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partnerships can usually attract financial capital more easily than proprietorships. They are generally larger and Partnerships Businesses owned by two or more people are called partnerships. Lawyers, doctors, and architects often form partnerships to limit overhead costs. How are partnerships founded? (l) Corbis, (r) Doug Menuez/Getty Images CHAPTER 3 Business Organizations 65 Liability In a partnership, all partners take on responsibility for the debts of the business. How do general partnerships and limited partnerships differCongratulations on becoming a partner - your share of company losses are $200,000.” have a better chance of getting a bank loan. The existing partners could also take in new partners who bring financial capital with them as part of their price for joining. A fifth advantage of partnerships is the more efficient operations that come with their slightly larger size. In some areas, such as medicine and law, a relatively small firm with three or four partners might be just the right size for the market. Other partnerships, such as accounting firms, may have hundreds of partners offering services throughout the United States. A sixth and final advantage is that partnerships often find it easier to attract top talent than proprietorships. Because most partnerships offer specialized services, top graduates seek out stable, well-paying firms to apply their recently acquired skills. Disadvantages The main disadvantage of the general partnership is that each partner is fully responsible for the acts of all other partners. If one partner causes the firm to suffer a huge loss, each partner is fully and personally responsible for the loss. This is similar to the unlimited liability feature of a proprietorship, but it is more complicated because more owners are involved. As a result, most people are extremely careful when they choose a business partner. In the case of the limited partnership, a partner’s responsibility for the debts of the business is limited by the size of his or her investment in the firm. If the business fails and debts remain, the limited partner loses only the original investment, leaving the general partners to make up the rest. Another disadvantage is that the partnership, like the proprietorship, has limited life. When a partner dies or leaves, the partnership must be dissolved and reorganized. However, the new partnership may try to reach an agreement with the older partnership to keep its old name. A third disadvantage is the potential for conflict between partners. Sometimes partners discover that they do not get along, so they have to either learn to work together or leave the business. If the partnership is large, these types of problems can easily develop, even though initially everyone thought they would get along. Reading Check Contrasting What are the differences between a general partnership and a limited partnership? 66 UNIT 1 Fundamental Economic Concepts John Morris/Cartoon Stock Corporations MAIN Idea Corporations are one of the most important forms of business and can easily raise large amounts of financial capital. Economics & You Do you know someone who works for a corporation? Read on to learn how corporations are organized. Corporations account for only about onefifth of the businesses in the United States, as shown in Figure 3.1, although they are responsible for a majority of all sales. A corporation is a form of business organization recognized by law as a separate legal entity with all the rights of an individual. This status gives the corporation the right to buy and sell property, to enter into legal contracts, and to sue and be sued. Forming a Corporation Unlike a sole proprietorship or partnership, a corporation is a very formal and legal arrangement. People who want to incorporate, or form a corporation, must file for permission from the national government or the state where the business will have its headquarters. If approved, a charter—a government document that gives permission to create a corporation— is granted. The charter states the company’s name, address, purpose, and other features of the business. The charter also specifies the number of shares of stock, or ownership certificates in the firm. These shares are sold to investors, called stockholders or shareholders. As shown in Figure 3.2, stockholders then own a part of the corporation. The money gained from the sale of stock is used to set up the corporation. If the corporation is profitable, it may eventually issue a dividend—a check that transfers a portion of the corporate earnings—to each stockholder. Corporate Structure When investors purchase stock, they become owners with certain ownership rights. The extent of these rights depends on the type of stock purchased: common or preferred. Common stock represents basic ownership of a corporation. The owner of common stock usually receives one vote for each share of stock. This vote is used to elect a board of directors, which in turn directs the corporation’s business by setting broad policies and goals. The board also hires a professional management team to run the business on a daily basis. corporation form of business organization recognized by law as a separate legal entity charter written government approval to establish a corporation stock certificate of ownership in a corporation stockholders or shareholders people who own a share or shares of stock in a corporation dividend check that transfers a portion of the company profits to stockholders, usually quarterly common stock most frequently used form of corporate ownership, with one vote per share for stockholders Figure 3.2 Stock Ownership 1/200th If a corporation has 200 shares of stock, and if you could divide the firm into 200 equal parts, the owner of a single share of stock would own 1/200th of the corporation. Economic Analysis How does common stock differ from preferred stock? CHAPTER 3 Business Organizations 67 preferred stock form of corporate ownership without vote, in which stockholders get their investments back before common stockholders Preferred stock represents nonvoting ownership shares of the corporation. Because the stock is nonvoting, preferred stockholders do not have the right to elect members to the board of directors. However, preferred stockholders receive their dividends before common stockholders receive theirs. If a corporation goes out of business, preferred stockholders get their investment back before common stockholders get theirs back. In theory, a stockholder who owns a majority of a corporation’s common stock can elect board members and control the company. In some cases, the common stockholder might elect himself or herself, or even other family members, to the board of directors. In practice, this is not done very often because most corporations are so large and the number of shares held by the typical stockholder is so small. Most small stockholders either do not vote or they turn their votes over to someone else. This is done with the use of a proxy, a ballot that gives a stockholder’s representative the right to vote on corporate matters. Although corporations differ in size and industry, they generally organize in similar ways. As Figure 3.3 shows, the day-to-day operations of a corporation are divided into different departments headed by vice presidents, who in turn report to the president of the company. Neither the president nor the other employees of the corporation have direct contact with the owners, or shareholders, of the company. Advantages The main advantage of a corporation is the ease of raising financial capital. If the corporation needs more capital, it can sell additional stock to investors. The revenue Figure 3.3 Corporate Structure See StudentWorks™ Plus or glencoe.com. Owners, the shareholders, elect the Board of directors, who select the President, who hires the Vice president, sales Vice president, production Vice president, finance Domestic International Quality control Research and development Payroll This organizational chart shows the chain of command of a typical organization. It also outlines the basic components of the business, such as sales, production, and payroll. Economic Analysis Who reports directly to the vice president of production? can then be used to finance or expand operations. A corporation may also borrow money by issuing bonds. A bond is a written promise to repay the amount borrowed at a later date. The amount borrowed is known as the principal. While the money is borrowed, the corporation pays interest, the price paid for the use of another’s money. A second and very important advantage is that the corporation provides limited liability for its owners. This means that the corporation itself, not its owners, is fully responsible for its obligations. To illustrate, suppose a corporation cannot pay all of its debts and goes out of business. Because of limited liability, stockholder losses are limited to the money they invested in stock. Even if other debts remain, stockholders are not responsible for them. Some firms will incorporate just to take advantage of the limited liability. For example, suppose Mr. Winters, who owns the hardware store and the auto repair business, now decides to set up each business as a separate corporation. If the hardware business should fail, his personal wealth, which includes stock in the automobile repair business, is safe. Mr. Winters may lose all the money invested in the hardware business, but that would be the extent of his loss. From a broader economic perspective, limited liability enables firms to undertake potentially profitable ventures which are inherently risky. For example, corporations rather than individuals usually introduce new medicines because of the limited liability feature. A third advantage of a corporation is that the directors of the corporation can hire professional managers to run the firm. This means that the owners, or stockholders, |
can own a portion of the corporation without having to know much about the business itself. Another advantage is unlimited life, meaning that the corporation continues to exist even when ownership changes. Because the corporation is recognized as a separate legal entity, the name of the company stays the same, and the corporation continues to do business. Cornered by Mike Baldwin ” . “ Double Taxation Shareholders have to pay corporate taxes and income taxes on their dividends. Why are people interested in owning stock when they have to pay so much in taxes? bond formal contract to repay borrowed money with interest principal amount borrowed when getting a loan or issuing a bond interest payment made for the use of borrowed money double taxation taxation of dividends both as corporate profit and as personal income This leads to a fifth advantage, the ease of transferring ownership of the corporation. If a shareholder no longer wants to be an owner, he or she simply sells the stock to someone else who then becomes the new owner. As a result, it is easier for the owner of a corporation to find a new buyer than it is for the owner of a sole proprietorship or a partnership. Disadvantages Because the law recognizes the corporation as a separate legal entity, the corporation must keep detailed sales and expense records so that it can pay taxes on its profits. This leads to the first disadvantage, the double taxation of corporate profits. Double taxation means that stockholder dividends are taxed twice. They are taxed the first time when the corporation pays taxes on its profits. Then they are taxed a CORNERED © 2004 Mike Baldwin. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. CHAPTER 3 Business Organizations 69 What’s a public corporation anyway? It’s one that has “gone public,” which means anyone with a little extra cash can buy stock and own a part of the company. A privately held corporation, on the other hand, sells shares only to a select group of people. Sometimes that group may consist of a few family members. The Securities and Exchange Commission (SEC) was set up in 1934 to regulate the sale of stock by public corporations. Skills Handbook See page R41 for more information on Evaluating Information. second time when investors, as the owners of the corporation, report their dividends as personal income. Another disadvantage of the corporate structure is the difficulty and expense of getting a charter. Depending on the state, attorney’s fees and filing expenses can cost several thousand dollars. A third disadvantage of the corporation is that the owners, or shareholders, have little voice in how the business is run. Shareholders vote for the board of directors, and the directors turn day-today operations over to a professional management team. The result is a separation of ownership and management. This is different from the proprietorship and partnership, where ownership and management are usually one and the same. Finally, the fourth disadvantage is that corporations are subject to more government regulation than other forms of business. Corporations must register with the state in which they are chartered. If a corporation wants to sell its stock to the public, it must register with the federal Securities and Exchange Commission (SEC). It will also have to provide financial information concerning sales and profits to the general public on a regular basis. Even an attempt to take over another business may require federal government approval. Reading Check Evaluating Why do many business owners prefer corporations over other forms of business organization? SECTION 1 Review Vocabulary 1. Explain the significance of sole proprietorship, Critical Thinking 4. The BIG Idea How do partnerships support the profit proprietorship, unlimited liability, inventory, limited life, partnership, general partnership, limited partnership, corporation, charter, stock, stockholder, shareholder, dividend, common stock, preferred stock, bond, principal, interest, and double taxation. Main Ideas 2. Discuss the advantages and disadvantages of the corporation. 3. Describing Use a graphic organizer like the one below to describe the characteristics of proprietorships, partnerships, and corporations. Business Form Characteristics Proprietorship Partnership Corporation motive of entrepreneurs? 5. Analyzing Visuals Look at Figure 3.3 on page 68. What is the relationship between the owners and the employees of the corporation? 6. Drawing Conclusions When a corporation wants to introduce a potentially profitable but risky product, it frequently sets up a separate company that has its own corporate structure. Why do you think the corporation does this? Applying Economics 7. Partnerships Assume that you and a friend want to start a partnership to run your own business, such as a music store. Draw up one-page articles of partnership that outline how you will address financial issues of the partnership. 70 UNIT 1 Fundamental Economic Concepts ENTREPRENEUR Profiles in Economics Andrea Jung (1958− ) • first female chief executive officer (CEO) in Avon Products’ 118-year history • ranked #5 on Fortune magazine’s “50 Most Powerful Women in Business” The Avon Lady When promoted to Avon’s top spot in 1999, Andrea Jung was charged with modernizing and restructuring what many considered to be a hopelessly antiquated company. Women have been selling Avon cosmetics directly to customers since 1886, but in the Internet era, this hands-on business model became a liability. If women had no Avon representative in their area, they had no way to purchase the products from the catalog—until Andrea Jung took charge. The Mobilization Campaign Jung faced a problem. Putting Avon products in retail stores or offering them online put the company in direct competition with its own army of 5 million independent sales representatives in 140 countries. Working closely with the “reps” was paramount to Jung. So when Jung took the company online, she made sure it directed users to local reps. She also gave the reps the opportunity to purchase kiosks in malls and other retail venues as franchises. Fluent in Mandarin Chinese, she helped strengthen Avon’s presence in China and other countries, such as Russia. She also updated and innovated products and introduced a new line, called Mark™ that was tailored to the increasing number of younger, collegeaged reps and their customers. These changes and others caused a rebound in Avon stock, led to increases in annual revenues from $5.3 billion to more than $8 billion, and made Jung a corporate celebrity. Jung also had an impact within the company. Avon has more women in management—86 percent—than any other Fortune 500 company. Jung serves as a mentor to other women in the company. She encourages questions and rewards success. Although she is a private person, Jung has learned to be more open with Avon reps and motivate them to enact the changes she sees ahead. Examining the Profile 1. Summarizing What changes did Jung make to Avon’s marketing strategy? 2. For Further Research What career steps did Jung take that allowed her to move from a degree in English literature to a top management position? After graduating from Princeton with a degree in English literature, Andrea Jung wanted to spend just two years in retail before pursuing a law degree. Instead, she turned retail into a career—and Avon into a global success. Nancy Kaszerman/Corbis CHAPTER 3 Business Organizations 71 SECTION 2 Business Growth and Expansion GUIDE TO READING Section Preview In this section, you will learn how businesses grow through merging with other companies or by reinvesting profits in themselves. Content Vocabulary • merger (p. 72) • income statement (p. 73) • net income (p. 73) • depreciation (p. 73) • cash flow (p. 73) • horizontal merger (p. 75) • vertical merger (p. 75) • conglomerate (p. 76) • multinational (p. 76) Academic Vocabulary • internally (p. 75) • dominant (p. 75) Reading Strategy Comparing As you read the section, complete a graphic organizer similar to the one below by comparing a vertical merger to a horizontal merger. Vertical merger Similarities Horizontal merger —Newsweek COMPANIES IN THE NEWS Reinvesting for Monster Growth How does a booming company spark new growth the year after its sales nearly double? If you’re Hansen Natural, maker of Monster Energy drinks, you start by signing a two-year endorsement deal with Ricky Carmichael, the Michael Jordan of motocross and supercross racing. It’s good for business when “R.C.” hoists a can of Monster on the victory stand. . . .[A] big endorsement deal is just one way Hansen hopes to build on its growth. CEO Rodney Sacks [and fellow South African-born company president Hilton Schlosberg] wants to roll out new products that reach . . . the key male market of 18- to 25-year-olds. In addition to regular Green Monster, there’s . . . Monster Assault in a camouflage can aimed at teens and a Lost Energy brand targeting surfers and skateboarders. ■ merger combination of two or more businesses to form a single firm When Hansen Natural decided to sign up a celebrity to endorse its products, the company hoped to increase profits by expanding its markets and sales. Investing these profits in new plant, equipment, and products is one way a business can grow. Another way a business can expand is by engaging in a merger—a combination of two or more businesses to form a single firm. Yet mergers can be risky because they often combine very different corporate cultures, and there is no guarantee that consumers will like the resulting products. Even so, the payoffs can be huge, so the temptation to merge is always attractive to businesses. 72 UNIT 1 Fundamental Economic Concepts Glencoe Photo Growth Through Reinvestment MAIN Idea Business owners can use their profits to update and expand their firms. Economics & You Do you know a local business that has expanded in recent year |
s? Read on to learn how business owners reinvest cash flow for growth. Most businesses use financial statements to keep track of their business operations. One of the most important of those is the income statement—a report showing a business’s sales, expenses, net income, and cash flows for a period of time, such as three months or a year. We can use the income statement to show how a business can use some of the revenue it receives from sales to grow through reinvestment. Estimating Cash Flows An income statement such as the one in Figure 3.4 shows a firm’s net income—the funds left over after all of the firm’s expenses, including taxes, are subtracted from its sales. These expenses include the cost of inventory, wages and salaries, interest payments, and all other payments the firm must make as part of its normal business operations. One of the most important of these payments is depreciation—a noncash charge the firm takes for the general wear and tear on its capital goods. Depreciation is called a noncash charge because the money stays in the firm rather than being paid to someone else. For example, interest may be paid to a bank, wages may be paid to employees, or payments may be made to suppliers to provide some of the inputs used in production. However, the money allocated to depreciation never goes anywhere. Since this money stays in the business, the firm treats it as a form of income. Because of this, firms usually prefer to take as much depreciation as possible. As you can see in the figure, an incease in depreciation would lower the earnings before tax but increase the cash flow. The cash flow—the sum of net income and noncash charges, such as depreciation—is the bottom line, a more comprehensive measure of profits. This is because the cash flow represents the total amount of new funds generated from operations. Reinvesting Cash Flows If the business has a positive cash flow, the owners can then decide how to allocate it. The board of directors of a corporation income statement report showing a firm’s sales, expenses, net income, and cash flows for a certain period, usually three months or a year net income common measure of business profits determined by subtracting all expenses, including taxes, from revenues depreciation gradual wear on capital goods cash flow total amount of new funds a business generates from operations Figure 3.4 Growth Through Reinvestment First quarter income statement Generates Investment in new plant, equipment, and technologies Sales of goods and services Less: Cost of goods sold Wages and salaries Interest payments Depreciation Earnings before tax Less: Taxes at (40%) Net income Plus: Depreciation Allows Cash flow $1,000 400 250 50 100 $200 80 $120 100 $220 See StudentWorks™ Plus or glencoe.com. Businesses use income statements to record sales and expenses. Cash flow includes the net income plus depreciation. Any cash flow not paid out to stockholders as dividends is money that businesses can use for reinvestment. Economic Analysis Which of the items on the income statement represents the real measure of profits for the business? Shareholder dividends CHAPTER 3 Business Organizations 73 may declare a dividend to be paid directly to shareholders as a reward for their investments. The owners of a proprietorship or partnership may keep some cash flow as the reward for risk-taking. The remainder of the funds could then be reinvested in new plant, equipment, or technologies. When cash flows are reinvested in the business, the firm can produce additional products. This generates additional sales and an even larger cash flow during the next sales period. As long as the firm has positive cash flows, and as long as the reinvested funds are larger than the wear and tear on equipment, the firm will grow. Finally, the concept of cash flow is also important to investors. In fact, if investors want to know about the financial health of a firm, a positive cash flow is one of the first things they look for. Reading Check Summarizing What is the benefit of reinvesting cash flow in a business? Growth Through Mergers MAIN Idea Mergers allow firms to quickly grow in size. Economics & You Can you think of any recent mergers and the issues those mergers raised? Read on to learn about the various types of mergers. When two companies merge, one gives up its separate legal identity. For public recognition purposes, however, the name of the new company may reflect the identities of both. When Chase National Bank and Bank of Manhattan merged, the new company was called the Chase Manhattan Bank of New York. Later it changed its name to the Chase Manhattan Corporation to reflect its geographically expanding business. Finally, after merging with JP Morgan, it settled on JPMorgan Chase. Likewise, Procter & Gamble kept the brand name Gillette after it bought the company. &The Global Economy YOU Know Your Manners As American businesses expand into other countries, they face a question that has nothing to do with actual business: how to interact with people from a different culture. You too may someday find yourself working in another country or traveling abroad to meet with businesspeople. How will you know what to do and say? Many books and Web sites offer advice on customs to Americans doing business in other countries. Here are some things to keep in mind as you travel around the globe: • Gift-giving is an important part of Japanese business protocol. Present your gift with both hands and note that it is of no large value. This tells your business partner that you value the relationship more than the gift itself. • In Argentina, it is not unusual for a business associate to arrive 30 to 40 minutes late to a meeting. • The amount of time you spend in negotiations will often determine the importance of a business arrangement in India. More time implies greater importance. • In Germany, avoid using first names. These are reserved for family and close friends. Even among long-time colleagues, it is common to address one another using titles and last names. • Local politics are open for discussion in South Africa. In fact, not knowing local and regional politics can end any business dealings. 74 UNIT 1 Fundamental Economic Concepts Digital Vision/Getty Images Figure 3.5 Types of Mergers VERTICAL MERGER Horizontal mergers combine two or more firms that produce the same kind of product. Vertical mergers bring together firms involved in different stages of manufacturing or marketing. Economic Analysis How does a company benefit from a vertical merger? H ORIZONTAL M ERGER + = Nickel Savings Bank People's Building & Loan Association Nickel Savings & Loan Association Hickory Tree Farms + Boston Baseball Bat, Inc. + Fast Delivery, Inc. = Boston Baseball Bat, Inc. horizontal merger combinationof two or more firms producing the same kind of product vertical merger combination of firms involved in different stages of manufacturing or marketing Types of Mergers There are two types of mergers, both of which are illustrated in Figure 3.5. The first is a horizontal merger, which takes place when firms that produce the same kind of product join forces. One such example is the bank merger of JP Morgan and Chase Manhattan to form JPMorgan Chase. When companies involved in different stages of manufacturing or marketing join together, it results in a vertical merger. One example of a vertical merger is the formation of the U.S. Steel Corporation. At one time it mined its own ore, shipped it across the Great Lakes, smelted it, and made steel into many different products. Vertical mergers take place when companies seek to protect against the potential loss of suppliers. Reasons for Merging Mergers take place for a variety of reasons. A business may seek a merger to grow faster, to become more efficient, to acquire or deliver a better product, to eliminate a rival, or to change its image. For example, some managers find that they cannot grow as fast as they would like using the funds they generate internally. As a result, one firm may consider merging with another firm. Sometimes a merger makes sense, and other times it may not, but the desire to become a larger company in the industry—if not the largest—is one reason that mergers take place. Efficiency is another reason for mergers. When two firms merge, they no longer need two presidents, two treasurers, and two personnel directors. The new company can have more retail outlets or manufacturing capabilities without significantly increasing management costs. In addition, the new company may be able to get better discounts by making volume purchases, and it may be able to make more effective use of its advertising. Sometimes the merging firms can achieve two objectives at once—such as dominant size and improved efficiency. CHAPTER 3 Business Organizations 75 Figure 3.6 Conglomerate Structure A conglomerate is a firm with at least four businesses that make unrelated products, none of which is responsible for a majority of its sales. General Electric is a U.S. conglomerate with products ranging from aircraft engines to movies. Economic Analysis How many different industries can you identify in the list of GE products? 8.5% 24.2% 28.1% 10.5% 20.2% 8.5% Source: www.ge.com, 2006 Commercial finance Consumer finance Health care Industrial Infrastructure NBC Universal photo on top: Engineer working on GE aircraft engine photo on bottom: Entrance to NBC Universal Studios conglomerate firm with four or more businesses making unrelated products, with no single business responsible for a majority of its sales multinational corporation producing and selling without regard to national boundaries and whose business activities are located in several different countries Some mergers are driven by the desire to acquire new product lines. When a telecommunications company such as AT&T buys a cable TV company, for example, it can offer faster Internet access and telephone service in a single pa |
ckage. Sometimes firms merge to catch up with, or even eliminate, rivals. Royal Caribbean Cruises acquired Celebrity Cruise Lines and nearly doubled in size to become the second largest cruise line behind Carnival. Finally, a company may use a merger to lose its corporate identity. For example, ValuJet merged with AirWays to form AirTran Holdings Corporation. The new company flew the same planes and routes as the original company, but AirTran hoped the name change would help the public forget ValuJet’s tragic Everglades crash in 1996 that claimed 110 lives. Conglomerates A corporation may become so large through mergers and acquisitions that it turns into a conglomerate. A conglomerate is a firm that has at least four businesses, each making unrelated products and none responsible for a majority of its sales. Diversification is one of the main reasons for conglomerate mergers. Some firms hope to protect their overall sales and profits by not “putting all their eggs in one basket.” Isolated economic events, such as bad weather or a sudden change of consumer tastes, may affect some product lines but not all of them at the same time. In recent years, the number of conglomerates in the United States has declined. In Asia, however, conglomerates remain strong. Samsung, Gold Star, and Daewoo are still dominant in Korea, as are Mitsubishi, Panasonic, and Sony in Japan. Multinationals Other large corporations have become international in scope. A multinational is a corporation that has manufacturing or service operations in a number of different countries. In effect, it is a citizen of several countries at one time. A multinational is likely to pay taxes in each country where it has operations and is subject to the laws of each. General Motors, 76 UNIT 1 Fundamental Economic Concepts (t) Brownie Harris/Corbis, (b) Robert Landau/Corbis Nabisco, British Petroleum, Royal Dutch Shell, Mitsubishi, and Sony are examples of multinational corporations that have attained worldwide economic importance. Multinational corporations are important because they have the ability to move resources, goods, services, and financial capital across national borders. A multinational with its headquarters in Canada, for example, could sell bonds in France. The proceeds could then be used to expand a plant in Mexico that makes products for sale in the United States. A multinational may also be a conglomerate if it makes unrelated products, but it is more likely to be called a multinational if it conducts operations in several different countries. Multinationals are usually welcome in a nation because they transfer new technology and generate new jobs in areas where jobs are needed. Multinationals also produce tax revenues for the host country, which helps that nation’s economy. At times, multinationals have been known to abuse their power by paying low wages to workers, exporting scarce natural resources, or interfering with the development of local businesses. Some critics point out that multinational corporations are able to demand tax, regulatory, and wage concessions by threatening to move their operations to another country. Other critics are concerned that multinationals may alter traditional ways of life and business customs in the host country. Most economists, however, welcome the lower-cost production and higher-quality output that global competition brings. They also believe that the transfer of technology that eventually takes place will raise the standard of living for everyone. On balance, the advantages of multinationals far outweigh the disadvantages. Reading Check Contrasting How do conglomerates and multinationals differ? Skills Handbook See page R42 to learn about Making Inferences. SECTION 2 Review Vocabulary 1. Explain the significance of merger, income statement, net income, depreciation, cash flow, horizontal merger, vertical merger, conglomerate, and multinational. Critical Thinking 5. The BIG Idea How could a merger between two large cellular phone companies provide better products in a more efficient manner? Main Ideas 2. Describe how a firm can generate funds internally to grow and expand. 3. Explain the basic difference between a conglomerate and a multinational corporation. 6. Analyzing Visuals Look at Figure 3.6 on page 76. Explain how the diversification of General Electric illustrates the saying: “Don’t put all your eggs in one basket.” 7. Inferring What are the possible benefits and drawbacks of multinationals to their host countries? 4. Identifying Use a graphic organizer like the one below to identify the reasons businesses merge. Applying Economics Reasons for mergers 8. Horizontal Mergers Research the ownership of radio stations in a nearby metropolitan area. Are any owned by the same company? Do the stations have the same types of broadcasts or the same advertising? Write a one- to two-page paper about your findings. In your paper, explain why a company would want to own multiple stations in the same geographical market. CHAPTER 3 Business Organizations 77 Case Study 7-Eleven “Convenience” Is Born In 1927 an employee of the Southland Ice Company in Dallas, Texas, began selling milk, bread, and eggs from the ice dock on Sundays and evenings when grocery stores were closed. This sparked the idea for the convenience store. In 1946 the stores were renamed 7-Eleven to reflect their new hours: 7 a.m. to 11 p.m. Japan Borrows the Idea In the early 1970s, Toshifumi Suzuki, a young Japanese executive, came to the United States to look into franchising Denny’s restaurants in Japan. He was more impressed by the 7-Elevens he saw. With its densely populated cities and small commercial lots, Japan was perfectly suited to the convenience-store format. In 1974 Suzuki opened a chain of stores under the 7-Eleven name. Since then, the retailer has changed the way the country shops and eats. Many stores offer banking services, dry-cleaning drop-off, parcel post, mobile-phone recharging, photocopying, and even voter registration. They also stock cheap, high-quality foods, such as gourmet rice balls, exotic salads, and other delicacies customized to local tastes. Technology, coordinated deliveries, and inventory control have boosted efficiency. The company uses a satellite-based ordering system that 78 UNIT 1 Fundamental Economic Concepts TWPhoto/Corbis includes detailed weather reports. This way, managers know to order more cold noodles on warm days or more fresh produce on rainy days, when customers want to avoid a trip to the grocery store. Today 7-Eleven is Japan’s most profitable retailer. 7-ELEVENS IN THE UNITED STATES AND JAPAN 300 200 100 ) 10,000 5,000 US* Population Japan 7-Elevens *Number of stores includes 7-Eleven stores in Canada The Student Buys the Teacher While 7-Eleven Japan boomed, its U.S. counterpart declined. In the late 1980s, 7-Eleven Japan and its parent company, Ito-Yokado, helped turn around the U.S. stores. They improved the U.S. distribution network and introduced new sandwiches, bakery items, and coffees. In 1991, ItoYokado bought 70 percent of the American company outright. Today nearly 30,000 7-Eleven stores generate total sales of more than $43 billion in 17 countries and U.S. territories. Analyzing the Impact 1. Drawing Conclusions How do you know that 7-Eleven is a multinational corporation? 2. Comparing and Contrasting In what ways do 7-Elevens in Japan differ from their U.S. counterparts? SECTION 3 Nonprofit Organizations GUIDE TO READING Section Preview In this section, you will learn about the economic benefits that cooperatives and other nonprofit organizations bring to their members. Content Vocabulary • nonprofit organization (p. 79) • cooperative (p. 80) • co-op (p. 80) • credit union (p. 80) • labor union (p. 81) • collective bargaining (p. 81) • professional association (p. 81) • chamber of commerce (p. 81) • Better Business Bureau (p. 82) • public utility (p. 83) Academic Vocabulary • analyze (p. 80) • devoting (p. 80) Reading Strategy Describing As you read the section, complete a graphic organizer similar to the one below by describing the benefits of nonprofit organizations. Organization Benefits Community organization Consumer cooperative PEOPLE IN THE NEWS Katrina Volunteer Vacation —adapted from American Red Cross News online Last semester, they studied textbook disasters. Over their winter break, they helped feed and comfort Hurricane Katrina victims. Each day, Nellie Afshar, Jemma Binder, Dawn Birk, Zachary Joyce, and graduate student Jessica Walsh from the State University of New York at New Paltz rose before dawn, helped load supplies, spent all day dispensing hot meals in flood-ravaged areas, and then pitched in to clean their vehicles afterward. Their service fulfilled a field work requirement for a disaster studies practicum, part of SUNY’s new disaster studies minor, but the experience was more than that for these students. “You couldn’t get me up at 6 a.m. for any other reason,” said Joyce, 21. “I wouldn’t get up at 6 a.m. to make money. This is the best work I’ve ever done.” ■ Most businesses use scarce resources to produce goods and services in hopes of earning a profit for their owners. Other organizations operate on a “not-for-profit” basis. A nonprofit organization works in a businesslike way to promote the collective interests of its members rather than to seek financial gain for its owners. The American Red Cross is one example of a nonprofit. Like other nonprofits, it relies on volunteers such as the SUNY students for much of its work. In this way, nonprofits and other community and civic organizations can perform useful services with minimal expense and without regard to earning a profit. nonprofit organization economic organization that operates like a business but does not seek financial gain Nam Y. Huh/AP/Wide World Photos CHAPTER 3 Business Organizations 79 cooperative or co-op nonprofit association performing some kind of economic activity for the benef |
it of its members credit union nonprofit service cooperative that accepts deposits, makes loans, and provides other financial services Community Organizations and Cooperatives MAIN Idea A variety of nonprofit organizations provide a wide range of goods and services to communities and members. Economics & You Have you volunteered for a community organization? Read on to find out how such organizations help their communities. Community Organizations Community organizations include schools, churches, hospitals, welfare groups, and adoption agencies. Many of these organizations are legally incorporated to take advantage of unlimited life and limited liability. They are similar to profit-seeking businesses but do not issue stock, pay dividends, or pay income taxes. Figure 3.7 Cooperatives Consumer Cooperatives Housing cooperatives Discount price clubs Bulk foods store Service Cooperatives Credit unions Insurance companies Babysitting services Producer Cooperatives Farmers marketing cooperatives Cooperatives are voluntary associations of people formed to carry on some kind of economic activity that will benefit their members. Economic Analysis How do the three kinds of cooperatives differ? If their activities produce revenues in excess of expenses, they use the surplus to further their work. Like for-profit businesses, nonprofit organizations use scarce factors of production. Their work is difficult to analyze economically because the value of their efforts is not easy to measure. Still, the large number of these organizations shows that they are important to our economic system. Cooperatives A common type of nonprofit organization is the cooperative, or co-op. A cooperative is a voluntary association formed to carry on some kind of economic activity that will benefit its members. As Figure 3.7 shows, cooperatives can have a variety of goals. Cooperatives fall into three major categories: consumer, service, and producer. The consumer cooperative is a voluntary association that buys bulk amounts of goods such as food or clothing on behalf of its members. Members usually help keep the cost of the operation down by devoting several hours a week or month to the operation. If successful, the co-op is able to offer its members products at prices lower than those charged by regular businesses. A service cooperative provides services such as insurance, credit, or child care to its members, rather than goods. One example is a credit union, a financial organization that accepts deposits from, and makes loans to, employees of a particular company or government agency. Like consumers, producers also can have co-ops. A producer cooperative helps members promote or sell their products. In the United States, most cooperatives of this kind are made up of farmers. The co-op helps the farmers sell their crops directly to central markets or to companies that use the members’ products. Some co-ops, such as the Ocean Spray cranberry co-op, market their products directly to consumers. Reading Check Explaining How does a cooperative work? Labor Unions Workers may join a labor union that represents their interests. How do labor unions help their members? labor union organization that works for its members’ interests concerning pay, working conditions, and benefits collective bargaining negotiation between union and company representatives over pay, benefits, and other job-related matters professional association nonprofit organization of professional or specialized workers seeking to improve working conditions, skill levels, and public perception of its profession chamber of commerce nonprofit organization of local businesses formed to promote their interests Labor, Professional, and Business Organizations Education Association for teachers, are independent and represent workers in specific industries. MAIN Idea Some nonprofit organizations are formed to promote the interests of workers and consumers. Economics & You You just learned about nonprofit organizations that help consumers and communities. Read on to find out about groups that support workers and businesses. Nonprofit organizations are not just limited to co-ops and civic groups. Many other groups also organize this way to promote the interests of their members. Labor Unions One important economic institution is the labor union, an organization of workers formed to represent its members’ interests in various employment matters. The union participates in collective bargaining when it negotiates with management over issues such as pay, working hours, health care coverage, vacations, and other jobrelated matters. Unions also lobby for laws that will benefit and protect their workers. The largest labor organization in the United States is the American Federation of Labor-Congress of Industrial Organizations (AFL-CIO), an association of unions whose members include workers in many different jobs. Other unions, such as the National Andrew Lichtenstein/Corbis Professional Associations Some workers belong to professional societies, trade associations, or academies. Such a professional association consists of people in a specialized occupation interested in improving the working conditions, skill levels, and public perceptions of the profession. The American Medical Association (AMA) and the American Bar Association (ABA) are examples of organizations that include members of specific professions. These groups influence the licensing and training of their members, set standards for conduct, and are actively involved in political issues. Other professional associations represent bankers, teachers, college professors, police officers, and hundreds of other professions. Business Associations Businesses also organize to promote their collective interests. Most communities have a local chamber of commerce, an organization that promotes the welfare of its member businesses. The typical chamber sponsors activities ranging from educational programs to lobbying for favorable business legislation. Industry or trade associations represent specific kinds of businesses. Trade associations are interested in shaping the CHAPTER 3 Business Organizations 81 Better Business Bureau businesssponsored nonprofit organization providing information on local companies to consumers government’s policy on such economic issues as free enterprise, imports and tariffs, the minimum wage, and new construction. Some business associations help protect the consumer. The Better Business Bureau is a nonprofit organization sponsored by local businesses. It provides general information on companies, maintains records of consumer inquiries and complaints, and offers consumer education programs. Reading Check Summarizing How do professional associations help their members? CAREERS Sociologist The Work * Study the development, interaction, and behavior of social groups, including various social, religious, and business organizations * Gather firsthand information from people and derive conclusions that can lead to formulating policies that impact educators, lawmakers, administrators, and others committed to resolving social problems * Knowledge of society and social behavior may be used by companies in product development, marketing, and advertising Qualifications * Strong mathematical skills, quantitative research and analysis skills, and the ability to communicate ideas clearly * Objectivity, an open mind, and systematic work habits * Master’s degree, with a Ph.D. required of sociologists teaching at the university level Earnings * Median annual earnings: $57,870 Job Growth Outlook * Slower than average Source: Occupational Outlook Handbook, 2006–2007 Edition 82 UNIT 1 Fundamental Economic Concepts Dawn Tardif/Corbis Government MAIN Idea The government provides some goods and services while helping to make sure the economy runs smoothly. Economics & You You read earlier about the role of the government in economic policy. Read on to learn more details about that role. Although you may not think of it that way, your local, state, or national government actually is a nonprofit economic organization. Sometimes government plays a direct role in the economy, while at other times the role is indirect. Direct Role of Government Many government agencies produce and distribute goods and services to consumers, giving government a direct role in the economy. The role is “direct” because the government supplies a good or service that competes with private businesses. One example of direct involvement is the Tennessee Valley Authority (TVA). The TVA supplies electric power for most of Tennessee and parts of Alabama, Georgia, Kentucky, North Carolina, Virginia, and Mississippi. This power supplier competes directly with other, privately owned, power companies. Another example is the Federal Deposit Insurance Corporation (FDIC), which insures deposits in our nation’s banks. Because the insurance the FDIC supplies could be provided by privately owned insurance companies, the FDIC is also an example of the direct role of government. Perhaps the best-known government corporation is the U.S. Postal Service (USPS). Originally an executive department called the Post Office Department, the USPS became a government corporation in 1970. Many of these federal agencies are organized as government-owned corporations. Like privately owned businesses, these corporations have a board of directors that hires a professional management team to oversee daily operations. These corporations charge fees for their products and services, and the revenue goes back into the “business.” Unlike private corporations, however, Congress supplies funds to cover any losses the public corporation may incur. State and local governments also play a direct role in the economy. State governments provide colleges and universities, retirement plans, and statewide police protection. Local governments provide police and fire protection, rescue services, and schools. At the same time, |
all levels of government help develop and maintain roads, libraries, and parks. Indirect Role of Government The government plays an indirect role when it acts as an umpire to help the market economy operate smoothly and efficiently. One such case is the regulation of public utilities, municipal or investorowned companies that offer products such as water, sewerage, and electric service to the public. Because many public utilities have few competitors, consumers often want government supervision. For example, the federal government established regulatory control over the cable television industry in 1993 because it felt that some operators were charging too much. Without competition, utilities with exclusive rights in certain areas have little incentive to offer services at reasonable rates. The government also plays an indirect role when it grants money to people in the form of Social Security checks, veterans’ benefits, financial aid to college students, rent subsidies, and unemployment compensation. Such payments give the recipients of these funds a power they otherwise might not have—the power to “vote” by making their demands known in the market. This power influences the production of goods and services, which in turn affects the allocation of scarce resources. Reading Check Evaluating Do you think one government role is more important than another? Why? Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 3—Student Web Activities for an activity on nonprofit organizations. public utility company providing an essential service such as water or electricity to consumers SECTION 3 Review Vocabulary 1. Explain the significance of nonprofit organization, cooperative, co-op, credit union, labor union, collective bargaining, professional association, chamber of commerce, Better Business Bureau, and public utility. Main Ideas 2. Describe the roles that federal, state, and local governments play in the economy. 3. Identifying Use a graphic organizer like the one below to identify the different types of nonprofit organizations. Critical Thinking 4. The BIG Idea Compare and contrast the purposes of the following nonprofits: American Red Cross, American Medical Association, and Teachers’ Credit Union. 5. Analyzing Visuals Look at Figure 3.7 on page 80. Select one of the cooperatives and explain the benefits it offers its members. 6. Inferring What motivates individuals to join professional associations and unions? 7. Drawing Conclusions Explain why the government, rather than private firms, operates agencies such as the TVA and the FDIC. Nonprofit organizations Applying Economics 8. Nonprofit Organizations Identify a nonprofit organization in your community. Discuss with an official or volunteer of the organization how the loss of nonprofit status would affect its activities and services. Write a paragraph about your findings. CHAPTER 3 Business Organizations 83 NEWSCLIP Running a cooperative doesn’t make being in business easier. In fact, it may be especially difficult to secure high prices for members while remaining competitive in the market. Ocean Spray Cranberries Inc., one of the largest producer cooperatives in the United States, has made it work. Ocean Spray’s Creative Juices Randy C. Papadellis has a corporate mandate that would make many CEOs blanch. . . . The chief executive officer of juice giant Ocean Spray Cranberries Inc. leads a cooperative that’s owned by about 800 cranberry and grapefruit farmers. Papadellis has to buy all the fruit his farmers produce—about two-thirds of the world’s cranberry crop—and buy it at the highest possible price. . . . It’s a dilemma that has sparked frenetic cranberryfueled creativity. After spurring supermarkets to add juice aisles in the 1960s, Ocean Spray followed with hits including the first juice boxes, low-calorie cranberry drinks, and white cranberry juice. Now Craisins, the dried-fruit snack made from husks that used to be thrown away but are now reinfused with juice, have exploded in popularity. Ocean Spray is spinning out variations—chocolate-covered Craisins, anyone?—as fast as it can. The company’s food product segment has doubled during the past two years, and total sales have grown 12%, to $1.1 billion. . . . Ocean Spray remains No. 1 in juices. . . . 1976 Membership expands to include grapefruit growers 1930 Cooperative formed by 3 cranberry growers 1981 First company to introduce juice boxes 2006 Ocean Spray cooperative has over 900 members 1963 First juice blend introduced 2004 Members vote down a joint venture with PepsiCo 1930 1940 1950 1960 1970 1980 1990 2000 2010 84 UNIT 1 Fundamental Economic Concepts Courtesy of Ocean Spray Cranberries, Inc. Of course, past success isn’t any guarantee of future results. . . . The cooperative is supposed to pay farmers the commodity price for fruit plus a dividend reflecting the profits of the Ocean Spray brand. But in 2000 overproduction sent the price of raw cranberries crashing from over $60 a barrel to under $20. . . . Papadellis quickly realized that the farmers needed to decide whether or not the cooperative still made sense. . . . After weeks of arguing the pros and cons, and with a buyout offer on the table from Pepsi, the farmers opted for Papadellis’ vision of a more focused Ocean Spray that would stay independent. . . . The plan not only improved the bottom line but also won back the trust of the farmers. . . . —Reprinted from BusinessWeek Examining the Newsclip 1. Summarizing What is the purpose of the Ocean Spray Cranberry Inc. cooperative? 2. Analyzing How does the organizational structure of the cooperative reflect member interests? CHAPTER 3 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Business Organizations Three main forms of business organizations exist in the United States today. Sole proprietorships Partnerships Corporations • Owned and run by a single owner • Easy to set up and operate with few or no requirements • Owner responsible for all operations but reaps all earnings • Owner has unlimited liability • Two or more owners • Requires legal papers • Can attract different talents as partners • Relatively easy to raise capital • All partners are equally liable • Owners purchase stock but do not run the company • Formal and legal arrangement • Easier to raise capital • Owners taxed twice • Limited liability Growth A company can reinvest its profits or merge with another firm in order to grow. R EINVESTMENT M ERGERS Net income + Depreciation = Cash flow Reinvest in new plant, equipment, or technology More products Increase in cash flow Horizontal Firms produce the same kind of products Vertical Firms involved in different stages of production Nonprofit Organizations Some organizations work in a businesslike way to promote the interests of their members. Unlike businesses, these nonprofit organizations do not seek to earn a profit. Community or civic organizations Cooperatives • Range from schools to churches and hospitals • Most are legally incorporated, with unlimited life and limited liability • Provide goods and services while trying to improve the quality of life for people • Consumer cooperatives provide goods to their members at lower prices • Service cooperatives offer specific services to members • Producer cooperatives help members sell their products Other organizations Government • Labor unions represent their members in employment matters • Professional associations seek to improve the skills, working conditions, and public perception of their members • Business associations support specific businesses or trade groups • Has a direct role in the economy by providing some goods and services • Has an indirect role in the economy by acting as a regulator and a provider of benefits CHAPTER 3 Business Organizations 85 CHAPTER 3 Assessment & Activities Review Content Vocabulary Review the Main Ideas On a separate sheet of paper, classify each of the numbered terms below into the following categories. Some terms may apply to more than one category. a. sole proprietorships b. partnerships c. corporations d. nonprofit organizations 1. bond 2. stock 3. cooperative 4. dividend 5. unlimited liability 6. charter 7. labor union Section 1 (pages 61–70) 21. Explain why sole proprietorships are attractive for entrepreneurs wanting to start a new business. 22. Identify the strengths and weaknesses of a partnership. 23. Describe the difference between owning stocks and owning bonds. Section 2 (pages 72–77) 24. Describe how a business obtains, and then disposes of, its cash flow. 25. Discuss the difference between a horizontal and a vertical merger. 26. Explain why a corporation might choose to become a conglomerate. Section 3 (pages 79–83) 8. professional association 27. Discuss the difference between a nonprofit and other 9. limited partner 10. credit union 11. limited liability 12. limited life 13. merger 14. cash flow forms of business organizations. 28. Describe the purpose of a labor union. 29. Identifying Use a graphic organizer like the one below to identify examples of the direct and the indirect roles of government. Role of Government Review Academic Vocabulary Direct Indirect Design a crossword puzzle using the terms below. Use a synonym or antonym (specify which) as your clue. For example, clues for “limited” could be “endless (ant.)” or “restricted (syn.).” 15. entity 16. comprise 17. internally 18. dominant 19. analyze 20. devoting 86 UNIT 1 Fundamental Economic Concepts Critical Thinking 30. The BIG Idea If you were planning to open a busi- ness such as a sportswear store or lawn service, which form of business organization would you prefer—sole proprietorship, partnership, or corporation? Explain. Economics: Principles and Practices Web site at glencoe.com and click on Chapter 3—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the 31. Drawing Conc |
lusions Do you think mergers are beneficial for the U.S. economy? Defend your response. 32. Analyzing Cite a case in your community where a cooperative would fulfill a definite economic need. Explain why you think so, and then describe what kind of cooperative you would set up. 33. Comparing and Contrasting What is the difference between the unlimited liability of proprietorships and partnerships, and the limited liability of corporations? 34. Understanding Cause and Effect What advantages might a multinational corporation bring to a host nation? Math Practice 35. Examine the table that follows. Then answer the following questions. Sole proprietorships, 1990–2002 1990 1995 2000 2002 Thinking Like an Economist 37. Identify two ways a firm’s cash flow can be used. Explain why these uses are a trade-off, and explain the opportunity costs of these choices in terms of the firm’s future growth. Analyzing Visuals 38. Look at Figure 3.5 on page 75. Describe in your own words each type of merger. Then discuss the benefits of each. Writing About Economics 39. Expository Writing Use the library or the Internet to research a conglomerate. Then write a paper describing where the company is headquartered, where its manufacturing plants are located, and where it sells its products. Also include reasons why the firm chose those particular locations. Business receipts Business deductions 731 589 807 1,021 1,030 638 806 809 Interpreting Cartoons 40. Look at the cartoon below. What message is the cartoonist trying to deliver? How does the cartoon relate to what you have learned about proprietorships and corporations Net income a. What is the net income for each of the years listed? How did you find the answer? b. In what year did sole proprietorships have the largest net income? c. In what year did sole proprietorships have the largest net income as a percentage of business receipts? How did you find your answer? Applying Economic Concepts 36. Business Organizations Return to your list from the Why It Matters activity on page 60. Now that you have learned about the different business forms, review the resources on your list and decide how you will organize your new business. Prepare an oral report and present your decision and rationale to the class. John S. Pritchett CHAPTER 3 Business Organizations 87 UNIT 2 Microeconomics: Prices and Markets CHAPTER 4 Demand CHAPTER 5 Supply CHAPTER 6 Prices and Decision Making CHAPTER 7 Market Structures Buyers and sellers in a music store show how supply and demand play out in the market. 88 UNIT 2 Spencer Grant/PhotoEdit Spencer Grant/PhotoEdit CHAPTER 4 Demand Why It Matters Think about the items you bought during the past two months. What influenced your purchases? Did you need the items, or did you buy them because you wanted them? Make a list of the items, and next to each one write why you bought it. Then add for each item whether you would have bought more if the price had been lower, or fewer had the price been higher. Read Chapter 4 to learn how economists interpret your actions. The BIG Idea Markets exist when buyers and sellers interact, and market prices are set by the interaction of demand and supply. When prices go down for products, such as the computers in this computer store, consumers demand more of them. 90 UNIT 2 AP/Wide World Photos Economics: Principles and Practices Web site at glencoe.com and click on Chapter 4—Chapter Overviews to preview chapter information. Chapter Overview Visit the SECTION 1 What Is Demand? GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that you express demand for a product when you are willing and able to purchase it. • prevail (p. 92) • inversely (p. 93) Content Vocabulary • demand (p. 91) • microeconomics (p. 91) • market economy (p. 92) • demand schedule (p. 92) • demand curve (p. 93) • Law of Demand (p. 93) • market demand curve (p. 94) • marginal utility (p. 95) • diminishing marginal utility (p. 95) Reading Strategy Identifying As you read this section, use a web diagram similar to the one below to identify the characteristics of demand. Characteristics of Demand PRODUCTS IN THE NEWS Wrist Watch —adapted from The Columbus Dispatch It’s all in the wrist. Actually, this spring, it’s all on the wrist. Skinny bracelets and subtle strands of bling are being replaced by chunky looks with boldness and color, often worn in multiples. “Last year, everything was thin; now, ‘big’ is being demanded everywhere,” said Toni Miller Dunleavy, owner of Etc. Gifts and Accessories. Big and brash wrist frosting takes its newest form with Wonder Woman-esque cuffs. . . . Other popular choices include wide, flexible “liquid metal” (a la chain mail) and oversize bangles strung with colored beads or seashells—or even bottle caps or typewriter keys. Meanwhile, those slim bangles from years past shouldn’t be tossed: A piling of 8, 10, or more easily makes the wearer a member of the bigger-is- better bracelet brigade. ■ When we talk about the “demand” for a product, we mean more than the desire to simply have or to own the item. In order for demand to be counted in the marketplace, desire must be coupled with the ability and willingness to pay for it. Only those people with demand—the desire, ability, and willingness to buy a product—can compete with others who have similar demands. Demand, like many of the other topics discussed in Unit 2, is a microeconomic concept. Microeconomics is the part of economic theory that deals with behavior and decision making by individual units, such as people and firms. Collectively, our microeconomic concepts help explain how prices are determined and how individual economic decisions are made. demand combination of desire, ability, and willingness to buy a product microeconomics part of economics that studies small units, such as individuals and firms AINACO/CORBIS CHAPTER 4 Demand 91 market economy economic system in which people and firms make all economic decisions (also see page 37) demand schedule a table that lists how much of a product consumers will buy at all possible prices An Introduction to Demand MAIN Idea Demand is a concept specifying the different quantities of an item that will be bought at different prices. Economics & You Do you buy more of an item when the price goes down, or less of it when the price goes up? Read on to see how this behavior illustrates the concept of demand. In a market economy people and firms act in their own best interests to answer the basic WHAT, HOW, and FOR WHOM questions. Demand is central to this process, so an understanding of the concept of demand is essential if we are to understand how the economy works. Demand Illustrated Fortunately, the concept of demand is easy to understand because it involves only two variables—the price and quantity of a specific product at a given point in time. For example, we might want to know how many people would want to see a movie on a given afternoon if the price was $5. Or we might want to know how many would want to view it if the price was $10. The answers would depend on a number of things, including the number of people living in the area, the number and types of other movies that were playing at the same time, and of course the popularity of the movie itself. But in the end, everything would be measured in terms of prices and quantities. The Individual Demand Schedule To see how an economist would analyze demand, look at Panel A in Figure 4.1. It shows the amount of a product that a consumer, whom we’ll call Mike, would be willing and able to purchase over a range of possible prices that go from $5 to $30. The information in Panel A is known as a demand schedule. The demand schedule shows the various quantities demanded of a particular product at all prices that might prevail in the market at a given time. Figure 4.1 The Demand for Compact Digital Discs A D EMAND S CHEDULE B D EMAND C URVE Price $30 25 20 15 10 5 Quantity demanded 30 25 20 15 10 5 0 a b 1 2 3 4 Quantity 5 6 7 8 The demand schedule and the demand curve both show the quantity of CDs an individual consumer demands at every possible price. Note how the three CDs demanded at a price of $15 are plotted as point a on the demand curve. Economic Analysis Why is the demand curve downward sloping? Demand and Prices If the prices of CDs drop, consumers will be better able and more willing to buy them. How does this situation reflect the Law of Demand? demand curve a curve that shows the quantities demanded at all possible prices Law of Demand rule stating that consumers will buy more of a product at lower prices and less at higher prices Personal Finance Handbook See pages R4–R5 for more information on budgeting. As you can see, Mike would not buy any CDs at a price of $25 or $30, but he would buy one if the price fell to $20, and he would buy three if the price was $15, and so on. Just like the rest of us, he is generally willing to buy more units of a product as the price gets lower. The Individual Demand Curve The demand schedule in Panel A of Figure 4.1 can also be shown graphically as the downward-sloping line in Panel B. All we have to do to is to transfer each of the price-quantity observations in the demand schedule to the graph, and then connect the points to form the curve. Economists call this the demand curve, a graph showing the quantity demanded at each and every price that might prevail in the market. For example, point a in Panel B shows that Mike purchased three CDs at a price of $15 each, while point b shows that he will buy five at a price of $10. The demand schedule and the demand curve are similar in that they both show the same information—one in the form of a table and the other in the form of a graph. Reading Check Interpreting How do you react to a change in the price of an item? How does this illustrate the concept of demand? The Law of Demand MAIN Idea There is an inverse relationship between the price of an item and the q |
uantity demanded. Economics & You When you go shopping, do you try to catch sale days? Read on to find out how an economic “law” describes your behavior. The prices and quantities in Figure 4.1 point out a feature of demand: for practically every good or service that we might buy, higher prices are associated with smaller amounts demanded. Conversely, lower prices are associated with larger amounts demanded. This is known as the Law of Demand, which states that the quantity demanded varies inversely with its price. When the price of something goes up, the quantity demanded goes down. Likewise, when the price goes down, quantity demanded goes up. Why We Call It a “Law” Expressing something as a “law” may seem like a strong statement for a social science like economics to make, but there are two reasons why economists prefer to do so. First, the inverse relationship between price and quantity demanded is something Brand X Pictures/PunchStock CHAPTER 4 Demand 93 Figure 4.2 Individual and Market Demand Curves The market demand curve shows the quantities demanded by everyone in the market who is interested in purchasing a product. Point a on the market demand curve represents the three CDs Mike and Julia each would purchase at a price of $15 for a total of six CDs. Economic Analysis How do the three demand curves differ? See StudentWorks™ Plus or glencoe.com. M IKE’S I NDIVIDUAL D EMAND C URVE J ULIA’S I NDIVIDUAL D EMAND C URVE M ARKET D EMAND C URVE $30 e c i r P 25 20 15 10 5 0 $30 $30 a’ b Quantity 25 20 15 10 5 0 a’’ b’’ Quantity 25 20 15 10 10 11 12 13 14 15 Quantity Skills Handbook See page R49 to learn about Using Line Graphs. market demand curve a curve that shows how much of a product all consumers will buy at all possible prices that we find in study after study, with people almost always stating that they would buy more of an item if its price goes down, and less if the price goes up. Second, common sense and simple observation are consistent with the Law of Demand. This is how people behave in everyday life—they normally buy more of a product at lower prices than they do at higher ones. All we have to do is to note the increased purchases at the mall whenever there is a sale. This is why economics is a social science: because it is the study of the way we behave when things around us change. The Market Demand Curve So far we have discussed a particular individual’s demand for a product. Sometimes, however, we are more concerned with the market demand curve, the demand curve that shows the quantities demanded by everyone who is interested in purchasing the product. Figure 4.2 shows the market demand curve D for Mike and his friend Julia, the only two people whom (for simplicity) we assume to be willing and able to purchase CDs. To get the market demand curve, all we do is add together the number of CDs that Mike and Julia would purchase at every possible price. Then, we simply plot the prices and quantities on a separate graph. To illustrate, point a in Figure 4.2 represents the three CDs that Mike would purchase at $15, plus the three that Julia would buy at the same price. Likewise, point b represents the quantity of CDs that both would purchase at $10. The market demand curve in Figure 4.2 is very similar to the individual demand curve in Figure 4.1. Both show a range of possible prices that might prevail in the market at a given time, and both curves are downward sloping. The main difference between the two is that the market demand curve shows the demand for everyone in the market. Reading Check Explaining How does the market demand curve reflect the Law of Demand? 94 UNIT 2 Microeconomics: Prices and Markets marginal utility additional satisfaction or usefulness a consumer gets from having one more unit of a product diminishing marginal utility decrease in satisfaction or usefulness from having one more unit of the same product Demand and Marginal Utility MAIN Idea As we buy more of an item, we get less satisfaction from each additional purchase. Economics & You When you buy clothes, why do you prefer a variety of colors and styles to identical items? Read to see how this relates to marginal utility. As you may recall from Chapter 1, economists use the term utility to describe the amount of usefulness or satisfaction that someone gets from the use of a product. Marginal utility—the extra usefulness or additional satisfaction a person gets from acquiring or using one more unit of a product—is an important extension of this concept because it explains so much about demand. The reason we buy something in the first place is because we feel that the product is useful and will give satisfaction. However, as we use more and more of a product, we encounter diminishing marginal utility, the principle which states that the extra satisfaction we get from using additional quantities of the product begins to decline. Because of our diminishing satisfaction, we usually are not willing to pay as much for the second, third, fourth, and so on, as we did the first unit. This is why our demand curve is downward-sloping, and this is why Mike and Julia won’t pay as much for the second CD as they did for the first. Diminishing satisfaction happens to all of us at some time. For example, when you buy a drink because you are thirsty, you get the most satisfaction from the first purchase. Since you are now less thirsty, you get less satisfaction from the second purchase, and even less from the next, so you are not willing to pay as much for the second and third purchases. Reading Check Describing How does the principle of diminishing marginal utility explain the price we pay for another unit of a good or service? SECTION 1 Review Vocabulary 1. Explain the significance of demand, microeconomics, market economy, demand schedule, demand curve, Law of Demand, market demand curve, marginal utility, and diminishing marginal utility. Main Ideas 2. Describing What is the relationship between the demand schedule and the demand curve? 3. Determining Cause and Effect Using a graphic organizer like the one below, explain how a change in price changes the quantity demanded of an item. Price floor price decreases Quantity demanded Quantity demanded Critical Thinking 4. The BIG Idea How does the principle of diminishing marginal utility explain the slope of the demand curve? 5. Inferring Although people buy more of a product when the seller lowers the price, some items such as luxury goods are not offered at a lower price. Why? 6. Analyzing Visuals Look at the demand schedules on page 94. Assume that Julia is willing to purchase different quantities at the same prices, and write down the new demand. Then plot a new market demand curve that incorporates the changed demand. 7. Using Graphs Create your own demand schedule for an item you currently purchase. Next, plot your demand schedule on a demand curve. Be sure to include labels. Applying Economics 8. Diminishing Marginal Utility Using what you have learned about diminishing marginal utility, find examples from your own experience and explain how they support this concept. CHAPTER 4 Demand 95 NEWSCLIP Oscar Mayer, one of the brands of Kraft Foods Inc., first launched its Lunchables product line in 1988. The prepackaged lunches quickly became popular, and today these snacks are available in many different flavor combinations. They also have come under attack by critics. Kraft is finding ways to satisfy these critics and keep consumer demand high. Slimmer Kids, Fatter Profits? Charles Davis, a Kraft food maven, is on a health kick. But then, he has no choice. Making cheese healthier is complicated. Add too much calcium, and it starts to taste chalky. Take out too much fat, and the cheese emerges from mechanical graters like Play-Doh. “It becomes a big glob instead of having good shredding integrity,” says Charles W. Davis, vice-president of global technology and quality for convenient meals at Kraft Foods Inc. Nutrition Facts Serving per package 1 Amount per serving Calories 410 Calories from Fat 90 % Daily Value 15% 23% 13% 37% 21% 8% Total Fat 10g Saturated Fat 4.5g Cholesterol 40mg Sodium 890mg Total Carbohydrate 64g Dietary Fiber 2g Sugars 27g Protein 16g Nutrition Facts Serving per package 1 Amount per serving Calories 780 Calories from Fat 290 % Daily Value 49% 35% 5% 57% 38% 24% Total Fat 32g Saturated Fat 7g Cholesterol 15mg Sodium 1380mg Total Carbohydrate 113g Dietary Fiber 6g Sugars 61g Protein 9g Davis can tell you all about finding that delicate balance between what tastes good and what’s good for you. Since 2004, the 48-year-old chemist has been leading a team of scientists, technicians, and engineers working to improve the nutritional content of Kraft’s popular Lunchables Lunch Combinations line, a process known industrywide as reformulation. That means he has spent an inordinate amount of time experimenting not only with cheese but also with the juice drinks, crackers, deli meats, and fruit snacks that make up these all-in-one meals. If you count all 41 varieties of Lunchables, Davis has cut calories by an average of 10%, fat by 24%, and sodium by 20%. Why do Davis and hundreds of other people throughout the company do nothing else but experiment in their kitchen labs all day? Because their employer has no choice. Kraft, the nation’s largest food manufacturer, and its competitors risk becoming this decade’s cigarette companies: vilified for pushing junk to children, restricted by oftenconflicted regulators, challenged in court. —Reprinted from BusinessWeek Examining the Newsclip 1. Understanding Cause and Effect Why did Kraft decide to reformulate a product that was already popular? 2. Making Inferences What might happen to demand for the Lunchables products if Kraft did not respond to consumer demands? 96 UNIT 2 Microeconomics: Prices and Markets SECTION 2 Factors Affecting Demand GUIDE TO READING Section Preview Reading Strategy Listing As you read about the determinan |
