Chapter 01 The Nature and Method of Economics
Economics Economics is the study of the efficient use of scarce resources in the production of goods and services to achieve the maximum satisfaction of economic wants.
Economic Perspective The economic perspective includes three elements: scarcity and choice, rational behavior, and marginalism. It sees individuals and institutions making rational decisions based on comparisons of marginal costs and marginal benefits.
Citizenship Knowledge of economics contributes to effective citizenship and provides useful insights for politicians, consumers, and workers.
Scientific Method Economists employ the scientific method, in which they form and test hypotheses of cause-and-effect relationships to generate theories, laws, and principles. Economists often combine theories into representations called models.
Generalizations Generalizations stated by economists are called principles, theories, laws, or models. The derivation of these principles
is the object of theoretical economics. Good theories explain real-world relationships and predict real-world outcomes.
Policy Because economic principles are valuable predictors, they are the bases for economic policy, which is designed to identify and solve problems to the greatest extent possible and at the least possible cost. This type of application of economics is called policy economics.
Shared Goals Our society accepts certain shared economic goals, including economic growth, full employment, economic efficiency, price-level stability, economic freedom, equity in the distribution of income, economic security, and a reasonable balance in international trade and finance. Some of these goals are complementary; others entail tradeoffs.
Macroeconomics Macroeconomics looks at the economy as a whole or its major aggregates; microeconomics examines specific economic units or institutions.
Positive versus Normative Positive statements state facts (“what is”); normative statements express value judgments (“what ought to be”).
Pitfalls of Economics In studying economics, we encounter such pitfalls as biases and preconceptions, unfamiliar or confusing terminology, the fallacy of composition, and the difficulty of establishing clear cause-effect relationships.
   
economics  
economic perspective  
utility  
marginal analysis  
scientific method  
theoretical economics  
principles  

generalizations
 
other-things-equal
assumption
 
policy economics  
tradeoffs  
macroeconomics  
aggregate  
microeconomics  
positive economics  
normative economics  
fallacy of composition  
“after this, therefore because of this,” fallacy  
   
Chapter 02 The Economizing Problem
Basic Facts

Economics is grounded on two basic facts: (a) Economic wants are virtually unlimited; (b) economic resources are scarce.

Resources

Economic resources may be classified as property resources— raw materials and capital—or as human resources—labor and entrepreneurial ability. These resources constitute the factors of production.

Scarce Resources Economics is concerned with the problem of using or managing scarce resources to produce the goods and services that satisfy the economic wants of society. Both full employment and the efficient use of available resources are essential to maximize want satisfaction.
Efficiency

Efficient use of resources consists of productive efficiency (producing all output combinations in the least costly way) and allocative efficiency (producing the specific output mix most desired by society).

Opportunity Cost

An economy that is achieving full employment and productive efficiency—one that is operating on its production possibilities curve—must sacrifice the output of some types of goods and services in order to increase the production of others. Because resources are not equally productive in all possible uses, shifting resources from one use to another brings the law of increasing opportunity costs into play. The production of additional units of one product requires the sacrifice of increasing amounts of the other product.

Allocative Efficiency

Allocative efficiency means operating at the optimal point on the production possibilities curve. That point represents the highest-valued mix of goods and is determined by expanding the production of each good until its marginal benefit (MB) equals its marginal cost (MC).

Growth Over time, technological advances and increases in the quantity and quality of resources enable the economy to produce more of all goods and services—that is, to experience economic growth. Society’s choice as to the mix of consumer goods and capital goods in current output is a major determinant of the future location of the production possibilities curve and thus of economic growth.
Economic Systems The market system and the command system are the two broad types of economic systems used to address the economizing problem. In the market system (or capitalism) private individuals own most resources and markets coordinate most economic activity. In the command system (or socialism or communism), government owns most resources and central planners coordinate most economic activity.
Circular Flow Model

The circular flow model locates the product and resource markets and shows the major real and money flows between businesses and households. Businesses are on the buying side of the resource market and the selling side of the product market. Households are on the selling side of the resource market and the buying side of the product market.

   
economizing problem  
economic resources  
land  
capital  
investment  
labor  
entrepreneurial ability  
factors of production  
full employment  
full production  
productive efficiency  
allocative efficiency  
consumer goods  
capital goods  
production possibilities table  
production possibilities curve  
opportunity cost  
law of increasing opportunity costs  
economic growth  
economic system  
market system  
capitalism  
command system  
resource market  
product market  
circular flow model  
   
