Economics Lecture Twelve
Traditionally there have been four major ways to make money:
- Perform labor to earn wages. This is how most people make most of their money.
- Invest capital to earn returns on the investment (usually in the form of interest on the money). This is what you can do once you save up some money.
- Allow someone to use your land in exchange for rent.
- Start a new business to earn profits. But watch out here: 9 out of 10 new businesses fail (often because the owners do not understand -- or do not follow -- basic economic rules).
Sounds simple enough, right? Look around you, and you’ll see people earning money each of the four above ways. Mostly, you’ll see the first way: get a job and earn some wages. That entails the least risk and is the easiest for most people. Adults and teenagers often follow the path of least resistance, and often imitate others. In economics, that means getting a job to work for a company. It’s great until the economy goes through a downturn and you get "laid off" (fired), or the job becomes tiresome and tedious, or the boss fires you because he did not like something you said. Then it’s not so great anymore. But as a teenager you can earn money from someone else while you are learning how business works. You may need experience and savings before you make money the other three ways.
Economists have their own terminology which, as you’ve seen in this course, is often different from common usage. In economics, the basic terms of wages, interest, rent and profit are all redefined. Here we go:
“Economic wages” are payments for the worker’s opportunity cost of time. When a student earns $7 per hour working for a dry cleaner, those wages are payments for his opportunity cost of time. He could be working someone else making money.
“Economic rent” is the payment for a perfectly inelastic input. If increasing the payment does not increase the supply of the input, then this extra amount above cost is a “rent”. It is similar, but not identical, to rent paid on scarce land. Increasing the rent does not increase the supply the land. The supply is limited.
“Interest” is straightforward: it is the cost of the use of money over time. If you borrow $10,000 for your business, then you have to pay interest (say 5% per year) for using that money. The person who lent you the money wants something for it. He’s not going to give it to you for free.
“Economic profits” is concept we’ve addressed before. It is total revenues minus total costs, including opportunity costs of time and money in the costs.
“There’s no free lunch,” according to the famous saying. “It costs money to make money” is another aphorism. Most banks' ATMs charge $2 or $3 just to withdraw cash from your account at a different bank.
If you asked me to loan you $1000, then I might answer: why? What’s in it for me? You would then say that you promise to give it back. I would then say why should I give it to you in the first place? If I just keep the money, then I won’t have to worry about your giving it back.
You would then offer to pay me extra money in exchange for loaning you $1000. We would bargain. You might offer me $25. I might reply that is not enough for me to go the trouble and take the risk to loan you $1000. Then you might offer me $50. I might wonder if I can get a better deal somewhere else. Ultimately we might settle on an amount that makes it worthwhile for me and advantageous for you. Some states have limits on how much interest can be charged. Query: should laws limit the amount of interest that can be charged?
If I agreed to loan you $1000 for an extra payment by you of $50, then the interest rate would be $50/$1000 = 5%. Usually rates are stated in annual terms. Requiring an extra $50 in interest after one year, on top of the repayment of the "principal" of the original $1000, is the equivalent of an interest rate of 5% per year.
The concept of "compounded interest" refers to earning interest on the interest. "Compounded yearly" or "compounded annually" means that the interest is added to the total amount due at the end of the year, and then the interest for the next year is calculated by including the interest for the first year. Here is an example:
- $1000 is loaned to you today at an interest rate of 5%, compounded annually.
- After one year, the amount due is $1000 plus 5% of $1000, for a total of $1050.
- After two years, the amount due is $1050 plus 5% of $1050, for a total of $1102.50, because the interest on the first year is included in calculating the interest for the second year.
The opposite of "compounded" interest is "simple" interest. In the above example, the total amount due the second year is $1000 plus 5% of $1000 (for the first year) plus another 5% of only the original $1000 (for the second year), for a total of $1100. Notice how the total amount under compounded interest is always larger than the total amount using simple interest.
If you are saving money, then you want as much compounding of the interest as possible. Ideally, you would like the interest on the money you save to be "compounded daily," such that the interest earned each day includes interest earned on the interest that was earned the day before.
Sometimes people repay money all at once, rather than with interest payments. Suppose I gave you $1000 and you promised to pay me back $1500 in 10 years. Then economists ask, what is the “rate of return” or “yield” on that investment?