ts of demand, list each on a table similar to the one below and provide an example of each. Determinants of Demand Determinant Example Effect on demand In this section, you will learn about the factors that cause changes in demand. Content Vocabulary • change in quantity demanded (p. 98) • income effect (p. 98) • substitution effect (p. 98) • change in demand (p. 99) • substitutes (p. 100) • complements (p. 101) Academic Vocabulary • principle (p. 98) • illustrated (p. 98) —TIME COMPANIES IN THE NEWS McMakeover Deluxe McDonald’s is getting a makeover. The fast-food force has launched its first restaurant redesign in 30 years. More than 6,000 locations will feature the new look by year’s end. Customers will have three zones to choose from, based on their dining needs. Counter seating will serve eat-and-run customers. Those looking to linger will find soft lighting and plush chairs. Mingling teens can cram tables together in a flexible seating area. “It’s something McDonald’s should have done years ago,” says restaurant analyst Howard Penney. The design suggests a certain coffee chain, but Penney says it could give McDonald’s an edge over fast-food rivals. ■ Why would McDonald’s go to the trou- ble and expense of redesigning its restaurants? The company realizes that consumer demand is changing. This means the company has to change too, or it risks losing business to competitors that better meet customer demand. Such changes in demand have an effect on both the demand schedule and the demand curve. When it comes to demand, there are two types of changes. When the price of a product changes while all other factors remain the same, we have a change in the quantity demanded. Sometimes other factors change while the price remains the same—similar to the change in consumer taste in our news story. When this happens, we see a change in demand. James Leynse/CORBIS CHAPTER 4 Demand 97 Change in the Quantity Demanded demanded. As we will see, the income and substitution effects also help us understand this principle. change in quantity demanded movement along the demand curve showing that the amount someone is willing to purchase changes when the price changes income effect that part of a change in quantity demanded due to a change in the buyer’s real income when a price changes substitution effect that part of a change in quantity demanded due to a price change that makes other products more or less costly MAIN Idea Only a change in price can cause a change in quantity demanded. Economics & You When you shop for an item, do you also consider prices of related items? Read on to learn how demand accounts for this behavior. Look at Figure 4.3 to see what happens when only the price changes and everything else remains constant. Point a on the demand curve shows that six CDs are demanded at a price of $15. When the price falls to $10, 10 CDs are demanded. This movement from point a to point b is a change in quantity demanded—a change that is graphically represented as a movement along the demand curve. When the price goes up, fewer CDs are demanded. When the price goes down, more are Figure 4.3 Change in the Quantity Demanded D EMAND C URVE e c i r P $30 25 20 15 10 5 0 Decrease in quantity demanded a b Increase in quantity demanded 10 11 12 13 14 15 Quantity Only a change in price can cause a change in quantity demanded. When the price goes down, the quantity demanded increases. When the price goes up, the quantity demanded decreases. Both changes appear as a movement along the demand curve. Economic Analysis Why do price and quantity demanded move in opposite directions? The Income Effect When the price of a product drops, consumers pay less and, as a result, have some extra income to spend. For example, we can see from Figure 4.3 that consumers spent $90 to buy six CDs when the price was $15 per CD. If the price drops to $10, they would spend only $60 on the same quantity, leaving them $30 “richer” because of the drop in price. They may even spend some of this extra income on more CDs. As a result, part of the increase from 6 to 10 units purchased, shown as the movement from point a to point b on the demand curve, is due to consumers feeling richer. If the price had gone up, consumers would have felt a bit poorer and would have bought fewer CDs. This illustrates the income effect, the change in quantity demanded because of a change in price that alters consumers’ real income. The Substitution Effect A lower price also means that CDs will be relatively less expensive than other goods and services such as concerts and movies. As a result, consumers will have a tendency to replace a more costly item— say, going to a concert—with a less costly one—more CDs. The substitution effect is the change in quantity demanded because of the change in the relative price of the product. Together, the income and substitution effects explain why consumers increase their consumption of CDs from 6 to 10 when the price drops from $15 to $10. Whenever a price change causes a change in quantity demanded, the change appears graphically as a movement along the demand curve. The change in quantity demanded, as illustrated in Figure 4.3, can be either an increase or a decrease, but in either case the demand curve itself does not shift. Reading Check Describing How is a change in the quantity demanded illustrated on the demand curve? Figure 4.4 Change in Demand A change in demand occurs when people decide to purchase different amounts of a product at the same price. When we plot the numbers from the demand schedule, we get two separate demand curves. An increase in demand appears as a shift of the demand curve to the right. A decrease in demand appears as a shift to the left. Economic Analysis What might cause a change in demand for CDs? A D EMAND S CHEDULE B D EMAND C URVE See StudentWorks™ Plus or glencoe.com. Price $30 25 20 15 10 5 D 0 1 3 6 10 15 D1 1 3 6 10 15 20 e c i r P $30 25 20 15 10 5 0 a a’ Decrease in demand Increase in demand b b’ D D1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Quantity change in demand shift of the demand curve when people buy different amounts at every price Change in Demand MAIN Idea Several factors can cause the demand curve to shift. Economics & You Can you remember something fashionable that quickly went out of style? Read on to learn how changing consumer tastes affect demand. Sometimes other factors change while the price remains the same. When this happens, people may decide to buy different amounts of the product at the same prices. This is known as a change in demand. As a result, the entire demand curve shifts—to the right to show an increase in demand, or to the left to show a decrease in demand. Therefore, a change in demand results in an entirely new demand curve, while a change in quantity demanded is a movement along the original demand curve. A change in demand is illustrated in the schedule and graph in Figure 4.4. Note that Panel A has a third column showing that people are willing to buy different amounts at each and every price. At a price of $15, for example, consumers are now willing to buy 10 CDs instead of 6, moving from point a to point a´. When this information is transferred to the graph, the demand curve appears to have shifted to the right. When demand changes, a new schedule or curve must be constructed to reflect the new quantities demanded at all possible prices. Demand can change because of changes in the determinants of demand: consumer income, consumer tastes, the price of related goods, expec tations, and the number of consumers. Consumer Income Changes in consumer income can cause a change in demand. An increase in income means people can afford to buy more at all possible prices. Suppose, for example, that CHAPTER 4 Demand 99 &The Global Economy YOU Digital Demand in South Korea The increasing demand for new technology is When a financial crisis hit Asia over a decade ago, South Koreans decided to invest in technology to spur economic development. Today over 70 percent of the country has high-speed Internet access, and South Korea boasts the world’s largest Wi-Fi network. South Koreans eagerly embrace the new technology, using it in ways unknown in the United States. For example, they pay for the subway fare by swiping their cell phones through readers. Students access Webcast tutorials as they study for their version of the SAT. most evident in cell phones. South Koreans replace their cell phones as often as every six months. That puts pressure on companies to constantly develop upgraded models with new and exciting features. It also has turned South Korea into a nation-wide focus group on cell phones. The phone you purchase today may well have features that your South Korean peers tested for you 6 to 12 months earlier. substitutes competing products that can be used in place of one another Mike and Julia get a raise, which allows them to buy more CDs. Instead of Mike and Julia each buying 3 for a total of 6 when the price is $15, they can now each buy 5— for a total of 10. If we plot how many CDs would be purchased at every possible price in the market as demand curve D1 in Figure 4.4, then it appears as if the curve has shifted to the right. Exactly the opposite could happen if there was a decrease in income and Mike and Julia bought less. The demand curve would then shift to the left, showing a decrease in demand. Consumer Tastes Consumers sometimes change their minds about the products they buy. Advertising, fashion trends, and even changes in the season can affect consumer tastes. For example, when a product is successfully advertised, its popularity increases and people tend to buy more of it. As a result, the demand curve shifts to the right. On the other hand, people will buy less of a product if they get tired of it. This is exactly what happens when a rumor or unfavorable report about a product appears. When fewer people want the product at all possible prices |
, the demand curve shifts to the left, showing a decrease in demand. In addition, the development of new products can have a dramatic and relatively sudden impact on consumer preferences. For example, when music CDs were first introduced on the market, they reduced the demand for cassette players and tapes, shifting the demand curves for both to the left. When the iPod and similar devices arrived, the demand for CDs and CD players decreased. Sometimes the change in consumer tastes and preferences is relatively rapid, and sometimes the change occurs more slowly. In recent years, for example, consumer concerns about health have slowly increased the demand for healthful foods. Substitutes A change in the price of related products can cause a change in demand. Some products are known as substitutes because they can be used in place of other products. For example, if people treat butter and margarine as substitutes, a rise in the price of butter will cause an increase in the demand for margarine. Likewise, a rise in the price of margarine would cause the demand for butter to increase. In general, the demand for a product tends to increase if the price of its substitute goes up. The demand for a product tends to decrease if the price of its substitute goes down. 100 UNIT 2 Microeconomics: Prices and Markets Motorola Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 4—Student Web Activities for an activity on change in demand. complements products that increase the use of other products Complements Other related goods are known as complements, because the use of one increases the use of the other. Personal computers and software are two complementary goods. When the price of computers decreases, consumers buy more computers and more software. If the price of computers spirals upward, consumers would buy fewer computers and less software. Thus, an increase in the price of one good usually leads to a decrease in the demand for its complement. Expectations The way people think about the future can affect demand. For example, suppose that a company announces a technological breakthrough in television picture quality. Even if the new product might not be available for a year, some consumers might hold off buying a TV today due to their expectations. Purchasing less at every price would cause demand to decline, illustrated by a shift of the demand curve to the left. Of course, expectations can also have the opposite effect on market demand. For example, if the weather service forecasts a bad year for crops, people might stock up on some foods before these items actually become scarce. The willingness to buy more because of expected future shortages would cause demand to increase, shown by a shift of the demand curve to the right. Number of Consumers A change in income, tastes, and prices of related products affects individual demand schedules and curves—and hence the market demand curve. The market demand curve can also change if there is a change in the number of consumers. Suppose that Devan, one of Mike’s and Julia’s friends, decides to purchase CDs. We would add the number of CDs that Devan would buy at all possible prices to those for Mike and Julia. The market demand curve would shift to the right to reflect an increase in demand. If Mike or Devan should leave the market, the total number of CDs purchased would decrease, shifting the market demand curve to the left. Reading Check Explaining How do changes in consumer income and tastes affect the demand curve? SECTION 2 Review Vocabulary 1. Explain the significance of change in quantity demanded, income effect, substitution effect, change in demand, substitutes, and complements. Main Ideas 2. Explaining What is the difference between a change in quantity demanded and a change in demand? 3. Describing Using a graphic organizer similar to the one below, describe the determinants of market demand. Determinants of market demand Critical Thinking 4. The BIG Idea How and why does a change in price affect the demand for substitutes? Provide an example. 5. Analyzing Visuals Look at Figure 4.4 on page 99. Assume that a new CD format will come out soon. What do you think will happen to the market demand curve D? Explain. 6. Interpreting Locate an article in your newspaper illustrating at least one determinant of demand. Write a brief explanation of the effect of the determinant(s). Applying Economics 7. Change in Demand Name a product that you recently purchased because it was on sale. Identify one substitute and one complement for the product and describe how your demand for the substitute and complement changed because of the sale. CHAPTER 4 Demand 101 ENTREPRENEUR Profiles in Economics Oprah Winfrey (1954– ) • first woman in history to produce and own her own talk show • first African American woman—and third woman in history— to own a major television and film studio The Gift of Gab Oprah Winfrey grew up in deep poverty. As a troubled teenager, she went to live with her father, who encouraged her education. Four years later Winfrey received a scholarship to attend Tennessee State University. At the same time, she got her first media job as a radio news announcer. Two years later Winfrey became cohost of a talk show—and found her calling. Winfrey felt comfortable talking in front of cameras, and viewers responded to her easygoing attitude by making her program the number-one talk show in the Baltimore market. In 1984 Winfrey relocated to Chicago to take over the failing talk show A.M. Chicago. Just as in Baltimore, the audience responded to her relaxed manner by watching in increasing numbers. Within two years, the show, renamed The Oprah Winfrey Show, became nationally syndicated, and today viewers watch her in more than 100 countries. The syndication deal made Winfrey the highestpaid entertainer at the time, with estimated earnings of over $37 million in 1987. Building a Media Empire Winfrey used this money and her personal ambition to build a wide-ranging business empire. In 1986 she established her own company, Harpo Inc. (Harpo is Oprah spelled backward.) A production company and movie studio grew from that venture. Since then, Winfrey has become cofounder of the Oxygen television network and branched out into print media through the publications O, The Oprah Magazine, and O at Home. Success has allowed Winfrey to spend a portion of her income on charities that support education and help families. That portion is rising. Forbes magazine listed Winfrey as the first African American woman to become a billionaire. Her annual income, estimated at over $225 million by 2006, has increased ever since. Examining the Profile 1. Drawing Conclusions Why is Oprah Winfrey considered to be one of the most powerful women in America? 2. Analyzing What characteristics helped Winfrey become a successful talk show host and entrepreneur? Most people know Oprah Winfrey as a talk show host. Over the years, though, the likable Winfrey has developed many other talents to become one of the wealthiest, most successful, and most influential women in America. 102 UNIT 2 Microeconomics: Prices and Markets Brad Barket/Getty Images SECTION 3 Elasticity of Demand GUIDE TO READING Section Preview Reading Strategy In this section you will learn about the factors that influence the size of a change in quantity demanded. Content Vocabulary • elasticity (p. 103) • demand elasticity (p. 104) • elastic (p. 104) • inelastic (p. 104) • unit elastic (p. 105) Academic Vocabulary • technical (p. 106) • adequate (p. 108) Describing As you read about price elasticity, complete a web diagram like the one below to describe what effect a change in price has on quantity demanded if the demand curve is elastic, inelastic, or unit elastic. Change in Price COMPANIES IN THE NEWS Netflix, Blockbuster Battle It Out —www.entertainmentculture.com Netflix and Blockbuster continue to battle head to head in the online movie rental arena. The monthly rental prices have dropped for DVD entertainment delivered to your door, ordered online. . . . Entertainment culture at its best, it seems—lots of competition and that is normally a better price point for the consumer. [Reed Hastings, the CEO of Netflix, says,] “One of the reasons our last year has been so successful is the market’s elasticity in response to our price cuts one year ago. . . . Obviously, if there’s enough elasticity to make additional price cuts work, this would increase the economic pressure on video stores, and the additional store closures would further increase Netflix growth for many years ahead.” In 2006, Netflix expects to grow to 5.65 million subscribers with pretax net income between $50 million and $60 million. ■ You can find cause-and-effect relation- ships everywhere, and they are especially important to businesses. For example, Netflix had hoped that lower prices would entice customers to rent more movies and thus increase its overall revenues. The gamble paid off. Company CEO Reed Hastings credited the market’s demand elasticity for the company’s success. Elasticity is a general measure of responsiveness—an important cause-and-effect relationship in economics. It tells us how a dependent variable, such as quantity demanded, responds to a change in an independent variable, such as price. Elasticity is a general concept that can also be applied to other measures such as income or supply. elasticity a measure of responsiveness that shows how one variable responds to a change in another variable Glencoe CHAPTER 4 Demand 103 demand elasticity a measure that shows how a change in quantity demanded responds to a change in price elastic type of elasticity where a change in price causes a relatively larger change in quantity demanded inelastic type of elasticity where a change in price causes a relatively smaller change in quantity demanded Demand Elasticity MAIN Idea When the price of an item changes, |
the change in quantity demanded can vary a little or a lot. Economics & You If there was a huge sale on table salt, would you stock up? Read on to learn how elasticity describes your response to the price change. Consumers react to a change in price by changing the quantity demanded, although the size of their reaction can vary. This response is known as demand elasticity— the extent to which a change in price causes a change in the quantity demanded. Elastic Demand Economists say that demand is elastic when a given change in price causes a relatively larger change in quantity demanded. To illustrate, look at how price and quantity demanded change between points a and b on the demand curve in Panel A of Figure 4.5. As we move from point a to point b, we see that price declines by one-third, or from $3 to $2. At the same time, the quantity demanded doubles from two to four units. Because the percentage change in quantity demanded is relatively larger than the percentage change in price, demand between those two points is elastic. This type of elasticity is typical of the demand for products like green beans, corn, or other fresh garden vegetables. Because prices of these products are lower in the summer, consumers increase the amount they purchase during that time. When prices are considerably higher in the winter, consumers tend to buy canned or frozen products instead. Inelastic Demand For other products, demand may be inelastic, which means that a given change in price causes a relatively smaller change in the quantity demanded. We can see the case of inelastic demand in Panel B of Figure 4.5. In this case, the one-third drop in price from point a´ to b´ causes quantity demanded to increase by only 25 percent, or from two to two and one-half units. This is typical of the demand elasticity for a product like table salt. A change in the price for salt does not bring about much change in the quantity purchased. Even if the price was cut in half, the quantity Figure. 4.5 Demand Elasticity and the Total Expenditures Test A E LASTIC D EMAND B I NELASTIC D EMAND e c i r P $4 3 2 1 0 a Expenditure $6 = $3 per 2 units b Expenditure $8 = $2 per 4 units 1 2 3 Quantity 4 5 e c i r P $4 3 2 1 0 a’ b’ Expenditure $6 = $3 per 2 units Expenditure $5 = $2 per 2.5 units 1 2 3 Quantity 4 5 104 UNIT 2 Microeconomics: Prices and Markets unit elastic type of elasticity where a change in price causes a proportional change in quantity demanded demanded would not increase by much because people can consume only so much salt. Similarly, if the price doubled, we would still expect consumers to demand about the same amount, because people spend such a small portion of their budget on salt. Unit Elastic Demand Sometimes demand is unit elastic, so that a given change in price causes a proportional change in quantity demanded. When demand is unit elastic, the percentage change in quantity equals the percentage change in price. For example, a five percent drop in price would cause a five percent increase in quantity demanded. Unit elastic demand is shown in Panel C of Figure 4.5. Examples of unit elasticity are difficult to find because the demand for most products is either elastic or inelastic. Unit elasticity is more like a middle ground that separates the other two categories of elasticity: elastic and inelastic. Reading Check Comparing What is the difference between elastic and inelastic demand? The Total Expenditures Test MAIN Idea The total expenditures test is used to estimate the demand elasticity of a product. Economics and You You just learned about demand elasticity. Read on to find out how businesses apply elasticity when setting prices. To estimate elasticity, it is useful to look at the impact of a price change on total expenditures, or the amount that consumers spend on a product at a particular price. This is sometimes called the total expenditures test. Determining Total Expenditures We find total expenditures by multiplying the price of a product by the quantity demanded for any point along the demand curve. To illustrate, the total expenditure under point a in Panel A of Figure 4.5 is $6, which is determined by multiplying two units times the price of $3. Likewise, the total expenditure under point b in Panel A is $8, or $2 times four units. By observing the change in total expenditures when the price changes, we can test for elasticity. C U NIT E LASTIC D EMAND D D ETERMINING E LASTICITY e c i r P $4 3 2 1 0 a’’ b’’ Expenditure $6 = $3 per 2 units Expenditure $6 = $2 per 3 units 1 2 3 Quantity 4 5 Type of demand Change in price Change in expenditure Elastic Inelastic Unit Elastic No change Panels A, B, and C show how quantity demanded responds to a price change for products with elastic, inelastic, and unit elastic demand. Panel D summarizes these changes in a chart. Economic Analysis Why is an understanding of elasticity important for a business? Three Results The relationship between changing prices and total expenditures is summarized in the four panels of Figure 4.5 on the previous page. The figure shows how a decrease in price from $3 to $2 impacts total expenditures for each of the demand curves. In each case, the change in expenditures depends on the elasticity of the demand curve. CAREERS Buyer The Work * Purchase merchandise for resale to the public * Study sales records, inventory levels of current stock, determine foreign and domestic suppliers, and determine supply and demand for products and materials * Choose suppliers, negotiate the lowest price, and award contracts * Stay informed about new products and trends, attend trade shows, assist in sales promotions and advertising campaigns, check on displays Qualifications * Ability to plan, analyze data provided by suppliers, make decisions quickly, work under pressure, and identify products that will sell * Good communication, negotiation, and mathematical skills * Knowledge of supply-chain management * Bachelor’s degree with a business emphasis Earnings * Median annual earnings: $42,230 Job Growth Outlook * Slower than average Source: Occupational Outlook Handbook, 2006–2007 Edition 106 UNIT 2 Microeconomics: Prices and Markets Jeff Greenberg/Photo Edit The demand curve in Panel A is elastic. When the price drops by $1 per unit, the increase in the quantity demanded is large enough to raise total expenditures from $6 to $8. The relationship between the change in price and total expenditures for the elastic demand curve is described as “inverse.” In other words, when the price goes down, total expenditures go up. The demand curve in Panel B is inelastic. In this case, when the price drops by $1, the increase in the quantity demanded is so small that total expenditures fall below $6. For inelastic demand, total expenditures decline when the price declines. Finally, the demand curve in Panel C is unit elastic. This time, total expenditures remain unchanged when the price decreases from $3 to $2. Determining Elasticity The relationship between the change in price and the change in total expenditures is shown in Panel D of Figure 4.5. If the changes in price and expenditures move in opposite directions, demand is elastic. If they move in the same direction, demand is inelastic. If there is no change in expenditure, demand is unit elastic. Even though all the price changes we just discussed were decreases, the results would be the same if prices had gone up instead of down. If the price rises from $2 to $3 in Panel A, spending falls from $8 to $6. Prices and expenditures still move in opposite directions, as shown in the table. Elasticity and Revenues While this discussion about elasticity may seem technical and somewhat unnecessary to you, knowledge of demand elasticity is extremely important to most businesses. Suppose, for example, that you run your own business and want to do something that will raise your revenues. You could try to stay open longer, or you could try to advertise in order to increase sales. You might, however, also be tempted to raise the price of your product in order to increase total revenue from sales . Total Expenditures and Demand Elasticity Some consumers, such as the painter in this cartoon, buy more than they need when items go on sale. What kind of demand elasticity is depicted in this cartoon, and what happened to total expenditures for green paint? Skills Handbook See page R36 to learn about Determining Cause and Effect. This might actually work in the case of table salt or medical services, because the demand for both products is generally inelastic. However, what would happen if you sold a product with elastic demand? If you raise the price, your total revenue— which is the same as consumer expenditures—will go down instead of up. This outcome is exactly the opposite of what you intended! This is exactly why some businesses experiment with different prices when they introduce a new product to the market. They may adjust prices repeatedly to see how customers respond to new prices. If a business can determine a new product’s demand elasticity, it can find the price that will maximize total revenues. This is why demand elasticity is more important than most people realize. Reading Check Explaining What happens to the total expenditures for a product with elastic demand when its price goes up? Determinants of Demand Elasticity MAIN Idea The answers to three questions help determine a product’s demand elasticity. Economics and You Can you think of an item you delayed buying because it was too expensive? Read on to learn how your decision to wait is a way to determine the elasticity of a product. What makes the demand for a specific good elastic or inelastic? To find out, we can ask three questions about the product. The answers will give us a reasonably good idea about the product’s demand elasticity. Can the Purchase Be Delayed? Sometimes consumers cannot postpone the purchase of a product. This tends to make demand inelastic, me |
aning that the quantity of the product demanded is not especially sensitive to changes in price. www.CartoonStock.com CHAPTER 4 Demand 107 Figure 4.6 Determinants of Demand Elasticity The elasticity of demand can usually be estimated by examining the answers to three key questions. All three answers do not have to be the same in order to determine elasticity, and in some cases the answer to a single question is so important that it alone might override the answers to the other two. Economic Analysis If you applied the three questions to a luxury product, what would be the elasticity of demand for that product? P RODUCTS Determinants of elasticity If yes: elastic If no: inelastic Fresh tomatoes, corn, or green beans Table salt Gasoline from a particular station Gasoline in general Services of medical doctors Insulin Butter Can purchase be delayed? Are adequate substitutes available? Does purchase use a large portion of income? Yes Yes No No No No Yes Yes Yes No No Yes No No Yes No No No Yes Yes No Type of elasticity Elastic Inelastic Elastic Inelastic Inelastic Inelastic Elastic For example, persons with diabetes need insulin to control the disorder. An increase in its price is not likely to make diabetes sufferers delay buying and using the product. The demand for tobacco also tends to be inelastic because the product is addictive. As a result, a sharp increase in price will lower the quantity purchased by consumers, but not by very much. The change in quantity demanded is also likely to be relatively small for these products when their prices go down instead of up. If the products were corn, tomatoes, or gasoline from a particular station, however, people might react differently to a price change. If the prices of these products were to increase, consumers could delay buying any of these items without suffering any great inconvenience. Figure 4.6 summarizes some of these observations. If the answer to the question “Can the purchase be delayed?” is yes, then the demand for the product is likely to be elastic. If the answer to the question is no, then demand is likely to be inelastic. Are Adequate Substitutes Available? If adequate substitutes are available, consumers can switch back and forth between the product and its substitute to take advantage of the best price. If the price of beef goes up, buyers can switch to chicken. With enough substitutes, even small changes in the price of a product will cause people to switch, making the demand for the product elastic. The fewer substitutes available for a product, the more inelastic the demand. Sometimes only a single adequate substitute is needed to make demand elastic. For example, in the past there were few substitutes for sending a letter through the post office. Then fax machines allowed messages to be transmitted over phone lines. Today many people use e-mail on the Internet or send instant messages on their cell phones. Because of all these alternatives, it is more difficult for the U.S. Postal Service to increase its total revenues by raising the price of a first-class stamp. 108 UNIT 2 Microeconomics: Prices and Markets Note that the size of the market is important. For example, the demand for gasoline from a particular station tends to be elastic because consumers can buy gas at another station. If we ask about the demand for gasoline in general, however, demand is much more inelastic because there are few adequate substitutes for gasoline. Does the Purchase Use a Large Portion of Income? The third determinant is the amount of income required to make the purchase. If the amount is large, then demand tends to be elastic. If the amount of income is small, demand tends to be inelastic. Finally, you may have noticed that the answers to our three questions is not always “yes” or “no” for each of the products shown in Figure 4.6. For example, some products such as salt may be easy to classify, since each of the answers is “no.” However, we have to use our judgment on others. For Inelastic Taxes? When you buy a product in a store, most states charge a sales tax when you get to the cash register. Many states also charge an excise tax, or a general revenue tax on the manufacture or sale of selected items, which is already included in the price of the item. The excise tax usually raises the price of the item. If demand for the product is inelastic, then so much the better for the tax collector, because the quantity demanded does not drop very much. That’s why so many excise taxes are on items like gasoline and concert admissions—items that have an inelastic demand. example, the demand for the services of medical doctors tends to be inelastic even though they require a large portion of income. This is because most people prefer to receive medical care right away rather than taking the time to look for adequate substitutes. Reading Check Identifying Can you think of other goods with inelastic demand? Why is the demand for those goods inelastic? SECTION 3 Review Vocabulary 1. Explain the significance of elasticity, demand elasticity, elastic, inelastic, and unit elastic. Main Ideas 2. Describing How do consumers react to price changes on products with elastic, inelastic, and unit elastic demand? 3. Explaining How do total expenditures relate to the demand elasticity for products? 4. Organizing Use a graphic organizer like the one below to describe the three determinants of demand elasticity. Determinant Description Critical Thinking 5. The BIG Idea Why is the demand for airplane tickets inelastic for last-minute ticket purchases? 6. Understanding Cause and Effect A hamburger stand raised the price of its hamburgers from $2.00 to $2.50. As a result, its sales of hamburgers fell from 200 per day to 180 per day. Was the demand for its hamburgers elastic or inelastic? Why? 7. Analyzing Visuals Based on Figure 4.6 on page 108, create your own chart for the following products: an MP3 player, electricity, a gallon of milk, an ink pen, and a pound of onions. Explain. 8. Drawing Conclusions Airlines in the United States generally do not offer reduced round-trip airfares during holidays such as Easter, Thanksgiving, and Christmas. What can you conclude about the elasticity of demand for airplane travel at these times? Applying Economics 9. Elasticity of Demand Interview an owner or manager of a local business about the effects of recent price increases for a product. Is the demand for these goods or services elastic or inelastic? Why? CHAPTER 4 Demand 109 CASE STUDY The iPod The Idea Handheld music devices date back to the 1970s, when Sony introduced the Walkman. So why has the iPod dominated the MP3 market in the early 2000s? When the iPod hit store shelves in November 2001, other MP3 players were already on the market. Yet they were larger than the 6.5-ounce iPod, and they could not hold nearly as many songs. The iPod was an instant hit. Innovation Technology set off the iPod in other ways. The mechanical scroll wheel allowed easy scrolling and navigation. FireWire allowed much faster transfer of music from the computer to the iPod. In 2003 Apple CEO Steve Jobs announced that the iTunes software, formerly used to store and play digital music on a Mac, would become a gateway to the online iTunes Store. The owners of iPods now were able to download songs for just 99¢ each. While Apple makes only about .10¢ per U.S. M ARKET FOR MP3s 24% 2% APPLE’S REVENUE 2000–2006* $24 20 18 16 12 2001 2002 2003 2004 Year 2005 2006* Source: www.apple.com *2006 earnings projected sale, it generates many more iPod sales. On top of that, music from the iTunes Music Store can be played only on Apple devices because of Apple’s digital rights management technology. This tempts more people to purchase iPods. Staying Ahead of the Pack Apple continues to innovate. In January 2004, Apple introduced the iPod mini. Its “click wheel” removed the need for buttons. Newer models can hold ever larger volumes of data, while tiny flashmemory chips keep the player size small. Today’s iPods can store up to 10,000 songs, hold hundreds of photos, and play entire movies. Adapters connect iPods with car or home stereo systems. By constantly updating, Apple has been able to keep its huge market share ever since the iPod was introduced. 74% Analyzing the Impact Apple Sony All others Source: BusinessWeek 1. Summarizing What features allowed Apple’s iPod to dominate the market? 2. Drawing Conclusions How does Apple continue to stay ahead of the competition? 110 UNIT 2 Microeconomics: Prices and Markets “Courtesy of Apple” www.apple.com CHAPTER CHAPTER 4 Visual Summary 4 Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Law of Demand The Law of Demand states that when the price goes up, quantity demanded goes down. When the price goes down, quantity demanded goes up. quantity quantity demanded demanded goes goes down . . . down . . . When the When the price goes price goes down . . . down . . . When the When the price goes price goes up . . . up . . . quantity quantity demanded demanded goes up . . . goes up . . . Change in Demand When a change in demand occurs, people want to buy different amounts of a product at the same price. A change in demand can happen for several reasons. Consumer income Number of consumers Consumer tastes Change in Demand Expectations Price of substitutes Price of complements Demand and Elasticity Changes in price and total expenditures help determine the demand elasticity of a product. Type of Demand Change in Price Change in Expenditure Movement of Price and Expenditure Elastic Inelastic Unit elastic Opposite Same No change CHAPTER 4 Demand 111 CHAPTER 4 Assessment and Activities Review Content Vocabulary Review the Main Ideas On a separate sheet of paper, match the letter of the term best described by each statement below. a. demand b. demand elasticity c. change in demand d. demand curve e. Law of Demand f. complement g. elastic demand h. substitutes i. |
marginal utility j. unit elastic demand Section 1 (pages 91–95) 17. Describe a demand schedule and a demand curve. How are they alike? How do they differ? 18. Discuss what is meant by the Law of Demand. 19. Explain how the principle of diminishing marginal utility is related to the downward-sloping demand curve. Section 2 (pages 97–101) 1. statement that more will be demanded at lower prices 20. Explain the difference between the income effect and and less at higher prices the substitution effect. 2. graph that shows the quantity demanded at all possible 21. Identify and describe the five factors that can cause a prices in the market at a given time 3. measure of responsiveness relating change in quantity demanded to a change in price 4. a given change in price causes a relatively larger change in quantity demanded 5. products that can be used in place of one another 6. a principle illustrating that consumers demand different amounts at every price, causing the demand curve to shift to the left or the right change in individual demand, using a graphic organizer similar to the one below. Change in Individual Demand 7. additional satisfaction or usefulness as more units of a Section 3 (pages 103–109) product are acquired 22. Describe the difference between elastic demand and 8. the desire, ability, and willingness to buy a product inelastic demand. 9. a given change in price causes a proportional change in 23. Explain how the total expenditures test can be used to quantity demanded determine demand elasticity. 10. product that increases the use of another product 24. Identify and then describe the determinants of demand elasticity. Review Academic Vocabulary Critical Thinking On a separate sheet of paper, use each of these terms in a sentence that reflects the term’s meaning in the chapter. 11. prevail 12. inversely 13. principle 14. illustrate 15. technical 16. adequate 25. The BIG Ideas Assume that demand for pizza has been steady for some time. How do you think the market demand curve for pizza would be affected by (1) an increase in everyone’s pay, (2) a successful pizza advertising campaign, (3) a decrease in the price of hamburgers, and (4) new people moving into the community? Explain your answers. 112 UNIT 2 Microeconomics: Prices and Markets Economics: Principles and Practices Web site at glencoe.com and click on Chapter 4—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the 26. Determining Cause and Effect Razor blades are complementary goods for razor handles, while electric razors are substitutes. Copy the demand curves below on a sheet of paper. Then show how the rise in the cost of razor handles, if they were sold separately, would affect the demand curves for its complementary and its substitute products. R AZOR B LADES E LECTRIC R AZORS Analyzing Visuals 30. Look at Figure 4.2 on page 94. Suppose that Avi, a friend of Mike’s and Julia’s, is also willing to buy CDs. Create a new market demand schedule by adding the numbers that you think Avi is willing to purchase at different prices. Then draw a market demand curve reflecting the new numbers Quantity Quantity Thinking Like an Economist 31. Write a paragraph describing a business you might like to own. Describe the product your business makes. Then use the three determinants of demand elasticity to predict the elasticity of demand for that product. Explain the pricing policy you would use to get consumers to maximize their expenditures on that product. 27. Making Generalizations Do you think the Law of Demand accurately reflects most people’s behavior regarding certain purchases? Explain. 28. Synthesizing Assume that you are a business owner. How would you use your knowledge of demand elasticity to determine the price of your product? Interpreting Cartoons 32. Critical Thinking Look at the cartoon below. What do you think Snoopy’s doghouse represents? What message is the cartoonist trying to convey? Explain whether or not he found a good way to discuss the topic. Math Practice 29. Mindy is trying to estimate the elasticity of demand for a product she wants to sell at a craft fair. She has been told that she can expect to sell 10 items if she charges a price of $10, six items if she charges a price of $20, and 18 items at a price of $5. a. Make a demand schedule to show the quantities demanded at each price, and plot a demand curve. b. At which price would the total expenditures by consumers be greatest for the product? At what price would expenditures be the smallest Chris Britt, Copley News Service. CHAPTER 4 Demand 113 &The Global Economy YOU China’s Thirst for Gas Hurricanes in the Gulf of Mexico, deteriorating pipelines in Alaska, and conflict in Iraq can cause gasoline prices to rise by restricting supply. Often the events we see in the headlines affect the supply of oil available to consumers, but changes in the level of world demand for petroleum products also affects the price of oil. China’s Growing Demand PROJECTED OIL CONSUMPTION, UNITED STATES AND CHINA (1994–2025) U.S. demand for petroleum products has been high for decades. The United States is the largest consumer of oil, using about a quarter of the world’s petroleum. This is quickly changing. Emerging nations are becoming thirsty for oil, and China is at the top of that list. How did such a rapid change happen? In the past, China has not needed much petroleum. As the country is industrializing, however, it needs more and more fuel to satisfy its growing energy needs. In fact, as the graph of oil consumption between 1995 and 2025 shows, China’s consumption is increasing much more rapidly than U.S. consumption. C OUNTRIES WITH H IGHEST O IL C ONSUMPTION ) 25,000 20,000 15,000 10,000 5,000 0 United States China Japan Germany Russia Countries 1995 2005 2025 1 barrel = 1 million barrels/day United States China While China still consumes considerably less petroleum than the United States, it has been responsible for over 25 percent of the growth in world petroleum consumption since 1994 and 30 percent of growth since 2000. This increase was enough to make China the second biggest consumer in the world market in 2003, and its demand is not expected to slow down soon. Worldwide Impact China’s growing energy needs have worldwide repercussions. The nation’s increasing demand has helped to push up prices for crude oil. In 2005 the International Monetary Fund (IMF), which promotes economic growth and cooperation, expressed concern that high oil prices could bring about a worldwide slowdown in economic growth because of these increased energy needs. 114 UNIT 2 Microeconomics: Prices and Markets Higher prices for food and items in stores because of higher transportation cost EFFECTS OF HIGHER OIL PRICES Higher Oil Prices Higher Oil Prices Cuts in school programs because of higher transportation costs Higher prices for plastics, paints, and other products made with petroleum Higher prices at the gas pump What Does It Mean for You? Why should you care whether China is increasing its demand for petroleum? Simply put, any increase in demand for oil on the world market can lead to rising prices for a variety of goods and services in the United States because so many other products are linked to energy costs. The results of all these increased costs are manifold. You may see a cut in school programs to pay for higher transportation costs. The products you buy in stores may become more expensive. And of course the price of gas you put into your car may increase. If you are on a limited or fixed budget, like most students, such increases will leave you with less money to spend on other things. As you see, China’s higher demand for petroleum has a direct impact on you and your wallet. Analyzing the Issue 1. Identifying Why has China’s demand for petroleum increased in recent years? 2. Describing What is the effect of increased oil prices on your or your family’s budget? 3. Applying Check your local newspaper, news magazines, or Internet news sources for recent reports about global issues affecting oil prices. On a separate piece of paper, summarize the issues discussed in these articles and describe how they affect you. (t) Texas Energy Museum, Beaumont, Texas, (b) Jeff Greenberg/PhotoEdit CHAPTER 5 Supply Why It Matters In order to earn some extra money, you are considering opening a lawn or babysitting service. Brainstorm the resources you would need. What specific services would you offer? What prices would you charge? What information do you need to determine answers to these and other questions? Read Chapter 5 to find out about the factors that influence how businesses make production decisions. The BIG Ideas 1. Buyers and sellers voluntarily interact in markets, and market prices are set by the interaction of demand and supply. 2. The profit motive acts as an incentive for people to produce and sell goods and services. Firms base their supply of products on production costs and the price they can charge for the product. 116 UNIT 2 Laurence Dutton/Getty Images Economics: Principles and Practices Web site at glencoe.com and click on Chapter 5—Chapter Overviews to preview chapter information. Chapter Overview Visit the SECTION 1 What is Supply? GUIDE TO READING Section Preview Reading Strategy In this section, you will learn that the higher the price of a product, the more of it a producer will offer for sale. Content Vocabulary • supply (p. 117) • Law of Supply (p. 117) • supply schedule (p. 118) • supply curve (p. 118) • market supply curve (p. 119) • quantity supplied (p. 119) • change in quantity supplied (p. 119) • change in supply (p. 120) • subsidy (p. 122) • supply elasticity (p. 124) Academic Vocabulary • various (p. 118) • interaction (p. 120) Describing As you read the section, complete a graphic organizer similar to the one below by describing the causes for a change in supply. Change in Supply —www.forbes.com COMPANIES IN THE NEWS Flu Shot Gold Rush Last year, t |
he U.S. flu shot market was so unappealing that only two players were producing injectable vaccine—leading to a serious shortage when one of them, Chiron, had to shut down its plant. Now, it seems, non-U.S. firms are rushing to make influenza vaccine. Today, CSL Limited, a $2 billion biopharmaceutical firm based in Melbourne, Australia, is announcing plans to invest more than $60 million to enter the U.S. flu shot business. It expects to compete with Sanofi-Aventis, GlaxoSmithKline and Novartis, which plans to buy Chiron. . . . CSL [hopes to] be able to move 20 million doses, giving it a 10% to 15% market share. ■ The concept of supply is based on volun- tary decisions made by producers, whether they are proprietorships working out of their homes or large corporations. A producer might decide to offer one amount for sale at one price and a different quantity at another price. Supply, then, is defined as the amount of a product that would be offered for sale at all possible prices that could prevail in the market. Because producers receive payment for their products, it comes as no surprise that they will offer more at higher prices. This forms the basis for the Law of Supply, the principle that suppliers will normally offer more for sale at high prices and less at lower prices. The promise of high prices, and hopefully high profits, is what lured the company in the news story into entering the U.S. market. supply amount of a product offered for sale at all possible prices Law of Supply principle that more will be offered for sale at higher prices than at lower prices Robert Giroux/Getty Images CHAPTER 5 Supply 117 supply schedule a table showing how much a producer will supply at all possible prices supply curve a graph that shows the different amounts of a product supplied over a range of possible prices An Introduction to Supply MAIN Idea Supply can be illustrated by a supply schedule or a supply curve. Economics & You Earlier you learned how to illustrate demand using schedules and graphs. Read on to learn how to illustrate supply. If you compare it to the demand schedule in Panel A of Figure 4.1 on page 92, you will see that the two are remarkably similar. The main difference between them is that for supply, the quantity goes up when the price goes up—rather than down as in the case of demand. All suppliers of products must decide how much to offer for sale at various prices—a decision made according to what is best for the individual seller. What is best depends, in turn, upon the cost of producing the goods or services. The concept of supply, like demand, can be illustrated in the form of a table or a graph. The Supply Schedule The supply schedule is a listing of the various quantities of a particular product supplied at all possible prices in the market. Panel A of Figure 5.1 presents a hypothetical supply schedule for CDs. It shows the quantities of CDs that will be supplied at various prices, other things being equal. The Individual Supply Curve The data presented in the supply schedule can also be illustrated graphically as the upward-sloping line in Panel B of Figure 5.1. To draw it, all we do is transfer each of the price-quantity observations in the schedule over to the graph, and then connect the points to form the curve. The result is a supply curve, a graph showing the various quantities supplied at all possible prices that might prevail in the market at any given time. All normal supply curves have a positive slope that goes up from the lower left-hand corner of the graph to the upper right-hand corner. This shows that if the price goes up, the quantity supplied will go up too. Figure 5.1 Supply of Compact Discs A S UPPLY S CHEDULE B S UPPLY C URVE Price $30 25 20 15 10 5 Quantity supplied 30 25 20 15 10 5 0 Decrease in quantity supplied a S b Increase in quantity supplied 1 2 3 4 Quantity 5 6 7 8 The supply schedule and the supply curve both show the quantity of CDs supplied in the market at every possible price. Note that a change in the quantity supplied appears as a movement along the supply curve. Economic Analysis How does the Law of Supply differ from the Law of Demand? Figure 5.2 Individual and Market Supply Curves The market supply curve shows the quantities supplied by all firms that offer the product for sale in a market. Point a on the market supply curve represents the four CDs that Firm A would supply and the two CDs that Firm B would supply, at a price of $15, for a total of six CDs. Economic Analysis Why are the supply curves upward sloping? See StudentWorks™ Plus or glencoe.com. S UPPLY C URVE OF F IRM A S UPPLY C URVE OF F IRM B M ARKET S UPPLY C URVE $30 S $30 S $30 S e c i r P 25 20 15 10 5 0 b’ a’ + e c i r P Add the first supply curve . . . 1 2 3 5 4 Quantity 6 87 25 20 15 10 5 0 b’’ a’’ . . . to the second supply curve . . . 1 3 2 Quantity 4 5 = e c i r P 25 20 15 10 5 0 b a . . . to get the market supply curve. 21 3 54 6 87 Quantity 9 10 11 12 13 market supply curve a graph that shows the various amounts offered by all firms over a range of possible prices quantity supplied amount offered for sale at a given price change in quantity supplied change in amount offered for sale when the price changes While the supply schedule and curve in Figure 5.1 represent the voluntary decisions of a single, hypothetical producer of CDs, we should realize that supply is a very general concept. In fact, you are a supplier whenever you look for a job and offer your services for sale. Your economic product is your labor, and you would probably be willing to supply more labor for a high wage than for a low one. The Market Supply Curve The supply schedule and curve in Figure 5.1 show the information for a single firm. Frequently, however, we are more interested in the market supply curve, the supply curve that shows the quantities offered at various prices by all firms that offer the product for sale in a given market. To obtain the data for the market supply curve, add the number of CDs that individual firms would produce, and then plot them on a separate graph. In Figure 5.2, point a on the market supply curve represents six CDs—four supplied by the first firm and two by the second—that are offered for sale at a price of $15. In the same way, point b on the curve represents a total of nine CDs offered for sale at a price of $20. A Change in Quantity Supplied The quantity supplied is the amount that producers bring to market at any given price. A change in quantity supplied is the change in amount offered for sale in response to a change in price. In Figure 5.1, for example, four CDs are supplied when the price is $15. If the price increases to $20, six CDs are supplied. If the price then changes to $25, seven units are supplied. These changes illustrate a change in the quantity supplied, which—like the case of demand—shows as a movement along the supply curve. Note that the change in quantity supplied can be an increase or a decrease, depending on whether more or less of a product is offered. For example, the movement from a to b in Figure 5.1 shows an increase because the number of products offered for sale goes from four to six when CHAPTER 5 Supply 119 change in supply situation where different amounts are offered for sale at all possible prices in the market; shift of the supply curve the price goes up. If the movement along the supply curve had been from point b to point a, there would have been a decrease in quantity supplied because the number of products offered for sale went down. It makes no difference whether we are talking about an individual supply curve or a market supply curve. In either case, a change in quantity supplied takes place whenever a change in price affects the amount of a product offered for sale. In a market economy, producers usually react to changing prices in just this way. While the interaction of supply and demand usually determines the final price of the product, the producer normally has the freedom to adjust production up or down. Take oil as an example. If the price of oil falls, the producer may offer less for sale, or even leave the market altogether if the price goes too low. If the price rises, the producer may offer more output for sale to take advantage of the better prices. Reading Check Synthesizing How might a producer of bicycles adjust supply when prices decrease? Change in Supply MAIN Idea Several factors can contribute to a change in supply. Economics & You Can you think of a time when you wanted to buy something, but the product was sold out everywhere? Read on to learn about factors that can affect supply. Sometimes something happens to cause a change in supply, a situation where suppliers offer different amounts of products for sale at all possible prices in the market. This is not the same as the change in quantity supplied illustrated in Figure 5.1, because now we are looking at situations where the quantity changes even though the price remains the same. For example, the supply schedule in Figure 5.3 shows that producers are now willing to offer more CDs for sale at every price than before. Where 6 units were offered at a price of $15, now there are 13. Where 11 were offered at a price of $25, 18 are now offered, and so on. Figure 5.3 A Change in Supply A S UPPLY S CHEDULE B C HANGE IN S UPPLY Price $30 25 20 15 10 5 S 13 11 9 6 3 0 S1 20 18 16 13 9 3 e c i r P $30 25 20 15 10 5 0 Decrease in supply b a S a’ S1 b’ Increase in supply 3 6 11 9 Quantity 13 16 18 20 A change in supply means that suppliers will supply different quantities of a product at the same price. When we plot the numbers from the supply schedule, we get two separate supply curves. An increase in supply appears as a shift of the supply curve to the right. A decrease in supply appears as a shift of the supply curve to the left. Economic Analysis How do change in supply and change in quantity supplied differ? Technology In this Ford manufacturing plant, robots assem |
ble the body of a new Fusion sedan. What effect does the introduction of new technology have on the supply curve? When both old and new quantities supplied are plotted in the form of a graph, it appears as if the supply curve has shifted to the right, showing an increase in supply. For a decrease in supply to occur, less would be offered for sale at all possible prices, and the supply curve would shift to the left. Changes in supply, whether increases or decreases, can occur for several reasons. As you read, keep in mind that all but the last reason—a change in the number of sellers—affects both the individual and the market supply curves. Cost of Resources A change in the cost of productive inputs such as land, labor, and capital can cause a change in supply. Supply might increase because of a decrease in the cost of inputs such as labor or packaging. If the price of the inputs drops, producers are willing to produce more of a product, thereby shifting the supply curve to the right. An increase in the cost of inputs has the opposite effect. If labor or other costs rise, producers would not be willing to produce as many units. Instead, they would offer fewer products for sale, and the supply curve would shift to the left. Productivity Productivity goes up whenever more output is produced using the same amount of imput. When management trains or motivates its workers, productivity usually goes up. Productivity should also go up if workers decide to work harder or more efficiently. In each case, more output is produced at every price, which shifts the supply curve to the right. On the other hand, if workers are unmotivated, untrained, or unhappy, then productivity could decrease. The supply curve then shifts to the left because fewer goods are produced at every possible price. Technology New technology tends to shift the supply curve to the right. The introduction of a new machine or a new chemical or industrial process can affect supply by lowering the cost of production or by increasing productivity. For example, improvements in the fuel efficiency of jet aircraft engines have lowered the cost of providing passenger air service. When production costs go down, the producer is usually able to produce more goods and services at all possible prices in the market. Oliver Berg/dpa/Corbis CHAPTER 5 Supply 121 Subsidies Some subsidies pay for farmers not to farm some land to avoid overproduction. Why does the federal government pay such subsidies? subsidy government payment to encourage or protect a certain economic activity New technologies do not always work as expected, of course. Equipment can break down, or the technology—or even replacement parts—might be difficult to obtain. This would shift the supply curve to the left. These examples are exceptions, however. New technologies are usually expected to be beneficial, or producers would not be interested in them. Taxes and Subsidies Firms view taxes as a cost of production, just as they do raw materials and labor. If a company pays taxes on inventory or pays fees for a license to produce, the cost of production goes up. This causes the supply curve to shift to the left. However, if taxes go down, then production costs go down as well. When this happens, supply normally increases and the supply curve shifts to the right. Technology and Supply New technology can affect supply. But did you realize that supply can also affect technology? When supplies are low and prices are high, companies have an incentive to use technology to develop substitute products they can sell for less. If the price of oil gets too high, for example, there is more of an incentive to develop new technologies for solar, geothermal, or wind power. 122 UNIT 2 Microeconomics: Prices and Markets LUCKY COW © 2003 Mark Pett. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. A subsidy is a government payment to an individual, business, or other group to encourage or protect a certain type of economic activity. Subsidies lower the cost of production, encouraging current producers to remain in the market and new producers to enter. When subsidies are repealed, costs go up, producers leave the market, and the supply curve shifts to the left. Historically, many farmers in the milk, cotton, corn, wheat, and soybean industries received subsidies to support their income. Some farmers would have quit farming without these subsidies. Instead, the subsidies kept them in business and even attracted additional farmers into the industry—thereby shifting the market supply curve to the right. Expectations Expectations about the future price of a product can also affect supply. If producers think the price of their product will go up, they may make plans now to produce more later on. When the new production is ready, the market supply curve will increase, or shift to the right. On the other hand, producers may expect lower future prices. In this case, they may try to produce something else or even stop producing altogether—causing the supply curve to shift to the left. Expectations can also affect the price a firm plans to pay for some of the inputs used in production, so expectations can affect a business in a number of different ways. This is often compounded by events in the news, so expectations tend to change relatively frequently. Government Regulations When the government establishes new regulations, the cost of production can change, causing a change in supply. For example, when the government requires new auto safety features such as air bags or emission controls, cars cost more to produce. Producers adjust to the higher production costs by producing fewer cars at every possible price. In general, increased—or tighter— government regulations restrict supply, causing the supply curve to shift to the left. Relaxed government regulations allow producers to lower the cost of production, which results in a shift of the supply curve to the right. Number of Sellers All of the factors we have discussed so far can cause a change in an individual firm’s supply curve and, consequently, the market supply curve. It follows, therefore, that a change in the number of suppliers can cause the market supply curve to shift to the right or left. As more firms enter an industry, the supply curve shifts to the right because more products are offered for sale at the same prices as before. In other words, the larger the number of suppliers, the greater the market supply. However, if some suppliers leave the market, fewer products are offered for sale at all possible prices. This causes supply to decrease, shifting the curve to the left. In the real world, sellers are entering and leaving individual markets all the time. You see this in your own neighborhood when one store closes and another opens in its place. Spencer Grant/PhotoEdit Personal Finance Handbook See pages R20–R23 for more information on getting a job. Changes in technology can also impact the number of sellers. For example, recently the Internet has attracted a large number of new businesses, as almost anyone with some Internet experience and a few thousand dollars can open an online store. Because of the ease of entry into these new markets, selling a product is no longer just for the big firms. Reading Check Explaining Why do factors that cause a change in individual supply also affect the market demand curve? CAREERS Retail Salesperson The Work * Demonstrate products and interest customers in merchandise in an efficient and courteous manner * Stock shelves, take inventory, prepare displays * Record sales transactions and possibly arrange for product’s safe delivery Qualifications * Ability to tactfully interact with customers and work under pressure * Knowledge of products and the ability to communicate this knowledge to the customer * Strong business math skills for calculating prices and taxes * No formal education required, although opportunities for advancement may depend on a college degree Earnings * Median hourly earnings (including commissions): $8.98 Job Growth Outlook * Average Source: Occupational Outlook Handbook, 2006–2007 Edition CHAPTER 5 Supply 123 Figure 5.4 Elasticity of Supply The elasticity of supply is a measure of how quantity supplied responds to a price change. If the change in quantity supplied is more than proportional to the price change, supply is elastic; if it is less than proportional, it is inelastic; and if it is proportional, it is unit elastic. Economic Analysis Which factors determine whether a firm’s supply curve is elastic or inelastic? A C e c i r P $2 1 0 S 1 2 4 3 Quantity 5 6 7 e c i r P $2 1 0 S 1 2 4 3 Quantity 5 6 7 B S 1 2 4 3 Quantity 5 6 7 D D E Type of elasticity Change in quantity supplied due to a change in price Elastic More than proportional Unit elastic Proportional Inelastic Less than proportional e c i r P $2 1 0 supply elasticity a measure of how the quantity supplied responds to a change in price Elasticity of Supply MAIN Idea The response to a change in price varies for different products. Economics & You You learned earlier that demand can be elastic, inelastic, or unit elastic. Read on to learn about the elasticity of supply. Just as demand has elasticity, supply also has elasticity. Supply elasticity is a measure of the way in which the quantity supplied responds to a change in price. If an increase in price leads to a proportionally larger increase in output, supply is elastic. If an increase in price causes a proportionally smaller change in output, supply is inelastic. If an increase in price causes a proportional change in output, supply is unit elastic. As you might imagine, there is very little difference between supply and demand elasticities. If quantities of a product are being purchased, the concept is demand elasticity. If quantities of a product are being brought to market for sale, the concept is supply elasticity. In both cases, elasticity is simply a measure of |
the way quantity adjusts to a change in price. Three Elasticities Figure 5.4 illustrates three examples of supply elasticity. The supply curve in Panel A is elastic because the change in price causes a proportionally larger change in quantity supplied. Doubling the price from $1 to $2 causes the quantity brought to market to triple from two to six units. 124 UNIT 2 Microeconomics: Prices and Markets Panel B shows an inelastic supply curve. In this case, a change in price causes a proportionally smaller change in quantity supplied. When the price doubles from $1 to $2, the quantity brought to market goes up only 50 percent, or from two units to three units. Panel C shows a unit elastic supply curve. Here a change in price causes a proportional change in the quantity supplied. As the price doubles from $1 to $2, the quantity brought to market also doubles. Determinants of Supply Elasticity The elasticity of a producer’s supply curve depends on the nature of its production. If a firm can adjust to new prices quickly, then supply is likely to be elastic. If the nature of production is such that adjustments take longer, then supply is likely to be inelastic. The supply curve for nuclear power, for example, is likely to be inelastic in the short run. No matter what price is being offered, electric utilities will find it difficult to increase output because of the huge amount of capital and technology needed—not to mention the issue of extensive government regulation—before nuclear production can be increased. However, the supply curve is likely to be elastic for many toys, candy, and other products that can be made quickly without huge amounts of capital and skilled labor. If consumers are willing to pay twice the price for any of these products, most producers will be able to gear up quickly to significantly increase production. Unlike demand elasticity, the number of substitutes has no bearing on supply elasticity. In addition, neither the ability to delay the purchase nor the portion of income consumed are important. Instead, only production considerations determine supply elasticity. If a firm can react quickly to a changing price, then supply is likely to be elastic. If the firm takes longer to react to a change in prices, then supply is likely to be inelastic. Reading Check Comparing How are the elasticities of supply and demand similar? How do they differ? SECTION 1 Review Vocabulary 1. Explain the significance of supply, Law of Supply, 3. Explaining What is the difference between a change in supply and a change in quantity supplied? supply schedule, supply curve, market supply curve, quantity supplied, change in quantity supplied, change in supply, subsidy, and supply elasticity. Main Ideas 2. Determining Cause and Effect Use a graphic organizer like the one below to explain how a change in the price of an item affects the quantity supplied. Original quantity supplied Price increase Price decrease Quantity supplied Quantity supplied 4. Describing How does the quantity supplied change when the price doubles for a unit elastic product? Critical Thinking 5. The BIG Idea Explain why the supply curve slopes upward. 6. Analyzing Visuals Look at Figure 5.4 on page 124. How do the supply curves in the three panels differ? How does that difference reflect the types of elasticity? 7. Comparing and Contrasting Explain how supply is different from demand. Applying Economics 8. Elasticity of Supply If you were a producer, what might prevent you from increasing the quantity supplied in response to an increase in price? Explain. CHAPTER 5 Supply 125 CASE STUDY “Green” Suppliers From Black Gold to Golden Corn? As the world supply of oil is spread among developing nations and becomes increasingly expensive, Americans are looking for alternative fuels. One option is ethanol, a renewable energy source made from corn and other plants. Ethanol suppliers and automakers are touting E85—a mixture of 15 percent gasoline and 85 percent ethanol—as a cleaner, domestic substitute for America’s gas tanks. Aventine and VeraSun Aventine Renewable Energy, Inc., is just one ethanol supplier that is banking on the potential of plants. So far it’s paying off. Aventine reported net income of $32 million on revenues of $935 million in 2005. That is an increase of 10 percent from 2004. Another ethanol supplier, VeraSun Energy Corp., has teamed up with General Motors and Ford to make E85 more available. Revenues for VeraSun look promising—from $194 million in 2004 to $111 million in just the first quarter of 2006. U.S. F UEL E THANOL P RODUC TION 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 1980 1985 1990 1995 Year 2000 2005 2010 Sources: U.S. Energy Information; Renewable Fuels Association U.S. E THANOL R EFINERIES Refineries in production Refineries under construction Source: Renewable Fuels Association Drawbacks vs. Benefits Ethanol does have some drawbacks. Only about 600 of the 180,000 U.S. service stations supply it. You also have to fill up more often, because ethanol contains less energy than gasoline. In addition, you have to drive a flexible-fuel vehicle (FFV) to use it. On the upside, ethanol yields about 26 percent more energy than it takes to produce it. Such a high yield is possible because sunlight is “free” and farming techniques have become highly efficient. As for the labor force, the ethanol industry supported the creation of more than 153,000 U.S. jobs in 2005. Perhaps the greatest benefit of increased ethanol supply will be reducing U.S. dependence on foreign oil. Analyzing the Impact 1. Comparing and Contrasting What are the advantages and disadvantages of E85? 2. Drawing Conclusions What is the relationship between the increased cost of oil and the supply of ethanol? 126 UNIT 2 Microeconomics: Prices and Markets SECTION 2 The Theory of Production GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn how a change in the variable input called “labor” results in changes in output. Content Vocabulary • production function • marginal product (p. 128) • short run (p. 128) • long run (p. 129) • total product (p. 129) (p. 129) • stages of production (p. 129) • diminishing returns (p. 130) • hypothetical (p. 128) • contributes (p. 130) Reading Strategy Listing As you read about production, complete a graphic organizer similar to the one below by listing what occurs during the three stages of production. Stage I Stage II Stage III —TIME COMPANIES IN THE NEWS The Hole in the Pipeline On December 5 [2005], known as Blank Monday in the surfing world, the $4.5 billion industry’s core snapped like a board caught in the Banzai Pipeline. Reason? The closure of Gordon (Grubby) Clark’s four-decade virtual monopoly on polyurethane blanks, the raw material for most surfboards. (Shapers then customize them for surfers.) Clark’s company produced 80% of blanks worldwide, and his sudden exit left surfers treading water as board prices doubled and deliveries were cut off. One man’s wipeout, though, could be another’s dream wave. Harold Walker and Gary Linden have quadrupled Walker Foam’s staff and are scouting for a new factory, hoping to produce 800 blanks a day by July, up from 125 now. ■ Changes in manufacturing, such as the fourfold increase in staff described in the news story above, happen all the time in any type of business. In fact, if you have ever worked in the fast food industry, you already know that the number of workers is the easiest factor of production for a business to change. How many times, for example, have you or one of your friends been called in when the business got busy, or were sent home when sales slowed down? Because it is so easy for firms to change the number of workers it employs whenever demand changes, labor is often thought of as being the variable factor of production. Darryl Bush/San Francisco Chronicle/Corbis CHAPTER 5 Supply 127 production function a graph showing how a change in the amount of a single variable input changes total output short run production period so short that only the variable inputs (usually labor) can be changed The Production Function MAIN Idea The production function shows how output changes when a variable input such as labor changes. Economics & You You have learned that changes in demand or supply can be illustrated with graphs. Read on to learn how changes in input are illustrated. Production can be illustrated with a production function—a figure that shows how total output changes when the amount of a single variable input (usually labor) changes while all other inputs are held constant. The production function can be illustrated with a schedule, such as the one in Panel A of Figure 5.5, or with a graph like the one in Panel B. Both panels list hypothetical output as the number of workers changes from zero to 12. According to the numbers in Panel A, if no workers are used, there is no output. If the number of workers goes up by one, output rises to 7. Add another worker and total output rises to 20. We can use this information to construct the production function that appears as the graph in Panel B, where the number of variable inputs is shown on the horizontal axis, and total production on the vertical axis. The Production Period When economists analyze production, they focus on the short run, a period so brief that only the amount of the variable input can be changed. The production function in Figure 5.5 reflects the short run because only the total number of workers changes. No changes occur in the amount of machinery, technology or land used. Thus, any change in output must be caused by a change in the number of workers. Figure 5.5 Short-Run Production See StudentWorks™ Plus or glencoe.com. A T HE P RODUCTION S CHEDULE Regions of production Marginal product* Total product Number of workers 10 11 12 0 7 20 38 62 90 110 129 138 144 148 145 135 0 7 13 18 24 28 20 19 9 6 4 –3 –10 Stage I Stage II Stage III * All figures in terms of output per day B |