Chapter 03 An Introduction to Economics and the Economy
   
Market A market is any institution or arrangement that brings together buyers and sellers of a product, service, or resource.
Demand Demand is a schedule or curve representing the willingness of buyers in a specific period to purchase a particular product at each of various prices. The law of demand implies that consumers will buy more of a product at a low price than at a high price. So, other things equal, the relationship between price and quantity demanded is negative or inverse and is graphed as a downsloping curve. Market demand curves are found by adding horizontally the demand curves of the many individual consumers in the market.
Determinants of Demand Changes in one or more of the determinants of demand (consumer tastes, the number of buyers in the market, the money incomes of consumers, the prices of related goods, and price expectations) shift the market demand curve. A shift to the right is an increase in demand; a shift to the left is a decrease in demand. A change in demand is different from a change in the quantity demanded, the latter being a movement from one point to another point on a fixed demand curve because of a change in the product’s price.
Supply Supply is a schedule or curve showing the amounts of a product that producers are willing to offer in the market at each possible price during a specific period. The law of supply states that, other things equal, producers will offer more of a product at a high price than at a low price. Thus, the relationship between price and quantity supplied is positive or direct, and supply is graphed as an upsloping curve. The market supply curve is the horizontal summation of the supply curves of the individual producers of the product.
Determinants of Supply Changes in one or more of the determinants of supply (resource prices, production techniques, taxes or subsidies, the prices of other goods, price expectations, or the number of sellers in the market) shift the supply curve of a product. A shift to the right is an increase in supply; a shift to the left is a decrease in supply. In contrast, a change in the price of the product being considered causes a change in the quantity supplied, which is shown as a movement from one point to another point on a fixed supply curve.
Equilibrium The equilibrium price and quantity are established at the intersection of the supply and demand curves. The interaction of market demand and market supply adjusts the price to the point at which the quantities demanded and supplied are equal. This is the equilibrium price. The corresponding quantity is the equilibrium quantity.
Rationing Function of Prices The ability of market forces to synchronize selling and buying decisions to eliminate potential surpluses and shortages is known as the rationing function of prices.
Changes in d or s => changes in p or q A change in either demand or supply changes the equilibrium price and quantity. Increases in demand raise both equilibrium price and equilibrium quantity; decreases in demand lower both equilibrium price and equilibrium quantity. Increases in supply lower equilibrium price and raise equilibrium quantity; decreases in supply raise equilibrium price and lower equilibrium quantity.
Direction and Relative Magnitudes (Vectors) Simultaneous changes in demand and supply affect equilibrium price and quantity in various ways, depending on their direction and relative magnitudes.
Price Ceiling A price ceiling is a maximum price set by government and is designed to help consumers. A price floor is a minimum price set by government and is designed to aid producers.
Fixed Prices stifle Rainoning Function Legally fixed prices stifle the rationing function of prices and distort the allocation of resources. Effective price ceilings produce persistent product shortages, and if an equitable distribution of the product is sought, government must ration the product to consumers. Price floors lead to persistent product surpluses; the government must either purchase the product or eliminate the surplus by imposing restrictions on production or increasing private demand.  
   
demand schedule  
law of demand In economics, the law of demand is an economic law that states that consumers buy more of a good when its price decreases and less when its price increases.
diminishing marginal utility  
income effect In economics, the income effect is the change in consumption resulting from a change in real income.
substitution effect  
demand curve  
determinants of demand  
normal goods In economics, normal goods are any goods for which demand increases when income increases and falls when income decreases but price remains constant, i.e. with a positive income elasticity of demand. The term does not necessarily refer to the quality of the good.
inferior goods In consumer theory, an inferior good is a good that decreases in demand when consumer income rises, unlike normal goods, for which the opposite is observed.[1] It is a good that consumers demand increases when their income increases. [2] Inferiority, in this sense, is an observable fact relating to affordability rather than a statement about the quality of the good. As a rule, too much of a good thing is easily achieved with such goods, and as more costly substitutes that offer more pleasure or at least variety become available, the use of the inferior goods diminishes.
substitute good  
complementary good  
change in demand  
change in quantity demanded  
supply  
supply schedule  
law of supply In economics, the law of supply is the tendency of suppliers to offer more of a good at a higher price.[1] The relationship between price and quantity supplied is usually a positive relationship. A rise in price is associated with a rise in quantity supplied. As firms produce more output, their total costs rise proportionately faster. The ratio of the change in total costs to the change in quantity is increasing. This ratio defines the firm's marginal cost of production (the additional cost of producing another unit of output). Because marginal costs rise and quantity produced rises, firms need to charge a higher price for each extra unit of output they produce[2].
supply curve  
determinants of supply  
change in supply  
change in quantity supplied  
surplus  
shortage  
equilibrium price  
equilibrium quantity  
rationing function of prices  
price ceiling  
price floor  
   
Chapter 20 Elasticity of Demand and Supply
Price Elasticity of Demand Price elasticity of demand measures consumer response to price changes. If consumers are relatively sensitive to price changes, demand is elastic. If they are relatively unresponsive to price changes, demand is inelastic.
   