That is more difficult to calculate. I am receiving 50% return on my investment, but ten years from now. At first glance, you may think to simply divide 50% by 10 years to calculate a rate of return of 5% per year. That is a rough approximation, but not entirely precise.
What is wrong with it? The flaw is that it fails to address the time value to money. We explain that next.
The Time Value of Money
Suppose I told you that I will be giving you $100, but that you have a choice: either (1) I will give you the $100 today, or (2) I will give it to you in two years. Which would you prefer?
Today, of course. But why? Is the $100 really worth more today than in two years in the future?
Yes, it is. You could take $100 today and invest it, and have it grow to more than $100 in two years. Or you could buy something with it that you could enjoy for the two years. Or you could give it to a charity that could make good use of it for the two years.
Money, like anything else, has an opportunity cost. Just as it is a waste of your time to sit and watch television for a few hours, it is a waste of money to have it sit idle without earning anything for several years. At a minimum, it could be earning interest.
This was explained by Jesus in His Parable of the Talents, in Matthew 25:14-30 (RSV):
- For it will be as when a man going on a journey called his servants and entrusted to them his property; to one he gave five talents, to another two, to another one, to each according to his ability. Then he went away.
- He who had received the five talents went at once and traded with them; and he made five talents more. So also, he who had the two talents made two talents more. But he who had received the one talent went and dug in the ground and hid his master's money.
- Now after a long time the master of those servants came and settled accounts with them. And he who had received the five talents came forward, bringing five talents more, saying, 'Master, you delivered to me five talents; here I have made five talents more.' His master said to him, 'Well done, good and faithful servant; you have been faithful over a little, I will set you over much; enter into the joy of your master.' And he also who had the two talents came forward, saying, 'Master, you delivered to me two talents; here I have made two talents more.' His master said to him, 'Well done, good and faithful servant; you have been faithful over a little, I will set you over much; enter into the joy of your master.' He also who had received the one talent came forward, saying, 'Master, I knew you to be a hard man, reaping where you did not sow, and gathering where you did not winnow; so I was afraid, and I went and hid your talent in the ground. Here you have what is yours.' But his master answered him, 'You wicked and slothful servant! You knew that I reap where I have not sowed, and gather where I have not winnowed? Then you ought to have invested my money with the bankers, and at my coming I should have received what was my own with interest. So take the talent from him, and give it to him who has the ten talents.
- For to every one who has will more be given, and he will have abundance; but from him who has not, even what he has will be taken away. And cast the worthless servant into the outer darkness; there men will weep and gnash their teeth.
Jesus was concerned with something far greater than money. But the point applies to money also: money does have a time value to it. Money tomorrow is not worth as much as the same amount of money today.
How can you compare future money to present money? By calculating the “present value of money.” That is how much one would need in the present which, with investment, would equal the proposed future payment. We use the interest rate to determine how much something today should be worth in the future, or how much a payment promised in the future is worth today.
If I promise to give you $100 in 5 years, and the interest rate is 5% annually, then ask yourself how much you would need today to generate that same $100 in 5 years. It would be less than $100, because you could earn interest on it. In fact, you would only need $100 divided by (1.05) times itself 5 times (i.e., 1.05 x. 1.05 x 1.05 x. 1.05 x. 1.05)
Using a calculator, that comes to $78.35. That’s amazing, isn’t it? Receiving $100 in 5 years is equivalent to only $78.35 today, assuming an interest rate of 5%.
We can check our work. If you had $78.35 today and you invested it the bank at an interest rate of 5%, then next year it would be worth 5% more: $78.35 x 1.05 = $82.27
You would do the same thing in the second year, investing it for a return of 5%: $82.27 x 1.05 = $86.38
And again in year three: $86.38 x 1.05 = $90.70
And again in year four: $90.70 x 1.05 = $95.24
And, finally, one more time for the fifth year: $95.24 x 1.05 = $100
So $100 to be paid five years from now is the same thing as receiving only $78.35 today. That’s due to the effect of the time value of money.
But notice that when interest rates are less than 5%, as they are now (less than 1%), the differences in the time value of money are smaller.
Using the time value of money, now we can make investment decisions. As an owner of a company or merely someone wanting to see your savings grow, you will need to make investment decisions.