T HE P RODUCTION F UNCTION 160 140 120 100 80 60 40 20 0 Stage I Stage II Stage III 1 2 3 4 5 6 7 8 9 10 11 12 13 Variable input: number of workers Short-run production can be shown both as a schedule and as a graph. In Stage I, total output increases rapidly with each worker added. In Stage II, output still increases, but at a decreasing rate. In Stage III output decreases. Economic Analysis How does marginal product help identify the stages of production? Other changes take place in the long run, a period long enough for the firm to adjust the quantities of all productive resources, including capital. For example, a firm that reduces its labor force today may also have to close down some factories later on. These are long-run changes because the amount of capital used for production changes. Total Product The second column in Figure 5.5 shows total product, or the total output produced by the firm. As you read down the column, you will see that zero units of total output are produced with zero workers, seven are produced with one worker, and so on. Again, this is a short-run relationship, because the figure assumes that only the amount of labor varies while the amount of other resources used remains unchanged. Now that we have total product, we can easily see how we get our next measure. Marginal Product The measure of output shown in the third column in Figure 5.5 is an important concept in economics. The measure is marginal product, the extra output or change in total product caused by adding one more unit of variable input. As we see in the figure, the marginal product, or extra output, of the first worker is 7. Likewise, the marginal product of the second worker is 13. If you look down the column, you will see that the marginal product for every worker is different, with some even being negative. Finally, note that the sum of the marginal products is equal to the total product. For example, the marginal products of the first and second workers is 7 plus 13, or 20—the same as the total product for two workers. Likewise, the sum of the marginal products of the first three workers is 7 plus 13 plus 18, or 38—the total output for three workers. Reading Check Analyzing Why does the produc- tion function represent short-run production? Tim Boyle/Getty Images Short Run When companies want to make quick changes in output, they usually change the number of workers. Why is a change in the number of workers considered a short-run change? long run production period long enough to change the amounts of all inputs total product total output or production by a firm marginal product extra output due to the addition of one more unit of input stages of production phases of production that consist of increasing, decreasing, and negative marginal returns Stages of Production MAIN Idea The stages of production help companies determine the most profitable number of workers to hire. Economics & You If you were a business owner, how would you decide on the number of workers you would hire? Read on to find out how the production function could help you. In the short run, every firm faces the question of how many workers to hire. To answer this question, let us take another look at Figure 5.5, which shows three distinct stages of production: increasing returns, diminishing returns, and negative returns. Stage I—Increasing Marginal Returns Stage I of the production function is the phase in which the marginal product of each additional worker increases. This happens because as more workers are added, they can cooperate with each other to make better use of their equipment. CHAPTER 5 Supply 129 diminishing returns stage where output increases at a decreasing rate as more units of variable input are added As we see in Figure 5.5, the first worker produces 7 units of output. The second is even more productive, with a marginal product of 13 units, bringing total production to 20. As long as each new worker contributes more to total output than the worker before, total output rises at an increasing rate. According to the figure, the first five workers are in Stage I. When it comes to hiring workers, companies do not knowingly produce in Stage I. When a firm learns that each new worker increases output more than the last, it tries to hire yet another worker. Soon, the firm finds itself in the next stage of production. Stage II—Decreasing Marginal Returns In Stage II, the total production keeps growing, but it does so by smaller and smaller amounts. Each additional worker, then, is making a diminishing, but still positive, contribution to total output. Stage II illustrates the principle of decreasing or diminishing returns—the stage where output increases at a diminishing rate as more variable inputs are added. In Figure 5.5, Stage II begins when the sixth worker is hired, because the 20- unit marginal product of that worker is less than the 28- unit marginal product of the fifth worker. The stage ends when the tenth worker is added, because marginal products are no longer positive after that point. Stage III—Negative Marginal Returns If the firm hires too many workers, they will get in each other’s way, causing output to fall. Stage III, then, is where the marginal products of additional workers are negative. For example, the eleventh worker has a marginal product of minus three, and the twelfth’s is minus 10, causing output to fall. Because most companies would not hire workers if this would cause total production to decrease, the number of workers a firm hires can only be found in Stage II. As we will see in the next section, the exact number of workers to be hired also depends on the revenue from the sale of the output. For now, however, we can say that the firm in Figure 5.5 will hire from 6 to 10 workers. Reading Check Interpreting What is unique about the third stage of production? SECTION 2 Review Vocabulary 1. Explain the significance of production function, short run, long run, total product, marginal product, stages of production, and diminishing returns. Main Ideas 2. Describing How does the length of the production period affect the output of a firm? 3. Explaining Use a graphic organizer like the one below to explain how marginal product changes in each of the three stages of production. Critical Thinking 4. The BIG Idea Explain how a change in inputs affects production. 5. Analyzing Visuals Look at Figure 5.5 on page 128. Explain what happens to marginal product when production moves from Stage II to Stage III. 6. Sequencing Information You need to hire workers for a project and add one worker at a time to measure the added contribution of each worker. At what point will you stop hiring workers? Relate this process to the three stages of the production function. Stage of production Marginal product Applying Economics I II III 7. Diminishing Returns Provide an example of a time when you entered a period of diminishing returns or even negative returns. Explain why this might have occurred. 130 UNIT 2 Microeconomics: Prices and Markets ENTREPRENEUR Profiles in Economics Kenneth I. Chenault (1952– ) • first African American to be CEO of a top-100 company • responsible for continuing American Express’s 155-year- old tradition of “reinvention” during global change Stepping Stones Kenneth Chenault did not start his career in business. Instead, he earned an undergraduate degree in history and a law degree at Harvard. He had keen instincts for business, however, and worked for a management consulting firm before joining American Express in 1981. At first, Chenault was responsible for strategic planning. His intelligence and hard work moved him up the corporate ranks. Each promotion brought him new challenges and opportunities. Tools of Success In 2001 Chenault became chairman and CEO of American Express. When the terrorist attacks of 9/11 brought a downturn for the company, Chenault acted fast to adjust to market conditions. He changed the focus of American Express from telephone and mail to the Internet. He also cut the workforce by 15 percent. “We had to focus on the moderate and long-term,” he explained. “In volatile times, leaders are more closely scrutinized. If you cannot step up in times of crisis, you will lose credibility.” Returning to Basics Four years later, Chenault decided to refocus on “plastic.” American Express sold off its many financial planning services and regrouped around its core business—credit cards, corporate travel cards, and “reloadable” traveler’s checks. In addition, a 2004 Supreme Court decision on an antitrust suit ended Visa’s and Mastercard’s control over U.S. bank cards—a $2.1 trillion business. This opened the door for U.S. banks to issue American Express cards. Examining the Profile 1. Summarizing How did Chenault’s decisions improve American Express? 2. Evaluating Do you agree with Chenault’s claim that being adaptable to change is the most important strategy for a successful business? Amilcar/Liaison/Getty Images As chairman and CEO of American Express, Kenneth Chenault believes the key to success in the global economy is adaptability. “It’s not the strongest or the most intelligent who survive, but those most adaptive to change.” CHAPTER 5 Supply 131 SECTION 3 Cost, Revenue, and Profit Maximization GUIDE TO READING Section Preview In this section, you will learn how businesses analyze their costs and revenues, which helps them maximize their profits. Content Vocabulary • fixed costs (p. 133) • overhead (p. 133) • variable costs (p. 133) • total cost (p. 134) • marginal cost (p. 134) • e-commerce (p. 135) • break-even point (p. 135) • total revenue (p. 136) • marginal revenue (p. 136) • marginal analysis (p. 137) • profit-maximizing quantity of output (p. 137) Academic Vocabulary • conducted (p. 135) • generates (p. 136) Reading Strategy Explaining As you read the section, complete a graphic organizer similar to the one below by explaining how total revenue differs from marginal revenue. Then |
provide an example of each. Total revenue is: Marginal revenue is: Example: Example: —BusinessWeek COMPANIES IN THE NEWS FedEx Saves the Day As soon as Motion Computing Inc. in Austin, Texas, receives an order for one of its $2,200 tablet PCs, workers at a supplier’s factory in Kunshan, China, begin assembling the product. When they’ve finished, they individually box each order and hand them to a driver from FedEx Corp., who trucks it 50 miles to Shanghai, where it’s loaded on a jet bound for Anchorage before a series of flights and truck rides finally puts the product into the customer’s hands. Elapsed time: as little as five days. Motion’s inventory costs? Nada. Zip. Zilch. “We have no inventory tied up in the process anywhere,” marvels Scott Eckert, Motion’s chief executive. “Frankly, our business is enabled by FedEx.” There are thousands of other Motion Computings that, without FedEx, would be crippled by warehouse and inventory costs. ■ The news story above features a problem that all businesses, nonprofit organizations, and even individuals face—that of having to deal with the costs of running an organization. Scott Eckert could have decided to build a warehouse to store an inventory of tablet PCs waiting for future orders. Instead, he builds the tablet PCs one order at a time and uses a shipping company to deliver orders immediately. Anyone who is in charge of a business or a nonprofit organization spends a lot of time with costs. The task may be to identify the costs, and at other times it may be to reduce them. Our first task here, however, is to classify the costs. 132 UNIT 2 Microeconomics: Prices and Markets ©2006 FedEx fixed costs costs that remain the same regardless of level of production or services offered overhead broad category of fixed costs that includes rent, taxes, and executive salaries variable costs production costs that change when production levels change Measures of Cost MAIN Idea Businesses analyze fixed, variable, total, and marginal costs to make production decisions. Economics & You Are you involved in student government? Organizing events can often cost more than you might have originally thought. Read on to find out about the costs that organizations face. Because businesses want to produce efficiently, they must keep an eye on their costs. For purposes of analysis, they use several measures of cost. Fixed Costs The first measure is fixed costs—the costs that an organization incurs even if there is little or no activity. When it comes to this measure of costs, it makes no difference whether the business produces nothing, very little, or a large amount. Total fixed costs, sometimes called overhead, remain the same. Fixed costs include salaries paid to executives, interest charges on bonds, rent payments on leased properties, and state and local property taxes. Fixed costs also include depreciation—the gradual wear and tear on capital goods through use over time. A machine, for example, will not last forever, because its parts will wear out slowly and eventually break. Variable Costs Other costs are variable costs, or costs that change when the business’s rate of operation or output changes. While fixed costs are generally associated with machines and other capital goods, variable costs are usually associated with labor and raw materials. For example, wage-earning workers may be laid off or work overtime as output changes. Other examples of variable costs include electric power to run machines and freight charges to ship the final product. For most businesses, the largest variable cost is labor. If a business wants to hire one worker to produce seven units of output per day, and if the worker costs $90 per day, the total variable cost is $90. If the business wants to hire a second worker to produce additional units of output, then its total variable costs are $180, and so on. Costs Businesses need to consider both fixed costs, such as rent and taxes, and variable costs, such as labor. Why can electricity be considered a variable cost Figure 5.6 Production, Costs, and Revenues When we add the costs and revenues to the production schedule, we can find the firm’s profits. Note that fixed costs don’t change. Marginal cost and marginal revenue are used to determine the level of productivity with the maximum level of profits. Economic Analysis How do total costs differ from marginal costs? P RODUCTION S CHEDULE C OSTS R EVENUES P ROFIT Regions of production Number of workers Total product Marginal product 10 11 12 0 7 20 38 62 90 110 129 138 144 148 145 135 0 7 13 18 24 28 20 19 9 6 4 –3 –10 Stage I Stage II Stage III Total fixed cost $50 50 50 50 50 50 50 50 50 50 50 50 50 Total variable cost Total cost Marginal cost Total revenue Marginal revenue $0 90 180 270 360 450 540 630 720 810 900 990 $50 140 230 320 410 500 590 680 770 860 950 1,040 1,080 1,130 -- $12.86 6.92 5.00 3.75 3.21 4.50 4.74 10.00 15.00 22.50 -- -- $0 105 300 570 930 1,350 1,650 1,935 2,070 2,160 2,220 2,175 2,025 -- $15 15 15 15 15 15 15 15 15 15 15 15 Total profit –$50 –35 70 250 520 850 1,060 1,210 1,300 1,300 1,270 1,135 895 total cost the sum of fixed costs and variable costs marginal cost extra cost of producing one additional unit of production Total Cost Figure 5.6 shows the total cost of production, which is the sum of the fixed and variable costs. Total cost takes into account all of the costs a business faces in the course of its operations. If the business decides to use six workers costing $90 each to produce 110 units of total output, then its total cost will be $590—the sum of $50 in fixed costs plus $540 of variable costs. Skills Handbook Marginal Cost See page R51 to learn about Using Tables and Charts. The most useful measure of cost is marginal cost—the extra cost incurred when producing one more unit of output. 134 UNIT 2 Microeconomics: Prices and Markets In fact, marginal cost is more useful than total cost because it shows the change in total variable costs when output increases. Figure 5.6 shows that the addition of the first worker increases total product by seven units. Because total variable costs increased by $90, each additional unit of output has a marginal cost of $12.86, or $90 divided by seven. If a second worker is added, 13 more units of output will be produced for an additional cost of $90. This means that the extra, or marginal, cost of producing each new unit of output is $90 divided by 13, or $6.92. Reading Check Analyzing If a firm’s total output increases, will the fixed costs increase? Explain. Applying Cost Principles MAIN Idea Fixed and variable costs affect the way a business operates. Economics & You Have you or anyone you know purchased something on the Internet? Read on to find out about the costs of doing business online. The types of cost a firm faces may affect the way it operates. That is why owners analyze the costs they incur when they run their business. Costs and Business Operation For reasons largely related to costs, many stores are flocking to the Internet, making it one of the fastest-growing areas of business today. Stores do this because the overhead, or the fixed costs of operation, on the Internet is so low. Another reason is that a firm does not need as much inventory. People engaged in e-commerce—an electronic business conducted over the Internet—do not need to spend a large sum of money to rent a building and stock it with inventory. Instead, for just a fraction of the cost of a typical store, the e-commerce business owner can purchase Web access along with an e-commerce software package that provides everything from Web catalog pages to ordering, billing, and accounting software. Then, the owner of the e-commerce business store inserts pictures and descriptions of the products for sale into the software and loads the program. When customers visit the “store” on the Web, they see a range of goods for sale. In some cases, the owner has the merchandise in stock; in other cases, the merchant simply forwards the orders to a distribution center that handles the shipping. Either Courtesy of Amazon.com Inc. or its affiliates. All rights reserved. way, the fixed costs of operation are significantly lower than they would be in a typical retail store. Break-Even Point Finally, when a business knows about its costs, it can find the level of production that generates just enough revenue to cover its total operating costs. This is called the break-even point. For example, in Figure 5.6, the break-even point is between 7 and 20 units of total product, so at least two workers would have to be hired to break even. However, the break-even point only tells the firm how much it has to produce to cover its costs. Most businesses want to do more—they want to maximize the amount of profits they can make, not just cover their costs. To do this, they will have to apply the principles of marginal analysis to their costs and revenues. Reading Check Contrasting What are the differences between an e-commerce store and a traditional business? e-commerce electronic business conducted over the Internet break-even point production level where total cost equals total revenue E-Commerce Companies such as Amazon.com have been able to offer a wide range of products while keeping their overhead low. What helps e-commerce firms to reduce cost? CHAPTER 5 Supply 135 &The Global Economy YOU It Is a Small World . . . After All If you can’t find a product at a local store, you can browse millions of Internet sources to find what you’re looking for. It’s a simple process that, like any other transaction, involves a buyer and a seller. The Internet serves as a neutral venue for buyers and sellers to come together. What makes this such a unique global process is the efficient shipping that allows you to receive your product in a matter of days from such faraway places as China, the United Kingdom, and Australia. Previously a luxury, shipping goods from country to country—and continent to conti |
nent—has expanded the global marketplace with overnight and express mail options. Companies such as DHL, FedEx, and UPS work around the clock—and around the world—delivering packages to businesses and consumers. FedEx, for example, operates 120 flights weekly to and from Asia, including 26 out of China alone. A IR & G ROUND S HIPPING M ARKET 50% 45 40 35 30 25 20 15 10 5 0 FedEx UPS DHL Other National International Source: Market Research Service Center total revenue total amount earned by a firm from the sale of its products marginal revenue extra revenue from the sale of one additional unit of output Marginal Analysis and Profit Maximization MAIN Idea Businesses compare marginal revenue with marginal cost to find the level of production that maximizes profits. Economics & You You just learned about the importance of costs to a business. Read on to learn how businesses use this information to maximize their profits. Businesses use two key measures of revenue to find the amount of output that will produce the greatest profits. The first is total revenue, and the second is marginal revenue. The marginal revenue is compared to marginal cost to find the optimal level of production. Total Revenue The total revenue is all the revenue that a business receives. In the case of the firm shown in Figure 5.6 on page 134, total revenue is equal to the number of units sold multi plied by the average price per unit. So, if seven units are sold at $15 each, the total revenue is $105. If 10 workers are hired and their 148 units of total output sell for $15 each, then total revenue is $2,220. The calculation is the same for any level of output in the table. Marginal Revenue The more important measure of revenue is marginal revenue, the extra revenue a business receives from the production and sale of one additional unit of output. You can find the marginal revenue in Figure 5.6 by dividing the change in total revenue by the marginal product. For example, when the business employs five workers, it produces 90 units of output and generates $1,350 of total revenue. If a sixth worker is added, output increases by 20 units and total revenues increase to $1,650. If we divide the change in total revenue ($300) by the marginal product (20), we have marginal revenue of $15. 136 UNIT 2 Microeconomics: Prices and Markets As long as every unit of output sells for $15, the marginal revenue earned by the sale of one more unit will always be $15. For this reason, the marginal revenue appears to be constant at $15 for every level of output in Figure 5.6. In reality, this may not always be the case, as businesses often find that marginal revenues vary. Marginal Analysis Most people, as well as most businesses, use marginal analysis, a type of decision making that compares the extra benefits of an action to the extra costs of taking the action. Marginal analysis is useful in a number of situations, from our own individual decision making to production decisions made by corporations. In the case of our own individual decision making, it is usually best for us to take small, incremental steps to determine if the additional benefits from each step are greater than the additional costs. A business does the same thing. It adds more variable inputs (workers) and then compares the extra benefit (marginal revenue) to the additional cost (marginal cost). If the extra benefit exceeds the extra cost, then the firm hires another worker. Profit Maximization We can now use marginal analysis to find the level of output that maximizes profits for the business represented in Figure 5.6. The business would hire the sixth worker, for example, because the extra output would cost only $4.50 to produce while generating $15 in new revenues. Having made a profit with the sixth worker, the business would hire the seventh and eighth workers for the same reason. While the addition of the ninth worker neither adds to nor takes away from total profits, the firm would have no incentive to hire the tenth worker. If it did, it would quickly discover that profits would go down, and it would go back to using nine workers. When marginal cost is less than marginal revenue, more variable inputs should be hired to expand output. Eventually, the profit-maximizing quantity of output is reached when marginal cost and marginal revenue are equal, as shown in the last column in Figure 5.6. Other levels of output may generate equal profits, but none will be more profitable. Reading Check Summarizing Why do people, especially business owners, use marginal analysis? Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 5— Student Web Activities for an activity on the operation of a company. marginal analysis decision making that compares the extra costs of doing something to the extra benefits gained profit maximizing quantity of output level of production where marginal cost is equal to marginal revenue SECTION 3 Review Vocabulary 1. Explain the significance of fixed costs, overhead, Critical Thinking 4. The BIG Idea Explain how businesses use marginal variable costs, total cost, marginal cost, e-commerce, break-even point, total revenue, marginal revenue, marginal analysis, and profit-maximizing quantity of output. Main Ideas 2. Identifying Use a graphic organizer like the one below to identify examples of both fixed and variable costs. Fixed Costs Variable Costs analysis to maximize profits. 5. Analyzing Visuals Look at Figure 5.6 on page 134. Using the numbers in the figure, write a paragraph to explain in your own words how many workers this company should hire and why it should make this decision. Provide specific examples based on the information in the table. 6. Inferring If the total output of a business increases, what will happen to fixed costs? To variable costs? Applying Economics 7. Total Cost Many plants use several shifts of workers in 3. Explaining What is the difference between break-even output and profit-maximizing quantity of output? order to operate 24 hours a day. How do a plant’s fixed and variable costs affect its decision to operate around the clock? CHAPTER 5 Supply 137 NEWSCLIP Profit maximization is the goal of all American businesses. Many increase profits by keeping costs as low as possible. One company has taken cost-cutting to new “lows”: Steve & Barry’s University Sportswear. Steve & Barry’s Rules the Mall Steven Shore and Barry Prevor love to fill a void — about 3.5 million square feet of it. That’s how much space Steve & Barry’s University Sportswear took in U.S. shopping centers last year, the most of any mall-based chain. The co-CEOs soaked up that space by opening 62 supermarket-sized stores, almost doubling their outlets in one year, to 134. The privately held chain, which lures shoppers with casual clothing priced at $7.98 or less—a 40% discount to prices at WalMart Stores Inc. and Target Corp.—plans to operate more than 200 stores by yearend. . . . How can Steve & Barry’s charge so little? One reason: the cut-rate deals it negotiates with landlords. Most of its stores are in middle-market malls, which have seen rising vacancies. . . . Low rents are hardly the only way the men keep costs low. While malls usually give new tenants allowances of $20 to $30 a square foot to build interiors, the popularity of Steve & Barry’s has allowed the chain to command [allowances] as high as $80, considerably more than actual costs. . . . Item Carpenter jeans Polo shirt Baseball cap Hooded sweatshirt Store Wal-Mart Target S&B’s Wal-Mart Target S&B’s Wal-Mart Target S&B’s Wal-Mart Target S&B’s Price $14.88 16.99 7.98 9.83 11.99 7.98 7.00 11.89 7.98 12.77 12.99 7.98 Sources: www.walmart.com, www.target.com, www.steveandbarrys.com 138 UNIT 2 Microeconomics: Prices and Markets Ara Koopelian Steve & Barry’s also saves money in purchasing. It buys direct from overseas factories, like many others, but cuts costs by accepting longer lead times. It also saves by offering steady production throughout the year rather than seasonal rampups. The chain cuts expenses further by deft navigation of import quotas and duties. . . . That’s why it buys more from factories in Africa and less from China than many rivals—most African countries face neither U.S. quotas nor duties. Advertising isn’t an expense Steve & Barry’s wrestles with, either—it relies mostly on word of mouth. —Reprinted from BusinessWeek Examining the Newsclip 1. Summarizing How has Steve & Barry’s University Sportswear cut costs? 2. Making Connections How do the cost-cutting steps help Steve & Barry’s increase its profits? CHAPTER 5 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Law of Supply When the price of a product goes up, quantity supplied goes up. When the price goes down, quantity supplied goes down. When the When the price goes price goes up . . . up . . . quantity quantity supplied supplied goes up. goes up. When the When the price goes price goes down . . . down . . . quantity quantity supplied supplied goes goes down. down. Production Function The production function helps us find the optimal number of variable units (labor) to be used in production. As workers are added in Stage I, production increases at an increasing rate. In Stage II, production increases at a decreasing rate because of diminishing returns. In Stage III, production decreases because more workers cannot make a positive contribution. T HE P RODUCTION F UNCTION 160 140 120 100 80 60 40 20 Stage I Stage II Stage III 3 4 11 2 Variable input: number of workers 10 9 6 5 8 7 12 13 Cost and Revenue While businesses have several types of costs, they can find the profitmaximizing quantity of output by comparing marginal cost to their marginal revenue. Cost Revenue Fixed cost: always the same and always has to be paid Variable cost: varies depending on level of production Marginal cost (MC) : extra cost per additional unit of output |
If MC = MR Profit- maximizing quantity of output Marginal revenue (MR): extra revenue from one additional unit of output Total revenue: revenue based on number of units multiplied by average price per unit CHAPTER 5 Supply 139 CHAPTER 5 Assessment & Activities Review Content Vocabulary Review Main Ideas On a separate sheet of paper, write the letter of the key term that best matches each definition below. a. change in quantity supplied b. diminishing returns c. fixed costs d. marginal analysis e. marginal product f. marginal revenue g. production function h. Law of Supply i. total cost j. change in supply k. overhead l. total product 1. a production cost that does not change as total business output changes 2. decision making that compares the additional costs with the additional benefits of an action 3. associated with Stage II of production 4. situation where the amount of products for sale changes while the price remains the same 5. a graphical representation of the theory of production 6. the additional output produced when one additional unit of input is added Section 1 (pages 117–125) 19. Describe what economists mean by supply. 20. Distinguish between the individual supply curve and the market supply curve. 21. Describe the factors that can cause a change in supply. 22. Identify the three types of elasticity, using a graphic organizer similar to the one below. Supply Elastic: Inelastic: Unit elastic: Section 2 (pages 127–130) 23. Explain the difference between total product and marginal product. 7. change in total revenue from the sale of one additional 24. Describe the three stages of production. unit of output 8. change in the amount of products for sale when the Section 3 (pages 132–137) price changes 25. Describe the relationship between marginal cost and 9. the sum of variable and fixed costs total cost. 10. principle that more will be offered for sale at high 26. Explain the difference between fixed and variable costs. prices than at lower prices 11. total output produced by a firm 12. total fixed costs 27. Discuss why businesses analyze their costs. 28. Explain how businesses determine their profit maximization output. Review Academic Vocabulary Critical Thinking On a separate sheet of paper, write a paragraph about “supply” that uses all of the following terms. 13. interaction 14. various 15. hypothetical 16. contributes 17. conducted 18. generates 29. The BIG Idea Imagine that gas prices have increased to $5.00 per gallon. What will happen to the supply of fuel-efficient cars in the short run and in the long run? Explain. 30. Determining Cause and Effect Explain why e-commerce reduces fixed costs. 140 UNIT 2 Microeconomics: Prices and Markets 31. Making Generalizations Why might production functions tend to differ from one firm to another? 32. Interpreting Return to the chapter opener activity on page 116. Now that you have learned about supply, review the questions you answered at the beginning of the chapter. How would you revise your earlier decisions on services and prices, and why? 33. Understanding Cause and Effect According to the Law of Supply, what will happen to the number of products a firm offers for sale when prices go down? What will happen if the cost of production increases while prices remain the same? 34. Drawing Conclusions Use a graphic organizer like the one below to illustrate what will happen to supply in each of the situations provided. Oranges Damaging frost Tractors Costs decrease Cars Federal taxes increase Applying Economic Concepts 35. Marginal Analysis Think about a recent decision you made in which you used the tools of marginal analysis. Describe in detail the problem, the individual steps you took to solve the problem, and the point at which you stopped taking further steps. Explain why you decided to make no further changes. 36. Overhead Overhead is a concern not just for businesses, but also for individuals. What overhead costs do you have to take into consideration if you want to own a car? Economics: Principles and Practices Web site at glencoe.com and click on Chapter 5—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Thinking Like an Economist 37. Label the following actions according to their placement in the stages of production: a. After many hours of studying, you are forgetting some of the material you learned earlier. b. You are studying for a test and learning rapidly. c. After a few hours, you are still learning but not as fast as before. Analyzing Visuals 38. Making Connections Look at Panel B in Figure 5.5 on page 128. Describe the shape of the curve as it goes through the three different stages. How does the shape correspond to the total product and the marginal product listed in Panel A? Writing About Economics 39. Persuasive Writing Research the way government regulates a business or industry in your region. Write a short paper discussing how you think the regulation affects the supply curve of the product both for the firm and for the industry. Math Practice 40. Using the schedule below as a starting point, create a supply schedule and a supply curve that shows the following information: American automakers are willing to sell 200,000 cars per year when the price of a car is $20,000. They are willing to sell 400,000 when the price is $25,000 and 600,000 at a price of $30,000. Price $20,000 $25,000 Quantity supplied 200,000 CHAPTER 5 Supply 141 CHAPTER 6 Prices and Decision Making Why It Matters Have you ever wondered why famous athletes and entertainers make millions of dollars each year? Imagine that you are one of these athletes or entertainers and will be interviewed on a major television program. Knowing that the interviewer will ask you why you make so much money, prepare a list of 5 to 10 reasons that explain why you are worth your salary. Read Chapter 6 to learn about how economic systems allocate goods and services. The BIG Ideas 1. Markets exist when buyers and sellers interact, and market prices are set by the interaction of demand and supply. 2. Governments strive for a balance between the costs and benefits of their economic policies to promote economic stability and growth. Every day prices help buyers make decisions about the quantities of goods and services they buy. 142 UNIT 2 WireImageStock/Masterfile Economics: Principles and Practices Web site at glencoe.com and click on Chapter 6—Chapter Overviews to preview chapter information. Chapter Overview Visit the SECTION 1 Prices as Signals GUIDE TO READING Section Preview Reading Strategy In this section, you will learn that prices act as signals that help us allocate scarce resources. Explaining As you read the section, complete a graphic organizer similar to the one below by explaining the advantages of prices. Advantages of Prices —New Orleans Times-Picayune Content Vocabulary • price (p. 143) • rationing (p. 145) • ration coupon (p. 145) • rebate (p. 146) Academic Vocabulary • neutral (p. 144) • criteria (p. 145) PRODUCTS IN THE NEWS Katrina Fallout The local real estate market soared after Hurricane Katrina, with home prices recording double-digit increases and the number of sales remaining surprisingly strong. . . . During the final four months of 2005—the months after Katrina—the average sale price in the metropolitan area was $215,769, or 21 percent higher than the average price of all homes sold in 2004. . . . The strong real estate figures send the clearest signal yet that the New Orleans housing market is not dead. In fact, they might make the city more appealing than ever to national investors . . . looking to snatch up bargain properties they can sell down the road for a profit. ■ Life is full of signals that help us make decisions. For example, when we pull up to an intersection, we look to see if the traffic light is green, yellow, or red. We look at the other cars to see if any have their blinkers on, signaling their intentions to turn. While these are clear and obvious signals, there are other, more hidden ones. Pain, for example, signals you that something is wrong with your body. But have you ever thought about signals in economics? It turns out that something as simple as a price—the monetary value of a product as established by supply and demand—is a signal that helps us make economic decisions. Prices give information to buyers and sellers. High prices signal buyers to buy less and producers to produce more. Low prices signal buyers to buy more and producers to produce less. Even housing prices, as we read in the news story above, send signals. price monetary value of a product as established by supply and demand Peter Horree/Alamy Images CHAPTER 6 Prices and Decision Making 143 Advantages of Prices MAIN Idea Prices help the economy run smoothly by providing a good way to allocate resources. Economics & You Have you ever seen news reports about rising prices for building materials after a hurricane? Read on to learn how the price system helps us deal with natural disasters. Prices help producers and consumers decide the three basic questions of WHAT, HOW, and FOR WHOM to produce. Without prices, the economy would not run as smoothly, and allocation decisions would have to be made some other way. Prices perform this function well for several reasons. First, in a competitive market economy, prices are neutral because they favor neither the producer nor the consumer. Since prices are the result of competition between buyers and sellers, they represent compromises that both sides can live with. Second, prices in a market economy are flexible. Unforeseen events such as natural disasters and war affect the prices of many items. Buyers and sellers then react to the new level of prices and adjust their consumption and production accordingly. Before long, the system functions as smoothly again as it had before. The ability of the price system to absorb unexpected “shocks” is one of the strengths of a market economy. Third, most people ha |
ve known about prices all their lives. As a result, prices are familiar and easy to understand. There is no ambiguity over a price—if something costs $1.99, then we know exactly what we have to pay for it. This allows people to make decisions quickly and efficiently, with a minimum of time and effort. Finally, prices have no cost of administration. Competitive markets tend to find their own prices without outside help or interference. No bureaucrats need to be hired, no committees formed, no laws passed, or other decisions made. Even when prices adjust from one level to another, the changes are usually so gradual that people hardly notice. Reading Check Summarizing In what way do prices perform the allocation function? &The Global Economy YOU Mobility on the Cheap Americans are constantly in motion. The popularity of cell phones and laptop computers illustrates this point. Luckily for on-the-go consumers, the prices of these mobile products are falling. The average cost of a laptop in 2000 was more than $2,000. Each year, the average price has dropped by several hundred dollars. Competition has played the biggest role in the downward spiral of profits for laptop makers. In 2006, the profit margin for most laptops was only $50. This meager profit means that manufacturers are aiming for high sales volume rather than high profit margins. They are also counting on consumers to spend more on expensive accessories, such as service plans, docking stations, and batteries. How does this competitive market impact you? Consumers can expect lower prices and a wider 144 UNIT 2 Microeconomics: Prices and Markets selection. In addition, the competition ensures innovation, as manufacturers search for the gadget or accessory that none of us can do without. A VERAGE L APTOP P RICES $2,000 e c i r P 1,500 1,000 500 2002 2000 Source: The Wall Street Journal. 2001 2004 2003 Year 2005 2006 Allocations Without Prices MAIN Idea Rationing has disadvantages that are not present in the price system. Economics & You How would you allocate goods like cars or food if there were no prices? Read on to learn about the problems associated with other systems. Prices help us make the everyday economic decisions that allocate scarce resources. But what would life be like without a price system? Would intelligence, good looks, or even political connections determine the allocations? These criteria may seem far-fetched, but this happens in countries with command economies. When the Baltimore Orioles played an exhibition baseball game in Cuba several years ago, there were not enough stadium seats for the local baseball fans who wanted to attend. Fidel Castro then solved the FOR WHOM questions by giving the seats to Communist Party members— whether or not they were baseball fans. Rationing Without prices, another system must be used to decide who gets what. One method is rationing—a system under which a government agency decides everyone’s “fair” share. Under such a system, people receive a ration coupon, a ticket or a receipt that entitles the holder to obtain a certain amount of a product. The coupon can be given to people outright, or the government can charge a modest fee that is less than the product’s market value. Rationing has been widely used during wartime, but it can lead to problems. Problems with Rationing The first problem with rationing is that almost everyone feels his or her share is too small. During the energy crisis of the early 1970s, the government made plans for, but never implemented, gasoline rationing. One problem was determining how to allocate Ed Quinn/Corbis Rationing This clerk in a grocery store in Cuba accepts ration coupons as payment for the products people are buying. How are ration coupons allocated? rationing system of allocating goods and services without prices ration coupon permit allowing holder to receive a given amount of a rationed product Skills Handbook See page R43 to learn about Comparing and Contrasting. the rationing coupons in a way that everyone would see as fair. A number of ways to allocate gas coupons were debated, but the issue of fairness was never resolved. A second problem is the administrative cost of rationing. Someone must pay the salaries and the printing and distribution costs of the coupons. In addition, no matter how much care is taken, some coupons will be stolen, sold, or counterfeited and used to get a product intended for someone else. A third problem is the negative impact on the incentive to produce. What if you were paid with ration coupons and you received the same number of coupons as your coworkers? Without the possibility of earning more coupons, you might lose some of your incentive to work. Reading Check Contrasting What are the differ- ences between the price system and rationing? CHAPTER 6 Prices and Decision Making 145 rebate partial refund of a product’s original price Prices as a System MAIN Idea Prices connect all markets in an economy. Economics & You Have you noticed ads for rebates on SUVs when gas prices soar? Read on to learn how these rebates are one way in which prices allocate resources between markets. Because of the difficulties with nonprice allocation systems, economists overwhelmingly favor the price system. In fact, prices do more than help individuals make decisions: they also serve as signals that help allocate resources between markets. Consider the way in which higher oil prices affected producer and consumer decisions when the price of oil went from under $35 to over $70 a barrel in 2005 and 2006. Because the demand for oil is basically inelastic, people spent a greater part of their income on energy. Higher energy costs left them with less to spend elsewhere. The SUV market was one of the first to feel the effects of high prices. Because most of these vehicles got poor gas mileage, people bought fewer SUVs, leaving dealerships with huge inventories. To move these inventories, some manufacturers offered consumers a rebate—a partial refund of the original price of the product. The rebate was the same as a temporary price reduction, because consumers were offered thousands of dollars back on each new car they bought. Other dealers offered zero-interest financing. Finally, automakers had to reduce their production of these vehicles. Ford Motor Company, for example, closed plants, laid off workers, and tried to sell more fuel-efficient cars. Many automobile workers who lost their jobs eventually found new ones in other industries. In the end, the result of higher international oil prices was to shift productive resources out of SUV production into other products. Although the adjustment process was painful for many in the industry, it was a natural and necessary shift of resources for a market economy. In the end, prices do more than convey information to buyers and sellers in a market: they also allocate resources between markets. This is why economists think of prices as a “system”—part of an informational network—that links all markets in the economy. Reading Check Identifying How do prices allocate resources between markets? SECTION 1 Review Vocabulary 1. Explain the significance of price, rationing, ration coupon, and rebate. Main Ideas 2. Describing What are the advantages of prices? 3. Identifying Use a graphic organizer like the one below to identify the problems associated with rationing. Problems of Rationing 4. Explaining Why are prices an efficient way to allocate goods and services? 146 UNIT 2 Microeconomics: Prices and Markets Critical Thinking 5. The BIG Idea Describe how prices help allocate scarce resources by answering the questions of WHAT, HOW, and FOR WHOM to produce. 6. Analyzing Visuals Look at the photograph on page 145. What effect does rationing seem to have on the number and variety of items in the store? 7. Understanding Cause and Effect Assume that there is a gasoline shortage and your state has imposed rationing. Write a paragraph about how this might affect you, your family, and your community. Applying Economics 8. Rationing List five items you would like to buy. How does the price of each item affect your decision to allocate scarce resources—your money and your time? CASE STUDY ‘I Bought It on eBay’ The World’s Online Marketplace Since its introduction in 1995, eBay has given rise to the phrase “I bought it on eBay.” Buyers and sellers flock to the online auction site to bid on and sell everything from snow and math tutoring to collectibles and used cars. The Perfect Price The site serves as an online forum where supply meets demand in a seamless process. Sellers enjoy the advantages of a huge customer base and little overhead. They also have the option to list a “reserve,” or minimum price. All of these features help maximize profits. Buyers appreciate the ability to browse millions of items, shop from home, and counter-offer with their own bid. Because eBay does not produce, sell, or distribute any of the products offered on its Web site, it makes money by charging a modest listing fee and commission for each item sold. In 2005 the number of registered eBay members topped 100 million, including potential buyers in more than 30 countries. EB AY R EVENUES’ 2001–2005 $ 2001 2002 2003 2004 2005 Year Source: moneycentral.msn.com E UROPEANS E ARNING AT L EAST 25% OF T HEIR I NCOME F ROM EB AY B USINESS Britain Germany France Italy Spain 0 10 20 50 40 30 Thousands 60 70 Source: eBay Inc. To some members, eBay is a great place to sell an item they no longer need or want, such as a baby stroller or CD. For others, eBay has turned from a hobby into a career. In 2005 more than 700,000 people in the United States earned full- or part-time income on eBay. Many sellers in Europe—especially Britain and Germany—also rely on eBay to make money. eBay Express In 2006 eBay faced serious competition from Google and Yahoo for a larger share of the e-commerce market. The company’s response was eBay Express, which allows shoppers to purcha |
se products immediately without waiting a week for an auction to close. The hope is that a brand new audience will tap into the eBay experience. Analyzing the Impact 1. Summarizing How is price determined for an item on eBay? 2. Explaining What change did eBay make to attract more shoppers? CHAPTER 6 Prices and Decision Making 147 SECTION 2 The Price System at Work GUIDE TO READING Section Preview Reading Strategy In this section, you will learn how economic models help us understand prices in competitive markets. Content Vocabulary • economic model (p. 149) • surplus (p. 150) • equilibrium price (p. 149) • shortage (p. 151) Academic Vocabulary • voluntary (p. 149) • fluctuates (p. 153) Describing As you read the section, complete a graphic organizer similar to this by describing how a surplus and a shortage affect prices, demand, and supply. Surplus Shortage Effects Effects —adapted from The Miami Herald COMPANIES IN THE NEWS Want Prime Seats? Get Ready to Bid Bids on the best seats in the house for Madonna’s concert . . . could start at the face-value price of $350. Do I hear $450? Going once, going twice . . . Sold! To the person online. Tired of competition from scalpers, Ticketmaster and its clients are now auctioning “premium seats” to concerts, sports meets, and other events. The practice, dubbed “dynamic pricing,” allows customers to set their own prices. Competitors see it differently, saying the practice allows Ticketmaster to scalp its own tickets. (Scalping is a second-degree misdemeanor under Florida state law, punishable by up to 60 days in jail and a $500 fine.) . . . Dynamic pricing endorses a free market economic principle: namely, that the market determines the fair value of a ticket. ■ One of the most appealing features of a competitive market economy is that everyone who participates has a hand in determining prices. This is why economists consider prices to be neutral and impartial. The process of establishing a price, as you read in the news story above, can be complicated—or even contentious— because buyers and sellers have exactly the opposite hopes and desires. Buyers want to find good buys at low prices. Sellers hope for high prices and large profits. Neither can get exactly what they want, so some adjustment is necessary to reach a compromise. Will consumers pay too much for tickets? Most economists would argue that as long as the process is competitive and the transaction voluntary, then the price will be about right under a bidding system. 148 UNIT 2 Microeconomics: Prices and Markets Evan Agostini/Getty Images economic model a simplified version of a complex behavior expressed in the form of an equation, graph, or illustration (also see page 23) equilibrium price price where quantity supplied equals quantity demanded The Price Adjustment Process MAIN Idea In a market economy, prices seek their own equilibrium. Economics & You You learned earlier that the price system is flexible. Read on to find out how prices adjust to changes in the economy. Because transactions in a market economy are voluntary, the compromise that settles the differences between buyers and sellers must be to the benefit of both, or the compromise would not occur. A Market Model To show how the adjustment process works, we use the supply and demand illustration shown in Figure 6.1—one of the more popular “tools” used by economists. The figure illustrates how we can use an economic model to analyze behavior and predict outcomes. The data in the figure show the demand for and supply of CDs at various prices. You are already familiar with these numbers, because they are the same ones you saw when you learned about demand in Chapter 4 and supply in Chapter 5. Panel A combines information from the market demand schedule in Figure 4.2 on page 94 and the market supply schedule in Figure 5.2 on page 119. Panel B shows both the market demand curve and the market supply curve, again from those two earlier figures. Separately, each of these graphs represents the demand or supply side of the market. When the curves are combined, we have a complete model of the market, which will allow us to analyze how the interaction of buyers and sellers results in a price agreeable to all market participants. Note that the supply and demand curves intersect at a specific point. This point is called the equilibrium price, the price at which the number of units produced equals the number of units sold. It means that at this price there is neither a surplus nor a shortage of the product in the market. But how does the market reach this equilibrium price, and why does it settle at $15 rather Figure 6.1 Market Equilibrium A M ARKET D EMAND AND S UPPLY S CHEDULES Quantity demanded Quantity supplied Price $30 25 20 15 10 5 0 1 3 6 10 15 13 11 9 6 3 0 B M ARKET D EMAND AND S UPPLY C URVES Surplus/ shortage 13 10 6 0 –7 –15 e c i r P $30 25 20 15 10 5 0 S Equilibrium price 10 11 12 13 14 15 16 Quantity The schedules provide the quantities demanded and the quantities supplied at different prices. The last column lists the surpluses or shortages at each price. When the demand and supply at each price are plotted, they show that the curves intersect at a price of $15. This is the equilibrium price. Economic Analysis Why is the equilibrium price important? surplus situation where quantity supplied is greater than quantity demanded at a given price Skills Handbook See page R53 to learn about Comparing Data. than some other price? To answer these questions, we have to examine the reactions of buyers and sellers to different market prices. When we do this, we assume that neither the buyer nor the seller knows the final price, so we’ll have to find it using trial and error. Surplus We start on Day 1 with sellers thinking that the price will be $25. If you examine the supply schedule in Panel A of Figure 6.1, you see that suppliers will produce 11 units for sale at that price. However, the suppliers soon discover that buyers will purchase only one CD at a price of $25, leaving a surplus of 10. A surplus is a situation in which the quantity supplied is greater than the quantity demanded at a given price. The 10unit surplus at the end of Day 1 is shown in column four of Panel A in Figure 6.1 as the difference between the quantity supplied and the quantity demanded at the $25 price. It is also shown graphically in Panel A of Figure 6.2 as the horizontal distance between the supply and demand curves at a price of $25. This surplus shows up as unsold products on suppliers’ shelves, and it begins to take up space in their warehouses. Sellers now know that $25 is too high, and they know that they have to lower their price if they want to attract more buyers and dispose of the surplus. Therefore, the price tends to go down as a result of the surplus. The model cannot tell us how far the price will go down, but we can reasonably assume that the price will go down only a little if the surplus is small, and much more if the surplus is larger. Shortage Suppliers are more cautious on Day 2, so they anticipate a much lower price of $10. At that price, the quantity they are willing to supply changes to three CDs. However, as Panel B in Figure 6.2 shows, this price turns out to be too low. At a market price of $10, only three CDs are supplied and 10 are demanded—leaving a shortage of seven CDs. Figure 6.2 Surpluses and Shortages A S URPLUS B S HORTAGE e c i r P $30 25 20 15 10 5 0 Surplus = 10 10 Quantity 11 12 13 14 15 16 17 e c i r P $30 25 20 15 10 5 0 S Shortage = 10 Quantity 11 12 13 14 15 16 17 A surplus occurs when sellers produce more units than buyers will purchase at a given price. A shortage is the result of buyers wanting to purchase more units than sellers offer at a given price. Surpluses will cause prices to drop, and shortages will cause prices to rise until prices reach an equilibrium. Economic Analysis Why did the surplus shown in Panel A occur? See StudentWorks™ Plus or glencoe.com. Equilibrium Price Supply and demand determine the final price of a product. Why does the price differ for the CDs in the cartoon shortage is a situation in which the quantity demanded is greater than the quantity supplied at a given price. When a shortage happens, producers have no more CDs to sell, and they end the day wishing that they had charged a higher price for their products. As a result of the shortage, both the price and the quantity supplied will go up in the next trading period. While our model does not show exactly how much the price will go up, we can assume that the next price will be less than $25, which we already know is too high. Equilibrium Price If the new price is $20 on Day 3, the result will be a surplus of six CDs. This surplus will cause the price to drop again, but probably not below $10, which already proved to be too low. However, if the price drops to $15, the market will have found its equilibrium price. As you learned earlier, the equilibrium price is the price that “clears the market” by leaving neither a surplus nor a shortage at the end of the trading period. While our economic model of the market cannot show exactly how long it will take to reach equilibrium, the temporary Mike Baldwin/Cartoon Stock shortage situation where quantity supplied is less than quantity demanded at a given price e k M i surpluses and shortages will always be pushing the price in that direction. Whenever the price is too high, the surplus will tend to force it down. Whenever the price is too low, the shortage will tend to force it up. As a result, the market tends to seek its own equilibrium. When the equilibrium price of $15 is finally reached, it will tend to remain there because the quantity supplied is exactly equal to the quantity demanded. Something could come along to disturb the equilibrium, but then new shortages, new surpluses, or both would appear to push the price toward its new equilibrium level. Think of how much more difficult it would be to reac |
h an equilibrium price if we did not have markets to help us with these decisions. You already learned that prices are neutral, flexible, understood by everybody, and free of administrative costs. It would be difficult to find another system that works equally well at setting the equilibrium price at exactly $15 and the equilibrium quantity at exactly six units. Also, when markets set prices, everybody has a hand in determining the outcome. Summarizing How do surpluses and shortages help establish the equilibrium price? CHAPTER 6 Prices and Decision Making 151 Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 6—Student Web Activities for an activity on prices. Explaining and Predicting Prices MAIN Idea Changes in supply and demand can result in changes in prices. Economics & You What happens to prices of concert tickets for bands that have become popular? Read on to find out how changes in demand affect prices. Economists use their market models to explain changes in prices. A change in price is normally caused by a change in supply, a change in demand, or changes in both. Elasticity is also important when predicting how prices are likely to change. Change in Supply Consider agriculture, which often experiences wide swings in prices from one year to the next. A farmer may keep up with all the latest developments and have the best advice experts can offer, but the farmer can never be sure what price to expect for the crop. For example, a soybean farmer may put in 500 acres of beans, hoping for a price of $9 a bushel. However, the farmer also knows that the actual price may end up being anywhere from $5 to $20. Weather is one of the main reasons for variations in agricultural prices. If it rains too much after planting, the seeds may rot or be washed away and the farmer must replant. If it rains too little, the seeds may not sprout. Even if the weather is perfect during the growing season, rain can still interfere with the harvest. The weather, then, often causes a change in supply. The result, shown in Panel A of Figure 6.3, is that the supply curve for agricultural products is likely to shift, causing the price to go up or down. At the beginning of the season, the farmer may expect supply to look like curve S. If a bumper, or record, crop is harvested, however, supply may look like S1. If severe weather strikes, supply may look like S2. In either case the price of soybeans is likely to change dramatically. Figure 6.3 Changes in Prices A F OOD P RICES 35 30 25 20 15 10 5 0 D S2 S S1 d l e yi d e t a ticip n A d l e yi ” “ yield ” er ath we “Bad Quantity (in bushels) B E NERGY P RICES $100 D2 D D1 90 80 70 60 50 40 30 Quantity (in barrels) The supply and demand curves are both inelastic. Panel A illustrates how a change in supply due to weather can cause a large change in food prices. Panel B shows that a large price change will also take place if there is a change in demand. Economic Analysis What would cause a change in the market demand for food? Change in Demand A change in demand, like a change in supply, can affect the price of a good or service. All of the factors we examined in Chapter 4—changes in income, tastes, prices of related products, expectations, and the number of consumers—affect the market demand for goods and services. One example is the demand for oil. In Panel B of Figure 6.3, a modest increase in demand, illustrated by a shift from D to D1, causes a large increase in the price. This is exactly what happened in 2005 and 2006 when economic growth in the U.S. economy and the rest of the world, especially China and India, increased the demand for energy. Because both the supply and the demand for oil are inelastic, the price of oil increased dramatically. On the other hand, if the world economy had declined instead, demand would have shifted to D2, bringing the price of oil down. Change in Supply and Demand In the real world, changes in both supply and demand often affect prices. For example, we know that strong economic growth in 2005 caused the demand curve for oil to increase (or shift to the right), which drove prices up. To make matters worse, hurricanes Katrina and Rita tore through the Gulf of Mexico, destroying and disabling hundreds of drilling platforms, refineries, and storage facilities. This caused the supply of oil to decrease (or shift to the left), driving the price of gasoline even higher. The resulting combination of increased demand and decreased supply gave the U.S. economy some of the highest energy prices it had seen since the 1970s. The Importance of Elasticity Whenever supply or demand for a product fluctuates, the elasticity of the two curves affects the size of the price change. To illustrate, both curves are relatively inelastic in Figure 6.3. If you look at Panel A, Michael Newman/PhotoEdit, Inc. you can see that the change in price is relatively large when supply changes. Panel B shows that the change in price is also large when demand shifts. If one or both curves are elastic, though, the change in price will be smaller. Fortunately, as we saw in Chapters 4 and 5, there are ways for us to determine the elasticity of both supply and demand. This means that we can predict how prices are likely to change if we know the elasticity of each curve and the underlying factors that cause the supply and demand curves to change. CAREERS Real Estate Agent The Work * Assist in renting, selling, and buying property for clients * Obtain listings (owner agreements to place properties for rent or sale), advertise the property, and show the property to prospective renters and buyers Qualifications * Knowledge of fair-market values, zoning laws, local land-use laws, housing and building codes, insurance coverage, mortgage and interest rates * Highly ambitious, flexible schedule, extensive social and business connections * High-school diploma, at least 18 years old, state real estate license * College courses in real estate, finance, business administra- tion, statistics, economics, law, and English helpful Earnings * Median annual earnings (including commissions): $35,670 Job Growth Outlook * Average Source: Occupational Outlook Handbook, 2006–2007 Edition CHAPTER 6 Prices and Decision Making 153 Competitive Markets In competitive markets, sellers need to adjust their prices to attract buyers. Why do economists like competitive marketsWell look at that! The store across the street has the same binoculars for $15 less.” Prices and Competitive Markets Economists like to see competitive markets because the price system is more efficient when markets are competitive. A perfectly competitive market requires a set of ideal conditions and outcomes that are seldom found in the real world, but fortunately markets don’t have to be perfect to be useful. As long as prices are allowed to adjust to new levels in response to the pressures exerted by surpluses and shortages, prices will perform their role as signals to both consumers and producers. The great advantage of competitive markets is that they allocate resources efficiently. As sellers compete to meet consumer demands, they are forced to lower the prices of their goods. This in turn encourages them to keep their costs down. At the same time, competition among buyers helps prevent prices from falling too far. In the final analysis, a competitive market economy is one that “runs itself.” There is no need for a bureaucracy, planning commission, or other agency to set prices, because the market tends to find its own equilibrium. In addition, the three basic economic questions of WHAT, HOW, and FOR WHOM to produce are decided by the participants— the buyers and sellers—in the market. Explaining How does the elasticity of a good affect its price? SECTION 2 Review Vocabulary 1. Explain the significance of economic model, equilibrium Critical Thinking 4. The BIG Idea Explain why competitive markets price, surplus, and shortage. allocate resources efficiently. Main Ideas 2. Determining Cause and Effect Use a graphic organizer like the one below to show how a change in demand or supply affects the price of a product. Demand/Supply r e a s e s I n c Price ________ / ________ Decreases Price ________ / ________ 3. Explaining How does the elasticity of supply and demand for a product affect the size of a price change? 5. Making Inferences What do merchants usually do to sell items that are overstocked? What does this tell you about the equilibrium price for the product? 6. Understanding Cause and Effect What will happen to the price you pay for concert tickets if a popular group has to move its show to a smaller facility? Why? 7. Analyzing Visuals Look at Figure 6.2 on p. 150. Create a graph showing what will happen at a price of $20. Applying Economics 8. Equilibrium Price Select a product that appears in newspaper ads of several different stores. Note the various prices and indicate whether any of these prices are sale prices. What does the information tell you about the equilibrium price of the product you selected? 154 UNIT 2 Microeconomics: Prices and Markets Jim Unger/Laughingstock Licensing NEWSCLIP The beauty of the supply and demand system lies in its ability to set prices. If demand is high and supply low, prices skyrocket and producers increase supplies. Simple, right? What happens, though, if suppliers are unable keep up with rapidly growing demand? What’s Raining on Solar’s Parade? The solar power industry has been on a tear, growing at more than 30% per year for the last six years. It’s poised to reach a surprising milestone within two years, when it will gobble up more silicon for its electricity-generating panels than semiconductor makers use in all their chips and devices. . . . So what’s the problem? “Global demand is stronger than the existing supply,” says Lee Edwards, president and CEO of BP Solar. His company and others can’t buy enough of the ultrapure polysilicon now |
used in 91% of solar panels. The raw material shortage has slashed growth for the industry from more than 50% in 2004 to a projected 5% in 2006. The shortage has caused prices for polysilicon to more than double over the last two years. As D EMAND AND P RICE OF S ILICON Demand for polysilicon in semiconductors Demand for polysilicon in solor photovolting Price of polysilicon 30 20 10 2003 Economics 101 teaches, that should prompt producers to expand capacity. But for suppliers such as Michigan-based Hemlock Semiconductor Corp., the world’s largest producer, the decision hasn’t been easy. For one thing, the company was badly burned in 1998. It had just built a new facility in response to pleas from semiconductor makers when Asia went into a slowdown. Demand for silicon plunged, and the factory had to be shuttered. . . . Hemlock finally decided that the industry is real, but only after solar companies agreed to share the risk by signing contracts to buy the future output. So in December the company began an expansion worth more than $400 million that will increase silicon production by 50%. Competitors are following suit. —Reprinted from BusinessWeek Examining the Newsclip $120 80 40 2004 2005† 2006 2007* 2008 1. Understanding Cause and Effect How did the Year shortage of polysilicon affect its price? Sources: Riper Jaffray, www.renewableenergyaccess.com * 2007 figure for price is estimated. † 2005–2008 figures for demand are estimated. 2. Analyzing Why was Hemlock Semiconductor Corp. at first reluctant to increase the production of polysilicon? Robert Harding Picture Library Ltd/Alamy CHAPTER 6 Prices and Decision Making 155 SECTION 3 Social Goals and Market Efficiency GUIDE TO READING Section Preview In this section, you will learn that governments sometimes use policies that interfere with the market in order to achieve social goals. Content Vocabulary • price ceiling (p. 157) • minimum wage (p. 158) • price floor (p. 158) • target price (p. 159) • nonrecourse loan (p. 159) • deficiency payment (p. 159) Academic Vocabulary • arbitrarily (p. 157) • stabilize (p. 159) Reading Strategy Explaining As you read the section, complete a cause-and-effect chart similar to the one below by explaining the effects of price ceilings and price floors. Policy Effects Price ceiling Price floor —The Washington Times ISSUES IN THE NEWS Minimum Wage Rise Hurts Students Maryland small business owners are bemoaning higher labor costs as the state’s minimum wage increases today from the federal threshold of $5.15 per hour to $6.15. . . . “A dollar an hour is a huge jump—people have no idea how that affects your payroll,” said Mike Kostinsky, who owns Sorrento of Arbutus, a pizza restaurant in Arbutus, Md. . . . Mr. Kostinsky, whose family has owned Sorrento for 41 years, said he typically adds four or five high school students at minimum wage during the summer to allow his 30 or so permanent employees to take vacations. As a result of the wage increase, “I won’t let anybody go, but I probably won’t hire anybody else,” he said. ■ In Chapter 2 we examined seven broad eco- nomic and social goals that most people seem to share. We also observed that these goals, while commendable, are sometimes in conflict with one another. These goals also have been partially responsible for the increased role that government plays in our economy. Attempts to achieve one of these goals—economic security—occasionally result in legislation such as the increase in the minimum wage in Maryland described in the news story above. While the legislation is clearly beneficial to some people, it can be detrimental to others. What is common to all of these situations, however, is that the outcome—wage control—can only be achieved by interfering with the price system and distorting the allocations made in the market. 156 UNIT 2 Microeconomics: Prices and Markets Robert W. Ginn/PhotoEdit, Inc. Distorting Market Outcomes MAIN Idea Price ceilings and price floors prevent prices from allocating goods and resources. Economics & You Do you think the minimum wage helps you or other people who are looking for jobs? Read on to learn how the minimum wage can affect the job market. One common way to achieve social goals is to have the government set prices at “socially desirable” levels. When this happens, prices are not allowed to adjust to their equilibrium levels, and the price system cannot transmit accurate information to other buyers and sellers in the market. Price Ceilings Some cities, especially New York City, have a long history of using rent controls to try to make housing more affordable. This is an example of a price ceiling, a maximum legal price that can be charged for a product. The case of a price ceiling is shown in Figure 6.4. Let us assume that without the ceiling, the market would establish monthly rents at $900, which is an equilibrium price because 2.0 million apartments would be supplied and rented at that rate. If authorities think $900 is too high, and if they want to achieve the social goals of equity and security for people who cannot afford these rents, they can arbitrarily establish a price ceiling at $600 a month. No doubt renters would love the lower price and might demand 2.4 million apartments. Landlords, on the other hand, would try to convert some apartments to other uses, such as condominiums and office buildings that offer higher returns. Therefore, the supply might only reach 1.6 million apartments at $600 per month, leaving a permanent shortage of 800,000 apartments. price ceiling highest legal price that can be charged for a product Are consumers better off? Perhaps not. More than likely, the better apartments will be converted to condos or offices—leaving the poorer ones to be rented. In addition, 800,000 people are now unhappy because they cannot get an apartment, although they are willing and able to pay for one. Prices no longer allocate apartments. Instead, landlords resort to long waiting lists or other nonprice criteria such as excluding children and pets to discourage applicants. Rent controls also freeze a landlord’s total revenue and threaten his or her profits. As a result, the landlord tries to lower costs by providing the absolute minimum upkeep. In addition, landlords have little incentive to add additional units if they feel rents are too low. Some apartment buildings may even be torn down to make way for shopping centers, factories, or high-rise office buildings. The price ceiling, like any other price, affects the allocation of resources—but not in the way intended. The attempt to limit rents makes some people happy, until their Figure 6.4 Price Ceilings P RICE C EILING S In housing markets, a rent control is a price ceiling1500 1200 900 600 300 0 Equilibrium price Price ceiling Shortage 1.6 2.0 2.4 Quantity (in millions) A price ceiling of $600 leaves 800,000 people permanently without apartments. Without the ceiling, an additional 400,000 people would have found an apartment at $900. Economic Analysis Why does government sometimes impose restrictions such as price ceilings on the market? minimum wage lowest legal wage that can be paid to most workers price floor lowest legal price that can be paid for a product buildings begin to deteriorate. Others, including landlords and potential renters on waiting lists, are unhappy from the beginning. Finally, some productive resources—those used to build and maintain apartments—slowly move out of the rental market. Price Floors Other prices are sometimes considered too low, so the government takes steps to keep them higher. The minimum wage, the lowest legal wage that can be paid to most workers, is such a case. The minimum wage in fact is a price floor, or lowest legal price that can be paid for a good or service. Figure 6.5 uses a minimum wage of $5.15 per hour as an illustration of a price floor. At this wage, the supply curve shows that 14 million people would want to offer their services. According to the demand curve for labor, however, only 10 million would be hired, leaving a surplus of 4 million workers without jobs. Figure 6.5 Price Floors P RICE F LOOR ) 8.00 6.00 5.15 4.00 2.00 0 Price floor Equilibrium price Surplus S In labor markets, a minimum wage is a price floor. D 10 14 Quantity (in millions) 12 At a price floor of $5.15 per hour, 10 million workers will be hired. At the equilibrium price of $4.00 per hour, 2 million more people would find jobs. Economic Analysis Who benefits from price floors? Who is placed at a disadvantage? 158 UNIT 2 Microeconomics: Prices and Markets The figure also shows that without the minimum wage, the actual demand and supply of labor would establish an equilibrium price of $4.00 per hour. At this wage, 12 million workers would offer their services and the same number would be hired—which means that there would be neither a shortage nor a surplus in the labor market. Most economists argue that the minimum wage actually increases the number of people who do not have jobs because employers hire fewer workers at higher wages. In the case of Figure 6.5, the number of people who lose jobs amounts to 2 million—the difference between the 12 million who would have worked at the equilibrium price and the 10 million who actually work at the higher wage of $5.15 per hour. Is the minimum wage good or bad for the economy? Certainly the minimum wage is not as efficient as a wage set by supply and demand, but not all decisions in our economy are made on the basis of efficiency. The basic argument in favor of the minimum wage is that it raises poor people’s incomes and provides a small measure of equity—one of our seven major economic and social goals. A federal minimum wage is evidence that the small measure of equity provided by the minimum wage is preferred to the loss of efficiency. Finally, it could be argued that the minimum wage is irrelevant because it is actually lower than the lowest wages paid in many areas. Consider the wages in your |
area, for example. More than likely, most employers pay wages higher than the minimum wage and would not lower them even if the minimum wage were eliminated. Do you think that your employer would pay you less if he or she were allowed to do so? Your response will provide a partial answer to the question. Reading Check Analyzing What are the negative and positive aspects of price ceilings and price floors? Agricultural Price Supports MAIN Idea Government programs to help stabilize prices for farmers have both positive and negative effects. Economics & You Do you remember learning in your history class about the plight of farmers during the Great Depression? Read on to find out how the government tried to help farmers. During the Great Depression of the 1930s, prices plummeted everywhere. Farmers, however, had an even more difficult time because they were having the “bumper yields” illustrated in Panel A of Figure 6.3 on page 152 that pushed prices even lower. Because both the demand for and supply of food were inelastic, farm prices fell much further than other prices in the economy. To help farmers, the federal government established the Commodity Credit Corporation (CCC), an agency in the Department of Agriculture. The CCC then used a target price, which is essentially a price floor, to help stabilize farm prices. Loan Supports Under one CCC support program, a farmer borrowed money from the CCC at the target price and pledged his or her crops as security in return. The farmer then used the loan to plant, maintain, and harvest the crops. When they were ready for harvest, the farmer had two choices: either sell the crop in the market and use the proceeds to repay the CCC loan, or keep the proceeds of the loan and let the CCC take possession of the crop. The farmer could get at least the target price because the loan was a nonrecourse loan—a loan that carries neither a penalty nor further obligation to repay if not paid back. Deficiency Payments While the CCC loan program helped farmers, it created new problems because the U.S. Department of Agriculture soon target price price floor for agricultural products set by the government to stabilize farm income nonrecourse loan agricultural loan that carries no penalty or further obligation if it is not repaid deficiency payment cash payment making up the difference between the market price and the target price owned enormous stockpiles of food. The deparment had to resort to storing surplus wheat in rented warehouses or on open ground. Surplus milk was made into cheese and stored in underground caves. The military received some of the food, while public schools received other food that they could use in their “free lunch” programs. Still the surpluses grew, leaving politicians to consider how they could support farm prices and avoid holding large surpluses at the same time. The solution was a new governmentprogram that combined the competitive market with price supports. Farmers sold their crops on the open market for the best price they could get based on demand and supply. The CCC then gave farmers a deficiency payment—a check the government sends to producers to make up the difference between the market price and the target price. Figure 6.6 Deficiency Payments D EFICIENCY P AYMENTS $6.00 5.00 4.00 3.00 2.00 1.00 Target price Market price 0 2 4 S The farmer is paid the difference between the target and the market price. D 16 18 6 8 10 Quantity (in thousands of bushels) 12 14 Under the CCC deficiency payment program, a target price such as $4 per bushel of wheat was set. At this price farmers would produce and sell 10,000 bushels. With 10,000 bushels produced, buyers would pay $2.50 per bushel in the marketplace, so the CCC would need to give an additional payment of $1.50 per bushel to farmers to hit the target price. Economic Analysis How much would the farmer have produced and earned without the deficiency payment program very popular with farmers and today accounts for nearly 10 percent of total farm subsidies Federal Land Bank The government currently pays some farmers to not farm in an effort to reduce production and to support farm income. How much land is in the land bank program? “...and here I was... only just getting used to being paid for NOT doing things.” Conservation “Land Banks” The loan support and deficiency payment programs of the 1930s continued for several decades. By the 1980s, though, two factors combined to make these programs increasingly expensive to maintain. For one, agricultural output increased dramatically because of increased farm productivity. In addition, there were simply too many farmers involved in agriculture. Many experts concluded that the solution was to get some farmers to stop farming. The result was the Conservation Reserve Program of 1985 that paid farmers to not farm. To enroll in the program, acreage where crops previously grew was set aside in a “land bank” to save the land for future use. The U.S. Department of Agriculture would then pay the farmer an annual fee as long as the land was not farmed. While the program was expensive for taxpayers, it has since become 160 UNIT 2 Microeconomics: Prices and Markets McArthur, Bill/www.CartoonStock.com Reforming Price Supports In an effort to make farming responsive to the market forces of supply and demand, Congress passed the Federal Agricultural Improvement and Reform (FAIR) Act in 1996. Under FAIR, “loan rates” took the place of target prices, and temporary cash payments replaced price supports and deficiency payments. Lawmakers hoped that when the law expired, farmers would be experienced enough with the laws of supply and demand to no longer need help. However, the new payments turned out to be larger than the ones they replaced, and the overall cost of the U.S. farm support programs actually went up. Then, when FAIR was about to expire in 2002, Congress replaced it with the Farm Security and Rural Investment Act of 2002, which provided for even larger price support payments that would last through 2007. Continued Agricultural Support Today, American agriculture is more dependent than ever on subsidies and price supports. In addition to subsidizing basic commodities like rice, corn, sugar, and cotton, crops such as peanuts, sunflower seeds, and mohair are also covered. The amount of land that farmers are paid to not farm has grown to be larger than the state of New York. Whether this is good or bad depends on your perspective. If you are a taxpayer supplying the funds for these payments, you might think that the government spends too much on these programs. If you are a farmer receiving payments, you are probably glad that the government is supporting the goal of economic security. Reading Check Summarizing What has been the effect of agricultural price supports? When Markets Talk MAIN Idea Markets send signals when prices change in response to events. Economics & You Have you heard stories in the news about changes in the stock market when a new government policy was announced? Read on to find out how markets “talk.” buy gold. As a result, stock prices would fall, and the price of gold would rise. In a sense, the market would “talk” by voicing its disapproval of the new tax policy. Markets are impersonal mechanisms that bring buyers and sellers together. Although markets do not talk in the usual sense of the word, they do send signals in that they speak collectively for all of the buyers and sellers who trade in the markets. Markets are said to “talk” when prices in them move up or down significantly in reaction to events that take place elsewhere in the economy. Suppose federal government announced that it would raise taxes to pay off some of the federal debt. If investors thought this policy would not work or that other policies might be better, they might decide to sell some of their stocks and other investments to the In this example, individual investors made decisions on the likely outcome of the new policy and sold stocks for cash or gold. Together, investor actions were enough to influence stock prices and to send a signal to the government that investors did not favor the policy. If investors’ feelings were divided about the new policy, some would sell while others bought stocks. As a result, prices might not change, and the message would be that, as yet, the market had not made up its mind. Reading Check Examining Can you think of any other examples of markets “talking”? Explain. Fed Alert Stock markets react quickly to any major news report. One such report is a change in the interest rate charged by the Federal Reserve for loans. Eight times a year, the Fed takes a look at this rate. Stock market reaction is swift: If it likes the change, stock prices will go up that day. Prices will drop just as quickly if changes are unexpected or undesired. Skills Handbook See page R35 to learn about Identifying the Main Idea. SECTION 3 Review Vocabulary 1. Explain the significance of price ceiling, minimum wage, price floor, target price, nonrecourse loan, deficiency payment. Main Ideas 2. Determining Cause and Effect Use a graphic organizer like the one below to illustrate how price floors affect quantity demanded and supplied. Quantity demanded ___________ Price floor Quantity supplied ___________ 3. Explaining Why did the federal government establish agricultural price support programs? 4. Describing How do markets speak collectively for buyers and sellers? Critical Thinking 5. The BIG Idea Explain why a government would consider imposing a price ceiling or price floor. 6. Analyzing Visuals Look at Figure 6.4 on p. 157. How does the price ceiling affect the relationship between quantity supplied and quantity demanded? Why does the price ceiling make this relationship permanent? 7. Predicting What would happen if the government eliminated all farm subsidies? Applying Economics 8. Price Floor Interview 10 classmates who have part-time jobs. Identify where they work and |
