Professional Documents
Culture Documents
Revised Edition
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Reviewers
Economic for Educators, Revised benefitted from many comments and suggestions from the reviewers listed alphabetically below. Sally Adamson Retired, Duncanville High School Duncanville ISD Dr. Steve Cotton University of Houston - Clear Lake
Dr. Alberto Davila University of Texas-Pan American Texas Council on Economic Education Center Director
Dr. Steve Cobb University of North Texas Texas Council on Economic Education Center Director
David Pruitt University of North Texas Texas Council on Economic Education Consultant
Support
Laura Ewing President, Texas Council on Economic Education
Preface
I wrote this short primer to help K-12 educators prepare to properly teach economic ideas to their students. Economics provides a useful way of thinking about how the world works and its main themes deserve a rightful place in each students mindset. The main themesefficiency, trade-offs and opportunity costecho throughout the eighteen Microeconomic and Macroeconomic lessons. Written in plain language, each lesson orients the busy educator on the meaning and application of core economic terms, concepts and tools. Other economic concepts then can be directly integrated with the more fundamental ones presented. It is my hope that the work enhances teacher knowledge and confidence, and then gets multiplied by the number of students they enlighten on this useful subject. I thank the Texas Council on Economic Education for financial support to pen this revision. I also thank Laura Ewing, President of the Texas Council for her generous assistance, along with the academic and professional manuscript reviewers for their valuable comments. Lingering errors remain mine alone. Robert F. Hodgin, Ph.D. Hodgin@uhcl.edu University of Houston - Clear Lake Houston, Texas
Biographical Sketch
Robert F Hodgin, Ph.D., has taught economics to K-12 teachers, undergraduates and graduate students at the University of Houston-Clear Lake campus for four decades. His zeal for the subject radiates through presentations, academic articles, lay writing and consulting. Motivated by the rigid grade-level content demands imposed by state legislators, he penned Economics for Educators, Revised Edition, to give teachers a very short and readable guide to the discipline. With a keen eye on common misunderstandings, he walks the reader through the major turns of the discipline in common language. With Economics for Educators, Revised Edition, a teacher can swiftly grasp a concept, develop a lesson plan and confidently address student questions class after class. Robert and his wife, Johnette, have two grown daughters, Kristen and Whitney, and two granddaughters, Sloane and Elle. They live on a lake near the Big Thicket area of East Texas.
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Table of Contents
Lesson 1: The Economic Problem 1
Economic Foundations 1 Economic Resources 1 Understanding Economic Behavior 2 The Economic Way of Thinking 3
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Economic resources and the market returns they earn: Labor earns wages from its human capital Land earns rent for its productive application Capital (plant and equipment) earns interest Entrepreneurship (leading, organizing) earns profit The US Bureau of Economic Analysis (BEA) measures resource payments to the factors of production each quarterthis is the income view of Gross Domestic Product (GDP)as part of the National Income and Product Accounts (NIPA). Economists at the BEA, using official methodologies compile figures for each resource category, as shown below for 2009. Each category is a resource building blocka factor of productionfor making goods and services, and each, in return, earns payment for its use.
Suppose the blue bars in the chart above reflect the personal value that you place on each T-shirt you might buy, beginning with the first one. Notice that you feel willing to pay as much as $30 for that T-shirt, well over the sale price. The value-to-cost ratio is certainly positive; 2-to-1 ($30 value/$15 cost). Also notice that as you anticipate purchasing each additional T-shirt, their value to you falls (just how many nice summer T-shirts does one need?). Will you purchase the first T-shirt? Yes. At the same price, what is the benefit-to-cost logic for the second T-shirt? Well, the cost is the same$15. But the value to you has fallen to about $25. You still feel the value is greater than the costand besides, the sale ends today. So you purchase that one also. Would you purchase the 3rd T-shirt? Yes, again. Your perceived value of about $20 is still greater than the cost of $15. Now what about the 4th T-shirt? Here you are indifferent, at the limitand in two ways. First, the value just equals the cost for the T-shirt. Second, you will have spent precisely all the money you allotted from your budget for the total T-shirt purchase. The action described above is smart economic choice makingthey are decisions made at the margin. What does that mean? You optimized the use of your scarce funds by individually assessing the benefit and the cost, and purchased the most T-shirts possible given their price and your budget. That means for each additional (i.e. marginal) T-shirt you considered its cost compared to its valuemaking sure that the value exceeded the cost, up to the count of T-shirts that used all funds allotted. In the end, you maximized your total net benefit.
In Sum Economics is the study of how society allocates scarce resources among competing options. The economic problem is how to satisfy the material well-being of people in the society. Scarcity means that economic goods have a cost in the form of the value sacrificed to acquire the desired good. Economic resources fall into one of four categories: land (earns rent), labor (earns wages), capital (earns interest) and entrepreneurship (earns profit). Economists believe that theory provides understanding of citizens behavior toward solving societys economic problem. Opportunity cost is the value of the next best option foregone when a more attractive option is chosen. Making trade-offs involves sacrificing some of one good to get more of another good, so that total benefit rises. Economic efficiency means making rational benefit-cost choices in the consumption, production and distribution of goods. An action is economically efficient if a person makes choices where the net benefit (expected additional benefits less the expected additional costs) is positive or rejects choices where the net benefit is negative.
Comparing Economic Systems An economic system provides mechanisms through which to achieve individual and collective well-being. Fundamentally, leaders must choose between sustaining traditional provisioning methods, centralizing economic decision-making, decentralizing economic decisions via a market mechanism or some mix of these options. The requirements necessary to meet all societys needs, including those labeled economic, are sufficiently complex that debate on which economic system is best requires judgments. Even so, identifying some of the major benefits and trade-offs in each system is possible. Three types of systems to address the economizing questions Traditionhistorical and customary social processes are sustained through law, religion and belief Commandimposed authority guides the system via orders from an economic general Marketsocietal members pursue their own economic well-being via free markets for goods Every economic system provides collective and individual benefits and costs. Traditional economic systems place much emphasis on group hierarchy, communal beliefs and maintaining social customs. Change halts in favor of cultural routine and familiarity. Tradition-based economies solve the economic problem, but at the expense of progress. In a command system, the central authority may own or control the means of production. Central authorities make major economic decisions related to wages, output and distribution of goods. Mandates from the central authority subsume individual choices. Command-based economic systems can be useful in times of war, or for mandated economic change, where direction by a central agent guides resources toward a goal that leaders envision more clearly than individuals can. Human motivation, efficiency, and critical resource supplyfood, clothing, and sheltermight suffer in the pursuit of the central authoritys goals. A market system vests control of economic resources with individuals who pursue their own self-interests for the relatively unintended betterment of all. The cornerstones of market-based exchange include the rights to freedom of choice, private property ownership and the reward of profits as incentives. Those rights support risk taking and self-determination. Yet, the sum of individual choices may not be socially optimal as time passes. A free markets most serious social trade-off is occasional dramatic fluctuations in the level of economic activity. Government, at least in principal, plays a relatively limited role in the private sector. Governments roles in a market system Oversee the economic system so it operates in agreement with and laws and property rights Provide public goods and services such as national defense, public education and public highways Sustain common resource utilization at a socially desirable level
Governments goals in a market system Protect citizens freedom to choose between opportunities Support efficient markets through competitive prices Maintain equity and a sense of fairness in dealings Ensure security and stability to support risk taking There is no compelling evidence that market-based economies naturally evolve from tradition or command systems. Free markets require political support, legal validation, social acceptance and institutional structures. The transformation from traditional economies, like India, or from command economies, such as the former Soviet Union, to a market system can be fraught with uncertainty and social upheaval. An Economys Production Possibilities No matter the chosen economic system, every country addresses the three economizing questions when bringing scarce economic resources into their desired use. No nation, however wealthy, can make economic choices without sacrifices. As the system allocates its scarce resources it must make trade-offs when producing goods to meet societys economic needs. A Production Possibilities Curve shows both the production limits and opportunity costs of resource trade-offs when a society produces two or more goods in a given time period, with fixed current resources and unchanging technology.
Consider a simple economy with just three people (Ann, Ben and Cal) and two product sectorsWidgets and Gadgetsboth socially useful. To begin, one question is the order of hiring into each sector. For example, who makes gadgets at lowest cost? Since no money values appear in the table above, how can the answer be motivated?