Suppose your widget company is considering a new machine that will last for two years and costs $3500. Suppose also that it will be worthless afterward. Suppose further that it will bring in revenue of $2000 per year, and that interest rates are 10%. Should you invest in the machine?
Ask yourself what the time value of the added income is. It equals:
- ($2000/1.10) + ($2000/(1.10x1.10)) = $1818.18 + $1652.89 = $3471.07
Look again at the cost of the new machine ($3500). What is your best decision? Don’t buy it, because it would bring in less money than it costs.
Banking and the Federal Reserve System
Created in 1913, the Federal Reserve System is a network of 12 banks (one for each Federal Reserve district around the country) that serve as a "bank for banks." In each district, hundreds of banks (and thousands of bank branches or offices) belong to the local Federal Reserve Bank and rely on it for loans and deposits. The vast majority of all bank deposits in the United States are with banks that belong to the Federal Reserve System.
Long ago the economy relied on "commodity monies," which consisted of a commodity (such as silver or gold) serving the function of money. To buy food or pay rent, someone would pay with silver or gold pieces. But now we use "bank-debt money," such as paper dollars. Special markings on each dollar bill signify which of the 12 Federal Reserve banks issued that dollar bill.
The Federal Reserve is supposed to protect the banking system against collapse, while also managing the system in an optimal manner. It has three basic tools for doing this. First, the "Fed" can modify the required percentage of deposits that banks must hold in reserves, in case many depositors wanted to withdraw their money at the same time. This may surprise you: banks ordinarily keep only a small percentage of customer deposits on hand. The vast majority of the deposits are loaned by banks to other people at a higher interest rate than what they are paying the depositors. This is how a bank makes money and can still pay interest to depositors. To guard against a "run on the bank" (when many depositors panic and demand to withdraw all their money at once), the Federal Reserve (the "Fed") can increase the percentage that banks must keep on reserves. Such an increase has the effect of "tightening the money supply," or making money more scarce.
The second policy tool -- and the one that attracts the most attention -- is when the Fed changes the interest rate it charges (its "discount rate") to banks. The higher that rate, the higher the interest becomes for many other types of borrowing, from mortgages to deposit rates. Increasing interest rates also reduces the supply of money, making it harder to obtain mortgages and business loans.
Finally, the third way that the Fed affects the economy is in its market operations: it buys and sells U.S. government securities, the instruments the government uses to finance itself. Buying these securities is the same as loaning the federal government itself money. Keep in mind that the Federal Reserve is not the government itself, but operates as an independent agency set up by the government. On its website, the Fed states that it "is not owned by anyone"!
Keynesian economics is a theory that began with a British economist named John Maynard Keynes (1883-1946). He became a favorite of liberals and his theories of economics were one reason England declined from being the greatest power in the world in the 19th century to a weak nation that could not fully defend itself against Germany in World War II (1940-1945).
His theory was the opposite of free-market or classical economics. Keynes insisted that government interference with the market was desirable and necessary. Keynes claimed that government spending was needed to reduce unemployment and stimulate economic growth. Under Keynesian economics, the more government spends, the better it is for the economy. Keynes argued that big deficits (excess of government spending over revenue) were actually a good thing to bring an economy out of a recession.
This course focuses on Microeconomics, while Keynesian economics is a topic in Macroeconomics, which is the study of national economies rather than individual firms and consumer decisions. So there will not be any questions on a CLEP Microeconomics exam about Keynesian economics. But you will see this term used in debates about the federal budget and overall economy, and its basic meaning is this: increase government spending to stimulate the economy and reduce unemployment. This did not work well for England in the 20th century, as it went from being the greatest economy to one that is weaker than the economy of the United States and several other nations.
Review: Short and Long Run
On the CLEP exam, at least 20% of the questions mention the "short run" or the "long run," or both. That is a big chunk of the exam. Do we fully understand the differences, and what they signify? Let's review this so you can feel comfortable when these terms pop up on exams.
The dictionary definitions for "short run" and "long run" are simple. The "short run" is a time period so brief that a firm is stuck with the resources it has. It cannot change its plant size or its workforce. Instead, it must use more expensive options to make changes in its output, since as paying for nightly overtime (when wages are 50% higher per hour), or buying airplane tickets at the last minute when they are more expensive. If you are traveling in a car and you notice you need gas soon, then you're stuck with the prices charged by the next one or two gas stations, which may not be the lowest price available. Your short run costs are higher than your long run costs. Short run costs are usually higher than long run costs, because the short run decisions are not optimal.
