the study of economics. It is the means and efforts by which humans satisfy unlimited wants with limited resources. 
It is the efficient utilization of limited economic resources to satisfy virtually unlimited human wants. 

D. Three central coordination problems any economic system must solve are Basic Economic Questions: 
1. What, and how much, to produce. 
2. How to produce it. 
3. For whom to produce it. 

E. Since individuals want more than can be produced, scarcity the goods available that are too few to satisfy individuals' desires ensues. 

1. Wants are changeable and partially society determined. 
2. The quantity of goods, services, and usable resources depends upon technology and human action. 
3. Two alternative definitions of economics: 
a. Economics is the study of the allocation of scarce resources to satisfy individuals' wants or desires. 
b. Economics is the study of how to get people to do things they're not wild about doing and not to do things they are wild about doing. 
 

II. What is Economics
A. Five important things to learn in economics are : 
1. Economic reasoning. 
a. Economic reasoning is how to think like an economist, making decisions on the basis of costs and benefits. 
b. Economic reasoning provides a framework within which to answer a question. 

2. Economic terminology. 

3. Economic insights economists have about issues, and theories that lead to those insights. 
a. These insights are based on economic theory- generalizations about the workings of an abstract economy. 
b. One insight is that no one coordinates the American economy, save the invisible hand. 

4. Information about economic institutions. 
a. An economic institution is a physical or mental structure that significantly affects economic decisions. 
b. Differences in economic institutions can help explain differences in economies among nations. 

5. Information about the economic policy options facing society today.
a. An economic policy is an action (or inaction) taken, usually by government, to influence events. b. Decision makers weight the advantages and disadvantages each option offers. 
 

III. A Guide to Economic Reasoning 

A. Since every choice has costs and benefits, decisions are made by comparing the two. 
1. The decision rule is that if the relevant benefits of doing something exceed the relevant costs, do it. 
2. The decision rule is that if the relevant costs of doing something exceed the relevant benefits, don't do it. 

B. Marginal costs and marginal benefits. 
1. The relevant costs and relevant benefits are the expected incremental or additional costs incurred and the expected incremental benefits of a decision that matter. 
2. In economists' jargon, marginal refers to additional or incremental. Think of it as 'one more. 
3. Marginal cost, then, is the additional cost to you over and above the costs you have already incurred. 
4. This means eliminating sunk costs, costs that have already been incurred and cannot be recovered. 
5. Marginal benefit is the additional benefit above and beyond what you've already incurred. 

C. Economics and passion. 
1. Economic reasoning is based on the premise that everything has a cost.
2. Although economists can be as passionate as the next person, they must squelch this normal human response in order to do their work. 

D. Opportunity cost. 
1. Opportunity cost is the basis of cost/benefit economic reasoning; it is the benefit forgone, or the cost, of the next best alternative to the activity you have chosen . 
2. In economic reasoning, opportunity cost is less than the benefit of what you have chosen. 
3. Opportunity costs are not limited to individual decisions but to government decisions as well. 

E. Economics and invisible forces . 
1. The opportunity cost concept applies to all aspects of life and is fundamental to understanding economic forces. 
2. Economic forces are the necessary reactions to scarcity. 
3. When goods are scarce, they must be rationed. Rationing is a structural mechanism for determining who gets what. Examples of rationing: price, lottery, first come, first served. 
4. One of the important choices that a society must make is to what extent economic forces are allowed free rein. 
5. A market force is an economic force that is given relatively free rein by society to work through the market. Market forces ration by changing prices. 
6. Economic reality is controlled by three invisible forces. 
 a. The invisible hand is the price mechanism, the rise and fall of prices that guides our actions in a market. 
 -Adam Smith, in his Wealth of Nations, argues that 'the propensity to truck, barter, and exchange one thing for another,' is part of human nature. And that 'it is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, from their regard to their own interest.'
b. The invisible handshake refers to social and historical forces which can play a significant role in the economy. 
c. The invisible foot refers to political and legal forces which also play their role. 
7. What happens in society can be seen as a reaction to, and interaction of, the invisible hand, the invisible foot, and the invisible handshake. 

IV. Economic Terminology A. Learning economic terminology takes repetition and memorization, hardly a fun things to do. 

V. Economic Insights 
A. General insights into how economies work are often embodied in economic theories - a formulation of highly abstract, deductive relationships that capture inherent empirically observed tendencies of economies. 
 -Alfred Marshall, in his 1890 masterpiece, Principles of Economics, argues that 'economic doctrine is not a body of concrete truth, but an engine of the discovery of concrete truth.' Marshall was the first to focus on economic reasoning rather than on economic truths. 

B. Since theories are too abstract to apply to specific cases, a theory is often embodied in: 
1. An economic model - a framework that places the generalized insights of the theory in a more specific contextual setting. 
2. Or in an economic principle - a commonly held insight stated as a law or general assumption. 

C. The invisible hand theory. 
1. An efficient economy is one that achieves a goal as cheaply as possible. 
2. This insight is called the invisible hand theory - a market economy through the price mechanism will allocate resources efficiently. 
3. Theories, and the models and principles used to represent them, are abstract but efficient means of conveying information. 
4. In order to understand the theory you must understand the assumptions underlying the theory. 

D. Economic theory and stories. 
1. Economic theories and its models are a shorthand means of telling a story. 
2. If you can't translate a theory into a story, you don't understand the theory. 

E. Economic theory is divided into two parts: microeconomics and macroeconomics. 

1. Microeconomics. 
a. Microeconomics is the study of individual choice, and how that choice is influenced by economic forces. 
b. Microeconomic theory considers economic reasoning from the viewpoint of individuals and firms and builds up from there to an analysis of the entire economy. 
c. Microeconomics studies such things as: 
(1) Pricing policy of firms. 
(2) Households' decisions on what to buy. 
(3) How markets allocate resources among alternative ends. 
d. Microeconomics analyses from the parts to the whole. 

2. Macroeconomics. 
a. Macroeconomics is the study of inflation, unemployment, business cycles, and economic growth. 
b. Macroeconomics analyses from the whole to the parts. 
3. One must simultaneously develop a micro foundation of macro and a macro foundation of micro. 

VI. Economic Institutions

A. Economic institutions are complicated combinations of historical circumstance, and economic, cultural, social, and political pressures. 

B. Cultural norms determine what you identify as legitimate activities by individuals, business, and government.. 
1. Cultural norms are standards people use when they determine whether a particular activity or behavior is acceptable. Examples: 
a. In the U.S., traffic proceeds on the right; in Britain, on the left. 
b. In the U.S., grownups often tousle children's' hair; Chinese consider it a transgression. 
c. In the U.S., black is the color for mourning; in India, white. 
2. In applying economic theory to reality, you've got to have a sense of economic institutions. 

VII. Economic Policy Options 

A. In order to carry out economic policy effectively, you must understand how institutions might change as a result of the economic policy. 

B. Good objective policy analysis is that which keeps your value judgments separate from the analysis. Objective analysis keeps, or tries to keep, subjective views, value judgments- separate. 

C. Subjective policy analysis is that which reflects the analyst's view of how things should be. 

D. In order to make clear the distinction between objective an subjective analysis, economists have divided economics into three categories. 

1. Positive economics is the study of what is, and how the economy works. 
Examples: 
a. How does the stock market work? 
b. What are the consequences of rent control on the market for housing? 
c. Are the costs of having children related to family income? 