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Should we hire Ann first to make gadgets? No. Hiring Ann first overlooks the economic basis for efficient choice makingopportunity cost. To see how, notice in the table that for every one gadget Ann produces each day, it costs her, and the society, 2 widgets not produced (10 widgets divided by 5 gadgets = 2 widgets lost per gadget made). Instead, can you see why Cal should be hired first to make the first 4 gadgets (where his gadget costs only a widget not made)? Its true. Using this same opportunity cost logic Ben will be hired second, where his opportunity cost of making 1 gadget is 1 widget. Finally, Ann should be the last hire, since her relative gadget-making cost is highest of the three (each of her gadgets costs 2 widgets not made). The same logic applied to making widgets will find the hiring order precisely reversed. How is this so? Look at Ann again, for her 10 widgets made per day, only 5 gadgets are sacrificedso a widget costs just half a gadget in production foregone. That cost is lower than either Cal or Ben in widget making. For Ben each widget made by him costs one gadget, while for Cal each widget costs two gadgets. Notice that when opportunity cost prevails as the criterion to determine the hiring order for either good, the least costly (opportunity cost, again) person is hired first and the most costly person is hired last. More, since society likely wants both widgets and gadgets at least one person will make the opposite good. Should it not be the last person hired in one sector (the most expensive and least efficient) who transfers to the alternate sector, where they can become a more efficient (less costly) maker in the other sector? Yes and their world will be better off for that.
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Demandthe quantity of a good or service that buyers are willing and able to purchase at a range of prices, all other market forces held constant. The definition of demand implies that potential buyers assess the prospective benefits from consuming a good compared to what it will cost. This statement is only half-right. Good economic decision-making always poses pairs of options. The first option is the offer immediately at hand. The second option is the next best offer known to be available, given its price and perceived benefits. By choosing one, the consumer sacrifices the other on the expectation that the benefits-to-cost assessment for the chosen option will deliver greater net satisfaction. How is it that the definition for demand presumes a range of prices for a given good? In any particular store, most American shoppers see only one price. Here, the economist makes two more mental assumptions: other vendors prices for the same or similar good are known, at little cost, and travel in the market place is free and fast. These useful assumptions let the buyer efficiently select the product from a potentially wide array of vendors and range of prices then available.
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Demand Responses to Non-price Changes Demand analysis for an individual buyer and demand analysis for an entire market of buyers are quite similar. This is true because a markets demand is the sum of the amounts demanded at every price by all buyers in the market. While the behavior of a single individual in the market may vary in magnitude from other buyers, the market demand curve still slopes downward and to the right. The definition of demand contains a phrase that reads all other market forces held constant. We have seen above that when time is artificially constrained, price changes bring about a change in the quantity demanded, noted by reading along a fixed-in-place demand curve. As you likely have suspected, other forces are at work in the market.
Inspect the chart above. Choose a price on the vertical axis, say $10, then read horizontally across to the right edge of the bright blue demand graph and read the quantity demanded; 30 units. If demand INcreased from that point and shifted rightward (like the green arrow) to the outer edge of the lighter blue graph, the number of units demanded at the original price would be larger, nearly 40 units. That is an increase in demand, current price held constant. Again, select a price on the axis, say $40, then move horizontally across to locate the outer edge of the light blue demand graph and read the quantity demanded; about 20 units. If demand DEcreased from that point by shifting leftward (like the red arrow) to the edge of the bright blue graph, the number of units at the original price would be smaller, about 15 units. That is a decrease in demand.
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Production cost categories Avoidable or variable (opportunity) costschange directly with production levels Fixed operating costscosts invariant to production levels Sunk costscosts not recoverable during the production period Total coststhe sum of fixed and avoidable production costs Marginal costthe cost of producing one more unit of the product Every fixed-in-size production operation has an output capacity limit. As the production level nears that capacity limit, per unit costs of the output will begin to rise. This natural phenomenon, the increase in per unit avoidable costs occurs because of a non-economic law, the law of diminishing returns. Law of diminishing marginal returnswhen at least one factor input, plant capacity, is fixed, the additional output produced from additions to labor will eventually decrease as more labor is added. The consequence of diminishing returns to labor in the short run is that variable costs per unit rise. Why? It takes increasingly more labor effort per time to compensate for the diminishing output per labor hour. So in the short run, labor cost per unit of output increasesan important marginal cost. Notice that during a production run it is variable costs, such as labor and materials, which must be covered. Fixed costs, which are sunk, at least during the production period, leave no opportunity for choice and need not be considered at the moment, though they eventually must be paid to preserve the ability to operate. What happens to product produced that does not sell as expected? The business runs a sale. The interesting economic dilemma is what price to set for the leftover inventory. Given that production, distribution and set-up costs have already been incurred for the unsold product, what costs are relevant and what price should be charged? Only current (new) opportunity costs are relevant and any price above zero just might do. How can this be? All prior costs not recoverable during the production period are sunk. Any cash flow generated from the inventory liquidation is of some benefit. There is even a case to be made for giving the inventory away, if it is preventing new merchandise from taking up valuable floor space and spoiling new sales. Each situation must be assessed in its own factual context. Do not be misled into thinking some earlier lost profit margin must still be considered. That, too, is a cost sunk by foiled market expectations. Economic goods can never sell for more than the buyers perceived value. Relevant costs are those incurred in a chosen action. Once the action has occurred, spent costs become sunk and unrecoverable. The only remaining decision is what price to set for the now excess goods.
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Derived Demand for Factor Inputs The business owner seeks and allocates productive resourcesfactors of production: land, labor and capitalbecause she needs them to meet the demand for the good or service offered by the business. Efficiency dictates that a match of capabilities be achieved using the productive resource inputsphysical with human capitalat the least possible cost. The owner must determine both the skill mix and number of people to hire. The prevailing market wage for the type of labor skills sought provides a good measure for labor costs. The market wage rate multiplied by the number of positions required per production cycle (time) determines the total wage cost for the firm. Crucially it is product demandthe number of units demanded per time multiplied by the market pricethat provides the ability to pay for the labor services. That is why economists call the demand for factor resources a derived demand. Derived demandthe relationship between the resource factor's price and quantity wanted by firms directly depends on market demand for the final product(s) the factor helps produce. So how many input units of each type will be hired? The economists rule is to hire input factors until the cost of the last unit acquired or last hour workedthe wage rate times the last factor input hired or last hour workedjust equals the value of its production product price times the additional output units produced. Yet another marginal efficiency rule that helps generate profits by keeping variable costs low.
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How Firms Grow in the Long Run As demand for the companys product increases and sales revenue grows, so does the need to hire additional resources. As the market for the product expands, requiring more jobs and equipment to produce the enhanced volume, jobs and tasks become more specialized. The profit motive and economic efficiency accommodate the specialization process as the expanding sales volume enables it. The entrepreneur must decide to expand or contract the level of factor inputs employed as demand for the product rises or falls, given current capacity. If sales volume continues to expand, the owner eventually faces the decision of whether or not to increase the size of the production facility. In the long run there can be no sunk costs. All costs, in a planning process are variable because projections are always fluid. Through time, the larger and more sustained the demand for the good, the larger the enterprise may be willing to grow. Long runa time-period long enough to make changes in the scale of production and where all costs are variable. All costs must be paid or the business enterprise has insufficient resources to continue and leaves the industry. Most successful large enterprises look 1 to 10 years ahead, predict the markets character then plan how to meet the anticipated demand. They spawn new product development and define new strategies to guide organizational shifts. The two basic dimensions always within a strategy are working to: 1) expand demand and 2) reduce operating costs within the evolving scale of the operating plant. An increasing industry product demand forces firm management to grow or it will lose relative market share to other sellers as competitors expand their own plants to meet the rising industry sales. Firms can grow internally, driven by product market expansion, or externally, driven by merger and acquisition. Three notable long run cost reducing effects work to lower long run costs as capacity expands. Economic reasons why long run production costs fall Economies of Scalea reduction in the average cost of per unit output as the firm increases its size (scale) achieved through enhanced market purchasing power, lower per unit overhead and engineering efficiencies Economies of Scopelower per unit costs from producing two goods in-house than producing them separately through outsourcing Learning Curve Effectsthe reduction in total production costs from improvements learned across many production cycles
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Producer Choices and Supply Demand from buyers elicits supply from producers. And supplying a product is feasible when the buyers maximum willing purchase price exceeds the sellers minimum willing offer price. Each firms production cost is a competitive factor so much effort is spent keeping opportunity costs of production low. A seller who offers output below its opportunity cost is not being rational, because the revenue would be insufficient to pay the total opportunity costs of production. Production cost differences exist between sellers, even for a similar product. So goods produced for market get offered at a range of prices, each price covering the respective firms anticipated opportunity cost.
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Supply Responses to Non-price Changes Supply analysis for an individual producer and supply analysis for an entire market of producers are similar. This is true because a markets supply is the sum of units supplied, at each and every price, by the sellers in the market. While the behavior or response of a particular seller in a market may occasionally vary from that of all sellers as a group, the total market supply curve commonly slopes upward and to the right. Recall that the last phrase in the definition of supply is all other market forces held constant. What is the meaning and importance of this phrase? You have seen when time is artificially held still, that price changes bring about a change in the quantity supplied, noted by reading along a fixed-in-place supply curve for the short run. Just as you suspected in the lesson on demand, forces other than price also are at work in the supplier market.