In the long run, the opposite is true. The long run is a period long enough that a firm can optimize its costs as it changes its level of output. The firm can change the size of its production facility. Put another way, in the long run all costs are variable, and thus can be reduced to their lowest levels.
The above definitions are good to know, and it is important to learn how to apply them correctly. When an exam question asks about "long-run equilibrium," then recall that all costs are minimized in the long run.
Example: The price charged by a perfectly competitive firm in the long run or the short run equals marginal cost, because that is always true when there is perfect competition. But the relation between that price and the firm's overall costs depends on whether it is in the long run or the short run. In the long run, the firm's costs are minimized, and thus the price will be equal to the firm's average total cost for a perfectly competitive firm. This is because the perfect competition drives the price down to its lowest possible level: average total cost. (On an exam question, assume that costs are "economic costs" that include everything from the owner's salary to the investors' profits to the opportunity costs.)
A question probing the difference between the short and long run might ask what the basic difference is. We learned that in the long run all costs are variable. What about the short run? In the short run, some costs of a firm are fixed and unchangeable. For example, the night before the March for Life bus trip to D.C., decisions about the buses must be made in the short run. It is too late then to change the number of buses. The cost of the buses is fixed, not variable, in the short run.
Review: Monopolistic Competition
We have thoroughly covered monopolies at one end of the economic spectrum, and we have also thoroughly covered perfect competition at the other end of the economic spectrum. But how well do we know "monopolistic competition," which is somewhere in the middle?
In the real world, monopolistic competition is very common. It is more common than a pure monopoly, and also more common than perfect competition. As its name suggestions, "monopolistic competition" has characteristics of both monopolies and competition.
Recall that monopolistic competition is characterized by:
- many firms, unlike a monopoly, which is only one firm
- the firms sell slightly differentiated goods that are not perfect substitutes
- no (or low) barriers to entry (new firms can easily enter the market)
- firms have some "market power," meaning that they can raise the price and still have lots of buyers at the higher price
How does monopolistic competition different from perfect competition? In monopolistic competition, the sales price is not the lowest possible cost. Instead, the firm is able to raise the price of sale above his marginal cost to earn an extra profit. Firms in monopolistic competition maximize their profits this way.
How is monopolistic competition created? Firms engage in "product differentiation," as in Wendy's advertising that its hamburger is better than McDonald's. That type of advertising differentiates Wendy's product from its competitors, and gives Wendy's the benefits of monopolistic competition. It can then raise its price and earn more profits, because its customers cannot just switch to McDonald's and expect to obtain the exact same hamburger.
Another example of monopolistic competition is a sports team, like the New York Yankees. However, it may be closer to a true monopoly, due to the extremely loyalty of its fans!
Inefficiencies exist in any market that is not perfectly competitive, so there are inefficiencies in markets that consist of monopolistic competition. The sales price is higher than it would be under perfect competition. Specifically, in perfect competition the price equals marginal cost, but in monopolistic competition the firms raise the price above marginal cost and take the excess as marginal profit.
Here is a challenging question: where is the long run equilibrium of a firm in monopolistic competition? To answer this, recall the conditions for this type of market. In monopolistic competition there are no (or low) barriers to entry. So if there are any profits, then other firms would rush into the market and undersell the existing firms. In the long run, there must not be any (economic) profit, due to this condition of no (or low) barriers to entry. Likewise, there must not be any long run losses for this type of market (or any other type of market in the long run), or else firms would exit the market. Thus the long run equilibrium of a firm in monopolistic competition is when price equals average total cost.
How can that be, you might ask. Recall that "economic cost" includes everything: salaries for everyone, interest on loans and the equivalent of interest on investments, and even opportunity cost. So zero profit while paying all those costs is still successful for the owners, investors, and workers connected with the firm.
Note also that a firm in monopolistic competition has some market power, and can increase its price above his marginal cost. So even in the long run, P exceeds MC for monopolistic competition. In contrast, price equals MC in a perfectly competitive market.