2. Normative economics is the study of what the goals of the economy should be. Tell the students that the word 'should' is a dead giveaway to a normative statement. Examples: 
a. People on welfare should work in order to get benefits. 
b. Inherited wealth should be taxed more heavily. 
c. Corporations should not be allowed to move their facilities overseas unless it is agreed to by labor unions. 

3. The art of economics is the application of the knowledge learned in positive economics to the achievement of the goals determined in normative economics DESCRIPTIVE ECONOMICS

4. Maintaining objectivity is easiest in positive economics- harder in normative economics. 

5. It is hardest to maintain objectivity in the art of economics since it embodies the problems of both positive and normative economics. 

6. One of the best ways to find out about feasible economic policy options is to compare them from one country to another. 
 

Chapter one OUTLINE: A Map of the Chapter 

I.  What Economics Is About.
A.  Economics is the study of how human beings coordinate their wants and desires, given the decision making mechanisms, social customs, and political realities of that society (Chapter Objective 1a).   One of the key words in the above definition is “coordination.” 
B.  Three central coordination problems any economic system must solve are (Chapter Objective 1b): 
1. What, and how much, to produce.
2. How to produce it. 
3. For whom to produce it. 
C.  Since individuals want more than can be produced, scarcity -- the goods that are too few to satisfy individuals’ desires -- ensues.  Scarcity, a relative term, is prevalent in economics, and is constantly changing. 

II.  In order to understand what economics is about, your students need to learn five important things about economics (Chapter Objective 2): 
A.  Economic reasoning, or how to think like an economist, making decisions on the basis of costs and benefits, is the most important lesson your students will learn from this book.  Economic reasoning once learned is infectious.  It provides a framework within which to approach a question. 
B.  The economic terminology that economists use to communicate. 
C.  Economic insights economists have about issues, and theories that lead to those insights. 
D.  Information about economic institutions. 
E.  Information about the economic policy options facing society today. 

III.  A Guide to Economic Reasoning. 
A.  Since every choice has costs and benefits, decisions are made by comparing the two  (Chapter Objective 2). The decision rule is that if the marginal benefits of doing something exceed the marginal costs, do it.  Similarly, the decision rule is that if the marginal costs of doing something exceed the marginal benefits, don't do it. 
B.  Marginal costs and marginal benefits.
1.  The relevant costs and relevant benefits are the expected incremental or additional costs incurred and the expected incremental benefits of a decision that matter. 
2.  In economists’ jargon, marginal refers to additional or incremental.  Think of it as "one more."  Marginal cost, then, is the additional cost to you over and above the costs you have already incurred. 
3. This means eliminating sunk costs -- costs that have already been incurred and cannot be recovered. 
4.  Marginal benefit is the additional benefit above and beyond what you've already accrued. 
C.  Economics and passion.  Economic reasoning is based on the premise that everything has a cost.  Although economists can be as passionate as the next person,  they must squelch this normal human response in order to do their work with objectivity. 
D.  Opportunity cost is the basis of cost/benefit economic reasoning; it is a cost of the activity you have chosen measured by the benefit foregone, of the next best alternative to the activity you have chosen (Chapter Objective 3). 
1.  In economic reasoning, opportunity cost must be less than the benefit of what you  have chosen. 
2.  Opportunity costs are not limited to individual decisions but to government decisions as well. 
E.  Economics and market forces  (Chapter Objective 4). 
1.  The opportunity cost concept applies to all aspects of life and is fundamental to understanding how society reacts to scarcity.  When goods are scarce, they must be rationed.  Rationing is a mechanism chosen to determine who gets what. 
2.  One of the important choices that a society must make is to what extent economic forces are allowed free rein. 
3.  A market force is an economic circumstance that is given relatively free rein by society to work through the market.  Market forces ration by changing prices. 
4.  Economic reality is controlled by three forces: (1) the invisible hand, (2) social and historic forces, and (3) political and legal forces. 
a.  Economic forces.  The invisible hand is the price mechanism, the rise and fall of prices, that guides our actions in a market.  When there is a shortage, the price goes up.  When there is a surplus, the price goes down. 
b.  Social and historical forces; political and legal forces.  Often political and social forces work together against the invisible hand.  What happens in society can be seen as a reaction to, and interaction of, the invisible hand, political and legal forces, and social and historical forces. 

IV.  Economic Terminology.  Learning economic terminology takes repetition and memorization, hardly fun things to do.  Hundreds of economic terms will be introduced in this book.  Students will learn them as we go along. 

V.  Economic Insights. 
A.  General insights into how economies work are often based on economic theory – generalizations about the workings of an abstract economy. 
B.  Theory ties together economists’ terminology and knowledge about economic institutions and leads to economic insights. 
C.  Since theories are too abstract to apply to specific cases, a theory is often embodied in an economic model -- a framework that places the generalized insights of the theory in a more specific contextual setting -- or in an economic principle -- a commonly held insight stated as a law or general assumption. 
D.  The invisible hand theory states that markets are efficient in coordinating individuals’ decisions, allocating scarce resources to their best possible use.  This insight is called the invisible hand theory -- a market economy through the price mechanism will allocate resources efficiently. 
1.  Theories, and the models and principles used to represent them, are abstract but efficient means of conveying information. 
2.  In order to understand the theory you must understand the assumptions underlying the theory. 
E.  Economic theory and stories.  Economic theory and its models are a shorthand means of telling a story.  If you can't translate a theory into a story, you don't understand the theory. 
F.  Economic theory is divided into two parts: microeconomics and macroeconomics (Chapter Objective 5). 
1.  Microeconomics.
a.  Microeconomics is the study of individual choice, and how that choice is influenced by economic forces. 
b.  Microeconomic theory considers economic reasoning from the viewpoint of individuals and firms and builds up from there to an analysis of the entire economy. 
c.  Microeconomics studies such things as: pricing policy of firms, households’ decisions on what to buy, and how markets allocate resources among alternative ends. 
d.  Microeconomics analyses from the parts to the whole. 
2.  Macroeconomics.
a.  Macroeconomics is the study of inflation, unemployment, business cycles, and economic growth. 
b.  Macroeconomics analyzes from the whole to the parts. 
3.  One must simultaneously develop a micro foundation of macro and a macro foundation of micro. 

VI.  Economic Institutions.
A.  Corporations, governments, and cultural norms are all economic institutions.  They differ significantly among nations.  They sometimes seem to operate in ways quite different than economic theory predicts. 
B.  In applying economic theory to reality, you've got to have a sense of economic institutions. 

VII.  Economic Policy Options. 
A.  Economic policies are actions (or inactions) taken by government to influence economic actions.  Those who wish to carry out economic policy effectively must understand how institutions might change as a result of the economic policy. 
B.  Good objective policy analysis keeps the value judgments separate from the analysis. 
C.  Subjective policy analysis is that which reflects the analyst's view of how things should be. 
D.  In order to make the distinction between objective and subjective analysis clear, economists have divided economics into three categories. 
1.  Positive economics is the study of what is, and how the economy works  (Chapter Objective 6a).  Examples include: (a) how does the stock market work, (b) what are the consequences of rent control on the market for housing, and (c) are the costs of having children related to family income? 
2.  Normative economics is the study of what the goals of the economy should be  (Chapter Objective 6b).  Tell the students that the word "should" is a dead giveaway to a normative statement.  Examples include: people on welfare should work in order to get benefits, inherited wealth should be taxed more heavily, and corporations should not be allowed to move their facilities overseas unless it is agreed to by labor unions. 
3.  Art of economics is the application of the knowledge learned in positive economics to the achievement of the goals determined in normative economics (Chapter  ). 
4.  Maintaining objectivity is easier in positive economics -- harder in normative economics. 
5.  It is hardest to maintain objectivity in the art of economics since it embodies the problems of both positive and normative economics. 
6.  One of the best ways to find out about feasible economic policy options is to compare them from one country to another. 
E.  Policy and social and political forces. 
1.  The choice of policy options depends on more than economic theory. 
2.  As soon as economists apply economy theory to policy, political and social forces must be taken into account. 