Price-elasticity Coefficient: Ed The price-elasticity coefficient Ed measures the degree of elasticity or inelasticity of demand. The coefficient is found by the formula Economists use the averages of prices and quantities under consideration as reference points in determining percentage changes in price and quantity. If Ed is greater than 1, demand is elastic. If Ed is less than 1, demand is inelastic. Unit elasticity is the special case in which Ed equals 1.
  Ed = ( percentage change in quantity demanded of X ) / ( percentage change in price of X )
   
Perfectly inelastic demand Perfectly inelastic demand is graphed as a line parallel to the vertical axis; perfectly elastic demand is shown by a line above and parallel to the horizontal axis.
Elasticity varies on the demand curve Elasticity varies at different price ranges on a demand curve, tending to be elastic in the upper left segment and inelastic in the lower right segment. Elasticity cannot be judged by the steepness or flatness of a demand curve.
Total Revenue

If total revenue changes in the opposite direction from prices, demand is elastic. If price and total revenue change in the same direction, demand is inelastic. Where demand is of unit elasticity, a change in price leaves total revenue unchanged.

Number of available substitutes

The number of available substitutes, the size of an item’s price relative to one’s budget, whether the product is a luxury or a necessity, and length of time to adjust are all determinants of elasticity of demand.

   
Coefficient of Price-elasticity of Supply: Es The elasticity concept also applies to supply. The coefficient of price elasticity of supply is found by the formula The averages of the prices and quantities under consideration are used as reference points for computing percentage changes. Elasticity of supply depends on the ease of shifting resources between alternative uses, which varies directly with the time producers have to adjust to a price change.
  Es = ( percentage change in quantity supplied of X ) / ( percentage change in price of X )
   
Cross elasticity fo demand Cross elasticity of demand indicates how sensitive the purchase of one product is to changes in the price of another product. The coefficient of cross elasticity of demand is found by the formula Positive cross elasticity of demand identifies substitute goods; negative cross elasticity identifies complementary goods.
  Exy = ( percentage change in quantity demanded of X ) / ( percentage change in price of Y )
   
Income elasticity of demand Income elasticity of demand indicates the responsiveness of consumer purchases to a change in income. The coefficient of income elasticity of demand is found by the formula The coefficient is positive for normal goods and negative for inferior goods.    
  Ei = ( percentage change in quantity demanded of X ) / ( percentage change in income )
   
price elasticity of demand  
elastic demand  
inelastic demand  
unit elasticity  
perfectly inelastic demand  
perfectly elastic demand  
total revenue (TR)  
total-revenue test  
price elasticity of supply  
market period  
short run  
long run  
cross elasticity of demand  

income elasticity of demand
 
   
   

 

Chapter 22 The Costs of Production
Economic Costs Economic costs include all payments that must be received by resource owners to ensure a continued supply of needed resources to a particular line of production. Economic costs include explicit costs, which flow to resources owned and supplied by others, and implicit costs, which are payments for the use of self-owned and self-employed resources. One implicit cost is a normal profit to the entrepreneur. Economic profit occurs when total revenue exceeds total cost ( explicit costs  implicit costs, including a normal profit).
Short Run In the short run a firm’s plant capacity is fixed. The firm can use its plant more or less intensively by adding or subtracting units of variable resources, but it does not have sufficient time in the short run to alter plant size.
Law of Diminishing Returnts The law of diminishing returns describes what happens to output as a fixed plant is used more intensively. As successive units of a variable resource, such as labor are added to a fixed plant, beyond some point the marginal product associated with each additional unit of a resource declines.
Variable versus Fixed Because some resources are variable and others are fixed, costs can be classified as variable or fixed in the short run. Fixed costs are independent of the level of output; variable costs vary with output. The total cost of any output is the sum of fixed and variable costs at that output.
Averages and Totals Average fixed, average variable, and average total costs are fixed, variable, and total costs per unit of output. Average fixed cost declines continuously as output increases because a fixed sum is being spread over a larger and larger number of units of production. A graph of average variable cost is U-shaped, reflecting the law of diminishing returns. Average total cost is the sum of average fixed and average variable costs; its graph is also U-shaped.
Marginal Cost Marginal cost is the extra, or additional, cost of producing 1 more unit of output. It is the amount by which total cost and total variable cost change when 1 more or 1 less unit of output is produced. Graphically, the marginal-cost curve intersects the ATC and AVC curves at their minimum points.
Curve Shifts Lower resource prices shift cost curves downward, as does technological progress. Higher input prices shift cost curves upward.
Long Run The long run is a period of time sufficiently long for a firm to vary the amounts of all resources used, including plant size. In the long run all costs are variable. The long-run ATC, or planning, curve is composed of segments of the short-run ATC curves, and it represents the various plant sizes a firm can construct in the long run.
ATC Curve The long-run ATC curve is generally U-shaped. Economies of scale are first encountered as a small firm expands. Greater specialization in the use of labor and management, the ability to use the most efficient equipment, and the spreading of start-up costs among more units of output all contribute to economies of scale. As the firm continues to grow, it will encounter diseconomies of scale stemming from the managerial complexities that accompany largescale production. The output ranges over which economies and diseconomies of scale occur in an industry are often an important determinant of the structure of that industry.
   