Inspect the chart above. Choose a price on the vertical axis, say $40. Then read the quantity supplied at the left edge of the yellow supply line. It is about 50 units. If supply increased, by shifting to the right, to become the blue supply line, the number of units supplied at the same price of $40 would be about 55 units. Thats an increase in supply, at the same price. Had we begun with the blue supply line at the price of $40, a movement back to the yellow supply line would have represented a decrease in supply. Forces that increase supply shift the curve to the right. Forces that decrease supply shift the curve to the left. Economists categorize the forces that move or shift market supply. As non-price market forces influence sellers, the actual supply curve position changes through time. Non-price forces on supply are factors that cause a change in supplya shift of the supply curvewithout a change in
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In Sum Cost means the opportunity costs of resources in use, reflected by the owner-made choices of each economic resource. Opportunity cost is the value of the next best option foregone. A seller-entrepreneur decides if an opportunity is a good business proposition by: o Assessing expected net profits from a venture o Comparing the first options net benefits to the next best alternative Business ownerssellersmust pay a resource opportunity cost to attract them into a particular use. Revenue left after paying resources their opportunity costs becomes profit for the entrepreneur-seller. Supplythe quantity of a good that sellers are willing and able to offer at a range of current pricesother market forces constant Law of Supplysellers will produce more of a product for sale at a higher current price than at a lower current price. Price elasticity of supplyA measure of proportionate producer output response to a relative change in current price. o The main determinant of supply elasticity is time and the ability to direct resources to different uses Non-price market forces shift the supply curve, as time passes, to reflect changes in the quantity supplied at all prices. o Increase in supply is a rightward shift of the curve; o Decrease in supply is a leftward shift of the curve; Number of sellersas the count of sellers rises/falls, the supply increases/decreases Technologyas technology is integrated, the supply increases Future price expectationsif future market price is expected to rise/fall, current supply falls/rises Input costsif the costs of material and labor rise/fall, the supply decreases/increases
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To the right of their intersection, both curves are dotted to suggest that no transactions can occur there. The only area where transactions can logically occur is in the reddish-silver triangular area bounded by the solid blue upper range of the demand curve and the solid red lower range of the supply curve up to their intersection. Why is this so? The reddish-silver triangular area is the only place where a potentially negotiable price is both below the maximum demand price for some buyers and above the minimum opportunity supply cost for some sellers. Buyers know their maximum value price for a good and wish to pay that price or less. Sellers know the minimum opportunity costs of bringing the good to market and wish to get that price or more.
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Inspect the chart above. See how the current market demand schedule (in blue) and the current market supply schedule (in green) together determine the market equilibrium Price (= $5) and quantity (= 5 units) for a good. Now suppose that buyers believe the future market price of the good will increase, and that sellers perceive the same thing to be true. What will happen to market equilibrium priceand why? Step 1: How to shift demand? Recall when buyers believe prices will rise in the future they tend to buy more now, at all current prices. That is an INcrease in demand, a shift to the right from the blue demand to the dotted blue demand curve, labeled B. Step 2: How to shift supply? Suppliers will want to restrict current supply (if the good is not perishable) and sell later at the higher expected price. That is a DEcrease in supply, a shift to the left from the green supply to the dotted green supply curve labeled A. Step 3: What is the effect on equilibrium price and quantity? The blue demand has increased to the now higher demand (more units are demanded at each price) labeled B. The green supply has decreased to the now lower supply (fewer units are supplied at each price) labeled A. The increased demand and decreased supply together raise the market equilibrium price to $7 and lower the equilibrium quantity to 4.5 units. When both demand and supply shift, it is necessary to work through the logic to correctly determine the effect on the resulting equilibrium price and quantity in the market.
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In Sum Trade creates wealth because both parties perceive a gain in a voluntary exchange. An economic good provides wealth only to someone who values it. A market exists anywhere an exchange transaction occurs. The forces of supply and demand working together efficiently determine market equilibrium price when: o Competitive markets tend toward an equilibrium priceone that clears the market, and o Many buyers and sellers exist to bargain freely when market information and mobility costs are low o Property rightswhat belongs to whom under what conditions are known and respected o Transactions coststhe costs of completing a transaction are low Efficient markets in economics means: o Goods are produced at their opportunity cost and exchanged for their perceived value o Goods flow to their highest valued use o Market exchanges occur when the buyers maximum willing price exceeds the sellers minimum offer price. o Market equilibrium is a tendency where the exchange price for the last buyer and last seller in that market are equal. Non-price market forces shift either the demand or supply curve and alter the market equilibrium price and quantity. Starting from a given demand and supply intersection with a given equilibrium price and quantity, the following are true: o Increased demand (supply constant)a rightward shift, increases both equilibrium price and quantity. o Decreased demand (supply constant)a leftward shift, decreases both equilibrium price and quantity. o Increased supply (demand constant)a rightward shift, decreases equilibrium price and increases equilibrium quantity. o Decreased supply (demand constant)a leftward shift, increases equilibrium price and decreases equilibrium quantity. o Mixed movements in demand and supply must be determined using the facts in the problem statement. Equilibrium price and quantity can rise, fall or stay the same.
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Inspect the chart above, and notice that equilibrium market price equals $20any sellers revenue per unit. Further note that opportunity cost rises as production increases. In this situation, a rational seller will gladly produce up to 4 units per period for sale. Why? Each unit of output up to the 4th unit sells at a price above its opportunity cost and adds to profit. To produce beyond that point, say the 5th unit is not rational because its cost ($25) is greater than the market equilibrium price received ($20) and lowers profit. So the optimum output rate, the one that will generate the most profit, if profits are being made, is 4 units. How could it be that the seller might not be making a profit if each unit sells for more than its opportunity cost? In the chart above, the amount of overhead cost was not provided. Once known, short run profit determination can be made. Profit maximizing ruleoperating at the level of output where market price equals marginal cost will either maximize profits or minimize losses, if they are incurred. The competitors rule is to produce at the level of output where price equals marginal cost, the opportunity cost of production. By doing so, any profits will be maximized or any losses will be minimized. This extreme competitive pressure guarantees private goods brought to market will sell for a price equal to marginal costthe opportunity cost. Further, there will be more product available at that price than would be available through any other market structure. These results reflect competitions efficiency promise for private goods in the short run. In the long run the efficient firms best able to sustain profits by controlling cost can survive and grow.
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Monopolys Efficiency Failure At the opposite end of the competitive spectrum lies monopoly, a market possessing only one seller but many buyers. Monopoly represents one of four cases of efficiency failure in economic analysis, where failure means an inefficient allocation of goods in comparison to competition. A monopoly may achieve its market power position by taking advantage of large economies of scale, growing so large that no other firms can effectively compete on cost. A monopoly also may be granted by regulatory authority, as with a patent, legally prohibiting other rivals. Finally, a monopolist can be the sole owner of a natural resource, like a water company. No matter the genesis of a monopoly, economists detest its effects on economic welfare. Because the monopolist faces the downward sloping demand for the entire market, two important observations can be made. One, there are no close substitutes available to the monopolists product, so the firm has significant price setting power. Two, market entry barriers are prohibitively high. The only way for another firm to enter the market is to slay the existing monopolist. A monopolist incurs opportunity costs to produce its output, just like a competitive firm does, though it is under less pressure to control those costs. It also has the same business objective as a competitive firm: maximize profits. To achieve that objective, the monopolist does something the competitor cannotchange price. The monopolist also knows that additional sales can only occur through a price drop. So what makes monopoly behavior loathsome in the economists mind? Compared to competition, a monopolists price-setting power enables it to search out the price that maximizes profits. That price is higher than marginal cost and achieved due to a restriction in output. How does this happen? Like a competitor, a monopolist will produce additional units of output only as long as the additional revenue exceeds the additional cost of each unit. The culprit is the monopolists down-sloping demand curve, allowing it price searching power to maximize profits as buyers have no or very few close substitutes. In the lower (and inelastic) half of a monopolists demand curve, price increases generate rising additional revenue so total revenue also rises. Inevitably, the monopolists profit maximizing price search stops short of the output level a competitor firm would attain. Finally, the quantity demanded at that output allows the firm to charge a price above the opportunity cost of production. In response, and in fairness, the monopolists management would claim that they are pursuing the same rational economic goal as competitor firms, acting on behalf of their stockholders. Their statement would be true but at the cost of reduced economic welfare fewer units available for purchase sold at a price above opportunity cost. This reality is one of the key justifications for government regulation of some monopolized markets.
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When a Few Firms Dominate the Market Moving away from the monopoly end of the competitive continuum, we find a structure where several firms compete for many buyers. US industries where competition is highly concentrated in the hands of relatively few firms include airlines, steel, petroleum refining, and automobiles. These rivalry-intense industries, dominated by a few large firms, employ competitive strategies directly related to the similarity of their products. Entering and exiting the industry is sufficiently expensive that a firms threat to enter or leave the industry must be credible. Rival firm competition may manifest in the form of price, output or product features. Advertising may be aggressively used as a common strategic tool to gain market share, especially where similar competing products or services show observable differences. Rival firms can also compete on the basis of price or output in a context not unlike a game.