NOTE:  For a review of graphs that may be used in economics, see Appendix A, "Graphish: The Language of Graphs." 

Lecture Notes Ch. 2

I. Economic Systems: Capitalism and Socialism 

A. Any economic system must coordinate individuals' wants and desires. It must answer three questions regarding coordination: 
1. What, and how much, to produce. 
2. How to produce it. 
3. For whom to produce it. 

B. One problem every economy faces is what to do with individuals who want to do what 'society' does not want them to do. 
1. Example: society may want and need a garbage dump and individuals may agree. 
2. NIMBY (Not In My Back Yard) may then become a problem. NIMBY is a mindset familiar in the 1990s, wherein individuals may approve of a project if it is placed somewhere else. 

C. Another problem every economy faces is what to do with individuals who sit around doing nothing since the economic system does not give them the incentive to do something. 

D. The coordination problems faced by society are immense. 

E. The two main economic systems of the past 50 years, socialism and capitalism, answer these coordination problems differently. 

1. Capitalism is an economic system based upon private property and the market in which, in principle, individuals decide how, what, and for whom to produce. Under capitalism: 
a. Individuals are encouraged to follow their own self-interest, while market forces of supply and demand are relied upon to coordinate those individual pursuits. 
b. Government must allocate and defend private property rights - the control a private individual or firm has over and asset or a right. 
c. Markets work through a system of rewards and payments. 
d. Individuals are free to do whatever they want as long as it is legal. 
e. Fluctuations in prices coordinate individuals' wants. 
f. The primary debate among economists is not about using markets; it is about how markets should be structured, and whether they should be modified and adjusted by government regulation. 

2. Socialism is, in theory, an economic system based on individuals' good will toward others, not on their own self-interest; in principle, society decides what, how, and for whom to produce. 
- from F.A. Hayek's famous, Road to Serfdom, emphasizes that markets, bolstered by law and tradition, are absolutely essential to keep the political power of the state from becoming to powerful. 

a. Socialism in theory. 
 (1) Socialism is an economic system that tries to organize society in the same way as families are organized, trying to see that individuals get what they need. 
(2) If individuals' inherent goodness will not make them consider the general good, government will force them. 
b. It is difficult to provide an unambiguous definition of socialism. 
c. Socialism in practice. 
-'Manifesto of the Communist Party,' Karl Marx and Friedrich Engels. 
(1) Economic systems based on upon people's goodwill have tended to break down. 
(2) Socialism in practice is often called Soviet style socialism - an economic system that uses administrative control or central planning to solve the coordination problems what, how, and for whom. 
(a) Soviet style socialism embodied both economic and political features. 
(b) Some say Soviet style social failed because it did not offer acceptable solutions to the three central coordination problems. 
(c) Other say Soviet style socialism is no reflection on the failure of true socialism because true socialism was never tried. 

3. Differences between Soviet style socialism and capitalism. 
a. The differences are in who does the planning, what the planners are trying to do, and how the plans are coordinated. 
b. In capitalist nations, businesspeople do the planning in order to make a profit and the market is relied upon to see that individual self-interest is consistent with society's interest. 
c. In Soviet style socialist nations, government planners decide what people need and should have and the coordination is forced upon society by the planner 

4. Evolving economic systems. 
a. Types of economic systems of the past. 
This selection, taken from Arnold Toynbee's, Lectures on the Industrial Revolution (1884), argues that the agrarian revolution played as large a role in the Industrial Revolution as does the manufacturing revolution. 
(1) Feudalism is an economic system in which traditions (the invisible handshake) rule. It dominated the Western world from about the 8th to the 15th century. 
(2) Feudalism gave way to mechantilism, an economic system in which government (the invisible foot) determines the what, how, and for whom decisions by doling out the rights to undertake certain economic decisions. 
(3) Mercantilism gave way to the Industrial Revolution - a time when technology and machines rapidly modernized industrial production and mass produced goods replaced handmade goods. 
(4) Capitalism evolved from the Industrial Revolution. Some economists prefer to call the system that evolved from mercantilism the market economic system - an economic system that relies on markets to coordinate economic activities. 
a. The need for coordination in an economic system. 
(1) Adam Smith in his classic, Wealth of Nations (1776), explained how markets could coordinate the economy without the active involvement of government. 
(2) Markets coordinate economic activity by using the price mechanism to direct individuals' self-interest into society's interest . 
b. Evolutionary changes within systems. 
-This selection, taken from Joseph Schumpeter's, Capitalism, Socialism, and Democracy (1950), argues that capitalism, by its very success, will undermine that which gives it life-entrepreneurship. 
(1) Economic systems are constantly evolving with changes in the three invisible forces. 
(2) A purer form of capitalism evolved into welfare capitalism - an economic system in which the market operates but government regulates markets significantly. 
(3) In socialist nations the opposite took place: socialism integrated capitalist institutions into its existing institutions. 
c. A blurring of the distinction between capitalism and socialism. 
(1) Recent events point to a blending of capitalism and socialism. 
(2) If this trend continues, the 21st century will see the emergence of a single general type of economic system, a blended capitalist - socialist system. 
 

II. The Production Possibilities Curve: Economic Reasoning, Trade, and Economic Systems 

A. The production possibility table. 
1. Every decision has a cost in forgone opportunities - its opportunity cost.
2. Opportunity cost can be seen numerically with a production possibilities table - a table that lists a choice's opportunity costs by summarizing what alternative outputs you can achieve with your inputs. 
a. An output is simply a result of an activity. 
b. An input is what you what you put into a production process to achieve an output. 
3. The production possibility curve. 
a. A production possibility curve is one that measures the maximum combination of outputs that can be achieved from a given number of inputs. 
Limitations: 
- It slopes downward from left to right. 
-Two goods/ services or inputs 
-Limited budget or income 
-Price of two commodities are fixed 
-Limited time 
(2) The production possibility curve not only represents the opportunity cost concept, it also measures the opportunity cost. 
b. The production possibility curve demonstrates that: 
(1) There is a limit to what you can achieve, given the existing institutions, resources, and technology. 
(2) Every choice made has an opportunity cost. You can get more of something only by giving up something else. 
c. Increasing marginal opportunity cost. 
(1) The production possibility curve is generally bowed outward since some resources are better suited for the production of some goods . 
(2) That some resources is better suited for the production of some goods lies behind the concept of comparative advantage to be better suited to the production of one good than to the production of another good. 
(3) The principle of increasing opportunity cost states that opportunity costs increase the more you concentrate on the activity. In order to get more of something, one must give up ever increasing quantities of something else . 

d. Comparative advantage, trade, and the production possibility curve. 
(1) When individuals trade using their comparative advantages, their combined production possibility curve shifts out. 
(2) The argument that the division of labor and trade makes individuals better off also hold for countries. 

e. Efficiency. 
(1) In our production, we would like to have productive efficiency achieving as much output as possible from a given amount of inputs or resources. 
(2) Efficiency involves achieving a goal as cheaply as possible. Efficiency has meaning only in relation to a specified goal. 
(3) Any point within the production possibility curve represents inefficiency - getting less output from inputs which, if devoted to some other activity, would produce more output. 
(4) Any point outside the production possibility curve represents something unattainable, given present resources and technology. 

f. Distribution and production efficiency. 
(1) An increase in output that goes to one person and not to anyone else would not necessarily be efficient in some societies. 
(2) In our society, where generally more is preferred to less, many policies have relatively small distributional effects. 

