Key Concepts:  Weeks 8-16

Supply and Demand

What is supply and demand?

a.       Tool Used by Traditional Economists to understand how prices work

b.      Market Clearing – Price at which quantity supplied exactly matches quantity demanded

c.       “Demand” refers to the quantity of an item purchased at a given price, or how the quantity changes of the price changes.  Supply is a similar conception

II.                 Drawing the curves

a.       Drawing a curve – Quantity on “x” axis, price on “y” axis – this is opposite of how you might draw this in mathematics classes!

b.      As price goes up, quantity demanded goes down – all other things being equal

c.       Curve does not cross each axis – demand can not be negative, zero prices are not measurable…

III.               Putting the curves together

a.       When the supply and demand curves are on the same graph, we can see that they intersect

b.      Where they intersect is where quantity demanded equals quantity supplied

c.       Look at points above and below curve

Example:

Problems with Supply and Demand

I.                    High-level issues with Market Mechanism: 

a.       Only recognizes one value – wealth.  Individuals with no wealth or ability to work can not earn income.  Without intervention, people would be starving.  Think of this compared to Feudalism, when labor did not work for a wage

b.      To ensure people are not starving, or to ensure resources are available during war, the government usually steps in with social programs

c.       Taxes and transfer payments are mentioned in the book as ways that the government interferes with the market mechanism

II.                 Issues with the Market Mechanism as a model:

a.       Even if we do agree that markets tend to clear, there is no consensus on how long it takes to clear

b.      Perfect rationality is not a valid assumption

                                                   i.      We do not have the time or resources to research everything we buy

                                                 ii.      Ignorance always remains part of the market mechanism

                                                iii.      Advertising also clouds our ability to accurately compare products and prices

c.       Perverse Expectations

                                                   i.      When prices go up, people buy more because they think prices will continue to go up

                                                 ii.      Suppliers withhold supply because they are waiting for the price to rise enough

                                                iii.      Result is very high prices, hyperinflation

                                               iv.      Example: Dutch tulip bulb market, beanie babies

d.      Pure Public Goods – goods that are not bought and sold in the private market

                                                   i.      Examples:  National Defense, Weather Service, Lighthouse, also Public Roads, Education (maybe)

                                                 ii.      Consumption of public good by any one individual does not interfere with it’s consumption by another

                                                iii.      No one can be excluded

                                               iv.      There is no way that these goods can be purchased individually – we must purchase them together

III.               Problems with the market mechanism in reality

a.       Externalities – effects of the output of private goods and services on persons other than those who are directly buying or selling the goods in question

                                                   i.      We’ve discussed this earlier with regard to GDP

                                                 ii.      Example:  Smoke from a factory

                                                iii.      Not all externalities are bad, but usually we think of them in a negative way – example of office building raising property values – think of the Condos in the Arts district

                                               iv.      How do we deal with externalities?  Regulation is used to internalize the externalities.  Three options:

1.      Force producers to reduce pollution

2.      Tax pollution

3.      Effluent charge – allows firms to pollute for a price

4.      Subsidize reduced pollution

b.      Long Time Horizons are not profitable

                                                   i.      Private firms are unable to undertake some very large projects – book talks about biotechnology and the internet

                                                 ii.      What happens when private firms undertake this – Pfizer and the price of drugs in the US today

c.       We need Public Goods

                                                   i.      There are also some things that we are unwilling to have regulated by the market – for example, health care or education

Alternatives to the traditional supply/demand pure-competition model

I.                    Oligopoly and Monopoly:

a.       Monopoly:  Market in which there exists only one seller

b.      Oligopoly:  A few firms control the output for a single industry

c.       Under competition, there is consumer sovereignty:  consumer ultimately controls what is created in the economy

d.      Under monopoly and oligopoly, the consumer loses this control.

e.       Firms have strategies to encourage consumers to purchase their products

II.                 What happens when firms grow larger

a.       Prices – may go up or down

                                                   i.      May go up because of increased cost of producing products

                                                 ii.      May go up because of increased market power

                                                iii.      May go down because of economies of scale

b.      Advertising Increases – may be good or bad!