In the strategic pricing table above, two airlines each face two route-pricing options that determine possible profit payoffs from independent choices made by each firm. The payoffs for each set of choices are shown in the respective cells as [Northwest/Southwest]. Suppose each firm must decide if and when to change their own pricing structure with the end of the travel season near. What choice should each airline make and why? Notice how both airlines could benefit by maintaining their current high prices. But the reward for low pricing to gain market share, if the rival does not also price low, is very appealing to airlines operating on thin profit margins. Should both airlines choose to price low, they each suffer a loss by splitting the market with lower fares. This is an example of a famous economic game know as the prisoners dilemma where actions that might benefit each separately injure both if undertaken jointly. Southwest must consider its best response to either action by Northwest. If Northwest prices high, Southwest earns more by pricing low. If Northwest prices low, Southwest still earns more by pricing low. Likewise, no matter what Southwest does, Northwest also is better off choosing to price low. The result of this game is that both airlines, playing strategically, will price lowunless they can successfully collude to keep prices high with neither cheating to earn more profit in the short run. This type of collusion is a violation of federal law, with serious penalties for the colluding if firms.
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Characteristic
Price setting power Product similarity Price to opportunity cost Excess capacity Advertising Market entry cost Information access
Pure Competition
None Identical Equal & Ideal None None Zero Total
Monopolistic Competition
Little Similar/Identical Price above Some Much Modest Modest
Oligopoly
Some Similar/ Identical Price above Some Much High Limited
Monopoly
Much N/A Price far above Much Little Great Limited
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Government Provision of Public Goods Consider the voluntary provision of national defense. National defense is a public good because individuals cannot be excluded from consuming it and consumption of national defense by one individual does not reduce the amount available to others. Caring people may contribute funds to national defense, but persons self-interested in maximizing their wealth have an incentive to ride free, letting others pay for the service while they also receive the benefits. Because of the incentive to ride-free and the inability to exclude non-payers, national defense would be under-provided if left to the private sector. So government uses tax revenue to fund national defense for the benefit of society. Government Regulation of Monopoly Lets consider a water company, which has characteristics of natural monopoly whereby the larger it gets the lower the cost of its output. Also, potential competitors are not eager to build a second network of pipes for a chance to compete, a barrier to market entry. Sufficient water means that its consumption is nonrival. An unregulated profit-maximizing monopolist would restrict quantity to charge higher prices, resulting in an inefficient level of water provision and economic losses. But if government owned the water supply, it can behave in a social-enhancing way rather than a profit-maximizing way and sell the water at cost. Or, if the water supply were privately owned, the government could regulate the price charged. Government Regulation of Common Resources The Tragedy of the Commons occurs when individuals, acting in their own self-interest, exhaust a common resource even though it was in no ones long-term interest to do so. Consider a public fishery, where the fish population doubles each year until it reaches a level that the ecology can support. Because users cannot be excluded from fishing, and the fish are a rival good (the fish one person catches is a fish another person cannot catch), the incentive is to catch as many fish as possible before others do so. One solution is to privatize the resource. In the case of fisheries, government might restrict the size of the catch or length of time catching is allowed (through fishing season definitions) to avoid depleting the resource, or it can tax the catch or act of fishing to reduce the benefits of fishing and the quantity caught.
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Private Goods with External Effects Private markets trading private goods often do achieve a socially optimal solution, without government intervention. So under what circumstances should government intervene in markets for private goods?
Production: Negative
Consumption: Negative
Private goods, when produced or when consumed, may unintentionally impose benefits or costs on a party that is neither the purchaser nor the producer. In short, externalities affect someone external to the transaction. For example, if Mary buys a pack of cigarettes from a machine in a restaurant and smokes it, the smoke is a negative externality imposed on other diners. Or, if Robert pays landscapers to plant a beautiful garden in his front lawn, the garden is a positive externality enjoyed by his neighbors. A now famous proposition put forth by Ronald Coase at the University of Chicago, says that if property rights are clearly defined, the transactions costs of bargaining are zero, and the affected parties are willing to bargain, efficient market-based resolutions can be achieved when the parties negotiate compensation or agreed upon restrictions. The Coase Theoremstates that if private parties can bargain without cost about how to allocate resources, then they can resolve the externality problem on their own. Property rightslimits on the use of private property, goods and services that help define the limits of social behavior. Transactions coststhe costs of negotiating a transaction with all relevant parties.
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The table above highlights the dilemma of equitably trading-off tax dollars by count of dollars versus tax dollars as a percent of income. Horizontal equity, while a seemingly good idea, is difficult to apply in practice. What criteria should determine the similarity between individuals or households? Does the act of imposing the criteria not bear upon the personal choice of lifestyle and expenditure pattern? For example, one simple approach is to apply the same tax rate to families with the same income level. But that single criterion presupposes that other dimensions such as family size, family member age, and the cost of supporting a chosen lifestyle are somehow similar. Vertical equity, too, suffers critical vagaries in the attempt to equitably apply it. While the objective is to tax less those with smaller incomes and to tax more those with larger incomes, what should the rate be for each income level and how fast should the tax rate rise as income rises? During Ronald Reagans presidency in the 1980s the marginal income tax ratethe rate applied to the last dollar of taxable earningswas reduced from a maximum of 70 percent on the highest income levels to 28 percent. Was vertical equity served? The answer is not immediately obvious. Tax Incidence and Efficiency Economists also are concerned about who ultimately pays a given taxthe incidence of the taxand how much a tax distorts the allocation of goods in the market placethe efficiency of the tax. Most people, to the extent legally possible, try to avoid paying more taxes than necessary. Business owners, to the extent allowed by the market, try to pass taxes on to their customers. This avoidance tendency illustrates the power of taxes to altereven distortthe allocation of resources in the market place. Two things are almost certain to occur in the market when a new tax is applied. First, the quantity sold of the taxed good or service will fall. A second, and not at all obvious, effect is that both the buyer and the seller share in paying the tax. The proportion of the tax paid by each party in the transaction depends on the markets competitiveness. The more competitive the market, the more the seller bears the burden of the tax. The less competitive the market, the more the buyer bears the tax burden. While it may sound strange to speak about an efficient tax, economists would favor the tax that least distorted the allocation of goodsthat is, was more efficient. To a person of limited means, a proposal to heavily tax luxury goods like yachts and fur coats might seem appropriate. Yet wealthy individuals can simply avoid such taxes by purchasing different luxury items, and they do. The
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A handy formula permits reasonably good estimates on the number of years it takes a single amount to double at a given compound interest rate. The Rule of 70 says to divide the compound interest rate an amount will earn each year into the number 70, for a good estimate for the number of years it will take to double the initial amount. The rule provides pretty accurate estimates for whole interest rates between 2 and 20. Notice that if the earnings on the initial $100 were 10% compounded annually, the $100 doubles almost 6 times over the 40-year periodto equal $4,526!
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Smart Investing in Any Market Most people would like to be financially independent. A sizeable percentage of Americans have achieved that goal. The fundamental ideas to be dealt with are the value of time and risk, due to an uncertain future. So the basic question becomes what proportion of current income needs to be saved, given an accumulation goal to meet future needs, lifestyle and contingencies? And how should those proportions be invested? Risk is the term economists use to describe the consequences of an uncertain outcome. Placing a portion of income into just a regular savings account likely is not sufficient. An investor also must recognize that higher expected rates of return mean greater levels of riskvariations in the portfolios value. A good investment plan has four key aspects: 1) the financial wealth goal, 2) the accumulation amount, 3) the year to achieve the financial goal, and 4) the level of risk, which is the level of uncertainty regarding the final value. The task is to determine the mix for various investments that on average honor the risk tolerance while heading toward the established goal.
Sample information in the table above reflects an overall moderate risk level, where the greater proportion of investments is in lower risk opportunities. The expected return represents the best guess, often the historical average, of what those types of assets will return in the future. By shifting the proportions among the components, for example, by moving savings into corporate stocks, higher overall risk levels are possible. Typically, higher expected returns come with greater risk, because as discussed before, borrowers must compensate lenders for that increased risk. Working with a qualified investment counselor can help determine the optimal allocation for any persons life situation. Placing the funds into chosen investment vehicles also requires a decision about who will manage the fund(s). The two choices are to directly place the funds yourself or hire an investment service for a fee. The fees vary widely and are a significant cost annually levied against your fund(s). High quality, low fee investment portfolios do exist. Realigning portfolio allocations at retirement can be complicated due to tax laws and usually requires professional advice.
