2-1 Understanding Basic Economics Chapter 2

Chapter 2 Objectives After studying this chapter, you will be able to: Define economics and explain why scarcity is central to economic decision making. Differentiate among the major types of economic systems. Explain the interaction between demand and supply. 2-2

Chapter 2 Objectives Cont. Identify four macroeconomic issues that are essential to understanding the behavior of the economy. Outline the debate over deregulation and identify four key roles that governments play in the economy. Identify the major ways of measuring economic activity. 2-3

What Is This Thing Called the Economy? Economy The sum total of all the economic activity within a given region Economics The study of how a society uses its scarce resources to produce and distribute goods and services 2-4

What is Economics? 2-5 Economics MacroMicro

Microeconomics and Macroeconomics Microeconomics The study of how consumers, businesses, and industries collectively determine the quantity of goods and services demanded and supplied at different prices Macroeconomics The study of “big picture” issues in an economy, including competitive behavior among firms, the effect of government policies, and overall resource allocation issues 2-6

Factors of Production 2-7

Economic Impact of Scarcity 2-8 Scarcity has two powerful effects: It creates competition for resources It forces trade-offs on the part of every participant in the economy Opportunity cost The value of the most appealing alternative not chosen

Economic Systems Economic system The policies that define a society’s particular economic structure; the rules by which a society allocates economic resources  Free-market, planned 2-9

Economic Systems 2-10

2-11 Free-market System In a free-market system, private individuals determine what products to produce, how and when to produce them, for whom, and at what price to sell them. Thus they have the chance to succeed or to fail by their own efforts.

2-12 Capitalism Capitalism or private enterprise are the terms most often used to describe the free-market system, one in which individuals own and operate the majority of businesses; where competition, supply and demand determine which goods and services are produced.

2-13 Ideal Capitalist Economy (Pure Capitalism) According to Smith, in the ideal capitalist economy (pure capitalism), the market (an arrangement beetween buyer and seller to trade goods and services) serves as a self- correcting mechanism as an “invisible hand” to ensure that production mirrors the wants of society, without regulation of any kind.

2-14 Mixed Economy (Mixed Capitalism) The government sometimes intervenes to accomplish goals that are deemed socially or economically desirable by way of tax incentives or price controls. This practice of limited intervention is characteristic of a mixed economy or mixed capitalism.

2-15 Planned System Government controls all or part of a society’s resources and limits the freedom of choice in order to accomplish government goals. Because social equality is a major goal of planned systems, private enterprise and the pursuit of private gain are generally regarded as unfair and exploitive.

2-16 Communism Communism is the most restrictive planned economy that allows individuals the least degree of economic freedom. Communism exists in Cuba and North Korea.

2-17 Communism  Almost all resources are under government control,  Private ownership is restricted to personal items,  Resource allocation is handled through rigid centralized planning by a handful of government officials. The degree to which communism is actually practiced varies. In its purest form;

2-18 Socialism Socialism involves a relatively high degree of government planning and some government ownership of capital resources. However, government involvement is focused on industries considered vital to the common welfare.

Nationalization versus Privatization 2-19 Nationalization  A government’s takeover of selected companies or industries Privatization  Turning over services once performed by the government and allowing private businesses to perform them instead

2-20 Understanding the Forces of Demand and Supply Demand refers to the amount of a good or service that customers will buy at a given time at various prices. Supply refers to the quantities of good and service that producer will provide on a particular date at various prices. Demand refers to the behavior of buyers, whereas supply refers to the behavior of sellers.

2-21 Understanding the Forces of Demand and Supply Customer should buy more when the price is low and buy less when the price is high. Producers would offer more when the price is high and offer less when the price is low. The quantity supplied and the quantity demanded continuously interact, and the balance between them at any given moment should be reflected by the current price on the open market.

2-22 Advertising and Promotion Spending Advertising and Promotion Spending Consumer Income Consumer Preferences Price of Substitute Products Price of Substitute Products Price of Complementary Goods Price of Complementary Goods Expectations About Future Prices Expectations About Future Prices Price Higher Lower Demand Lower Higher Understanding Demand

2-23 Understanding Demand In most cases as the price of a good or service goes up, people buy less. In other words, as the price rises, the quantity demanded declines. Alternatively, at lower prices, consumers generally are willing to purchase more goods and services.

2-24 Demand Curve for Airline Tickets

2-25 Consumer Income Consumer Preferences Price of Substitutes Price of Complementary Goods Advertising-Promotion Consumer Expectations Number of Buyers Variable Shifts Right When: Increases More Favorable Increases Decreases Increases Optimistic Increases Shifts Left When: Decreases Less Favorable Decreases Increases Decreases Pessimistic Decreases Expected Shifts in Demand Curve

2-26 Demand Curve for Airline Tickets

2-27 Understanding Supply The quantity of goods or service the producers will provide at a given time at various prices; refers to the behaviour of sellers. In general, a company’s willingness to produce and sell a good or service increases as the price it can charge and its profit potential per item increase.

2-28 Goods and Services Supply Price Variables Higher MoreLess Lower Understanding Supply

2-29 Supply Curve for Airline Tickets

2-30 Expected Shifts in Supply Curve Costs of Inputs Number of Competitors New Technology Suppliers Expect That Future Sales Prices Variable Shifts Right When: Decreases Production Costs Will Decline Shifts Left When: Increases Production Costs Will Increase

2-31 Supply Curve for Airline Tickets

2-32 How Demand and Supply Interact In the real word, variables that affect demand and supply do not change independently. Instead, they change simultaneously and continually.

