You are on page 1of 20

1

MARKET STRUCTURES

Market Structure: ​The environment of a firm, whose characteristics influence the firm’s pricing and output decisions.

PERFECT COMPETITION

Perfect Competition: a theory of market structure based on 4 assumptions: ​(1) there are many buyers and sellers; (2) sellers sell a homogenous good;
(3) buyers and sellers have all relevant information; (4) firms have easy entry and exit.

A perfectly competitive firm is a price taker.


*​Price taker: ​a seller that does not have the ability to control the price of the product it sells; the seller “takes” the price determined in the market.

Market Demand Curve: buyers


Market Supply Curve: sellers

(1) The market, composed of all buyers and sellers, establishes the equilibrium price.
(2) A single perfectly competitive firm has a horizontal (flat, perfectly elastic) demand curve at the equilibrium price/

Marginal Revenue (MR): ​the change in total revenue (TR) that results from selling one additional unit of output (Q.)
ΔT R
MR = ΔQ

For a perfectly competitive firm, price (P) is equal to marginal revenue (MR).
P = MR

Perfect Competition in the Short Run

P = MR, therefore, firm’s demand curve is the same as its marginal revenue curve.
The firm will continue to increase its quantity of output as long as the marginal revenue is greater than the marginal cost.

Profit Maximization Rule: ​Profit is maximized by producing the quantity of output at which
MR = MC.

Other interpretations:
P = MR = MC
2
The Perfectly Competitive Firm and Resource Allocative Efficiency

Resources (Inputs):​ used to produce goods and services


Resource Allocative Efficiency: ​the situation when firms produce the quantity of the output at which price equals marginal cost. (P = MC).
Short-run (Firm) Supply Curve: t​ he portion of the firm’s marginal cost curve lies above the average variable cost curve.
Short-run Market (Industry) Supply Curve:​ the horizontal addition of all existing firm’s short-run supply curves.
Perfect Competition in the Long-run: Long-run Competitive Equilibrium

(1) Economic profit is zero: Price (P) is equal to the short-run average total cost (SRATC).
P = SRATC

(2) Firms are producing the quantity of the output at which price (P) is equal to marginal cost (MC).
P = MC

(3) No firm has an incentive to change its plant size to produce its current output; that is, at the quantity of output at which P = MC, the following
condition holds:
SRATC = LRATC

SUMMARY: ​no incentive​ to ​(1) enter or exit the industry; (2) produce more or less output; (3) change plant size.

Productive Efficiency:​ the situation when a firm produces its output at the lowest possible per unit cost (lowest ATC).
Long-run (Industry) Supply Curve: graphic representation of the quantities of output that the industry is prepared to supply at different prices after the
entry and exit of firms are completed.
Constant-cost Industry: An industry in which average total costs do not change as industry (output) increases or decreases when firms enter or exit the
industry, respectively.
Increasing-Cost Industry: An industry in which average total costs increase as output increases and decreases when firms enter and exit the industry,
respectively.
Decreasing-Cost Industry: A ​ n industry in which average total costs decreases as output increases and decreases when firms enter and exit the
industry, respectively.

MONOPOLY

Monopoly: A ​ theory of market structure based on three assumptions: (1) there is one seller; (2) the single seller sells a product that has no close
substitutes; (3) the barriers to entry are extremely high.
Monopoly resources:​ A key resource required for production is owned by a single firm.
Public Franchise: A ​ right granted to a firm by the government that permits the firm to provide a particular good or service and that excludes all others
from doing so.
Natural Monopoly: ​A condition where economies of scale are so pronounced that only one firm can survive.
Government Monopoly:​ a monopoly that is legally protected from competition
Market Monopoly: a ​ monopoly that is NOT legally protected from competition

A monopolist is a price searcher.


*Price Searcher:​ A seller that has the ability to control to some degree the price of the product it sells.

In the theory of monopoly, the monopoly firm is the industry and vice versa. Therefore, the demand curve for the monopoly firm is the market demand
curve. For a monopolist,​ ​P > MR. P > MC.

For a monopolist, the marginal revenue curve lies below the demand curve.

The monopolist the quantity of output (Q) at which ​MR = MC​, and charges the highest price per unit at which this quantity of output can be sold
( P 1 ).

A monopoly seller is not guaranteed any profits. (a) Price is above total average cost at Q1 , the quantity of output in which MR = MC. Therefore, TR >
TC and profits. (b) Price is below average total cost at Q1 . Therefore, TR < TC and losses.

Profit = TR - TC

TC is the sum of total fixed costs (TFC) and total variable costs (TVC).
Profit = TR - (TFC + TVC)
3

Maximizing profit is the same as maximizing total revenue under one condition: when TVC = 0.
Profit = TR - TFC

Other formulas:
Profit = (TR/Q - TC/Q) × Q
Profit = (P - ATC) × Q

Deadweight Loss of Monopoly: ​The net value (value to buyers over and above costs to suppliers) of the difference between the competitive quantity of
output (where P = MC) and the monopoly quantity of output (where P > MC); the loss of not producing the competitive quantity of output.
Rent seeking: Actions of individuals and groups who spend resources to influence public policy in the hope of redistributing (transferring) income to
themselves from others.
X-inefficiency: THe increase in costs due to the organizational slack in a monopoly resulting from the lack of competitive pressure to push costs down
to their lowest possible level.
Price Discrimination: A price structure when the seller charges different prices for the product it sells and the price differences do not reflect cost
differences.
Perfect Price Discrimination: ​A price structure in which the seller charges the highest price that each consumer is willing to pay for the product rather
than go without it.
Second-degree Price Discrimination: A ​ price structure wherein the seller charges a uniform price per unit for one specific quantity, a lower price for an
additional quantity and so on.
Third-Degree Price Discrimination: A price structure in which the seller charges different prices in different markets or charges different prices to
various segments of the buying population.