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Insurance as Risk Coverage Insurance is the rare product people purchase hoping not to use it. Yet fear due to uncertainty coerces most people to purchase some form(s) of insurance. What consumers are buying when they purchase insurance is a reduction of risk. More specifically, the insurance company is being paid to take on risk on the consumers behalf. This is economically efficient, because insurance companies, using the law of large numbers, diversify policy holders across a wide range of locations and policy types and are unlikely to be financially crippled. The insurance concept works by pooling risks among a group of policyholders so the expected losses are estimable. If these loss estimates are correct, then a policy premium plus overhead expenses can be determined and charged to each policyholder to cover them. In the case of life insurance, the cynical view is that the policy holder is betting they die before the policy expires and the insurance company is betting the insured lives is not accurate. Insurance is a means to protect an individual or single business against catastrophic economic loss of unknown size and date, for a known price. The vexing question for customers is how much and what type insurance to purchase? The three main categories of insurance are life, health and property. All insurance carries inherent aspects and risks Independent risk-the value of one risk gives no information about the value of any other risk For example, a fire downtown does not influence a fire in the suburbs Premium-cost of the policy per year, the expected dollar amount of the groups losses plus a margin for expenses and profit spread over all policy holders Face value-the amount of insurance paid in the event of a specific named loss Adverse Selection-situation where those more in need of insurance seek insurance coverage Moral Hazard-a reduction in an insureds level of care to avoid or minimize losses Life insurance should be considered when others depend on the insured for economic well-being. Loss of income from the bread winner would place most families in financial peril. Two related questions are the type of life insurance to acquire and the payoff amounts. Whole life insurance charges relatively high premiums to cover the cost of insurance but provides an accumulation value in the policy. Premiums continue as long as the policy is in force or until the accumulated balance is large enough to generate the premiums. Term life insurance is purchased for a named time-period, usually no longer than 20 years. The premiums are smaller than for whole life because they cover only the expected payoff and do not accumulate value. At the end of the specified term, insurance coverage ceases, with no residual policy value. The insured gets more insurance coverage for the premium dollar than with a whole life policy. Which insurance type to purchase depends on personal needs and goals. The question of how much insurance face value to carry must balance after-death economic needs with the ability to meet premium payments. The range can run from sufficient funds to cover burial costs to supporting a spouse and children until the youngest child reaches the age of majority.
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Source: www.IRS.gov First CarSo Many Options Nothing represents freedom to an American teenager so much as their first car. As a virtual right-of-passage, and whether its a shiny new one or a dented used one, it places nearly unlimited mobility and opportunity into the hands of its youthful driver. As with all material fascinations, this one too has an anchor in hard reality. The thing just costs a lot of money. To give our teen a taste of adult responsibility, most parents want their driving child to help support the 4-wheeled chariot. Some insist their child bear the total financial cost of car ownership. The table on the next page divides representative monthly automobile expenses into two categories; fixed and variable. The example assumes the car, a used 2006 Honda Civic, is financed for 4 years.
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Even if we suppose that our driving teens parents are financially able and willing to cover the fixed expenses of owning the vehicle, variable expenses still total $190 monthly. If our teen is the same one from the example above who nets $437.64 per month ($109.41 per week X 4) from their 20-hour per week minimum wage job, they have just under half ($247.64) left for dating and personal purchases. If the parents insisted their teen pay for the car insurance, spendable monthly earnings would be $122.64. Not many expensive dates possible there. The Economics of Attending College The strong and positive relationship between education and earnings is hard to over-state. The national data in the table on the next page are compelling. Completing four years of college opens doors to opportunities not available through any other social institution. National studies using sound methodologies confirm that investing in ones own human capital may offer the greatest long-term benefits of any personal investment. Education also returns dividends to society in the form of economic growth. That is one economic reason why the federal government offers direct loans and grants to willing and qualified candidates to complete their college education. Even with tuition costs rising, the rate of return on training and educational investment is high.
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Source: www.Census.gov. *2009 inflation-adjusted values Credit Cards High Cost There is an almost irresistible allure to reach into our expected future income and use some of it for current purchases. Hard reality also attends the act. First, the borrower will have to pay for the privilege in the form of interest, often at an unconscionably high rate. Second, the borrower is contractually committed to pay back the principal and the interest from expected future income, whether or not expectations about the future incomes size come true. Credit CardA short-term loan agreement that enables holders to enjoy goods and services today by borrowing against tomorrows income for a fee called interest. When should a consumer borrow money? The best response is when current income is insufficient to cover an unexpected expense and there is room in expected future income to repay the loan with interest. If living expenses exceed income every month, credit card coverage for the difference is a very poor choice, serving only to postpone an inevitable and bad end. Monthly expenses must somehow be reduced or monthly income enhanced. Ultimately, using credit cards, or any borrowing instrument, in this fashion only adds misery to an already serious personal financial situation. The credit-seeking customer should shop for credit lending rates, just as they would shop the price of any economic good. Cardissuing companies set rates according to each customers credit profile: lower rates for good paying customers and higher rates for customers with a poor history. Commercial credit counseling firms offer services to those needing advice.
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Costs of Credit Card Use and Misuse Categories Option 1 Option 2 Option 3 Beginning Balance $1,000 $1,000 $1,000
Monthly Payment Balance $100 Minimum
$0 1
$74.10 11
$700 260
The table above illustrates three options to manage credit card debt. Option 1 pays off the entire balance due monthly. It is possible to accomplish this by first limiting credit purchases, then using part of the following months income to pay the entire balance. Most card issuing companies now assesses the monthly annual percentage rate (APR) on the average daily balance (ADB) from the date of purchase. So some interest charge is unavoidable. Options 2 and 3 assume an initial $1,000 purchase, a 15% APR (15%/12 = 1.25% per month) and a minimum monthly payment equal to 3% of the average daily balance (ADB). Option 2 for managing credit purchases assumes the cardholder pays $100 monthly toward the entire balance, and makes no additional purchases on credit ever. Option 3 assumes the cardholder pays only the minimum balance printed on the monthly statement, and makes no additional credit purchases-ever. All options show results as of the year the card balance is zero or very close to zero. Option 2 illustrates the benefit from limiting credit card use and for making payments larger than the issuer-prescribed monthly minimum. Total interest paid equals $74.10 on the $1,000 purchase and the balance is paid off in 11 months. Option 3 vividly demonstrates how the credit balance is almost never extinguished if the cardholder pays only the companyprescribed minimum amount each month. How can this be? Customer payments on the credit card balance apply first to the monthly interest due, only the remainder goes toward the principal balance. The monthly interest charge is about one-third of the small minimum monthly payment of $30.00. So, the principal balance shrinks but by only $17.50 per month at first then falls very slowly over time as the balance is reduced. Imagine how quickly our minimum balance-paying customer would sink financially if they continued to add new purchases each month while pursuing this minimum payment habit. Is this legal? Yes. Is it fair? Economics alone cannot answer that, but most certainly it can be ruinous to those unaware of the facts and the consequences. First CareerLooking at the Long Run The annual expenditure profile in the table on the next page is based on an average household income before taxes of $62,857 per year. Notice that housing consumes just over a third of all expenditures. Transportation costsprimarily a personal automobile and related expensesaccount for 15 percent of total expenditures. Then food absorbs almost 13 percent. Taken together, basic needs; living space, mobility and food account for just under two-thirds of average total expenditures. In a modern society, these expense categories are difficult to reduce beyond some livable level.
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A typical US workers career income path shows income rising as a trend through their late 40s to mid-50s. Thereafter income tends to level off or even fall slightly through age 65. In the early career years there is much pressure to spend on family needs. Setting ones sights on a distant retirement date is hard to do during the child-rearing years. Yet, the benefits of following a consistent personal savings program are economically profound. Contemporary job market studies indicate that the average worker will change jobs at least five times in a career and the rate of job turnover is rising. Coping with change of that magnitude requires sticking to a personal wealth accumulation plan. The secret law of financial success is to pay ones self first. No matter what, set aside a certain amount of current monthly income in an interestbearing account and do not touch it until retirement. Take advantage of special programs such as 401(k)s, where employers match contributions you make up to a certain amount, essentially giving you free money for saving. Other options such as IRA (Individual Retirement Accounts) allow you to invest income without paying taxes on it, reducing the cost of saving (e.g. if your tax bracket was 25%, you could take $300 in net pay now, or invest $400 in your retirement account). First Home or Last HomeRent or Buy? A home remains the largest single investment most people make. The Internal Revenue Service permits homeowners to deduct from taxable income the interest payments annually made to their mortgage company. This deduction provides a large financial inducement for homeownership. It also helps support one of the largest sub-industry construction sectorsnew home buildingin the US economy.