4. Some examples of shifts in the production possibility curve. 

5. The production possibility curve and economic systems. 
a. The production possibility curve presents choices in a timeless fashion but most choices are dependent on previous choices made sequentially with a time dimension. 
b. Sequential decisions can best be seen within a framework of a decision tree - a visual description of sequential choices. 
(1) Low -level choices are choices that involves general acceptance of the path one has taken. 
(2) Institutional choices are choices that make major institutional changes. 
(3) Systemic choices are fundamental choices that determine the set of institutional and low - level choices available. 

c. All decisions are made in context - what makes sense in one context may not make sense in another. 

d. Because decisions are contextual, what the production possibility curve for a particular decision looks like depends on existing institutions, and the analysis can be applied only in the institutional and historical context. 

6. The production possibility curve and tough choices. 
a. Politicians make promises as though the production possibility curve did not exist or that the economy can operate outside the economy's production possibility curve. 
b. Economists, on the other hand, continually point out that seemingly free lunches often involve significant costs thus earning for themselves the nickname, the dismal science. 
 

      Lecture Notes Ch. 4 and  Ch. 5 Supply; Demand and Equilibrium
 
 

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Garcia's Approach to Questions Dealing with Supply and Demand

1. Determine which commodity is the one under consideration. 

2. Is the price of the commodity under consideration changing? 
 a. If no, go to Questions #3. 
 b. If yes:  Is the change in the price of the commodity affecting demand, supply, or both? 
  1. If only the price of the commodity under consideration is changing, there is a change in the quantity supplied, a change in the quantity demanded, or both; move along the supply curve, the demand curve, or both. 
  2. If the price of the commodity under consideration is changing and something else is also affecting the relationship between price and quantity, go to Question #3. 

3. What non-price determinants are affecting the relationship between price and quantity? 
 a. If the price of the commodity remains the same and the non-price determinants of demand are affecting the relationship, shift the demand curve upward or downward. 
 b. If the price of the commodity remains the same and the non-price determinants of supply are affecting the relationship, shift the supply curve upward or downward. 
 c. If the price of the commodity remains the same and both non-price determinants of demand and non-price determinants of supply are affecting the relationship, shift both the demand curve and the supply curve.  NOTE:  Key question is to understand which are determinants of demand and which are determinants of supply. 
 d. If the price of the commodity under consideration is changing and non-price determinants of demand, non-price determinants of supply, or both are affecting the relationship, move along and then shift the supply curve, the demand curve, or both.  NOTE:  In some cases, shift the curve first, and then move along the curve; this occurs rarely, and only when the non-price determinants have a stronger effect than  price. 

4. The determinants of demand or supply will have an indirect effect on each other.  Therefore, a non-price determinant of demand or supply will shift the demand or supply curve first (direct effect), and then will shift the other curve (indirect effect). 

5. Are there any substitutes or complements of the commodity 
          under consideration, and what are the effects? 

6. Determine the equilibrium (i.e., QD = QS). 
 a. After determination of equilibrium, if supply curve or demand curve shifts, a new equilibrium will be established. 
 b. If moves along the supply and/or demand curves (changes in quantity supplied and/or demanded) are made and neither curve shifts, there will be surpluses and shortages in the market. 

7. Is the government intervening in the market through a price control?  If so, determine if it is a price ceiling or a price floor, and determine how it will affect the market. 
 

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I. Demand 

A. The law of demand. 
1. More of a good will be demanded the lower its price, other things constant. Thus, there is an inverse relationship between price and quantity demanded. 
2. Less of a good will be demanded the higher its price, other things constant. Again, there is an inverse relationship between price and quantity demanded. 

B. The demand curve is the graphic representation of the law of demand. 
1. The demand curve slopes downward and to the right. 
2. The slope tells us that quantity demanded varies indirectly in the opposite direction with price. 

C. Important qualifications of the law of demand. 
1. The law of demand refers to a good's relative price. The relative price of a good is the price of that good compared to the price of another good or combination of goods. Example: a cafe latte costs $2, while a New York Yankees baseball cap costs $10. Thus, the relative price of the caps relative to the price of cafe lathes is $10/2 = 5. 
2. The actual price paid for the goods is called the money price. 
a. The price of $10 for the cap is relative to the composite price of all other goods. 
b. The opportunity cost of buying a cap is what must be sacrificed to buy the cap. 
c. In an inflation, money prices are not a good representation of relative prices. 
d. Opportunity cost and the individuals' ability to substitute . 
(1) If the relative price of a good rises, the opportunity cost of that good will also rise. 
(2) Demanders will substitute a good with a lower opportunity cost for it. 

3. Other things constant. 
a. Other things constant means that all other factors that affect the analysis are assumed to remain constant, whether they actually remain constant or not. 
b. Since analysts must reasonably assume that all other things remain constant, Alfred Marshall called this partial equilibrium analysis. 

D. Shifts in demand versus movements along a demand curve .
1. Demand refers to a schedule of quantities of a good that will be bought per unit of time at various prices, other things constant. Graphically, it refers to the entire demand curve. 
2. Quantity demanded refers to a specific amount that will be demand per unit of time at a specific price. Graphically, it refers to a specific point on the demand curve. 
3. A movement along a demand curve is the graphical representation of the effect of a change in price on the quantity demanded. 
4. A shift in demand is the graphical representation of the effect of anything other than price on demand. 

E. Shift factors of demand are those that cause shifts in the demand curve to the right or left. These include (but are not limited) to the following: 
1. Society's income. 
2. The prices of other goods. 
3. Tastes. 
4. Expectations. 

F. The demand table assumes all the following: 
1. As price rises, quantity demanded declines. 
2. Quantity demanded has a specific time dimension to it. 
3. All the products involved are identical in shape, size, quality, etc. 
4. The price the table refers to is a relative price even though it is expressed as a money price. 
5. The schedule assumes that everything else is held constant. 

G. From a demand table to a demand curve. 
1. To derive a demand curve from a demand table, you plot each point on the demand table on a graph and connect the points. 
2. The curve represents the maximum price that you will for various quantities of a good - you will happily pay less. 

H. Individual and market demand goods. 
1. A market demand curve is the horizontal sum of all individual demand curves. 
2. This is determined by adding the individual demand curves of all the demanders. 
3. In the real world sellers do not add up individual demand curves but estimate total market demand for their product which becomes smooth and downward sloping. This is based on two phenomena: 
a. At lower prices, existing demanders buy more. 
b. At lower prices, new demanders enter the market. 

II. Supply 

A. Individuals control the factors of production - resources or inputs, necessary to produce goods or services. 

B. Individuals supply factors of production to intermediaries or firms - organizations of individuals that transform the factors of production into usable goods or services. 