Conditions of Price Discrimination


(1) The seller must exercise some control over price; that is, it must be a price searcher.
(2) The seller must be able to distinguish among buyers who are willing to pay different prices.
(3) Reselling the good to other buyer must be too impossible or too costly. A ​ rbitrage​, selling low or high, must not be possible.

MONOPOLISTIC COMPETITION

Monopolistic Competition: A ​ theory of market structure based on three assumptions: ​(1) there are many sellers and buyers; (2) each firm (in the
industry) produces and sells a slightly different product; (3) entry and exit are easy.

The ​monopolistic competitor’s demand curve is not horizontal; it is ​downward sloping. Therefore, it has to lower its price to sell an additional unit of
the good it produces. It is ​a price searcher​. It usually​ produces close substitutes​. Other modes of differentiation: nonprice competition.
MR = MC
P > MR. P > MC.
4
Excess Capacity Theorem: ​A monopolistic competitor in equilibrium produces an output smaller than the one that would minimize its costs of
production.

The monopolistic competitor is in the long-run equilibrium since price is equal to zero. Therefore, ​P = ATC.
In short, the monopolistic competitor ​operates at excess capacity ​as a consequence of its downward-sloping demand curve, and its downward-sloping
demand curve is a consequence of differentiated products.
OLIGOPOLY

Oligopoly: ​A theory of market structure based on three assumptions: (1) There are few sellers and many buyers; (2) Firms produce and sell either
homogeneous or differentiated products; (3) the barriers to entry are significant.
Concentration Ratio: T ​ he percentage of industry sales (or assets, output, labor force, or some other factor) accounted for by x number of firms in the
industry.
Collusion: ​an agreement among firms in a market about quantities to produce or prices to charge.
Nash equilibrium: a ​ situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the
other actors have chosen.
Cartel Theory: ​A theory of oligopoly in which oligopolistic firms act as if there were only one firm in the industry
Cartel: ​An organization of firms that reduces output and increases price in an effort to increase joint profits.
Issues of cartels:​ free riders, trust issues, cheating
Game Theory: A mathematical technique used to analyze the behavior of decision makers who try to reach an optimal position for themselves through
game playing or the use of strategic behavior, who are fully aware of the interactive nature of the process at hand and who anticipate the moves of other
decision makers.

Contestable Market:
(1) Entry to the market is easy and exit from it is costless.
(2) New firms entering the market can produce the product at the same costs as current firms.
(3) Firms exiting the market can easily dispose their fixed assets by selling them elsewhere.

The theory of contestable markets has been criticized because of its assumptions—in particular, ​the assumption that entry into the industry is free
and exit is costless​. However, even though this theory, like most theories, does not perfectly describe the real world, it has its usefulness. At a
minimum, the contestable markets theory has rattled orthodox market structure theory. Here are a few of its conclusions:
(1) Even if an industry is composed of a small number of firms or even just one firm, the firms do not necessarily perform in a noncompetitive way.
They might be extremely competitive if the market they are in is contestable.
(2) Profits can be zero in an industry even if the number of sellers in the industry is small.
(3) If a market is contestable, inefficient producers cannot survive. Cost inefficiencies invite lower-cost producers into the market, driving price
down to minimum ATC and forcing inefficient firms to change their ways or exit the industry.
(4) If, as the previous conclusion suggests, a contestable market encourages firms to produce at their lowest possible average total cost and
charge a price equal to average total cost, then they will also sell at a price equal to marginal cost. (The marginal cost curve intersects the
average total cost curve at its minimum point.)
5
PRICE AND UNEMPLOYMENT

PRICE

​ weighted average of all the goods and services


Price level: a
Price index: a​ measure of the price level
Consumer Price Index (CPI): T ​ he weighted average of prices of a specific set of goods and services purchased by a typical household; a widely cited
index number for the price level. Based on a representative group of goods and services, ​the market basket​, purchased by a typical household: ​(1) food
and beverages, (2) housing, (3) apparel, (4) transportation, (5) medical care, (6) recreation, (7) education and communication, and (8) other goods and
services.
Base Year: ​The year chosen as a point of reference or basis of comparison for prices in other years; a benchmark year.

