Changes

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?

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.

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.

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 it is paying the depositor.  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 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.

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.

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.

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 fairly 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.

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'''.

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'''.

''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.)

''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, for example to change the number of buses.  The cost of the buses is fixed, not variable, in the short run.

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 ==

== Review: Monopolistic Competition ==

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!

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 difference as profits.

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.

''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.