   
economic (opportunity) cost  
explicit costs  
implicit costs  
normal profit  
economic profit  
short run  
long run  
total product (TP)  
marginal product (MP)  
average product (AP)  
law of diminishing returns  
fixed costs  
variable costs  
total cost  

average fixed cost (AFC)
 
average variable cost (AVC)  
average total cost (ATC)  
marginal cost (MC)  
economies of scale  
diseconomies of scale  
constant returns to scale  
minimum efficient scale
(MES)
 
natural monopoly  
   
Chapter 23 Pure Competition
Four Models Economists group industries into four models based on their market structures: (a) pure competition, (b) pure monopoly, (c) monopolistic competition, and (d) oligopoly.
Pure Competitive Industry A purely competitive industry consists of a large number of independent firms producing a standardized product. Pure competition assumes that firms and resources are mobile among different industries.
Competition In a competitive industry, no single firm can influence market price. This means that the firm’s demand curve is perfectly elastic and price equals marginal revenue.
Profit Maximization in the Short Run We can analyze short-run profit maximization by a competitive firm by comparing total revenue and total cost or by applying marginal analysis. A firm maximizes its shortrun profit by producing the output at which total revenue exceeds total cost by the greatest amount.
Max Profit / Min Loss Provided price exceeds minimum average variable cost, a competitive firm maximizes profit or minimizes loss in the short run by producing the output at which price or marginal revenue equals marginal cost. If price is less than average variable cost, the firm minimizes its loss by shutting down. If price is greater than average variable cost but is less than average total cost, the firm minimizes its loss by producing the P  MC output. If price also exceeds average total cost, the firm maximizes its economic profit at the P  MC output.
Marginal Revenue Applying the MR ( P)  MC rule at various possible market prices leads to the conclusion that the segment of the firm’s short-run marginal-cost curve that lies above the firm’s average-variable-cost curve is its short-run supply curve.
Long Run Market Price In the long run, the market price of a product will equal the minimum average total cost of production. At a higher price, economic profits would cause firms to enter the industry until those profits had been competed away. At a lower price, losses would force the exit of firms from the industry until the product price rose to equal average total cost.
LR Supply Curve The long-run supply curve is horizontal for a constant-cost industry, upsloping for an increasing-cost industry, and downsloping for a decreasing-cost industry.
LR Equality of Price The long-run equality of price and minimum average total cost means that competitive firms will use the most efficient known technology and charge the lowest price consistent with their production costs.
Resources allocated to meet consumer tastes The long-run equality of price and marginal cost implies that resources will be allocated in accordance with consumer tastes. The competitive price system will reallocate resources in response to a change in consumer tastes, in technology, or in resource supplies and will thereby maintain allocative efficiency over time.
   
pure competition  
pure monopoly  
monopolistic competition  
oligopoly  
imperfect competition  
price taker  
average revenue  
total revenue  
marginal revenue  
break-even point  
MR  MC rule  
short-run supply curve  
long-run supply curve  
constant-cost industry  
increasing-cost industry  
decreasing-cost industry  
productive efficiency  
allocative efficiency  
   

 

Chapter 23 Pure Competition
Four Models Economists group industries into four models based on their market structures: (a) pure competition, (b) pure monopoly, (c) monopolistic competition, and (d) oligopoly.
Pure Competitive Industry A purely competitive industry consists of a large number of independent firms producing a standardized product. Pure competition assumes that firms and resources are mobile among different industries.
Competition In a competitive industry, no single firm can influence market price. This means that the firm’s demand curve is perfectly elastic and price equals marginal revenue.
Profit Maximization in the Short Run We can analyze short-run profit maximization by a competitive firm by comparing total revenue and total cost or by applying marginal analysis. A firm maximizes its shortrun profit by producing the output at which total revenue exceeds total cost by the greatest amount.
Max Profit / Min Loss Provided price exceeds minimum average variable cost, a competitive firm maximizes profit or minimizes loss in the short run by producing the output at which price or marginal revenue equals marginal cost. If price is less than average variable cost, the firm minimizes its loss by shutting down. If price is greater than average variable cost but is less than average total cost, the firm minimizes its loss by producing the P  MC output. If price also exceeds average total cost, the firm maximizes its economic profit at the P  MC output.
Marginal Revenue Applying the MR ( P)  MC rule at various possible market prices leads to the conclusion that the segment of the firm’s short-run marginal-cost curve that lies above the firm’s average-variable-cost curve is its short-run supply curve.
Long Run Market Price In the long run, the market price of a product will equal the minimum average total cost of production. At a higher price, economic profits would cause firms to enter the industry until those profits had been competed away. At a lower price, losses would force the exit of firms from the industry until the product price rose to equal average total cost.
LR Supply Curve The long-run supply curve is horizontal for a constant-cost industry, upsloping for an increasing-cost industry, and downsloping for a decreasing-cost industry.
LR Equality of Price The long-run equality of price and minimum average total cost means that competitive firms will use the most efficient known technology and charge the lowest price consistent with their production costs.
Resources allocated to meet consumer tastes The long-run equality of price and marginal cost implies that resources will be allocated in accordance with consumer tastes. The competitive price system will reallocate resources in response to a change in consumer tastes, in technology, or in resource supplies and will thereby maintain allocative efficiency over time.
   