                                                   i.      Good – we are informed of new goods

                                                 ii.      Bad – it’s unbelievable

c.       More money for R&D, technology can actually increase faster than perfect competition

III.               Concentration ratio:  determines how concentrated an industry is

a.       Percentage of total sales or production accounted for by the 4 largest firms in an industry

Monopoly

I.                    How it happens

a.       Patents

b.      Government Action

c.       Declining costs of production

d.      Control of input

I.                    Why Monopoly may be bad

a.       Since there is no competition, monopolists are less likely to control costs and using resources efficiently

b.      Monopolists are slow to innovate and adopt new techniques and products

c.       Monopoly redistributes income in favor of the monopolist

II.                 Why Monopoly may be good

a.       Ensures socially necessary products can be made and available for a large group

b.      Easier for government oversight – regulation is less expensive

c.       Sometimes less efficiency is good – more people have jobs

Monopolistic Competition

I.                    Key feature is product differentiation

a.       Contrast to perfect competition, where firms sell identical output

b.      Monopolistic competition may look like regular pure competition if there are many firms within a product group – group of similar products

c.       Firms offer a wider variety of styles, brands, and qualities

d.      Spend more on advertising

Oligopoly –Domination by a few firms

a.       Key concept – interdependence, actual and perceived, among firms

b.      How does it happen?

                                                   i.      Economies of scale of production

                                                 ii.      Economies of scale of promotion

                                                iii.      Barriers to entry

c.       Non-price competition is important

II.                 Forms of Oligopoly – collusion and cartels

a.       Collusion:  when firms get together and agree on price and output:  illegal

b.      Cartel:  An open, formal collusive arrangement among firms:  legal

c.       Price leadership:  a few firms set the price for the rest to follow

III.               Barriers to collusion – or, why Oligopolies may not form

a.       Legal problems

b.      Technical problems:  doesn’t work with a lot of heterogeneous firms

c.       Cheating

d.      **Most cartels/collusions fall apart on their own

Concentration and mergers

a.       Mergers are one way for firms to grow and stay in business, but they also cause concentration – oligopolies or monopolies

b.      Three types of mergers:  horizontal, vertical, and conglomerate

                                               iv.      Vertical:  buy out buyers or sellers.  For example, the merger of Time Warner (HBO, cable )and Turner (CNN, TBS).  Time Warner could have refused to sell Turner programming to competitors.  Merger was allowed, with stipulations

                                                 v.      Horizontal:  Buy out competitors.  For example, Daimler-Benz and Chrysler

                                               vi.      Conglomerate:  Buy out potential competitors – firms in a nearby industry, firms planning on entering the market.  Monopolies often do not raise prices if they believe that there is a threat of entry by nearby industries, and after merging with these firms they can raise prices. 

1.      Conglomerates are also a way to diversify risk

2.      Popular in the ‘80s, now many realize that they are difficult to manage

Inflation

I.                    Inflation – what is it?

a.       Period of rising prices

b.      80’s was an excellent example of rising inflation, 11-12% increases

c.       Today, acceptable level is 3-4%

II.                 Inflation and interest rates

a.       Just like GDP, there is a difference between real and nominal interest rates

b.      Fischer Equation:  Real Interest Rate = Nominal Interest Rate – Inflation

c.       During inflation, nominal interest rates go up, but real interest rates may go up or down

III.               CPI – A measure of inflation

a.       CPI is Consumer Price Index

b.      Similar to GDP deflator, but doesn’t have industrial goods, etc

c.       Allows us to compare prices across years

d.      Each month, Department of Labor sends a team of observers to 50 Urban centers to record the prices of 400 items.

e.       To determine inflation, compare CPI at one period to CPI from another

f.        For example, September CPI is 189.9.  August is 189.5 = .2% change.

IV.              Causes of Inflation

a.       Cost-Push

                                                   i.      Caused by increased cost of supplies/factors of productio

                                                 ii.      Occurred in 70’s during oil crisis

b.      Demand-Pull

                                                   i.      Too little supply, too much demand

                                                 ii.      Short-run phenomenon

                                                iii.      Occurred in 1960’s as a result of Vietnam war purchases

c.       Stagflation – Inflation with no increase in real GDP

                                                   i.      Occurred in 80’s – costs were going up, prices were rising too, production was going down