CPI = ( T otal dollar expenditure on market basket in current year


T otal dollar expenditure on market basket in base year ) × 100

When We Know the CPI for Various Years, We Can Compute the Percentage Change in Prices. To find the percentage change in prices between
any two years, use the following formula:

Percentage change in prices =​ ( CP I LAT ER Y EAR − CP I EARLIER Y EAR


CP I EARLIER Y EAR ) × 100
Inflation:​ increase in price level. Measured in an annual basis
Inflation rate: ​the positive percentage change in the price level on an annual basis
Real income: ​nominal income adjusted for price changes
Nominal income:​ the current dollar amount of a person’s income

Real income​ = ( N ewCPincome


I ) × 100
​ ased on all goods and services produced in an economy
GDP Implicit Price Deflator: b

Salary in today’s (current) dollars = Salary earlier year × ( CP I current year


CP I earlier year )
6
UNEMPLOYMENT

Persons not in the labor force: ​persons who are (1) under 16 years of age, (2) in the armed forces, or (3) institutionalized (in a prison, mental
institution, or home for the aged).
Civilian noninstitutional population: divided into two groups: persons not in the labor force and persons in the civilian labor force. (Economists often
refer to this group as the labor force instead of the civilian labor force.)
Civilian noninstitutional population = Persons not in the labor force + Civilian labor force

(1) Persons not in the labor force are neither working nor looking for work. In this category, for example, are people who are retired, who are
engaged in own-home housework, or who choose not to work.
(2) Persons in the civilian labor force fall into one of two categories: employed or unemployed.
Civilian labor force = Employed persons + Unemployed persons

According to the Bureau of Labor Statistics (BLS),​ employed persons​ consist of:
(1) All persons who did any work for pay or profit during the survey reference week.
(2) All persons who did at least 15 hours of unpaid work in a family-operated enterprise.
(3) All persons who were temporarily absent from their regular jobs because of illness, vacation, bad weather, industrial dispute, or various
personal reasons.

According to the BLS, ​unemployed persons​ consist of:


(1) All persons who did not have jobs, who made specific active efforts to find a job during the prior four weeks, and who were available for work.
(2) All persons who were not working and who were waiting to be called back to a job from which they had been temporarily laid off.

Unemployment Rate:​ The percentage of the civilian force that is unemployed


N umber of unemployed persons
Unemployment rate (U) = Civilian labor f orce × 100

Employment Rate:​ The percentage of the civilian noninstitutional population that is employed
N umber of employed persons
Employment Rate (E) =​ Civilian noninstitutional population × 100

Labor Force Participation Rate:​ The percentage of the civilian noninstitutional population that is in the civilian labor force
Civilian labor f orce
Labor force participation rate (LFPR) =​ Civilian noninstitutional population × 100
According to the BLS, an ​unemployed person​ may fall into one of four categories.
(1) Job Loser. This person was employed in the civilian labor force and was either fired or laid off. Most unemployed persons fall into this
category.
(2) Job Leaver. This person was employed in the civilian labor force and quit the job. For example, if Jim quit his job with company X and is
looking for a better job, he is a job leaver.
(3) Reentrant.​ This person was previously employed, hasn’t worked for some time, and is currently reentering the labor force.
(4) New Entrant. T ​ his person has never held a full-time job for two weeks or longer and is now in the civilian labor force looking for a job.
Unemployed persons = Job losers + Job leavers + Reentrants + New Entrants

Discouraged worker:​ initially was actively looking for a job but stopped because he/she was discouraged. individuals who would like to work but have
given up looking for a job

Frictional unemployment: T ​ he difference between the unemployment rate and the natural unemployment rate. Unemployment that is due to the natural
frictions in the economy and that is caused by changing market conditions and represented by qualified individuals with transferable skills who change
jobs.
N umber of f rictionally unemployed persons
UF = Civilian labor f orce

Structural unemployment: Unemployment due to structural changes in the economy that eliminate some jobs and create others for which the
unemployed are unqualified.
N umber of structurally unemployed persons
US = Civilian labor f orce

​ nemployment caused by frictional and structural factors in the economy


Natural unemployment: U
Natural unemployment rate ( U N )= Frictional unemployment rate ( U F ) + Structural unemployment rate ( U S ).
7
Full employment​: The condition that exists when the unemployment rate is equal to the natural unemployment rate.
Cyclical unemployment rate:​ The difference between the unemployment rate and the natural unemployment rate.
Job search:​ the process by which workers find appropriate jobs given their tastes and skills
Unemployment insurance: a ​ government program that partially protects workers’ incomes when they become unemployed

Underemployed: ​people who work part time, but they really want to work full-time if they could find a full-time job
Full employment output: t​ he amount of output that is produced in the economy when that economy is using all of its resources efficiently
Natural rate of unemployment (NRU): ​the unemployment rate that exists when an economy is producing the full employment output
Frictional unemployment: ​the​ component of the NRU that occurs because a job search process is not instantaneous
Structural unemployment: an unemployment that occurs as a result of a structural change in the economy, such as the development of new
technology or industry
Cyclical unemployment: ​the unemployment associated with the recessions and expansions
8

GDP/RGDP

Gross Domestic Product (GDP):​ The total market value of all final goods and services produced annually within a country’s borders.
GDP = ΣP Q

GDP = ($2 *10) + ($3 *20) + ($5 *30) = $230

Final Good: A ​ good in the hands of its final user.


Intermediate Good: ​A good that is an input to the production of a final good.
Double Counting: ​Counting a good more than once when computing GDP.
GDP omits: (1) certain non market goods and services; (2) underground activities, both legal and illegal; (3) sales of used goods; (4) financial
transactions; (5) government transfer payments; (6) leisure
Transfer market:​ A payment to a person that is not made in return for goods and services currently supplied.