pure competition  
pure monopoly  
monopolistic competition  
oligopoly  
imperfect competition  
price taker  
average revenue  
total revenue  
marginal revenue  
break-even point  
MR  MC rule  
short-run supply curve  
long-run supply curve  
constant-cost industry  
increasing-cost industry  
decreasing-cost industry  
productive efficiency  
allocative efficiency  
   
Chapter 24 Pure Monopoly
Pure Monopolist A pure monopolist is the sole producer of a commodity for which there are no close substitutes.
Barriers to Entry The existence of pure monopoly and other imperfectly competitive market structures is explained by barriers to entry in the form of (a) economies of scale, (b) patent ownership and research, (c) ownership or control of essential resources, and (d) pricing and other strategic behavior.
Monopolists Demand Curve The pure monopolist’s market situation differs from that of a competitive firm in that the monopolist’s demand curve is downsloping, causing the marginal-revenue curve to lie below the demand curve. Like the competitive seller, the pure monopolist will maximize profit by equating marginal revenue and marginal cost. Barriers to entry may permit a monopolist to acquire economic profit even in the long run. However, (a) the monopolist does not charge “the highest price possible”; (b) the price that yields maximum total profit to the monopolist rarely coincides with the price that yields maximum unit profit; (c) high costs and a weak demand may prevent the monopolist from realizing any profit at all; and (d) the monopolist avoids the inelastic region of its demand curve.
Restrict Output With the same costs, the pure monopolist will find it profitable to restrict output and charge a higher price than would sellers in a purely competitive industry. This restriction of output causes resources to be misallocated, as is evidenced by the fact that price exceeds marginal cost in monopolized markets.
Income Inequality In general, monopoly transfers income from consumers to the owners of the monopoly. Because, on average, consumers of monopolized products have less income than the corporate owners, monopoly increases income inequality.
Costs The costs monopolists and competitive producers face may not be the same. On the one hand, economies of scale may make lower unit costs available to monopolists but not to competitors. Also, pure monopoly may be more likely than pure competition to reduce costs via technological advance because of the monopolist’s ability to realize economic profit, which can be used to finance research. On the other hand, X-inefficiency—the failure to produce with the least costly combination of inputs—is more common among monopolists than among competitive firms. Also, monopolists may make costly expenditures to maintain monopoly privileges that are conferred by government. Finally, the blocked entry of rival firms weakens the monopolist’s incentive to be technologically progressive.
Price Discrimination A monopolist can increase its profit by practicing price discrimination, provided (a) it can segregate buyers on the basis of elasticities of demand and (b) its product or service cannot be readily transferred between the segregated markets. Other things equal, the perfectly discriminating monopolist will produce a larger output than the nondiscriminating monopolist.
Fair Return Price regulation can be invoked to eliminate wholly or partially the tendency of monopolists to underallocate resources and to earn economic profits. The socially optimal price is determined where the demand and marginal-cost curves intersect; the fair-return price is determined where the demand and average-total-cost curves intersect.
   
explicit costs  
pure monopoly  
barriers to entry  
simultaneous consumption  
network effects  
X-inefficiency  
rent-seeking behavior  