V.                 The Phillips Curve:  Inflation and Unemployment

a.       Mapped out the relationship of unemployment to the rate of money wage increase in UK from 1861-1957, found in inverse relationship

b.      Unemployment on X axis, Inflation % on Y

c.       2.5% unemployment seemed to be sustainable with 2% inflation

d.      A similar study done in the US from 1964-1992 showed a random pattern

e.       1983 – High unemployment, high inflation (stagflation) 8/14

f.        1967 – Low unemployment, low inflation 3.5/2

Inflation Solutions

I.                    Impacts of Inflation

a.       Redistribution of Income – Inflation decreases the real cost of debt (good for debtors) but also real wealth of creditors

b.      Continuous increase of price is good for expectations of producers

c.       Speculation – in times of hyperinflation, producers may choose to speculate rather than produce – use inventories to make capital gains

d.      Confidence in money is very low – payment system does not work smoothly

II.                 Solutions for Inflation

a.       Raise Interest Rates

                                                   i.      Reason:  People buy less when interest rates are high

                                                 ii.      Problem:  Monthly payments matter to people, not interest rates

                                                iii.      Interest rates only matter if people have a high debt load

                                               iv.      Problem:  Interest rates are a cost to the entire economy…business use short-term loans to finance operations, higher interest rates get passed on to consumers

                                                 v.      Result:  More inflation, not less!!

b.      Increase Unemployment

                                                   i.      Reason:  Wages push up inflation

                                                 ii.      Problem:  Unemployment has bad consequences – lost output and lost income to workers

                                                iii.      Problem:  Unemployment only works if unemployed workers are substitutes for employed workers

1.      Two sectors of employment:  The highly paid primary sector with stable jobs and “career paths”, and the competitive sector offering temporary, low-skilled and lowly paid jobs – the secondary sector

2.      For example:  unemployment in secondary industry (food service, etc) does not impact wages in high-tech sector.  Unemployment in secondary sector does not relieve bottleneck in primary sector, and high levels of employment do not cause rising wages

c.       Buffer Stock – for spot-reducing inflation

                                                   i.      Reason – government buys commodity (like oil or energy) when price is low, and sells when price is high, in an attempt to lesson price changes

                                                 ii.      Problem – no problems if government is willing to do this, but only works for that one commodity

Unemployment

I.                    Definition –  A person in unemployed if he or she does not have a job but is available for work, willing to work, and has made some effort to find work within the previous four weeks

a.       Working age population – total number of people 16 and over who are not in jail, hospital, or some other form of institutional care.  This is divided into two groups – labor force and not labor force

b.      Labor Force – sum of people that are employed and people that are unemployed

c.       Discouraged Worker – Someone no longer seeking work

II.                 Types of Unemployment

a.       Structural -  arises when changes in technology or international competition destroy jobs that use different skills or are located in different regions from the new jobs created.  This can last longer than frictional, and is sometimes a concern

b.      Frictional – arises from normal labor turnover.  People entering and leaving jobs, jobs creation and job destruction.  Permanent and ongoing, but not considered a problem

c.       Cyclical – Fluctuating unemployment that that coincides with the business cycle.  Gets worse in recession, better in expansion.  For example, assembly line worker that is laid off during recession but re-hired when business is back up.

III.               Measures of Unemployment

a.       BLS does phone surveys of around 60,000 households and ask “are you employed” and if not, “have you looked for work in the past four weeks”

b.      Unemployment is calculated by dividing Unemployed by the Labor Force

c.       Unemployment in US:  5.5% in October

IV.              What’s not included in Unemployment Rates

a.       Discouraged workers – people no longer looking for work

b.      Women without adequate or affordable child care

c.       People without adequate transportation

d.      Working in a family business with no pay

e.       Homeless

f.        Phoneless

V.                 Jobless Rate

a.       Jobless rate is an attempt to bring in these other statistics to get a true view of unemployment

b.      The jobless rate is the officially unemployed, involuntary part time workers, and discouraged workers. The discouraged are also added to the denominator. This rate is usually almost 1.5 times higher than the official unemployment rate and can be double.

c.       {[Unemployed+Discrged+Involuntary Part-timers]/[Labor force+Discrged]} X 100

Inequality and Poverty

I.                    Definitions:

a.       Inequality: Tthe unequal distribution of the economic surplus and of wealth.  It can also be extended to mean unequal access to jobs, bank loans, or other related elements.

b.      Poverty:  refers to the proportion of people close to or below the poverty line level.  The latter is calculated as a function of the income necessary to satisfy the basic needs of a person or a family (food, clothes, etc).  Poor people are persons that do not have enough income to survive decently.