A tariff is a tax on imports. A tariff raises the price of imported goods, and the supplier must then reduce its received price to attain the same level where supply meets demand. This has the effect of reducing supply. A tariff on Toyota cars, for example, would reduce the supply of Toyota cars at a low price in the market. Ford and GM would like that, because it would reduce their competition from foreign countries.
But in the 1980s, our government used quotas rather than a tariff to appease Ford and GM. Instead of imposing a tariff on Toyota’s imports, our government negotiated an agreement with it so that it would not sell more than a fixed quota of certain types of cars each year. This would also reduces supply, but without the tariff revenue to the government. Many criticize these import quotas by observing that the effect is the same as a tariff, but without the benefits of the revenue that government would receive from a tariff.
For most of our country’s history (until the Sixteenth Amendment legalized the income tax), our federal government’s major source of revenue was tariffs. The issue of the tariff was a recurrent controversy that divided the pro-tariff North from the anti-tariff South, and was a cause of the Civil War.
The key to mastering economics is to learn to quiz yourself on the principles to make sure you understand them fully.
What is the most important concept of this course? Perhaps it is the obvious desire of companies to maximize their profits. Whether it is a monopoly or a perfectly competitive firm, each firm shares this common goal with all other firms: it wants to make more profits. You can answer 20% or more of the questions on any microeconomics exam simply by applying that basic rule. And at what point does any company maximize its profits? Where marginal revenue (MR) declines to the point where it equals marginal cost (MC). When marginal revenue declines further (or marginal cost increases more), then the company is losing profits. A company won't want to lose money this way.
You need to understand the supply and demand curves thoroughly. Know what elasticity is, in all its forms. Appreciate what substitutes and complements are.
Know the difference between the “short run” and the “long run,” as discussed above. In the “short run,” inefficient changes to inputs and outputs are made. For example, an employee is asked to work overtime at wages 1.5 times ordinary wages. But in the “long run,” inefficiencies are eliminated by better planning. Overtime is avoided.
Please read and, if necessary, reread the above lecture. Answer the first question, and then 5 out of the following 7 questions:
1. Which concept in Economics do you think is the best self-motivator, which you might use to achieve more?
2. Which is true about the average fixed costs (AFC) of a firm?
(a) A firm can eliminate these costs by shutting down in the short run.
(b) As output increases, AFC decreases.
(c) As output increases, AFC increases.
(d) AFC is part of average variable costs.
Briefly explain your answer.
3. What is one of the primary responsibilities of the Federal Reserve Bank?
4. Review: Suppose that after completing this course, you start a new company. In your first year, you "broke even" (had zero profits), and in your second year you want to increase your revenue and profits. After careful study of your market, you decide that you can increase your revenue by increasing your price. Therefore your good must be price elastic/inelastic (choose one).
5. A monopolistic competitive firm has the following characteristic that is lacking for a perfectly competitive firm:
(a) There are low barriers to entry.
(b) MR = MC in the long run.
(c) P > MC
(d) There are many competitors.
Choose one of the above and explain your answer.
6. If you were to loan someone money, why would you want him to pay you something extra (interest) when he pays back the loan? Give at least one reason.
7. Review: is the cost of the bus for the March for Life trip to D.C. a "fixed cost" or a "variable cost"? Explain, assuming for the purpose of this question that one and only one bus can be used (in reality, we used several buses).
8. Suppose I will pay you $1000 in two years, and the interest rate is 10% per year, compounded annually. How much should you pay me today to receive $1000 in two years? Show your work.
Answer question 9, and then 2 out of the following 4 questions:
9. Explain why in long-run equilibrium the price charged in monopolistic competition is greater than marginal cost but equal to average total cost.
10. Economics is sometimes called the “dismal science” because economists predicted population to grow faster than the food supply, marginal returns to diminish, and profits to vanish. But, in fact, there is an abundance of food and profits have not vanished. Why is economics not so dismal after all?
11. What is "Keynesian economics" and what is your view of it?
12. An agreement by different firms with each other to reduce output is illegal. Why should that be illegal?
13. Nash equilibrium, revisited: What is the Nash equilibrium for two gas stations (an oligopoly) that are situated immediately across the street from each other? In other words, what price do they sell at, expressed in terms of one of their cost measures? Explain the process that reaches that "equilibrium".