who gets paid at, below, or above the federal minimum wage. Use that information to predict how increasing the federal minimum wage by $1.00 per hour would impact employment for teenagers in your area. CHAPTER 6 Prices and Decision Making 161 ENTREPRENEUR Profiles in Economics Margaret (Meg) Whitman (1956– ) • ranked by Fortune magazine as the “Most Powerful Woman in Business” in 2005 • turned eBay into one of the fastest-growing companies in U.S. history Excellence Leads eBay As president and CEO of eBay Inc. since 1998, Meg Whitman runs the world’s leading Internet auction site. Although eBay was invented by software engineer Pierre Omidyar in 1995, it has been Whitman’s leadership and branding expertise that made the site a household name. The year Whitman took over eBay, the company earned about $6 million. Seven years into her leadership, the company’s revenues grew to $4.6 billion. Her secret? She works quickly to fix problems, such as removing counterfeit items for auction and instituting PayPal to help streamline the payment process. She asks questions instead of issuing orders, and she shares what she learns with her employees. She also listens to customers and employees and seeks their feedback. The Power of All of Us Business analysts agree that Whitman’s success has more to do with her willingness to listen than anything else. As she says, “Our army of users figures out what’s hot before we even know.” That attitude keeps Whitman in the chat room instead of the boardroom. She reads hundreds of e-mails from users every day, and her “Voice of the Customer” program has been known to reverse business decisions based on user complaints. She trusts what she calls “The Power of All of Us” to sustain a community of users that will essentially guide itself. When eBay management thought car sales would be too complicated and risky, the eBay community demanded the capability. Because Whitman was open to the suggestion, more than 1 million cars have now been sold on eBay. If Meg Whitman were to have a feedback profile similar to the ones kept by the buyers and sellers on eBay, her rating would be high indeed. Examining the Profile 1. Summarizing What management techniques have made eBay so successful? 2. Drawing Conclusions Do you think Whitman’s philosophy of “The Power of All of Us” could work in other industries? Explain. When Meg Whitman became CEO, many of the items auctioned on eBay were small collectibles like Star Wars toys. Today eBay sells everything consumers demand. Says Whitman, “It is the users who build the company.” 162 UNIT 2 Microeconomics: Prices and Markets Kim Kulish/Corbis CHAPTER 6 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Allocation of Resources Prices are signals that help buyers and sellers make economic decisions. Without prices, societies must find other ways to allocate resources. With Prices: • Prices serve as link between producers and consumers • Allocation easy because prices are neutral, flexible, and have no cost Allocation of resources Without Prices: • Must find another system such as rationing • Allocation difficult because of problems with fairness, high cost of administration, and less incentive for people to work Market Equilibrium When buyers and sellers can freely make production and purchase decisions, the price of a product will move toward market equilibrium. At this point, the quantity supplied is exactly equal to the quantity demanded. M ARKET D EMAND AND S UPPLY C URVES e c i r P $30 25 20 15 10 5 0 S Equilibrium price 10 11 12 13 14 15 16 Quantity Social Goals and Prices The social goals of equity and security sometimes can be achieved only by giving up parts of other goals. Price ceilings or price floors can help achieve these goals, but they may result in fewer goods and services offered overall. P RICE C EILING P RICE F LOOR S In housing markets, a rent control is a price ceiling1500 1200 900 600 300 0 Equilibrium price Price ceiling Shortage 1.6 2.0 2.4 Quantity (in millions8.00 6.00 5.15 4.00 2.00 0 Price floor Equilibrium price Surplus S In labor markets, a minimum wage is a price floor. D 10 14 Quantity (in millions) 12 CHAPTER 6 Prices and Desicion Making 163 CHAPTER 6 Assessment & Activities Review Content Vocabulary Review the Main Ideas Use the terms below to identify the missing cause or effect in the following situations. a. rationing b. surplus c. shortage d. equilibrium price e. price ceiling f. price floor 1. Cause: The government tries to keep prices down by legislating a price ceiling. Effect: ______ 2. Cause: The government wants to allocate scarce goods and services without the help of a price system. Effect: ______ 3. Cause: A reasonably competitive market experiences brief, minor shortages and surpluses. Effect: ______ 4. Cause: ______ Effect: New York City has many apartments with very low rents but also has a shortage of apartment units. 5. Cause: A market is at equilibrium, but the product falls out of style before producers can reduce production. Effect: ______ 6. Cause: ______ Effect: Farmers receive higher prices for milk and cheese but also experience a surplus. Review Academic Vocabulary 7. Create the clues for the crossword puzzle below. Your Section 1 (pages 143–146) 8. Describe four advantages of using price as an allocating mechanism. 9. Discuss why allocating resources without prices is difficult. 10. Explain why prices are neutral. Section 2 (pages 148–154) 11. Explain what is meant by the term market equilibrium. 12. Describe the role of shortages and surpluses in competitive markets. 13. Identify three causes of a price change in a market, using a graphic organizer like the one below. Add examples and identify the possible results for each. Price changes Section 3 (pages 156–161) 14. Explain why shortages and surpluses are not temporary when price controls are used. clues should relate to the chapter content. 15. Identify and describe two of the programs that have been used to stabilize farm incomes. 16. Explain what is meant by the statement that “markets talk.” Critical Thinking 17. The BIG Idea Explain why and how a reasonably competitive market is always moving toward equilibrium. 18. Making Generalizations Some people argue that providing price supports to farmers is unfair to consumers. In a short paper, describe the positive and negative results of these price supports. Then explain why you support or oppose such programs. 164 UNIT 2 Microeconomics: Prices and Markets 19. Making Predictions Suppose that your state wanted to make health care more affordable for everyone. To do this, state legislators put a series of price controls— price ceilings—in place that cut the cost of medical services in half. In short paragraphs, explain your answers to the following questions: a. What would happen to the demand for medical services at the new, lower price? b. What would happen to the supply of medical services that doctors would be willing to provide at the new, lower price? c. What considerations would new doctors take into account when they decide where to set up their practice? Explain the reasons for your answers. 20. Synthesizing You were invited to speak to a middle school class about the activities available at your school. You brought 20 ballpoint pens with the high school logo, but there were 30 students in the class. What kind of nonprice rationing system would you devise to fairly allocate the scarce item? 21. Predicting Assume that the price of school lunches has become too high, and you need to set a price ceiling to remedy the problem. What would the consequences of such a policy be for both students and the school? Math Practice 22. A shoe store is having a sale. The first pair of shoes sells for $40. The second pair sells for half price, or $20. The next pair sells for half of that, and so on. Create a table like the one below that tracks the total cost of the shoes as each pair is added. Stop when the selling price of the last pair of shoes is less than $1.50. Number of pairs Total cost 1 Th Economics: Principles and Practices Web site at glencoe.com and click on Chapter 6—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Analyzing Visuals 23. Examine the figure below, then answer the questions that follow. P RICE A DJUSTMENT P ROCESS e c i r P $30 25 20 15 10 10 11 12 13 14 15 16 Quantity a. What is the quantity demanded at a price of $20? At $15? b. What is the quantity supplied at a price of $10? At a price of $20? c. How large is the shortage or surplus at $5? Explain your answer. d. If the price started at $5 today, what would likely happen to the price tomorrow? Why? Thinking Like an Economist 24. Economists like to use cost-benefit analysis to assess the merits of any program. Use this decision-making strategy to evaluate the desirability of continuing rent control. Write a paragraph describing your strategy and results. Writing About Economics 25. Persuasive Writing Research newspapers and news magazines for recent articles about the minimum wage. Using what you have learned about price floors and the information in the articles, decide whether you favor or oppose raising the minimum wage. Write a 2-page paper outlining your views. CHAPTER 6 Prices and Decision Making 165 DEBATES IN ECONOMICS Should College Athletes Be Paid? $ College athletes—particularly basketball and football players—rake in millions of dollars for their universities and the National Collegiate Athletic Association (NCAA). Some people argue that these athletes deserve to be compensated for their role in generating this revenue, whereas others maintain that free-ride scholarships and the potential to “go pro” are more than enough compensation. Can you sift through the debate to determine whether college athletes should receive more than a free college education for their efforts? As you read the selections, ask yourself: Should college athle |
tes be paid? PRO COLLEGE ATHLETES SHOULD BE PAID Vince Young fakes the pass, pulls the ball down and runs for the game-winning touchdown in the national championship game. Those connected with Texas are smiling as one of the greatest players in its storied history has led the Longhorns to a national title. The higher-ups at the school had reason to smile much earlier. . . With the chance to claim a national title also came $3.5 million from the [Bowl Championship Series] directly to Texas and another $14.9 million distributed among the Big 12 conference teams. The problem is, the athletes who help schools and conferences make that money do not see a dime of it. They may receive scholarships, but so do students who don’t help the school make money in any way. . . . If schools can profit off of student athletes, why should those athletes not be paid for helping schools make money? . . . Paying [college athletes] would improve quality of play by keeping borderline professional athletes in college. Also, it would help those same players develop their skills so they could make more money at the professional level. $453,000,000 $13,000,000 NCAA REVENUES • CBS broadcast and marketing rights, including Division I men’s basketball tournament • ESPN broadcast rights for 21 championships, including Division I women’s basketball, baseball, ice hockey, and softball • Other broadcast rights • Division I men’s basketball tickets • Tickets for other Division I championships • Tickets for Division II and III championships • Investments, fees, and services • Membership dues —Andrew Zivic, writer for iMPrint Magazine $4,450,000 $27,870,000 $13,175,000 $705,000 $8,790,000 $1,010,000 Source: IndyStar.com, 2005–2006 NCAA Revenues 166 UNIT 2 Microeconomics: Prices and Markets Ronald Martinez/Getty Images CON COLLEGE ATHLETES SHOULD NOT BE PAID As my opening kick against this notion, please accept the obvious premise that college athletes do trade on their skill for financial gain. This gain is realized in the form of a scholarship. . . . Four (or five) years on a free ride at, say, the University of Michigan can cost a person well over 100,000 [dollars]. . . . $129,435,000 $122,800,000 NCAA EXPENDITURES * The NCAA maintains that 95 percent of its money is returned to the membership via direct payments or event services. • Division I athletic departments and conferences • Division I conferences, based on performance in the men’s basketball tournament • Division I academic support; need-based emergency aid for players; “student-athlete opportunity fund” • Division I championships and other programs, including team travel and officials • Division II and III expenditures • Association-wide expenses, including insurance, enforcement, communications, and legal services • General administration • Legal contingencies; president’s reserve; endowment $55,357,000 $55,100,800 $39,411,000 $87,779,400 $22,836,800 $9,280,000 How much loot-gathering should be attributed to the play of [a] backup left guard? How about the second-string corner? Should there be a salary scale that bestows a stipend commensurate with the player’s productivity? What a hayride that would be to administrate. . . . Another problem with paying or subsidizing Source: IndyStar.com, 2005–2006 NCAA Revenues college athletes is the danger of tipping an already unbalanced playing surface. While it’s assumed that most Division I schools are rolling in dough, reality finds many athletic departments in the red. At more than a few schools, some of the low-revenue sports often are sacrificed. Schools with huge football revenues—such as Michigan, Texas, Ohio State, and USC—would have an even bigger advantage if paying players became an option. —Randy Hill, writer for FOXSports.com Analyzing the Issue 1.1. Identifying What are the arguments in favor of paying college athletes to play? 2. 2. Summarizing What reasons does Hill give against paying college athletes? 3. 3. Deciding With which opinion do you agree? Explain your reasoning. CHAPTER 6 Prices and Decision Making 167 Ronald Martinez/Getty Images CHAPTER 7 Market Structures Why It Matters A developer has acquired the large piece of vacant land across the street from your house and plans to build a large shopping mall on the property. How might you benefit from the mall? How might it negatively impact your life? Read Chapter 7 to learn about market structures and economic growth. The BIG Ideas 1. The profit motive acts as an incentive for people to produce and sell goods and services. 2. Economists look at a variety of factors to assess the growth and performance of a nation’s economy. 3. Governments strive for a balance between the costs and benefits of their economic policies to promote economic stability and growth. When many companies offer similar products, each firm tries to differentiate its goods to attract customers. 168 UNIT 2 Powerstock/Index Stock Imagery Economics: Principles and Practices Web site at glencoe.com and click on Chapter 7—Chapter Overviews to preview chapter information. Chapter Overview Visit the SECTION 1 Competition and Market Structures GUIDE TO READING Section Preview In this section, you will learn that market structures include perfect competition, monopolistic competition, oligopoly, and monopoly. Content Vocabulary • laissez-faire (p. 169) • market structure (p. 169) • perfect competition (p. 170) • imperfect competition (p. 172) • monopolistic competition (p. 173) • product differentiation (p. 173) • nonprice competition (p. 173) • oligopoly (p. 174) • collusion (p. 174) • price-fixing (p. 175) • monopoly (p. 175) • natural monopoly (p. 176) • economies of scale (p. 176) • geographic monopoly (p. 176) • technological monopoly (p. 176) • government monopoly (p. 177) Academic Vocabulary • theoretically (p. 170) • equate (p. 177) Reading Strategy Identifying As you read the section, complete a graphic organizer similar to the one below by identifying the characteristics of different market structures. Market Structure Characteristics Perfect competition ISSUES IN THE NEWS Profits, Prices Spur Oil Outrage —The Washington Post Exxon Mobil Corp. reported $8.4 billion in first-quarter profit yesterday, as members of Congress, outraged over high gasoline prices, hastened to propose measures that would boost taxes on oil firms, open new areas to drilling and provide rebates to taxpayers but would not necessarily alter prices at the pumps. “What you have today is an oligopoly, effectively, and I think it’s a disaster for the American people,” said Senator Dianne Feinstein. Federal Reserve Chairman Ben S. Bernanke cautioned Congress on the various proposals being floated. “I would like to let the market system work as much as possible to generate new supplies. . . .” ■ When Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations in 1776, the average factory was small, and businesses were competitive. Laissez-faire, the French term that means “allow them to do,” was the prevailing philosophy that limited government’s role to protecting property, enforcing contracts, settling disputes, and protecting firms against foreign competition. Conditions are much different today. An industry, or the supply side of the market, has many firms of different sizes producing slightly different products. These conditions help determine market structure, or the nature and degree of competition among firms doing business in the same industry. Economists group firms into four different market structures that reflect the competitive conditions in those markets. laissez-faire philosophy that government should not interfere with business activities market structure nature and degree of competition among firms in the same industry The McGraw-Hill Companies CHAPTER 7 Market Structures 169 perfect competition market structure with many well-informed and independent buyers and sellers who exchange identical products Perfect Competition MAIN Idea Perfect competition is an ideal market situation used to evaluate other market structures. Economics & You You learned earlier about industries. Read on to find out how perfect competition is the ideal market structure in an industry. Perfect competition is a market structure characterized by a large number of wellinformed independent buyers and sellers who exchange identical products. It represents a theoretically ideal situation that is used to evaluate other market structures. In Perfect Competition A farmers’ market comes closest to satisfying the conditions for a perfectly competitive market. What conditions for perfect competition are met in this photograph, and how? order for a market to have perfect competition, it needs to meet five necessary conditions that other market structures lack. Necessary Conditions The first condition is that there must be a large number of buyers and sellers. No single buyer or seller is large enough or powerful enough to single-handedly affect the price. The second condition is that buyers and sellers deal in identical products. With no difference in the products, there is no need for brand names and no need to advertise, which keeps prices low. With no differences between products, one seller’s merchandise is just as good as another’s. The third condition is that each buyer and seller acts independently. This ensures that sellers compete against one another for the consumer’s dollar, and that consumers compete against one another to obtain the best price. The fourth condition is that buyers and sellers are reasonably well-informed about products and prices. Well-informed buyers shop at the stores that have the lowest prices. Well-informed sellers match the lowest prices of their competitors to avoid losing customers. The fifth condition is that buyers and sellers are free to enter into, conduct, or get out of business. This freedom makes it difficult for producers in any industry to keep the market to themselves. Producers hav |
e to keep prices competitive, or new firms can take away some of their business. Collectively, these conditions help ensure the competition that is necessary to keep prices low and quality high. Profit Maximization Under perfect competition, market supply and demand set the equilibrium price for the product. Because the price is determined in the market, and because each firm by itself is too small to influence the market price, the perfect competitor is often called 170 UNIT 2 Microeconomics: Prices and Markets Mika/zefa/Corbis Figure 7.1 Perfect Competition and Profit Maximization Under perfect competition, the market forces of supply and demand establish the equilibrium price. The perfectly competitive firm treats this price as its demand curve and its marginal revenue (MR) because the firm will receive $15 for each and every unit it sells. Economic Analysis What would happen to total profits if the firm used 10 workers instead of 9? A M ARKET B I NDIVIDUAL F IRM See StudentWorks™ Plus or glencoe.com. e c i r P $30 25 20 15 10 5 0 S Equilibrium market price D Profits are maximized where MR = MC MC Price = $15 = D = MR Additions to profit Subtractions from profit 22.50 10.00 4.74 4.50 Quantity 110 129 Quantity 138 144 148 a “price taker.” The firm then must find the level of output it can produce that will maximize its profits. To understand how this is done, it helps to examine Figure 7.1. This figure shows the relationship between the perfectly competitive firm and its industry. In Panel A, supply and demand set the equilibrium market price at $15 per unit of output. Because the firm in Panel B receives $15 for the first and every additional unit it sells, the market price is the same as the firm’s marginal revenue curve (MR). In order to show a graphical example, the firm in Figure 7.1 is the same one that appeared earlier in Figure 5.6 on page 134. While the number of workers are not shown in Figure 7.1, the total production, marginal cost, and marginal revenue are the same in both figures. When it comes to determining the profit maximizing quantity of output in Figure 7.1, the logic of marginal analysis is the same as before. For example, Panel B in the figure above tells us that the firm would make a profit on the 110th unit of output because it would only cost $4.50 to produce and could be sold for $15. As long as the marginal cost of producing one more unit of output is less than the marginal revenue from the sale of that output, the firm would continue to hire more workers and expand its output. Given its marginal cost and marginal revenue conditions, the firm shown in Figure 7.1 would find it profitable to hire enough workers to expand production until 144 units of output are produced. Of course, total output would continue to go up if the firm hired more workers and expanded production. However, total profits would start to go down because the marginal cost of production would then become increasingly larger than the $15 marginal revenue from sales. In the end, the profit maximizing quantity of output is found where the marginal cost of production is equal to the marginal revenue from sales, or where MC = MR. This occurs at 144 units of output. Other levels of output may generate equal profits, but none will generate more. CHAPTER 7 Market Structures 171 imperfect competition market structure that does not meet all conditions of perfect competition A Theoretical Situation Few perfectly competitive markets exist because it is difficult to satisfy all five necessary conditions. Local vegetable farming, sometimes called “truck” farming, comes close. In these markets many sellers offer nearly identical products. Individual sellers are generally unable to control prices, and both buyers and sellers have CAREERS Market Researcher The Work * Gather, record, and analyze facts about products and sales using company or government records, published materials, statistical files, and other sources * Print and circulate questionnaires or survey people over the phone or door-to-door to help companies forecast future sales trends, design new products, and develop advertising strategies Qualifications * Strong analytical and writing skills * Experience with computerized data * College courses in marketing, statistics, English composition, speech, psychology, and economics * Bachelor’s degree, with many positions requiring a master’s or Ph.D. Earnings * Median annual earnings: $53,810 Job Growth Outlook * Faster than average Source: Occupational Outlook Handbook, 2006–2007 Edition 172 UNIT 2 Microeconomics: Prices and Markets age fotostock/SuperStock reasonable knowledge of most products and prices. Finally, anyone who wants to enter the business by growing tomatoes, corn, or other products can easily do so. When markets are perfectly competitive, several things combine to keep prices low. For example, when everyone is dealing with identical products, there is no need to advertise, which keeps the cost down. Second, when the products that everyone sells are identical, there is no reason for one seller to charge a price higher than anyone else. If the seller does try to charge a higher price, buyers will simply go elsewhere. Third, if there are a large number of independent buyers and sellers, then no single buyer is big enough to push the price down and no single seller is big enough to force the price up. As a result, buyers will always try to purchase from the seller with the lowest price. Finally, if it is easy for sellers to enter or leave the market, then new sellers can always come in if they think they can make a profit. Likewise, sellers who cannot match the new competition are free to leave. Imperfect Competition Although perfect competition is rare, it is important because economists use it to evaluate other, less competitive, market structures. Imperfect competition is the name given to any of three market structures—monopolistic competition, oligopoly, and monopoly—that lacks one or more of the conditions required for perfect competition. Most firms and industries in the United States today fall into one of these categories. When we examine imperfect competition, we will see that it results in less competition, higher prices for consumers, and fewer products offered. This is why perfectly competitive markets are theoretically ideal situations that can be used to evaluate other market structures. Reading Check Describing Why does perfect competition serve as a theoretical market structure? Product Differentiation Monopolistic competitors must find ways to attract the attention of buyers. How does the advertisement on this billboard differentiate this product from other colas? monopolistic competition market structure that meets all conditions of perfect competition except identical products product differentiation real or imagined differences between competing products in the same industry nonprice competition sales strategy focusing on a product’s appearance, quality, or design rather than its price Monopolistic Competition MAIN Idea Monopolistic competition shares all the conditions of perfect competition except the same goods or services. Economics & You How many stores do you know that offer similar products? Read on to learn how this reflects monopolistic competition. Monopolistic competition is the market structure that has all the conditions of perfect competition except for identical products. Under monopolistic competition, products are generally similar and include things such as designer clothing, cosmetics, and shoes. The monopolistic aspect is the seller’s ability to raise the price within a narrow range. The competitive aspect is that if sellers raise or lower the price enough, customers will ignore minor differences and change brands. Product Differentiation Monopolistic competition is characterized by product differentiation—real or perceived differences between competing products in the same industry. Most items produced today—from the many brands of athletic footwear to personal computers— are differentiated. Nonprice Competition do this with nonprice competition—the use of advertising, giveaways, or other promotions designed to convince buyers that the product is somehow unique or fundamentally better than a competitor’s. In a monopolistically competitive industry, advertising is important. This explains why producers of designer clothes spend so much on advertising and promotion. If a seller can differentiate a product in the mind of the buyer, the firm may be able to raise the price above its competitors’ prices. Because advertising is expensive, it raises the cost of doing business for the monopolistic competitor, and hence the price the consumer pays. Profit Maximization The profit maximizing behavior of the monopolistic competitor is no different from that of other firms. The firm will expand its production until its marginal cost is equal to its marginal revenue, or where MC = MR. If the firm’s advertising convinces consumers that its product is better, then it can charge a higher price. If not, the firm must charge less. Finally, it is easy for firms to enter the monopolistically competitive industry. Each new firm makes a product only a little different from others on the market. The result is a large number of firms producing a variety of similar products. To make their products stand out, monopolistic competitors try to make consumers aware of product differences. They Reading Check Comparing How is profit maximization in a monopolistic firm different from that of a perfect competitor? Todd Gipstein/Corbis CHAPTER 7 Market Structures 173 &The Global Economy YOU Poco, Heart, and Wisdom If you invent a product, remember that an important part of selling it is the brand name. In the global economy, Western brands sometimes get lost in translation. The real genius in selling overseas is to capture foreign consumers’ attention with a Western product, but relate it to their lives |
and culture in a familiar way. PepsiCo, for example, sells its popular Lays potato chips in China. It also introduced a local brand of potato chips called Poco. In addition to changing the name of the chips, PepsiCo adjusted the flavor to satisfy local tastes. German carmaker Volkswagen used its slogan, “For the love of the automobile,” as a springboard for the Asian market. Savvy marketing gurus took this catchy slogan and attached it to the Chinese-language written character for heart. The VW brand campaign includes 16 total characters, including those for compassion, loyalty, and wisdom, and associates the characters with VW automobiles. The VW Golf model represents loyalty, for example, whereas the Passat is a blend of heart and goal. oligopoly market structure in which a few large sellers dominate the industry collusion agreement, usually illegal, among producers to fix prices, limit output, or divide markets Personal Finance Handbook See pages R30–R31 for more information on buying a car. Oligopoly MAIN Idea Oligopoly describes a market in which a few sellers dominate an industry. Economics & You What products can you think of that are sold by a small number of sellers? Read on to learn about oligopolies. Oligopoly is a market structure in which a few very large sellers dominate the industry. The product of an oligopolist may have distinct features, as do the many makes and models of cars in the auto industry; or it may be standardized, as in the steel industry. As a result, oligopoly is further from perfect competition than monopolistic competition. In the United States, many markets are already oligopolistic, and many more are becoming so. For example, Burger King, McDonald’s, and Wendy’s dominate the fast-food industry. A few large corporations control other industries, such as the domestic airline and automobile industries. Interdependent Behavior Because oligopolists are so large, whenever one firm acts, the other firms in the industry usually follow—or they run the risk of losing customers. For example, when Chrysler introduced the first minivan, other companies soon followed. The tendency of oligopolists to act together often shows up in their pricing behavior, such as copying a competitor’s price reduction in order to attract new customers. For example, if Ford or General Motors announces zero-interest financing or thousands of dollars back on each new car purchased, its competitors will match the promotion almost immediately. In extreme cases this can lead to a price war, or a series of price cuts that result in unusually low prices. Because oligopolists usually act together when it comes to changing prices, many firms prefer to compete on a nonprice basis by enhancing their products with new or different features. Automobile companies do this every year when they introduce models. If an oligopolist finds a way to enhance a product, its competitors are at a disadvantage for a period of time. After all, it takes longer to develop a new physical attribute for a product than it does to match a price cut. Sometimes the interdependent behavior takes the form of collusion, a formal agreement to set specific prices or to otherwise behave in a cooperative manner. One form 174 UNIT 2 Microeconomics: Prices and Markets AP Images price-fixing agreement, usually illegal, by firms to charge the same price for a product monopoly market structure with a single seller of a particular product of collusion is price-fixing, or agreeing to charge the same or similar prices for a product. In almost every case these prices are higher than those determined under competition. The firms also might agree to divide the market so that each is guaranteed to sell a certain amount. Because collusion usually restrains trade, it is against the law. Profit Maximization The oligopolist, like any other firm, maximizes its profits when it finds the quantity of output where its marginal cost is equal to its marginal revenue, or where MC = MR. The oligopolist will then charge the price consistent with this level of sales. Because of all the nonprice competition, the product’s final price is likely to be higher than it would be under monopolistic competition, and much higher than it would be under perfect competition. Nonprice competition is always expensive for a firm, and these expenses usually come back to the consumer in the form of higher prices. Reading Check Explaining Why do oligopolists frequently appear to act together? Monopoly MAIN Idea A monopoly is a market with only one seller for a particular product. Economics & You Did you ever play the game of Monopoly? Read on to learn how this game reflects the problems caused by having one seller in the market. At the opposite end of the spectrum from perfect competition is monopoly. A monopoly is a market structure with only one seller of a particular product. This situation—like that of perfect competition—is an extreme case. In fact, the American economy has very few, if any, cases of pure monopoly— although the local cable TV operator or telephone company may come close. Even the telephone company, however, faces competition from other communication companies, from the United States Postal Service, and from Internet providers that supply e-mail and telephone services. Local cable providers face competition from video rental stores, satellite cable systems, and the Internet. Consequently, when people talk about monopolies, they usually mean near-monopolies. Figure 7.2 Characteristics of Market Structures Number of firms in industry Many Many Few One Perfect competition Monopolistic competition Oligopoly Pure monopoly Influence over price Product differentiation Advertising Entry into market Examples None None None Limited Some Fair amount Fair amount Extensive None Fair amount Some None Easy Easy Difficult Almost impossible Perfect: None Near: Truck farming Gas stations Women’s clothing Automobiles Aluminum Perfect: None Near: Water The term market structure refers to the nature and degree of competition among firms operating in the same industry. Individual market structures, listed on the left, are determined by the five characteristics listed in the columns above. Economic Analysis In which market structure does nonprice competition play a major role? Public utility companies fall into this category because it would be wasteful to duplicate the networks of pipes and wires that distribute water, gas, and electricity throughout a city. To avoid these problems, the government often gives a public utility company a franchise—the exclusive right to do business in a certain area without competition. By accepting such franchises, the companies also accept a certain amount of government regulation. The justification for the natural monopoly is that a larger firm can often use its personnel, equipment, and plant more efficiently. This results in economies of scale, a situation in which the average cost of production falls as the firm gets larger. When this happens, it makes sense for the firm to be as large as is necessary to lower its production costs. Sometimes a monopoly exists because of a specific location. A drugstore operating in a town too small to support two or more such businesses becomes a geographic monopoly. This is a monopoly based on the absence of other sellers in a certain geographic area. Similarly, the owner of the only gas station on a lonely interstate highway exit also has a type of geographic monopoly. A technological monopoly is a monopoly that is based on ownership or control of a manufacturing method, process, or other scientific advance. The government may grant a patent—an exclusive right to manufacture, use, or sell any new and useful invention for a specific period—to the inventor. Inventions are covered for 20 years; however, a product’s design can be patented for shorter periods, after which it becomes public property available for the benefit of all. Art and literary works are protected through Monopolies A geographic monopoly exists when there is only one seller of a product in a particular area. What would indicate that this gas station has a geographic monopoly? natural monopoly market structure where average costs of production are lowest when a single firm exists economies of scale situation in which the average cost of production falls as a firm gets larger geographic monopoly market structure in which one firm has a monopoly in a geographic area technological monopoly monopoly based on a firm’s ownership or control of a production method, process, or other scientific advance We have few monopolies today because Americans traditionally have disliked them and have tried to outlaw them. Another reason is that new technologies often introduce products that compete with existing monopolies. The development of the fax machine allowed businesses to send electronic letters that competed with the U.S. Postal Service. Later, e-mail became even more popular than the fax. Today, telephone service over the Internet is yet another technology challenging phone monopolies. Types of Monopolies Sometimes the nature of a good or service dictates that society would be served best by a monopoly. A natural monopoly—a market situation where the costs of production are minimized by having a single firm produce the product—is one such case. Natural monopolies often can provide services more cheaply than several competing firms could. For example, two or more competing telephone companies serving the same area would be inefficient if each company needed its own telephone poles and lines. 176 UNIT 2 Microeconomics: Prices and Markets Ric Ergenbright/Corbis government monopoly a monopoly owned and operated by the government Skills Handbook See page R41 to learn about Drawing Conclusions. a copyright—the exclusive right of authors or artists to publish, sell, or reproduce their work for their lifetime plus 50 years. Still another kind of monopoly is the government mono |
poly—a monopoly owned and operated by the government. Government monopolies are found at all three levels of government—national, state, and local. In most cases they involve products or services that private industry cannot adequately supply. Many towns and cities have monopolies that oversee water use. Some states control alcoholic beverages by requiring that they be sold only through state stores. The federal government controls the processing of weapons-grade uranium for military and national security purposes. Profit Maximization Monopolies maximize profits the same way other firms do: they equate marginal cost with marginal revenue to find the profit-maximizing quantity of output. Even so, there are differences between the monopolist and other profit-maximizing firms—especially the perfect competitor. First, the monopolist is much larger than the perfect competitor. This is because there is only one firm—the monopolist—supplying the product, rather than thousands of smaller ones. Second, both because of its large size and the lack of meaningful competition, the monopolist is able to behave as a “price maker.” This differs from the perfect competitor, who faces competition and is a price taker. Because there are no competing firms in the industry, there is no equilibrium price facing the monopolist. In order for the monopolist to maximize its profits, it will do exactly as all the other firms have done: it will equate MC with MR because this method always shows the level of output that produces the highest total profits. The result will be a very high price—higher than would be charged under conditions of perfect competition, monopolistic competition, or oligopoly. Reading Check Analyzing Why do natural monopolies sometimes result in economies of scale? SECTION 1 Review Vocabulary 1. Explain the significance of laissez-faire, market structure, perfect competition, imperfect competition, monopolistic competition, product differentiation, nonprice competition, oligopoly, collusion, price-fixing, monopoly, natural monopoly, economies of scale, geographic monopoly, technological monopoly, and government monopoly. Main Ideas 2. Explaining Why is the perfect competitor often called a “price taker”? 3. Identifying Use a graphic organizer like the one below to identify the characteristics of imperfect competition. Critical Thinking 4. The BIG Idea Describe the four basic market structures and explain how they differ from one another. 5. Differentiating Which characteristics of firms selling designer clothing are monopolistic? Which are competitive? Write a brief paragraph explaining your answer. 6. Inferring If Americans traditionally dislike monopolies, why do some monopolies exist today? What types of monopolies are they, and what are their characteristics? 7. Analyzing Visuals Compare the photos of the farmers on page 170 and the gas station on page 176. How do market conditions differ for these sellers? Imperfect Competition Applying Economics 8. Product Differentiation Search your local newspaper for local clothing stores ads. You should find at least two different ads. Describe how the advertisements succeed or fail to differentiate the products. CHAPTER 7 Market Structures 177 ENTREPRENEUR Profiles in Economics Bill Gates (1955– ) • co-founder and chairman of Microsoft Corporation • ranked the richest man in the world for 12 years in a row Early Start Bill Gates was not the first computer geek, but he was probably the most passionate. In high school, he designed a class-scheduling program so that he could take courses with the prettiest girls in his school. He also started Traf-O-Data, a computer traffic analysis company. At Harvard University, he and his friend Paul Allen wrote an operating-system language that they licensed to a computer manufacturer. With this early success, at age 19 Gates dropped out of Harvard and, with Allen, established Microsoft Corporation in 1975. Five years later, computer industry giant IBM asked Gates to develop an operating system for its new personal computer. Gates modified a system he had bought from a small company and called it MS-DOS, for Microsoft Disk Operating System. Gates decided to license rather than sell it to IBM. This allowed him to market MS-DOS to other companies. By 1993 Microsoft’s Windows operating system ran nearly 90 percent of the world’s PCs. Gates and the Average Computer User Much of Gates’s success came from understanding the needs of average computer users. His software encompasses a range of programs integrated to work together seamlessly for everyday users and businesses. Gates made sure that all programs were written to be user-friendly to make computing fun. As a result, computers became accessible to non-techies worldwide. Gates is also known for his business stance. “He expects energy and commitment from his employees,” said one Microsoft employee. “He insists on a thoughtful, thorough, complete analysis.” Even Gates admits his tenacity. “In the early days, I liked to review every line of code, to interview every job applicant,” he said. “I’ve had to lighten up in both of those areas.” Examining the Profile 1. Analyzing What characteristics made Gates a successful entrepreneur? 2. Predicting Consequences How might the Microsoft story have been different if Gates had sold MS-DOS to IBM rather than licensing it? Personal computers had appeared in the marketplace by 1975, but they were still a novelty. Many people saw them as science fiction gadgets from the set of Star Trek. But Seattle teenagers Bill Gates and Paul Allen had a vision to “put a computer on every desktop and in every home.” 178 UNIT 2 Microeconomics: Prices and Markets Getty Images SECTION 2 Market Failures GUIDE TO READING Section Preview In this section, you will find out that inadequate competition, inadequate information, immobile resources, public goods, and externalities can lead to market failures. Academic Vocabulary • collude (p. 180) • sustain (p. 181) Reading Strategy Content Vocabulary • market failure (p. 180) • public goods (p. 181) • externality (p. 181) • negative externality (p. 182) • positive externality (p. 182) Listing As you read the section, think about why maintaining adequate competition is a worthwhile goal. Use a graphic organizer like the one below to list some of the effects of competition. If markets are competitive . . . Effects —USA Today COMPANIES IN THE NEWS Enron A federal judge in Houston sentenced Richard Causey, former chief accounting officer of Enron, to 5 1/2 years in prison Wednesday, bringing an end to the government’s prosecution of top managers at what was once the nation’s seventh-largest company. . . . Enron collapsed into bankruptcy five years ago after acknowledging that [Andrew] Fastow, the CFO, had entered into numerous business deals with the company that helped prop up Enron’s earnings. Fastow later admitted that he embezzled close to $30 million from the company. Enron’s market capitalization, which at one point exceeded $60 billion, was wiped out in the ensuing sell-off of stock. In January 2002, the Department of Justice formed the Enron Task Force. Since then, prosecutors induced 16 former executives to plead guilty to related crimes, while several others were convicted at trial. . . . [W]ith Causey’s sentencing, the last of the big Enron cases has been disposed of. ■ The story about Enron reminds us of a serious fact of economic life—that markets sometimes fail. In fact, the Enron scandal was not the only accounting scandal dominating the news in the early 2000s. WorldCom, a telecommunications company, had to declare bankruptcy in 2002 amid charges of breaking the law. These news stories showed clearly that a competitive free enterprise economy works best when several conditions, including adequate information, are met. If we want to avoid problems like this in the future, we need to be able to identify and then deal with different types of market failures. AP Images CHAPTER 7 Market Structures 179 market failure condition that causes a competitive market to fail Types of Market Failures MAIN Idea Markets can sometimes fail because of inadequate competition, inadequate information, resource immobility, public goods, and externalities. Economics & You Have you ever been affected by something that somebody did to another person? Read on to learn how this can also happen in the economy. Unfortunately markets sometimes fail. A market failure occurs whenever one of the conditions necessary for competitive markets does not exist. As you will learn, five main causes of market failures exist. Inadequate Competition Over time, mergers and acquisitions result in larger and fewer firms dominating various industries. The decrease in competition tends to reduce the efficient use of scarce resources—resources that could be put to other, more productive uses if they were available. For example, why would a firm with few or no competitors have the incentive to use its resources carefully? Inadequate competition can occur on both the demand and supply sides of the market. If we consider the supply side of the market, there is no competition when a monopolist dominates. In an oligopolistic market, the temptation to collude is strong. Expensive Memories The first law to fight monopolies, the Sherman Antitrust Act, was enacted in 1890 as a response to growing concern over the power of trusts. Enforcement was left to the courts, and judges considered the language of the act too vague to make big companies change the way they did business. As a result, the number of trusts increased following passage of the act. It took another 14 years before the first major lawsuit, Northern Securities v. the United States, was filed. Laws have become stronger since then, but price collusion still is a problem. In May 2006 three computer memory chip manufacturers were accused of fixing prices over a three-year period. This increased the price of chips for |
computer manufacturers, and thus the price of computers for consumers. The chipmakers agreed to pay $160 million to settle the case. 180 UNIT 2 Microeconomics: Prices and Markets If we look at the demand side of the market, there is little or no competition if the government is the only buyer for space shuttles, hydroelectric dams, super computers, M-1 tanks, or high-technology fighter jets. A firm that does not face adequate competition could easily spend its profits on huge salaries and bonuses, executive jets, country club memberships, and generous retirement plans. This is one of the reasons that public utilities such as electricity are regulated by the government—to make sure that the firms do not use their monopoly status to waste or abuse resources. Inadequate competition also may enable a business to influence politicians in order to get special treatment that enriches its managers and owners. In fact, some of the players in the huge Enron energy scandal were accused of doing just that—lobbying administration and Energy Department officials for favorable treatment on policy issues that benefited Enron executives. Inadequate Information If resources are to be allocated efficiently, everyone—consumers, businesspeople, and government officials—must have adequate information about market conditions. A secretary or an accountant may receive a competitive wage in the automobile industry, but wages for the same skills might be higher in the insurance or banking industry. Some information is easy to find in the classified ads in the newspaper or on the Internet. Other information is more difficult to find. If this knowledge is important to buyers and sellers but is difficult to obtain, then it is an example of a market failure. The consequences of inadequate information may not always be immediately visible, but in the long run it will put a slow drain on the economy, lowering the rate of growth and the overall standard of living. Resource Immobility A difficult problem in any economy is that of resource immobility. This means that land, capital, labor, and entrepreneurs Public Goods Funding floodwalls is expensive, but failing to keep up with maintenance can have catastrophic results, as the photo of New Orleans after Hurricane Katrina shows. Why does the market not provide more public goods? public goods goods or services whose benefits are available to everyone and are paid for collectively externality economic side effect that affects an uninvolved third party do not move to markets where returns are the highest. Instead they tend to stay put and sometimes remain unemployed. What happens, for example, when a large auto assembly plant, steel mill, or mine closes, leaving hundreds of workers without employment? Certainly some workers can find jobs in other industries, but not all can. Some of the newly unemployed may not be able to sell their homes. Others may not want to move away from friends and relatives to find new jobs in other cities. Public Goods Another form of market failure shows up in the form of public goods. Public goods are products that are collectively consumed by everyone. Their use by one individual does not diminish the satisfaction or value available to others. Examples of public goods are uncrowded highways, floodcontrol measures, national defense, and police and fire protection. When left to itself, the market either does not supply these items at all, or it supplies them inadequately. This is because a market economy produces only those items that can be withheld if people refuse to pay for them. It would be difficult, for example, to deny one person the benefits of national defense while supplying it to others. Because it is so difficult to have all individuals pay for their fair share of a public good, private markets produce too few of them. In the aftermath of Hurricane Katrina, it was evident that the floodwalls in New Orleans could not sustain the onslaught of the hurricane. Floodwalls are public goods that are normally funded out of government expenditures; they are not built by the private sector because there is little profit to be gained by building them. A related problem is that government does not always see the need to spend tax dollars on public goods. In the case of the floodwalls, it was all too easy to postpone the necessary expenditures because they would have resulted in higher taxes or in not building other public goods. Externalities Many activities generate some kind of externality, or unintended side effect that either benefits or harms a third party not involved in the activity that caused it. Smiley N. Pool/Dallas Morning News/Corbis CHAPTER 7 Market Structures 181 Externalities Air pollution is a negative externality that affects those who did not cause it. How can government action lead to the cleanup of pollution? negative externality harmful side effect that affects an uninvolved third party positive externality beneficial side effect that affects an uninvolved third party A negative externality is the harm, cost, or inconvenience suffered by a third party because of actions by others. The classic case of a negative externality is the noise and inconvenience some people suffer when an airport expands. A positive externality is a benefit someone receives who was not involved in the activity that generated the benefit. For example, people living on the other side of town may benefit from the additional jobs generated by the airport expansion, or a nearby restaurant may sell more meals and hire more workers. Both the restaurant owners and the new workers gain from the airport expansion even though they had nothing to do with the expansion in the first place. Externalities are market failures because their costs and benefits are not reflected in the market prices that buyers and sellers pay. For example, airlines do not compensate homeowners for the diminished value of properties located near a new runway extension. Nor does a restaurant owner share any additional profits with the airport. As a result, the prices that travelers pay for air travel will not reflect the external costs and benefits that an airport expansion generates. Reading Check Analyzing What type of market failure do you think is most harmful to the economy? Dealing with Externalities MAIN Idea Externalities indicate a market failure and can be corrected with government action. Economics & You Have you ever been affected by someone else’s pollution? Read on to learn how this can be remedied. The problem with externalities is that they distort the decisions made by consumers and producers. Overall this makes the economy less efficient. Correcting Negative Externalities A classic example of pollution sheds some light on the distortions caused by negative externalities. Firms historically located near rivers because transportation was convenient. However, the firms also used the rivers as a giant waste disposal system, which helped keep their production cost low. This led to lower market prices for the final product, and consumers were able to buy more. The negative externality of pollution generated several problems. Firms had the incentive to pollute because it was the most profitable way to produce. The low prices also encouraged more sales, and hence 182 UNIT 2 Microeconomics: Prices and Markets Steve Starr/Corbis more pollution. Finally, people living downstream from the polluting firms were, in effect, paying for some of the production costs even if they did not necessarily buy the products. Suppose the government decided to force the firms to clean up their pollution by putting a $1 “pollution tax” on every unit of output sold. The firms, of course, would try to pass some of this expense on to the consumer in the form of higher prices. While higher prices might at first seem to be a problem, they would force the people who bought the products to pay for the increase in production costs. The tax would help alleviate pollution problems. First, all firms would have less incentive to pollute because the tax drives up the price of their products. Second, higher prices would reduce the quantity demanded, so firms would produce less and therefore generate less pollution. Third, the people living downstream of the affected rivers would face less pollution. Correcting Positive Externalities Externalities can be positive as well as negative. You have learned that negative externalities lead to distortions. Yet even when externalities are positive, so that uninvolved third parties experience beneficial side effects, distortions can occur. A classic example is education. We know that people generally earn more when they have more education. In addition, a community with a well-educated workforce will attract more industry, have more economic development, and enjoy a higher standard of living. For these and other reasons, it makes sense for the government to subsidize the cost of public education. This is exactly what happens when local governments pay for the cost of primary and secondary public education. When it comes to the higher education offered by state universities, however, state governments only pay for part of the cost, leaving students to pick up the rest in the form of tuition payments. Given education’s value to the community, many experts feel that the government subsidies should be larger than they are. This is expensive, however, so government tends to underfund higher education even though more subsidies are warranted. Reading Check Explaining If externalities are positive, why should they be corrected? SECTION 2 Review Vocabulary 1. Explain the significance of market failure, public goods, externality, negative externality, and positive externality. Critical Thinking 4. The BIG Idea List and explain the reasons why markets fail. Main Ideas 2. Explaining Why do markets need both adequate competition and adequate information? 3. Identifying Use a graphic organizer like the one bel |
ow to identify and describe both types of externalities. 5. Understanding Cause and Effect Describe some of the positive and negative externalities that could result from the closing of a military base. 6. Making Inferences Under what circumstances would a private firm be willing to build private toll roads? EXTERNALITIES Positive: Negative: Applying Economics 7. Negative Externality Identify a situation in your com- munity that resulted in a negative externality. How would you advise the government to reduce these negative effects? Write a short paper outlining your suggestions. CHAPTER 7 Market Structures 183 NEWSCLIP In 1984 concerns over a telecommunications monopoly led to the breakup of AT&T into eight different companies. Just a little over 20 years later, AT&T mergers seem to recreate the former corporation. When such mergers result in larger and fewer firms dominating an industry, some economists worry. Lord of the Rings Competition in communications seems cutthroat. Companies are invading each other’s turf, and prices are falling. You can make a video-phone call to Australia via the Internet, chat for three hours, and never pay a penny. Citing all this hubbub, AT&T Inc. argues that there’s no threat of remonopolization even as it bids to reunite five of the eight companies that emerged from the 1984 breakup of the Bell System. Look out, though. The competition we’re seeing is just a phase, and an unstable one at that. The key thing about communications networks is that they’re very costly to build, but once they’re built, it’s cheap to add customers to them. This industry structure has special economic properties. At times it produces price wars. At other times it leads to merger waves, resulting in a small number of competitors with the ability to raise prices and garner big profits. . . . Fragile Competition Communications companies may be shifting strategies from battling to consolidating. Strategy 1 Strategy 2 Price War Companies need lots of traffic to cover the costs of their expensive networks, so they cut prices. That forces other companies to reciprocate. Eventually profits vanish. Merger Wave Companies merge, with the strong buying the weak. As competition diminishes, profits rise. This strategy is more desirable to the companies, but may be banned by regulators. 184 UNIT 2 Microeconomics: Prices and Markets Getty Images In this delicate situation, [communications companies] have used two main strategies over the years. One has been to cut prices to fill up their networks. Remember, additional customers are cheap to serve, so there’s room to cut. . . . The alternative strategy, which [the CEO of AT&T] and others have also pursued, is consolidation. As long as regulators permit, the strong buy the weak and extinguish the excess capacity. As competition eases, the survivors can raise prices and restore their profitability. (Good for shareholders; bad for customers.) —Reprinted from BusinessWeek Examining the Newsclip 1. Summarizing What two strategies has AT&T used in recent years to gain new business, and why? 2. Determining Cause and Effect How does lack of competition increase prices for the consumer? SECTION 3 The Role of Government GUIDE TO READING Section Preview Reading Strategy In this section, you will learn that one of the economic functions of government in a market economy is to maintain competition. Describing As you read the section, complete a graphic organizer like the one below by describing how governments try to avoid market failures. Content Vocabulary • trust (p. 186) • price discrimination (p. 186) • cease and desist order (p. 186) • public disclosure (p. 188) Academic Vocabulary • restrained (p. 186) • intervention (p. 189) Government in Economic Affairs PRODUCTS IN THE NEWS Electric Bass Recalled —www.cpsc.gov The U.S. Consumer Product Safety Commission, in cooperation with Hoshino USA Inc., of Bensalem, Pa., and Chesbro Music Company, of Idaho Falls, Idaho, today announced a voluntary recall of about 700 Ibanez basses. If the battery is improperly installed, the bass can overheat, causing internal damage and a fire hazard. The firm has received three reports of the bass not working due to improper battery installation. There have been no reports of injuries or property damage. This recall involves 2005 and 2006 Ibanez Soundgear, Roadgear and Gary Willis series basses. Model numbers are located on the back of the headstock. Consumers should stop using the basses immediately and contact their local Ibanez dealer for a free inspection and repair. Dealers will remedy the hazard by having affected basses updated with a new battery snap connector. ■ We know that resources are scarce, and because of scarce resources we have to make careful choices if we are to satisfy our many wants and needs. We also know that competitive markets are one of the best ways to make this happen. At the same time, markets can fail. When they do, the government can step in and fix the problem. One way in which the federal government acts is by protecting the public from unreasonable risks of serious injury or death. For that task, it created the U.S. Consumer Product Safety Commission (CPSC), which oversees the safety of more than 15,000 types of consumer products. When necessary, the CPSC orders a recall of products for repair or replacement, as in the news story. Corbis CHAPTER 7 Market Structures 185 trust illegal combination of corporations or companies organized to hinder competition price discrimination practice of selling the same product at different prices to different buyers cease and desist order ruling requiring a company to stop an unfair business practice that reduces or limits competition Maintain Competition MAIN Idea The government exercises its power to maintain competition within markets. Economics & You When you play sports, a referee regulates the game to make sure both sides are playing fairly. Read on to learn how the government can regulate the economy to do the same thing. There are two ways that government can maintain competitive markets. One is by prohibiting market structures that are not competitive. The other is by regulating markets where full competition is not possible. Antitrust Legislation In the late 1800s, the United States passed laws to restrict monopolies and trusts— combinations of firms designed to restrict competition or control prices in a particular Figure 7.3 Anti-Monopoly Legislation Sherman Antitrust Act 1890 Clayton Antitrust Act 1914 Outlawed all contracts “in restraint of trade” to halt the growth of trusts and monopolies Strengthened the Sherman Act by outlawing price discrimination Federal Trade Commission Act 1914 Established the Federal Trade Commission to regulate unfair methods of competition in interstate commerce Robinson-Patman Act 1936 Forbade rebates and discounts on the sale of goods to large buyers unless the rebates and discounts were available to all The federal government passed four major legislative acts to curb monopolistic practices. Economic Analysis What is the purpose of the Federal Trade Commission? industry. Since then, several laws have been passed that allow the government to either prevent or break up monopolies and trusts, thus preventing market failures due to inadequate competition. In 1890 Congress passed the Sherman Antitrust Act “to protect trade and commerce against unlawful restraint and monopoly.” The Sherman Act, described in Figure 7.3, was the nation’s first significant law against monopolies. It sought to do away with monopolies and restraints that hindered competition. By the early 1900s, a number of businesses, including the Standard Oil Company, had been convicted of restraint of trade under the Sherman Act. The Sherman Act laid down broad foundations for maintaining competition. However, the act was not specific enough to stop many other practices that restrained competition. As a result, Congress passed the Clayton Antitrust Act in 1914 to give the government more power over monopolies. This outlawed price discrimination— the practice of selling the same product to different consumers at different prices if it substantially lessens competition. The Federal Trade Commission Act was passed in the same year to enforce the Clayton Antitrust Act. The act set up the Federal Trade Commission (FTC) and gave it the authority to issue cease and desist orders. A cease and desist order is an FTC ruling requiring a company to stop an unfair business practice, such as price-fixing, that reduces or limits competition among firms. In 1936 Congress passed the RobinsonPatman Act in an effort to strengthen the Clayton Act, particularly the provisions that dealt with price discrimination. Under this act, companies could no longer offer special discounts to some customers while denying them to others. Government Regulation Not all monopolies are bad, and for that reason not all should be broken up. In the case of a natural monopoly, it makes sense to let the firm expand to take advantage of lower production costs, and then regulate its activities so that it cannot take advantage of the consumer. Local and state governments regulate many monopolies, such as cable television companies, and water and electric utilities. For example, if a public utility wants to raise rates, it must argue its case before a public utility commission or other government agency. Agencies of the federal government, such as those listed in Figure 7.4, regulate many different kinds of businesses. However, as you can see from the dates in the figure, in recent years the government has been less inclined to set up new regulatory bodies. Instead, the emphasis has shifted to promoting efficiency. Reading Check Describing Why are some government regulations beneficial for consumers? Skills Handbook See page R37 to learn about Making Generalizations. Figure 7.4 Federal Regulatory Agencies Agency Food and Drug Administration (FDA), 1906 Federal Trade Co |
mmission (FTC), 1914 Federal Communications Commission (FCC), 1934 Securities and Exchange Commission (SEC), 1934 National Labor Relations Board (NLRB), 1935 Federal Aviation Administration (FAA), 1958 Tasks Enforces laws to ensure purity, effectiveness, and truthful labeling of food, drugs, and cosmetics; inspects production and shipment of these products Administers antitrust laws forbidding unfair competition, price fixing, and other deceptive practices Licenses and regulates radio and television stations and regulates interstate telephone and telegraph rates and services Regulates and supervises the sale of listed and unlisted securities and the brokers, dealers, and bankers who sell them Administers federal labor-management relations laws; settles labor disputes; prevents unfair labor practices Oversees the airline industry Equal Employment Opportunity Commission (EEOC), 1964 Investigates and rules on charges of discrimination by employers and labor unions Environmental Protection Agency (EPA), 1970 Protects and enhances the environment Occupational Safety and Health Administration (OSHA), 1970 Investigates accidents in the workplace; enforces regulations to protect employees at work Consumer Product Safety Commission (CPSC), 1972 Nuclear Regulatory Commission (NRC), 1974 Federal Energy Regulatory Commission (FERC), 1977 Develops standards of safety for consumer goods Regulates civilian use of nuclear materials and facilities Supervises transmission of various forms of energy The government has created a number of federal regulatory agencies to oversee the economy. Because of government’s involvement in the economy, we have a modified free enterprise system. Economic Analysis Which agencies listed in the table are familiar to you? Which affect you directly? Why? CHAPTER 7 Market Structures 187 public disclosure requirement that a business reveal information about its products or its operations to the public Personal Finance Handbook See page R14-R15 for more information on loans. Improve Economic Efficiency MAIN Idea Providing public goods and promoting transparency can improve economic efficiency. Economics & You Can you name some public goods in your community? Read on to learn why public goods must be provided by the public sector. Fortunately, the government has the ability to correct two market failures that interfere with competitive markets: inadequate information and public goods. Promote Transparency Efficient and competitive markets need adequate information. Transparency is a term used to indicate that information and actions are not hidden and instead are easily available for review. Public disclosure, the requirement that businesses reveal certain information to the public, is an important way to do this. For example, all corporations that sell stock to the public must disclose financial and operating information on a regular basis to both their shareholders and the Securities and Exchange Commission (SEC). This data is stored in a free database that can be accessed by anyone on the Internet. Disclosure requirements also exist for consumer lending. If you obtain a credit card or borrow money to buy a car, the lender will explain in writing the method for computing the monthly interest, the length of the loan, the size of the payments, and other lending terms. This is not an act of kindness on the lender’s part because federal law requires these disclosures. Finally, “truth-in-advertising” laws prevent sellers from making false claims about their products. Most government documents, studies, and reports are available on the Internet. This includes the annual budget of the U.S. government, the Statistical Abstract of the United States, Census Bureau reports, and nearly every other publication that you can find in the government documents section of your local public library. Transparency Governments require disclosure to prevent companies from providing mis leading information. What requirements protect you as a borrower? “This isn’t rocket science, folks. One, we substitute code words for substantive ideology. Two, we create misleading advertising. Three, we issue bold pronouncements on phony profit margins. It’s all right here in the corporate training manual.” 188 UNIT 2 Microeconomics: Prices and Markets www.CartoonStock.com . Provide Public Goods A free enterprise economy does not produce public goods in sufficient quantity because such efforts usually do not result in direct financial gain. This means that many of the things society values—good roads and highways, museums and libraries, and education—must be provided by government. Public goods are important because they make the economy more productive. For example, businesses need reliable transportation so that they can move their raw materials and final products. In addition, their employees need to be able to easily communite to and from work. Firms also need an educated workforce that is both productive and able to purchase the products that are produced. Reading Check Interpreting What negative things could happen in a market without disclosure? Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 7—Student Web Activities for an activity on the government’s role in promoting fair business practices. Skills Handbook See page R45 to learn about Synthesizing Information. Modified Free Enterprise MAIN Idea Because the government is involved in certain aspects of our economy, it is a modified version of free enterprise. Economics & You What role does government play in your life? Read on to learn why some government regulation is desirable. The U.S. economy has changed dramatically over the years. One of the outcomes of this evolution is the rise of the modified free enterprise economy. In the late 1800s, the freedom to pursue self-interests led some people to seek economic gain at the expense of others. Under the label of competition, many larger firms used their power to take advantage of smaller ones. In some markets, less competitive market structures such as monopoly replaced competition, and the economy became less efficient. Because of these developments, Congress passed laws to prevent “evil monopolies” and to protect the rights of workers. It also passed food and drug laws to protect people from false claims and harmful products. Even public utilities faced significant government regulation to prevent the price gouging of consumers. Collectively, these actions have resulted in a modification of free enterprise. More recently, concern has shifted to economic efficiency and the role of the government in promoting it. Markets have become increasingly important, and we recognize that markets can fail in several different ways. When this happens, the government can take steps to remedy the situation. In addition to occasional interventions to keep markets reasonably competitive, the government can make the economy more efficient by supplying public goods and promoting transparency. People will continue to debate the proper role of government, but it turns out that markets alone cannot provide all of our wants and needs. Over the years, government’s role in the economy has slowly evolved from concern over consumer protection to the promotion of economic competition and efficiency. As a result of this government intervention, we now have a modified private enterprise economy, or an economy based on markets with varying degrees of government regulation. Reading Check Summarizing Why do we use the term modified to describe the American free enterprise economy? SECTION 3 Review Vocabulary 1. Explain the significance of trust, price discrimination, Critical Thinking 4. The BIG Idea Why is the government involved in cease and desist order, and public disclosure. economic affairs? Main Ideas 2. Identifying Use a graphic organizer similar to the one below to identify how the federal government can maintain competition and improve economic efficiency. 5. Making Inferences Why do governments regulate monopolistic cable companies and not prohibit them? 6. Synthesizing Information Identify at least two instances where you have personally benefited from government regulations. Explain the benefits. Action Antitrust legislation Purpose Applying Economics 3. Explaining Why is the United States considered to have a modified free enterprise economy? 7. Public Disclosure Obtain literature describing the computation of interest and conditions for withdrawal on various savings accounts from a local bank. Summarize the information in a short paragraph. Why do you think the bank is so forthcoming with this information? CHAPTER 7 Market Structures 189 CASE STUDY Pixar and Disney Birth of Pixar The short, happy tale of Pixar began when John Lasseter left Walt Disney studios in 1984 to join Lucasfilm, Ltd. Two years later, Steve Jobs, CEO of Apple Computer Inc., bought the computer graphics division of Lucasfilm for $10 million and renamed it Pixar. After winning numerous awards for short films and commercials, Pixar, with just 44 employees, teamed up with mega-studio Disney in 1991 to coproduce major films. D ISNEY S TOCK P RICES, 1995–2006 140 120 100 80 60 40 e c i r P 20 0 1995 1997 1999 2001 2003 2005 Year Disney’s management hoped to boost its stock price and remedy the sometimes tumultuous relationship between Disney and Pixar by entering into merger negotiations. Animation Merger By that time, Pixar had grown to a company of hundreds of employees, and federal regulatory authorities reviewed the merger for possible antitrust problems.The two companies finally merged in 2006 when Disney paid $7.5 billion for Pixar. As hoped, the price of Disney stock started to increase. A few months later, Cars zoomed into theaters, bringing in more than $60 million its first weekend. If you think stock prices follow ticket sales, though, think again. Despite that impressive showing, Disney’s stock fell sligh |