II.                 Measurement of Inequality:  The Gini Coefficient

a.       Gini coefficient is a way to measure income inequality. 

b.      “0” means everyone has the same income

c.       “1” is perfect inequality (1 person has all of the income, everyone else has zero)

d.      In the US, inequality (based on Gini Coefficient) has been rising slightly

e.       US has highest inequality of  industrialized nations

III.               Causes of Inequality

a.       Productivity of each individual:  Inequality is normal because it reflects the difference in the productive effectiveness of each individual

b.      Wealth:  Those who are already rich will also have bigger interest incomes and dividends

c.       Power:  capacity to influence policy makers and knowledge of the right persons are very important to determine wealth

d.      ***These factors are not independent!  If you are poor, you can’t get an education and become more productive.

V.                 Getting out of poverty:  or why poverty is persistent

a.       Education is a crucial factor to get a stable and well-paid job.  However, it costs money to get a good education

b.      Social and familial context is very important:  if one knows people it is easier to find a job or to grab good opportunities

c.       Discouragement:  It is very hard to get out of poverty and discouragement can rapidly overcome the willingness of poor people to change their situation.

d.      Poverty is self-perpetuating:  children who grow up without positive role models – educated and successful people – are less likely to be successful themselves.

VI.              Access to Jobs:  Another factor

a.       Spatial mis-match:  Poor in inner cities find it difficult to even get to jobs outside of the inner city:  poor public transportation. 

b.      Spatial mis-match occurs because it is difficult to get to suburban jobs:  most public transportation is meant for getting surburbanites to city center, not other way around.

c.       Commuting time does impact access to jobs:  differences in commute times accounts for ½ of differences in employment. 

d.      Black high school graduates commute roughly 22% longer than comparably skilled white workers.

Globalization

I.                    What is globalization? 

a.       The exchange of goods and services, flows of income and financial transactions between countries are growing.

b.      Countries are becoming increasingly dependant upon one another in the exchange of goods and services

c.       There are several types of super-national organizations that specifically deal with the issues of international trade and cooperation:

                                                   i.      General Governing Bodies – that deal with a wide variety of issues and cooperation between nations

                                                 ii.      Trade agreements and organizations – deal specifically with trade issues

                                                iii.      Private Enterprise – Have adapted to their role in international trade

General Institutions

I.                    UN

a.       Established:  1945

b.      Secretary General:  Kofi Annan from Ghana

c.       Membership:  Founded with 51 countries, now has 191 countries as members.  This is *almost* every country in the world (Vatican, Taiwan not included)

d.      Purpose:  4 purposes set out in charter: 

                                                   i.      Maintain international peace and security

                                                 ii.      Develop friendly relations among nations

                                                iii.      Cooperate in solving international problems and in promoting respect for human rights

                                               iv.      Center for harmonizing the actions of nations

e.       UN is *not* a government and does not make laws!!  Members do work together to resolve international conflicts, and create policies, and all countries have a vote

f.        Two major assemblies in the UN:  The General Assembly and the Security Council

                                                   i.      General Assembly:  All member states are represented.  Each Member State has one vote. 

                                                 ii.      Security Council:  Responsible for maintaining international peace and security.  According to the charter, decisions of the Security Council are binding on members

II.                 IMF – International Monetary Fund

a.       Founded:  1945

b.      Membership: 184 Countries

c.       Purpose:  Promote the health of the world economy.  It is the central institution of the international monetary system – the system of international payments and exchange rates among national currencies that enables business to take place between countries

                                                   i.      It aims to prevent crises by encouraging countries to adopt sound economic policies

                                                 ii.      It is a fund that can be tapped by members needing temporary financing to address balance of payments problems

                                                iii.      IMF is the principal forum for discussing not only national economic policies in a global context, but also issues important to the stability of the international monetary and financial system

                                               iv.      provides the governments and central banks of its member countries with technical assistance and training in its areas of expertise.

III.               World Bank

a.       Not a “bank” as we know it, but an agency of the United Nations

b.      Membership:  184 countries.

c.       Purpose:  Provides low-interest loans, interest-free credit, and grants to developing countries.  Carries out the Millennium Development Goals that were agreed to by the members of the UN in 2000.