Expenditure approach: economists sum the spending (on final goods and services) in usually four sectors of the economy: ​(1) household, (2) business,
(3) government, and (4) foreign.
Expenditures: (​ 1) consumption; (2) gross private domestic investment, or simply investment; (3) government consumption expenditures and gross
investment, or simply government purchases; and (4) net exports.

​ he sum of spending on durable goods, nondurable goods, and services.


Consumption: T
(1) Durable Goods.​ Durable goods are goods that are expected to last for more than three years, such as refrigerators, ovens, or cars.
(2) Nondurable Goods.​ Nondurable goods are goods that are not expected to last for more than three years, such as food.
(3) Services. ​Services are intangible items such as lawn care, car repair, and entertainment.

​ he sum of all purchases of newly produced capital goods, changes in business inventories, and purchases of new residential housing. The
Investment:T
sum of:
(1) Purchases of newly produced capital goods.
(2) Changes in business inventories, sometimes referred to as ​inventory investment (Changes in the stock of unsold goods.)​.
(3) Purchases of new residential housing.
Fixed investment:​ Business purchases of capital goods, such as machinery and factories, and purchases of new residential housing
Investment = Fixed investment + Inventory Investment

Government Purchases:​ Payments to persons that are not made in return for currently supplied goods and services.

Net Exports:​ Exports minus imports


Imports:​ Total domestic (U.S.) spending on foreign goods.
Exports:​ Total foreign spending on domestic (U.S.) goods.
NX = EX - IM

Firms’ inventory investment can rise in two ways:


(1) Planned inventory investment. ​Firms may deliberately produce more units of a good and add them to inventory.
(2) Unplanned inventory investment. C ​ onsumers don’t buy as many units of output as firms have produced, and unsold units are added to
inventory.

Income approach: (National income - Income earned from the rest of the world + income earned by the rest of the world + indirect business
taxes + capital consumption allowance + Statistical Discrepancy)
9
National income: Total income earned by U.S. citizens and businesses, no matter where they reside or are located; the sum of the payments to
resources (land, labor, capital, and entrepreneurship)
National income = Compensation of employees + Proprietors’ income + Corporate profits + Rental income of persons +
Net interest

Compensation of employees: ​The compensation of employees is equal to the total of (1) wages and salaries paid to employees, (2) employers’
contributions to Social Security and employee benefit plans, and (3) the monetary value of fringe benefits, tips, and paid vacations.
Proprietor’s income: ​Proprietors’ income includes all forms of income earned by self-employed individuals and the owners of unincorporated
businesses, including unincorporated farmers.
Corporate profits: C ​ orporate profits include all the income earned by the stockholders of corporations.
Rental income of persons: ​Rental income is the income received by individuals for the use of their nonmonetary assets (land, houses, offices). It also
includes returns to individuals who hold copyrights and patents. Finally, it includes an imputed value to owner-occupied houses.
Net interest:​ Net interest is the interest income received by U.S. households and government minus the interest they paid out.

Indirect Business Taxes: ​Indirect business taxes are made up mainly of excise taxes, sales taxes, and property taxes.
Capital Consumption Allowance: ​The cost to replace these capital goods is called the capital consumption allowance, or depreciation.
Statistical Discrepancy: GDP and national income are computed using different sets of data. Hence, statistical discrepancies or pure computational
errors often occur and must be accounted for in the national income accounts.

Net Domestic Product (NDP):​ GDP minus the capital consumption allowance.
Net Domestic Product (NDP) = GDP - Capital consumption allowance

Personal income: ​The amount of income that individuals actually receive. It is equal to national income minus undistributed corporate profits, social
insurance taxes, and corporate profits taxes, plus transfer payments.
Personal income = National income - Undistributed corporate profits - Social insurance taxes - Corporate profits taxes +
Transfer payments

Disposable income: The portion of personal income that can be used for consumption or saving; equal to personal income minus personal taxes
(especially income taxes).
Disposable income = Personal income - Personal taxes

REAL GDP (RGDP)

​ he value of the entire output produced annually within a country’s borders, adjusted for price changes.
Real GDP: T
Real GDP = Σ (Base − year prices × current − year quantities)

Economic Growth: ​Increases in Real GDP. Annual economic growth has occurred if Real GDP in one year is higher than Real GDP in the previous
year.

Percentage change in Real GDP = ( Real GDP later year − Real GDP earlier year
Real GDP earlier year ) × 100
Business cycle:​ Recurrent swings (up and down) in Real GDP.
Economists usually talk about four or five phases of the business cycle:
(1) Peak.​ At the peak of the business cycle, Real GDP is at a temporary high. In Exhibit 7, Real GDP is at a temporary high at Q1.
(2) Contraction. The contraction phase represents a decline in Real GDP. According to the standard definition of recession, two consecutive
quarter declines in Real GDP constitute a recession.
(3) Trough. ​The low point in Real GDP, just before it begins to turn up, is called the trough of the business cycle.
10
(4) Recovery. T​ he recovery is the period when Real GDP is rising. It begins at the trough and ends at the initial peak. The recovery in Exhibit 7
extends from the trough until Real GDP is again at Q1 .
(5) Expansion. T ​ he expansion phase refers to increases in Real GDP beyond the recovery. In Exhibit 7, it refers to increases in Real GDP above
Q1 .

