Economics Lecture Thirteen

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Economics Lectures - [1 - 2 - 3 - 4 - 5 - 6 - 7 - 8 - 9 - 10 - 11 - 12 - 13 - 14]

We’ve covered nearly all of the issues concerning individual decisions by companies (firms) and consumers (the public). We’ve discussed supply and demand. We’ve addressed marginal revenue and marginal cost. We've discussed numerous other concepts of the free market, including substitutes, complements, consumer surplus, price controls (ceilings and floors), the Law of Demand, normal goods, inferior goods, elasticity, cost measures, utility and indifference curves.

Television host Stephen Colbert, when interviewing your instructor on the Colbert Report on Tuesday, asked if we learn about "Keynesian economics." Your instructor answered "no", we learn "free market economics." What is the difference?

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, "bigger is better" with respect to government. 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 one of the very strongest economies to a distant second behind other world powers. Does it work any better for the United States today? The "stimulus bill" passed earlier this year is based on Keynesian economics, and provides a test for its validity.

Banking and the Federal Reserve System

On the same Colbert Report, Stephen Colbert discussed the "Federal Reserve Bank" and interviewed Senator Bernie Sanders, who calls himself a Democratic Socialist (which generated a humorous question about whether "Democratic Socialist" is an oxymoron). Senator Sanders called for the resignation or removal of Bernard Bernanke as Chairman of the Federal Reserve. What, you might ask, is the Federal Reserve?

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 but 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, as Stephen Colbert humorously observed on his show, the Fed states that it "is not owned by anyone"!

So why are politicians calling for Bernard Bernanke to resign as Chairman of the Federal Reserve? Operating with virtually no oversight or accountability, Chairman Bernanke does not seem to have helped the economy much. National unemployment is 10% (as of December 2009) and many businesses are failing. In addition, American taxpayers were socked with nearly a trillion dollar bailout package to save many banks from collapse, which is what the Fed was supposed to be making sure did not happen.

Undeterred, however, students from Rutgers University just won second place in the annual College Fed Challenge, which requires acting like the Fed in analyzing about 40 economic indicators like unemployment, inflation, and gross national product (GNP), which is the total market value of all goods and services produced by a nation's economic during the year.

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.

The above definitions are good to know, but it is important to learn how to apply them correctly. When an exam question asks about "long-run equilibrium," then immediately think about how 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 our bus trip to D.C., decisions about the bus must be made on a short-run basis. 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 his 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.


What is “trade”? It is an exchange of goods or services or money by one person for goods or services or money from another. When I give you an Alex (“A-Rod”) Rodriguez baseball card in exchange for your giving me a Derek Jeter card in return, this is called a trade. We would not make the exchange unless each of us felt we would be better off as a result. Maybe I have two “A-Rod” cards and the second one doesn’t mean as much to me as it would to you, for example.

When Pokeman cards were the big fad for children, they quickly learned to trade cards to improve their collections. Note that both sides must perceive a benefit for a trade to occur.

Dutch traders supposedly bought the island of Manhattan from Native Americans for only $24 in beads and trinkets over 300 years ago. At the time, Manhattan did not appear to be worth much. Land was plentiful, and it was difficult to get to Manhattan from the New Jersey side. If the story is true, then both sides felt they were better off from the trade. In the 1970s, New York City nearly went bankrupt. Would the Indians have taken it back?!

Trade benefits both sides to the deal. It appears “win-win” for both parties, or one would not do it (assuming there is not any trickery involved). Generally, economists favor “free” trade, which means trade without government interference.

Now move to the big picture. Consider the massive amounts of trade that occurs between companies and people located in different countries. “Exports” are the goods that companies in one country make to be sold in another country. Those goods exit the country of origin and are purchased by foreigners. “Imports” are the opposite: they are goods that are made in a foreign country but purchased here.

Whenever you hear new economic concepts, try to think of examples yourself. What are some imports that you buy? Look at where your clothes are made. Labels disclose this information when you buy the clothes. Clothes are usually imports, often made in Mexico or China (if inexpensive) or Italy (if expensive). What are some cars that are imported? Examples are Toyota (made in Japan), Hyundai (made in Korea), BMW (made in Germany), and Jaguar (made in England).

More difficult is to imagine goods that we export. You do not purchase any of those. Those are goods made in the United States for sale in a foreign country. Can you think of any examples? Music and movies are examples, as people around the world like to buy what Hollywood produces. Computer software is an other example, as the Microsoft monopoly exports its products to the rest of the world.

Here is something we export that is controversial: we export jobs. Called “outsourcing”, this consists of a company firing an employee in the United States and then hiring a replacement at much lower wages in a foreign country, such as India. The foreign employee can be hired free of many government regulations that make jobs costly here, such as social security taxes, health benefits, taxes, risk of lawsuits, pensions, and so on. An employee hired at a wage of $30,000 in the United States may cost the employer $60,000 when all the regulatory costs are added. Not so if the company can hire a similar employee in a foreign country.

Do we ever import jobs from foreign countries? Not many. The Japanese car company Toyota did build some car manufacturing facilities here in response to complaints that it was hurting our automobile industry. Generally, however, it is more expensive for foreign countries to hire workers here than it would be to hire them elsewhere in the world.

China is the fastest growing exporter of goods in the world, and India is second. In 1980, China exported $18.2 billion in goods to other countries. By 2000, China exported $249.3 billion in goods. Why? Because China has very cheap labor. But it is also a Communist country. Some of those profits go into building up its military, and menacing its democratic neighbors. It points nuclear missiles at our western cities, like Los Angeles.