price discrimination
 
socially optimal price  
fair-return price  
   
Chapter 25 Monopolistic Competition and Oligopoly
Monopolistic Competition The distinguishing features of monopolistic competition are (a) there are enough firms in the industry to ensure that each firm has only limited control over price, mutual interdependence is absent, and collusion is nearly impossible; (b) products are characterized by real or perceived differences so that economic rivalry entails both price and nonprice competition; and (c) entry to the industry is relatively easy. Many aspects of retailing, and some manufacturing industries in which economies of scale are few, approximate monopolistic competition.
Normal Profits in the long run Monopolistically competitive firms may earn economic profits or incur losses in the short run. The easy entry and exit of firms result in only normal profits in the long run.
Less Efficient The long-run equilibrium position of the monopolistically competitive producer is less efficient than that of the pure competitor. Under monopolistic competition, price exceeds marginal cost, suggesting an underallocation of resources to the product, and price exceeds minimum average total cost, indicating that consumers do not get the product at the lowest price that cost conditions might allow.
Nonprice Competition Nonprice competition provides a way that monopolistically competitive firms can offset the long-run tendency for economic profit to fall to zero. Through product differentiation, product development, and advertising, a firm may strive to increase the demand for its product more than enough to cover the added cost of such nonprice competition. Consumers benefit from the wide diversity of product choice that monopolistic competition provides.
Combination for maximizing profit In practice, the monopolistic competitor seeks the specific combination of price, product, and advertising that will maximize profit.
Oligopilistic Oligopolistic industries are characterized by the presence of few firms, each having a significant fraction of the market. Firms thus situated engage in strategic behavior and are mutually interdependent: The behavior of any one firm directly affects, and is affected by, the actions of rivals. Products may be either virtually uniform or significantly differentiated. Various barriers to entry, including economies of scale, underlie and maintain oligopoly.
Oligopoly power High concentration ratios are an indication of oligopoly (monopoly) power. By giving more weight to larger firms, the Herfindahl index is designed to measure market dominance in an industry.
Interdependence of Pricing policies Game theory (a) shows the interdependence of oligopolists’ pricing policies, (b) reveals the tendency of oligopolists to collude, and (c) explains the temptation of oligopolists to cheat on collusive arrangements.
Noncollusive Oligopolists Noncollusive oligopolists may face a kinked-demand curve. This curve and the accompanying marginal-revenue curve help explain the price rigidity that often characterizes oligopolies; they do not, however, explain how the actual prices of products were first established.
Collusion The uncertainties inherent in oligopoly promote collusion. Collusive oligopolists such as cartels maximize joint profits—that is, they behave like pure monopolists. Demand and cost differences, a “large” number of firms, cheating through secret price concessions, recessions, and the antitrust laws are all obstacles to collusive oligopoly.
Price Leadership Price leadership is an informal means of collusion whereby one firm, usually the largest or most efficient, initiates price changes and the other firms in the industry follow the leader.
Market Share Market shares in oligopolistic industries are usually determined on the basis of product development and advertising. Oligopolists emphasize nonprice competition because (a) advertising and product variations are less easy for rivals to match and (b) oligopolists frequently have ample resources to finance nonprice competition.
Advertising Advertising may affect prices, competition, and efficiency either positively or negatively. Positive: It can provideconsumers with low-cost information about competing products, help introduce new competing products into concentrated industries, and generally reduce monopoly power and its attendant inefficiencies. Negative: It can promote monopoly power via persuasion and the creation of entry barriers. Moreover, it can be self-canceling when engaged in by rivals; then it boosts costs and creates inefficiency while accomplishing little else.
Research and Development Neither productive nor allocative efficiency is realized in oligopolistic markets, but oligopoly may be superior to pure competition in promoting research and development and technological progress.
Characteristics Table 23.1, page 414, provides a concise review of the characteristics of monopolistic competition and oligopoly as they compare to those of pure competition and pure monopoly.
   
monopolistic competition  
product differentiation  
nonprice competition  
excess capacity  
oligopoly  
homogeneous oligopoly  
differentiated oligopoly  
strategic behavior  
mutual interdependence  
concentration ratio  
interindustry competition  
import competition  
Herfindahl index  
game-theory model  
collusion  
kinked-demand curve  
price war  
cartel  
tacit understandings  
price leadership  
   
   
Chapter 26 Technology, R&D, and Efficiency
Technological Advance Technological advance is evidenced by new and improved goods and services and new and improved production or distribution processes. In economists’ models, technological advance occurs only in the very long run.
Invention Invention is the discovery of a product or process through the use of imagination, ingenuity, and experimentation. Innovation is the first successful commercial introduction of a new product, the first use of a new method, or the creation of a new form of business enterprise. Diffusion is the spread of an earlier innovation among competing firms. Firms channel a majority of their R&D expenditures to innovation and imitation, rather than to basic scientific research and invention.
Part of Capitalism Historically, most economists viewed technological advance as a random, external force to which the economy adjusted. Many contemporary economists see technological advance as occurring in response to profit incentives within the economy and thus as an integral part of capitalism
Anticipate the Future Entrepreneurs and other innovators try to anticipate the future. They play a central role in technological advance by initiating changes in products and processes. Entrepreneurs often form start-up firms that focus on creating and introducing new products. Sometimes, innovators work in the R&D labs of major corporations. Entrepreneurs and innovative firms often rely heavily on the basic research done by university and government scientists.
Optimal R&D A firm’s optimal amount of R&D spending occurs where its expected return (marginal benefit) from the R&D equals its interest-rate cost of funds (marginal cost) to finance the R&D. Entrepreneurs and firms use several sources to finance R&D, including (a) bank loans, (b) bonds, (c) venture capital (funds lent in return for a share of the profits if the business succeeds), (d) undistributed corporate profits (retained earnings), and (e) personal savings.
Product Innovation Product innovation, the introduction of new products, succeeds when it provides consumers with higher marginal utility per dollar spent than do existing products. The new product enables consumers to obtain greater total utility from a given income. From the firm’s perspective, product innovation increases net revenue sufficiently to yield a positive rate of return on the R&D spending that produced the innovation.
Process Innovation Process innovation can lower a firm’s production costs by improving its internal production techniques. Such improvement increases the firm’s total product, thereby lowering its average total cost and increasing its profit. The added profit provides a positive rate of return on the R&D spending that produced the process innovation.
Imitation Threat Imitation poses a potential problem for innovators, since it threatens their returns on R&D expenditures. Some dominant firms use a fast-second strategy, letting smaller firms initiate new products and then quickly imitating the successes. Nevertheless, there are significant protections and potential benefits for firms that take the lead with R&D and innovation, including (a) patent protection, (b) copyrights and trademarks, (c) lasting brand-name recognition, (d) benefits from trade secrets and learning by doing, (e) high economic profits during the time lag between a product’s introduction and its imitation, and (f ) the possibility of lucrative buyout offers from larger firms.
Each Market Structure has different innovation strengths and weaknesses Each of the four basic market structures has potential strengths and weaknesses regarding the likelihood of R&D and innovation. The inverted-U theory holds that a firm’s R&D spending as a percentage of its sales rises with its industry four-firm concentration ratio, reaches a peak at a 50 percent concentration ratio, and then declines as concentration increases further. Empirical evidence is not clear-cut but lends general support to this theory. For any specific industry, however, the technological opportunities that are available may count more than market structure in determining R&D spending and innovation.
Potential to increase monopoly power In general, technological advance enhances both productive and allocative efficiency. But in some situations patents and the advantages of being first with an innovation can increase monopoly power. While in some cases creative destruction eventually destroys monopoly, most economists doubt that this process is either automatic or inevitable.
   