Recession: a period between a peak and a trough. . . . During a recession, a significant decline in economic activity spreads across the economy and
can last from a few months to more than a year. a period of declining real incomes and rising unemployment
Depression: A ​ severe recession.

AGGREGATE DEMAND AND AGGREGATE SUPPLY


11

Aggregate demand:​ buying side of the economy. The quantity demanded of all goods and services (Real GDP) at different price levels, ceteris paribus.
Aggregate Demand (AD) Curve: A ​ curve that shows the quantity demanded of all goods and services (Real GDP) at different price levels, ceteris
paribus. Downward sloping. Price level and quantity demanded of real GDP are inversely related

Real Balance Effect:​ The change in the purchasing power of dollar-denominated assets that results from a change in the price level.
Monetary Wealth: ​The value of a person’s monetary assets. Wealth, as distinguished from monetary wealth, refers to the value of all assets owned,
both monetary and nonmonetary. In short, a person’s wealth equals his or her monetary wealth (e.g., $1,000 cash) plus nonmonetary wealth (e.g., a car
or a house).
Purchasing Power: The quantity of goods and services that can be purchased with a unit of money. Purchasing power and the price level are inversely
related: As the price level goes up (down), purchasing power goes down (up).
Interest Rate Effect: The changes in household and business buying as the interest rate changes (in turn, a reflection of a change in the demand for or
supply of credit brought on by price level changes).
International Trade Effect:​ The change in foreign sector spending as the price level changes.

Total expenditures on U.S. goods and services = C + I + G + NX

Consumption:​ Four factors can affect consumption: wealth, expectations about future prices and income, the interest rate, and income taxes.
Wealth:​ The value of all assets owned, both monetary and nonmonetary.
(1) Increases in wealth lead to increases in consumption. If consumption increases, aggregate demand rises and the AD curve shifts to the right.
(2) Decreases in wealth lead to a fall in consumption, which leads to a fall in aggregate demand. Consequently, the AD curve shifts to the left.
Expectations About Future Prices and Income: Individuals’ expectations of future prices can increase or decrease aggregate demand: (a) If
individuals expect higher prices in the future, they increase their current consumption expenditures to buy goods at the lower current prices. The
increase in consumption leads to an increase in aggregate demand. (b) If individuals expect lower prices in the future, they decrease current
consumption expenditures. The reduction in consumption leads to a decrease in aggregate demand.
(1) Expectations of a higher future income increase consumption, leading to an increase in aggregate demand.
(2) Expectations of a lower future income decrease consumption, leading to a decrease in aggregate demand.
Interest Rate:​ Current empirical work shows that spending on consumer durables is sensitive to the interest rate.
(1) Buyers often pay for these items by borrowing; so an increase in the interest rate increases the monthly payment amounts linked to the
purchase of durables and thereby reduces their consumption. The reduction in consumption leads to a decline in aggregate demand.
(2) Alternatively, a decrease in the interest rate reduces monthly payment amounts and thereby increases the consumption of durables. The
increase in consumption leads to an increase in aggregate demand.
Income Taxes: ​Taxes a person payson earned income.
(1) As income taxes rise, disposable income decreases. When people have less take-home pay to spend, consumption falls. Consequently,
aggregate demand decreases.
(2) A decrease in income taxes has the opposite effect; it raises disposable income. When people have more take-home pay to spend,
consumption rises and aggregate demand increases.

Investment:​ Three factors can change investment: the interest rate, expectations about future sales, and business taxes.
Interest Rate:​ Changes in interest rates affect business decisions.
(1) As the interest rate rises, the cost of an investment project rises and businesses invest less. As investment decreases, aggregate demand
decreases.
(2) As the interest rate falls, the cost of an investment project falls and businesses invest more. Consequently, aggregate demand increases.
Expectations About Future Sales:​ Businesses invest because they expect to sell the goods they produce.
(1) If businesses become optimistic about future sales, investment spending grows and aggregate demand increases.
(2) If businesses become pessimistic about future sales, investment spending contracts and aggregate demand decreases.
Business Taxes: ​Businesses naturally consider expected after-tax profits when making their investment decisions.
(1) An increase in business taxes lowers expected profitability. With less profit expected, businesses invest less. As investment spending
declines, so does aggregate demand.
(2) A decrease in business taxes, on the other hand, raises expected profitability and investment spending. This increases aggregate demand.

Net Exports: T ​ wo factors can change net exports: foreign real national income and the exchange rate.
Foreign Real National Income. Just as Americans earn a national income, so do people in other countries. That is the foreign national income. By
adjusting this foreign national income for price changes, we obtain foreign real national income.
(1) As foreign real national income rises, foreigners buy more U.S. goods and services. Thus, U.S. exports (EX ) rise. As exports rise, net exports
rise, ceteris paribus. As net exports rise, aggregate demand increases.
(2) This process works in reverse. As foreign real national income falls, foreigners buy fewer U.S. goods and exports fall. This lowers net exports,
reducing aggregate demand.
Exchange Rate. ​The exchange rate is the price of one currency in terms of another currency; for example, $1.25 may be exchanged for €1. A currency
has appreciated in value if more of a foreign currency is needed to buy it. A currency has depreciated in value if more of it is needed to buy a foreign
currency.
(1) Depreciation in a nation’s currency makes foreign goods more expensive.
12
(2) This process is symmetrical. An appreciation in a nation’s currency makes foreign goods cheaper.