2-33 How Demand and Supply Interact

2-34 Equilibrium point : The point at which quantity supplied equals quantity demanded  Because the supply and demand curves are dynamic, so is the equilibrium point.  As variables affecting supply and demand change, so will the equilibrium price.

2-35 How Demand and Supply Interact As variables affecting supply and demand change, so will the equilibrium price. For example, increased concerns about passenger safety or longer lines at airport security checkpoints could encourage travelers to make alternative economic choices such as automobile travel or videoconferencing, thus reducing the demand for air travel at every price.

Supply and Demand ©2007 Prentice Hall Pairs of blue jeans (quantity) Price $35 $30 $25 $20 $15 $10 Not enough demand D Right price makes supply & demand equal E Not enough supply S 2-36

Competition in the Free-Market System 2-37 Competition Rivalry among businesses for the same customers.

2-38 Pure Competition  A marketplace of multiple buyers and sellers  A product or service that is nearly identical in features  Low barriers to entry In theory, the ideal type of competition is pure competition, which is characterized by three conditions:

2-39 Monopoly At the other extreme, in a monopoly there is only one producer of a product in a given market, that single producer can determine the price (with in regulatory limits).

2-40 Oligopoly An industry is dominated by only a few providers (suppliers), a situation known as an oligopoly. Although few players, competition can be extremely fierce because of so few alternatives.

2-41 Monopolistic Competition Most of competition in advanced free-market economies is monopolistic competition, in which a large number of sellers, no single company dominates the market and offer products from competition companies are distinguishable.

Categories of Competition 2-42

Business Cycles Expansion Contraction Recession Depression Recovery 2-43 Business cycles Fluctuations in the rate of growth that an economy experiences over a period of several years.

2-44 Business Cycles Economic expansion occurs when the economy is growing and people are spending more money. Consumer purchases stimulate businesses to produce more goods and services. Economic contraction occurs when such spending declines. Businesses cut back on production, employees are laid off, and the economy as a whole slows down.

2-45 Business Cycles If economic contraction is severe, the nation may enter into a recession, which is defined as two consecutive quarters of decline in the gross domestic product (GDP), a basic measure of a country’s economic output.

2-46 Business Cycles A deep and prolonged recession can be considered a depression, which doesn’t have an official definition but is generally considered to involve a catastrophic collapse of financial markets. Recovery is the period during which income, employment, production, and spending rise.

Unemployment Frictional unemployment Structural unemployment Cyclical unemployment Seasonal unemployment 2-47 Unemployment rate The portion of the labor force (everyone over 16 who has or is looking for a job) currently without a job

2-48 Types of Unemployment

Inflation and Deflation ©2007 Prentice Hall 2-49 Inflation An economic condition in which prices rise steadily throughout the economy Deflation An economic condition in which prices fall steadily throughout the economy

2-50 InflationDeflation

Government’s Role in a Free-Market System 2-51 Regulation Relying more on laws and policies than on market forces to govern economic activity De-regulation Removing regulations to allow the market to prevent excesses and correct itself over time

Government’s Role in a Free-Market System Protecting stakeholders Fostering competition Encouraging innovation and economic development Stabilizing and stimulating the economy 2-52

2-53 Every economy has a certain amount of “spendable” money in it at any given time, a quantity known as the money supply. Monetary policy involves adjusting the nation's money supply by increasing or decreasing interest rates. Monetary policy is controlled by the Federal Reserve Board or Central Bank, a group of government officials who oversee the country’s central banking system. Monetary Policy

2-54 Fiscal policy involves changes in the government's revenues and expenditures to stimulate a slow economy or dampen a growing economy that is in danger of overheating. On the revenue side, governments can adjust the revenue they bring in by changing tax rates and various fees collected from individuals and businesses. Fiscal Policy

2-55 On the expenditure side, local, state, and federal government bodies constitute a huge market for goods and services, with billions of dollars of collective buying power. Governments can stimulate the economy by increasing their purchases, expanding employment opportunities and increasing demand for goods and services. Fiscal Policy

Economic Measures and Monitors Leading indicators Lagging indicators Price indexes 2-56 Interest rates Unemployment rates Housing data Industrial productivity Economic indicators Statistics that measure the performance of the economy

2-57 Price Indexes Consumer Price Index (CPI) A monthly statistic that measures changes in the prices of a representative collection of consumer goods and services Producer Price Index (PPI) A statistical measure of price trends at the producer and wholesaler levels

2-58 Composition of the Consumer Price Index

National Economic Output Gross Domestic Product (GDP) Gross National Product (GNP) 2-59

2-60 The gross domestic product (GDP) measures a country’s output—its production, distribution, and use of goods and services—by computing the sum of all goods and services produced for final use in a country during a specified period (usually a year). The products may be produced by either domestic or foreign companies as long as the production takes place within a nation’s boundaries. National Economic Output

2-61 GDP has largely replaced an earlier measure called the gross national product (GNP), which excludes the value of production from foreign- owned businesses within a nation’s boundaries and includes receipts from the overseas operations of domestic companies. GNP considers who is responsible for the production; GDP considers where the production occurs. National Economic Output

Applying What You’ve Learned 1. Define economics and explain why scarcity is central to economic decision making 2. Differentiate among the major types of economic systems 3. Explain the interaction between demand and supply 2-62

Applying What You’ve Learned 4. Identify four macroeconomic issues that are essential to understanding the behavior of the economy 5. Outline the debate over de-regulation and identify four key roles that governments play in the economy 6. Identify the major ways of measuring economic activity 2-63