C. The law of supply. 

1. More of a good will be supplied the higher its price, other things constant. Thus, there is a direct relationship between price and quantity supplied. 
2. More of a good will be supplied the higher its price, other things constant. Again, there is a direct relationship between price and quantity supplied. 
3. The law of supply is accounted for by two factors: 
a. In the face of rising prices, firms arrange their activities in order to supply more of that good to the market, substituting production of that good for the production of other goods. 

D. The supply curve is the graphic representation of the law of supply. 
1. The supply curve slopes upward to the right. 
2. The slope tells us that the quantity supplied varies directly - in the same direction - with the price. 

E. Important qualifications to the law of supply . 
1. Relative price. Suppliers will substitute toward goods for which they receive higher relative prices. 
2. The law of supply is based on opportunity cost and the individual firm's ability to substitute. 

F. Other things constant. 

G. Shifts in supply versus movements along a supply curve. 
1. Supply refers to a schedule of quantities a seller is willing to sell per unit of time at various prices, other things constant. 
2. If the amount supplied is affected by anything other than a change in price, that is by a shift factor of supply, there will be a shift in supply - the graphic representation of the effect of a change in a factor other than price on supply. 
3. Quantity supplied refers to a specific amount that will be supplied at a specific price. 
4. Changes in price causes changes in quantity supplied; such changes are represented by a movement along a supply curve- the graphic representation of the effect of a change in price on the quantity supplied. 

H. Shift factors of supply are those factors that cause shifts in the entire supply curve to the left or right. 
1. Changes in the prices of inputs used in the production of a good. 
2. Changes in technology. 
3. Changes in suppliers' expectations. 
4. Changes in taxes and subsidies. 

I. The supply table. 

J. From a supply table to a supply curve. 
1. In order to derive a supply curve from a supply table, you plot each point in the supply table on a graph and connect the points. 
2. The supply curve represents the set of minimum prices an individual seller will accept for various quantities of a good. 
3. Competing suppliers' entry into the market places a limit on the price any supplier can charge. 

K. Individual and market supply curves. 
1. The market supply curve is derived by adding the individual supply curves of each supplier. 
2. The law of supply is based on two phenomena: 
a. At higher prices, existing suppliers supply more. 
b. At higher prices, new suppliers enter the market. 

III. The Marriage of Supply and Demand 

A. The dynamic laws of supply and demand. 
1. If quantity demanded is greater than quantity supplied (excess demand), prices tend to rise; if quantity supplied is greater than quantity demanded (excess supply), prices tend to fall. 
2. The larger the difference between quantity demanded and quantity supplied, the greater the pressure for prices to rise (if there is excess demand) or fall (if there is excess supply. 
3. When quantity demanded equals quantity supplied, prices have no tendency to change. 

B. The graphical marriage of supply and demand. 

IV. Equilibrium 

A. Equilibrium is a concept in which opposing dynamic forces pushing cancel each other out. 

B. In supply and demand analysis, equilibrium means that the upward pressure on price is exactly offset by the downward pressure on price. 

C. Equilibrium price is the price toward which the invisible hand drives the market. 

D. Equilibrium isn't: 
1. Inherently good or bad - but simply a state in which dynamic pressures offset each other. 
2. A state of the world - t's a characteristic of of the model used to look at the world. 

E. In the real world, there exist other forces besides pure supply and demand. These include: 
1. Political pressures (the invisible foot). 
a. Farmers use political pressure to receive higher than supply/demand equilibrium prices. 
b. Suppliers conspire to limit market entry by other suppliers.    In housing rental markets, renters often organize politically to get local government to enact rent controls favorable to them. 
2. Social pressures (the invisible handshake). For example, it is socially difficult for outsiders to take the jobs of striking workers. 

V. Changes in Supply and Demand 

A. A shift in demand that moves the demand curve to the right causes upward pressure on price. Eventually, a new equilibrium is reached at a higher price. 

B. A shift in supply that moves the supply curve to the left, causes upward pressure on price. Eventually, a new equilibrium is reached at a higher price. 

NOTE: For those classes with a greater emphasis on mathematical tools, see Appendix A, 'Algebraic Representation of Demand, Supply, and Equilibrium.' 

********************************************************************* 

I. Supply and Demand in Action 

1. Some delegates to OPEC reasoned that they could get more revenue by selling less oil. 
2. It worked. By cutting supply by 25 percent they doubled revenues. 
3. As prices rose: 
a. People switched to fuel efficient cars. 
b. Thermostats were lowered. 
c. A large number of non-OPEC suppliers increased output. 
d. Oil companies were encouraged to discover more oil, which they did. 
4. Long before these market driven forces could come into play, the U.S. government imposed a price ceiling - a government imposed limit on how high a price can be charged - on oil (Exhibit 1d). Price ceilings cause shortages. 
a. When price ceilings are imposed, it places upward pressure on price while government policy places downward pressure on price. 
b. Shortages ensued. There were long lines at the gasoline pumps. 
c. When the price ceilings were eliminated, prices rose substantially, but the shortages were eliminated - the long lines disappeared. 

B. Examples of shifts in supply and demand. 
1. The British 'mad cow disease,' and the market there and in the EU for beef 
a. This involved a threat to consumer health, shifting the demand curve to the left. 
b. Since the British government mandated that older beef could not be sold, the supply curve shifted to the left to an equilibrium point lower than the original equilibrium price. 

2. The UN trade sanctions on oil from Iraq and the price of oil on the world market. 
a. Initially, the supply curve for world oil shifted to the left. 
b. As production resumed after the Gulf War, the supply curved moved to the right but not back to its original price. 
3. The push for technology development in being able to deal with traditional Chinese characters in designing computers for the Chinese market. 
a. Increased income, being a shift factor of demand, originally moved the demand curve to the right causing prices to rise. 
b. As prices rose, suppliers addressed the task of improving the technology, moving the supply curve to the right. 
4. American baby boomers' push to create their own retirement plans and the exploding stock market. 
a. Demographic changes among baby boomers moved the demand curve for financial assets to move to the right. 
b. The same phenomenon occurred in the surging demand for housing among this group during the 1980s. 
5. The imposition of a 10 percent surtax on the market for luxury boats. 
a. Taxes levied on suppliers shift the supply curve to the left. 
6. The development of new programming languages for use on the Internet and the market for high end PCs. 
a. Technological advances move the supply curve for high end PCs to the right. 
b. As demand for dumb boxes increases, the demand for high end PCs shifts to the left. 
7. As these examples show, supply and demand can shed light on a variety of real world events 
C. Exchange rate determination. 
1. Exchange rates are the rates at which one currency exchanges for another. 
a. The price at which currencies will exchange is determined by the supply and demand for each. The example used is U.S. dollars and Mexican pesos. 
b. Due to political upheavals in Mexico in early 1995, the peso experienced a depreciation, a decrease in the value of that currency. 
c. The fall in the value of the peso caused the U.S. dollar to experience an appreciation, an increase in value. The consequence was: 
(1)  To make U.S. goods more expensive for Mexicans to buy. 
(2) To throw Mexico's economy into a recession. 
2. A government may pass a law determining what the exchange will be regardless of supply and demand. 
a. When governments do this they make their currencies nonconvertible - that is, it becomes a currency that cannot be freely exchanged except at the government set rate. 
b. The effect is that this become a price floor - a government imposed limit on how low a price may be charged. 
c. Non convertible currency laws are very difficult to police, therefore, black markets in currency quickly ensue. 
3. Fixed exchange rates. 
a. Most Western economies have fixed exchange rates - rates set by government at which a currency can be freely exchanged among individuals. 
(1) The government works with market forces not against them as in the non convertible currency situation. 
(2) The government makes a commitment, after setting the exchange rate, to buy and sell sufficient currency desired so that the quantity supplied always equals the quantity demanded at the exchange rate. 
(a) If the quantity supplied is less than the quantity demanded, the government must sell (supply) its currency. 
(b) If the quantity supplied is more than the quantity demanded, the government must buy (demand) its currency. 