*The depreciation and appreciation of the U.S. dollar affect net exports.
(1) As the dollar depreciates, foreign goods become more expensive, Americans cut back on imported goods, and foreigners (whose currency
has appreciated) increase their purchases of U.S. exported goods. If exports rise and imports fall, net exports increase and aggregate demand
increases.
(2) As the dollar appreciates, foreign goods become cheaper, Americans increase their purchases of imported goods, and foreigners (whose
currency has depreciated) cut back on their purchases of U.S. exported goods. If exports fall and imports rise, net exports decrease, thus
lowering aggregate demand.

Aggregate supply:​ production side of the economy. The quantity supplied of all goods and services (Real GDP) at different price levels, ceteris paribus.
Aggregate Supply (AS) Curve: ​A curve that shows the quantity supplied of all goods and services (Real GDP) at different price levels, ceteris paribus.
Short-run aggregate supply (SRAS):​ production in the short-run
Long-run aggregate supply (LRAS):​ production in the long-run

Sticky wages​: Some economists believe that wages are sticky, or inflexible. This may be because wages are locked in for a few years due to labor
contracts that workers and management enter into.
Firms pay nominal wages, but they often decide how many workers to hire based on real wages. R ​ eal wages a
​ re nominal wages divided by the price
level.
N ominal wage
Real wage = P rice level

Worker Misconceptions:​ Another explanation for the upward-sloping SRAS curve holds that workers may misperceive real wage changes.
Nominal wages and price level decline by equal percentage => Real wage remains constant => But workers mistakenly
think real wage has fallen => Workers reduce quantity supplied of labor => Less output is produced

Wage Rates: C ​ hanges in wage rates have a major impact on the position of the SRAS curve because wage costs are usually a firm’s major cost item.
The impact of a rise or fall in equilibrium wage rates can be understood in terms of the following equation:
Profit per unit = Price per unit - Cost per unit

Prices of Nonlabor Outputs: Changes in the prices of nonlabor inputs affect the SRAS curve in the same way as changes in wage rates do. An
increase in the price of a nonlabor input (e.g., oil) shifts the SRAS curve leftward; a decrease in their price shifts the SRAS curve rightward.
Productivity:​ the output produced per unit of input employed over some period of time.
Supply shocks: ​Major natural or institutional changes that affect aggregate supply are referred to as supply shocks. Supply shocks are of two varieties.
Adverse supply shocks ​shift the SRAS curve leftward. Bad weather that wipes out a large part of the Midwestern wheat crop would be a supply shock.
So would a major cutback in the supply of oil coming to the United States from the Middle East. ​Beneficial supply shocks shift the SRAS curve
13
rightward; for example, a major oil discovery or unusually good weather leading to increased production of a food staple. These supply shocks are
reflected in resource or input prices.

Short-Run Equilibrium: The condition in the economy when the quantity demanded of Real GDP equals the (short-run) quantity supplied of Real GDP.
This condition is met where the aggregate demand curve intersects the short-run aggregate supply curve.

LONG-RUN AGGREGATE SUPPLY

Natural Real GDP: T ​ he Real GDP that is produced at the natural unemployment rate. The Real GDP that is produced when the economy is in long-run
equilibrium.
Long-Run Aggregate Supply (LRAS) Curve. T ​ he LRAS curve is a vertical line at the level of Natural Real GDP. It represents the output the economy
produces when wages and prices have adjusted to their final equilibrium levels and when workers do not have any relevant misperceptions.
Long-Run Equilibrium: The condition that exists in the economy when wages and prices have adjusted to their (final) equilibrium levels and when
workers do not have any relevant misperceptions. Graphically, long-run equilibrium occurs at the intersection of the AD and LRAS curves.

SIMPLE QUANTITY THEORY OF MONEY (MONEY)


14

Money: Any good that is widely accepted for purposes of exchange and the repayment of debt. The set of assets in an economy that people regularly
use to buy goods and services from other people
Barter: ​Exchanging goods and services for other goods and services without the use of money.
Medium of Exchange: A ​ nything that is generally acceptable in exchange for goods and services; a function of money.
Unit of Account:​ A common measure in which relative values are expressed; a function of money.
Store of Value: T ​ he ability of an item to hold value over time; a function of money.
Double Coincidence of Wants: In a barter economy, a requirement, which must be met before a trade can be made. It specifies that a trader must find
another trader who at the same time is willing to trade what the first trader wants and wants what the first trader has.
The Effects of Self-Interest:T ​ he statement that people in a barter economy “accept good G because they know they can easily trade it for most other
goods at a later time (unlike the item originally in their possession)” brings up the role of self-interest. At some point in time, people in a barter economy
simply wanted to make life easier on themselves; they wanted to cut down on the time and energy required to obtain their preferred bundle of goods. In
other words, they began to accept the most marketable or acceptable of all goods out of self-interest—a process that eventually led to the creation of
money.
Liquidity: ​the ease with which an asset can be converted into the economy’s medium of exchange
Commodity money:​ money that takes the form of a commodity with intrinsic value ​(e.g. gold bullion)
Fiat money:​ money without intrinsic value that is used as money by government decree ​(e.g. paper bills)