tly when the movie missed its $70 million goal. Analyzing the Impact 1. Summarizing How did Disney expect to gain from the merger with Pixar? 2. Drawing Conclusions Why might federal regulators be concerned about the merger of these two movie companies? Box Office Magic, Stock Ticker Woes Toy Story, the first collaboration by Disney and Pixar, was a box office home run, earning $358 million in box office receipts around the world as the highestgrossing film of 1995. B OX O FFICE RECEIPTS Toy Story $358.1 million A Bug’s Life Toy Story 2 $357.9 million $485.7 million Monster’s Inc. $528.9 million Finding Nemo $865.0 million The Incredibles $624.0 million Cars $367.6 million (and counting) The dynamic duo produced six more commercial hits, but Disney’s other work did not please moviegoers. Nor did its stock price satisfy stockholders. 190 UNIT 2 Microeconomics: Prices and Markets Photofest/Disney/Pixar CHAPTER 7 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Market Structures We can differentiate among four different market structures. One is called perfect competition; the other three are different kinds of imperfect competition. P ERFEC T C OMPETITION I MPERFEC T C OMPETITION Perfect Competition Monopolistic Competition Oligopoly Monopoly Large number of well-informed independent buyers and sellers who freely exchange identical products Has all characteristics of perfect competition except product differentiation A few very large sellers dominate the industry Only one seller for a particular product Market Failures When one of the conditions necessary for competitive markets does not exist, market failures can occur. Markets usually fail because of five factors. Inadequate competition Inadequate information Market Failures Resource immobility Need for public goods Externalities Government Roles In order to carry out its legal and social obligations, the government can encourage competition and regulate monopolies. Government Roles Restrict monopolies that hinder competition Regulate monopolies that provide services Provide public disclosure to prevent market failures CHAPTER 7 Market Structures 191 CHAPTER 7 Assessment & Activities Review Content Vocabulary Section 2 (pages 179–183) Use all of the terms below to write a paragraph about each of the four types of markets. Underline the terms within your paragraphs. 1. market failure 2. geographic monopoly 3. imperfect competition 4. monopolistic competition 5. natural monopoly 6. oligopoly 7. product differentiation 8. trust 9. price-fixing 10. nonprice competition Review Academic Vocabulary Use each of these terms in a sentence that reflects the term’s meaning in the chapter. 11. theoretically 12. equate 13. collude 14. sustain 15. restrained 16. intervention Review the Main Ideas Section 1 (pages 169–177) 17. Explain why perfect competition is a theoretical situation. 18. Describe the four types of monopolies by using a graphic organizer similar to the one below. 19. Explain what happens when markets do not have enough competition. 20. Describe what is meant by externalities. 21. Explain why the private sector is reluctant to produce public goods. Section 3 (pages 185–189) 22. Identify the purpose of antitrust legislation. 23. Explain how public disclosure is used as a tool to prevent market failures. 24. Describe the characteristics that make the U.S. economy a “modified free enterprise” economy. Critical Thinking 25. The BIG Idea Why does the federal government attempt to preserve competition among business enterprises? What different methods does the government have available for this task? 26. Making Inferences Do you think there would be any advantages to making monopolies or near monopolies break up into smaller, competing firms? Explain your answer. 27. Comparing and Contrasting Why are monopolies faced with more government regulations than other market structures? 28. Making Generalizations To what extent do you think government should be involved in the free enterprise economy? Defend your answer. Type of Monopoly Description Analyzing Visuals 29. Look at Figure 7.2 on page 175. Analyze the columns labeled “Influence over price” and “Entry into market.” How do the various types of market structures influence the results, and why? Present your answer and reasons in a short paragraph. 192 UNIT 2 Microeconomics: Prices and Markets Economics: Principles and Practices Web site at glencoe.com and click on Chapter 7—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Math Practice 30. The table below shows the price, market demand, market supply, and the surplus and shortage for a firm providing a product under perfect competition. Study the information in the table, and then answer the questions below. Thinking Like an Economist 32. Profit Maximization Economists like to analyze decisions incrementally, taking small steps and analyzing the costs and benefits of the steps as they are made. How is this way of thinking similar to the profit maximization logic illustrated in Figure 7.1 on page 171? Price 10 9 8 7 6 5 4 3 2 Market demand Market supply Surplus/ Shortage 600 ---- 850 990 ---- 1300 1470 1650 1840 1550 1500 1450 1400 1350 ---- ---- 1200 1150 950 780 ---- ---- 210 0 –220 ---- –690 a. Some of the information is missing from the table. Calculate the correct information. b. What is the equilibrium price? How can you tell? c. What price(s) will produce a surplus? d. What price(s) will produce a shortage? Applying Economic Concepts 31. Product Differentiation Choose a product offered by several producers that is advertised in newspapers or magazines. Then follow the steps below: a. Clip and save at least three different advertisements. b. In a journal, evaluate each advertisement and write why you would or would not buy a particular brand. c. Based on the evaluations, develop an advertisement for a product of your choice. d. Present your ad to the class and have other stu- dents evaluate how effectively you were able to differentiate your product from that of “competitors.” www.CartoonStock.com Writing About Economics 33. Expository Writing Select any five of the regulatory agencies described in Figure 7.4 on page 187 that relate directly to you. Write a short essay that discusses these agencies and evaluates whether they have a positive or negative effect on your life. Interpreting Cartoons 34. Critical Thinking Look at the cartoon below. What does the cartoon imply about monopolies? What can the government do to prevent such business practicesFreddie, the Little Merger Mogul, didn’t expect to have a monopoly right away. He planned to start small by rigging markets, restraining trade, and suppressing competition—then...” ’ CHAPTER 7 Market Structures 193 UNIT 3 Economic Institutions and Issues CHAPTER 8 Employment, Labor, and Wages CHAPTER 9 Sources of Government Revenue CHAPTER 10 Government Spending CHAPTER 11 Financial Markets Congress approves the federal budget, while the executive branch administers revenue collection and spending. 194 UNIT 3 (tl) Elizabeth Simpson/Getty Images, Larry Lee Photography/Corbis Larry Lee Photography/Corbis CHAPTER 8 Employment, Labor, and Wages Why It Matters Yesterday you found out that your first college choice has accepted you and offered you a scholarship to cover your tuition and books. You will still have to pay for your room and board. Today, your best friend announced that she has received a “full ride” basketball scholarship to the same college— all her expenses will be covered. Why do you think she received a larger scholarship even though your grades are much better than hers? Read Chapter 8 to find out more about labor and wages. The BIG Idea The labor market, like other markets, is determined by supply and demand. The more skills workers such as these construction workers have, the more they can expect to be paid. 196 UNIT 3 David Sailors/Corbis Economics: Principles and Practices Web site at glencoe.com and click on Chapter 8—Chapter Overviews to preview chapter information. Chapter Overview Visit the SECTION 1 The Labor Movement GUIDE TO READING Section Preview In this section, you will find out that labor unions are organizations that attempt to improve the working conditions of their members. Content Vocabulary • Great Depression (p. 201) • right-to-work law (p. 202) • craft union (p. 199) • trade union (p. 199) • industrial union (p. 199) • independent union (p. 203) • strike (p. 199) • picket (p. 199) • boycott (p. 199) • lockout (p. 199) • company union (p. 199) • closed shop (p. 203) • union shop (p. 204) • modified union shop • agency shop (p. 204) • civilian labor force (p. 204) (p. 204) Academic Vocabulary • legislation (p. 198) • prohibited (p. 201) Reading Strategy Sequencing As you read this section, note major events in the history of the U.S. labor movement by creating a time line similar to the one below. 1788 New York City Printers join to demand higher pay—first attempt to organize labor 1750 1800 1850 1900 1950 2000 —The Associated Press ISSUES IN THE NEWS Restaurant Fined over Youth Program Alex Ray, owner of the Common Man restaurants, has been fined by the government for a program that helped a dozen teenagers start and run their own business last summer. Ray paid a $2,000 fine after the Labor Department said the program violated child-labor laws. The teenagers, ages 13 to 15, worked at the Common Man Restaurant in Plymouth [New Hampshire], where they designed a business model, managed the business, scheduled fellow students to staff breakfast and made bank deposits. Ray said the project through a program called Communities for Alcohol- and Drug-Free Youth was a huge success, but the Labor Department sent a violation notice, because kids under 16 worked before 7 a.m. ■ The restaurant owner in the news article did not intend to violate the Fair Labor Standards Act of 1938, but good intentions sometimes |
have unforeseen consequences. Even so, working is one of the single most important things we do. After all, how well we do, as measured by the satisfaction we get or the income we receive, affects virtually every aspect of our lives. Thus, in our study of economics it is important to examine the way the “labor” factor of production earns its income. We also want to study the labor movement because the United States has a rich and colorful labor history. The historical struggle between workers and employers has shaped today’s working environment, and the evolution is still continuing. Jeff Cadge/Getty Images CHAPTER 8 Employment, Labor, and Wages 197 Skills Handbook See page R52 to learn about Sequencing Events. Colonial Times to the 1930s MAIN Idea Early unions formed to negotiate terms for their members, but employers and courts opposed them. Economics & You Do you or any members of your family belong to a union? Read on to learn about the early years of the American union movement. Today, only one out of every eight working Americans is a member of a labor union. Even so, unions are important because they played a major historical role in helping to create the legislation that affects our pay and working conditions today. Early Union Development In 1778 printers in New York City joined together to demand higher pay. This was the first attempt to organize labor in America. Before long, unions of shoemakers, carpenters, and tailors developed, each hoping to negotiate agreements that covered hours, pay, and working conditions. While only a small fraction of all workers belonged to unions, most unions were comprised of skilled workers and possessed strong bargaining power. Until about 1820, most of America’s workforce was made up of farmers, small business owners, and the self-employed. Soon immigrants began to arrive in great numbers. Because they provided a supply of cheap, unskilled labor, they posed a threat to the unions that were working to preserve existing wage and labor standards. In addition, public opinion was largely against union activity, and some parts of the country even banned labor unions. Labor organizers often were viewed as troublemakers, and many workers believed they could better negotiate with their employers on a one-to-one basis. Civil War to the 1930s The Civil War led to higher prices and a greater demand for goods and services. Manufacturing expanded, and the farm population declined. Hourly workers in industrial jobs made up about one-fourth of the country’s working population. Working conditions in some industries were difficult, and hostile attitudes toward unions slowly began to soften. Many of the cultural and linguistic differences between immigrants and American-born workers began to fade, and the labor force became more unified. Types of Unions In the industrial post–Civil War period, the two main types of labor unions shown in Figure 8.1 dominated. The first was the Figure 8.1 Trade (Craft) and Industrial Unions T RADE (C RAFT) U NIONS I NDUSTRIAL U NIONS Printers’ union Electricians’ union Machinists’ union Carpenters’ union Plumbers’ union All belong to the same union Labor unions can be categorized as either trade or industrial unions. Economic Analysis How do trade unions differ from industrial unions? Labor Strikes This woodcut shows workers and firefighters during the Baltimore and Ohio Railroad strike of 1877. What did unions try to accomplish with strikes? craft union or trade union, an association of skilled workers who perform the same kind of work. The Cigar Makers’ Union, begun by union leader Samuel Gompers, is an example of this type of union. The second type of union was the industrial union— an association of all workers in the same industry, regardless of the job each individual worker performs. The development of basic mass-production industries such as steel and textiles provided the opportunity to organize this kind of union. Because many of the workers in these industries were unskilled and could not join trade unions, they organized as industrial unions instead. Union Activities Unions tried to help workers by negotiating for higher pay, job security, and better hours and working conditions. If an agreement could not be reached, workers would strike, or refuse to work until certain demands were met. Unions also pressured employers by having the striking workers picket, or parade in front of the employer’s business carrying signs about the dispute. The signs might ask other workers not to seek jobs with the company, or they might ask customers and suppliers to show union support by taking their business elsewhere. If striking and picketing did not force a settlement of the dispute, a union could organize a boycott—a mass refusal to buy products from targeted employers or companies. When a boycott was effective, it hurt the company’s business. Employer Resistance Employers resented the strikes, pickets, and boycotts, so they fought unions in a number of ways. Sometimes the owners called for a lockout, a refusal to let employees work until they agreed to management demands. At other times, management responded to a strike, or the threat of a strike, by hiring all new workers. Some owners even set up company unions—unions organized, supported, or run by employers—to head off efforts by others to organize workers. The Ludlow Massacre Perhaps nothing typified such struggles more than a strike in Colorado. The United Mine Workers of America had organized a strike against a mining company owned by craft union or trade union labor union whose members perform the same kind of work industrial union labor union whose members perform different kinds of work in the same industry strike union organized work stoppage designed to make an employer meet union demands picket demonstrate or march before a place of business to protest a company’s actions boycott refusal to buy products from an employer or company lockout management refusal to let employees work until demands are met company union union organized, supported, or run by an employer Bettmann/Corbis CHAPTER 8 Employment, Labor, and Wages 199 John D. Rockefeller to demand better pay and working conditions. When the company forced workers out of companyowned homes, the miners and their families moved into tents set up by the union. The strike, expected to end after a few days, instead lasted 14 months. At times, fights broke out between striking miners and company guards. The mining company also hired a private detective agency and received assistance from the Colorado National Guard. One fight in spring 1914 turned into an all-day battle and a devastating fire. In the end, dozens of people were killed, including 2 women and 11 children. The violence, quickly called the Ludlow massacre, sparked rioting in other coal mining communities. The resulting conflict eventually claimed nearly 200 lives. Attitude of the Courts Throughout this period, the courts had an unfavorable attitude toward unions. Under English common law, unions were considered conspiracies against business and were prosecuted in the United States. Even the Sherman Antitrust Act of 1890, aimed mainly at curbing monopolies, was used to keep labor in line. For example, in 1902 the United Hatters Union called a strike against a Danbury, Connecticut, hat manufacturer that had rejected a union demand. The union decided to apply pressure on stores to not stock hats made by the Danbury firm. The hat manufacturer, charging a conspiracy in restraint of trade under the Sherman Act, filed a damage suit that went all the way to the Supreme Court. The Supreme Court ruled that the union had organized an illegal boycott in restraint of trade, thereby dealing a severe blow to organized labor. The Danbury Hatters case and several subsequent antiunion decisions pushed organized labor to call for relief. The passage of the Clayton Antitrust Act of 1914 helped to remedy the threat to unions by expressly exempting labor unions from prosecution under the Sherman Act. Reading Check Recalling How did trade unions and industrial unions develop? Antiunion Attitudes A nationwide strike on May 3, 1886, turned violent in Chicago’s Haymarket Square when strikers and police clashed. How did the Supreme Court view union activity? 200 UNIT 3 Economic Institutions and Issues Bettmann/Corbis Unemployment During the Great Depression, the unemployed lined up for food and other assistance. What was the impact of the Great Depression on the labor movement? Labor Since the 1930s MAIN Idea Most of the significant labor laws in effect today were passed in the 1930s, 1940s, and 1950s. Economics & You Did you try to find a job before you turned 16 but were turned down? Read to learn how early labor legislation affects you today. During the 1930s, times were especially hard for working people who lacked unemployment insurance. In response, Congress passed a series of laws that supported organized labor. Although a backlash against labor followed, these laws provided the most important labor protections that are still in effect today. Labor in the Great Depression The Great Depression—the worst period of economic decline and stagnation in the history of the United States—began with the collapse of the stock market in October 1929. Economic output reached bottom in 1933 and did not recover to its 1929 level until 1939. At times, as many as one in four workers was without a job. Others kept their jobs but saw pay cuts. In 1929 the average hourly manufacturing wage was 55 cents. By 1933 it plummeted to 5 cents. Bettmann/Corbis The Great Depression brought misery to millions, but it also changed attitudes toward the labor movement. Common problems united factory workers, and union promoters renewed their efforts to organize workers. Great Depression worst period of economic decline in U.S. history, lasting from 1929 to approximately 1939 Pro-Union Legislation New legislation soon aided labor. The No |
rris-LaGuardia Act of 1932 prevented federal courts from issuing rulings against unions engaged in peaceful strikes, picketing, or boycotts. This forced companies to negotiate directly with their unions during labor disputes. The National Labor Relations Act, or Wagner Act, of 1935 established the right of unions to collective bargaining. The act also created the National Labor Relations Board (NLRB), giving it the power to police unfair labor practices. The NLRB also could oversee and certify union election results. If a fair election resulted in a union as the employees’ bargaining agent, employers had to recognize and negotiate with it. The Fair Labor Standards Act of 1938 applied to businesses that engage in interstate commerce and set the first minimum wage. It established time-and-a-half pay for overtime, which was defined as more than 40 hours per week. The act also prohibited CHAPTER 8 Employment, Labor, and Wages 201 Figure 8.2 Right-to-Work, State by State Today, 22 states have right-to-work laws that limit the power of unions. If a state has such a law, unions cannot force workers to join the union as a condition of continued employment. Economic Analysis Which regions have the fewest states with right-to-work laws? AK HI WA OR NV CA MT WY ID UT CO AZ NM States with right-to-work laws States without right-to-work laws Source: National Right to Work Commitee, 2006 ND SD NE MN IA KS MO OK TX AR LA NH VT ME NY PA VA NC WV MA RI CT NJ DE MD WI MI IN OH IL KY TN MS AL GA SC FL right- to- work law state law making it illegal to require a worker to join a union oppressive child labor, which includes any labor for a child under 16 and work that is hazardous to the health of a child under 18. Antiunion Backlash The union movement had grown strong by the end of World War II, but then public opinion shifted again. Some people feared that Communists had secretly entered the unions. Others were concerned over production losses due to the increased number of strikes. People began to think that management, not labor, was the victim. Growing antiunion feelings led to the Labor-Management Relations Act, or TaftHartley Act, of 1947. The act had a tough anti union provision known as Section 14(b) that allows individual states to pass rightto-work laws. A right-to-work law is a state law making it illegal to force workers to join a union as a condition of employment, even though a union may already exist. If a state does not have a right-to-work law, new workers may be required to join an 202 UNIT 3 Economic Institutions and Issues existing union as a condition for employment shortly after being hired. If a state has a rightto-work law, then new hires can decide for themselves whether or not they want to join the union—even if the overwhelming majority of workers at the company support the union. Today, the 22 states shown in Figure 8.2 have taken advantage of Section 14(b) to pass right-to-work laws. Other legislation was aimed at stopping criminal influences that had begun to emerge in the labor movement. The most important law was the Labor-Management Reporting and Disclosure Act, or LandrumGriffin Act, of 1959. This act required unions to file regular financial reports with the government and limited the amount of money union officials could borrow from the union. The AFL-CIO The American Federation of Labor (AFL) began in 1886 as an organization of craft or trade unions. It later added several industrial unions. The craft and industrial unions, however, did not always agree over the future of the union movement. As a result, eight of the AFL industrial unions formed a separate group headed by John L. Lewis, the president of the United Mine Workers of America. The AFL and Lewis did not get along, so Lewis and his industrial unions were expelled in 1937 and formed the Congress of Industrial Organizations (CIO). The CIO quickly set up unions in industries that had not been unionized before, such as the steel and automobile industries. By the 1940s, the CIO had nearly 7 million members. As the CIO grew stronger, it began to challenge the dominance of the AFL. In 1955 the AFL and the CIO joined to form the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO). In 2005, a disagreement over the best way to spend union funds resulted in a breakup of the AFL-CIO. Initially, the Service Employees International Union (SEIU), the largest union in the federation, left with several other large unions to form the rival Change to Win Coalition. Other unions soon followed, leaving the labor movement split for the first time since 1955. It is still too early to tell how this split will affect the power of organized labor. The remaining AFL-CIO unions want to focus their efforts on lobbying politicians. The Change to Win Coalition wants to focus its efforts on recruiting new union members. Independent Unions Although the AFL-CIO is still a major force, other unions are also important in the labor movement. Many of these are independent unions—unions that do not belong to the AFL-CIO or the Change to Win Coalition—such as the Brotherhood of Locomotive Engineers. Other examples of independent unions are the United Campus Workers at the University of Tennessee and the Virginia Public Service Workers Union. Reading Check Analyzing Why did the Great Depression have such a strong and lasting impact on the labor movement? Organized Labor Today MAIN Idea Unionized workers can participate in several types of union arrangements. Economics & You Have you ever noticed “Union Made” labels on clothing or other items? Read on to learn more about the different kinds of unions that make these products. Unionized workers participate in several kinds of union arrangements. In addition, union participation in the labor force varies widely from one industry to another. Kinds of Union Arrangements The most restrictive kind of union arrangement is the closed shop, in which an employer agrees to hire only union members. In effect, this allows the union to determine who is hired by giving or denying a person union membership. In some cases, union members could get family members and friends hired as long as the union controlled membership access, which most employers strongly opposed. This kind of union arrangement was common in the 1930s and early 1940s. However, the Taft-Hartley Act of 1947 made the closed shop illegal for all companies involved in interstate commerce. Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 8— Student Web Activities for an activity on labor unions. independent union labor union not affiliated with the AFL-CIO or the Change to Win Coalition closed shop arrangement under which workers must join a union before they are hired Power of Unions While unions remain a strong force, their bargaining power often is limited by economic conditions. What recent event may change the power of unions? REAL LIFE ADVENTURES © 2005 GarLanco. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. CHAPTER 8 Employment, Labor, and Wages 203 REAL LIFE ADVENTURES © 2005 GarLanco. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. &The Global Economy YOU The Union Safety Net Unravels If you have a part-time job, you are part of the reason that unions have declined. But don’t blame yourself—other factors are causing this trend as well. In fact, union membership has declined both in the United States and around the globe. In 2005, 12.5 percent of American wage and salary workers were union members, down from the most recent peak of 20.1 percent in 1983. Although union membership is higher in Europe— 26.3 percent—experts predict the downward trend to continue there as well, with union membership falling under 20 percent by 2010. Many factors have contributed to the decline of unions, including the increase in part-time workers, the rise in the number of women in the workforce, the growth in the number of white-collar workers, and the expansion of service industries. In addition, the trend toward smaller workplaces has hurt unionization. EU’ S F OUR L ARGEST C OUNTRIES —P ERCENTAGE OF U NION W ORKERS 40% 30 20 10 0 Italy United Kingdom Germany France Countries United States Sources: Federation of European Employees, Bureau of Labor Statistics union shop arrangement under which workers must join a union after being hired modified union shop arrangement under which workers have the option to join a union after being hired agency shop arrangement under which nonunion workers must pay union dues civilian labor force noninstitutionalized part of the population, aged 16 and over, either working or looking for a job Because most firms in the United States today are directly or indirectly engaged in interstate commerce, few, if any, closed shops exist. The second union arrangement is the union shop, where workers do not have to belong to the union to be hired, but must join soon after and remain a member for as long as they keep their jobs. Another union arrangement is the modified union shop. Under this arrangement, workers do not have to belong to a union to be hired and cannot be made to join one to keep their jobs. If workers voluntarily join the union, however, they must remain members for as long as they hold their jobs. Finally, agency shop is an agreement that does not require a worker to join a union as a condition to get or keep a job. It does require the worker to pay union dues to help pay for collective bargaining costs. Nonunion workers also are subject to the contract terms negotiated by the union, whether or not they agree with the terms. An agency shop is also known as “fair share.” Unions like to use this term to remind everyone that the dues the non- members pay to the union are used on behalf of all the workers, whether they are union members or not. Unionized Workers in the Labor Force Today, the United States |
has a population of about 300 million people. Approximately half of the people belong to the civilian labor force—men and women 16 years old and over who are either working or actively looking for a job. The civilian classification excludes the prison population, other institutionalized persons, and members of the armed forces. Approximately 12.5 percent of working Americans are union members. An additional 1.2 percent of working people are represented by unions in the form of the agency shop discussed above. Union membership is uneven among the different demographic groups in the United States. Men are more likely than women to be union members, although the gap has narrowed considerably in the last 20 years. Older workers, especially those over the age of 45, are more likely to be organized 204 UNIT 3 Economic Institutions and Issues than younger workers. African Americans are more likely than others to belong to unions, while Asian Americans and Hispanic Americans are least likely to join. Finally, the rate of union memberships among full-time workers is more than twice as high as the rate for part-time workers. Union membership also differs considerably by state. Five states—Alaska, Hawaii, Michigan, New Jersey, and New York—all have union membership rates above 20 percent, which means that one in five workers is unionized. Five other states— Arkansas, North Carolina, South Carolina, Virginia, and Utah—all have membership rates of less than five percent. As shown in Figure 8.3, local, state, and federal governments have the highest rate of unionization. In fact, the rate of union membership in all levels of government is nearly three times that of workers in manufacturing. The food services industry, where most teenagers work, is the least likely to be unionized. Reading Check Contrasting How do the types of union arrangements differ? Figure 8.3 Union Membership and Representation by Industry Industry Local government State government Federal government Utilities Transportation and warehousing Telecommunications Motion pictures and sound recording Construction Manufacturing Education and health services Mining Retail trade Agriculture and related Finance and insurance Food services and drinking places Source: Bureau of Labor Statistics, 2006 Percentage of employed workers who are: Members of unions Represented by unions 41.9 31.3 27.8 27.4 23.4 21.4 15.0 13.1 13.0 8.3 8.0 5.2 2.7 1.6 1.3 45.8 35.0 33.1 28.6 24.4 22.6 15.5 13.8 13.7 9.4 9.5 5.8 3.0 2.1 1.5 Labor unions are most influential in the service industries, which include government, communications, public utilities, and transportation. Economic Analysis Which industries have few union members? SECTION 1 Review Vocabulary 1. Explain the significance of craft union, trade union, industrial union, strike, picket, boycott, lockout, company union, Great Depression, right-to-work law, independent union, closed shop, union shop, modified union shop, agency shop, and civilian labor force. Main Ideas 2. Stating What is the purpose of labor unions? 3. Explaining Why did the AFL-CIO break up? 4. Describing Use a graphic organizer like the one below to describe the different types of union arrangements. Labor Arrangements Critical Thinking 5. The BIG Idea How do the major legislative acts discussed in the section reflect the rise and decline of the labor movement? 6. Making Inferences Why has union support in the United States gone through cycles of resistance and strong support? Write a short essay explaining your opinion. 7. Comparing and Contrasting Which of the four kinds of union arrangements would you prefer, and why? 8. Analyzing Visuals Look at Figure 8.2 on page 202. What does the pattern of right-to-work and non–rightto-work states imply about the strength of labor unions? Applying Economics 9. Civilian Labor Force How would joining the armed services affect your participation in the civilian labor force? CHAPTER 8 Employment, Labor, and Wages 205 Profiles in Economics LABOR LEADER To Chávez and the farm workers he represented, La Causa (The Cause) was about something much bigger than themselves. According to Chávez, “The consumer boycott is . . . a gate of hope through which [farm workers] expect to find the sunlight of a better life for themselves and their families.” César Chávez (1927–1993) • led the only successful union to organize farmworkers • posthumously awarded the Presidential Medal of Freedom in 1994, the highest honor given to civilians ¡Sí, se puede! César Chávez was born in Yuma, Arizona. Like that of many farmworkers, his life was grueling and impoverished. As a boy, he and his family worked all day in the fields picking fruits or vegetables. They moved from place to place throughout the year, forcing César to drop out of school in eighth grade. Farmworkers who tried to organize for safer working conditions, better pay, and benefits were often harassed by farm owners and police. Some were even sprayed with agricultural poisons. With farms spread so far apart, it was difficult to organize strikes by migrant workers. But Chávez believed “it can be done.” Chávez joined the Community Service Organization (CSO) and began helping people with everyday tax, immigration, and education concerns. In 1962 he set up the National Farm Workers Association (NFWA). For three years, Chávez traveled all over California, discussing problems and goals with farm workers. The Grape Boycott When the Agricultural Workers Organizing Committee (AWOC), another farmworkers group, orchestrated a strike against the Delano table grape growers in 1965, Chávez and the NFWA decided to join their efforts. A year later, the two groups became the United Farm Workers (UFW). Chávez mobilized thousands of churches and student activists across the country to boycott grapes. At the peak of the boycott, table grape shipments were down by 24 percent in the top 10 North American markets, and more than 14 million people had participated. The boycott’s astounding success led to historic contracts between the UFW and the Delano growers in 1969. Chávez and his team had won union recognition, higher wages, a health plan, and other concessions. Yet for all of his labor struggles for others, Chávez never made more than $5,000 a year. Examining the Profile 1. Summarizing How did Chávez initially try to approach farmworkers? 2. Applying Information How would a successful boycott impact the demand for grapes? 206 UNIT 3 Economic Institutions and Issues Arthur Schatz/Time Life Pictures/Getty Images SECTION 2 Wages and Labor Disputes GUIDE TO READING Section Preview In this section, you will learn that unions and management negotiate contracts through a process known as collective bargaining. Academic Vocabulary • anticipate (p. 211) • distorted (p. 212) Content Vocabulary • wage rate (p. 208) • unskilled labor (p. 208) • semiskilled labor (p. 208) • skilled labor (p. 208) • professional labor (p. 208) • market theory of wage determination (p. 209) • equilibrium wage rate (p. 209) • theory of negotiated wages (p. 210) • seniority (p. 210) • signaling theory (p. 210) • collective bargaining (p. 211) • grievance procedure (p. 211) • mediation (p. 212) • arbitration (p. 212) • binding arbitration (p. 212) • fact-finding (p. 212) • injunction (p. 212) • seizure (p. 212) Reading Strategy Describing As you read the section, complete a graphic organizer similar to the one below that describes the different ways labor disputes are resolved. Resolution ISSUES IN THE NEWS NHL Shakes Off Lockout, Long Layoff —National Public Radio [The] NHL owners took a very hard line with the Player’s Association and in the end the players accepted a big salary cut and a per team salary cap. Now the NHL has reduced its spending on players’ salaries to about 54 percent of revenue, down from about 75 percent. [The NHL] says it’s going to save up to 400 million dollars. Twice as many teams are going to be in the black. Fans are returning to the rinks, but there’s still some operating issues for teams in smaller markets. They’re sort of facing a choice, do we lose five or $10 million or do we spend up to the salary cap and compete? ■ Over the years, many disputes have occurred between labor and management. Sometimes employees take action against their employer, as during the 2005 transit worker strike in New York City that shut down buses and subways. Sometimes the employer takes action against its employees, as during the 2004 National Hockey League (NHL) player lockout that cancelled the professional hockey season for a full year. Most labor disputes occur over pay and working conditions. If a dispute results in an actual work stoppage, both sides stand to lose enormous sums of money. As a result, and regardless of the reason for the dispute, the deliberations to end it are usually intense. While the NHL was finally able to settle its labor dispute through negotiation, there are other ways to resolve a deadlock. Getty Images CHAPTER 8 Employment, Labor, and Wages 207 wage rate prevailing pay scale for work performed in an occupation unskilled labor workers not trained to operate specialized machines and equipment semiskilled labor workers who operate machines that require a minimum amount of training skilled labor workers who are trained to operate complex equipment and require little supervision professional labor workers with a high level of training, education, and managerial skills Skills Handbook See page R53 to learn about Comparing Data. Wage Determination MAIN Idea Different occupations and levels of training are rewarded with different wages. Economics & You When you choose an occupation, do you want to earn as much income as possible? Read on to learn how your choices can result in a higher wage. Most occupations have a wage rate, a standard amount of pay given for work performed. Wage rates usually differ from one occupation to the next, and sometimes even within the same occupation. There are four explan |
ations as to why this happens. Noncompeting Categories of Labor One explanation recognizes four broad categories of labor that have different levels of knowledge and skills. The highest pay goes to people in jobs that require the most skills and training. Because workers in one category do not compete with those in other categories, wages differ. The first category is unskilled labor and consists of workers in jobs that do not require people with special training and skills. People in these jobs work primarily with their hands at tasks such as picking fruit or mopping floors. The second category comprises semiskilled labor—workers in jobs that require enough mechanical skills to operate machines for which they need a minimum amount of training. These workers may operate basic equipment such as electric floor polishers, cleaning equipment, lawnmowers, and other machines that call for a modest amount of training. The third category is skilled labor and consists of workers who operate complex equipment and perform most of their tasks with little supervision. These workers have a higher investment in education, knowledge, and training. Examples include carpenters, electricians, tool and die makers, computer technicians, and computer programmers. The final category is professional labor, or those individuals that have the highest level of knowledge-based education and managerial skills. Examples include teachers, doctors, scientists, lawyers, and top managers such as corporate executives. If you examine the occupations shown in Figure 8.4, you will see that the income each occupation earns is closely associated with these four categories of labor. For example, semiskilled workers, such as transportation and material movers, generally receive more than unskilled workers in the food-service occupations. Likewise, the professional workers in legal and managerial occupations earn more than any of the other occupations in the figure. Figure 8.4 Median Weekly Earnings by Occupation and Union Affiliation Weekly earnings are significantly higher for workers in highly skilled occupations or with union representation. Economic Analysis Why is the earnings gap between union and nonunion workers smaller in managerial occupations than in other occupations? Occupation Represented by unions Nonunion workers Legal occupations Management occupations Computer and mathematical Education, training, and library Protective service occupations Transportation and material moving Office and administrative support Sales and related occupations Building and grounds, cleaning, maintenance Food preparation and serving related Source: Bureau of Labor Statistics, 2006 $1,147 1,137 1,009 913 896 721 689 623 528 439 $1,042 1,076 1,141 710 568 508 528 622 378 350 Figure 8.5 Market Theory of Wage Determination The market theory of wage determination explains how the market forces of supply and demand determine the equilibrium wage rate. Panel A shows what happens when a relatively large supply of roofers is coupled with a relatively low level of demand. Panel B shows what happens when a relatively small supply of professional athletes is paired with a relatively high level of demand. Economic Analysis How does this theory differ from the theory of negotiated wages? See StudentWorks™ Plus or glencoe.com. A R OOFER B P ROFESSIONAL A THLETES Low demand and high supply result in low annual wages. $18,000 D $1,000,000 High demand and low supply result in high annual wages. D 0 Quantity 0 Quantity Market Theory of Wage Determination Another explanation for the differences in pay many people receive is based on the market theory of wage determination. This theory states that the supply and demand for a worker’s skills and services determine the wage or salary. For example, if there is a low demand for roofers but a relatively large supply, the result would be relatively low wages for roofers. If conditions are reversed, so that the demand is high and supply is low, then wages would be much higher. This describes the market for the services of professional athletes. In this market, a small supply of talent combined with relatively high demand results in higher wages. You can see this interaction of supply and demand in Figure 8.5. In each market, the intersection of supply and demand determines the equilibrium wage rate— the wage rate that leaves neither a surplus nor a shortage in the labor market. Exceptions to the market theory may appear to exist at certain times. Some unproductive workers may receive high wages because of family ties or political influence. Highly skilled workers may receive low wages because of discrimination based on their race or gender. market theory of wage determination explanation of wage rates relying on theory of supply and demand equilibrium wage rate wage rate leaving neither a surplus nor a shortage in the market Million-Dollar Paychecks The pay for top CEOs reflects the high demand for the best business leaders in the nation. Their base salary actually may not be all that high. Yet CEOs usually pocket a variety of extras, such as retirement benefits, bonuses, stock options, and—for some—tax reimbursements. Add all this together, and total compensation can easily reach into the millions of dollars. CHAPTER 8 Employment, Labor, and Wages 209 Signaling Theory The fourth explanation for differences in wage rates is based on signaling theory. This theory states that employers are willing to pay more to people with certificates, degrees, and other indicators that “signal” superior knowledge or ability. For example, a sales firm might prefer to hire a college graduate with a major in history than a high school graduate who excelled in business courses. While this may seem odd, some firms view the degree as a signal that the individual possesses the intelligence, perseverance, and maturity to succeed. You might hear from friends that they did not need their college degree to do the job they currently have—as if their education was not important. They overlook the signaling theory, which helps explain why they got the job in the first place. Reading Check Explaining What is the difference between the market theory of wage determination and the theory of negotiated wages? Theory of Negotiated Wages Unions sometimes threaten with a boycott to get wage concessions. What factor is necessary for effective bargaining? Signaling Theory People who enter the workforce with a college degree can expect higher pay. What signal does a degree send to a potential employer? theory of negotiated wages explanation of wage rates based on the bargaining strength of organized labor seniority length of time a person has been on a job signaling theory theory that employers are willing to pay more for people with certificates, diplomas, and other indicators of superior ability Personal Finance Handbook See pages R16—R19 for more information on education. Theory of Negotiated Wages The third approach to wage rate determination recognizes the power of unions. The theory of negotiated wages states that the bargaining strength of organized labor is a factor that helps to determine wages. A strong union, for example, may have the power to force higher wages on some firms because the firms would not be able to afford work interruptions in case of a threatened strike. Figure 8.4 on page 208 helps validate the theory of negotiated wages. With only one exception, the figure shows that workers who are represented by unions receive weekly salaries that are higher than those of nonunion workers. One important factor for unions is seniority— the length of time a person has been on the job. Because of their seniority, some workers receive higher wages than others who perform similar tasks, even if they do not have better skills. 210 UNIT 3 Economic Institutions and Issues (l) Art Vandalay/Getty Images, (r) David H. Wells/Corbis Resolving Labor Disputes MAIN Idea There are a number of different ways to resolve a labor dispute if collective bargaining fails. Economics & You Have you ever bargained with someone to get something you wanted? Read on to find out how unions do the same thing to get the wages and benefits they want for their workers. When organized labor negotiates with management, disputes are bound to happen. Both sides can use collective bargaining to minimize such disputes. If this fails, they can turn to mediation, arbitration, fact-finding, injunction and seizure or, in extreme cases, presidential intervention. Collective Bargaining Labor-management relations usually require collective bargaining—negotiations that take place between labor and management over issues such as pay, working CAREERS Labor Relations Specialist collective bargaining process of negotiation between union and management representatives over pay, benefits, and job-related matters grievance procedure provision in a labor contract that outlines how future disputes and disagreements will be resolved hours, health care coverage, and other jobrelated matters. During collective bargaining, elected union officials represent workers, and company officials in charge of labor relations represent management. Collective bargaining requires compromise from both parties, and the discussions over issues may go on for months. If the negotiations are successful, both parties agree on basic issues such as pay, working conditions, and benefits. Because it is difficult to anticipate future problems, a grievance procedure—a provision for resolving issues that may come up later— may also be included in the final contract. Normally, union and management are able to reach an agreement because the costs of failure are so high. Workers, for example, still have to make regular payments on car loans and mortgages, and companies don’t want to lose customers to other businesses. In short, everyone has a big stake in resolving labor issues. The Work * Formulate labor policy, oversee industrial labor relations, a |
nd negotiate collective bargaining agreements * Coordinate grievance procedures between unions, workers, and management * Handle complaints that result from contract disputes Qualifications * Knowledge of fair wages and salaries, benefits, pensions, labor law, collective bargaining trends, and union and management practices * Ability to be patient, fair- minded, and persuasive, and to function under pressure * College courses in labor law, collective bargaining, labor economics, labor history, and industrial psychology * Many positions require graduate studies in industrial or labor relations Earnings * Median annual earnings: $93,895 Job Growth Outlook * Faster than average Source: Occupational Outlook Handbook, 2006–2007 Edition Comstock Premium/Alamy CHAPTER 8 Employment, Labor, and Wages 211 . Arbitration is finding its way into areas beyond labor-management relations. Today, for example, most credit card companies require disputes with cardholders to be solved by an arbitrator rather than in the courts. This means that a credit card holder can no longer sue the credit card company in the event of a dispute because the matter goes to arbitration instead. “A good negotiator can stand back and gain perspective.” Mediation Mediators need to objectively consider the viewpoints of all involved parties in their decisions Why would unions and management agree to mediation? mediation process of resolving a dispute by bringing in a neutral third party arbitration or binding arbitration agreement by two parties to place a dispute before a third party for a binding settlement fact-finding agreement between union and management to have a neutral third party collect facts about a dispute and present nonbinding recommendations injunction court order issued to prevent a company or union from taking action during a labor dispute seizure temporary government takeover of a company to keep it running during a labor-management dispute Mediation One way to resolve differences is through mediation, the process of bringing in a neutral third person or persons to help settle a dispute. The mediator’s primary goal is to find a solution that both parties will accept. A mediator must be unbiased so that neither party benefits at the expense of the other. If the mediator has the confidence and trust of both parties, he or she will be able to learn what concessions each side is willing to make. In the end, the mediator recommends a compromise to both sides. Neither side has to accept a mediator’s decision, although it often helps break the deadlock. Arbitration Another popular way to resolve differences is through arbitration, a process in which both sides agree to place their differences before a third party whose decision will be accepted as final. Because both sides must agree to any final decision the arbitrator makes, this type of negotiation is also called binding arbitration. 212 UNIT 3 Economic Institutions and Issues www.CartoonStock.com Fact-Finding A third way to resolve a dispute is through fact-finding, an agreement between union and management to have a neutral third party collect facts about a dispute and present nonbinding recommendations. This process can be especially useful in situations where each side has deliberately distorted the issues to win public support, or when one side simply does not believe the claims made by the other side. Neither labor nor management has to accept the recommendations of the fact-finding committee. Injunction and Seizure A fourth way to settle labor-management disputes is through injunction or seizure. During a dispute, one of the parties may request an injunction—a court order not to act. If issued against a union, the injunction may direct the union not to strike. If issued against a company, it may direct the company not to lock out its workers. In 1995, after professional baseball players ended their strike and went back to work, the owners promptly called a lockout. The players then got an injunction against the owners, and the 1995 baseball season began—but without a labor agreement. Under extreme circumstances, the government may resort to seizure—a temporary takeover of operations—while the government negotiates with the union. This occurred in 1946 when the government seized the bituminous coal industry. While operating the mines, government officials worked out a settlement with the miners’ union. Presidential Intervention The president of the United States may enter a labor-management dispute by publicly appealing to both parties to resolve their differences. While rarely used, this can be effective if the appeal has broad public support. The president also can fire federal workers. In 1981 President Ronald Reagan fired striking air traffic controllers because they were federal employees who had gone on strike despite having taken an oath not to do so. The president also has emergency powers that can be used to end some strikes. When pilots from American Airlines went on strike in 1997 during a peak travel weekend, President Clinton used a 1926 federal law, the Railway Labor Relations Act, to order an end to the strike less than 30 minutes after it began. Reading Check Summarizing In what ways can labor and management resolve disputes? Intervention In 1981 President Reagan replaced striking air traffic controllers. Why did the president think this step was necessary? SECTION 2 Review Vocabulary 1. Explain the significance of wage rate, unskilled labor, semiskilled labor, skilled labor, professional labor, market theory of wage determination, equilibrium wage rate, theory of negotiated wages, seniority, signaling theory, collective bargaining, grievance procedure, mediation, arbitration, binding arbitration, fact-finding, injunction, and seizure. Main Ideas 2. Describing Use a graphic organizer like the one below to describe the four approaches to wage determination. Characteristics Method Skill level Market theory Negotiated theory Signaling theory 3. Discussing How do mediation, arbitration, and fact- finding differ from other ways to resolve labor disputes? Critical Thinking 4. The BIG Idea How does the market theory of wage determination reflect the forces of supply and demand? 5. Sequencing Information If you represented a company during a collective bargaining session, and if negotiations were deadlocked, what course of action would you recommend? Why? 6. Interpreting If you were a semiskilled worker, what could you do to move into a higher category of noncompeting labor? 7. Analyzing Visuals Look at Figure 8.5 on page 209. The graphs show wage determination based on demand and supply. What might the demand and supply curves look like for a lawyer or for a person working in a fast-food restaurant? Applying Economics 8. Signaling Theory Look at some help-wanted ads in your local paper. What criteria do they often specify, and how do these criteria relate to signaling theory? Roger Ressmeyer/Corbis CHAPTER 8 Employment, Labor, and Wages 213 CASE STUDY Harley-Davidson Revving It Up Since its founding in 1903, Harley-Davidson Motor Company has survived wartime economies, the Great Depression, overseas competition from Japanese manufacturers, and in 1985 the threat of bankruptcy. When it went public in 1986, a new era began. Harley tackled problems of global competition and the need for U.S. expansion. More importantly, it broke away from the adversarial model of management versus union by creating a “circle organization based around the core processes at Harley—create demand, produce product, and provide support.” Partners in Business Harley-Davidson’s unique partnership style of management allied with labor was labeled the High Performance Work Organization (HPWO). The strategy minimizes red tape and calls on employees for leadership, responsibility, and ingenuity. Workers provide input at every stage of the manufacturing process. The absence of the “us against them” mentality so often found in labor relations—coupled with a true sense of ownership by unionized workers— has motivated Harley employees to work toward H ARLEY-D AVIDSON R EVENUES, 2001–2005 ) 6 5 4 3 2 1 0 2001 2002 2003 Year 2004 2005 a common goal. In addition, the process has lowered the company’s costs, allowing it to create new jobs and expand operations. Happy Workers, Humming Hogs The HPWO is paying off for the motorcycle manufacturer, which in 2004 was named one of America’s “100 Best Places to Work” by Fortune magazine. Employees and shareholders alike have cause for celebration. Since its turnaround in 1986, the company has experienced tremendous growth and reaped impressive profits. Harley-Davidson now sells motorcycles in over 60 countries. In 2006 it opened its first retail store in China. Now Chinese bikers donned in leather can buy a true American icon. Bandana sold separately. Analyzing the Impact 1. Summarizing What change in business practices helped Harley-Davidson boost production and profits? 2. Drawing Conclusions Harley-Davidson also made a commitment to using only U.S. workers and parts suppliers. How might this commitment help or hinder the company? Explain. Source: harley-davidson.com 214 UNIT 3 Economic Institutions and Issues Simone Romeo/Alamy SECTION 3 Employment Trends and Issues GUIDE TO READING Section Preview In this section, you will learn that important employment issues include union decline, unequal pay, and the minimum wage. Academic Vocabulary • trend (p. 216) • equivalent (p. 219) Reading Strategy Content Vocabulary • giveback (p. 217) • two-tier wage system (p. 217) • glass ceiling (p. 219) • set-aside contract • minimum wage (p. 219) • current dollars (p. 219) • constant dollars (p. 221) • real dollars (p. 221) • base year (p. 221) (p. 219) Explaining As you read the section, complete a graphic organizer similar to the one below to explain why women face an income gap. Lower pay for women —The Oregonian ISSUES IN THE NEWS Foreign Exchange at Minimum Wage Four decade |
s ago . . . Congress created a student exchange program intended to burnish America’s worldwide reputation. The idea was simple: College students would visit for a few months, take a job, and return to their native lands imbued with affection for the red, white and blue. Today, that initiative [is] a source of cheap labor for hotels, ski resorts and restaurants. Mt. Bachelor hired 30 exchange students from Peru for the winter, paying them $7.50 an hour. Timberline Lodge, at Mount Hood, employed 20 students from Chile and also paid them the Oregon minimum wage. The tourism industry says it needs the cheap work force to keep prices down. In [such a] tight labor market, . . . the lures of a free ski pass and minimum wage are no longer enough for local ski bums, who can find longer-term jobs for better wages in town. ■ Important issues abound in today’s labor market. While some workers are faced with layoffs when factories close, other industries have problems filling all their available jobs. This is especially true for those positions that pay only federal or state minimum wages, such as some of the resort jobs in the news story. Difficulties in finding enough qualified workers to fill temporary jobs at the minimum wage is just one issue facing the national economy. Workers have seen a decline of unions, which limits their ability to influence wages, while women have to deal with differences in pay in the labor market. Tim Fuller CHAPTER 8 Employment, Labor, and Wages 215 Skills Handbook See page R36 to learn about determining Cause and Effect. Decline of Union Influence MAIN Idea Labor unions have been losing their influence and power ever since the 1940s. Economics & You You learned earlier about the rise of unions. Read on to learn about the decline of unions today. A significant trend in today’s economy is the decline in union membership and influence. As Figure 8.6 shows, 35.5 percent of nonfarm workers were union members in 1945. This number has dropped since then to about 12.5 percent by 2006. Reasons for Decline Several reasons account for this decline. The first is that many employers have made a determined effort to keep unions out of their businesses. Some companies hire consultants to map out legal strat egies to fight unions. Others try to head off the formation of a union by making workers part of the management team, adding employees to the board of directors, or setting up profit-sharing plans to reward employees. A second reason for union decline is that new additions to the labor force—especially women and teenagers—traditionally have had little loyalty to organized labor. In addition, more Americans are working in part-time jobs to help make ends meet. People who work a second job have less time to join or even support a union. Perhaps the most important reason is that unions are the victims of their own success. When union wages are higher than those of nonunion workers, union-made products become more expensive than those of foreign and nonunion producers. Renegotiating Union Wages Because unions have generally kept their wages above those of nonunion workers, union wages have been under pressure to come down. In fact, in recent years, there have been almost as many news reports of Figure 8.6 Union Membership U NION M EMBERSHIP 40% 35 30 25 20 15 10 1930 1935 1940 1945 1950 1955 1960 1965 1970 Year 1975 1980 1985 1990 1995 2000 2005 2010 Source: Bureau of Labor Statistics, 2005 Union membership grew rapidly after 1933 and peaked at 35.5 percent in 1945. Economic Analysis How would you describe the trend of union membership during the last decade? Figure 8.7 Gender and Income Over the years, the income earned by females has been only a fraction of that earned by males. Economic Analysis When did median female income first reach 70 percent of male median income? M EDIAN F EMALE I NCOME AS A P ERCENTAGE OF M EDIAN M ALE I NCOME 100 90 80 70 60 50 40 30 20 10 0 1955 1960 1965 1970 1975 1980 Year 1985 1990 1995 2000 2005 2010 Source: Bureau of Labor Statistics, 2006 unions fighting to maintain wage levels as there were reports of union wages rising. One way employers have been able to reduce union wages is by asking for givebacks from union workers. A giveback is a wage, fringe benefit, or work rule given up when a labor contract is renegotiated. Some companies were able to get rid of labor contracts by claiming bank ruptcy. If a company can show that wages and fringe benefits contributed significantly to its problems, federal bankruptcy courts usually allow management to terminate union contracts and establish lower wage scales. Another way to reduce union salary scales is with a two-tier wage system—a system that keeps high wages for current workers, but has a lower wage for newly hired workers. This practice is becoming widespread and often has union approval. Reading Check Identifying Why do successful unions create problems for themselves? Lower Pay for Women MAIN Idea Men are generally paid more than women because of differences in skills, the types of jobs they choose, and discrimination. Economics & You Are you or anyone in your family concerned about a job for which men are paid more than women? Read to find out about laws that will help correct the situation. giveback wage, fringe benefit, or work rule given up when renegotiating a contract two-tier wage system wage scale paying newer workers a lower wage than others already on the job Overall, women face a substantial gap between their income and the income received by men. As Figure 8.7 shows, female income has been only a fraction of male income over a 50-year period. Human Capital Differences About one-third of the male-female income gap is due to differences in the skills and experience that women bring to the labor market. For example, women tend to drop out of the labor force to raise families more often than men. Working women also CHAPTER 8 Employment, Labor, and Wages 217 tend to have lower levels of education than their male counterparts. If these two factors— experience and education— were the same for men and women, about onethird of the wage gap would disappear. Gender and Occupation Slightly less than one-third of the wage gap is due to the uneven distribution of men and women among various occupations. For example, more men work in higher-paying construction and engineering trades than women. Likewise, more women work in lower-paying household service and office occupations than men. The distribution of men and women in various occupations as reported by the Bureau of Labor Statistics is shown in Figure 8.8. As long as construction and engineer ing wages are higher than personal care and office worker wages, on average, men will earn more than women. Discrimination Finally, slightly more than one-third of the gap cannot be explained by specific reasons. Economists attribute this portion of differences in income to discrimination that women face in the labor market. In fact, women and minorities often encounter difficulties in getting raises and promotions Figure 8.8 Gender and Occupation D ISTRIBUTION OF W OMEN AND M EN BY O CCUPATION Construction and extraction trades Installation, maintenance, and repair Architecture and engineering Transportation and material moving Protective services (fire and police) Farming, fishing, and forestry Computer and mathematical Building and grounds cleaning, maintenance Sales and related Legal occupations Food preparation and serving related Community and social services Health care practitioner and technical Education, training, and library Office and administrative support Personal care and service Health care support occupations 60% 40% 80% Females 100% 20% 0% 20% 40% 60% 80% 100% Males Source: Bureau of Labor Statistics, 2006 One of the reasons for the difference in pay between men and women is their uneven distribution among occupations. Economic Analysis In which occupations do women make up between 60 and 80 percent of the workforce? glass ceiling seemingly invisible barrier hindering advancement of women and minorities in a male-dominated organization set-aside contract guaranteed contract or portion of a contract reserved for a targeted group, usually a minority minimum wage lowest legal wage that can be paid to most workers (also see page 58) current dollars dollar amounts or prices that are not adjusted for inflation that are like reaching a glass ceiling— an invisible barrier that obstructs their advance ment up the corporate ladder. Legal Remedies Two federal laws are designed to fight wage and salary discrimination. The first is the Equal Pay Act of 1963, which prohibits wage and salary discrimination for jobs that require equivalent skills and responsibilities. This act applies only to men and women who work at the same job in the same business establishment. The second law is the Civil Rights Act of 1964. Title VII of this act prohibits discrimination in all areas of employment on the basis of gender, race, color, religion, and national origin. The law applies to employers with 15 or more workers. The Civil Rights Act also set up the Equal Employment Opportunity Commission (EEOC). The EEOC investigates charges of discrimination, issues guidelines and regulations, conducts hearings, and collects statistics. The government can sue companies that show patterns of discrimination. Market Remedies Another way to overcome unfair hiring practices is by reserving some market activity for minority groups. One example is the government set-aside contract, a guaranteed contract reserved for a targeted group. The federal government, for example, requires that a certain percentage of defense contracts be reserved exclusively for minority-owned businesses. Some state governments do the same for state contracts. Many set-aside programs include a “grad uation” clause that “promotes” minority-owned businesses out of the program once they reach a certain size or have received set-aside co |
ntracts for a certain number of years. Such limits are set because the program is intended to give these firms an initial boost, not a permanent subsidy. Reading Check Synthesizing What are similarities between the Equal Pay Act and set-aside contracts? The Minimum Wage MAIN Idea The minimum wage has lost purchasing power over time because it was fixed at $5.15 while prices were rising. Economics and You Have you or any of your friends ever had a job that paid exactly $5.15 an hour? Read on to learn why this wage does not buy as much as it did in the past. The minimum wage—the lowest wage that can be paid by law to most workers— was intended to prevent the exploitation of workers and to provide some degree of equity and security to those who lacked the skills need ed to earn a decent income. First set at $.25 per hour in 1939, the minimum wage increased to $5.15 by 1997. Debate Over the Minimum Wage The minimum wage has always been controversial. Supporters of the minimum wage argue that the objectives of equity and secur ity are consistent with U.S. economic goals. Besides, the wage is not very high in the first place. Opponents object to it on the grounds of economic freedom, another economic goal. This group also believes that the wage discriminates against young people and is one of the reasons that many teenagers cannot find jobs. Some parts of the country have instituted their own equivalent of a minimum wage. For example, the “living wage” of Los Angeles is substantially higher than the federal minimum wage. Any company doing business with the city is required to pay its workers at least that amount. Current Dollars Panel A in Figure 8.9 on the following page illustrates the minimum wage in current dollars, or dollars not adjusted for inflation, from 1939 to 2006. In this view the minimum wage appears to have increased dramatically over time. However, the figure does not account for inflation, which erodes the purchasing power of the minimum wage. CHAPTER 8 Employment, Labor, and Wages 219 Figure 8.9 The Minimum Wage The minimum wage is expressed in current dollars in Panel A, adjusted for inflation in Panel B, and as a percentage of the average wage for workers in manufacturing in Panel C. The minimum wage has been fixed at $5.15 since 1997. Economic Analysis How does the minimum wage compare to average manufacturing wages? A T HE M INIMUM W AGE IN C URRENT D OLLARS See StudentWorks™ Plus or glencoe.com. $6.00 5.00 4.00 3.00 2.00 1.00 1940 1945 1950 1955 1960 1965 1970 1975 Year 1980 1985 1990 1995 2000 2005 2010 B T HE M INIMUM W AGE A DJUSTED FOR I NFLATION 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0 1940 1945 1950 1955 1960 1965 1970 1975 Year 1980 1985 1990 1995 2000 2005 2010 C T HE M INIMUM W AGE AS A P ERCENTAGE OF THE A VERAGE M ANUFACTURING W AGE 60% 50 40 30 20 10 1940 1945 1950 1955 1960 1965 1970 1975 Year 1980 1985 1990 1995 2000 2005 2010 Sources: Statistical Abstract of the United States; Economic Report of the President, various issues 220 UNIT 3 Economic Institutions and Issues real dollars or constant dollars dollar amounts or prices that have been adjusted for inflation base year year serving as point of comparison for other years in a price index or other statistical measure Inflation To compensate for inflation, economists like to use real or constant dollars—dollars that are adjusted in a way that removes the distortion of inflation. This involves the use of a base year—a year that serves as a comparison for all other years. Although the computations are complex, the results are not. Panel B, using constant base-year prices, shows that the minimum wage had relatively more purchasing power in 1968 than in any other year. As long as the base year serves as a common denominator for comparison purposes, the results would be the same regardless of the base year used. Panel B also shows that the purchasing power of the minimum wage goes up whenever the wage increases faster than inflation. This was the case in 1997, when the wage was increased to $5.15. However, the minimum wage remained the same through 2006 while prices went up during the same time period. This means that the wage actually purchased a little less each year. As long as the minimum wage remains unchanged and inflation continues, the purchasing power of the wage will continue to decline. Manufacturing Wages Panel C shows the minimum wage as a percentage of the average manufact uring wage. In 1968, for example, the minimum wage was $1.60 and the average manufacturing wage $3.01, or 53.2 percent of the manufacturing wage for that year. The ratio peaked in 1968 and then slowly declined. As long as the minimum wage stays fixed and manufacturing wages go up, this ratio will continue to decline. The minimum wage will certainly be raised again. What is not certain is when this will happen. When the minimum wage becomes unacceptably low to voters and their elected officials, Congress will increase it. Some people even want to link the minimum wage to inflation, so that the wage will automatically rise when prices rise. Reading Check Summarizing What is the difference between current dollars and real dollars? SECTION 3 Review Vocabulary 1. Explain the significance of giveback, two-tier wage system, glass ceiling, set-aside contract, minimum wage, current dollars, real or constant dollars, and base year. Main Ideas 2. Listing List three ways firms renegotiate union contracts by using a graphic organizer like the one below. Renegotiating Union Contracts Givebacks 3. Identifying What are the reasons for the income gap between men and women? 4. Explaining Why is it necessary to consider inflation when examining the minimum wage? Critical Thinking 5. The BIG Idea Have labor unions outlived their usefulness? Why or why not? 6. Synthesizing Information A number of arguments exist both in favor of and against having a minimum wage. With which side do you agree? Why? Explain your answer in a brief paragraph. 7. Analyzing Visuals Look at Figure 8.9 on page 220. When was the purchasing power of the minimum wage highest? When was it lowest? Applying Economics 8. Minimum Wage Search the employment ads in your local or regional newspaper and list at least five jobs for which you qualify. Include the advertised salary for each job. Explain why each wage is higher, lower, or the same as the current federal minimum wage. CHAPTER 8 Employment, Labor, and Wages 221 NEWSCLIP For more than a century, unions have fought hard for benefits many workers today take for granted—an 8-hour workday, paid vacations, and health care insurance. Unions, however, have now declined in both membership and influence. Twilight of the UAW For more than two decades, the United Auto Workers (UAW) has grudgingly allowed Detroit carmakers to slash jobs as they have struggled to keep pace with the onslaught from foreign rivals. That’s what UAW President Ron Gettelfinger agreed to when he signed off on General Motors Corp.’s buyout of more than 40,000 jobs at the No. 1 carmaker and its former parts unit, bankrupt Delphi Corp. Where the union has always drawn the line is on bedrock issues: wages and benefits for workers and retirees. This time, though, that line won’t hold. GM’s buyouts are the beginning, not the end, of the concessions the union will have to make over the next few years. . . . What’s going on is nothing less than the slow death of what was once the country’s most powerful industrial union. Despite years of relentless global pressure, the UAW has been able to maintain some of the best blue-collar posts in the U.S. But like lumbering GM itself, the union failed to realize what it would take to compete in a world UAW M EMBERSHIP economy. In the 1980s and 1990s, it fought concessions that would have helped U.S. carmakers fend off imports. . . . Like GM and Ford, it’s paying the price today. . . . The UAW’s setbacks highlight a broader challenge faced by blue-collar America. Just as union bargaining muscle helped make the middle class, so too does its weakening signal the stiffer barriers less-skilled workers face in today’s globalized economy. . . . There’s another buzzsaw coming: cars from China. Every big automaker is expanding production in the Chinese market, and analysts expect most to start exporting vehicles to the U.S. in a few years. —Reprinted from BusinessWeek 600,000 Examining the Newsclip 1980 2006 Year 1. Summarizing On what two issues did the UAW refuse to negotiate in the past? 2. Determining Cause and Effect How has globalization led to the decline of the UAW? 1.5 million ) ,600 1,400 1,200 1,000 800 600 400 200 0 Source: BusinessWeek 222 UNIT 3 Economic Institutions and Issues Bill Pugliano/Getty Images CHAPTER 8 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Wage Determination Wage rates can be explained in three ways. The market theory of wage determination relies on the tools of supply and demand. The theory of negotiated wages recognizes the influence of unions in bargaining for higher wages. The signaling theory states that employers are willing to pay higher wages to people with diplomas and other signals of ability. M ARKET T HEORY OF W AGE D ETERMINATION S Low demand and high supply result in low annual wages18,000 0 Quantity D Labor Dispute Resolution Union and management representatives can use several strategies to resolve deadlocks when collective bargaining fails. Collective bargaining fails Mediation Arbitration Fact-finding Injunction and seizure Presidential intervention Conflict resolved Employment Issues Current labor issues include the loss of influence and power since the 1940s, the wage gap between women and men, and the minimum wage and its purchasing power. Employment Trends and Issues Decline of unions since the 1940s Wage gap and glass ceiling for women and minorities Decline in purchasing power of the minimum wage CHAPTER 8 Employment, Labor, and Wages 223 CHAPTER |