D. Rent controls. 
1. Rent control is a price ceiling on rents, set by government. The example used is rent control in Paris following World War I and again following World War II. The consequences were: 
a. A huge shortage of living quarters. 
b. New housing construction stopped. 
c. Existing housing was allowed to deteriorate. 
d. For many, the only way to get living quarters was to offer a huge bribe to the landlord. 
e. Many families had to double up with other family members. 
2. A similar situation is described that has occurred in New York City. 
a. All of the above (called non price rationing) have occurred. 
b. In addition, preferences based upon gender, race, and other characteristics of tenants, although illegal, are brought into play. 

E. The effects of taxes, tariffs, and quotas. 
1. An excise tax is a tax that is levied on a specific good. 
2. A tariff is an excise tax on an imported good. Taxes and tariffs raise prices and reduce quantity ). 
3. A quota is a quantitative restriction on the amount that one nation can export to another. 
4. The effect of an excise tax on price and quantity. 
a. The example used was a 10 percent luxury tax on expensive boats imposed in 1990. 
b. Since the luxury tax was imposed on the boat builders, the supply curve moved to the left by the amount of the tax. 
c. Since at a price equal to the original price plus the tax there is excess supply, the price for boats rose by less than the tax, while quantity supplied and demanded fell. 
d. The tax was repealed in 1993 because of tax revenue shortfalls. 
5. Quantity restrictions: quotas. 
a. The example used was the effort of the U.S. to restrict U.S. imports of Japanese cars. 
b. The effect is that it raises the prices Japanese automobiles in the U.S. See Exhibit 9a. 
6. The relationship of a quota and a tariff. See Exhibit 9. 
a. Tariffs and quotas can both be used to reduce quantity and raise prices. 
b. There is a difference between imposing a tariff and imposing a quota. 
c. In the case of a quota, the profits from a higher price goes to the manufacturer. 
d. In the case of the tariff, the tax goes to the government. See Exhibit 9b. 
e. As a consequence, once quotas are instituted, Japanese firms compete intensely to get them. See 

II. The Limitations of Supply and Demand Analysis 

A. It is not enough to be able to explain what happens when supply or demand curves shift. It is necessary to understand the assumptions underlying the analysis. 
1. One of the most important of these assumptions is the other things constant assumption. 
a. Supply/demand analysis is called partial equilibrium analysis - analysis that is incomplete because it holds other things constant. 
b. Supply/demand analysis is the first step to analysis, not the complete analysis. 
c. Material effects - effects that can affect the results in a substantive way may be present. 
d. Deciding on the materiality of effects requires a knowledge of the structure of the economy since all actions have ripple or feedback effects. 
e. Partial equilibrium analysis is most appropriate for questions where the relative prices refer to the prices of goods that are a small percentage of the entire economy. 
f. When one analyzes goods that are a large percentage of the entire economy, the other-things-constant assumption is likely not to hold true. 

2. The fallacy of composition. 
a. The fallacy of composition is the false assumption that what is true for a part will also be true for the whole. 
b. Thousands of small effects taken together add up to a large effect. 
c. When analyzing the aggregate, small effects that can be put aside in micro, can add up, and hence cannot be forgotten. 
d. Small effects comprise microeconomics while large effects comprise macroeconomics. 
3. Examples: chickens, eggs, and composite goods. 
a. A chicken and egg example 
(1) Assuming a technological change greatly increases the ability of hens to lay more eggs. 
(2) The supply curve for eggs moves to the right. 
(3) Prices drop while the quantity demanded increases. 
b. A composite good example. 
(1) Assuming a technological change greatly effect the production of all goods in the economy. 
(2) The supply curve for all goods moves to the right. 
(3) Will prices drop while the quantity demanded increase as in the egg example? Not necessarily. 
(4) Since the technological advance affect production costs, it also affects people's income. 
(5) As people's income goes up, demand will also go up, moving the demand curve to the right. See  (6) When there is an interdependence between supply and demand, as in this case, a movement along one curve can cause a shift of the other curve. Thus, supply and demand used alone, is not enough to determine where the equilibrium will be. 

4. Why a separate macroeconomics exists. 
a. The lines between macro and micro are not hard and fixed. 
b. Topics to the right are pure macro, while topics to the left are pure micro. Those in the middle are ambiguous. 
c. In macroeconomics aggregate supply and aggregate demand are interdependent. When the output side increases, so does the income side. 
d. It is to account for interdependency between supply and demand that we have a separate micro analysis and a separate macro analysis. 
 Inferences with Supply and Demand.' 
The McGraw-Hill Companies, Inc. 

         Lecture Notes Chapter 3 A 

I. The U.S. Economy 
A. The power of the U.S. economy. 
1. Ultimately the U.S. economy's strength is its people and its other resources. 
2. But the U.S. economy is far from perfect. 
a. Crime is rampant. 
b. Drugs are omnipresent. 
c. Economic resources such as oil and minerals are declining. 
d. The environment is deteriorating. 
e. The distribution of income is skewed toward the rich. 
f. Great effort goes into economic gamesmanship. 
g. The U.S. is the largest debtor nation in the world. 
B. The U.S. economy. The U.S. economy is divided into three groups: business, households, and government. 
1. Households supply factors of production to business and are paid by business for doing so. The place where this takes place is called the factor market. 
2. Business produces goods and services and sells them to households and government. The place where this takes place is called the goods market. 
3. Government engages in the following activities. 
a. It buys goods and services from business and buys labor services from households. 
b. With tax revenues, it provides services to both business and households. 
c. It gives some of its tax revenues directly back to individuals (income redistribution). 
d. It taxes, barrows and prints money. 
4. It overseas the interaction of business and households in the goods and factor markets. 

II. Business 
A. Introduction. 
1. Business is responsible for over 80 percent of U.S. production. 
2. Business is the name given to private producing units in our society. 
3. Businesses decide what to produce, how much to produce, and for whom to produce it. 
B. Entrepreneurship and business. 
1. Businesses are people organized together to accomplish some end. 
2. Entrepreneurship is the ability to organize and get something done; it is an important part of business. 
C. Consumer sovereignty and business. 
1. Although businesses decide what to produce, they are guided by consumer sovereignty. 
2. Consumer sovereignty means that consumers' wishes rule what is produced by businesses. 
3. Before deciding to start a business, the key question to ask is : can I make a profit? - Profit is what's left over from total revenues after all the appropriate costs have been subtracted. 
4. The U.S. economic system, by channeling individual's desires to make a profit for the general good of society, is allowing the invisible hand to work. 
D. Categories of business: importance and size ranked by sales and employment. 
E. Forms of business. 
1. The three primary forms of businesses are sole proprietorships, partnerships, and corporations. 
2. Of the 18 million businesses in the U.S., 69 percent are sole proprietorships, 8 percent partnerships, and 23 percent corporations. 
3. In terms of sales, however, 90 percent are made by corporations, 5 percent by sole proprietorships, and 5 percent by partnerships. 
a. Sole proprietorships are businesses that have only one owner 
(1) They are the easiest to start. 
(2) They have the fewest bureaucratic hassles. 
(3) The owner has unlimited liability. 
b. Partnerships are businesses with two or more owners. 
(1) They create possibilities for sharing the burden. 
(2) Partners have unlimited liability. 
c. Corporations are businesses that are treated as a person, and are legally owned by their stockholders who are not liable for the actions of the corporate 'person.' 
(1) When a corporation is formed, it issues stock certificates of ownership in a corporation. 
(a) Proceeds of the sales of stock makes up the equity capital of the corporation. 
(b) Ownership of stock entitles you to vote on corporate matters. 
(2) A corporation provides owners with limited liability - the stockholder's liability is limited to the amount that stockholder has invested in the corporation. 
(3) A corporation's stock can be bought or sold: 
(a) In an independent transaction between two people. 
(b) In an over the counter trade. 
(c) Through a broker and a stock exchange. See Added Dimension, 'Trading in Stocks.' 
(4) In corporations, ownership is separated from control of the firm. 
(5) In many cases, owners' control of management is limited, especially in the case of mutual funds (financial institutions that invest individuals' money for them), and pension funds (financial institutions that hold that hold people's money for them until it is paid out to them upon their retirement). 
(6) According to economic theory, managers do not have the same incentive to maximize that owners do. 
4. The advantages and disadvantages of each form of business are important to differentiate them. 