MONEY SUPPLY

M1: ​Currency held outside banks plus checkable deposits plus traveler’s checks.
Currency: C​ oins and paper money.
Federal Reserve Notes: ​Paper money issued by the Federal Reserve.
Checkable Deposits: ​Deposits on which checks can be written.
Demand Deposits: b ​ alances in bank accounts that depositors can access on demand by writing a check

M2: M1 plus savings deposits (including money market deposit accounts) plus small-denomination time deposits plus money market mutual funds
(retail).
Savings Deposit: An interest-earning account at a commercial bank or thrift institution. Normally, checks cannot be written on savings deposits, and the
funds in a savings deposit can be withdrawn at any time without a penalty payment.
Time Deposit: An interest-earning deposit with a specified maturity date. Time deposits are subject to penalties for early withdrawal, that is, withdrawal
before the maturity date. Small-denomination time deposits are less than $100,000.
Money Market Deposit Account (MMDA): A ​ n interest-earning account at a bank or thrift institution, for which a minimum balance is usually required
and most of which offer limited check-writing privileges.
Money Market Mutual Fund (MMMF): ​An interest-earning account at a mutual fund company, for which a minimum balance is usually required and
most of which offer limited check-writing privileges. Only retail MMMFs are part of M2.

Where Do Credit Cards Fit In?


A credit card is commonly referred to as plastic money, but it is not money. A credit card is an instrument or a document that makes it easier for the
holder to obtain a loan. When Tina Ridges hands the department store clerk her MasterCard or Visa, she is, in effect, spending someone else’s money
(which already existed). The department store submits the claim to the bank, the bank pays the department store, and then the bank bills the holder of its
credit card. By using her credit card, Tina spends someone else’s money, and she ultimately must repay her credit card debt with money. These
transactions shift around the existing quantity of money among individuals and firms, but they do not change the total.

Fractional Reserve Banking: A ​ banking arrangement that allows banks to hold reserves equal to only a fraction of their deposit liabilities.
Federal Reserve System (the Fed)): T ​ he central bank of the United States.
​ n institution designed to oversee the banking system and regulate the quantity of money in the economy
Central bank: a
Money supply:​ the quantity of money available in the economy
Monetary policy: t​ he setting of the money supply by policymakers in the central bank
Reserves:​ The sum of bank deposits at the Fed and vault cash.
Reserves = Bank deposits at the Fed + Vault cash

Reserve ratio:​ the fraction of deposits that banks hold as reserves


Required Reserve Ratio (r): ​A percentage of each dollar deposited that must be held in reserve form (specifically, as bank deposits at the Fed or vault
cash).
Required Reserves:​ The minimum dollar amount of reserves that a bank must hold against its checkable deposits, as mandated by the Fed.
Required reserves = r × Checkable deposits

Reserve Requirement:​ The Fed rule that specifies the amount of reserves a bank must hold to back up deposits.
Excess Reserves: ​Any reserves held beyond the required amount; the difference between (total) reserves and required reserves.
15
Excess reserves = Reserves - Required reserves

Money Multiplier:​ the amount of money the banking system generates with each dollar of reserves
The money multiplier is the reciprocal of the reserve ratio.

Bank capital: ​the resources a bank’s owners have put into the institution
Leverage: t​ he use of borrowed money to supplement existing funds for purposes of investment
Leverage Ratio: ​the ratio of assets to bank capital
Capital requirement: ​a government regulation specifying a minimum amount of bank capital

HOW THE FED INFLUENCES THE QUANTITY OF RESERVES

Open-market operations:​ the purchase and sale of U.S. government bonds by the Fed
FED Lending to Banks:​ banks can borrow from FED with a discount rate (the interest rate on the loans that the Fed makes to banks)

Federal Funds rate:​ the interest rate at which banks make overnight loans to one another

A ​financial system​ is essentially a means of getting people with surplus funds together with people who have a shortage of funds.
Direct Finance: ​Borrowers and lenders come together in a market setting, such as in the bond market.
Indirect Finance: F ​ unds are loaned and borrowed through a financial intermediary.
Financial Intermediary:​ A financial intermediary transfers funds from those who want to lend funds to those who want to borrow them.
Asymmetric Information: ​Relates to an economic agent on one side of a transaction having information that an economic agent on the other side of the
transaction does not have.
Adverse Selection: (before the loan is made) A ​ phenomenon that occurs when the parties on one side of the market, who have information not known
to others, self-select in a way that adversely affects the parties on the other side of the market.
Moral Hazard: (after the loan is made) A ​ condition that exists when one party to a transaction changes his or her behavior in a way that is hidden from
and costly to the other party

Balance Sheet:​ A record of the assets and liabilities of a bank.


Asset: A​ nything of value that is owned or that one has claim to.
Liability:​ Anything that is owed to someone else.
Bank capital (or net worth) = Assets - Liabilities

Insolvency:​ A condition in which one’s liabilities are greater than one’s assets.
Insolvency => Liabilities > Assets

EQUATION OF EXCHANGE

Equation of Exchange:​ An identity stating that the money supply (M) times velocity (V ) must be equal to the price level (P ) times Real GDP (Q)
MV = PQ
Money supply (M):​ currencies (preferably M1) in circulation
Velocity of money (V):​ movement of money. The rate at which money changes hands
Price level (P):​ price level of money (CPI)
Real GDP (Q):​ gross domestic product

Interpretations:
(1) MV = PQ
(2) MV = GDP (nominal GDP)
(3) TE = TSR

SIMPLE QUANTITY THEORY OF MONEY (short-run)

Simple quantity theory of money: T ​ he theory assuming that velocity (V ) and Real GDP (Q) are constant and predicting that changes in the money
supply (M) lead to strictly proportional changes in the price level (P ).