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Those who choose to buy a home, most often are young married couplesstarter homes, couples with childrenmore established homes, empty nesters and early retireesboth to smaller residences. Each purchase typically is financed through a mortgage company at the agreed upon sales price less down payment, at the current mortgage lending rate for either 15 or 30 years. A consumers past actions follow them in the financial world. Creditworthy customers get the lowest mortgage interest rates. Customers, whose credit history reflects payment problems or prior defaults, pay a higher rate to compensate for additional lender risk. The lender profiles all loan applicants based on certain criteria to determine their financial risk. Traditionally the three Cs of credit: characterpersonal financial history, capacityfinancial ability to repay the obligation and capitalcollateral value, are used to determine the worthiness of a prospective loan customer. Refer to the table above and suppose a young married couple has just agreed to purchase a $140,000 home for 30 years at 5 percent. Further suppose the couple paid 1 point plus closing costs to process the loan package. A point equals 1 percent of the loan amount and reduces the interest rate to be paid on the loan, thereby lowering the monthly interest cost on the loan. Buying points for cash may or may not make good economic sense. Analysis is required to see if the value of the monthly payment reduction is worth the upfront cash cost of a point. Closing costs are bundled fees for processing, a title search and for closing on the mortgage loan. Minimum down payment for a home purchase is commonly 10 percent of the agreed upon price. If the buyers make a down payment of 20 percent or more, then mortgage insurancea policy to protect the lender, not the purchaser, is not required. For the home in the table, the monthly payment is $663.30 for principal plus interest, only. The Annual Percentage Rate (APR) is slightly greater than 5 percent because the point costs and closing costs affect the effective rate. To the monthly payment can be added hazard (homeowners) insurance and, often, local taxes on a pro rata monthly basis, paid through the mortgage company as a service. For
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In Sum Think about your future before you act rashly today. Your income is based on your ability and education. Your financial ability to have a full life begins with a plan for the future. Control monthly expenses; keep the fixed costs of home and auto as low as possible. If possible, attend college and earn a degree, at least a certification. Loans and scholarships are available. The labor market likely will reward you. Prudently use credit cards, if at all. If you must, then strictly limit their use. Pay as much as possible toward the balance each month. Never be content paying only the company prescribed minimum balance. Investigate large and non-routine purchases to make sure your income expectations likely will be met, before buying. Have a regular savings plan that earns compound interest. Let it grow without interruption. Follow an investment plan. Diversify your investments. Spread your investment dollars across independent assets to achieve a return that will meet your objective within your risk tolerance. Buying versus renting a home has lifestyle and economic motivations. Total price per square foot can be a useful guide. o The tax deduction for mortgage interest is the largest single financial incentive for buying a home. o A good credit history qualifies one for the lowest current market interest rate. Retirement needs to be prepared for. o Estimate expected income, medical coverage costs and keep fixed living expenses as low as possible. o Consider bartering for services instead of making outright purchases Make legal and economic preparations for lifes final turn.
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$14,119.0
Income Earned by Factor Resources = GDP GDP = Expenditures on Goods & Services
$14,119.0
Businesses produce and sell goods and services to households Households Purchase Goods and Service from Businesses $ Source: www.bea.gov; *Billions of US Dollars
To interpret the economic circular flows in the table above, the upper brown clockwise arrow represents the physical flow of labor and other inputs from households to businesses. The lower brown clockwise arrow represents the goods and services produced by business using the factor inputs. The upper green counter clockwise arrow is the dollar income earned by households for supplying factor inputs (wages, interest and rent). The lower green counter clockwise arrow represents dollar expenditures for goods and services purchased from businesses by households.
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The Supply View of GDP From Factor Income to Household Consumption Factor Income (F = $11,114.4 billion) is the total National Income paid by business for using all economic resources (land, labor, capital, entrepreneurship) as a cost of production. Factor costs to businesses are income payments to households. Households use their income, after paying income (direct) taxes, to consume or to save. From Depreciation to Business Investment Depreciation (D = $1,861.1 billion) accounts for the depletion of productive assets during the year. These are real costs in the sense that productive assets have limited useful lives and must be replaced when worn out. From Direct and Indirect Taxes to Government Purchases Indirect business taxes (T = $1,024.7 billion) are taxes levied on productive business enterprises and are a cost of doing business. Indirect business taxes transfer income from businesses to the government so it can make purchases. Direct taxes are levied directly against an individuals income. Income taxes are a good example. Direct taxes are not a cost of doing business. These taxes, a percentage of each individuals personal income, generate flows moving directly from the income earner to the government so it can make purchases. The Demand (Expenditure) View of GDP Total economic activity (GDP = $14,119.0 billion) from the supply view must equal the sum of goods purchased by the four demandside sectors. The largest demand-side sector, household consumption (C = $10,001.3 billion), measures purchases by the households from the factor income paid to them, and accounts for nearly seventy percent of total demand for GDP. Next, government purchases of goods and services (G = $2,914.9 billion) provide public goods, market regulation, common resource oversight and other public functions to account for 18 percent of GDP.
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Business cycle phases Expansionrising GDP and employment Recessionfalling GDP and rising unemployment Depressionsignificantly falling GDP and rising unemployment Recoveryrising GDP and employment after a recession Separating time into two distinct periods helps. In the long run, a period of several years, an economy will tend to settle into what economists define as its natural rate of unemploymentthe rate around which unemployment fluctuates in a healthy economy. In this long period, changes in total economic demand affect only prices, not output, because the economy is producing along its natural growth path, about 3.5% annually for GDP in the US. In the short run, a period of one to three years, much can change, and suddenly, from either the demand side or the supply side of the economy. When one sector of the economy shifts, the resulting chain of events can be described but not easily predicted in time sequence, since the underlying economic responses at work stem from all too human group behavior. Even for the 2008-2010 recessionary cycle the pace and character of economic recovery were difficult to predict and to manage.
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In Sum Gross Domestic Product (GDP) is the current dollar value of all final goods and services produced within a country in one year; and serves as the official measure of a nations economic activity. o GDP measurement ignores: population growth, technology changes, investment above replacement and variances in industry market structure. o GDP is a rather narrow measure that ignores: product quality changes, household production, used good sales, inkind transactions and illegal transactions. The two views of GDP allow economists to measure and assess activity by the income earned by factors of production (supply) and the product purchased by economic sectors (demand). o Supply view measures factor income in the form of rent, wages, interest and profit plus capital depreciation and indirect business taxes, the sum of which equals GDP. o Demand view measures household consumption, government purchases, business investments and net exports, the sum of which equals GDP. Demand = C + I + G + NE = F + T + D = Supply, is the basic macroeconomic relationship. In words, the total dollar value of goods supplied in the economy in one year equals the total amount of those goods demanded by the sum of household consumption, business investment, government purchases and net exports. Law of diminishing marginal returnsgiven fixed amounts of land and capital, as the quantity of labor input increases, total output increases but at an eventually diminishing rate. Standard of livingA societys economic standard of living is measured by dividing total production for a year by total population Productivity measures and determinants of economic growth o Quantity and quality of the labor force o Quantity and quality of capital equipment o Level of work force education o Technology Business cyclefluctuations in economic activity caused by changes in business conditions affect income, production, employment, prices and interest rate o Expansion rising GDP and employment o Recession falling GDP and rising Unemployment o Depression significantly falling GDP and rising Unemployment o Recovery rising GDP and employment after a recession
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In the chart above, you can see the two components of the increased unemployment from a higher minimum wage rate. Those jobs where the value of work lies below the new minimum wage will be laid offthe demand-side market response. The markets supplyside reveals formerly discouraged job seekers, enticed by the new higher minimum wage, trying to re-join the labor force but unable to find work. Workers in minimum wage positions who manage to keep their jobs do get higher pay. Though the higher minimum wage may or may not sustain a life style above the government defined poverty level. Persons unemployed due to the new minimum wage have
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Source: www.BLS.gov
The US Bureau of Labor Statistics is charged with the task of measuring inflation. Among several related measures is the popular consumer price index (CPI). The BLS also tracks other price indexes like the producer price index, the wholesale price index and the GDP deflator, the broadest of the inflation measures. Consumer Price Index (CPI)a measure of the average change in prices over time, paid by urban consumers for a market basket of goods and services. The idea behind the CPI is to measure consistently the price of representative consumer purchases in a particular year compared to prices for the same items prevailing in a base year. The CPI market basket contains 200 goods and services in 8 major groups. From the table above, in 2009, average consumer prices were 117.2% higher than in 1982-1984. As a consequence, to have the same purchasing power in 2009 as in 1982-1984, your income would need to more than double over that same period. Between 2009 and 2010, average consumer prices rose less than one-half of one percent (see table above). The base year choice for a given price index series is arbitrary and does not alter the results.