technological advance  
very long run  
invention  
patent  
innovation  
product innovation  
process innovation  
diffusion  
start-ups  
venture capital  
interest-rate cost-of-funds curve  
expected-rate-of-return curve  
optimal amount of R&D  
imitation problem  
fast-second strategy  
inverted-U theory of R&D  

creative destruction
 
   

 

Chapter 13 Money and Banking
Money Anything that is accepted as (a) a medium of exchange, (b) a unit of monetary account, and (c) a store of value can be used as money.
The Federal Reserve System The Federal Reserve System recognizes three “official” definitions of the money supply. M1 consists of currency and checkable deposits; M2 consists of M1 plus savings deposits, including money market deposit accounts, small (less than $100,000) time deposits, and money market mutual fund balances; and M3 consists of M2 plus large ($100,000 or more) time deposits.
Debts Money represents the debts of government and institutions offering checkable deposits (commercial banks andthrift institutions) and has value because of the goods, services, and resources it will command in the market. Maintaining the purchasing power of money depends largely on the government’s effectiveness in managing the money supply.
Total Demand for Money The total demand for money consists of the transactions demand and the asset demand for money. The transactions demand varies directly with the nominal GDP; the asset demand varies inversely with the interest rate. The money market combines the total demand for money with the money supply to determine the equilibrium interest rate.
Decrease in supply increases interest rates Other things equal, decreases in the supply of money raise interest rates, whereas increases in the supply of money decrease them. Interest rates and bond prices move in the opposite direction. At the equilibrium interest rate, bond prices tend to be stable and the amounts of money demanded and supplied are equal.
US Banking System The U.S. banking system consists of (a) the Board of Governors of the Federal Reserve System, (b) the 12 Federal Reserve Banks, and (c) some 7800 commercial banks and 11,800 thrift institutions (mainly credit unions). The Board of Governors is the basic policymaking body for the entire banking system. The directives of the Board and the Federal Open Market Committee (FOMC) are made effective through the 12 Federal Reserve Banks, which are simultaneously (a) central banks, (b) quasi-public banks, and (c) bankers’ banks.
Functions of the Fed The major functions of the Fed are to (a) issue Federal Reserve Notes, (b) set reserve requirements and hold reserves deposited by banks and thrifts, (c) lend money to banks and thrifts, (d) provide for the rapid collection of checks, (e) act as the fiscal agent for the Federal government, (f ) supervise the operations of the banks, and (g) regulate the supply of money in the best interests of the economy.
Fed Independence The Fed is essentially an independent institution, controlled neither by the president of the United States nor by Congress. This independence shields the Fed from political pressure and allows it to raise and lower interest rates (via changes in the money supply) as needed to promote full employment, price stability, and economic growth.
Recent Developments Between 1980 and 2002, banks and thrifts lost considerable market share of the financial services industry to pension funds, insurance companies, mutual funds, and securities firms. Other recent banking developments of significance include the consolidation of the banking and thrift industry; the convergence of services offered by banks, thrifts, mutual funds, securities firms, and pension companies; the globalization of banking services; and the emergence of the Internet and electronic money, including smart cards.
   
medium of exchange  
unit of account  
store of value  
M1, M2, M3  
token money  
Federal Reserve Notes  
checkable deposits  
commercial banks  
thrift institutions  
near-monies  
savings account  
money market deposit  
account (MMDA)  
time deposits  
money market mutual fund (MMMF)  
legal tender  
transactions demand  
asset demand  
total demand for money  
money market  
Federal Reserve System  
Board of Governors  
Federal Open Market  
Committee (FOMC)  
Federal Reserve Banks  
financial services industry  
electronic transactions  
   