Many eighteenth-century classical economists, as well as ​American economist Irving Fisher (1867–1947)​ and ​English economist Alfred Marshall
(1842–1924)​, made the following assumptions:
(1) Changes in velocity are so small that for all practical purposes velocity can be assumed to be constant (especially over short periods of time).
(2) Real GDP, or Q, is fixed in the short run.
16

AD Curve in the Simple Quantity Theory of Money

MV = TE
TE = C + I + G + NX
MV = C + I + G + NX

(1) An increase in the money supply will increase aggregate demand and shift the AD curve to the right.
(2) A decrease in the money supply will decrease aggregate demand and shift the AD curve to the left.
(3) An increase in velocity will increase aggregate demand and shift the AD curve to the right.
(4) A decrease in velocity will decrease aggregate demand and shift the AD curve to the left.

AS Curve in the Simple Quantity Theory of Money


In the simple quantity theory of money, the level of Real GDP is assumed to be constant in the short run. The AS curve is vertical at this level of Real
GDP.

In the long-run, drop the assumptions that V and Q are constant. In this theory, price level (P) depends upon M, V, and Q. Derivations.*
Monetarism:​ ​the theory or practice of controlling the supply of money as the chief method of stabilizing the economy.
17
Four Monetarist Positions:
(1) Velocity changes in a predictable way.
(2) Aggregate demand depends on the money supply and on velocity.
(3) The SRAS curve is upward sloping.
(4) The economy is self regulating (prices and wage are flexible).

Nominal variables:​ variables measured in monetary units


Real Variables:​ variables measured in physical units
Classical dichotomy:​ the theoretical separation of nominal and real variables
Monetary neutrality:​ the proposition that changes in the money supply do not affect real variables

Inflation:​ refers to the increase in price level


Inflation tax:​ the revenue the government raises by creating money
One-shot inflation:​ A one-time increase in price level; an increase in the price level that does not continue
Continued inflation: A ​ continued increase in price level

The ​money supply​ is the only factor that can continually increase without causing a reduction in one of the four components of total expenditures.
18

(1) Government purchases cannot go beyond both real and political limits.
(2) Some economists argue that government purchases that are not financed with new money may crowd out one of the other expenditure
components. Thus, increases in government purchases are not guaranteed to raise total expenditures because if government purchases rise,
consumption may fall to the degree that government purchases have increased.

Hyperinflation:​ periods of extreme inflation


A ​change in money supply ​affects: ​(1) the supply of loans; (2) real GDP); (3) the price level; and (4) the expected inflation rate.
Liquidity effect: t​ he change in the interest rate due to a change in the supply of loanable funds
A ​change in real GDP ​affects​ both the supply of and the demand for loanable funds.
Income Effect:​ the change in the interest rate due to a change in the real GDP
Price-level effect: ​the change in the interest rate due to a change in the price level
Expectations effect:​ the change in the interest rate due to a change in the expected inflation rate
Fisher effect:​ the one-for-one adjustment of the nominal interest rate to the inflation rate
Nominal interest rate:​ the interest rate actually changed (or paid) in the market; the market interest rate.
Nominal interest rate = Real interest rate + Expected inflation rate

Real interest rate:​ the nominal interest rate minus the expected inflation rate
Real interest rate = Nominal interest rate - Expected inflation rate

Inflation does not in itself reduce people’s real purchasing power.


Inflation is bad, but deflation may be worse.

Shoeleather costs: t​ he resources wasted when inflation encourages people to reduce their money holdings
Menu costs:​ the costs of changing prices
19
INTERNATIONAL TRADE

International trade: Trade makes people better off. (foreign aspect)


Comparative advantage: The advantage a country has when it can produce a good at a lower opportunity cost than another country can.

International trade theory: countries gain from international trade from specializing in goods and services they have a comparative advantage on
Consumer’s surplus: the difference between the maximum price a consumer is willing and able to pay for a good or service and the price actually paid
Consumers’ surplus = Maximum buying price - Price paid

Producer’s surplus: the difference between the price sellers receive for a good and the minimum price for which they would have sold the good
Producers’ surplus = Price received - Minimum selling price

Tariff: tax on imports (maycause net losses)


Effects of tariffs: (1) decreases consumers’ surplus, (2) increases producers’ surplus, (3) generates tariff revenue
Quota: a legal limit imposed on the amount of a good that may be imported

WHY NATIONS SOMETIMES RESTRICT TRADE?

(1) The National Defense Argument


(2) The Infant Industry Argument
(3) The Antidumping Argument
Dumping: the sale of goods at a price below their cost and below the price charged in the domestic market
(4) The Foreign Export Subsidies Argument
(5) The Low Foreign Wages Argument
(6) The Saving Domestic Jobs Argument

KEYNESIAN CONSUMPTION FUNCTION


20