III. Households 
A. Households are a single person or groups of related or unrelated persons living together and making decisions. 
1. They ultimately control the other two economic institutions, government and business. 
2. Although, in principle, ultimate power resides with the people and households (consumer sovereignty), in practice the representatives of the people, firms and government are sometimes removed from the people and, in the short run, are only individually monitored by the people . 
3. In many spheres of the economy households are not active producers of output but merely passive recipients of income. 
B. Household types and income. 
C. Households as suppliers of labor. 
1. The largest source of household income is wages and salaries. Households supply the labor with which businesses produce and government governs. 
2. Many jobs are service jobs. 
3. The jobs trend toward more service related jobs away from manufacturing is continuing. The fastest gains are in services while the fastest declining are in manufacturing and agriculture. 
4. One of the greatest changes in labor markets has been the decline in unionization. 
a. Union power pushed wages up relative to wages in other nations. 
b. This wage increase also caused manufacturers to move production facilities to nations with lower wages. 
c. Service workers have fewer unions, and their jobs are more difficult to move to other countries. 

IV. Government 
A Two general roles of government are as an actor (collecting money in taxes and spending that money on its own projects, such as defense and education) and as a referee (setting the rules that determine relations between businesses and households. 
B. Government as an actor. 
1. All levels of government consume about 20 percent of the nation's total output and employ about 19 million persons. 
2. State and local government. 
a. State and local government employ 16 million workers and spend about $1 trillion per year. 
b. They spend their tax revenues on administration, education, and roads. See Exhibit 7b. 
3. Federal government. 
a. Income taxes make up 42 percent of the federal government's revenue, while payroll taxes make up about 40 percent. 
b. The two largest categories of spending are income maintenance and defense. See Exhibit 8b. 
B. Government as a referee. 
1. Government controls the interaction of households and business. 
a. Government sets the rules of interaction and acts as a referee, changing the rules when it sees fit. 
b. Government decides whether the invisible hand will be allowed to operate freely. 
(1) Businesses are not free to hire and fire whomever they want. 
(2) Many working conditions are subject to government regulation. 
(3) Businesses cannot collude. 
(4) Unions cannot require workers to join a union prior to being hired. 
2. Economic roles of government. 
a. Providing a stable institutional framework. 
(1) Only the government can create a stable environment and enforce contracts through its legal system. 
(2) Stability of rules is a benefit to society. 
(3) Sometimes government changes unfair rules which are perceived by some as being even more unfair. Then government must try to strike a balance between two degree of unfairness. 
b. Promoting effective and workable competition. 
(1) Most Americans disdain monopoly power - the ability of individuals or firms currently in business to prevent other individuals or firms from entering the same kind of business. 
(2) Monopoly can raise existing firms' prices. 
(3) Most Americans favor competition - individuals' or firms' ability to enter freely into business activities. 
(4) Government's job is to promote competition and prevent monopoly power from limiting competition. 
(5) The problem is that most individuals and firms believe that competition is far better for the other guy than it is for themselves. 
c. Correcting for externalities. 
(1) Unless they are required to do so, parties to any exchange are unlikely to take into account any externality - the effect that an action may have on a third party that the person who undertook that action did not take into account. 
(2) The externality may be positive in which case society benefits even more than the two parties. An example is education. 
(3) The externality may be negative in which case society as a whole benefits less than the two parties. An example is pollution. 
(4) When negative externalities exist government has the potential role to change the rules so that the parties must take into account the effect of their actions on society as a whole. 
d. Providing for public goods. 
(1) Public goods are those whose consumption by one individual does not prevent their consumption by other individuals. An example is a public park. 
(2) A private good is one that, when consumed by one individual, cannot be consumed by other individuals. An example is an apple. 
(3) A free rider is a person who participates in something without having to pay for it. 
(4) Since most everyone would enjoy having public parks without have to pay for them, government requires that the public be taxed to pay for public parks, thereby eliminating free riders. 
e. Ensuring economic stability and growth. 
(1) In addition to providing general stability, government has the potential role of providing economic stability as well (promoting economic growth, maintaining a steady price level, dealing with unemployment). These involve macroeconomic externalities. 
(2) These goals are macroeconomic goals. 
(3) They are justified as appropriate goals for government because they involve macroeconomic externalities - those that affect the level of unemployment, inflation, or growth in the economy as a whole. 
2. Political roles of government. 
a. Providing for a fair distribution of society's income. 
(1) This is the first, and probably the most controversial role government plays. 
(2) In providing for income redistribution, government can use: 
(a) A progressive tax - a tax whose rate rises as a person's income increases. An example is federal personal income taxes. 
(b) A regressive tax - a tax whose rate decreases as a person's income increases. An example is a local sales tax. 
(c) A proportional tax - a tax whose rates are constant at all income levels, no matter what the income is. An example is the federal Medicare tax. 
(3) Should there be exemptions to any of these taxes? 
(4) Should tax loopholes be eliminated? Tax loopholes are legal but unfair exemptions. 
b. Determining demerit and merit goods or activities. 
(1) Should government prohibit demerit goods and activities? Demerit goods and activities are things government believes are bad for you, although you may like them. Addictive drugs are a demerit good; using addictive drugs is a demerit activity. 
(2) Merit goods and activities are things the government believes are good for you, although you may not like them. Motorcycle helmets are a merit good; using helmets while driving a motorcycle is a merit activity. 
(3) The reasons for government intervention are often summed up under the words market failure - situations where the market does not lead to a desired result. 
(4) There is also government failure - situations where the government intervenes and makes things worse. 
C. The limits of government action. 
1. Political pressures often force government to act, regardless of what rational examination suggests. 
2. Economists on all sides of the political spectrum speak in the voice of reason: 'Look at all the costs; at all the benefits. Then decide whether government should or should not intervene. 

nbsp; The McGraw-Hill Companies, Inc. 
 

    Lecture Notes Chapter 3 B 

I. Introduction 
A. International issues must now be taken into account in just about any economic decision a country or a firm faces. 
B. Global corporations - those with substantial operations on both the production and sales sides in more than one country are becoming increasingly important. 
C. The economic focus has shifted to the world economy in finance as well as manufacturing. 