8 Assessment & Activities Review Content Vocabulary Review the Main Ideas Classify each of the terms below as pro-union, antiunion, or neither. Section 1 (pages 197–205) 1. boycott 2. closed shop 3. company union 4. seniority 5. fact-finding 6. giveback 7. grievance procedure 8. lockout 9. modified union shop 10. seizure 11. injunction 12. picket 13. right-to-work law 14. agency shop 15. strike 16. two-tier wage system 17. arbitration 18. mediation 19. theory of negotiated wages 20. signaling theory Review Academic Vocabulary Use each of these words in a sentence that reflects the word’s meaning in the chapter. Then create a word search puzzle using the sentences—without the word— as clues. 21. legislation 22. prohibit 23. anticipate 24. distort 25. trend 26. equivalent 224 UNIT 3 Economic Institutions and Issues 27. Describe several reasons for the rise of unions prior to 1930. 28. Identify the effects of union activities during the post– Civil War period by using a graphic organizer similar to the one below. Union activities Employers: Supreme Court: 29. Describe current union influence in terms of membership and workers represented by unions. Section 2 (pages 207–213) 30. Explain why a college degree can lead to higher wages. 31. Identify the purpose of collective bargaining. 32. List the approaches to resolving a deadlock between a union and a company’s management. Section 3 (pages 215–221) 33. Explain why men and women are said to have “human capital” differences. 34. Describe two corrective measures being taken to close the income gap between men and women workers. 35. Identify the original intent of the minimum wage. Critical Thinking 36. The BIG Idea Unions generally argue that the best interests of workers can be served when employees are members of a union. Do you agree or disagree with this statement? Defend your answer. Economics: Principles and Practices Web site at glencoe.com and click on Chapter 8—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the 37. Contrasting Identify the differences between mediation and arbitration. Which method do you think is more effective? Write a paragraph explaining your answer. 38. Analyzing Information Some people believe that in today’s economy, the market theory of wage determination is more useful than the theory of negotiated wages. Explain why you agree or disagree. 39. Analyzing Visuals Look at Figure 8.2 on page 202. How does your state’s position on this issue affect you? Why do you think your state supports or opposes right-to-work laws? 40. Inferring Why are workers in the food service industry least likely to be unionized? Applying Economic Concepts 43. Civilian Labor Force As you go to and from school, take note of the various occupations around you. List at least 10 occupations, and then classify them according to the four major categories of labor. Which category is represented most? Is a category not represented at all? Why do you think that might be? 44. Minimum Wage Poll at least 10 people of various ages, asking for their opinions on the following statement: There should be no minimum wage. Compile the responses and present your findings to the class. Analyzing Visuals 41. Critical Thinking Explain how a supporter of raising the minimum wage would use the information from the graph below. M INIMUM W AGE Interpreting Cartoons 45. Critical Thinking Look at the cartoon below. What goal of the labor union movement does the cartoonist illustrate? What labor action are the beanie babies utilizing to achieve their goal10 1943 Constant dollars Current dollars 1947 1951 1955 1959 1963 1967 1971 1983 1987 1991 1995 1999 2003 2007 1975 1979 Year Writing About Economics 42. Persuasive Writing Based on what you have learned about wage determination, write a short essay persuading a friend to continue his or her education after graduating from high school Atlantic Feature ©2000 Off The Mark/Mark Parisi CHAPTER 8 Employment, Labor, and Wages 225 &The Global Economy YOU “Offshoring” American Jobs to India Have you called a customer service center recently? If so, you may have talked to a person with an American name and an unfamiliar accent. Many U.S. companies have decided to outsource a portion of their business, such as customer support, to companies located in the United States. Others send these jobs abroad, a practice called “off shoring.” India is a favorite location. Job Exodus Customer service positions are not the only jobs headed for India. Work moving offshore also includes processing mortgages, overseeing payrolls, balancing business accounts, and handling insurance claims. When you surf the Internet, you’re using search terms and archives keyed in or scanned mostly by Indian technicians. India is attractive for several reasons. The country provides a large pool of educated people who speak English. In addition, India’s day begins when ours ends, which means that U.S. com panies can work all day and increase productivity by offshoring overnight work to India. With fiber-optic cables wrapped around the world, it is cheap to transmit data from North America to South Asia. Perhaps the most important reason for looking overseas is cheap labor. A software programmer in India earns about $10,000 compared to an American programmer’s salary of roughly $60,000. Salary Comparisons Job United States Software programmer Mechanical engineer IT manager Accountant Financial operations $66,100 $55,600 $55,000 $41,000 $37,625 Sources: Paàras Group; International Labour Organization India $10,000 $5,900 $8,500 $5,000 $5,500 226 UNIT 3 Economic Institutions and Issues Projected Number of U.S. Jobs to Move Overseas by 2015 Art, design Life sciences Legal Architecture Sales Management Business Computer Office Source: Forrester Research, Inc. 29,654 36,770 76,642 184,347 226,564 288,281 348,028 472,632 1,659,310 White-Collar Workers Feel the Pinch Previously reserved for low-wage jobs such as those in textile manufacturing, offshoring today impacts white-collar workers. Some studies estimate that offshoring cost U.S. workers 400,000 jobs in 2004 and predict that it will cost more than 3 million jobs by 2015. Others foresee as many as 4 million jobs lost in the services sector alone. The ranks of high-profile American companies moving parts of their operations to India include Charles Schwab, AOL, American Express, GE, and Microsoft. And the list continues to grow. More than half of Fortune 500 companies have shipped jobs overseas, including Oracle, Dell, Delta Air Lines, J.P. Morgan Chase, British Airways, and Hewlett-Packard. Lower prices for goods and services purchased in the United States Around the clock and around the world productivity for U.S. companies, resulting in more profits Loss of jobs for U.S. workers Bengaluru (Bangalore), India, with a highly educated workforce and a total population of more than 6 million, is a magnet for U.S. companies looking to offshore jobs. Effects of Offshoring Work to India What Does It Mean For You? The good news is that cheaper labor for goods and services means lower prices for you and other consumers. You also benefit from services that are available to you any time of day. For example, if you have a medical emergency that requires x-rays, the digital images can be interpreted by an Indian radiologist overnight, with results reported back to your doctor by the next morning. The bad news is that many Americans may lose their jobs. Offshoring can even change your likelihood of future success. A college degree—even an M.D. or Ph.D.—may not be enough to compete with India’s growing employment pool of cheap, educated labor. Analyzing the Issue 1. Identifying How can using workers in India increase an American company’s productivity? 2. Determining Cause and Effect What are the main reasons why American jobs are sent overseas? 3. Applying Check your local newspaper or Internet news sources for recent reports about companies in your community or state that have sent jobs overseas. On a separate piece of paper, summarize the issues discussed in these articles and describe how they affect you and your community. (t) CARO/Peter Arnold, Inc., (b) Sherwin Crasto/Reuters/Corbis CHAPTER 9 Sources of Government Revenue Why It Matters You have just received your first paycheck and are looking forward to being paid $8 per hour for the 20 hours you worked. You look at your check and . . . “What? This check isn’t for $160! Where’s the rest of my money?” Make a list of the deductions that might be subtracted from your earnings. Read Chapter 9 to learn more about how governments raise revenue. The BIG Idea All levels of government use tax revenue to provide essential goods and services. When we receive paychecks for our work, a portion of our earnings goes to the government for taxes. 228 UNIT 3 Tim Fuller Economics: Principles and Practices Web site at glencoe.com and click Economics: Principles and Practices Web site at glencoe.com and click on Chapter 9—Chapter Overviews to preview chapter information. on Chapter 4—Chapter Overviews to preview chapter information. Chapter Overview Visit the Chapter Overview Visit the SECTION 1 The Economics of Taxation GUIDE TO READING Section Preview In this section, you will learn that taxes are the most important way of raising revenue for the government. Academic Vocabulary • validity (p. 230) • evolved (p. 234) Reading Strategy Content Vocabulary • sin tax (p. 230) • incidence of a tax (p. 231) • tax loophole (p. 232) • individual income tax (p. 232) • sales tax (p. 233) • tax return (p. 233) • benefit principle of taxation (p. 234) • ability-to-pay principle of taxation (p. 234) • proportional tax (p. 235) • average tax rate (p. 235) • Medicare (p. 235) • progressive tax (p. 235) • marginal tax rate (p. 235) • regressive tax (p. 236) Defining As you read the section, complete a graphic organizer similar to the one below by listing the criteria for taxes to be effective. Then |
define each of the criteria in your own words. Effective Taxes PEOPLE IN THE NEWS Teenage Tax Preparers —Atlanta Journal-Constitution Since the tax season got under way . . . [Oakwood High School’s business management students] have prepared 44 returns for community members, fellow students and faculty members, so far netting more than $50,000 in refunds for their clients. The only high school-based Volunteer Income Tax Assistance program in [Georgia], Oakwood provide[s] free tax services for lower-income residents, nonspeakers of English and the disabled. The student volunteers are saving taxpayers money. “Since we’re targeting the low-income, many are not in a position to pay $200 or $300,” [said Gloria Carithers, a senior tax specialist in the IRS Atlanta office]. “That could make the difference in paying a bill or buying something for the family.” ■ An enormous amount of money is required to run all levels of government— and the need seems to be growing every year. Taxes are the primary way to do this, and taxes affect the things we do in more ways than you think. Governments levy a variety of taxes, from sales taxes on items we purchase in stores to the income tax we have to pay on our wages. One way in which we try to minimize taxes is by finding all the exemptions and deductions we are allowed to claim when we file our income tax returns. That is what the students in the news story were doing: helping their clients get the largest refund possible. Comstock Images/Alamy CHAPTER 9 Sources of Government Revenue 229 sin tax relatively high tax designed to raise revenue and discourage consumption of a socially undesirable product Economic Impact of Taxes MAIN Idea Taxes affect the decisions we MAIN Idea make in a variety of ways. Economics & You Have you ever not bought something because you could not afford the tax on it? Read on to find out how taxes affect our behavior. Taxes and other governmental revenues influence the economy by affecting resource allocation, consumer behavior, and the nation’s productivity and growth. In addition, the burden of a tax does not always fall on the party being taxed. Resource Allocation The factors of production are affected whenever a tax is levied. A tax placed on a good or service at the factory raises the cost of production and the price of the product. People react to the higher price in a predictable manner—they buy less. When sales fall, some firms cut back on production, which means that some resources— land, capital, and labor—will have to go to other industries to be employed. Behavior Adjustment Taxes are sometimes used to encourage or discourage certain types of activities. For example, homeowners can use interest payments on mortgages as tax deductions—a practice that encourages home ownership. Interest payments on other consumer debt, such as credit cards, are not deductible—a practice that makes credit card use less attractive. A so-called sin tax—a relatively high tax designed to raise revenue while reducing consumption of a socially undesirable product such as liquor or tobacco—is another example of how a tax can change behavior. For the tax to be effective, however, it has to be reasonably uniform from one city or state to the next so that consumers do not have alternative sales outlets that allow them to avoid the tax. Productivity and Growth Taxes can affect productivity and economic growth by changing the incentives to save, invest, and work. For example, some people think that taxes are already quite high. Why, they argue, should they work to earn additional income if they have to pay much of it out in taxes? While these arguments have validity, it is difficult to tell if we have reached the point where taxes are too high. For example, even the wealthiest individuals pay less than half of their taxable income to state and local governments in the form of income taxes. Are these taxes so high that people do not have the incentive to earn Home Ownership People who purchase homes can deduct the interest on their mortgages. How do deductions affect the total amount of taxes people owe? Corbis Figure 9.1 Shifting the Incidence of a Tax A tax on the producer increases the cost of production and causes a change in supply. Less of the tax can be shifted back to the taxpayer if demand is elastic, as in panel A. More of the tax can be shifted to the taxpayer if demand is inelastic, as in Panel B. Economic Analysis If a tax is placed on medicine, who is likely to bear the greater burden—the producer or the consumer? A E LASTIC D EMAND B I NELASTIC D EMAND See StudentWorks™ Plus or glencoe.com. S + tax S $1 tax on producer D incidence of a tax final burden of a tax Skills Handbook See page R39 to learn about Formulating Questions. Buyer pays 60 cents more because of elastic demand. e c i r P $15.60 $15.00 S + tax S $1 tax on producer D Buyer pays 90 cents more because of inelastic demand. e c i r P $15.90 $15.00 0 6 5 Quantity 0 5.8 6 Quantity an additional $10 million because they can only keep half of it? Would they work any harder if income taxes took only 30 percent of their income? While we do not have exact answers to these questions, we do know that there must be some level of taxes at which productivity and growth would suffer. Incidence of a Tax Finally, there is the matter of who actually pays the tax. This is known as the incidence of a tax—or the final burden of the tax. Suppose a city wants to tax a local electric utility to raise revenue. If the utility is able to raise its rates, consumers will likely bear the burden of the tax in the form of higher utility bills. However, if the company’s rates are regulated, and if the company’s profits are not large enough to absorb the tax increase, then shareholders may get smaller dividends—placing the tax burden on the owners. The company also might delay a pay raise—shifting the burden to its workers. Supply and demand analysis can help us analyze the incidence of a tax. To illustrate, Figure 9.1 shows an elastic demand curve in Panel A and an inelastic demand curve in Panel B. Both panels have identical supply curves labeled S. Now, suppose that the government levies a $1 tax on the producer, thereby shifting the supply curve up by the amount of the tax. In Panel A, the product’s market price increases by 60 cents, which means that the producer must have absorbed the other 40 cents of the tax. In Panel B, however, the same tax on the producer results in a 90cent increase in price, which means that the producer absorbed only 10 cents of the tax. The figure clearly shows that it is much easier for a producer to shift the incidence of a tax to the consumer if the consumer’s demand curve is relatively inelastic. Reading Check Summarizing How do taxes affect businesses and consumers? CHAPTER 9 Sources of Government Revenue 231 Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 9—Student Web Activities for an activity on the individual income tax. tax loophole exception or oversight in the tax law allowing a taxpayer to avoid paying certain taxes individual income tax federal tax levied on the wages, salaries, and other income of individuals Criteria for Effective Taxes MAIN Idea To be effective, taxes must be equitable, easy to understand, and efficient. Economics & You Do you look forward to preparing your personal income tax returns? Read on to learn why you may be apprehensive about tax time. Some taxes will always be needed, so we want to make them as fair and as effective as possible. To do so, taxes must meet three criteria: equity, simplicity, and efficiency. Equity The first criterion is equity, or fairness, which means that taxes should be impartial and just. Problems arise when we ask, what is fair? You might believe that everyone should pay the same amount. Your friend may think that wealthier people should pay more than those earning less. There is no overriding guide to make taxes completely equitable. However, it does make sense to avoid tax loopholes— exceptions or oversights in the tax law that allow some people and businesses to avoid paying taxes. Loopholes are fairness issues, and most people oppose them based on equity. As a result, taxes generally are viewed as being fairer if they have fewer exceptions, deductions, and exemptions. Simplicity A second criterion is simplicity. Tax laws should be written so that both taxpayers and tax collectors can understand them. People seem more willing to tolerate taxes when they understand them. The individual income tax—the federal tax on people’s earnings—is a prime example of a complex tax. The entire federal code is thousands of pages long, and even the simplified instructions from the Internal CAREERS Certified Public Accountant The Work * Prepare, analyze, and verify financial reports that inform the general public and business firms * Provide clients with sound advice on tax advan- tages and disadvantages, and repare their income tax statements * Establish an accounting system and manage cash resources Qualifications * Strong mathematical skills and ability to analyze and interpret numbers and facts * Ability to communicate results of analyses to clients and managers, both verbally and in writing * Bachelor’s degree in accounting, with many positions requiring an additional 30 hours beyond the usual 4-year bachelor’s degree * Successful completion of Uniform CPA Examination 232 UNIT 3 Economic Institutions and Issues JLP/Jose L. Pelaez/Corbis Earnings * Median annual earnings: $50,770 Job Growth Outlook * Faster than average Source: Occupational Outlook Handbook, 2006–2007 Edition Highway Taxes In many states, you have to pay a toll to use certain roads. What does this photo imply about the efficiency of tolls? sales tax general state or city tax levied on a product at the time of sale tax return annual report by a taxpayer filed with the local, state, or federal gov ernment detailing |
income earned and taxes owed Revenue Service (IRS) are lengthy and difficult to understand. As a result, many people dislike the individual income tax code. A sales tax—a general tax levied on most consumer purchases—is much simpler. The sales tax is paid at the time of purchase, and the amount of the tax is computed and collected by the merchant. Some goods such as food and medicine may be exempt, but if a product is taxed, then everyone who buys the product pays the tax. Efficiency A third criterion for an effective tax is efficiency. A tax should be relatively easy to administer and reasonably successful at generating revenue. The individual income tax satisfies this requirement fairly well. An employer usually withholds a portion of an employee’s pay and sends it to the IRS. At the end of the year, the employer notifies each employee of the amount of tax withheld so that the employee can settle any under- or overpayment with the IRS. Because of computerized payroll records, this withholding system is relatively easy. After the close of the tax year on December 31 and before April 15 of the next year, employees file a tax return—an annual report to the IRS summarizing total income, deductions, and taxes withheld. Any difference between the amount already paid and the amount actually owed is settled at that time. Most differences are due to deductions and expenses that lower the amount of taxes owed, as well as additional income not subject to tax withholding. State and local governments usually require tax returns to be filed at the same time. Other taxes, especially those collected in toll booths on state highways, are considerably less efficient. The state has to invest millions of dollars in heavily reinforced booths that span the highway. The cost to commuters, besides the toll, is the wear and tear on their automobiles as they brake for toll booths along the road. Efficiency also means that a tax should raise enough revenue to be worthwhile while not harming the economy. One example is the federal luxury tax on small private aircraft in the early 1990s. The IRS collected only $53,000 in revenues during the first year of this tax because few planes were sold. This turned out to be less than the unemployment benefits paid to workers who lost jobs in that industry, so Congress quickly repealed that luxury tax. Reading Check Stating Why is equity important? Chris Minerva /Index Stock Imagery CHAPTER 9 Sources of Government Revenue 233 benefit principle of taxation belief that taxes should be paid according to benefits received regardless of income ability-to-pay principle of taxation belief that taxes should be paid according to level of income, regardless of benefits received Two Principles of Taxation MAIN Idea Taxes can be levied on the basis of benefits received or the ability to pay. Economics & You Do you think the taxes you pay are fair? Read on to see if you prefer one principle of taxation over another. Taxes in the United States are based on two principles that have evolved over the years. These principles are the benefit principle and the ability-to-pay principle. Benefit Principle Gasoline and tire taxes are used to pay for the upkeep of roads. What are the limitations of gasoline taxes? Benefit Principle The benefit principle of taxation states that those who benefit from government goods and services should pay in proportion to the amount of benefits they receive. Gasoline taxes are a good example of this principle. Because the gas tax is built into the price of gasoline, people who drive more than others pay more gas taxes—and therefore pay for more of the upkeep of our nation’s highways. Taxes on truck tires operate on the same principle. Since heavy vehicles like trucks are likely to put the most wear and tear on roads, a tire tax links the cost of highway upkeep to the user. Despite its attractive features, the benefit principle has two limitations. The first is that those who receive government services may be the ones who can least afford to pay for them. Recipients of welfare payments or people who live in subsidized housing, for example, usually have the lowest incomes. Even if they could pay something, they would not be able to pay in proportion to the benefits they receive. The second limitation is that benefits are often hard to measure. After all, the people who buy the gas are not the only ones who benefit from the roads built with gas taxes. Owners of property, hotels, and restaurants along the way are also likely to benefit from the roads that the gas tax helps provide. Ability-to-Pay Principle The belief that people should be taxed according to their ability to pay, regardless of the benefits they receive, is called the ability-to-pay principle of taxation. An example is the individual income tax, which requires people with higher incomes to pay more than those who earn less. This principle is based on two factors. First, we cannot always measure the benefits derived from government spending. Second, it assumes that people with higher incomes suffer less discomfort paying taxes than people with lower incomes. For example, a family of four with an annual taxable income of $20,000 needs every cent to pay for necessities. At a tax rate of about 13 percent, this family pays $2,623—a huge amount for them. A family of four with taxable income of $100,000 can afford to pay a higher average tax rate with much less discomfort. Reading Check Explaining Which principle of taxation do you prefer, and why? Royalty Free/Corbis Figure 9.2 Three Types of Taxes Progressive, proportional, and regressive are the three main types of taxes. Economic Analysis Under which type of tax do individuals with lower incomes pay a smaller percentage than do those with higher incomes? Type of tax Income of $10,000 Income of $100,000 Summary Proportional (City income tax) $97.50 or 0.975% of income $975.00 or 0.975% of income As income goes up, the percentage of income paid in taxes stays the same. Progressive (Federal income tax) $1,000 paid in taxes, or 10% of total income $25,000 paid in taxes, or 25% of total income As income goes up, the percentage of income paid in taxes goes up. Regressive (State sales tax) $5,000 in food and clothing purchases, taxed at 4% for a total tax of $200 or 2% of income $20,000 in food and clothing purchases, taxed at 4% for a total tax of $800 or 0.8% of income As income goes up, the percentage of income paid in taxes goes down. Three Types of Taxes MAIN Idea All taxes can be broken down into three categories—proportional, progressive, and regressive. Economics & You You just learned about two principles of taxation. Find out how the principles apply to different types of taxes. Three general types of taxes exist in the United States today—proportional, progressive, and regressive. As Figure 9.2 shows, each type of tax is classified according to the way in which the tax burden changes as income changes. To calculate the tax burden, we divide the amount that someone pays in taxes by their taxable income. If a person pays $100 in taxes on a $10,000 income, then the tax burden is 0.01, or 1 percent. Proportional Tax A proportional tax imposes the same percentage rate of taxation on everyone, regardless of income. If the income tax rate is 20 percent, an individual with $10,000 in taxable income pays $2,000 in taxes. A person with $100,000 in taxable income pays $20,000. If the percentage tax rate is constant, the average tax rate—total tax paid divided by the total taxable income—also is constant, regardless of income. If a person’s income goes up, the percentage of total income paid in taxes does not change. Few proportional taxes are used in the United States. One example is the 15 percent tax rate on corporate dividends. Regardless of overall income and how much someone receives in corporate dividends, individuals only pay 15 percent of that amount in personal income taxes. Another example is the tax that funds Medicare—a federal health-care program available to all senior citizens, regardless of income. The Medicare tax is 1.45 percent of income, with no limit on the amount of income taxed. As a result, everyone who receives a paycheck pays exactly the same rate, regardless of the size of the paycheck. Progressive Tax A progressive tax is a tax that imposes a higher percentage rate of taxation on higher incomes than on lower ones. This tax uses a progressively higher marginal tax rate, the tax rate that applies to the next dollar of taxable income. proportional tax tax in which the percentage of income paid in tax is the same regardless of the level of income average tax rate total taxes paid divided by the total taxable income Medicare federal health-care program for senior citizens progressive tax tax in which the percentage of income paid in tax rises as the level of income rises marginal tax rate tax rate that applies to the next dollar of taxable income CHAPTER 9 Sources of Government Revenue 235 regressive tax tax in which the percentage of income paid in tax goes down as income rises For example, suppose the law required everyone to pay a rate of 10 percent on all taxable income up to $7,500, and then a rate of 15 percent on all income after that. If someone had taxable income of $5,000, this person would have to pay 10 percent on the 5,001st dollar earned. In this case, the marginal tax rate on the 5,001st dollar would be 10 percent. However, if the same person had taxable income of $7,500, then the marginal tax rate would be 15 percent on the 7,501st dollar earned. In either case, the marginal tax is always the tax that is paid on the very next dollar of taxable income. The individual income tax code used in the United States today is structured just this way. It currently starts at 10 percent and then jumps to 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent, depending on the amount of taxable income. One important outcome of this structure is that |
progressively higher marginal brackets also cause the average tax rate to go up as taxable income goes up. Regressive Tax A regressive tax is a tax that imposes a higher percentage rate of taxation on low incomes than on high incomes. For example, a person in a state with a 4 percent sales tax and an annual income of $10,000 may spend $5,000 on food and clothing and pay sales taxes of $200 (or .04 times $5,000). A person with an annual income of $100,000 may spend $20,000 on food and clothing and pay state sales taxes of $800 (or .04 times $20,000). On a percentage basis, the person with the lower income pays 2 percent (or $200 divided by $10,000) of income in sales taxes, while the person with the higher income pays 0.8 percent (or $800 divided by $100,000). As a result, the 4 percent sales tax is regressive because the individual with the higher income pays a smaller percentage of income in sales taxes than does the individual with the lower income. Reading Check Synthesizing Which of the types of taxes should be used for income taxes? Why? SECTION 1 Review Vocabulary 1. Explain the significance of sin tax, incidence of a tax, Critical Thinking 5. The BIG Idea Compare and contrast the characteristics tax loophole, individual income tax, sales tax, tax return, benefit principle of taxation, ability-to-pay principle of taxation, proportional tax, average tax rate, Medicare, progressive tax, marginal tax rate, and regressive tax. Main Ideas 2. Describing Use a graphic organizer like the one below to describe the economic impact of taxes. Impact of Taxes 3. Identifying What are the criteria for effective taxes? 4. Summarizing What are the main points of the two principles of taxation? 236 UNIT 3 Economic Institutions and Issues of proportional, progressive, and regressive taxes. 6. Evaluating Using the criteria described in this chapter, how would you evaluate the effectiveness of the personal income tax? 7. Analyzing Visuals School districts often are supported by property taxes. These taxes are based on a percentage of the value of a house or other real estate. Look at Figure 9.2 on page 235. In which category of taxes does the property tax fall? Applying Economics 8. Equity Which of the two principles of taxation—the benefit principle or the ability-to-pay principle—do you think is more equitable? Explain your answer. Be sure to include in your answer how the two principles differ from one another. ENTREPRENEUR Profiles in Economics Monica Garcia Pleiman (1964– ) • president and CEO of OMS, a technology consulting firm • publisher of Hispanic lifestyles magazine Latino SUAVE • cofounder of the Latina Chamber of Commerce Small Start Denver-based businesswoman Monica Garcia Pleiman knew early what she wanted to do with her life. As the daughter of a small business owner, she learned that “hard work and entrepreneurial skills” could bring financial success. She also took her high school’s only computer class—and loved it. In 1987 Pleiman earned a degree in Information Science, a 95 percent male program. After working for both large corporations and small companies, she formed the consulting firm Optimum Management Systems (OMS). Small Business Pleiman uses several successful strategies. Her practice of sharing the credit and allowing employees to grow in their jobs has resulted in a loyal OMS workforce—unusual in today’s highly competitive, ever-changing technology sector. She tries to maintain a small-business environment while providing large-company benefits. She also focuses on serving small and minority businesses. Finally, she has taken advantage of assistance by the federal government’s Small Business Administration, including attending the Minority Business Executive Program sponsored by the SBA. These strategies have paid off. OMS grew 910 percent from its start in 1998 to 2003. Revenues over $7 million per year make it one of the country’s most successful minority-owned businesses. This success allowed Pleiman to branch out and publish a new bilingual lifestyle magazine, Latino SUAVE. Examining the Profile 1. Summarizing What strategies helped Pleiman become a successful entrepreneur? 2. For Further Research What types of assistance does the Small Business Administration offer to entrepreneurs? Pleiman descends from a long line of hard workers. Her Spanish ancestors settled Colorado 200 years ago. With six brothers, “I learned how to compete against men, to prove I could make it as a woman and as a minority.” Dave Neligh CHAPTER 9 Sources of Government Revenue 237 SECTION 2 Federal, State, and Local Revenue Systems GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that federal, state, and local governments rely on different revenue sources. • implemented (p. 242) • considerably (p. 243) Content Vocabulary • Internal Revenue Service (IRS) (p. 238) • payroll withholding system (p. 239) • indexing (p. 239) • FICA (p. 239) • payroll tax (p. 239) • corporate income tax (p. 240) • excise tax (p. 240) • estate tax (p. 241) • gift tax (p. 241) • customs duty (p. 241) • user fee (p. 241) • intergovernmental revenue (p. 242) • property tax (p. 244) • tax assessor (p. 244) • natural monopoly (p. 244) Reading Strategy Describing As you read the section, complete a graphic organizer like the one below to identify and describe the revenue sources for federal, state, and local governments. Revenue sources Federal Local State —The Columbus Dispatch ISSUES IN THE NEWS Taxing Tycoons Come to Newport, Rhode Island, and see what America was like before the income tax. The Elms is a Gilded Age mansion graced by a Louis XV ballroom and tapestries from Imperial Russia. Its owner made his tax-free fortune off the coal mines of Pennsylvania and West Virginia. [B]ut by the dawn of the 20th century, American farmers, miners, and factory workers started thinking that the Vanderbilts and their ilk should contribute more to the country. And so on October 3, 1913, President Wilson signed the bill that created an income tax. It touched only the wealthiest 4 percent of Americans. ■ Internal Revenue Service (IRS) branch of the U.S. Treasury Department that collects taxes The first federal income tax was enacted by the Union government in 1861 to help finance the Civil War. It was repealed in 1872. A later income tax was found unconstitutional in 1893, but it had the potential to be a major source of revenue. It was not until the ratification of the Sixteenth Amendment in 1913 that Congress could enact the current individual income tax. Since then, the top marginal tax rate has varied widely, from 1 percent for incomes over $3,000 in 1913 to 94 percent for the highest incomes during World War II. The Internal Revenue Service (IRS) is the branch of the U.S. Treasury Department in charge of collecting taxes today. 238 UNIT 3 Economic Institutions and Issues James Lemass/Index Stock Imagery Federal Government Revenue Sources MAIN Idea Individual income taxes, FICA, and borrowing constitute the main sources of government revenue. Economics & You Have you ever wondered what “FICA” on your pay stub means? Read on to find out about one of the main federal revenue sources. The federal government gets its revenue from a number of sources. Taxes are the primary source of revenue, but borrowing also plays a big part. As shown in Figure 9.3, the four largest sources of government revenue are individual income taxes, Social Security taxes, borrowing, and corporate income taxes. Individual Income Taxes The main source of federal government revenue is the individual income tax. In most cases, the tax is collected with a payroll withholding system, a system that requires an employer to automatically deduct income taxes from a worker’s paycheck and send them directly to the IRS. Because inflation can push a worker into a higher tax bracket, the tax code is also indexed. Indexing is an upward revision of the tax brackets to keep workers from paying more in taxes just because of inflation. Workers might otherwise move into a higher tax bracket when they receive a pay raise that makes up for inflation. FICA Taxes The second most important federal revenue source is FICA. FICA is the Federal Insurance Contributions Act tax, which is levied on employers and employees equally to pay for Social Security and Medicare. These two taxes are sometimes called payroll taxes because they are deducted from paychecks. In 2007 the Social Security component of FICA was 6.2 percent of wages and salaries up to $97,500. Above that amount, Social Security taxes are not collected, regardless of income. This means that a person with Figure 9.3 Federal Government Revenue Sources payroll withholding system system that automatically deducts income taxes from paychecks on a regular basis indexing adjustment of the tax brackets to offset the impact of inflation FICA Federal Insurance Contributions Act; tax levied on employers and employees to support Social Security and Medicare payroll tax tax on wages and salaries deducted from paychecks to finance Social Security and Medicare 2007 2001 34.9% Social security taxes 31.9% 7.6% Corporate income taxes 9.4% 3.3% 1.0% 1.4% 0% 1.9% Excise taxes Customs duties Estate and gift taxes Borrowing Miscellaneous 2.7% 1.0% 0.9% 12.8% 1.7% 49.9% Individual income taxes 39.6% Source: Economic Report of the President, 2006 In 2001 the federal government saved 1.7¢ of every dollar it spent. By 2007, the government was borrowing 12.8¢ for every dollar spent. The federal government now borrows more from investors than it collects from corporations in taxes. Economic Analysis What is the percentage of total revenue for the first four items? &The Global Economy YOU High Taxes—Are You Sure? You examine your paycheck and are dismayed to see how much money has been taken out for taxes. Before you get too outraged, however, do the math. What percentage of the total amount has been withheld for taxes? Ten percent? Twenty pe |
rcent? This is a far cry less than would be withheld in many other countries. One measure of a country’s tax burden is the ratio of its tax revenues to gross domestic product (GDP). Despite the criticism over high taxes in the United States, our federal government’s revenues as a percentage of GDP are much lower than people realize. Sweden is usually ranked first as the country with the world’s highest taxes, whereas the United States boasts one of the lowest tax revenue-to-GDP ratios in the industrial world. TOTAL TAX REVENUE AS A PERCENTAGE OF GDP 50% 40 30 20 10 0 Sweden d Finlan France Spain Canada nited dom U g Kin ustralia nited States U A Japan Source: Organization for Economic Co-operation and Development (OECD) corporate income tax tax on corporate profits excise tax general revenue tax levied on the manufacture or sale of selected items taxable income of $97,500 pays the same Social Security tax—$6,045—as does someone who earns $1,000,000,000. In 1965 Congress added Medicare to the Social Security program. The Medicare component of FICA is taxed at a flat rate of 1.45 percent. Unlike Social Security, there is no cap on the amount of income taxed, which makes it a proportional tax. Borrowing Borrowing by the federal government is the third-largest source of federal revenue. Because tax revenues fluctuate, the government never knows exactly how much it will need to borrow. Therefore, it continues with its spending as allocated in the budget. If it does not collect enough money in taxes and user fees, it simply borrows the rest by selling bonds to investors. Figure 9.3 shows that the federal government has become dependent on this source of funds, with the amount of money borrowed exceeding the total amount of taxes collected from corporations. The increased 240 UNIT 3 Economic Institutions and Issues borrowing has been mainly due to the increased levels of government spending since 2001 that have outpaced federal revenue collection. Corporate Income Taxes The fourth-largest source of federal revenue is the corporate income tax—the tax a corporation pays on its profits. The corporation is taxed separately from individuals because the corporation is recognized as a separate legal entity. Several marginal tax brackets, which are slightly progressive, apply to corporations. The first is at 15 percent on all income under $50,000. The marginal brackets then rise slightly after that, and eventually a 35 percent marginal tax applies to all profits in excess of $18.3 million. Excise Taxes The excise tax—a tax on the manufacture or sale of selected items such as gasoline and liquor—is the fifth-largest source of federal government revenue. Some early excise taxes were on carriages, snuff, and liquor. Today federal excise taxes are levied on telephone services, tires, legal betting, and coal. Because low-income families spend larger portions of their incomes on these goods than do high-income families, excise taxes tend to be regressive. Estate and Gift Taxes The estate tax is the tax on the transfer of property when a person dies. Estate taxes can range from 18 to 50 percent of the value of the estate, although estates worth less than $2,000,000 are exempt. The exemption will be raised to $3,500,000 by 2009, but because these amounts are so high, fewer than 2 percent of all estates pay any tax at all. The gift tax is a tax on the transfer of money or wealth and is paid by the person who makes the gift. The gift tax is used to make sure that wealthy people do not try to avoid taxes by giving away their estates before they die. Figure 9.3 shows that estate and gift taxes account for only a small fraction of total federal government revenues. Customs Duties A customs duty is a charge levied on goods brought into the United States from other countries. The Constitution gives Congress the authority to levy customs duties. Congress then can decide which foreign imports will be taxed and at what rate. Many types of goods are covered, ranging from automobiles to silver ore. The duties are relatively low and produce little federal revenue today. Before the enactment of the income tax amendment, however, they were the largest income source for the federal government. Miscellaneous Fees Finally, only a fraction of federal revenue is collected through various miscellaneous fees. One example of a miscellaneous fee is a user fee—a charge levied for the use of a good or service. User fees were widely promoted by President Ronald Reagan, who wanted to find revenue sources that did not involve taxes. User fees include entrance charges at national parks, as well as the fees ranchers pay when their animals graze on federal land. These fees are essentially taxes based on the benefit principle, because only the individuals who use the services pay them. People also seem more comfortable with them since they are not called “taxes.” Reading Check Explaining Why are corporations taxed separately from individuals? estate tax tax on the transfer of property when a person dies gift tax tax paid by the donor on transfer of money or wealth customs duty tax on imported products user fee fee paid for the use of a good or service User Fees Visitors to national parks such as Kenai Fjords National Park in Alaska have to pay an entrance fee. How are user fees assessed intergovernmen tal revenue funds that one level of government receives from another level of government Skills Handbook See page R50 to learn about Using Bar and Circle Graphs. State Government Revenue Sources government to help fund the state’s expenditures for welfare, education, highways, health, and hospitals. MAIN Idea States rely on funds from the federal government in addition to income taxes and sales taxes. Economics & You Do you ever wonder why you pay a tax on items you purchase in a store? Read on to learn about sales taxes. State governments collect their revenues from several sources. Figure 9.4 shows the relative proportions of these sources, the largest of which are examined below. Intergovernmental Revenues The largest source of state revenue consists of intergovernmental revenue—funds collected by one level of government that are distributed to another level of government for expenditures. States receive the majority of these funds from the federal Sales Taxes Most states also have implemented sales taxes to add to their revenue. A sales tax is a general tax levied on consumer purchases of nearly all products. The tax is a percentage of the purchase price, which is added to the final price the consumer pays. Merchants collect the tax at the time of sale. The taxes are then turned over to the proper state government agency on a monthly or other periodic basis. Most states allow merchants to keep a small portion of what they collect to compensate for their time and bookkeeping costs. The sales tax is the second largest source of revenue for states, although five states—Alaska, Delaware, Montana, New Hampshire, and Oregon— do not have a general sales tax. Figure 9.4 State and Local Government Revenue Sources See StudentWorks™ Plus or glencoe.com. State governments Local governments State and local governments have their own sources of revenue. While many have an individual income tax, this is not a major source of funding. Economic Analysis What are the two largest sources of state and local revenues? 26.6% 20.1% 13.4% Intergovernmental revenue 34.9% Sales taxes Individual income tax 5.4% 1.5% 12.2% Employee retirement and insurance 0.8% 4.7% 4.4% 2.2% 2.1% 1.8% 0.9% 0.8% Borrowing Higher education fees Interest earnings Corporate income tax Hospital fees Utility revenue Property taxes 10.8% Other 4.5% 0.6% 2.4% 0.2% 3.7% 7.6% 24.0% 14.4% Taxes Most people have to pay taxes to all levels of government. What does the cartoon imply about the impact of taxes on people Individual Income Taxes All but seven states—Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming—rely on the individual income tax for revenue. The tax brackets in each state vary considerably, and taxes can be progressive in some states and proportional in others. Other Revenues States rely on a variety of other revenue sources, including interest earnings on surplus funds; tuition and fees collected from state-owned colleges, universities, and technical schools; corporate income taxes; and hospital fees. While the percentages for revenue sources in Figure 9.4 are representative of most states, wide variations among states exist. For example, Alaska is the only state without either a general sales tax or an income tax, so it has to rely on other taxes and fees for its operating revenue. Reading Check Contrasting How do states without individual income taxes find sources of revenue? Local Government Revenue Sources MAIN Idea Local governments rely mostly on intergovernmental revenue and property taxes. Economics & You Do you hope to own a house some day? Read on to learn how this will add another tax to those you are already paying. Like state governments, local governments have a variety of revenue sources, as shown in Figure 9.4. These sources include taxes and funds from state and federal governments. The main categories are discussed below. Intergovernmental Revenues Local governments receive the largest part of their revenues—slightly more than one-third—in the form of intergovernmental transfers from state governments. These funds are generally intended for education and public welfare. A much smaller amount comes directly from the federal government, mostly for urban renewal. Harley Schwadron/www.CartoonStock.com CHAPTER 9 Sources of Government Revenue 243 Figure 9.5 State and Local Taxes as a Percentage of State Income State income is the sum of all income earned by all people in the state. State and local governments receive a percentage of that income as tax revenue from a number of sources. The five states without sales taxes—Alaska, Delaware, Montana, New Hampshire, and Oregon |
—rely on other taxes to provide state revenues. Economic Analysis Which states have the highest level of taxes? The lowest level? 6.4 11.5 10.0 9.6 9.5 10.3 9.5 10.1 10.0 10.9 9.5 10.2 9.9 U.S. Average 10.1 Source: Tax Foundation, 2006 9.4 8.8 10.9 10.7 10.0 11.4 9.8 10.9 9.4 9.4 9.3 10.5 10.4 7.4 11.1 13.0 10.1 10.3 11.0 10.5 10.3 8.3 12.0 9.7 9.7 10.0 9.8 11.4 10.5 10.4 8.0 10.3 12.2 10.0 8.7 9.8 9.9 9.2 property tax tax on tangible and intangible possessions such as real estate, buildings, furniture, stocks, bonds, and bank accounts tax assessor person who examines and assesses property values for tax purposes natural monopoly market structure in which average costs of production are lowest when a single firm exists (also see page 176) Property Taxes Utility Revenues The second-largest source of revenue for local governments is the property tax—a tax on tangible and intangible possessions. Such possessions usually include real estate, buildings, furniture, farm animals, stocks, bonds, and bank accounts. Most states also assess a property tax on automobiles. The property tax that raises the most revenue is the tax on real estate. Taxes on other personal property, with the exception of automobiles, are seldom collected because of the problem of valuation. For example, how would the tax assessor—the person who assigns value to property for tax purposes—know the reasonable value of everyone’s wedding silver, furniture, clothing, or other tangible property? Instead, most communities find it more efficient to hire one or more individuals to assess the value of a few big-ticket items such as buildings and motor vehicles. The third-largest source of local revenue is the income from public utilities that supply water, electricity, sewerage, and even telecommunications. Because of economies of scale, many of of these companies are natural monopolies. A community needs only one set of electrical power lines or underground water pipes, for example, so one company usually supplies all of the services. When people pay their utility bills, the payments are counted as a source of revenue for local governments. Sales Taxes Many cities have their own sales taxes. Merchants collect these taxes along with the state sales taxes at the point of sale. While these taxes typically are much lower than state sales taxes, they are the fourth most important source of local government revenues. 244 UNIT 3 Economic Institutions and Issues Other Revenue Sources Figure 9.4 on page 242 shows a variety of ways in which local governments collect their remaining revenues. Some local governments receive a portion of their funds from hospital fees. Others may collect income taxes from individuals and profit taxes from corporations. Still another revenue source for local governments is the interest on invested funds. If local governments spend more than they collect in revenues, they can borrow from investors. While borrowed funds are small compared to those of the federal government, they form an important source of local government funding. Local governments look for revenues in a number of ways. Still, the revenue sources available in general are much more limited than those available to the state and federal levels of government. Reading Check Recalling Which property tax earns the most revenue for local governments? Tax Assessments Tax assessors determine the value of property for tax purposes. Why are property taxes important for local communities? SECTION 2 Review Vocabulary 1. Explain the significance of Internal Revenue Service (IRS), payroll withholding system, indexing, FICA, payroll tax, corporate income tax, excise tax, estate tax, gift tax, customs duty, user fee, intergovernmental revenue, property tax, tax assessor, and natural monopoly. Main Ideas 2. Listing Use a graphic organizer like the one below to list the federal government’s major revenue sources. Major Sources of Federal Government Revenue 3. Describing How do the major revenue sources for state and local governments differ? Critical Thinking 4. The BIG Idea Federal, state, and local governments receive revenue from various sources. Which source do you think best satisfies the tax criteria discussed in Section 1? Defend your answer in a written paragraph. 5. Drawing Conclusions Why do you think sales taxes are generally applied to food and beverages purchased in restaurants, but not to those purchased in stores? 6. Analyzing Visuals Look at Figure 9.4 on page 242. Why do you think the revenue from income taxes and property taxes differ so much between state and local governments? 7. Synthesizing How do excise taxes differ from other taxes such as sales taxes or estate taxes? Applying Economics 8. User Fees User fees have been compared to taxes based on the benefit principle of taxation. Define user fees in your own words. What are the pros and cons of user fees for national parks? photocritic.org/Alamy Images CHAPTER 9 Sources of Government Revenue 245 CASE STUDY Dreaded Tax Returns Buried in Paper Every spring, you can tell it’s close to the April 15 tax deadline by the anxious faces of frustrated taxpayers and exhausted accountants. The U.S. tax system is one of the most complicated in the world, with almost 17,000 pages of tax code and more than 600 forms. Record keeping, education, and compliance cost the nation $265 billion annually. In 2005 it took about 115,000 Internal Revenue Service (IRS) employees and almost $10.7 billion to collect about $1 trillion from 125 million taxpayers and 7 million businesses. P ERCENTAGE OF T AXPAYERS U SING P ROFESSIONAL H ELP 65% 60 55 50 45 40 35 ’85 ’87 ’89 ’91 ’93 ’95 Year ’97 ’99 ’01 ’03 Source: Internet Revenue Service Time is Money Because the tax code has become so complex, more and more Americans hire tax preparers to help them with their returns. On top of that, about 2.2 million taxpayers overpay—by an average of $438—because they either don’t itemize deductions or don’t include all deductions or exemptions they could claim. Although many Americans file their tax returns online, they still spend an average of 17 hours completing the forms. The complexity of the system has caused many people to long for a simpler flat-tax system. 246 UNIT 3 Economic Institutions and Issues Royalty-Free/Corbis The European Solution Several eastern European countries have adopted a flat tax, where everyone pays the same percentage above an exempt amount, regardless of income. The first was the Baltic republic of Estonia, which adopted a flat tax rate of 26 percent in 1994. Most Estonians take only 5 to 20 minutes to complete and electronically file an “e-postcard.” The country’s tax department spends one penny for every dollar of income tax collected, compared to 25 cents the IRS spends in the United States. NEWS FLASH The Longest Return General Electric’s 2006 tax return was 24,000 pages long. Had they filed a paper return, it would have been a stack 8 feet high; instead, they filed a 237-megabyte electronic return. Analyzing the Impact 1. Summarizing Why is the U.S. income tax system so complicated? 2. Drawing Conclusions Do you think it is easier for a small country like Estonia to implement a flat tax than it would be for the United States? Explain. SECTION 3 Current Tax Issues and Reforms GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that one consequence of tax reform was to make the individual tax code more complex than ever. Content Vocabulary • payroll withholding statement (p. 248) • accelerated depreciation (p. 249) • investment tax credit (p. 249) • alternative minimum tax (p. 249) • capital gains (p. 250) • flat tax (p. 251) • value-added tax (VAT) (p. 252) • concept (p. 251) • controversial (p. 252) Reading Strategy Listing As you read the section, complete a graphic organizer like the one below by listing the advantages and disadvantages of the flat tax. Include a definition of flat tax in your own words. Advantages Disadvantages Flat tax Value-added tax ISSUES IN THE NEWS A Trophy Loophole —The San Francisco Chronicle One of the looniest tax loopholes imaginable . . . [is] . . . a tax break for big-game hunters who can deduct the cost of an expensive safari when they donate the stuffed trophy to a museum. By using tax-code provisions designed to encourage charitable donations, a hunter can give away a trophy specimen. This gives a fat tax break to the hunter. It’s also created a system of tax dodging and shady dealing. Little-known museums exist largely to take in the trophies and sign tax receipts. Senator Charles Grassley . . . wants to end such hunting deductions [but] a similar proviso is missing from a tax overhaul in the House. . . . ■ The individual tax code is incredibly complex. The complete code is about 17,000 pages long and contains approximately 9 million words. It has been estimated that Americans spend more than 7 billion hours every year filling out their federal tax returns for the IRS. Every year, magazines like Money ask professional tax preparers to fill out tax returns for a hypothetical family—only to find out that no two returns are the same. If experts can’t get it right, then the rest of us will obviously have a difficult time. Also, it is all too easy for lawmakers to insert special-interest provisions in the tax code, such as the one in the news story above. It is no wonder that the tax code has been amended about 14,000 times in the last 20 years—and Congress is still not done with changes! Randy Wells/Corbis CHAPTER 9 Sources of Government Revenue 247 payroll withholding statement document attached to a paycheck summarizing pay and deductions Personal Finance Handbook See pages R24–R27 for more information on paying taxes. Examining Your Paycheck MAIN Idea The income taxes you pay are summarized on the stub that is attached to your paycheck. Economics & You Do you have a job where your taxes are taken out before you are paid? Read on to learn how these taxes |
are deducted from your paycheck. Most of the federal, state, and local taxes are deducted directly from your paycheck. Employers list these deductions on the payroll withholding statement—the stub attached to a paycheck that summarizes income, tax withholdings, and other deductions, as shown in Figure 9.6. The worker to whom the check belongs makes $10 an hour and receives a check every two weeks. If the length of the workweek is 40 hours, the worker’s gross pay amounts to $800. The worker is single, has no deductions, and lives and works in Kentucky. According to withholding tables the federal government supplied for that year, biweekly workers making at least $800, but less than $820, have $104.70 withheld from their paychecks every pay period. Similar tables for the state of Kentucky specify that $40.01 is withheld for state income taxes. Because these are both estimates, and because even minor differences between the amounts withheld and the amount actually owed can grow, the worker will file state and federal tax returns between January 1 and April 15 of the following year to settle the differences. Another deduction is the half-percent city income tax that amounts to $4. Because the amount is relatively small, most cities do not require taxpayers to file separate year-end tax forms. The FICA tax amounts to 7.65 percent (6.20 percent for Social Security and 1.45 percent for Medicare) of $800, or $61.20. The FICA is deducted from the gross pay, along with $3.20 in miscellaneous deductions, which leaves a net pay of $586.89. If the worker has insurance payments or retirement contributions, or puts money into a credit union, more deductions will appear on the pay stub. Reading Check Summarizing How are payroll deductions calculated? Figure 9.6 Biweekly Paycheck and Withholding Statement 2,195,903 21-2 000 Number Date June 29 07 20 The withholding statement attached to your paycheck summarizes the federal and state tax deductions from your pay. Other withholdings may include city income taxes and voluntary deductions, such as health insurance payments and savings plans. Economic Analysis What percentage of this individual’s pay has been deducted from the paycheck? Pay to the order of Sara Pena ˜ $ 586.89 Five Hundred Eighty-Six Dollars and 89/100 Dollars Memo Treasurer PLEASE DETACH AND RETAIN THIS PORTION AS YOUR RECORD OF EARNINGS AND DEDUCTIONS Date Pay End Vo. No. Emp. No. Hrs. Misc. Cr. Un. Ins. Gross 6/29/07 6/23/07 1376 80 3.20 104 70 40 01 4 00 61 20 800 00 586 89 Federal State City FICA Ret. Bonds Other Net Figure 9.7 Tax Table for Single Individuals, 2006 If taxable income is over . . . But not over . . . The tax is: $0 $7,550 $30,650 $74,200 $154,800 $336,550 $7,550 $30,650 $74,200 $154,800 $336,550 no limit 10% of the amount over $0 $755 plus 15% of the amount over $7,550 $4,220 plus 25% of the amount over $30,650 $15,107.50 plus 28% of the amount over $74,200 $37,675.50 plus 33% of the amount over $154,800 $97,653.00 plus 35% of the amount over $336,550 According to the individual income tax table, a single individual with $6,000 of taxable income would pay $6,000 x .10, or $600 in taxes. Economic Analysis How much in taxes would an individual with $40,000 of taxable income pay? Source: IRS Schedule X Tax Reform MAIN Idea Numerous changes have been made to the federal income tax code since 1981. Economics and You Do you or your family pay federal income taxes? Read on to learn why keeping up with the tax code is so difficult. Tax reform has received considerable attention recently. Since 1981, there have been more changes in the tax code than at any other time in our nation’s history. Tax Reform in 1981 When Ronald Reagan was elected president in 1980, he believed that high taxes were the main stumbling block to economic growth. In 1981 he signed the Economic Recovery Tax Act, which included large tax reductions for individuals and businesses. Before the Recovery Act, the individual tax code had 16 marginal tax brackets ranging from 14 to 70 percent. The act lowered the marginal rates in all brackets, capping the highest marginal tax at 50 percent. In comparison, today’s tax code, shown in Figure 9.7, has six marginal brackets ranging from 10 to 35 percent. Businesses also got tax relief in the form of accelerated depreciation—earlier and larger depreciation charges—which allowed firms to reduce federal income tax payments. Another section of the act introduced the investment tax credit—a reduction in business taxes that are tied to investment in new plants and equipment. For example, a company might purchase a $50,000 machine that qualified for a 10 percent, or $5,000, tax credit. If the firm owed $12,000 in taxes, the credit reduced the tax owed to $7,000. Tax Reform: 1986, 1993 By the mid-1980s, the idea that the tax code favored the rich and powerful was gaining momentum. In 1983 more than 3,000 millionaires paid no income taxes. In 1986 Congress passed sweeping tax reform that made it difficult for the very rich to avoid taxes altogether. The alternative minimum tax—the personal income tax rate that applies whenever the amount of taxes paid falls below a designated level—was strengthened. Under this provision, people had to pay a minimum tax of 20 percent, regardless of other circumstances or loopholes in the tax code. As the United States entered the 1990s, the impact of 10 years of tax cuts was beginning to show. Government spending was growing faster than revenues, and the government had to borrow more. The resulting tax reform of 1993 was driven more by the need for the government to balance its accelerated depreciation schedule that spreads depreciation over fewer years to generate larger tax reductions investment tax credit tax credit given for purchase of equipment alternative minimum tax personal income tax rate that applies to cases in which taxes would otherwise fall below a certain level Skills Handbook See page R54 to learn about Understanding Percentages. CHAPTER 9 Sources of Government Revenue 249 Figure 9.8 Total Government Receipts per Capita, Adjusted for Inflation Although a recession in 2001 reduced revenues from 2002 to 2003, total revenue collections by all levels of government have grown dramatically over the years. Economic Analysis How does the graph reflect the tax reforms since 1981? T OTAL G OVERNMENT R ECEIPTS AS A P ERCENTAGE OF GDP Total government Federal government State and local government 40 35 30 25 20 15 10 5 0 1959 1962 1965 1968 1971 1974 1977 1980 1986 1989 1992 1995 1998 2001 2004 2007 1983 Year Source: Economic Report of the President, 2006 capital gains profits from the sale of an asset held for 12 months or longer budget than to overhaul the tax brackets. As a result, two top marginal tax brackets of 36 and 39.6 percent were added. Tax Reform in 1997 The next significant reform followed four years later with the Taxpayer Relief Act of 1997. The forces that created it were both economic and political. On the economic side, the government found itself with unexpectedly high tax revenues in 1997. The two new marginal tax brackets of 36 and 39.6 percent that had been added in 1993, along with the closure of some tax loopholes, meant that most people paid more taxes than before. On the political side, the Republicans had gained a firm majority in Congress and now saw a need to fulfill a commitment to their supporters. They reduced the tax on capital gains—profits from the sale of an asset held for 12 months or longer—from 28 to 20 percent. The new law also lowered inheritance taxes. 250 UNIT 3 Economic Institutions and Issues Some people thought that the tax cuts favored the wealthy, and even the government agreed. An analysis by the United States Treasury Department determined that nearly half of the benefits went to the top 20 percent of wage and income earners. The lowest 20 percent received less than 1 percent of the tax reductions. With all its changes, the 1997 federal tax law became the most complicated ever. Tax Reform in 2001 By 2001 politicians faced a new issue : the federal government was actually collecting more taxes than it was spending. These surpluses were projected to continue to the year 2010. Surpluses could have been used to repay some of the money the government borrowed in the 1980s or to fund new federal spending. The government also could cut taxes to “give the money back to the people.” In the end, President Bush backed a massive $1.35 billion, “temporary” 10-year tax cut due to expire in 2011. The main feature of the 2001 tax reform was to reduce the top four marginal tax brackets of 27, 30, 35, and 38.6 percent to 25, 28, 33, and 35 percent by 2006. The law also introduced a 10 percent tax bracket and eliminated the estate tax on the wealthiest 2 percent of taxpayers by 2010. Tax Reform in 2003 Slow economic growth in 2002 convinced the Bush administration and Congress to accelerate many of the 2001 tax reforms. Specifically, the top four marginal tax brackets were reduced immediately rather than in 2006. For lower income taxpayers, the top end of the 10 percent bracket was increased modestly. The child tax credit was also expanded from $600 to $1,000. Finally, the 20 percent capital gains tax bracket was reduced from 20 to 15 percent. The 2003 tax cuts put the federal government back in the same situation as in 1993. A series of tax cuts reduced taxes in upper income brackets, and government was still spending more than it collected in taxes. Permanent Tax Cuts by 2011? The tax cuts of 2001 and 2003 were “temporary” in the sense that they were due to expire in 2011. Whether that happens or not will depend on several things. One complicating factor is that the rate of economic growth in the six years following the 2001 tax cuts was slightly lower than the rate of growth in the six years following the 1993 tax increase. This makes it difficult to argue that lower taxes are needed for higher rates of growth. However, the bigge |
st factor will be the extent to which the federal government continues to spend more than it collects in taxes. If the present trend continues, it will be difficult to preserve the tax cuts because the government will need so much additional revenue. Reading Check Inferring Why have tax reforms occurred so frequently in recent years? flat tax proportional tax on individual income after a specified threshold has been reached Alternative Tax Approaches MAIN Idea The need for new federal revenues will influence future tax reform. Economics and You You learned earlier about state sales taxes. Read on to find out how another tax is similar to the sales tax. Some people want to change the personal income tax; others want to replace it with something else. Because of this, we hear a lot about two alternatives: the flat tax and the value-added tax. The Flat Tax The concept of a flat tax—a proportional tax on individual income after a specified threshold has been reached—did not receive much attention until Republican candidate Steve Forbes and others raised the issue in the 1996 presidential elections. The primary advantage of the flat tax is the simplicity it offers to the taxpayer. A person would still have to fill out an income tax return every year but could skip many current steps, such as itemizing deductions. A second advantage is that a flat tax would close most tax loopholes if it did away with most deductions and exemptions. Finally, a flat tax reduces the need for tax accountants, tax preparers, and even a large portion of the IRS. As a result, Americans would no longer have to spend 7 billion hours every year preparing tax returns. However, a flat tax also has disadvantages because it would remove many of the incentives built into the current tax code. Tax Exempt? Each year taxpayers take advantage of a long list of deductions and tax credits to reduce their tax burden. In the year 2006, the Tax Foundation reported that a record 43.4 million tax returns from 91 million individuals showed no taxes due. Combined with the 15 million Americans who don’t file returns at all, about 41 percent of the U.S. population did not contribute to the federal treasury. CHAPTER 9 Sources of Government Revenue 251 Figure 9.9 The Value-Added Tax The VAT is like a national sales tax added to each stage of production. As a result, it is built into the final price of a product and is less visible to consumers. The third and fifth columns show the value added at each stage, and the fourth and sixth columns show the cumulative values. Economic Analysis Is a VAT regressive, proportional, or progressive? Why? No taxes With a 10% value-added tax Value added Cumulative value Value added with a 10% VAT Cumulative with VAT Step 1 Step 2 Step 3 Step 4 Step 5 Step 6 Loggers fell trees and sell the timber to the mills for processing. Mills cut the timber into blanks that will be used to make bats. Bat manufacturers shape and paint or varnish the bats and sell them to wholesalers. Wholesalers sell the bats to retail outlets where consumers can buy them. Retailers put the bats on the shelves and wait for consumers. Consumers buy the bats for: $1 $1 $5 $1 $2 $1 $2 $7 $8 $10 $10 $1 + $.10 = $1.10 $1 + $.10 = $1.10 $5 + $.50 = $5.50 $1 + $.10 = $1.10 $2 + $.20 = $2.20 $1.10 $2.20 $7.70 $8.80 $11.00 $11.00 value-added tax (VAT) tax on the value added at every stage of the production process For example, the tax code now allows homeowners to deduct interest payments on home mortgages. Other incentives include deductions for education, training, and child care. Another problem is that no one knows exactly what rate is needed to replace the revenues collected under the current tax system. Supporters of the flat tax argue that a 15 percent rate would work. Other estimates by the U.S. Treasury put the tax closer to 23 percent—which represents more of a burden on low-income earners because their taxes would increase compared to current rates. Finally, there is no clear answer as to whether a flat tax would further stimulate economic growth. After all, the extraordinary growth of the American economy in the 1990s, the longest period of peacetime prosperity in our history, took place when taxes were much higher. The Value-Added Tax Another controversial proposal is to adopt the equivalent of a national sales tax by taxing consumption rather than income. This could be done with a value-added tax (VAT)—a tax placed on the value that manufacturers add at each stage of production. The United States currently does not have a VAT, although it is widely used in Europe. To see how the VAT works, consider how the tax impacts the manufacturing and selling of wooden baseball bats. First, loggers cut the trees and sell the timber to lumber mills. The mills process the logs for sale to bat manufacturers. The manufacturers then shape the wood into baseball bats. After the bats are painted or varnished, they are sold to a wholesaler. The wholesaler sells them to retailers, who sell them to consumers. As Figure 9.9 shows, a VAT tax is levied at each stage of production. 252 UNIT 3 Economic Institutions and Issues The VAT has several advantages. First, it is hard to avoid because it is built into the price of the product being taxed. Second, the tax incidence is widely spread, which makes it harder for a single firm to shift the burden of the tax to another group. Third, the VAT is easy to collect, because firms make their VAT payments directly to the government. Consequently, even a relatively small VAT can raise a tremendous amount of revenue, especially when it is applied to a broad range of goods and services. Finally, some supporters claim that the VAT would encourage people to save more than they do now. After all, if none of your money is taxed until it is spent, you might think more carefully about purchases, decide to spend less—and save more. The main disadvantage of the VAT is that it tends to be virtually invisible. In the baseball bat example, consumers may be aware that bat prices went from $10 to $11, but they might attribute this to a shortage of good wood, higher wages, or some other factor. In other words, it is difficult for taxpayers to be vigilant about higher taxes if they cannot see them. Inevitability of Future Reforms The tax code is more complex now than at any time since 1981—a fact that virtually guarantees future attempts to simplify it. The recent flat tax movement provides just one such example. While simplification is desirable, unexpected events often require new expenditures—which in turn may require changes in the tax code. The unexpected cost of the war in Iraq, along with the enormous damage inflicted by hurricane Katrina in 2005, are two examples of such unexpected costs. Reform also can result from political change, which tends to be abrupt as one party leaves office and another enters. New administrations often display a sense of urgency to finally do things the “right” way, or to clean up the presumed excesses of their predecessors. Finally, it is difficult for politicians to give up the power to modify behavior, influence resource allocation, support pet projects, or grant concessions to special interest groups by changing the tax code. Reading Check Describing How does a value- added tax work? Why is it useful? SECTION 3 Review Vocabulary 1. Explain the significance of payroll withholding statement, accelerated depreciation, investment tax credit, alternative minimum tax, capital gains, flat tax, and value-added tax (VAT). Main Ideas 2. Identifying What are the major types of federal, state, and local taxes on the payroll withholding statement? 3. Listing Use a graphic organizer like the one below to list the advantages and disadvantages of the value-added tax. Critical Thinking 4. The BIG Idea What factors led to the tax reform measures passed in 1981, 1986, 1997, and 2001? 5. Summarizing What changes would you recommend if you were in charge of revising the federal tax code? Explain your answer in a written paragraph. 6. Analyzing Visuals Look at Figure 9.7 on page 249. How can you tell whether this tax is progressive, regressive, or proportional? 7. Cause and Effect Describe the factors that are likely to cause future revisions of the tax code. Value-Added Tax Applying Economics Advantages Disadvantages 8. Flat Tax Use examples to explain what might happen to donations for charitable organizations under a flat tax. CHAPTER 9 Sources of Government Revenue 253 NEWSCLIP A flat tax has often been debated in the United States. Today Russia and several countries in Eastern Europe utilize it as a way to keep taxes simple and avoid tax loopholes. This has spurred Western Europe to take a closer look. Europe Circles the Flat Tax The flat tax. In the eyes of many fiscal conservatives, it’s the Holy Grail of public policy: One low income tax rate paid by all but the poorest wageearners, who are exempt. No loopholes for the rich to exploit. No graduated rates that take a higher percentage of income from people who work hard to earn more. No need for a huge bureaucracy to police fiendishly complex tax laws. U.S. conservatives have been pushing the idea for decades. But it has gotten its first real road test in the former Soviet bloc, where at least eight countries, from minuscule Estonia to giant Russia, have enacted flat taxes since the mid-1990s. Most of these countries’ economies are growing at a far-healthier clip than those of their neighbors to the west. So it’s no surprise that calls for a flat tax are now being heard in Western Europe, the most heavily taxed zone on the planet. . . . Even without pressure from the East, many Western European governments face growing complaints about the complexity of their tax regimes. . . . F LAT T AXES Country Estonia Latvia Russia Serbia Slovakia Ukraine Georgia Romania Source: Hoover Institution Year 1994 1995 2001 2003 2003 2003 2004 2005 Rate 23% 25% 13% 14% 19% 13% 12% 16% 254 UNIT 3 Econ |