                                                   i.      Low-income countries can usually not borrow funds in the international market.  World Bank provides funds for development projects, and for special issues such as dealing with AIDs epidemic.

d.      Funds are raised in two ways: 

                                                   i.      Donations by developed countries

                                                 ii.      Funds raised by selling bonds on the open market

Trade Organizations

What is Free Trade?  Or, why do trade agreements exist?

I.                    There are several barriers to “free trade” that governments can set up.  They are:

a.       Tariffs – Tax imposed on a product when it is imported into a country

b.      Quotas – Specifies maximum amount of imports from a country for a specific year

c.       Dumping - Dumping is the sale of goods in foreign markets at prices below those charged for comparable sales in the home market or that are below the cost of producing the goods.

I.                    WTO

e.       Founded:  1995

f.        Membership:  150 Countries (97% of world trade)

g.       Purpose:  Help trade flow smoothly, freely, fairly, and predictably

h.       Activities:

                                                iii.      Administer trade agreements

                                               iv.      Act as a forum for trade negotiations

                                                 v.      Settle trade disputes

                                               vi.      Assist developing countries in trade policy issues

I.                    NAFTA – North America Free Trade Agreement

a.       Established:   January 1, 1994

b.      NAFTA is a regional trade agreement between the Government of Canada, the Government of the United Mexican States and the Government of the United States of America to implement a free trade area.

c.       Goals:

                                                   i.      eliminate barriers to trade in, and facilitate the cross-border movement of goods and services between the territories of the Parties;

                                                 ii.      promote conditions of fair competition in the free trade area;

                                                iii.      increase substantially investment opportunities in the territories of the Parties;

                                               iv.      provide adequate and effective protection and enforcement of intellectual property rights in each Party's territory

Multinational Firms

I.      Multinationals, or Transnationals, or MNCs, cross country borders and have operations in many different countries.

a.       Today, even most US-owned corporations have a large number of overseas operations

b.      US production facilities in another country is called “foreign direct investment”, or “FDI”.  FDI is often used in Development Economics as a way for underdeveloped countries to develop

c.       Multinationals bring in some of their home country culture, but also must live by the laws set by the host country

II.      Locating offshore provides advantages:

a.       When exporting to other countries, distribution and operations are near customers.

                                                   i.      Firms that have competed successfully in the US often have superior competitiveness in other countries

                                                 ii.      Producing in another country helps a firm avoid tariffs

b.      Locating offshore provide advantages when competing against other domestic companies (cheaper labor available in other countries)

III.      Problems with Multinationals

a.       Difficult to compete with companies that have gone overseas

b.      What do you do with displaced labor in the US? – NAFTA increased US unemployment as jobs went “south”

                                                   i.      Traditional explanation is that it simply changes the composition of US labor – from manual to managerial, etc

                                                 ii.      Problem is that this takes time, and labor mobility is a problem

c.       Monetary and Fiscal policy become more difficult – stimulative fiscal policy may generate demand for imports….etc

Exchange Rates – Or, how international trade occurs

I.                    Exchange Rates – history

a.       In US, dollar was based on gold standard until the 1970’s – dollar exchange rate was fixed because it was based on the value of gold.

b.      After WWII, the entire world had fixed exchange rates – currencies were tied to the US dollar, which was tied to gold.  This was abandoned in 1971.

c.       After US went off of gold standard, the value of a dollar was determined by supply and demand, just like other goods

d.      The “value of a dollar” is how much a dollar is worth compared to other currencies

II.                 Fixed vs. Floating

a.       Fixed:  Central Bank of a country ties the value of its currency to another country's currency, gold (or another commodity), or a basket of currencies.

                                                   i.      To maintain the exchange rate, Central Bank buys and sells foreign currencies or adjusts interest rates

                                                 ii.      Example:  Mexico ties the value of the Peso to the dollar.  As of Nov. 30, the fixed rate is 11.226 pesos per dollar

b.      Floating:  Exchange rate fluctuates according to supply and demand

                                                   i.      Supply of a currency = purchase of foreign goods and services

                                                 ii.      Demand for a currency = purchase of FDI, foreign capital, holding

c.       What it means

                                                   i.      High dollar = high in relation to another currency.  It’s “cheaper” for US citizens to buy products in/from that country

                                                 ii.      Low dollar = low in relation to another currency.  It’s more expensive for US citizens to buy foreign products, or to travel

                                                iii.      Currency is high/low only in relation to another currency.  Dollar is currently low compared to Euro, high compared to Yen