You can export or import cash itself. We export dollars to pay for imported goods. More generally, exports are what we sell in exchange for imports.

Sometimes you will read on the news a mention of the “balance of payments” or “trade deficits.” These terms apply to the difference between how much we import versus how much we export. Because goods are made more cheaply in foreign countries, we typically import far more than we export. That means the United States has a large trade deficit (amount that total exports exceed total imports).

The “balance of payment account” consists of two accounts that keep track of the goods and services entering and leaving a country: the “capital account” and the “current account.” The capital account monitors physical and financial assets; the current account monitors goods and services. Familiarity with these terms suffices, and do not worry if you do not fully understand them.

“Free Trade” versus “Protectionism”

One of the oldest political issues is the debate between “free trade” and “protectionism”. This has been debated in American politics for over 200 years. What is the controversy?

Supporters of “free trade” oppose government interference in trade between foreign countries. They feel that we should be able to import as many goods as possible from China, and export as many jobs as desired to China. They argue that trade makes both sides better off, so it should be allowed.

But what about the jobs that are lost in the United States due to the shift to foreign producers of goods and the outsourcing of the work? Advocates of “free trade” point out that the people who buy the imports are better off, and they save money by obtaining goods at a lower price. They do not need to make as much money from jobs because their expenses are decreasing.

The free trade advocates also argue that our economy becomes stronger due to the imports, and new jobs will be created for those who lost their prior jobs. When jobs were lost in the steel industry due to cheaper imports, new jobs were created in the services industry. The dot-com internet boom created many new jobs in the 1990s. There are temporary dislocations, but these are like growing pains until better jobs arise. That’s the argument in favor of free trade.

Free traders cite the Law of Comparative Advantage: nations are better off by exporting goods it produces at a lower relative price than others, and importing goods that it cannot make as cheaply. If China makes trinkets more cheaply than we can, then let’s save money by buying them from China and let’s focus our work on what we do best.

Opportunity cost supports this view. You lower your opportunity cost by spending your time most efficiently working on what you do best. Ford Motor can make a car more efficiently than you can. But perhaps you can provide medical or legal services more efficiently than Ford Motor can. So spend your time making money as a doctor or lawyer, and buy your cars from Ford Motor. You’ll have extra money that way. If you spend all your time trying to build a car, then you’d go broke and incur enormous opportunity costs.

For the purposes of economics courses and the CLEP exam, “free trade” and the above arguments are the correct answers. There is much to be said in their favor. The free traders also think they are promoting peace. “If goods cannot cross borders, then soldiers will” is one of their favorite sayings.

However, there are many smart people who would be considered “protectionists” (though they would dislike the pejorative label). Can you think of reasons to oppose “free trade”?

The first argument is the simplest: money isn’t everything. Put another way, overall utility is about more than money. Even if free trade makes me wealthier, I may still not want to do it if it helps wrongdoing or promotes evil. Someone may choose not to buy lottery tickets even if he thinks he will win, if he is morally opposed to gambling. Many of us oppose how China persecutes Christians, promotes abortion, and points nuclear weapons at our cities. Even if we benefit from trading with China, we don’t want them to benefit and continue the activities we oppose. But you won’t hear economists making this argument.

The second argument for “protectionism” questions whether the foreign trade is really “free”. China is a Communist country. What is “free” about trading with it? It does not have free enterprise. Neither does India. Why should we let these government-controlled economies take jobs away from ours? With great risk and many failures through trial and error, we developed successful industries. Why should we allow foreign governments to be copycats for our successes, at our expense in siphoning away jobs? Let them promote free enterprise in their countries first. Perhaps less trade with government-controlled economies will encourage them internally to embrace free enterprise first, for their own benefit.

The third argument for “protectionism” is as follows. Workers facing the loss of jobs due to the outsourcing to other countries ask this: why aren’t the executive jobs exported in addition to the jobs of the employees? Sure, workers are cheaper in China and India than American counterparts. But moving the highly paid executive jobs to those countries would save even more money (per worker)! The advocates of free trade appear to be selective about which jobs they support moving offshore. Why not start with moving their job to a foreign country first? They do not seem to be volunteering for that.


Recall that 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, which is exactly what the protectionists want. A tariff on Toyota cars, for example, would reduce the supply of Toyota cars in the market. Ford and GM like that.

But 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 reduces supply also, but without any 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 major cause of the Civil War.

General Review

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 the 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. It won’t do that.

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. Then complete 5 out of the following 7 questions (leave TWO blank):

1. 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.

2. Some politicians complain about how people are losing their jobs to workers in China. Is this problem the result of "free trade" or "protectionism"?

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. You can go on and watch the price of airline tickets change from day-to-day. If you pick fixed dates of travel, such as Jan. 15 to fly somewhere and Jan. 18 to return, then you will notice that the closer you get to those dates, the higher the price of the ticket usually is. In other words, the earlier in advance that you can buy a ticket, the cheaper it usually is. Explain how this illustrates a basic difference between long run and short run costs.

7. Pick any aspect of monopolistic competition (other than problem 5 if you answered that) and explain it.


Answer question 8, and then 2 out of the following 3 questions:

8. Explain why in long-run equilibrium the price charged in monopolistic competition is greater than marginal cost but equal to average total cost.

9. 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?

10. "Protectionism" is a pejorative (negative) word. Can you think of a more positive, flattering word to express the same concept in a supportive way?

11. What is "Keynesian economics" and what is your view of it?