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Source: www.BEA.gov The CPI adjusts for prices in a consumers market basket of goods. A different index (see the table above), the GDP Deflator is used to adjust prices for all goods and services produced. A base year, currently 2005, is selected and subsequent years GDP output is valued using the 2005 base year prices. Using that technique allows the government to measure real GDPactual goods and services produced, without the effect of price changes. Inspect the GDP Deflator column in the table to see that 2010 4th quarter prices are 11.1% greater than in the 2005 base period. To adjust the 2010Q4 current dollar value GDP figure (where both output and prices have changed from 2005) divide the 2010Q4 deflator value into the current GDP of $14,870.4 to get $13,382.6 billion in real GDP. Hence, between 2009 and 2010 fourth quarters, US real GDP grew by $363.6 billion ($13,382.6 minus $13,019.0). Inflations Winners and Losers While it is easy to typecast inflation as evil, in moderationabout 2 or 3 percent per yearit has beneficial economic effects. Entrepreneurs like modest inflation when they decide to invest, because they expect higher prices for their companys product in the future. Some leading economists credibly claim that moderate expected inflation helps stimulate economic growth. The difficulty with inflation is its drain on purchasing power and wealth among citizens and institutions in the economy. There are recognizable groups who lose and other groups who gain from inflation. Persons on fixed incomes, or whose incomes increase much less rapidly than the inflation rate, lose relative purchasing power through time. Creditors also can fall into the category of inaccurate inflation forecasters. If a bank or mortgage company lends funds at 5 percent per year and the inflation rate over time turns out to be 5 percent annually, the lender will be paid back a fixed quantity of money with the same purchasing power as was loaned. But if future inflation is greater than 5 percent, the lender is paid back in dollars of lesser purchasing power. Taxpayers can also lose during inflationary times in a more subtle way. An inflated personal income level can fall into higher tax bracket, making the tax filer pay more federal tax dollars. Inflations winners appear as debtors who can pay off loans in less valuable dollars, especially if their own incomes are among those keeping pace with the inflation rate. Owners of inflation-sensitive assets often win during inflationary times when they sell the priceinflated asset. Landowners and homeowners may see the value of their homes rise, though their property taxes also may increase.
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In Sum Money is denoted by the government as legal tender and the public validates it by honoring it in transactions. Money fulfills its role as a useful medium of exchange as long as its value does not change rapidly. Inflation cannot manifest in a barter economy because each transaction involves different commodities and different people. Inflation is a rise in the general level of prices over time. Consumer goods inflation is measured by the Consumer Price Index (CPI) as the change in value from a given base year for a market basket of typical goods. The GDP Deflator is used to adjust all of a given years GDP to the prices prevailing in another year. Inflations winners and losers o Winners include debtors, tax collectors, holders of inflating real assets o Losers include creditors, fixed income earners, income tax payers Inflation nearly always owes its origin to prior increases in the money supply. Curing inflation requires systematic and consistent reduction in the money supply, which can cause a recession. Hyper-inflation is particularly damaging because it is very difficult to break and overwhelms economic institutions.
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Money and the Federal Reserve The Fed sits outside the US economy and interacts with the financial system using its monetary tools. To understand how the Fed influences the money supply, we must define what money is. The domestic money supply (officially called M1) is the sum of coins and currency in circulation (including vault cash on hand in commercial banks) in the US plus demand deposits (checking accounts) in US commercial banks. US money supply control rests on the idea of fractional reserves. A small fraction, currently 10 percent of each member commercial banks deposits are held on reserve at the regional Fed bank, outside the economy. The remaining 90% of demand deposits are available for loans to qualified borrowers or for investment. These reserves are not imposed to protect customer accounts. That is the job of the Federal Deposit Insurance Corporation (FDIC). The reserve requirement is an instrument of monetary control that limits the maximum volume of money growth in the economy. Federal Reserve district banks monitor the commercial banks in their district, which must balance their accounts daily. On Wednesday morning every other week, commercial member banks must comply with the reserve requirement based on deposits resident in their own bank. So how does this process limit the money supply? The Money Multiplier The composition of the nations money supply divides evenly between cash in circulation and checkable accounts that serve as money (M1). The reason that demand deposits are part of the money supply is that they perform much the same functions as cash. It may seem strange, but the volume of money stock supports several times its volume in US gross domestic product flow over a years time. The money supply is spent several times over to accomplish the feat. Commercial banks, Fed policy and the non-bank public impersonally collaborate to grow or shrink the money supply. Money is created in the act of borrowing from a commercial bank and destroyed in the act of repaying the loan. If a customer enters a bank and comes out with a loan, the bank honors the agreement by creating a line of credit in the borrowers name. As the newly loaned funds are spent they become deposited into other banks as cashnew money by definition. Perhaps equally surprising, the money supply is reduced when loans are repaid. The check that clears through the system to extinguish the loan debt also reduces the borrowers checking account (money by definition, or cash holdings) by the same amount. The interesting economic aspect of these actions is that the money supply available at any one time depends on both Fed monetary policies and the borrowing behavior of citizens and businesses. To more fully appreciate this process, consider that the Fed literally sits outside the US financial system and works to accommodate the economys money stock needs, in line with established goals like keeping inflation and unemployment low. The Fed is not
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Monetary Tools of the Fed Reserve Requirements-The percentage of demand deposits commercial banks must hold as reserves.
The Federal Reserve Systems charter provided for three major monetary tools, and several lesser tools. We have already mentioned its most powerful, and least often utilized, toolreserve requirements. It is powerful because it affects all banks in the system and because even small changes in the reserve requirement percentage can bring about large changes in the money supplys upper limit. Open Market Operations-Buying and selling existing US government financial instruments from or to willing customers (individuals, businesses and banks) in the economy.
The Feds most often used tool is open market operations. The Fed has the financial authority to buy and sell prior-issued US government bonds. These bonds originated from the Treasury as debt instruments to finance congressionally-approved increases in the federal debt. Investors willingly purchase or sell the instruments, as part of their financial portfolios, even though their interest yields are low, because they are very safe.
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The Fed does not control the general level of interest rates in the economy. At most, it influences the money supply to nudge interest rates in the desired direction. The Fed sets only one interest ratethe discount rate charged member banks for borrowing from the Fed, when a bank comes up short on the bi-weekly reserve requirement. That rate is called the discount rate because, unlike common loans where the interest due is included in regular payments with the principal, the Fed collects the interest immediately from the amount borrowed. The member bank borrower repays the full amount of the loan typically within 12 to 72 hours. Member banks actually have two sources from which they can borrow to cover a required reserve deficit. First, they can borrow the excess reserves (named Fed Funds) from other member banks in the system and pay the interest rate determined in that sub-market. That interest rate is established by the amount of excess reserves available versus the amount of deficit reserves demanded in the banking system. Second, the deficit bank can borrow directly from the Fed. The choice is simple, the banks with the reserve shortfall borrow from whichever sourcesystem banks or the Fedoffers the lower interest rate. The Feds responsibility is to accommodate financial needs and maintain market stability. In normal times, Fed changes in the discount rate are interpreted as signals of the Feds view of the economy and its future. A decrease in the discount rate might signal a looser money supply, lower interest rates or possible future inflation. An increase in the discount rate could signal a tightening of the money supply and higher interest rates and reduce private market investment.
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In Sum Commercial banks are financial intermediaries in business to make a profit loaning and investing depositors funds. The Fed regulates commercial banks and controls the money supply toward the goals of low inflation, full employment and stable interest rates. Money supply (M1) equals the sum of coins and currency in circulation plus commercial bank demand deposits. The money multiplier is based on the fractional reserve requirement for commercial banks. o Reserve requirements are now 10% of demand deposits, leaving as much as 90% available for loans and investments o The money multiplier is limited by the Feds reserve requirement percentage and the publics demand to borrow Money is created in the act of borrowing and destroyed by loan repayment. The Feds primary obligation is to regulate the economys monetary sector to achieve the goals of low inflation, stable interest rates and full employment. o The Fed operates from outside the monetary sector and works to maintain an adequate supply of money in the economy o The Feds objective is not to profit from any of its policy moves or operational transactions. The Feds main tools for controlling the money supply are: o Reserve requirements10% of demand deposits on reserve o Open market operationsthe Feds buying (to increase the money supply) and selling (to decrease the money supply) prior issued US government bonds in financial markets o Discount ratethe interest rate the Fed charges member banks for borrowing to maintain the reserve requirement
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Mainstream macro economists accept that the Classical economists view of two centuries on how the economy works is correct in the long run. Inspect the graph below to see what that means, in terms of aggregate demand (the down sloping green curve) and aggregate supply (the curved upward red curve). In the long runperhaps several yearsthe economy tends to adjust into equilibrium at or near full employmentthe vertical dark line in the graph. That happens because the production of real GDP ultimately depends on the supply of labor, capital and natural resources. Once at full employment and equilibrium, the price level then depends only on the volume of money in the systemand the central bank can influence the growth of the money supply to maintain price stability. Aggregate demand [AD]a down sloping line that shows the quantity of GDP demanded [the sum of household consumption (C), business investment (I), government spending (G) and foreign customers (NE = Net Exports)] purchased at each price level. Aggregate Supply [AS]an up sloping line that shows the quantity of goods and services businesses choose to produce and sell at each price level. In symbols: Aggregate Supply is a function of Labor, Capital, Land and Technology. The economys real economic variablesproduction and employment (human activity and goods production)are most important. The nominal economic variablesthose measured in money or percentage terms: prices, wages and interest rates,
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For the Fed to achieve its stated targets without making other economic measures worse they must accurately read both the current condition and mood of the economy. The Fed must then correctly anticipate how each major economic sector is likely to respond to their monetary policy change. For example, should the Fed pursue a policy of stabilizing interest rates or stabilizing growth in the money supply, M1cash and demand deposits? If the Fed attempts to keep interest rates low by increasing banks excess reserves and expanding the money supply, short-term interest rates will fall. But over time, interest rates and prices could rise if there is more money than the economy needs to purchase current production. The inflation arises because people want to hold only so much money, so they shed any excess money balances by purchasing other goods or making investments. While one person can lower his or her money holdings, all people in the economy cannot do so without consequences. So, general prices rise from excess dollars chasing too few goods. Banks enter the picture again as they try to preserve the purchasing power of future loan payments by bumping up their loan rates as protection against future inflation. With interest rates now starting to rise, the Fed finds itself having to increase the money supply again to temporarily lower interest rates. This sequence of actions is the beginning of a monetary policy-induced inflationary spiral. So what is the best proscription for the Fed regarding monetary policy? Perhaps to match the growth of the money supply to the long run real growth rate of the US economyabout 3.5% per year. If the Fed were able to control the money supply that closely, at least some relative sense of stability could be achieved. Yet steadfast reliance on this policy can be criticized from two positions. First, it tends to inhibit economic growth above 3.5% per year. Second, it ignores the economys liquidity needs during unexpected economic downturns.