omic Institutions and Issues Kia Motors Slovakia, s.r.o Drawn by low taxes, Kia built a manufacturing plant in Slovakia. There’s no guarantee, of course, that flat taxes would work as well in Western Europe as they have in the countries to the east. In the former Soviet bloc, most of the countries that enacted flat taxes gained revenue as people who had worked in the shadow economy began reporting their income and paying taxes. The former tax dodgers figured that with rates so low, it was no longer worth running the risk of breaking the law. Moscow, which introduced a flat tax in 2001, saw its income tax revenues more than double in real terms from 2000 to 2004. —Reprinted from BusinessWeek Examining the Newsclip 1. Analyzing According to the article, why do fiscal conservatives promote a flat tax? 2. Determining Cause and Effect Why might Western European countries not see similar revenue increases? CHAPTER 9 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Types of Taxes All taxes in the United States can be broken down into three categories: proportional, progressive, and regressive. Proportional Progressive Regressive • Percentage of income paid in taxes stays the same regardless of income • Example: Medicare • Percentage of income paid in taxes goes up as income • Percentage of income paid in taxes goes down as income goes up • Example: individual income tax goes up • Example: sales tax Government Revenue Sources Federal, state, and local revenue sources differ. Much of the federal revenue is sent on to state and local governments. Federal Government • • • • • • • • Individual income taxes FICA Borrowing Corporate income taxes Excise taxes Estate and gift taxes Customs duties Miscellaneous fees State Governments Local Governments • • • • • • • Intergovernmental revenue Sales taxes Individual income taxes Tuition and fees from colleges and universities Corporate income taxes Hospital fees Other • • • • • • • Intergovernmental revenue Property taxes Public utilities Sales taxes Individual income taxes Hospital fees Other Alternative Tax Approaches Because the federal tax code has become so large and cumbersome, people have discussed the flat tax and the value-added tax as two alternatives. F LAT T AX V ALUE-A DDED T AX Pro gressiv e Flat Regressive Income Stages of bat manufacture Value-added tax Cumulative value Retailer sells bats Value-added: $2 Wholesaler sells bats Value-added: $1 Manufacture creates bats Value-added: $5 Lumber mill cuts into shape Value-added: $1 Raw lumber Value-added: $1 $.20 $11.00 $.10 $.50 $.10 $.10 $8.80 $7.70 $2.20 $1.10 CHAPTER 9 Sources of Government Revenue 255 CHAPTER 9 Assessment & Activities Review Content Vocabulary Review the Main Ideas On a separate sheet of paper, choose the letter of the term identified by each phrase below. a. ability-to-pay b. payroll tax c. estate tax d. excise tax e. FICA f. VAT g. tax return h. regressive tax i. sales tax j. capital gains 1. tax on wages and salaries withheld from paycheck 2. average tax per dollar decreases as taxable income increases Section 1 (pages 229–236) 17. Describe how taxes can be used to affect people’s behavior. 18. Describe the limitations of the benefit principle of taxation. 19. Explain why a sales tax is considered to be a regressive tax. 20. Explain the three criteria used to evaluate taxes. Section 2 (pages 238–245) 3. profits from an asset held 12 months or longer 21. Identify the two components of FICA. 4. tax on the manufacture or sale of certain items 22. Distinguish between excise taxes, estate and gift taxes, 5. annual report to the government detailing income earned and taxes owed 6. large source of revenue for state governments 7. national sales tax on value added at each stage of production 8. Social Security and Medicare taxes 9. tax on the transfer of property when a person dies 10. tax paid by those who can most afford to pay and customs duties. 23. List the main sources of revenue for state and local governments by using a graphic organizer like the one below. Sources of Revenue State Local Section 3 (pages 247–253) 24. Discuss the deductions that are withheld from Review Academic Vocabulary paychecks. Replace the underlined word in each sentence below with the appropriate synonym from the following list: validity, evolved, implement, considerably, concept, and controversial. 25. Describe the major tax reform bills enacted since 1981. 26. Explain why Congress enacted the alternative minimum tax. 27. Identify the advantages and disadvantages of a flat tax. 11. The tax code has developed into a complicated system. 12. The idea of a flat tax has been debated for a long time. 13. The government needs tax revenue to fulfill its goals. Critical Thinking 14. The IRS questioned the legitimacy of the deduction. 28. The BIG Idea If you were an elected official who 15. The tax code has changed substantially since its origin. 16. Abolishing tax deductions would be an unpopular move by the government. wanted to increase tax revenues, which of the following taxes would you prefer to use: individual income, sales, property, corporate income, user fees, VAT, or flat? Provide reasons for your decision. 256 UNIT 3 Economic Institutions and Issues 29. Inferring Why do you think Alaska has no sales tax or personal income tax? 30. Comparing and Contrasting What were the goals of the Economic Recovery Tax Act of 1981, the 1986 tax reform, and 2001 tax changes? 31. Synthesizing For one week, keep a list of all taxes you hear or read about in the news media or pay in your community. Classify your journal entries into three categories: federal, state, and local taxes. Then draw a matrix like the one below and classify each in the appropriate place. Which taxes appeared in the news most frequently? Ability-to-pay principle Benefit principle Regressive Proportional Progressive 32. Analyzing What provisions of tax measures enacted in the last 20 years benefit taxpayers with higher incomes? Applying Economic Concepts 33. User Fees In your own words, write a rationale for a user fee that you think should be enacted. 34. Taxes Some people object to state and local governments imposing sales and property taxes. What would you say to these people in defense of the two taxes? Thinking Like an Economist 35. Critical Thinking Describe how an economist might go about analyzing the consequences of shifting from the individual income tax to a consumption tax like the VAT. Economics: Principles and Practices Web site at glencoe.com and click on Chapter 9—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Writing About Economics 36. Expository Writing Does the concept of a flat income tax meet the three criteria for effective taxes? Write a brief summary of your findings and use it to either support or oppose such a proposal. Math Practice 37. After deductions and exemptions, Mindy’s unmarried brother had taxable income of $98,000 in 2006. According to the tax table in Figure 9.7 on page 249, what will he owe in federal income taxes? What did he pay in Social Security taxes? What did he pay in Medicare taxes? Analyzing Visuals 38. Look at Figure 9.3 on page 239 and compare the reve- nue from the various sources for the years 2001 and 2007. In which categories did revenues decrease? How did the federal government make up these decreases? Interpreting Cartoons 39. Critical Thinking Look at the cartoon below. Who are the people seated in the chairs? Whom do the figures in the bottom left corner represent? What statement is the cartoonist trying to make? OLIPHANT ©2003 UNIVERSAL PRESS SYNDICATE. Reprinted withpermission. All rights reserved. OLIPHANT © 2003 UNIVERSAL PRESS SYNDICATE. Reprinted with permission. All rights reserved. CHAPTER 9 Sources of Government Revenue 257 DEBATES IN ECONOMICS Should E-Commerce Be Taxed? $ A lot of buying and selling occurs on the Internet—so much, in fact, that rumblings of an e-commerce sales tax have become a roar. In 2005 more than 700,000 people in the United States earned either full- or part-time income on eBay. This statistic alone ensures that a tax showdown between the IRS and e-commerce retailers is on the horizon. Can you sift through the debate to determine whether or not buying and selling online should be subject to taxation? As you read the selections, ask yourself: “Should e-commerce be taxed?” PRO SALES TAX REVENUE LOSSES Inability to collect the [e-commerce sales] tax potentially has a number of important implications. Firms have an incentive to locate production and sales activity to avoid tax collection responsibility, thereby imposing economic efficiency losses on the overall economy. The sales tax becomes more regressive as those who are least able to purchase online are more likely to pay sales taxes than those who purchase online more frequently. Further, state and local government Internet sales in 2003 $1.27 trillion Taxable internet sales in 2003 $751 billion Sales on which taxes were not collected $236.3 billion in 2003 $329.2 billion in 2008* State and local revenue loss $15.5 billion in 2003 $21.5–33.7 billion in 2008* * 2008 figures are estimated tax revenues are reduced. . . . [T]he Census Bureau reports a combined $1.16 trillion in . . . e-commerce transactions by manufacturers, whole salers, service providers, and retailers, and Forrester Research, Inc.’s expectations continue to be for strong growth in e-commerce in coming years. Thus, the revenue erosion continues to represent a significant loss to state and local government. —Dr. Donald Bruce and Dr. William F. Fox, Professors, Center for Business and Economic Research, University of Tennessee 258 UNIT 3 Economic Institutions and Issues Colin Young-Wolff/PhotoEdit CON ONLINE TAX PROPOSAL MISGUIDED The Direct Marketing Association (DMA) is cau- tioning legislators about bills introduced . . . that would allow states to force online sellers t |
o collect sales taxes for all state and local taxing jurisdictions. . . . The failure of . . . these bills to address a reduction in the number of tax jurisdictions is a key flaw, and remains a critical obstacle to a workable streamlined sales tax program. There are currently approximately 7,600 different sales tax jurisdictions in this country, including states, counties and municipalities, and even block-by-block areas that collect additional sales taxes, such as sewer districts, sports arena districts or library districts. Currently, only businesses with a physical presence or “nexus” within a state are required to collect taxes for the jurisdictions within that state. . . . The bills would also create a barrier to entry for small entrepreneurs, who rely on the Internet to help create markets, and a barrier to growth for medium-sized businesses seeking to grow Tax Jurisdiction Based on the Census State Municipality County Township Hospital Local improvement E911/Police/Fire/ Public Safety School Open Space Special Districts (not Based on the Census) Convention center Sports arena Convention center Drainage/ sewer Scientific/ cultural Public library operations or expand a customer base. Many would not be able to afford the effort and expense it would take to collect and remit sales taxes for each of the thousands of jurisdictions, much less the cost of a possible audit at any time by 46 different state revenue departments. —Direct Marketing Association, www.the-dma.org Analyzing the Issue 1. Identifying What is the main argument in support of an 1. Identifying e-commerce sales tax? 2. Summarizing Why does the DMA think it is not possible 2. Summarizing for online merchants to implement sales taxes? 3. Deciding 3. Deciding With which opinion do you agree? Explain your reasoning. CHAPTER 9 Sources of Government Revenue 259 Colin Young-Wolff/PhotoEdit CHAPTER 10 Government Spending Why It Matters Have you ever wondered what the government does with the money withheld from your paycheck? As you travel from home to school over the next three days, list all the examples you see of goods and services provided by federal, state, or local government. Try to determine which level of government funded them and who benefits from them the most. Share your list with the class. The BIG Idea All levels of government use tax revenue to provide essential goods and services. Spending for national defense is a responsibility of the federal government. 260 UNIT 3 Getty Images Economics: Principles and Practices Web site at glencoe.com and click on Chapter 10—Chapter Overviews to preview chapter information. Chapter Overview Visit the SECTION 1 The Economics of Government Spending GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that the role of the federal government has grown, making it a vital player in the economy. Content Vocabulary • pork (p. 261) • public sector (p. 262) • private sector (p. 263) • transfer payment (p. 263) • grant-in-aid (p. 263) • subsidy (p. 264) • distribution of income (p. 264) • constituents (p. 261) • reluctant (p. 265) Reading Strategy Listing As you read the section, complete a graphic organizer similar to the one below by listing reasons for the increase in government spending since the 1940s. Reasons Rise in government spending ISSUES IN THE NEWS Grand Old Spenders —George Will, Washington Post Conservatives have won seven of 10 presidential elections, yet . . . per-household federal spending [is] more than $22,000 per year, the highest in inflation-adjusted terms since World War II. Federal spending . . . has grown twice as fast under President Bush as under President Bill Clinton, 65 percent of it unrelated to national security. In 1991, the 546 pork projects . . . cost $3.1 billion. In 2005, the 13,997 pork projects cost $27.3 billion, for things such as improving the National Packard Museum in Warren, Ohio (Packard, an automobile brand, died in 1958). Washington subsidizes the cost of water to encourage farmers to produce surpluses that trigger a gusher of government spending to support prices . . . [and] . . . almost $2 billion is spent each year paying farmers not to produce. ■ The amount of net spending by all levels of government—federal, state, and local— amounts to an ever-increasing portion of our GDP, the dollar measure of all final goods and services produced in a country in a year. It wasn’t always this way, but sometimes politicians have a hard time saying “no” when it comes to taking care of their constituents and the interests of their home districts. A recent political trend, as discussed in the news article above, is the increasingly popular use of pork in the federal budget. Pork is a term used by some to describe a line-item budget expenditure that circumvents normal budget-building procedures. Because most pork projects provide generous benefits to a small number of individuals or businesses, taxpayers generally would not otherwise approve the projects. pork a line-item budget expenditure that circumvents normal budget procedures and benefits a small number of people or businesses K Hart/Vikki Hart/Getty Images CHAPTER 10 Government Spending 261 public sector that part of the economy made up of local, state, and federal governments Government Spending in Perspective MAIN Idea The government spends its revenues on goods, services, and transfer payments. Economics & You Do you wonder how the taxes you pay are spent? Read on to learn about government expenditures. Spending by the public sector—the part of the economy consisting of federal, state, and local governments—was relatively low prior to the Great Depression. Since then, attitudes have shifted and spending has increased sharply. Spending Since the 1930s The growth in government spending since the 1930s had two main causes. First, a major change in public opinion gave government a larger role in everyday economic affairs. This change, in turn, was a response to President Franklin D. Roosevelt’s New Deal, which used large-scale government projects to fight the Great Depression. The Tennessee Valley Authority (TVA), for example, brought low-cost electricity to millions of people in the rural South during the mid-1930s. Second, massive government spending funded the United States involvement in World War II. This resulted in more people working, as factories converted to war production. Most people, some of whom faced unemployment during the 1930s, seemed to become more comfortable with the government’s larger role in the domestic economy. As shown in Figure 10.1, expenditures by all levels of government—federal, state, and local—have grown ever since. From about 23 percent of GDP in 1960, they have increased to over 31 percent today. In fact, public-sector spending has grown so large that all levels of government combined now spend more than all of the privately owned businesses in the United States. Figure 10.1 Government Spending G OVERNMENT S PENDING AS A P ERCENTAGE OF GDP 40% 35 30 25 20 15 10 1960 Total government Federal government State and local government 1965 1970 1975 1980 1985 Year 1990 1995 2000 2005 2010 Source: Economic Report of the President, 2006 Spending by all levels of government has grown considerably since 1959. Between 2000 and 2005 alone, government expenditures have consumed an additional 5.4 percent of GDP, a $674 billion increase. Economic Analysis Does the graph show any period of decreased government spending? See StudentWorks™ Plus or glencoe.com. Some people question how many goods and services government should provide and, therefore, what level of revenue collection is required to support these expenditures. Others question which services the government should provide and which services the private sector—the part of the economy made up of private individuals and privately owned businesses—should provide. Two Types of Spending In general, government makes two broad kinds of expenditures. The first is in the form of goods and services. The government buys many goods, such as tanks, planes, ships, and even space shuttles. It needs office buildings, land for parks, and capital goods for schools and laboratories. The government also needs to purchase supplies and pay for utilities. Finally, it must hire people to work in its agencies and staff the military. Payments for these services include the wages and salaries for these workers. State and local governments have similar expenditures. The second type of government expenditure is a transfer payment—a payment for which the government receives neither goods nor services in return. Transfer payments can be made to individuals and include Social Security, unemployment compensation, welfare, and aid for people with disabilities. With the exception of Social Security, people normally receive these payments solely because they need assistance. A transfer payment that one level of government makes to another is known as a grant-in-aid. The receiving government counts this payment as intergovernmental revenue. Interstate highway construction programs are examples of grants-in-aid. The federal government grants money to cover the major part of the cost, while the states in which the highways will be built pay the rest. The construction of new public schools also can be financed through grants-in-aid. Reading Check Contrasting What is the difference between transfer payments and government spending on goods and services? Grants-in-Aid States usually receive federal funds to pay for the majority of highway construction projects. Why do states rely on federal funds for such projects? private sector that part of the economy made up of private individuals and businesses transfer payment payment for which the government receives neither goods nor services in return grant-in-aid transfer payment from one level of government to another that does not involve compensation AP Photo/Terry Gilliam CHAPTER 10 Government Spendi |
ng 263 Allocation of Resources States require students to take graduation exams because of federal legislation. How can such laws affect the economy? Impact of Government Spending MAIN Idea Government spending has a direct impact on our economy. Economics & You Have you considered attending a public college because a private one seems out of reach? Read on to find out how government spending affects your life. The enormous size of the public sector gives it the potential to affect people’s daily lives in many ways. It can affect resource allocation, the distribution of income, production in the private sector, and the tax burden on people. subsidy government payment to encourage or protect a certain economic activity (also see page 122) distribution of income way in which the nation’s income is divided among families, individuals, or other designated groups Affecting Resource Allocation Government spending decisions directly affect how resources are allocated. If the government spends its revenues on missile systems in rural areas, for example, rather than on social welfare programs in urban areas, the shift of resources stimulates economic activity in rural areas. Public sector spending can indirectly affect allocation of resources. In agriculture, the decision to support the prices of cotton, milk, grains, or peanuts keeps the factors of production working in those industries. 264 UNIT 3 Economic Institutions and Issues Jose Luis Pelaez, Inc./Corbis If the government withdraws the subsidies for these crops, farmers would produce less of each and resources would be released for employment in other industries. Government is so involved in the economy that even seemingly modest decisions can have an enormous impact on the things we produce. For example, because of the No Child Left Behind legislation, the government now requires schools to conduct extensive testing in reading and math. As a result, some schools have increased the amount of time they spend on these subjects and therefore have decreased the amount of time spent on other subjects. The decision to downgrade or even drop other subjects diminishes the demand and eventually the production of textbooks and educational supplies used in those areas, while increasing the demand for resources needed for reading and math. Redistributing Income Government spending also influences the distribution of income, or the way in which income is allocated among families, individuals, or other groups. Increasing or decreasing transfer payments, for example, can directly affect the incomes of needy families who receive financial support from the government. Government decisions about where to make expenditures indirectly affect many people’s incomes. The decision to buy fighter planes from one factory rather than another has an impact on the communities near both factories. The decision to spend billions on rebuilding Iraq and Afghanistan increased the incomes of those working in the national defense industries but not those who work in inner cities or other areas that lack such factories. Competing With the Private Sector When the government produces goods and services, it often competes with the private sector. In higher education, many public colleges and universities compete with more expensive private ones. The cost difference often is due to the subsidies public institutions receive from their states. In the area of health care, the government runs a system of hospitals for military veterans, which are funded with taxpayer dollars. At the same time, these facilities compete with hospitals in the private sector that offer similar services. Increasing the Tax Burden Finally, the growth of government spending has not gone unnoticed by the average American. The increased tax burden that is needed to support the expenditures has attracted enormous attention in recent years. Most people would like to reduce their taxes, but most people are also reluctant to give up the many benefits that government provides. In short, spending by all levels of government, which amounts to about one-third of our GDP, has a large and often controversial impact on the American economy. Finding the money to pay for these expenditures is a difficult task. Yet many people seem to want even more of these goods, services, and transfer payments. Reading Check Explaining How does government spending affect the distribution of income? Skills Handbook See page R44 to learn about Detecting Bias. SECTION 1 Review Vocabulary 1. Explain the significance of pork, public sector, private sector, transfer payment, grant-in-aid, subsidy, and distribution of income. Main Ideas 2. Identifying In which three ways might government spending impact the economy? 3. Listing Use a graphic organizer like the one below to list two kinds of government spending and provide three examples of each. Types of Government Spending Critical Thinking 4. The BIG Idea Describe two reasons for the growth of government spending since the 1930s. 5. Analyzing Visuals Look at Figure 10.1 on page 262. How does the spending by state and local governments compare to federal spending? What might explain any differences? 6. Explaining Why are people often reluctant to support a reduction in government spending? 7. Detecting Bias How does the “pork” spending described by the columnist on page 261 illustrate a conflict between political and economic goals? Applying Economics 8. Transfer Payments Do you think that transfer payments, such as unemployment compensation, are a successful or unsuccessful way to accomplish the goal of economic security? Explain your answer. CHAPTER 10 Government Spending 265 NEWSCLIP In the United States, the government sector competes with the private sector for scarce resources. This does not just mean the resources to build interstate highways or ensure food safety. In fact, there is a particularly scarce resource the government is trying to lure from the private sector—brains. The NSA: Security in Numbers The job offers arrived in plain envelopes. For decades, the mathematicians who accepted them stole off to Washington and the hush-hush National Security Agency, the nation’s top techno-spy center. Through the cold war, NSA math whizzes matched wits with the Soviets. Each side protected its own secret codes while trying to break the other’s. Math is more important than ever at the NSA. Chances are, the world’s growing rivers of data contain terrorist secrets, and it’s up to the agency’s math teams to find them. But to land the best brains, the NSA must compete with free-spending Web giants such as Google and Yahoo! This is leading the agency to open up its recruiting process. “We have to look at new and innovative ways to find talent,” says Cynthia Miller-Wentt, chief of the NSA’s recruitment office. . . . There’s a second hitch: Unlike the tech companies it must compete with, H OW M ATH T RANSFORMS I NDUSTRIES Marketing Umbria: The Colorado startup assigns numeric values to “picks” and “pans” of products that pop up on blogs and podcasts. Consulting IBM: Big Blue is building math profiles of 50,000 consultants so that computers can pick the perfect team for every assignment. Other tools eventually will be able to track their progress, hour by hour, and rate their performance. Advertising Efficient Frontier: The Silicon Valley startup calculates response rates and return on investment for every advertisement of online ad campaigns. It provides a broad shift from hunch-based campaigns to mathematical targeting. Source: BusinessWeek 266 UNIT 3 Economic Institutions and Issues Larry Williams/Corbis the NSA can hire only U.S. citizens. This is a severe constraint. About half of the estimated 20,000 math graduate students at U.S. universities are foreigners. They’re off bounds, as are the bountiful math brains in India, China, Eastern Europe, and elsewhere. The NSA’s pitch? First the agency appeals to the recruits’ patriotism. But there’s also a lifestyle lure. NSA officials say a good number of mathematicians prefer a suburban Maryland life and a government job with predictable hours to the more frantic pace and market gyrations of an Internet company. . . . —Reprinted from BusinessWeek Examining the Newsclip 1. Summarizing What work do mathematicians perform for the NSA? 2. Analyzing Why is it difficult for the NSA to compete with the Internet giants in hiring mathematicians? SECTION 2 Federal, State, and Local Government Expenditures GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that governments provide money for many services and programs. • ambiguity (p. 267) • coincide (p. 268) Reading Strategy Describing As you read the section, complete a graphic organizer similar to the one below by describing the different types of government spending. Government Spending Content Vocabulary • federal budget (p. 267) • fiscal year (p. 268) • appropriations bill (p. 268) • budget deficit (p. 269) • budget surplus (p. 269) • mandatory spending (p. 269) • discretionary spending (p. 270) • Medicare (p. 270) • Medicaid (p. 271) • balanced budget amendment (p. 271) • intergovernmental expenditures (p. 272) —Los Angeles Times ISSUES IN THE NEWS The President’s Budget Plan President Bush on Monday sent Congress a proposed $2.77 trillion budget for 2007 that would boost Defense and Homeland Security while trimming the growth of Medicare and other social service programs . . . [and] . . . leave a deficit of $354 billion next year— the fourth-largest ever in dollar terms—which would settle down to around $200 billion for the subsequent four years. . . . . Departments that would gain the most under Bush’s budget include the Pentagon, which would see spending rise 7%, and the Department of Homeland Security, where a 6% increase would go largely to immigration enforcement, air travel security and the Federal Emergency Management Agency. ■ When it comes to the numbers presented in the federal budge |
t—the annual plan outlining proposed revenues and expenditures for the coming year—there is often a fair amount of ambiguity. As the news article above shows, the federal budget offers only a rough estimate of the actual revenues and expenditures. For example, the economy could suddenly slow down or speed up, affecting the amount of tax revenues collected. In addition, events might occur that require unanticipated spending. This was the case after the terrorist attacks on September 11, 2001, and the subsequent wars in Afghanistan and Iraq. federal budget annual plan outlining proposed expendi tures and anticipated revenues Andy Nelson/The Christian Science Monitor/Getty Images CHAPTER 10 Government Spending 267 Federal Government Expenditures MAIN Idea The federal government establishes a budget and allocates funds accordingly. Economics and You Has your family created a budget to control income and expenses? Read on to learn how the federal government makes its budget decisions. The federal budget spans a fiscal year— a 12-month financial planning period that may or may not coincide with the calendar year. The government’s fiscal year starts on October 1 and expires on September 30 of the following calendar year. Establishing the Federal Budget The president’s Office of Management and Budget (OMB), part of the executive branch, is responsible for preparing the federal budget. However, the president’s budget is only a request, and Congress can approve, modify, or disapprove it. By law, the budget must be sent to both houses of Congress by the first Monday in February. Once the House of Representatives receives the president’s budget request, it breaks down the budget into 13 major expenditure categories and assigns each to a separate House subcommittee. Each of the subcommittees then prepares an appropriations bill, an act of Congress that allows federal agencies to spend money for a specific purpose. Subcommittees hold hearings, debate, and vote on each bill. An approved bill is sent to the full House Appropriations Committee. If it passes there, the bill is sent to the entire House for a vote. The Senate acts on the budget after the House has approved it. The Senate may approve the bill as sent by the House, or it may draft its own version. If differences exist between the House and the Senate versions, a joint House-Senate conference committee tries to work out a compromise bill. During this process, the House and the Senate often seek advice from the Congressional Budget Office (CBO). The CBO is a nonpartisan congressional agency that evaluates the impact of legislation and projects future revenues and expenditures that will result from the legislation. If the House and Senate both approve the compromise bill, they send it to the president for signature. Because Congress literally took apart, rewrote, and put back together the president’s budget, the final Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 10—Student Web Activity for an activity on the federal budget. fiscal year 12-month financial planning period that may not coincide with the calendar year appropriations bill legislation authorizing spending for certain purposes Public Hearings Secretary of State Condoleezza Rice discusses the State Department’s budget with an appropriations committee. Which part of Congress holds hearings? 268 UNIT 3 Economic Institutions and Issues Ken Cedeno/Corbis Figure 10.2 The Federal Budget for Fiscal Year 2007 In its budget, the federal government projected revenues of $2,416 billion and planned on spending $2,770 billion in fiscal year 2007. The difference of $354 billion, or 12.8 cents of every dollar spent, would be borrowed from investors. Economic Analysis What is the largest mandatory spending item in the budget? The largest discretionary item? D EFICIT AND R EVENUE = E XPENDITURES See StudentWorks™ Plus or glencoe.com. Deficit = $354 billion Deficit 12.8% Revenues = $2,416 billion Individual income taxes 39.6% Social insurance and retirement receipts 31.9% Corporate income taxes 9.4% Excise taxes Miscellaneous receipts Customs duties and fees Estate and gift taxes 2.7% 1.7% 1.0% 0.9% Expenditures = $2,770 billion 21.2% Social security 19.0% National defense 14.2% 13.3% 10.1% 8.9% 3.2% 2.8% 2.7% 1.6% 1.2% 1.0% 0.8% Medicare Income security Health Net interest Education, training, employment, and social services Transportation Veterans benefits and services Administration of justice International affairs Community and regional development Other Sources: Department of the Treasury, Office of Management and Budget, 2006 version may not resemble the original proposal. In many cases, a bill may have changed considerably, with items added to the president’s original budget. If the budget was altered too much, the president can veto the bill and force Congress to come up with a budget closer to the original version. However, once signed by the president, the budget becomes the official document for the next fiscal year that starts on October 1. The federal budget shown in Figure 10.2 is called the fiscal year 2007 budget because 9 of the 12 calendar months fall within the year 2007. The figure shows $2,416 billion (over $2 trillion) of revenues and $2,770 billion of spending, leaving a budget deficit—an excess of expenditures over revenues—of $354 billion. If expenditures were less than revenues, the result would be a budget surplus. Social Security The individual expenditures in the federal budget can be grouped into broad categories. The largest is for payments to aged and disabled Americans through the Social Security program. Retired persons receive benefits from the Old-Age and Survivors Insurance (OASI) program. Those unable to work receive payments from disability insurance (DI) programs. Spending for Social Security is sometimes called mandatory spending, or spending authorized by law that continues budget deficit a negative balance after expenditures are subtracted from revenues budget surplus a positive balance after expenditures are subtracted from revenues mandatory spending federal spending authorized by law that continues without the need for annual approvals by Congress CHAPTER 10 Government Spending 269 discretionary spending spending for federal programs that must receive annual authorization Medicare federal health-care program for senior citizens, regardless of income without the need for annual approvals by Congress. This is because the total Social Security payments in any given year are dependent on the number of people eligible for Social Security and the level of benefits already approved by Congress. National Defense For much of the late 1900s, national defense comprised the largest category of spending, although it is now second to Social Security. National defense includes CAREERS Budget Analyst The Work * Research, analyze, develop, and execute annual budgets or financial plans * Seek new ways to improve a company’s efficiency and increase profits * Review financial requests, examine past and current budgets, and research developments that can affect spending Qualifications * Keen analytical skills and knowledge of mathematics, statistics, accounting, and computer science * Strong oral and written communication skills to present— and defend—budget proposals * Ability to work well under deadlines * Bachelor’s degree, with most firms and government employers requiring a master’s degree Earnings * Median annual earnings: $56,040 Job Growth Outlook * Average Source: Occupational Outlook Handbook, 2006–2007 Edition 270 UNIT 3 Economic Institutions and Issues Michael Newman/PhotoEdit military spending by the Department of Defense and defense-related atomic energy activities, such as the development of nuclear weapons and the disposal of nuclear wastes. Defense expenditures are called discretionary spending—spending that must be approved by Congress in the annual budgetary process. Unlike Social Security payments, which normally go up as the population gets older, annual defense expenditures can go up, down, or remain the same, depending on the will of the president and Congress. Income Security Income security consists of a wide range of programs that includes retirement benefits for both federal civilian employees and retired military. Other programs are designed to support people unable to fully care for themselves. Federal programs pay for child care, foster care, and adoption assistance. Those unable to support themselves receive Supplemental Security Income (SSI), subsidized housing, federal child support, Temporary Assistance for Needy Families (TANF), and food stamps. Most income security expenditures are mandatory and therefore not authorized annually. Medicare Medicare, a health-care program available to all senior citizens regardless of income, began in 1966 and is another mandatory program. It provides an insurance plan that covers major hospital costs. Medicare also offers optional insurance that provides additional coverage for doctor and laboratory fees, outpatient services, and some equipment costs. In recent years, Medicare expenditures have risen dramatically as the population has aged and the cost of caring for the elderly has gone up. Given the increasing cost of medicine and current population trends, increases in this category of expenditure are expected to continue. Health Health-care services for low-income people, disease prevention, and consumer safety account for a significant part of the federal budget. Medicaid, for example, is a joint federal-state medical insurance program for low-income persons. Because the payments have already been determined by Congress, this is one of the mandatory expenditure programs. Other mandatory programs include health-care services for working and retired federal employees. Some programs in this category are discretionary. The Occupational Safety and Health Administration |
(OSHA), which monitors occupational safety and health in the workplace, is one such program. Other discretionary programs include AIDS and breast cancer research, substance abuse treatment, and mental health services. Net Interest on Debt When the federal government spends more than it collects in taxes and other revenues, it borrows money to make up the difference. The government has to pay interest on this debt, and the interest currently makes up the sixth-largest category of federal spending. The amount of interest paid is a mandatory expenditure that varies with changes in interest rates and the size of the federal debt. The federal government is still running deficits and therefore adding to its total debt. If interest rates rise, then this will become an increasingly larger category in the federal budget. Other Expenditure Categories Other broad categories of the federal budget include education, training, employment, and social services; transportation; veterans’ benefits; administration of justice; and natural resources and the environment. They include both mandatory and discretionary spending. Reading Check Summarizing What steps are involved in establishing the federal budget? SW Production/Index Stock Imagery Medicaid People with disabilities are among those eligible for Medicaid if they cannot afford health care. Why is Medicaid a mandatory expenditure? State Government Expenditures MAIN Idea At the state level, expenditures include public welfare and higher education. Economics and You If you want to attend college, have you found money available for financial aid? Read on to learn where these funds come from. Individual states, like the federal government, also have expenditures. Like the federal government, states must approve spending before distributing funds. The Budget Process At the state level, the process of creating a budget and getting approval for spending can take many forms. For example, some states such as Kentucky have biannual budgets, or budgets that cover two years at a time. In most states, the process is loosely modeled after that of the federal government. Unlike the federal government, however, some states have a balanced budget amendment—a constitutional provision requiring that annual spending not exceed revenues. Medicaid joint federal-state medical insurance program for low-income people balanced budget amendment constitutional amendment requiring government to spend no more than it collects in taxes and other revenues, excluding borrowing CHAPTER 10 Government Spending 271 intergovernmental expenditures funds that one level of government transfers to another level for spending Under this provision, states often must cut spending when revenues drop. A reduction in revenues may occur if sales taxes or state income taxes fall because of a decline in the general level of economic activity. Intergovernmental Expenditures As Figure 10.3 on the opposite page shows, the largest category of state spending is intergovernmental expenditures— funds that one level of government transfers to another level for spending. These funds come from state revenue sources such as sales taxes, and they are distributed to counties, cities, and other local communities to cover a variety of educational and other municipal expenditures. employees retire, become unemployed, or are injured on the job. Contributions to these funds make this category a significant expenditure. Their main beneficiaries are teachers, legislators, highway workers, police, and other state employees. Higher Education State governments have traditionally taken responsibility for the large task of funding state colleges and universities. In most states, the tuition that students pay covers only a portion of higher education expenses. States usually budget funds to pay the remainder of the cost. On average, higher education is the fifth-largest state expenditure. Public Welfare Other Expenditures The second largest category of state expenditures is public welfare. These payments take the form of cash assistance, payments for medical care, spending to maintain welfare institutions, and other welfare expenditures. Insurance Trust and Retirement Many states have their own insurance and retirement funds for state employees. The money in these funds is invested until The expenditures in the remaining state budget categories are relatively small. As Figure 10.3 shows, states spend money on a wide range of activities including corrections; utilities such as electricity, gas, and water; hospitals; and parks and recreation. Highways and road improvements are possible exceptions because they may require larger amounts of state money. Reading Check Explaining How does a balanced budget amendment work Higher Education States usually fund part of the expenses for state colleges and universities. What are other large categories of state expenditures? 272 Figure 10.3 State and Local Expenditures Both state and local expenditures consist of a myriad of categories. Intergovernmental expenditures and public welfare use up almost half of state budgets, while education is the main expenditure for local governments. Economic Analysis How do expenditures for public welfare, education, and utilities compare between state and local governments? See StudentWorks™ Plus or glencoe.com. State $1,359 billion Local $1,195 billion 28.1% 19.5% 12.4% Intergovernmental expenditure Public welfare Unemployment and workers’ compensation, retirement 3.5% 2.0% Elementary and secondary education 35.5% 10.1% Higher education Highways Government administration Hospitals Corrections Interest on general debt Health Utilities Fire protection Police protection Parks and recreation 2.2% 3.6% 4.7% 4.6% 1.6% 3.8% 2.6% 10.2% 2.3% 4.8% 2.3% Housing and community development 2.6% Other 12.5% 5.3% 3.2% 2.8% 2.7% 2.3% 2.2% 1.6% 0.7% 0.3% 7.9% Source: Bureau of the Census, August 2006 Variations due to rounding CHAPTER 10 Government Spending 273 &The Global Economy YOU Footing the Bill for Public Education Nearly 50 million students are enrolled in public elementary and secondary schools in the United States. Property taxes and intergovernmental revenues are the largest funding sources for these schools. lower in the test than did those of other countries. Perhaps money can buy schools, but it cannot buy student learning. How much does your education cost in taxpayer dollars? For the 2002—2003 school year, expenditures per student averaged $8,044 in the Unites States. New Jersey had the highest expenditures with $12,568 per student. Utah was at the lowest end of the range, with expenditures at $4,838 per student. As the world becomes more economically interdependent, you will face increasing global competition for jobs after you graduate. While the United States spends on average more on education to prepare you and other students, this spending is no guarantee of success. When students all over the world participated in a math achievement test, U.S. students ranked INTERNATIONAL EDUCATION SPENDING Slovakia Hungary Czech Republic South Korea Netherlands Finland Belgium Japan Australia Canada United States 0 1,000 2,000 3,000 4,000 6,000 Annual K–12 per pupil spending 5,000 7,000 $8,000 Source: National Center for Education Statistics Local Government Expenditures MAIN Idea Local governments spend money mainly on education, utilities, and public safety. Economics and You Have you ever wondered who pays for textbooks or extracurricular activities at your school? Read on to find out about the responsibilities of local governments. Local governments include counties, parishes, townships, municipalities, tribal councils, school districts, and other special districts. The different categories of expenditures made by these local governments are illustrated in Figure 10.3 on the previous page. The Budget Process At the local level, power to approve spending often rests with the mayor, the city council, the county judge, or some other elected representative or body. The methods used to approve spending and the dates of the fiscal year itself are likely to vary considerably from one local government to the next. Generally, the amount of revenues collected from property taxes, city income taxes, and other local sources is relatively small and limits the spending of local agencies. Some local governments are even bound by state requirements to avoid deficit spending. Elementary and Secondary Education Local governments have primary responsibility for elementary and secondary education. Expenditures budgeted in this category include administrators’ and teachers’ salaries, wages for maintenance and cafeteria workers, textbooks, and other supplies. School districts also pay 274 UNIT 3 Economic Institutions and Issues for the construction and upkeep of all school buildings. Schools account for more than one-third of all local government spending, making it the largest item in most local budgets. Utilities Public utilities serve communities by providing services such as sewerage, electricity, natural gas, and water. For most local governments, spending on these utilities amounts to the second-largest expenditure and consumes about 10 percent of local spending. In the typical community, the majority of expenditures on utilities are for schools, libraries, civic centers, and administrative buildings. Street lighting and traffic lights account for other expenditures. Public Safety and Health Most communities maintain a full-time, paid police force. Many have fire departments with paid, full-time firefighters as well. However, some communities, especially those with smaller populations and limited budgets, maintain volunteer fire departments to keep the cost down. On the other hand, some communities, especially larger cities, own and staff their own hospitals. Spending for health and safety in general tends to be about equal for each local government. However, the spending on these categories vari |
es greatly from one state to another. Other Expenditures Highways, roads, and street repairs absorb most of the remaining spending. This category includes the repair of potholes, the installation and repair of street signs, snow removal, and other streetrelated items that are not covered by state budgets. Reading Check Synthesizing Which local expenditures would you categorize as mandatory spending, and why? Skills Handbook See page R47 to learn about Making Predictions. SECTION 2 Review Vocabulary 1. Explain the significance of federal budget, fiscal year, appropriations bill, budget deficit, budget surplus, mandatory spending, discretionary spending, Medicare, Medicaid, balanced budget amendment, and intergovernmental expenditures. Main Ideas 2. Listing Use a graphic organizer like the one below to list the five largest federal government expenditures. Federal Spending 3. Discussing What is the focus of state budgets? 4. Describing How do local governments spend their funds? Critical Thinking 5. The BIG Idea Describe the difference between mandatory and discretionary spending. 6. Making Predictions People are living longer, and families have fewer members. How will the combination of these two factors affect future transfer payments such as Social Security? 7. Making Generalizations If you were to argue for reduced spending at the state and local levels, which categories would you choose? 8. Analyzing Visuals Look at Figure 10.3 on page 273. Why do state expenditures not include elementary and secondary education? Do they not pay for it? Explain. Applying Economics 9. Local Government Spending Conduct research on the budget procedures for your local city or county government. Write an essay describing how the budget is created and who has spending authority. CHAPTER 10 Government Spending 275 CASE STUDY Boeing Going Strong Wide Range of Products The United States government spends billions of dollars for defense every year; in 2005 alone, that amount exceeded $500 billion. One of the companies the government has turned to for its defense needs is aircraft manufacturer Boeing. Employees at Boeing have built helicopters and passenger planes, fighter planes and missiles, satellites and spacecraft. They have sent astronauts to the moon and brought countries together aboard the International Space Station. NEWS FLASH Fighting Terrorism In 2002, Boeing was awarded a contract by the U.S. Department of Transportation to provide explosive detection systems in 438 U.S. airports. Boeing’s Defense Link William Boeing, founder and owner, started the company in 1916 with the incorporation of the Pacific Aero Products Company. That same year, Boeing produced its first airplane, the B&W B OEING D EFENSE AND T OTAL R EVENUES ) 60 50 40 30 20 10 0 Total revenues Defense revenues 2000 2001 2002 2003 2004 2005 Year Source: www.defensenews.com 276 UNIT 3 Economic Institutions and Issues Getty Images Seaplane. Just a year later the company began its relationship with the government through test flights for the U.S. Navy. The Navy responded by ordering 50 seaplane trainers for a total of $116,000. Almost 90 years later in 2003, the Navy purchased 210 Super Hornets for a staggering $8.6 billion. Ahead of the Pack Over time, Boeing has become the world’s leading aerospace producer and the largest manufacturer of commercial jetliners and military aircrafts combined. From its small beginnings, the company now has customers in nearly 150 countries, with 150,000 workers in 48 states and 67 countries. While Boeing sells its products to both governments and private customers, defense revenues make up more than half of total revenues—and help Boeing to be the secondlargest defense company in the United States. Analyzing the Impact 1. Summarizing Why is defense spending important to Boeing? 2. Drawing Conclusions What world events may have contributed to the increase in defense revenues from 2000 to 2005? SECTION 3 Deficits, Surpluses, and the National Debt GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that deficit spending has helped create a national debt. • mandate (p. 282) • instituted (p. 282) Reading Strategy Discussing As you read the section, list the various attempts by government to reduce the federal deficit and the national debt, then discuss the results. Attempt Result Content Vocabulary • deficit spending (p. 278) • national debt (p. 278) • balanced budget (p. 278) • trust funds (p. 278) • per capita (p. 279) • crowding-out effect (p. 281) • “pay-as-you-go” provision (p. 282) • line-item veto (p. 282) • spending cap (p. 282) • entitlement (p. 283) —The Kentucky Post ISSUES IN THE NEWS Expensing Our Wars [T]he chairman of the Senate Budget Committee, Judd Gregg, a Republican from New Hampshire, is considering treating the cost of the wars in Iraq and Afghanistan as a regular budget item. The Bush administration has spent $440 billion so far on those wars, $120 billion of it this fiscal year, and the meter is running at the rate of $4.5 billion a month in Iraq and $800 million a month in Afghanistan. The wars have been funded in a series of five emergency spending measures [that] are intended to deal with sudden, unexpected and short-term emergencies like [hurricane] Katrina. The bills are passed outside the regular appropriations process and are carried off budget, [which] tends to minimize the apparent cost. ■ In the past 45 years, the federal budget has shown a surplus only five times. The first was in 1969, and the last four occurred in the years 1998 to 2001. Federal budget deficits in most years have added to the total amount of debt that the government owes. Since 2001 more than $2 trillion in debt has been added, bringing the total national debt to about $8.5 trillion. Deficits occur for a number of reasons. For one, tax reductions are politically popular. For another, most people are in favor of the government spending more money on them. Finally, expenses such as wars and natural disasters are difficult to predict. However, as we read in the news article, expenditures don’t go away simply because they are not recorded in the budget. Nicolas Cotto/Corbis CHAPTER 10 Government Spending 277 deficit spending annual government spending in excess of taxes and other revenues national debt total amount borrowed from investors to finance the government’s deficit spending balanced budget annual budget in which expenditures equal revenues trust fund special account used to hold revenues designated for a specific expenditure such as Social Security, Medicare, or highways From Deficits to Debt MAIN Idea Because of deficit spending, the national debt has increased dramatically. Economics and You Do you recall news stories about the nation’s budget deficit? Read on to learn how deficits are created. Historically, a remarkable amount of deficit spending—or spending in excess of revenues collected—has characterized the federal budget. Sometimes the government plans deficit spending. At other times, the government is forced to spend more than it collects because unexpected developments cause a drop in revenues or a rise in expenditures. Predicting the Deficit The government projected a $354 billion deficit for fiscal year 2007. Whether this is the actual amount at the end of the fiscal year, however, depends on the way expenditures are reported and the state of the economy. For example, no money was budgeted for the wars in Afghanistan and Iraq in the fiscal year 2007 budget. Instead, the president and Congress made nearly $100 billion of “supplemental requests” to cover the anticipated war costs. These war expenditures will ultimately be reflected in the amount of money the government spends, but they did not appear in the budget when it was first released. Second, changes in the economy affect budget projections. Strong economic growth could cause the deficit to shrink because of Deficits Anyone? European countries that want to become members of the European Union (EU) and adopt the euro as their currency have to take their deficits seriously. To be eligible, they must be able to control their economies—and that includes their budgets. In order to be accepted into the “euro zone,” a nation is expected to keep its budget deficit at less than 3 percent of its GDP and its public debt at less than 60 percent of its GDP. 278 UNIT 3 Economic Institutions and Issues higher tax collections and lower unemployment claims. Likewise, a downturn in the economy could result in lower tax collections and higher unemployment insurance payments. Deficits Add to the Debt Panel A of Figure 10.4 on the opposite page shows the history of the federal budget deficit since 1965. When the federal government runs a deficit, it must finance the revenue shortage by borrowing. It does this by selling U.S. Treasury notes and other securities to the public. If we add up all outstanding federal notes, bonds, and other debt obligations, we have a measure of the national debt—the total amount borrowed from investors to finance the government’s deficit spending. As Panel B in Figure 10.4 shows, the national debt grows whenever the government runs a deficit by spending more than it collects in revenues. If the federal budget runs a surplus, then some of the borrowed money is repaid and the amount of total debt goes down, as it did from 1998 to 2001. If the federal government achieves a balanced budget—an annual budget in which expenditures equal revenues—the national debt will not change. A Growing Public Debt The national debt has grown almost continuously since 1900, when the debt was $1.3 billion. By 1929 it had reached $16.9 billion, and by 1940 it was $50.7 billion. By mid-2006 the total national debt had reached about $8.5 trillion. Some of this debt is money that the government owes itself. For example, approximately $3.5 trillion of this debt is in government trust funds—special accounts used to fund specific types of expen |
ditures such as Social Security and Medicare. When the government collects the FICA or payroll tax, it puts the revenues in these trust accounts. The money is then invested in government securities until it is paid out. Figure 10.4 The Federal Deficit and the National Debt Panel A shows the annual budget deficit since 1962. Panel B shows the national debt during the same time period. The government ran a surplus from 1998 to 2001 which allowed it to pay off some of the national debt. Economic Analysis Why has the deficit increased so rapidly since 2002? A A NNUAL B UDGET D EFICIT 400 200 0 –200 –400 –600 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year B N ATIONAL D EBT $6,000 5,000 4,000 3,000 2,000 1,000 ) 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year Sources: Congressional Budget Office, 2006; Economic Report of the President, 2006 per capita per person basis; total divided by population Because trust fund balances represent money the government owes to itself, most economists tend to disregard this portion of the debt. Instead, they view the public portion of the debt—which amounted to nearly $5 trillion in mid-2006—as the economically relevant part of the debt. Figure 10.5 on the next page presents two alternative views of the total national debt held by the public. Panel A shows the debt as a percentage of GDP. In Panel B, the national debt is computed on a per capita, or per person, basis. Public vs. Private Debt Despite the size of the public debt, several important differences between public and private debt mean that the country can never go bankrupt. One is that we owe most of the national debt to ourselves— whereas private debt is owed to others. Another difference is repayment. When private citizens borrow, they usually make plans to repay the debt by a specific date. When the government borrows, it gives little thought to repayment and simply issues new bonds to pay off the old bonds. CHAPTER 10 Government Spending 279 Figure 10.5 Two Views of the National Debt The national debt as a percent of GDP has ranged from about 34 to almost 50 percent since 1965. The amount owed per person increased most years during the same period. Economic Analysis What has happened to the size of the national debt since 2001? A AS A P ERCENTAGE OF GDP 60% 50 40 30 20 0 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year B O N A P ER-C APITA B ASIS 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year Source: Congressional Budget Office A third difference has to do with purchasing power. When private individuals repay debts, they give up purchasing power because they have less money to buy goods and services. The federal government does not give up purchasing power, because the taxes collected from some groups are simply transferred to other groups. The exception is the 15 to 20 percent of the public debt owned by foreigners. When payments are made to investors outside the United States, some purchasing power is temporarily diverted from the U.S. economy. Reading Check Contrasting What are the differences between public and private debt? Impact of the National Debt MAIN Idea The national debt affects the distribution of income and transfers purchasing power from the private to the public sector. Economics and You Do you hear your parents talk about interest rates? Read on to learn how the national debt affects interest rates. Even though we owe most of the national debt to ourselves, it affects the economy by transferring purchasing power, reducing economic incentives, causing a crowdingout effect, and redistributing income. 280 UNIT 3 Economic Institutions and Issues National Debt The more the government borrows today, the more future generations will have to repay. What other effects does the national debt have on the nation Transferring Purchasing Power The national debt can cause a transfer of purchasing power from the private sector to the public sector. In general, when the public debt increases, taxes increase and people have less money for themselves. Purchasing power can also be transferred from one generation to another. If the government borrows today and leaves the repayment to future taxpayers, then today’s adults will consume more and their children less. The accumulation of debt by one generation can thus reduce the economic well-being of the next. Reducing Economic Incentives Government can reduce economic incentives if it appears to spend money in a careless manner. A community, for example, may use a federal grant to purchase expensive equipment that its citizens would not want to pay for themselves. If the taxpayers that benefit from a project would not fund it themselves, other taxpayers would not want their taxes to go to such projects. Crowding Out When the federal government uses deficit spending, it must borrow money in financial markets. This borrowing can drive John Cole / Scranton Times-Tribune interest rates up, forcing all borrowers to pay more for the temporary use of funds. Because the government borrows so much, it competes with businesses and individuals such as potential home buyers for available money. This competition can cause a crowding-out effect—the higherthan-normal interest rates caused by heavy government borrowing. If private borrowers cannot afford the higher interest rates, they are squeezed out of the market. crowding-out effect higher-than-normal interest rates and diminished access to financial capital faced by private borrowers when they compete with government borrowing in financial markets Redistributing Income Finally, the national debt and the tax structure can impact the distribution of income. Suppose that the government taxes upper-income individuals and spends the money on the poor. This would redistribute income from the rich to the poor. The opposite would happen if the poor were taxed and the money spent on the rich. In either case, the people paying less in taxes would benefit from the tax policy. This is not a purely hypothetical situation. The individual income tax cuts made since 2001 have made income taxes less progressive, shifting some of the tax burden from higher- to lower-income groups. Reading Check Analyzing How does the transfer of purchasing power between generations affect you? CHAPTER 10 Government Spending 281 Figure 10.6 The Size of the National Debt The public ly held portion of the national debt reached $5 trillion in 2006 and continues to rise. Attempts to reduce the debt by legislation alone have failed. The only other ways to reduce it are by raising taxes or reducing federal spending. Economic Analysis Why is it difficult for legislators to increase revenues or reduce spending? WILL WE EVER SHRINK THE NATIONAL DEBT? A $1 bill is about 6 inches (15.2 cm) long. If 5 trillion of these bills were laid end to end, they would form a chain 474 million miles (764 km) long—more than enough to stretch from the surface of the earth to the surface of the sun and back—two and a half times! “pay-as-you-go” provision require ment that new spending proposals or tax cuts must be offset by reductions elsewhere line-item veto power to cancel specific budget items without rejecting the entire budget spending cap limits on annual discretionary spending Skills Handbook See page R35 to learn about Identifying the Main Idea. Reducing Deficits and the Debt MAIN Idea Congress has tried a number of measures to reduce deficits and the national debt. Economics and You Did your parents teach you how to avoid overspending? Read on to learn about attempts to limit the nation’s debt. In order to control the size of the national debt, we have to first address the federal budget deficit. Concern over deficit spending since the 1980s has led to a number of attempts to control it. Legislative Failures One of the first significant attempts to control the federal deficit took place when Congress tried to mandate a balanced budget. The legislation was formally called the Balanced Budget and Emergency Deficit Control Act of 1985, or Gramm-RudmanHollings (GRH) after its sponsors. Despite high hopes, GRH failed for two reasons. First, Congress discovered that it could get around the law by passing spending bills that took effect two or three years later. Second, the economy started to decline in 1990, triggering a suspension of budget cuts when the economy was weak. In 1990 Congress passed the Budget Enforcement Act (BEA). The BEA’s main feature was a “pay-as-you-go” provision— a requirement that new spending proposals or tax cuts must be offset by reductions elsewhere in the budget. If no agreement on the reductions could be reached, then automatic, across-the-board spending cuts would be instituted. Congress soon discovered that cutting spending was more difficult than it thought, so it sus pended the provision in order to increase spending. In 1996 Congress gave the president a line-item veto—the power to cancel specific budget items without rejecting the entire budget—but the Supreme Court declared it unconstitutional. This was followed by the Balanced Budget Agreement of 1997, which featured rigid spending caps—legal limits on annual discretionary spending—to assure that Congress balanced the budget by 2002. However, the caps required politically unpopular cuts in many programs such as health, science, and education, so the caps were also abandoned. 282 UNIT 3 Economic Institutions and Issues entitlement program or benefit using established eligibility requirements to provide health, nutritional, or income supplements to individuals Raising Revenues President Clinton’s Omnibus Budget Reconcil iation Act of 1993 was an attempt to trim $500 billion from the deficit over a five-year period. The act featured a combination of spending reductions and tax increases that made the individual income tax more progressive—especially for the wealthiest 1.2 percent of taxpayers. Higher tax rates, along wit |
h strong economic growth, combined to produce four consecutive years of federal budget surpluses. By 2001 Congress expected annual surpluses for another 10 years. Rather than pay down the debt, however, Congress cut tax rates while also increasing spending. Reducing Spending Another way to control the deficit is by reducing federal spending. This can be more difficult than it sounds because spending is subject to unexpected change. For example, the 2001 terrorist attacks led to unplanned government spending on homeland security and wars in Afghanistan and Iraq. Because this was also the first year of President Bush’s tax cuts, and because economic activity was low, the federal government had fewer tax revenues to spend. As a result, record federal budget deficits returned in 2002. In addition, spending was difficult to reduce because the federal budget had so many entitlements—broad social programs with established eligibility requirements to provide health, nutritional, or income supplements to individuals. People are entitled to draw benefits if they meet the eligibility requirements. Although most entitlements are classified as mandatory spending, Congress can revise them. Still, this is difficult to do for members of Congress because the programs are so popular. In the end, Congress has a difficult task ahead. Any action to reduce budget deficits and the national debt will depend on the willpower of Congress to make unpopular and difficult choices. Reading Check Describing What events in 2001 have added to the national debt? SECTION 3 Review Vocabulary 1. Explain the significance of deficit spending, national Critical Thinking 5. The BIG Idea Why is it so difficult to rein in the debt, balanced budget, trust fund, per capita, crowding-out effect, pay-as-you-go provision, line-item veto, spending cap, and entitlement. Main Ideas 2. Describing What is the difference between the national national debt? Use examples to explain your answer. 6. Analyzing Visuals Look at Figure 10.5 on page 280. Why do you think the national debt as a percentage of GDP has not risen at the same rate as the debt per capita? 7. Determining Cause and Effect How can the federal debt and the federal deficit? debt affect worker incentives? 3. Listing Use a graphic organizer like the one below to list five ways the national debt can affect the economy. National Debt: Possible Effects on the Economy 1. 2. 4. Identifying What were the results of government efforts to reduce deficits? 8. Drawing Conclusions Which do you think is a better way to reduce budget deficits: pay-as-you-go provisions or line-item vetoes? Explain your answer in a brief paragraph. Applying Economics 9. Deficit Spending If you were given the task of reducing entitlement programs to limit deficit spending, which ones would you select to reduce or alter? Write a short essay that includes the reasons for your choices. CHAPTER 10 Government Spending 283 Profiles in Economics ECONOMIST Alice Rivlin is an outspoken critic of budget deficits. She argues that spending cannot be brought under control until Congress is willing to take action. While the problems are large, Rivlin believes that “we will find ways to solve them.” Alice Rivlin (1931– ) • founding director of the Congressional Budget Office • director of the White House Office of Management and Budget • vice chair of the Federal Reserve Board Ms. Economics At a time when few women had full-time jobs, fewer went to college, and almost none pursued economics, Alice Rivlin discovered the subject and found her niche. Rivlin is well known for her insistence on solid analysis, innovative thinking, and a steadfast insistence on “fiscal sanity”—balanced federal budgets and a low national debt. These traits served her well as the founding director of the Congressional Budget Office. Rivlin likened the job to an entrepreneurship, because she had to find ways to provide Congress with nonpartisan projections on the impact of proposed legislation on the nation’s budget and debt. Balancing the Federal Checkbook Rivlin believed that Reaganomics had a negative effect on the U.S. economy. In 1992 she published Reviving the American Dream: The Economy, the States, and the Federal Government, which outlined her plan for “fiscal sanity” and the responsibilities of national and state governments. She believes that competition between states to attract corporations leads to too many tax breaks, resulting in too few tax dollars to implement needed—and often federally mandated—social programs. Instead states should engage “in an aggressive effort to improve their infrastructure and improve their education systems in order to attract business.” The book influenced then-presidential candidate Bill Clinton, for whom she became Director of the White House Office of Management and Budget. In this position she oversaw a transition from federal debt to surplus in just two years. This success led her to membership on the Federal Reserve Board. Today Rivlin looks for ways to fight budget deficits as a Senior Fellow at the Brookings Institution, an economics and policy think tank located in Washington, D.C. Examining the Profile 1. Summarizing How does Rivlin define “fiscal sanity”? 2. Determining Cause and Effect According to Rivlin, what is the best way for states to attract business? 284 UNIT 3 Economic Institutions and Issues Time Life Pictures/Getty Images CHAPTER 10 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Federal Budget Process Each year, the president sends a federal budget to Congress. The budget undergoes a lengthy approval process until it is signed into law. Office of Management and Budget prepares a budget President submits budget to Congress House breaks down budget and assigns to subcommittees Subcommittees prepare appropriations bills House Appropriations Committee votes on bills President vetos bill and sends back to Congress Conference committee writes compromise bill President signs bill Bill sent to president Senate drafts different version of bill Senate approves House bill Full House votes on bills and sends to Senate Major Budget Categories The major budget categories vary for federal, state, and local governments. The focus of the federal government is on nationwide programs and expenditures. States pass on much of their budget to local governments and spend the rest on state-level programs. Local governments focus their expenditures on local needs. Federal government • Social Security • National defense • Income security • Health care State governments Intergovernmental expenditure Public welfare Insurance trust and retirement Higher education • • • • • • • Local governments Elementary and secondary education Utilities Public safety and health Surpluses, Deficits, and Debt When revenues exceed expenditures, governments enjoy a budget surplus. If revenues are less than expenditures, governments are faced with a budget deficit. They then have to borrow money to meet expenditures and incur debt. Budget Surplus Budget Deficit Revenues Surplus Expenditures Deficit Borrowing Debt Expenditures Revenues CHAPTER 10 Government Spending 285 CHAPTER 10 Assessment & Activities Review Content Vocabulary Review the Main Ideas Write a sentence about each pair of terms below. The sentences should show how the terms are related. 1. public sector, private sector 2. transfer payment, grant-in-aid 3. distribution of income, deficit spending 4. federal budget, fiscal year Section 1 (pages 261–265) 17. Explain the two kinds of government spending. 18. Describe the way the government competes with the private sector. 19. Explain why politicians insert “pork” items into other legislation. 5. appropriations bill, balanced budget amendment Section 2 (pages 267–275) 6. deficit spending, national debt 7. deficit spending, crowding-out effect 8. entitlement, balanced budget 9. mandatory spending, discretionary spending 10. spending cap, budget deficit Review Academic Vocabulary Each of the sentences below contains a synonym for one of the following terms. Match the sentence to the term. a. constituents b. reluctant c. coincide d. ambiguity e. mandate f. instituted 11. States have a requirement to provide public schools. 12. The federal budget leaves some uncertainty about actual expenditures. 13. The state legislature was hesitant when it came to reducing spending for roads. 14. The fiscal year often does not correspond with the calendar year. 15. The representative was concerned about maintaining the support of the voters in his district. 16. Some states have passed balanced budget amendments. 286 UNIT 3 Economic Institutions and Issues 20. Identify the purpose of a balanced budget amendment. 21. Identify the categories of federal, state, and local spending by using a graphic organizer like the one below. Categories of Spending Federal State Local 22. List the three major categories of spending by local governments. Section 3 (pages 277–283) 23. Discuss the relationship of the federal deficit to the federal debt. 24. List four legislative attempts to deal with the problem of federal budget deficits. 25. Explain why entitlements are so named. Critical Thinking 26. The BIG Idea Why is it more difficult for politicians to reduce mandatory spending than discretionary spending? 27. Comparing and Contrasting What is the difference between transfer payments and government spending on goods and services? 28. Drawing Conclusions Review the discussion on attempts to reduce the deficit on pages 282 and 283. Use a chart similar to the one below to outline the main features and weaknesses of these legislative attempts. Can you find a common reason why these attempts have failed? What do you think would need to be done to avoid future failures? Legislation Features Weaknesses 29. Determining Cause and Effect How does a balanced budget amendment affect the budget process? 30. Making Inferences Do you thin |