II. International Economic Statistics: 
A. Classifications of international economies. 
1. Industrial economies such as the U.S., Germany, and Britain, have a large industrial base and a per capita income of about $20,000 a year. 
2. Countries such as Kuwait and Saudi Arabia have high per capita incomes, but do not have an industrial base. They are known as high income oil exporters. 
3. The developing countries of the world include low- and medium income economies that have a per capita income of between $300 and $2,000 per year. 
4. Transitional economies consist of formerly socialist economies. An example is the Czech Republic. 
5. The last category is Soviet style socialist economies. Only Cuba and North Korea fit this model. 

B. Alternative methods of classification. 
1. By region, Latin America, Africa, Middle East, Asia, Western Europe, North America, and Eastern Europe. 
2. None of the above classifications are airtight. 

C. Economic geography. 
1. It is not enough to know of a nation's productive capacities but a knowledge of economic geography as well. 
2. Some major producing areas for some important raw materials are: 
a. Aluminum: Guinea, Australia. 
b. Cobalt: Zaire, Zambia, Russia. 
c. Copper: Chile, U.S., Poland. 
d. Iron: Russia, Brazil, Australia. 
e. Zinc: Canada, Australia, Russia. 

3. Differing economic problems. 
a. In the U.S., a significant problem is its trade deficit imports (buying goods produced in a foreign country) exceed exports (selling U.S. goods in foreign markets). 
b. In Japan, the opposite is true. 
c. Some groups of nations have formed free trade associations - groups of countries that have reduced or eliminated trade barriers among themselves. 

(1) The European Union (EU) is one such association. 
(2) The North American Free Trade Association (NAFTA) is another. 

4. Comparative advantage and trade. 
a. A nation has a comparative advantage in producing a good if it can produce that good at a lower opportunity cost than any other country can. 
b. Developing countries generally have lower labor costs. 
(1) This does not necessarily mean that production will flow to that country. 
(2) Labor costs are just one element in the total costs structure of a company. 
c. If trade were to flow to a nation because of its lower opportunity costs, soon its exchange rate - the rate at which one country's currency exchanges for another country's currency would rise, thereby changing the comparative cost structure. 

III. How International Trade Differs From Domestic Trade
A. International trade differs from domestic trade in two ways. 
1. International trade involves potential barriers to trade. 
a. Quotas are limitations on how much of a good can be shipped into a country. 
b. Tariffs are taxes on imports. 
c. Non tariff barriers are indirect regulatory restrictions on imports and exports. 
2. International trade involves multiple currencies that are bought and sold in foreign exchange markets. 
B. By looking at an exchange rate table, you can determine how much various goods will likely cost in different countries. 

IV. The U.S. International Trade Deficit 
A. The balance of trade is the difference between the value of goods and services a nation imports and the value of the goods and services it exports. 
1. A trade deficit occurs when imports exceed exports. 
2. A trade surplus occurs when exports exceed imports. 
B. Since the mid-1970's, the U.S. has been running a trade deficit. See Exhibit 4. 
C. Debtor and creditor nations. 
1. Countries have the option of financing their international debts by living off foreign aid, past savings, or loans. 
2. Following World War II, the U.S. was a creditor nation. 
3. In the 1980s, the U.S. became the largest debtor nation - it has borrowed more from abroad than it has lend abroad. 
D. Balance of payments accounts. 
1. Balance of payments accounts are those that record all transactions between the residents of a country and residents of all foreign nations. See Exhibit 5. 
a. A balance of payments account is comprised of: 
(1) A current account. 
(a) It is made up of foreign demand for domestic goods and services (exports). 
(b) It is made up of domestic demand for other nations' goods and services (imports). 
(2) A capital account. 

(a) It is made up of foreign demand for domestic assets (inflows) and domestic demand for foreign assets (outflows) 
(b) An official transactions account measures the net amount of its currency that a country buys and sells. 
b. The current and capital accounts represent the private demand and supply for the country's domestic currency. 
c. When the balance of payments is in equilibrium, the quantity of a currency supplied equals the quantity of currency demanded. 
E. Determinants of the trade deficit. 
1. Two important causes of a trade deficit are: 
a. U.S. competitiveness. 
(1) Probably the most important factor in determining whether a nation runs a trade deficit or surplus is its competitiveness - the ability to produce goods more cheaply than other nations. 
(2) Competitiveness depends on productivity. 
(3) Another determinant of a nation's competitiveness is the value of its currency. 
(a) A currency that is low in value relative to other currencies encourages the country's exports by lowering domestic prices to foreigners. 
(b) It also discourages its imports by raising foreign prices for residents. 
b. The state of the U.S. economy. 
(1) The level of U.S. income affects the trade balance. As U.S. income rises, the U.S. imports more, the trade deficit increases. 
(2) There is a second effect - the trade balance's effect on U.S. income. 
(a) For a nation running a trade deficit, as that nation imports more, the trade deficit worsens, its production falls, thereby lowering its citizens' income. 
(b) It works in the opposite way too. For a nation running a trade surplus, as that nation exports more, the trade surplus expands, production increases, thereby raising its citizens' income. 
(c) This last effect is called export led growth. 

2. Economists' view of trade restrictions. 
a. Large trade deficits inspire politicians to call for trade restrictions. 
b. Most economists, both liberal and conservative, oppose such measures because of their negative effects. 
(1) Trade restrictions reduce domestic competition. 
(a) Domestic prices rise. 
(b) The quality of the goods producers sell falls. 
(2) Trade restrictions invite retaliation that sometimes end in trade wars. 
c. In order to prevent trade wars, nations have entered into a variety of international agreements and organizations. 

(1) World Trade Organization (WTO) is committed to getting nations to agree not to impost new tariffs or other trade restrictions except under certain limited conditions. 

(2) The WTO is the successor to the General Agreement on Tariffs and Trade (GATT) - an agreement among many subscribing nations on certain conditions of international trade. 

V. International Economic Policy and Institutions 
A. There is no international counterpart to the U.S. federal government. 
1. Any meeting of a group of nations to discuss trade policy is voluntary. 
2. No international body has powers of compulsion. 
B. Governmental international institutions. 
1. The United Nations. 
2. The World Trade Organization (see above). 
3. The World Bank - a multinational, international financial institution that works with developing countries to secure low interest loans. 
4. The International Monetary Fund (IMF) -a multinational, international financial institution concerned primarily with monetary issues. 
5. The European Union (EU). 

C. Informal organizations.
1. The Group of Five meets to promote negotiations and coordinate economic relations among nations. The Five are Japan, Germany, Britain, France, and the U.S. 
2. The Group of Seven does the same work as the Group of Five. It includes the Group of Five plus Canada and Italy. 

D. Since governmental membership in international organizations is voluntary, their power is limited. 

E. Global corporations. 
1. Global corporations offer great benefits for nations. 
a. They create jobs 
b. They bring new ideas and new technologies to a country. 
c. They provide competition for domestic companies, keeping them on their toes. 
2. Global corporations pose a number of problems for governments. 
a. Since a global corporation exists in a number of nations, no single government regulates or controls it. 
b. Nations often compete for these global corporations by changing their regulations to encourage companies to use them as their home base. 
c. At times, it seems that global corporations are governments unto themselves - they can dominate the economy of a small nation. 
d. Global corporations can distance themselves from questionable economic activities by setting up dummy corporations - one that exists only on paper. 

VI. The Importance of Knowing About Other Countries