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Fiscal Policy Tools Fiscal policy influences aggregate demand through Congressional legislation that alters federal spending and tax rates to achieve macroeconomic goals. Americas discretionary fiscal policy debut occurred during the Great Depression. Prior to that time, incurring federal debt was unthinkable for a capitalist-based economy and politically supported only as a last resort to finance foreign wars. There are legitimate economic and political reasons why the public should pay for social assets like highways, public education and national defense. As long as tax revenues are raised in a relatively equitable fashion and do not outstrip government expenditures, citizens usually raise little protest. Fiscal policyactions altering federal spending levels via Congressional policy on government programs and taxation.
The role of government as business cycle steward raises more difficult questions. How much federal government presence in the market is desirable and necessary to stabilize the economy? Does active government spending during times of rapid growth or decline do more good than harm on balance? Fiscal policy management is an inherently political process. Federal legislation to alter spending or taxes is subject to the voting and procedural rules of every congressional bill. The new policy must be crafted, debated, voted on and signed into law. No matter the urgency of the economic need, partisanship is part of the process. Once the legislation is signed into law it may take some time to implement, then more time to have its desired effect. By that point, the economy may have already healed or may be too ill for the legislated remedy to cure the problem. While the US track record on fiscal remedies achieving desired targets is mixed, the logically anticipated effects of fiscal policies on the economy are mechanically direct. National Debt and Fiscal Policy When the federal government spends more than it receives in tax collections, it borrows the difference from society. To authorize the bond sale, Congress must pass legislation approving an increase in the statutory federal debt ceiling. Then, on instructions from Congress, the Treasury prepares new financial instrumentsUS Government Bondsand offers them for sale in domestic financial
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In Sum The demand to hold money as a liquid asset has direct bearing on the effectiveness of government economic policies. Monetary policy aims to influence aggregate demand using Federal Reserve System tools to alter bank reserves and the money supply to achieve desired macroeconomic goals o Raising the Fed discount rate discourages member bank borrowing while discount rate decreases encourage borrowing o The Fed raising member bank reserve requirements discourages borrowing and reductions encourage borrowing o The Fed buying US government bonds encourages borrowing and selling them discourages borrowing Fiscal policy aims to influence aggregate demand using Congressional processes to alter government and private sector spending, then via tax rates and deficit spending, toward desired economic goals. o Lowering tax rates encourages private sector spending, raising taxes reduces private sector spending o Increasing government spending encourages economic activity and decreasing government spending reduces economic activity o Decreasing tax rates encourages, but does not guarantee, more private sector spending; increasing tax rates reduces private sector spending. o Increasing (decreasing) transfers and subsidies increases (decreases) spending National Debt increases occur when government spending is greater than government tax revenues Crowding Out occurs when the government deficit finances new spending, then increased demand for money from the governments bond sale increases interest rates and discourages some level of private business investment.
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As between the two, who produces fruit with the least real sacrifice? Francis. Her 4/3 (1 fruit costs 1 1/3 sugar units) is less than Sidneys 2 (1 fruit costs 2 sugar units). So, Francis should specialize in producing fruit. It is also true that Sidney should specialize in producing sugar because her cost is units of fruit while Francis cost is units of fruit. After specialization, they can trade the goods between them, where total output would be greater than before and both goods get produced at a lower opportunity cost than before specialization. Any barrier to free trade erodes the comparative advantage one country may possess, reduces the quantity of goods available and increases their relative cost. There may be political arguments for limiting trade by imposing barriers but there always are economic costs in so doing. Barriers to Free Trade Tariffsa tax on imports or exports makes imported goods more expensive and erodes the opportunity cost advantage from comparative advantage. Quotasa quantity limit on imports or exports reduces the gains of comparative advantage by restricting the amount of a named good that can be traded. Embargostrade prohibition against a good eliminates the possibility of any gains from comparative advantage by preventing trade for the named good.
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Currency Markets and Exchange Rates Trade with other countries also contains a transaction complication that carries a cost. Each country legalizes its own currency for use within its borders. US currency legally circulates domestically but foreign goods sellers want payments made in their own currencys denomination. So for every trade of goods or services between countries, an exchange of currencies also must occur. Countries can only trade, buy and sell goods and services with another country, if they possess a sufficient volume of their trading partners currency. They most easily acquire a stock of international currency by selling goods or services, directly or indirectly, to the country with whom they wish to trade. Without enough of the correctly denominated currency, exchange cannot easily take place between two countries. Dollar Exchange RateHow much of another countrys currency one US dollar will buy.
Reciprocal supply and demand for goods (and, hence, currency supply and demand) between countries largely determine currency exchange rates for international trade. But currencies do not always exchange for price parityequivalent product valuedue to exchange market forces like different national inflation rates, exporter or importer currency price expectations or government intervention that shift currency supply and demand. US Currency appreciationwhen the international currency market requires fewer dollars in exchange for another currency OR the US dollar buys more of another currency, the US dollar has appreciated in value and, simultaneously, the other currency has depreciated in value against the dollar. The other countrys goods become less expensive for US purchasers, increasing US imports and US goods become more expensive to the other countrys purchasers, reducing US exports. US Currency depreciationwhen the international currency market requires more dollars in exchange for another currency OR the same US dollar buys less of another currency, the US dollar has depreciated in value and, simultaneously, the other currency has appreciated in value against the dollar.
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It is an accounting truism that for every current account transaction, there is an equal capital account transaction. One country always pays another through some financial instrument or money transaction. Current account transactions must equal capital account transactions (and are opposite in algebraic sign), including unilateral transfers, gifts and discrepancies. Trade between countries does not stop just because a countrys trade balance is negative. Rather, the deficit country must offer some asset other than goods or services in return. Most commonly financial debt instruments from private companies or from the government are accepted, as long as the borrowers credit is good. The benefits to trade are large, continuing and within the grasp of any country that produces goods or services desired by another countrys citizens. The law of comparative advantage shows that even developing countries may have an opportunity cost advantage in producing some good or goods and can trade them to their benefit.
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In Sum Law of one pricein principle, the exchange rate between currencies should reflect equivalent values for identical tradable goods between the countries. Comparative advantage means that individuals and countries should specialize in producing those goods with the lowest opportunity cost compared to the opportunity costs of potential trading partners. With specialization: o More total goods will be available and at lower cost o The terms of tradethe good-to-good exchange pricebetween parties must fall between their comparative opportunity costs of production or there is no economic basis for trade. Any inhibition to free trade reduces the amount of goods available and raises the cost (price) of those goods o Tariffsa tax on imports o Quotasa limit on physical volume of imports o Embargosa prohibition on imports or exports Currency exchange ratethe value of one countrys currency expressed in units of another countrys currency o Appreciationa countrys currency buys more units of another countrys currency o Depreciationa countrys currency buys fewer units of another countrys currency Balance of paymentsthe means of accounting for all international transactions o Current accountexchanges of goods and services o Capital accountexchanges of real assets or financial assets o Current account transactions = capital account transactions after adjustments for transfers and omissions.
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The Texas Council on Economic Education (TCEE) thanks the Council for Economic Education and the Department of Education Office of Innovation and Improvement for awarding the Replication of Best Practices Program grant that allowed Economics for Educators, Revised Edition to be written and published.
The Texas Council on Economic Education also thanks six of its major partners whose support allows TCEE to provide the staff development that utilizes content and skills provided in Economics for Educators.
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