   
Chapter 14 How Banks and Thrifts Create Money
Commercial Bank The operation of a commercial bank can be understood through its balance sheet, where assets equal liabilities plus net worth.
Fractional Reserve Systems Modern banking systems are fractional reserve systems: Only a fraction of checkable deposits is backed by currency.
Required Reserves Commercial banks keep required reserves on deposit in a Federal Reserve Bank or as vault cash. These required reserves are equal to a specified percentage of the commercial bank’s checkable-deposit liabilities. Excess reserves are equal to actual reserves minus required reserves.
Checks Banks lose both reserves and checkable deposits when checks are drawn against them.
Loans Commercial banks create money—checkable deposits, or checkable-deposit money—when they make loans. The creation of checkable deposits by bank lending is the most important source of money in the U.S. economy. Money is destroyed when lenders repay bank loans.
Creating Money The ability of a single commercial bank to create money by lending depends on the size of its excess reserves. Generally speaking, a commercial bank can lend only an amount equal to its excess reserves. Money creation is thus limited because, in all likelihood, checks drawn by borrowers will be deposited in other banks, causing a loss of reserves and deposits to the lending bank equal to the amount of money that it has lent.
Bonds Rather than making loans, banks may decide to use excess reserves to buy bonds from the public. In doing so, banks merely credit the checkable-deposit accounts of the bond sellers, thus creating checkable-deposit money. Money vanishes when banks sell bonds to the public, because bond buyers must draw down their checkable-deposit balances to pay for the bonds.
Interest, Liquidity Banks earn interest by making loans and by purchasing bonds; they maintain liquidity by holding cash and excess reserves. Banks having temporary excess reserves often lend them overnight to banks that are short of required reserves. The interest rate paid on loans in this Federal funds market is called the Federal funds rate.
Conservation of reserves The commercial banking system as a whole can lend by a multiple of its excess reserves because the system as a whole cannot lose reserves. Individual banks, however, can lose reserves to other banks in the system.
Reserve Ratio The multiple by which the banking system can lend on the basis of each dollar of excess reserves is the reciprocal of the reserve ratio. This multiple credit expansion process is reversible.
Pro-cyclical The fact that profit-seeking banks would alter the money supply in a pro-cyclical direction underlies the need for the Federal Reserve System to control the money supply.
   
balance sheet  
fractional reserve  
banking system  
vault cash  
required reserves  
reserve ratio  
excess reserves  
actual reserves  
Federal funds rate  
monetary multiplier  
   
   
Chapter 15 Monetary Policy
Goal of Monetary Policy The goal of monetary policy is to help the economy achieve price stability, full employment, and economic growth.
Securities and Loans As they relate to monetary policy, the most important assets of the Federal Reserve Banks are securities and loans to commercial banks. The Federal Reserve Banks’ most important liabilities are the reserves of member banks, Treasury deposits, and Federal Reserve Notes.
Three Instruments The three instruments of monetary policy are (a) openmarket operations, (b) the reserve ratio, and (c) the discount rate.
Operation Monetary policy operates through a complex cause-effect chain: (a) Policy decisions affect commercial bank reserves; (b) changes in reserves affect the money supply; (c) changes in the money supply alter the interest rate; (d) changes in the interest rate affect investment; (e) changes in investment affect aggregate demand; (f ) changes in aggregate demand affect the equilibrium real GDP and the price level. Table 15-3 draws together all the basic ideas relevant to the use of monetary policy.
Fed Communications The advantages of monetary policy include its flexibility and political acceptability. Recently, the Fed has communicated its changes in monetary policy via announcements concerning its targets for the Federal funds rate. When it deems it necessary, the Fed uses open-market operations to change that rate, which is the interest rate banks charge one another on overnight loans of excess reserves. Interest rates in general, including the prime interest rate, rise and fall with the Federal funds rate. The prime interest rate is the benchmark rate that banks use as a reference rate for a wide range of interest rates on short-term loans to businesses and individuals.
Stabilization In the recent past, the Fed has adroitly used monetary policy to hold inflation in check as the economy boomed, to limit the depth of the recession of 2001, and to promote economic recovery. Today, nearly all economists view monetary policy as a significant stabilization tool.
Limitations of Monetary Policy Monetary policy has some limitations and potential problems: (a) Recognition and operation lags complicate the timing of monetary policy. (b) Changes in the velocity of money may partially offset policy-instigated changes in the supply of money. (c) In a severe recession, the reluctance of firms to borrow and spend on capital goods may limit the effectiveness of an expansionary monetary policy.
  Some economists recommend that the United States follow the lead of several other nations, including Canada and the United Kingdom, in replacing or combining the “artful management” of monetary policy with so-called inflation targeting.
Trade Balance The effect of an easy money policy on domestic GDP is strengthened by the increase in net exports that results from a lower domestic interest rate. Likewise, a tight money policy is strengthened by a decline in net exports. In some situations, there may be a tradeoff between the effect of monetary policy on the international value of a nation’s currency (and thus on its trade balance) and the use of monetary policy to achieve domestic stability.
   
monetary policy  
open-market operations  
reserve ratio  
discount rate  
easy money policy  
tight money policy  
Federal funds rate  
prime interest rate  
velocity of money  
cyclical asymmetry  
inflation targeting