k transfer payments are the best way to distribute tax revenue? How would the tax collection system have to change if the government levels that actually spend the money had to collect the taxes themselves? Applying Economic Concepts 31. Human Capital Which of the categories in Figure 10.3 on page 273 reflect an investment in human capital? 32. Government Spending Make a list of ways you and your family benefit from government expenditures. Provide at least one example each for the federal, state, and local government. Math Practice 33. A neighbor spent $25,000 a year for 10 years and had an annual income of $20,000 during this period. What is the neighbor’s total debt? Economics: Principles and Practices Web site at glencoe.com and click on Chapter 10—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Analyzing Visuals 34. Classifying Information Examine the major types of federal expenditures in Figure 10.2 on page 269. Classify each as to whether they are entitlement or nonentitlement programs. Thinking Like an Economist 35. Critical Thinking An economist likes to think in terms of trade-offs and opportunity costs. If you wanted to make changes to a balanced state budget in any given year, what would be the opportunity cost of lowering taxes? Of increasing discretionary spending? Writing About Economics 36. Persuasive Writing Which of the two types of government spending has the most impact on the economy? Explain your answer in a two-page paper. Interpreting Cartoons 37. Critical Thinking What is the topic of the cartoon below? What point is the cartoonist making about the topic? How does he do it? Do you think the cartoon is effective Paul Combs, Editorial Cartoonist/The Tampa Tribune. CHAPTER 10 Government Spending 287 CHAPTER 11 Financial Markets Why It Matters You have just been hired as a financial planner to provide advice on how to invest wisely and effectively. Miguel, your client, is a widower raising two young children. He wants to be sure that (1) he will have enough money to send his children to college, and (2) he will be financially secure in his retirement. What advice would you give Miguel? Read Chapter 11 to learn more about how people can accomplish their financial goals. The BIG Idea Governments and institutions help participants in a market economy accomplish their financial goals. Traders on the Chicago Mercantile Exchange talk to one another with hand signals. 288 UNIT 3 Getty Images Economics: Principles and Practices Web site at glencoe.com and click on Chapter 11—Chapter Overviews to preview chapter information. Chapter Overview Visit the SECTION 1 Savings and the Financial System GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn how the components of a financial system work together to transfer savings to investors. Content Vocabulary • saving (p .289) • savings (p. 289) • certificate of deposit (p. 290) • financial asset (p. 290) • financial system (p. 290) • financial intermediary (p. 290) • nonbank financial institution (p. 292) • finance company (p. 292) • premium (p. 292) • pension (p. 292) • pension fund (p. 292) • risk (p. 293) ISSUES IN THE NEWS Follow My Money • sector (p. 291) • compensation (p. 294) Reading Strategy Describing As you read the section, complete a graphic organizer like the one below by describing how financial intermediaries channel money. Financial intermediary Way to channel money —www.businessweek.com Jonathan Ping is not a financial guru. And he’s not a millionaire (yet). He’s simply a 27-year-old engineer living with his wife and dog in a rented house in Portland, Oregon. Within the next 18 months he hopes to scrape up $100,000 for a down payment on a home, and he wants to build a net worth of $1 million by age 45. So far he’s at $88,953. How do I know this? It’s in bold type in the top right-hand corner of his Web log, where Ping keeps a daily tally of his progress. He’s one of more than 150 bloggers, mostly 22 to 35, who have adopted an open-source approach to personal finance. In stark contrast to their parents’ generation, for whom comparing incomes can be awkward, if not downright taboo, bloggers list financial information down to the dollar in retirement, brokerage, and savings accounts. They recommend investments, decry credit-card debt, and wallow together over high taxes. ■ For an economic system to grow, it must produce capital—the equipment, tools, and machinery used in production. In order for this to happen, saving must take place. To the economist, saving means the absence of spending, while savings refers to the dollars that become available when people abstain from consumption. Our financial system continually evolves to meet the needs of both savers and investors. If you decide to save your income, as Jonathan Ping in the news story and other bloggers are doing, you should learn about some important investment considerations. You also will see that you can choose from a wide variety of options. saving absence of spending that frees resources for use in other activities or investments savings the dollars that become available for investors to use when others save Jonathan of MyMoneyBlog.com, a Personal Finance Blog CHAPTER 11 Financial Markets 289 Saving and Economic Growth MAIN Idea The financial system brings savers and borrowers together and helps the economy grow. Economics & You Do you have a personal savings account? Read on to learn how your savings are used to help the economy. When people save, they make funds available for others to use. Businesses can borrow these savings to produce new goods and services, build new plants and equipment, and create more jobs. Saving thus makes economic growth possible. Savers and Financial Assets People can save in a number of ways. They can open a savings account, buy a bond, or purchase a certificate of deposit— a document showing that an investor has made an interest-bearing loan to a bank. In each case, savers obtain a receipt for the funds they save. Economists call these documents financial assets—claims on the property and the income of the borrower. The documents are assets because they are property that has value. They represent claims on the borrower because they specify the amount loaned and the terms at which the loan was made. Stocks, or ownership claims on a corporation, are another type of financial asset. However, because stocks have some unique features that require additional consideration, we will discuss them separately in the last section of this chapter. Collectively, investors have a full range of financial assets from which to choose. The Circular Flow of Finance In order for people to use the savings of others, the economy must have a financial system—a network of savers, investors, and financial institutions that work together to transfer savings to investors. The financial system has three parts. The first part is made up of the funds that a saver transfers to a borrower. The second consists of the financial assets that certify conditions of the loan. The third comprises the organizations that bring the surplus funds and financial assets together. Financial intermediaries are the institutions that lend the funds that savers provide. Financial intermediaries include depository institutions such as banks and credit unions, life insurance companies, pension funds, and other institutions that channel savings to borrowers. These institutions are especially helpful to small savers, who have only limited funds available to deposit. certificate of deposit document showing that an investor has made an interest bearing loan to a financial institution financial asset a stock or other document that represents a claim on the income and property of a borrower, such as a CD, bond, Treasury bill, or mortgage financial system network of savers, investors, and financial institutions working together to transfer savings for investment uses financial intermediary institution that channels savings to investors Personal Finance Handbook See pages R6–R9 for more information on saving and investing. Saving When you open a savings account, you make money available for business investments. How does money from savers reach investors? 290 Ariel Skelley/Corbis Figure 11.1 Overview of the Financial System Financial intermediaries help channel surplus funds from savers to borrowers, who put the money to work. Savers also lend directly to governments and businesses, who issue bonds or other financial assets for the money they borrow. Economic Analysis What do lenders receive in return for their funds? See StudentWorks™ Plus or glencoe.com. Surplus funds Households, businesses Financial Intermediaries Commercial banks Savings and loan associations Savings banks Mutual savings banks Credit unions Life insurance companies Mutual funds Pension funds Finance companies Governments, businesses Financial assets Figure 11.1 shows the circular flow that takes place when funds are transferred from savers to borrowers. Savers can provide their funds directly to the borrower. They also can do so indirectly through the many financial intermediaries in the economy, such as banks, life insurance companies, and credit unions. The documents that certify the ownership of the funds—the certificates of deposit, savings and other bank accounts, as well as bonds— are the financial assets that return to the lender. Financing Capital Formation Any sector of the economy can borrow, but governments and businesses are the largest borrowers. If a corporation borrows directly from savers—or indirectly from savers through financial intermediaries— the corporation will issue a bond or other financial asset to the lender. When the government borrows, it issues government bonds or other financial assets to the lender. Any sector of the economy can supply savings, but households and businesses are the biggest sources of funds. Savers can provide some funds directly |
to borrowers, as when households or businesses purchase bonds directly from government or businesses. Capital formation depends on saving and borrowing. When households borrow, they invest some of the funds in homes. When businesses borrow, they invest some of the funds in tools, equipment, and machinery. When governments borrow, they invest some of the funds in highways, hospitals, universities, and other public goods. In the end, everyone benefits from the financial system. The smooth flow of funds through the system helps ensure that savers will have an outlet for their savings. Borrowers, in turn, will have a source of financial capital that can be invested in capital goods to benefit future economic growth. Reading Check Summarizing How does the financial system bring savers and borrowers together? CHAPTER 11 Financial Markets 291 nonbank financial institution nondepository institution that channels savings to investors finance company firm that makes loans directly to con sumers and specializes in buying installment contracts from merchants who sell on credit premium price paid at regular intervals for an insurance policy pension regular payment to someone who has worked a certain number of years, reached a certain age, or has suffered an injury pension fund fund that collects and invests income until payments are made to eligible recipients Nonbank Financial Intermediaries MAIN Idea Organizations other than banks can transfer money from savers to borrowers. Economics & You Have you ever heard your parents discuss pensions? Read on to learn why these are called nonbank financial intermediaries. Banks, credit unions, and savings associations obtain funds when they accept regular deposits. Another important group of financial intermediaries is called nonbank financial institutions—or nondepository institutions that also channel savings to borrowers. Finance companies, life insurance companies, and pension funds are examples of nonbank financial institutions. Finance Companies A finance company is a firm that specializes in making loans directly to consumers. It also buys installment contracts from merchants who sell goods on credit. Many merchants, for example, cannot afford to wait years for their customers to pay off high-cost items purchased on an installment plan. Instead, a merchant will sell a customer’s installment contract to a finance company for a lump sum. This allows the merchant to advertise easy credit terms without actually accepting the full risks of the loan. The finance company then carries the loan full term, absorbing losses for an unpaid account or taking customers to court if they do not pay. Tough Payoff Finance companies charge much higher interest rates than banks or credit unions, which makes their loans much more expensive. Let’s assume you want a 60-month car loan for $6,000. A bank loan with an 8-percent interest rate would cost you $1,300 in interest over the life of the loan. Interest on the same loan at a finance company charging 12 percent interest would total $2,008, or at 16 percent, $2,755. A few percentage points make a big difference! 292 UNIT 3 Economic Institutions and Issues Some finance companies make loans directly to consumers. These companies generally check a consumer’s credit rating and will make a loan only if the individual qualifies. Because they make some risky loans and pay more for the funds they borrow, finance companies charge more than commercial banks for loans. Life Insurance Companies Another financial institution that does not get its funds through deposits is the life insurance company. Although its primary purpose is to provide financial protection for the people who are insured, it also collects a great deal of cash. The head of a family, for example, may purchase a life insurance policy to leave money for a spouse and children in case of his or her death. The premium is the price the insured pays for this policy, usually paid monthly, quarterly, or annually for the length of the protection. Because insurance companies collect cash for these premiums on a regular basis, they often lend surplus funds to others. Pension Funds The pension fund is another nondepository financial institution. A pension is a regular payment intended to provide income security to someone who has worked a certain number of years, reached a specified age, or suffered a particular kind of injury. A pension fund is a fund set up to collect income and disburse payments to those persons eligible for retirement, old-age, or disability benefits. In the case of private pension funds, employers regularly withhold a percentage of workers’ salaries to deposit in the fund. During the 30- to 40-year lag between the time the savings are deposited and the time the workers generally use them, the money is usually invested in high-quality corporate stocks and bonds. Reading Check Comparing and Contrasting How do finance companies, life insurance companies, and pension funds channel savings to borrowers? Figure 11.2 The Power of Compound Interest This table shows the balance in an account if monthly deposits of $10 were compounded monthly. The higher the interest rate and the longer money is invested, the larger the final balance will be. Economic Analysis How much interest is earned after the first 10 years at 6 percent? See StudentWorks™ Plus or glencoe.com. C OMPOUND I NTEREST Annual interest (in percent) 5 0 2 4 6 8 10 12 $600 $630 $663 $698 $735 $774 $817 10 $1,200 $1,327 $1,472 $1,639 $1,829 $2,048 $2,300 Value at end of year 20 15 $1,800 $2,097 $2,461 $2,908 $3,460 $4,145 $4,996 $2,000 $2,948 $3,668 $4,620 $5,890 $7,594 $9,893 25 $2,500 $3,888 $5,141 $6,930 $9,510 $13,268 $18,788 30 $3,600 $4,927 $6,940 $10,045 $14,904 $22,605 $34,950 Basic Investment Considerations would grow with a larger deposit! That is why many investment advisers tell people to save something every month. MAIN Idea Investors should consider several factors before investing their money. Simplicity Economics & You Have you thought about investing some of your savings? Read on to learn what factors to consider. You may want to participate in the financial system by investing in stocks, bonds, and other financial assets. Before you do so, you should be aware of four basic investment considerations. Consistency Most successful investors invest consistently over long periods of time. In many cases, the amount invested is not as important as investing on a regular basis. Figure 11.2 shows how a monthly deposit of $10 would grow over a 5- to 30-year period at various interest rates. Even at modest rates, the balance in the account accumulates fairly quickly. Because $10 is a small amount, imagine how the account Most analysts advise investors to stay with what they know. Thousands of investments are available, and many are quite complicated. Knowing a few fundamental principles can help you make good choices among these options. One rule that many investors follow is to ignore any investment that seems too complicated. Another often-cited rule is that an investment that seems too good to be true probably is. A few investors do get lucky, but most build wealth because they invest regularly, and they avoid the investments that seem too far out of the ordinary. The Risk-Return Relationship Another important factor is the relationship between risk and return. Risk is the degree to which the outcome is uncertain but a probable outcome can be estimated. Investors realize that some investments are riskier than others, so they normally risk situation in which the outcome is not certain, but the probabilities can be estimated Skills Handbook See page R57 to learn about Interest Rates. CHAPTER 11 Financial Markets 293 Figure 11.3 Risk and Return T HE R ELATIONSHIP B ET WEEN R ISK AND R ETURN Junk bonds Speculative stock Common stock Preferred stock Investment-grade bonds Prime commercial paper U.S. Treasury bills Increasing degrees of risk The level of risk for investments can vary considerably. U.S. Treasury bills are regarded as the safest investments, while speculative stock and junk bonds are considered among the riskiest. Economic Analysis Why do investors require higher returns for some investments? demand higher returns as compensation. This relationship between increasing risks and returns is illustrated in Figure 11.3. As an investor, you must consider the level of risk that you can tolerate. If you are comfortable with high levels of risk, then you may want to purchase risky investments that promise high returns. Otherwise consider lower-risk investments instead. Investment Objectives Finally, you need to consider your reason for investing. For example, if you want to cover living expenses during periods of unemployment, you might want to accumulate assets that can easily be converted into cash. If you want to save for retirement, you might want to purchase common stocks that generate dividend income and appreciate in value over time. Investors have a large number of stocks, financial assets, and other investments from which to choose. The investor’s knowledge of his or her own needs is important in making these decisions. Reading Check Identifying If you were to invest your money, what would your objectives be? SECTION 1 Review Vocabulary 1. Explain the significance of saving, savings, certificate of deposit, financial asset, financial system, financial intermediary, nonbank financial institution, finance company, premium, pension, pension fund, and risk. Main Ideas 2. Describing How does saving compare to savings? 3. Identifying Use a graphic organizer like the one below to describe the nonbank financial intermediaries. Nonbank Financial Intermediaries 4. Explaining Why is consistency important when saving? 294 UNIT 3 Economic Institutions and Issues Critical Thinking 5. The BIG Idea What is the relationship between the financial system and the economy? 6. Comparing and Contrasting How do life insurance companie |
s and pension funds differ in the way they serve their clients? 7. Analyzing Visuals Look at Figure 11.2 on page 293. If you invested $10 a month for 20 years at an annual interest rate of 6 percent, what would be your ending balance? How much of that would be your initial investment? How much would be the interest earned? Applying Economics 8. Financial Assests Why is an I.O.U. that you write and give to a friend in payment of a debt considered an example of a financial asset? ENTREPRENEUR Profiles in Economics Sallie Krawcheck (1965– ) • chief financial officer for Citigroup Inc., the world’s largest financial institution • ranked number 6 on Forbes’s top 100 of “The World’s Most Powerful Women” for 2006 Sallie Krawcheck thinks that nothing prepared her better for Wall Street than feeling like an outcast in seventh grade. Ready to take contrarian stands today, she believes that one of the best lessons she learned then was to “zig when everyone else is zagging.” Indirect Road to Success While Sallie Krawcheck came to her current position at a fast pace, it was not on a straight path. Armed with a journalism degree, she became an investment banker but did not enjoy it. Instead she decided to pursue an MBA at Columbia University, only to return to investment banking when she could not find other job opportunities. Then, in a quick series of events, Krawcheck got married, had a baby, quit her job, and discovered within just two weeks of quitting that she enjoyed working too much to give it up. She decided to try her hand as a research analyst, but was rejected by every firm except the one—Sanford C. Bernstein—that would eventually help launch her fast-track career. Rising Star As a research analyst, Krawcheck evaluated the stock of financial institutions. She looks back on this time as the best possible training for her future roles. Krawcheck learned to be persistent, work hard, be willing to learn from mistakes and, perhaps most importantly, stand by her decisions: “As an analyst, I was very comfortable being uncomfortable, and as a CFO I have to be comfortable being uncomfortable. I have to be fine with delivering bad news.” Krawcheck’s reputation grew along with her success. Called “Mrs. Clean” because of her unwavering insistence on ethics and honesty, she was hired as the CEO of Smith Barney, the research and brokerage division of Citigroup which had gone through a period of ethical turmoil. Two years later, she found herself in the position of CFO at Citigroup, with an annual salary of $500,000 in 2005. Bonuses and other benefits pushed the total up to nearly $10 million. Examining the Profile 1. Identifying What skills helped Krawcheck most in being promoted and becoming a successful CFO? 2. Making Inferences What lessons do you think Krawcheck learned from her early career? Mark Peterson/Corbis CHAPTER 11 Financial Markets 295 SECTION 2 Financial Assets and Their Markets GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn about the characteristics of various investments to help with your investments. • offset (p. 298) • presumed (p. 300) Content Vocabulary • bond (p. 297) • coupon rate (p. 297) • maturity (p. 297) • par value (p. 297) • current yield (p. 297) • junk bond (p. 299) • municipal bond (p. 299) • tax-exempt (p. 300) • savings bond (p. 300) • beneficiary (p. 301) • Treasury note (p. 301) • Treasury bond (p. 301) • Treasury bill (p. 301) • Individual Retirement Account (IRA) (p. 302) • capital market (p. 302) • money market (p. 302) • primary market (p. 303) • secondary market (p. 303) Reading Strategy Identifying As you read the section, use a graphic organizer similar to the one below to identify and describe at least four financial assets. Financial Assets ISSUES IN THE NEWS Want More Interest? Meet Bond, Junk Bond —www.usatoday.com Let’s think about a little number: 4.59%. It’s not the percentage of Americans who understand Olympic curling rules. It’s the amount of interest you can earn annually on a 10-year Treasury note. That would be $45.90 a year on a $1,000 investment. Ah, good times. Good times. You might be wondering, “Is there any way I can get a bit more interest?” Well, yes. You could invest some of your portfolio in a junk-bond fund. Bonds are long-term, interest-bearing IOUs . . . [and] . . . bonds issued by corporations tend to pay higher interest. That’s because they can go bankrupt and default on their bonds. Bonds issued by companies with poor credit ratings pay the highest interest of all. The only problem: When you buy junk bonds at high prices, you run the risk of nastiness if the economy gets smacked. ■ When you decide to invest your money, you will have a variety of investment options. As you read in the news story, not all options are alike. Some investments carry only a small risk, but they also offer a smaller return. Other investments may offer the possibility of larger returns, but the higher risk means you may never see that money if the company defaults on its promise to pay. Many financial assets are available in the market. Before you invest in any of these, it helps to know the risks involved in each. 296 UNIT 3 Economic Institutions and Issues JosÈ Fuste Raga/zefa/Corbis Bonds as Financial Assets MAIN Idea A bond is a long-term investment, with the price determined by supply, demand, and the buyer’s assessment of repayment risk. Economics and You Have you ever received a government bond as a birthday present? Read on to learn how the value of a bond is determined. Governments and businesses issue bonds when they need to borrow funds for long periods. A bond is a formal long-term contract that requires repayment of borrowed money and interest on the borrowed funds at regular intervals over time. Increasingly bonds are taking on an international flavor, with companies in one country issuing bonds in another. While this may seem complex, the main components of a bond are relatively simple. Bond Components A bond has three main components: the coupon rate, or the stated interest on the debt; the maturity, or the life of the bond; and the par value, the principal or the total amount initially borrowed that must be repaid to the lender at maturity. Suppose, for example, that a corporation sells a 6 percent, 20year, $1,000 par value bond that pays interest semiannually. The coupon payment to the holder is $30 semi annually (.06 times $1,000, divided by 2). When the bond reaches maturity after 20 years, the company retires the debt by paying the holder the par value of $1,000. Bond Prices The investor views the bond as a financial asset that will pay $30 twice a year for 20 years, plus a final par value payment of David Waisglass/Laughingstock $1,000. Investors can offer $950, $1,000, $1,100, or any other amount for this future payment stream. Investors consider changes in future interest rates, the risk that the company will default, and other factors before they decide what to offer. Supply and demand among buyers and sellers will then establish the final price of the bonds. Bond Yields In order to compare bonds, investors usually compute the bond’s current yield, the annual interest divided by the purchase price. If an investor paid $950 for the bond described above, the current yield would be $60 divided by $950, or 6.32 percent. If the investor paid $1,100 for the bond, the current yield would be $60 divided by $1,100, or 5.45 percent. It may appear as if the issuer fixes the return on a bond when the bond is first issued. However, the interest received and the price paid determine the actual current yield of each bond. The result is that the bond yield, like the bond price, is determined by supply and demand bond contract to repay borrowed money and interest on the borrowed money at regular future intervals coupon rate stated interest on a corporate, municipal, or government bond maturity life of a bond or length of time funds are borrowed par value principal of a bond or total amount borrowed current yield bond’s annual coupon interest divided by purchase price; measure of a bond’s return Bonds Corporate and government bonds are attractive because they can be safe and may be tax-exempt. How is the actual return of a bond determined? CHAPTER 11 Financial Markets 297 Bond Ratings Because the credit-worthiness, or financial health, of corporations and governments differ, all 6 percent, 20-year, $1,000 bonds will not cost the same. There are no guarantees that the issuer will be around in 20 years to redeem the bond. Therefore, investors will pay more for bonds issued by an agency with an impeccable credit rating. However, investors will pay less for a similar bond if it is issued by a corporation with a low credit rating. Fortunately, investors have a way to check the quality of bonds. Two major corporations, Standard & Poor’s and Moody’s, publish bond ratings. They rate bonds on a number of factors, including the basic financial health of the issuer, the expected ability to make the future coupon and principal payments, and the issuer’s past credit history. Bond ratings, shown in Figure 11.4, use letters scaled from AAA, which represents the highest investment grade, to D, which generally stands for default. If a bond is in default, the issuer has not kept up with the interest or other required payments. These ratings are widely publicized, and investors can find the rating of any bond they plan to purchase. Bonds with high ratings sell at higher prices than do bonds with lower ratings. A 6 percent, 20-year, $1,000 par value bond with an AAA-grade rating may sell for $1,100 and have a current yield of 5.45 percent. Another 6 percent, 20-year, $1,000 par value bond issued by a different company may have a BBB rating, and may therefore only sell for $950 because of the higher risk. The second bond, however, has a higher current yield of 6.32 percent. This is consistent with the basic risk-return relationship, which states that inv |
estors require higher returns to offset increased levels of risk. Bonds issued by the U.S. government are considered to be the safest of all financial assets because they have almost no risk of ever being in default. Because of this, these bonds also have the lowest yields. Reading Check Describing What factors determine a bond’s value? Figure 11.4 Bond Ratings Standard & Poor’s Moody’s Highest investment grade High grade Upper medium grade Medium grade Lower medium grade Speculative Vulnerable to default Subordinated to other debt rated CCC Subordinated to CC debt Bond in default AAA AA A BBB BB B CCC CC C D Aaa Aa a Baa Ba B Caa Ca C D Best quality High quality Upper medium grade Medium grade Possesses speculative elements Generally not desirable Poor, possibly in default Highly speculative, often in default Income bonds not paying income Interest and principal payments in default Sources: Standard & Poor’s; Moody’s. Both Standard & Poor’s and Moody’s publish bond ratings. Junk bonds, those with ratings of BB or Ba and lower, are generally the riskiest types of bonds. Economic Analysis How do bond ratings affect the price of bonds Certificates of Deposit CDs can vary in cost and length of maturity. What are other characteristics of Certificates of Deposit? junk bond bond that carries an exceptionally high risk of nonpayment and a low rating municipal bond bond, often tax exempt, issued by state and local governments Skills Handbook See page R58 to learn about Interpreting Cartoons. Financial Assets and Their Characteristics insurance limit. The National Credit Union Association insures most CDs issued by credit unions. MAIN Idea Investments include CDs, bonds, bills, and IRAs, all of which vary in cost, maturity, and risk. Economics and You Have you seen bank advertisements for CDs? Read to find out how these compare to other investments. The modern investor has a wide range of financial assets from which to choose. These include certificates of deposit, bonds, and Treasury notes and bills. They vary in cost, maturity, and risk. Certificates of Deposit Certificates of deposit (CDs) are one of the most common forms of investments available. Many people think of them as just another type of account with a bank, but they are really loans investors make to financial institutions. Because banks and other borrowers count on the use of these funds for a certain time period, they usually impose a penalty if people try to cash in their CDs early. CDs are attractive to small investors because they can cost as little as $500 or $1,000. Investors can also select the length of maturity, giving them an opportunity to tailor the expiration date to future expenditures such as college tuition, a vacation, or some other expense. Finally, the CDs issued by commercial banks, savings banks, and savings associations are included in the $100,000 FDIC King Features Syndicate, Inc. Corporate Bonds Corporate bonds are an important source of corporate funds. Some individual corporate bonds have par values as low as $1,000, but par values of $10,000 are more common. The actual prices of the bonds are usually different from the par values. Investors generally decide on the highest level of risk they are willing to accept. They then try to find a bond that has the best current yield. Junk bonds— exceptionally risky bonds with a Standard & Poor’s rating of BB or lower, or a Moody’s rating of Ba or lower—carry a high rate of return as compensation for the higher possibility of default. Investors usually purchase corporate bonds as long-term investments, but these bonds can be quickly sold if investors need cash for other purposes. The Internal Revenue Service considers the interest, or coupon, payments on corporate bonds as taxable income, a fact investors must consider when they invest in bonds. Municipal Bonds Municipal bonds, or “munis,” are bonds issued by state and local governments. States issue bonds to finance highways, state buildings, and some public works. Cities issue bonds to pay for baseball parks and football stadiums, or to fund libraries, parks, and other civic improvements. CHAPTER 11 Financial Markets 299 tax-exempt not subject to tax by federal or state governments savings bond low-denomination, non-transferable bond issued by the federal government Municipal bonds are attractive investments for several reasons. First, they are generally regarded as safe investments. Unlike companies, state and local governments do not go out of business and therefore rarely default. In addition, because governments have the power to tax, it is generally presumed that in the future they will be able to pay interest and principal for any bonds they have issued. CAREERS Stockbroker The Work * Supply the latest price quotations on stocks and keep informed about the financial activities of corporations issuing stock * Provide clients with financial counseling and advice on the purchase or sale of particular securities * May design an individual client’s financial portfolio, which could include securities, life insurance, corporate and municipal bonds, mutual funds, certificates of deposit, annuities, and other investments Qualifications * Excellent sales skills and communication skills * Ability to act quickly is helpful in building and keeping a strong customer base * College degree in business administration, economics, or finance * Must pass licensing exam Earnings * Median annual earnings: $69,200 Job Growth Outlook * Average Source: Occupational Outlook Handbook, 2006–2007 Edition 300 UNIT 3 Economic Institutions and Issues Robert Essel NYC/Corbis More importantly, municipal bonds are generally tax-exempt, meaning that the federal government does not tax the interest paid to investors. In some cases, the states issuing the bonds also exempt the interest payments from state taxes, which makes them very attractive to investors. The tax-exempt feature also allows the government agencies to pay a lower rate of interest on the bonds, thereby lowering the government’s cost of borrowing. Government Savings Bonds The federal government generates financial assets when it sells savings bonds. Savings bonds are low-denomination, nontransferable bonds issued by the U.S. government that are also called EE savings bonds. Investors can purchase them through banks and financial intermediaries, obtain them through payroll-savings plans, or buy them directly from the U.S. Treasury over the Internet. Regardless of how they are purchased, there are two kinds of savings bonds; one is paper-based, and the other is paperless. The paper bonds are available in denominations ranging from $50 to $10,000, and they are purchased at a 50 percent discount from their redemption value. For example, you might obtain a new $50 savings bond today for $25, or a $10,000 bond for $5,000. You may then have to hold the bond for up to 30 years before you can redeem it for the full face value, depending on the purchase date and the interest rate. The government pays interest on these bonds, but it builds the interest into the redemption price rather than sending checks to millions of investors on a regular basis. Paperless bonds are purchased directly from the Treasury over the Internet. All an investor has to do is open an account, and the bonds will be issued electronically to the investor ’s account. The electronic bonds sell at face value, so you pay $50 for a $50 bond, or $10,000 for a $10,000 bond. Interest is added monthly and compounded semi annually, but to take some of the beneficiary person designated to take ownership of an asset if the owner of the asset dies Treasury note U.S. government obligation with a maturity of 2 to 10 years Treasury bond U.S. government bond with a maturity of 10 to 30 years Treasury bill short-term United States government obligation with a maturity of one year or less in denominations of $1,000 Although these financial assets have no collateral or backing, they are popular because they are generally regarded as the safest of all financial assets. Due to the trade-off between risk and return, however, these assets also have the lowest returns of all financial assets. Treasury Bills Federal government borrowing generates other financial assets known as Treasury bills. A Treasury bill, also called a T-bill, is a short-term obligation with a maturity of 4, 13, or 26 weeks and a minimum denomination of $1,000. T-bills do not pay interest directly but instead are sold on a discount basis, much like government savings bonds. For example, an investor may pay the auction price of $960 for a 26-week bill that matures at $1,000. The $30 difference between the amount paid and the amount received Savings Bonds The federal government issues paper-based EE Savings Bonds in low denominations. How can you purchase these bonds? uncertainty out of the investment, the U.S. Treasury guarantees that the bond will at least double in value every 20 years. Savings bonds are popular because they are easy to obtain and there is virtually no risk of default. They cannot be sold to someone else if the investor needs cash, but they can be redeemed early, with some loss of interest, if the investor must raise cash for other purposes. Most investors who purchase long-term savings bonds treat them as a form of automatic savings. Other investors buy the bonds for their heirs by designating a beneficiary, or someone who inherits the ownership of the financial asset if the purchaser dies. A grandmother, for example, may buy EE saving bonds in her name and designate a grandchild as the beneficiary. When the grandmother dies, the beneficiary automatically takes ownership of the savings bond without having to pay any inheritance taxes. Treasury Notes and Bonds When the federal government borrows funds for periods lasting longer than one year, it issues Treasury notes and bonds. Treasury notes are United States government obligations with maturities of 2 to 10 years, while Tre |
asury bonds have maturity dates ranging from more than 10 to as many as 30 years. The only collateral that secures both is the faith and credit of the United States government. Treasury notes and bonds come in denominations of $1,000, which means that small investors can afford to buy them. The notes and bonds are issued electronically, and investors purchase them directly from the U.S. Treasury. Since the investors’ accounts are computerized, the Treasury adds the periodic interest payments directly to these accounts rather than mailing checks to the investors. Comstock Images/SuperStock Figure 11.5 Financial Assets and Their Markets Assets in the money or capital market differ in the length of maturity. The ability to sell the asset to someone other than the original issuer determines whether that asset is part of the primary or the secondary market. Economic Analysis Why do some financial assets, such as CDs, appear in more than one market? Money market (less than 1 year) Capital market (more than 1 year) Primary market Money market mutual funds Small CDs Secondary market Jumbo CDs Treasury bills Government savings bonds IRAs Money market mutual funds Small CDs Corporate bonds International bonds Jumbo CDs Municipal bonds Treasury bonds Treasury notes Individual Retirement Account (IRA) retirement account in the form of a long-term time deposit, with annual contributions not taxed until withdrawn during retirement capital market market in which financial capital is loaned and/or borrowed for more than one year money market market in which financial capital is loaned and/or borrowed for one year or less is the investor ’s return. The investor receives $30 on a $960 investment, for a semiannual return of $30 divided by $960, or 3.1 percent. Individual Retirement Accounts Many employees invest money in Individual Retirement Accounts (IRAs), long-term, tax-sheltered time deposits that can be set up as part of an individual retirement plan. For example, a worker may decide to deposit $4,000 annually in such an account. If the worker’s spouse does not work outside the home, the spouse also can deposit $4,000 per year in a separate account. The worker deducts these deposits from the taxable income, thereby sheltering up to $8,000 from the individual income tax. Taxes on the interest and the principal will eventually have to be paid. However, the tax-deferment feature gives the worker an incentive to save today, postponing the taxes until the worker is retired and in a lower tax bracket. IRAs cannot be transferred, and penalties exist if they are liquidated early. In addition, the government sets annual contribution limits. Reading Check Analyzing What features of a government bond appeal most to you? Markets for Financial Assets MAIN Idea Financial assets are grouped into different markets depending on their maturity and liquidity. Economics and You Would you be willing to invest your money for a 20-year term? Read to learn in which market you would be involved. Investors often refer to markets according to the characteristics of the financial assets traded in them. These markets overlap to a considerable degree. Capital Markets Investors speak of the capital market when they mean a market in which money is loaned for more than one year. Longterm CDs and corporate and government bonds that take more than a year to mature belong in this category. Capital market assets are shown in the right-hand column of Figure 11.5. Money Markets Investors refer to the money market when they mean a market in which money is loaned for periods of less than one year. 302 UNIT 3 Economic Institutions and Issues primary market market in which only the original issuer can sell or repurchase a financial asset secondary market market in which financial assets can be sold to someone other than the original issuer The financial assets that belong to the money market are shown in the left-hand column of Figure 11.5. Note that a person who owns a CD with a maturity of one year or less is involved in the money market. If the CD has a maturity of more than one year, the person is involved in the capital market as a supplier of funds. Many investors purchase money market mutual funds. These funds are created when stockbrokers or other financial managers pool the deposits of their customers to purchase stocks or bonds. Money market mutual funds usually pay slightly higher interest rates than banks. Primary Markets Another way to view financial markets is to focus on the liquidity of a newly created financial asset. One market for financial assets is the primary market, a market where only the original issuer can sell or repurchase a financial asset. Government savings bonds and IRAs are in this market because neither of them can be transferred. Small CDs are also in the primary market because investors tend to cash them in early if they need cash, rather than trying to sell them to someone else. Secondary Markets If a financial asset can be sold to someone other than the original issuer, it then becomes part of the secondary market, where existing financial assets can be resold to new owners. The major difference between the primary and secondary markets is the liquidity the secondary market provides to investors. If a strong secondary market exists for a financial asset, investors know that the asset can be liquidated fairly quickly and without penalty, other than the fees for handling the transaction. Reading Check Contrasting How are capital and money markets different? How do primary and secondary markets differ? SECTION 2 Review Vocabulary 1. Explain the significance of bond, coupon rate, maturity, par value, current yield, junk bond, municipal bond, tax-exempt, savings bond, beneficiary, Treasury note, Treasury bond, Treasury bill, Individual Retirement Account, capital market, money market, primary market, and secondary market. Main Ideas 2. Explaining What is the relationship between a bond rating and the price of the bond? 3. Identifying Use a graphic organizer like the one below to identify the characteristics of financial assets. Financial Asset Characteristics Certificate of deposit 4. Stating What are markets for financial assets? Critical Thinking 5. The BIG Idea Why would an investor want to choose a certificate of deposit over a corporate bond? 6. Comparing and Contrasting What do corporate bonds, municipal bonds, and government savings bonds have in common? How do they differ? 7. Drawing Conclusions Why would someone be willing to invest in “junk” bonds? 8. Analyzing Visuals Look at Figure 11.5 on page 302. If you wanted to invest your money for retirement, in which market would you most likely invest? In which market would you invest to save for a vacation? Explain your answer using specific examples of financial assets. Applying Economics 9. Risk-Return Relationship If you had money to invest, which financial asset or assets, if any, would you choose? Explain your answer in a brief paragraph. CHAPTER 11 Financial Markets 303 CASE STUDY The NYSE Starting Small . . . On a warm May afternoon in 1792, 24 New York City stockbrokers and merchants met beneath a buttonwood tree to sign an agreement. This deal— the Buttonwood Agreement—marked the creation of the New York Stock Exchange (NYSE). . . . and Growing Big Today the 37,000-square-foot floor of the New York Stock Exchange is where the action is. Although some shares are traded electronically, traders on the floor of the exchange match buyers and sellers of listed stocks in a daily high-stakes dance. Companies pay an initial fee of up to $250,000 just to be listed on the NYSE, and yearly listing fees can reach $500,000. The NYSE, also called the “Big Board,” serves as auctioneer for about 2,600 U.S. and foreign companies. It also works to earn a profit for its own shareholders. After nearly 214 years as a notfor-profit exchange, the NYSE went public on March 8, 2006, selling shares in itself. It also Market Capitalization* of Listed Companies (in trillions) NYSE 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1990 NYSE $13.3 $12.6 $11.4 $9.0 $11.0 $11.5 $11.4 $10.3 $8.9 $6.8 $5.7 $2.7 NYSE % of all Euronext 33% 34% 36% 39% 41% 37% 32% 39% 40% 34% 33% 28% $2.70 $2.40 $2.10 $1.60 $1.80 $2.30 $2.40 $1.80 $1.30 $1.10 $0.90 $0.50 * Number of common shares multiplied by current price of those shares Source: 2006 NYSE Group, Inc. 304 UNIT 2 Macroeconomics: Institutions Mark Lennihan/AP Images merged with Archipelago Holdings Inc. and the Pacific Exchange to become the NYSE Group, the largest stock exchange ever. Competition From Abroad After corporate accounting scandals such as Enron were made public in the early 2000s, Congress and the Securities and Exchange Commission instituted the Sarbanes-Oxley Act in 2002. SarbOx created reams of new rules and regulations aimed at eliminating corporate corruption. The fallout from SarbOx has led many investors, companies, and even the NYSE Group itself to look to overseas exchanges, where regulations are less strict. In May 2006, the NYSE announced its $10 billion intention to merge with Euronext, which runs the Amsterdam, Brussels, Paris, and Lisbon exchanges. By merging with Euronext, the NYSE can bypass the red tape created by SarbOx and tap into new markets. Analyzing the Impact 1. Summarizing Why did the NYSE decide to expand into overseas markets? 2. Analyzing Visuals Look at the market capitalization table. What has happened to NYSE’s share of market capitalization since the enactment of SarbOx? SECTION 3 Investing in Equities and Options GUIDE TO READING Section Preview In this section, you will learn more about the equities, or stocks, that are traded in markets. Content Vocabulary • equities (p. 306) • stockbroker (p. 306) • Efficient Market Hypothesis (EMH) (p. 307) • portfolio diversification (p. 307) • mutual fund (p. 307) • net asset value (NAV) (p. 307) • 401(k) plan (p. 307) • stock exchange (p. 308) • securities exchang |
e (p. 308) • over-the-counter market (OTC) (p. 309) • Dow Jones Industrial Average (DJIA) (p. 310) • Standard & Poor’s 500 (S&P 500) (p. 310) • bull market (p. 310) • bear market (p. 310) • spot market (p. 311) • futures contract (p. 311) • option (p. 311) • call option (p. 311) • put option (p. 311) Academic Vocabulary • prospects (p. 306) • implication (p. 307) Reading Strategy Describing As you read the section, use a graphic organizer similar to the one below to describe the different stock markets. Stock Market Characteristics NYSE —www.cme.com COMPANIES IN THE NEWS Snowfall Futures The Chicago Mercantile Exchange (CME), the world’s largest and most diverse financial exchange, announced today that it will begin listing and trading snowfall futures and options. Snowfall futures will be based on a CME Snowfall Index and will be offered initially on two U.S. cities—Boston and New York. These contracts will trade on a monthly basis from October through April. “CME weather futures provide the safety and soundness investors are seeking to manage their weather-related risk,” said CME’s Rick Redding. “From municipal snow removal budgets to holiday retail sales, snowfall, or lack thereof, can have a major impact on local and regional economies.” ■ While government bonds rank among the safest financial assets, equities and futures, such as the snowfall futures in the news story, are at the opposite end of the risk spectrum. They offer the lure of large returns—or a complete loss. Purchasing stock used to be complicated and required professional help. With computers and the Internet, though, today anyone can easily invest in stocks, mutual funds or, as you read in the news story, the snowfall depth futures for New York. Stinger/Getty Images CHAPTER 11 Financial Markets 305 equities stocks that represent ownership shares in corporations stockbroker person who buys or sells securities for investors Skills Handbook See page R59 to learn about Reading the Stock Market Report. Stocks and Efficient Markets MAIN Idea Investors can purchase stock through stockbrokers on exchanges, through mutual funds, or through 401(k) plans. Economics and You Does anyone in your family save for retirement through a 401(k)? Read on to learn how this is a way to invest in the stock market. Equities, or shares of common stocks that represent ownership of corporations, form another type of financial asset that is available to investors. Share Values investor may want There are different ways to buy equities. An to use a stockbroker—a person who buys or sells equities for clients. The investor can also open an Internet account with a discount brokerage firm. This allows the investor to buy, sell, and monitor his or her stock portfolio from a personal computer. The value of a single share of stock depends on several things. Both the number of outstanding shares to be traded and a company’s profitability influence the price. Expectations are especially important, because demand for a company’s stock increases when the prospects for its growth improve. Common to almost all stocks is that their value goes up and down daily, sometimes gaining or losing a few cents a share and at other times gaining or losing much more. This is due to a change in either the supply or the demand for a share of stock. Figure 11.6 shows a typical listing of several stocks. During the last 12 months, Exxon stock sold for as much as $65.96 and as little as $53.08 a share. Its annual dividend (DIV) is $1.28, paid in four equal installments. The yield (Yld%) is the dividend divided by the closing price. The PE, or price-earnings ratio, is a stock’s closing price divided by annual earnings of each share of common stock outstanding. Finally, Exxon closed at $60.18, which is $1.78 lower than the day before, as indicated by the Net Change (NET CHG) column. Stock Market Efficiency Most large equity markets are reasonably competitive, especially if they have a large number of buyers and sellers. When these condistions exist, stocks can be easily bought and sold, so any news that affects the supply or demand for stocks can affect stock prices on a daily basis. Figure 11.6 A New York Stock Exchange Listing 52 weeks Hi Lo Stock (SYM) 42.01 29.98 Estee Lauder (EL) 65.96 53.08 ExxonMobil (XOM) 120.01 76.81 Fedex Corp (FDX) 11.48 6.75 Ford Motor (F) DIV 0.40 1.28 0.32 0.40 Yld% PE 100S LAST NET CHG 1.00 2.10 0.30 5.60 34.02 10.25 20.11 691 25,966 41.16 60.18 3,175 109.92 N/A 19,606 6.91 0.26 –1.78 –5.51 –0.11 A typical New York Stock Exchange newspaper listing might include the highest and lowest prices for a 52-week period, the annual dividend payment, yield, price-earnings ratio, number of shares traded in 100s, closing price, and price change from the previous day. Other listings on the Internet show even more information. Economic Analysis Which of the stocks had the largest variation in a year? There is no sure way to invest in stocks in order to always make a profit. Stock prices can vary considerably from one company to the next, and the price of any stock can change dramatically from one day to the next. Because of this variability, investors are always looking at stocks to find the best ones to buy or sell and those to avoid. All of this attention makes the market more competitive . Diversification Many investors put their money into a variety of stocks. Why is it a good idea to diversify? Many stock market experts subscribe to a theory called the Efficient Market Hypothesis (EMH)—the argument that stocks are usually priced correctly and that bargains are hard to find because stocks are followed closely by so many investors. The theory states that each stock is constantly analyzed by many different professional analysts in a large number of stock investment companies. If the analysts observe anything that might affect the fortunes of the companies they watch, they buy or sell the stocks immediately. This in turn causes stock prices to adjust almost immediately to new market information. The main implication for the investor is that if all stocks are priced correctly, it does not matter which ones you purchase. You might be lucky and pick a stock about to go up, or you might get unlucky and pick a stock about to go down. Because of this, portfolio diversification—the practice of holding a large number of different stocks so that increases in some stocks can offset declines in others—is a popular strategy. Mutual Funds Because of the advantages of diversification, many investors buy shares in a mutual fund. A mutual fund is a company that sells stock in itself to individual investors. It then invests the money it receives in stocks and sometimes bonds issued www.CartoonStock.com “This next song’s about spreading risk in a volatile market by diversification.” by other corporations. Mutual fund stockholders receive dividends earned from the mutual fund’s investments. Stockholders can also sell their mutual fund shares for a profit, just like other stocks. The market value of a mutual fund share is called the net asset value (NAV)— the net value of the mutual fund divided by the number of shares issued by the mutual fund. Mutual funds allow people to invest in the market without risking all they have in one or a few companies. The large size of the typical mutual fund makes it possible to hire a staff of experts to monitor market conditions and to analyze many different stocks and bonds before deciding which ones to buy or sell. 401(k) Plans Portfolio diversification and the need for retirement planning have also increased the popularity of the 401(k) plan—a taxdeferred investment and savings plan that acts as a personal pension fund for employees. To contribute to the plan, employees of a company authorize regular payroll deductions. The money from all employees Efficient Market Hypothesis (EMH) argument that stocks are always priced about right because they are closely watched portfolio diversification strategy of holding different investments to protect against risk mutual fund company that sells stock in itself and uses the proceeds to buy stocks and bonds issued by other companies net asset value (NAV) the market value of a mutual fund share found by dividing the net value of the fund by the number of shares issued 401(k) plan taxdeferred investment and savings plan that acts as a personal pension fund for employees CHAPTER 11 Financial Markets 307 stock exchange or securities exchange physical place where buyers and sellers meet to exchange securities is then pooled and invested in mutual funds or other investments approved by the company. Contributing to a plan lowers your taxable income because you don’t have to pay income taxes on the money you contribute until you withdraw it. An added benefit of a 401(k) plan is that most employers typically match a portion of an employee’s contributions. For example, if your employer matches your contribution at 50 cents on the dollar, you have an immediate 50 percent return on the investment—even before the funds are invested. Figure 11.7 illustrates that an annual contribution of $2,000 with an employer match of 25 percent can provide a substantial retirement fund in 30 years. The 401(k) is popular because it provides a simple, consistent, and relatively safe way for employees to save—and you can take the 401(k) with you if you change jobs. Reading Check Explaining What determines the value of a stock? Stock Markets and Their Performance MAIN Idea Several different stock markets exist, and each is organized in a different way. Economics and You Have you ever heard the closing bell of the New York Stock Exchange on the news? Read on to learn about different stock markets. Stocks, like almost everything else, are traded in markets. Investors follow these markets daily because the performance of the market is likely to affect their stocks. Stock Exchanges Historically, investors would gather at an organized stock or securities exchange |
, a place where buyers and sellers meet to trade stocks. An organized exchange gets its name from the way it conducts business. Members pay a fee to join, and trades can only take place on the floor of the exchange. The oldest, largest, and most prestigious of the organized stock exchanges in the United States is the New York Figure 11.7 How Much Money Will You Have at Retirement? I NVESTMENTS R ETURNS D ATA B ASED ON: 401(k) Traditional IRA Basic savings $225,000 200,000 175,000 150,000 125,000 100,000 Source: Quicken.com • $2,000 in income invested each year for 30 years • 8% return on investment • Company matching 25% of employee contributions • 28% income tax; 20% capital gains tax (paid yearly for basic savings) See StudentWorks™ Plus or glencoe.com. Returns from retirement investment plans vary. Economic Analysis How much more would a traditional IRA earn than a basic savings plan? &The Global Economy YOU Sell, надувательство, Verkaufen N ATIONAL AND I NTERNATIONAL I NVESTMENTS After you have saved some money, you may decide to become part-owner of a company by purchasing its stock. Your investment options are not limited to those companies listed on the NYSE, however. The United States is home to an additional nine stock exchanges. You can also buy stocks in international companies. At last count, nearly 100 world stock exchanges spanned the globe. In 2005 investors spent more on international and global markets than on U.S. stocks. Where does this global trading take place? Among others, investors can buy and sell on the Bolsa de Comercio de Buenos Aires in Argentina, the Moscow Stock Exchange, or the Tokyo Stock Exchange180 160 140 120 100 80 60 40 20 0 –20 Source: Lipper U.S. stock funds International/global stock funds 2000 2001 2002 2003 2004 2005 Year Stock Exchange (NYSE), located on Wall Street in New York City. The NYSE lists stocks from about 2,700 companies. The firms have to pay a membership fee. They also must meet profitability and size requirements, which virtually guarantees that they are among the largest and most profitable publicly held companies. Another national exchange is the American Stock Exchange (AMEX), which also is located in New York City. It features companies that are smaller and more speculative than those listed on the NYSE. Many regional exchanges are located in other cities such as Chicago, Philadelphia, and Memphis. They list corporations that are either too small or too new to be listed on the NYSE or the AMEX. Organized stock exchanges are found in major cities all over the world, including in developing countries such as Ghana, Pakistan, and China. Developments in computer technology and electronic trading have linked the biggest markets. This means that today you can trade in most major stocks around the clock, somewhere in the world. Over-the-Counter Markets Despite the importance of the organized exchanges, the majority of stocks in the United States are not traded on these exchanges. Instead, they are traded in an over-the-counter market (OTC)—an electronic marketplace for securities that are not traded on an organized exchange such as the NYSE. The most important OTC market is the National Association of Securities Dealers Automated Quotation (NASDAQ), the world’s largest electronic stock market. Rather than being limited to a single trading location, NASDAQ trading is executed with a sophisticated telecommunications and computer network that connects investors in more than 80 countries. The total number of stocks listed on NASDAQ exceeds the combined total of the NYSE and AMEX. The organized exchanges and the OTC markets may differ, but this means little to individual investors. An investor who opens an Internet account with a brokerage firm may buy and sell stocks in both markets. When the investor places an order to buy shares, the broker forwards the order Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 11—Student Web Activity for an activity on the stock market. over-the-counter market (OTC) electronic marketplace for securities not listed on organized exchanges such as the NYSE CHAPTER 11 Financial Markets 309 Performance of Stocks Investors use several indicators to help with their investments. What does the DJIA measure? Dow Jones Industrial Average (DJIA) measure of stock market performance based on 30 representative stocks Standard & Poor’s 500 (S&P 500) measure of stock market performance based on 500 stocks traded on the NYSE, AMEX, and OTC market bull market period during which stock market prices move up for several months or years in a row bear market period during which stock market prices move down for several months or years in a row to the exchange where the stock is traded— whether it is on the NYSE, AMEX, or NASDAQ—and the purchase is made there. Measures of Performance Because they are concerned about the performance of their stocks, most investors consult one of two popular indicators. When these indicators go up, stocks in general also go up. When they go down, stocks in general go down. The first of these indicators is the Dow Jones Industrial Average (DJIA), the most popular and widely publicized measure of stock market performance. The DJIA began in 1884, when the Dow Jones Corporation published the average closing price of 11 active stocks. Coverage expanded to 30 stocks in 1928. Since then, some stocks have been added and others deleted, but the sample remains at 30. Because of these changes, the DJIA is no longer a mathematical average of stock prices. Also, the evolution of the DJIA has obscured the meaning of a “point” change in the index. At one time, a one-point change in the DJIA meant that an average share of stock changed by $1. Since this is no longer true, it is better to focus on the percentage change of the index rather than the number of points. Investors also use another popular benchmark of stock perfor mance, the Standard & Poor’s 500 (S&P 500). It uses the price changes of 500 representative stocks as an indicator of overall market performance. Because the sum of 500 stock prices would be very large, it is reduced to an index number. Unlike the Dow Jones, which focuses primarily on the NYSE, the Standard & Poor’s 500 reports on stocks listed on the NYSE, AMEX, and OTC markets. The NASDAQ also computes several measures of market performance for investors. The most popular is the NASDAQ composite. In addition, there are more than 20 sub-indices that focus on everything from the size of the firms traded on the NASDAQ to the performance of individual industries. Bull vs. Bear Markets Investors often use colorful terms to describe which way the market is moving. For example, a bull market is a “strong” market with the prices moving up for several months or years in a row. One of the strongest bull markets in history began in 1995, when the DJIA broke 4,000—and then reached 12,000 five years later. A bear market is a “mean” or “nasty” market, with the prices of equities falling sharply for several months or years in a row. The most spectacular bear market since the 1930s was in 2001–2003, when the DJIA lost more than one-third of its value. These two terms take their names from the characteristics people associate with the animals for which they are named. Reading Check Contrasting What is the difference between an over-the-counter market and the NYSE? 310 UNIT 3 Economic Institutions and Issues FOXTROT © 2001 Bill Amend. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. Trading in the Future MAIN Idea Financial assets can be bought and sold in the future as well as the present. Economics and You Have you ever bought something that later went on sale? Read on to learn how an investor can protect against future price changes. Most buying and selling takes place in the present, or in a spot market. In this market, a transaction is made immediately at the prevailing price. The spot price of gold in London, for example, is the price as it exists in that city at that moment. Sometimes the exchange takes place later, rather than right away. This occurs with a futures contract—an agreement to buy or sell at a specific future date at a predetermined price. For example, you may agree to buy gold at $580 an ounce in six months, hoping that the actual price will be higher when the date arrives. A futures contract can be written on almost anything, including the size of the S&P 500 or the level of future interest rates. In most cases, the profit or loss on the contract is settled with a cash payment rather than the buyer taking delivery. An option is a special type of futures contract that gives the buyer the right to cancel the contract. For example, you may pay $5 today for a call option—the right to buy something at a specific future price. If the call option gives you the right to purchase 100 shares of stock at $70 a share, and if the price drops to $30, you tear up the option and buy the stock elsewhere for $30. If the price rises to $100, you execute the option, buy the stock for $70, and resell it for $100—or take a cash settlement. You could also buy a put option—the right to sell something at a specific future price. The put option, like the call option, gives the buyer the right to tear up the contract if the actual future price is not advantageous to the buyer. Reading Check Explaining Why might a contract that takes place in the future be an advantage to the buyer or seller? spot market market in which a transaction is made immediately at the prevailing price futures contract an agreement to buy or sell at a specific date in the future at a predetermined price option futures contract giving a buyer the right to cancel the contract call option futures contract giving a buyer the right to cancel a contract to buy something put option futures contract giving a buyer the right to cancel a contract to sell something SECTION 3 Review |
Vocabulary 1. Explain the significance of equities, stockbroker, Efficient Market Hypothesis, portfolio diversification, mutual fund, net asset value, 401(k) plan, stock or securities exchange, over-the-counter market, Dow Jones Industrial Average, Standard & Poor’s 500, bull market, bear market, spot market, futures contract, option, call option, and put option. Main Ideas 2. Describing What are the stock performance measures? 3. Evaluating Use a graphic organizer like the one below to evaluate the risks and rewards of investments. 4. Defining What is a futures contract? Critical Thinking 5. The BIG Idea What options are available to individuals who wish to invest in stocks? 6. Analyzing Would you ever invest in a futures contract? Why or why not? 7. Determining Cause and Effect If the price of a share of stock goes up, what does this suggest about the quantity demanded and quantity supplied for that stock? 8. Analyzing Visuals Look at Figure 11.6 on page 306. If you wanted to buy stock that paid large dividends, which stock would you choose? Investment Major Advantage Risk Level Applying Economics Stocks 9. Market Efficiency What does the Efficient Market Hypothesis mean to you as a potential investor as you investigate your future stock portfolio? CHAPTER 11 Financial Markets 311 NEWSCLIP Wall Street in New York City has long been synonymous with wealth and corporate power. This is no longer true. Home to the New York Stock Exchange, Wall Street is losing some of its prestige to Paternoster Square in London, site of the London Stock Exchange. Taking Their Business Elsewhere If the state-owned Russian giant OAO Rosneft Oil Co. had been going public a decade ago, it would have jumped through hoops to list its shares on a U.S. stock exchange. Back then a U.S. listing was viewed as a rite of passage for up-and-coming global companies, offering not only direct access to the world’s largest capital market but also a certain cachet. This is 2006, though, and Rosneft plans to list its shares on the London Stock Exchange. . . . Rosneft isn’t alone. Companies are increasingly forsaking the U.S. for friendlier overseas environs. The New York Stock Exchange and NASDAQ pin much of the blame on the Sarbanes-Oxley Act (SarbOx), the controversial 2002 corporate governance rules, for their recent woes in attracting new listings. . . . The exchanges say the expense and difficulty of dealing with SarbOx could transform the U.S. from one of the most attractive markets in the world to one of the least. But beyond SarbOx lies a troubling trend that’s far less easily remedied—companies N UMBER OF N EW F OREIGN L ISTINGS AT N EW Y ORK AND L ONDON S TOCK E XCHANGES 140 120 100 80 60 40 20 0 1999 NASDAQ NYSE London 2000 2001 2002 Year 2003 2004 2005 Sources: NASDAQ, NYSE, London Stock Exchange 312 UNIT 3 Economic Institutions and Issues Daniel Berehulak/Getty Images Europe/Getty Images simply don’t need to list in New York anymore. Globalization and electronic trading have made U.S. investors mobile as never before. While some argue that the higher governance standards in the U.S. boost investor confidence, lead to higher valuations, and could prevent fraud, many companies no longer want to put up with the regulatory nuisances given the availability of money abroad. . . . Europe’s three main exchanges—the London Stock Exchange, the Deutsche Börse, and Euronext, which runs the Paris, Amsterdam, and Brussels exchanges—are ready for the business. . . . —Reprinted from BusinessWeek Examining the Newsclip 1. Determining Cause and Effect What has enabled investors to buy shares on overseas exchanges? 2. Drawing Conclusions Why did SarbOx have a negative impact on American stock exchanges? CHAPTER 11 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Financial System Households and businesses invest their surplus funds to earn interest. Governments and businesses invest this money for economic growth. Surplus funds Households, businesses Financial Intermediaries Commercial banks Savings and loan associations Savings banks Mutual savings banks Credit unions Life insurance companies Mutual funds Pension funds Finance companies Governments, businesses Financial assets Investment Risk and Return Investors must weigh the risks of their investments against the returns they expect. Generally, the higher the risk of an investment, the higher the return investors require. T HE R ELATIONSHIP B ET WEEN R ISK AND R ETURN Junk bonds Speculative stock Common stock Preferred stock Investment-grade bonds Prime commercial paper U.S. Treasury bills Increasing degrees of risk Equities and Futures The riskiest investments consist of equities and futures. Equities can be purchased as individual stocks, or as part of a mutual fund or 401(k) plan. Futures allow investors to speculate on future prices of commodities. Equities Futures Single stock Mutual fund 401(k) plan Futures contract Call option Put option CHAPTER 11 Financial Markets 313 CHAPTER 11 Assessment & Activities Review Content Vocabulary Review the Main Ideas Assume that you are an investment adviser who has to advise a 30-year-old, single client who earns $35,000 a year and has saved $10,000 to invest for retirement. Use the terms below to prepare a report advising your client of the best investment course. 1. financial asset 2. financial system 3. risk 4. capital market 5. money market 6. bond 7. Treasury note 8. IRA 9. 401(k) plan 10. mutual fund 11. pension fund 12. certificate of deposit 13. portfolio diversification 14. stock exchange 15. over-the-counter market Section 1 (pages 289–294) 22. Describe how financial assets are created in a free enterprise system. 23. Explain the role of the major nondepository financial institutions in the financial system. 24. Identify the factors one should consider when investing by completing a graphic organizer like the one below. Basic Investment Considerations 1. 2. 3. 4. Section 2 (pages 296–303) 25. Explain what determines a bond’s current yield. 26. Explain how CDs can appear in multiple markets. 27. Identify the characteristics of Treasury notes, bonds, and bills. Section 3 (pages 305–311) 28. Describe how options contracts are different from Review Academic Vocabulary futures contracts. Match each term with its synonyms in the list below. a. sector b. compensation c. offset d. presumed e. prospects f. implication 16. payment, reparation, payback 17. supposed, expected, believed 18. likelihood, possibilities, expectations 19. counterbalance, neutralize, cancel out 20. section, part, segment 21. association, meaning, consequence 314 UNIT 3 Economic Institutions and Issues 29. Explain why equity markets are reasonably competitive. 30. Explain how the NASDAQ differs from the NYSE. Critical Thinking 31. The BIG Idea How might the four basic investment considerations vary for people in different age groups? Write a paragraph explaining your answer. 32. Making Generalizations Why might an individual choose to borrow money from a finance company that charges higher interest rates rather than from a commercial bank with lower interest rates? Economics: Principles and Practices Web site at glencoe.com and click on Chapter 11—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the 33. Determining Cause and Effect How does each of the following affect saving? a. A decrease in the federal personal income tax is implemented. b. The United States undergoes a prolonged period of inflation. Analyzing Visuals 38. Look at Figure 11.1 on page 291. In a brief paragraph, describe the financial assets savers would receive from financial intermediaries. Then describe those that savers would receive directly from governments and businesses. 34. Drawing Conclusions Interest rates on CDs usually 39. Look at Figure 11.7 on page 308 and compare the vary only slightly from one institution to another. What do you think causes these similarities? 35. Drawing Conclusions Which investments are the safest and which are the riskiest? Why would investors choose either of those investments? Explain. Math Practice 36. Determine income, consumption, and saving in each row by completing the following table. Total Income Consumption Saving a. b. c. $2,000 $7,000 d. $10,000 e. $12,500 $1,800 $2,500 $10,000 $1,000 –$500 $400 Applying Economic Concepts 37. Investing in Stocks Assume that you have saved $10,000 and have decided to invest in stocks. Research the performance of 2 to 3 stocks listed on the NYSE, AMEX, or NASDAQ. Then write a short paper that includes the following: a. Reasons you chose the stocks b. Stock performance c. Factors influencing the gain/loss in value d. Analysis of why you would hold your stocks for either the short term or the long term John S.Pritchett/www.pritchettcartoons.com returns for investments in traditional IRAs and 401(k) plans. If the annual investment amounts and interest rates are the same, what accounts for the large difference in returns for these investment options? Writing About Economics 40. Expository Writing Return to the activity in the chapter opener on page 288. Based on what you have learned in the chapter, devise a general investment plan for Miguel. In your planning, keep in mind the mid-term goals of college cost and long-term goals of retirement. Interpreting Cartoons 41. Critical Thinking What do the figures of bulls and bears in the cartoons depict? What point is the cartoonist trying to make about the stock market . . CHAPTER 11 Financial Markets 315 n h o J UNIT 4 Macroeconomics: Performance and Stabilization CHAPTER 12 Macroeconomic Performance CHAPTER 13 Economic Instability CHAPTER 14 Money, Banking, and the Fed CHAPTER 15 Economic Stabilization Policies Economists like to monitor all economic activity, including the productivity of the workers and the output of this aircraft engine plant. 316 UNIT 4 Stewart Cohen/Getty Images Stewart Cohen/Getty Images CHAPTE |
R 12 Macroeconomic Performance Why It Matters Have you ever thought about what it means when someone is described as “successful”? Is the person wealthy, happy, or well known? Work with a partner and develop a list of the qualities or characteristics for your definition of successful. Share your list with the class and listen carefully to what the other students think. Is there a consensus among your classmates? Read Chapter 12 to learn more about how economists assess the success of a nation’s economy by measuring its growth and performance. The BIG Idea Economists look at a variety of factors to assess the growth and performance of a nation’s economy. Busy factories such as this car manufacturing plant are indicators of economic growth. Economics: Principles and Practices Web site at glencoe.com and click on Chapter 12—Chapter Overviews to preview chapter information. Chapter Overview Visit the 318 UNIT 4 Jose Luis Pelaez, Inc./Corbis SECTION 1 Measuring the Nation’s Output and Income GUIDE TO READING Section Preview In this section, you will learn how we measure the output and income of a nation. Content Vocabulary • macroeconomics (p. 319) • gross domestic product (GDP) (p. 320) • intermediate products (p. 321) • secondhand sales (p. 321) • nonmarket transactions (p. 321) • underground economy (p. 321) • base year (p. 321) • real GDP (p. 322) • current GDP (p. 322) • GDP per capita (p. 322) • gross national product (GNP) (p. 324) • net national product (NNP) (p. 324) • national income (NI) (p. 324) • personal income (PI) (p. 324) • disposable personal income (DPI) (p. 324) • household (p. 325) • unrelated individual (p. 326) • family (p. 326) • output-expenditure model (p. 327) • net exports of goods and services (p. 327) Academic Vocabulary • excluded (p. 321) • components (p. 325) Reading Strategy Describing As you read the section, complete a graphic organizer like the one below by describing how the different economic sectors contribute to the nation’s economic activity. Economic Sectors Consumer sector Investment sector Government sector Foreign sector ISSUES IN THE NEWS GDP posts smallest gain in 3 years The nation’s economy grew at its slowest pace in three years in the fourth quarter, according to the government’s gross domestic product report Friday, which came in far weaker than economists’ forecasts. The broad measure of the nation’s economic activity showed an annual growth rate of 1.1 percent in the fourth quarter, down from the 4.1 percent growth rate in the final reading of third-quarter growth. ■ —CNNMoney.com The report in the news story above may be of little interest to many people, but it was worrisome for economists. When the nation’s economic growth rate drops to a meager 1.1 percent, the news is not good. Welcome to macroeconomics, the branch of economics that deals with the economy as a whole, using aggregate measures of output, income, prices, and employment. Gross Domestic Product is one of our most important macro measures and the most important statistic in the National Income and Product Accounts (NIPA). The NIPA keeps track of the nation’s production, consumption, saving, and investment. Other key measures exist, and collectively they tell us a great deal about the economic health and performance of our country. macroeconomics part of economics that deals with the economy as a whole and uses aggregate measures of output, income, prices, and employment James Leynse/Corbis CHAPTER 12 Macroeconomic Performance 319 gross domestic product (GDP) the dollar value of all final goods, services, and structures produced within a country’s national borders during a oneyear period (also see page 9) GDP—The Measure of National Output MAIN Idea GDP measures national output. Economics and You Did you know that your work may be counted in our GDP? Read on to find out how we measure output. Gross domestic product (GDP) is our most comprehensive measure of national output. This means that Japanese automobiles produced in Kentucky, Ohio, and Indiana count in GDP even if the owners of the plants live outside the United States. On the other hand, production in U.S.owned plants located in Mexico, Canada, or other countries is not counted in GDP. Measuring Current GDP The measurement of GDP is fairly easy to understand. Conceptually, all we have to do is to multiply all of the final goods and services produced in a 12-month period by their prices, and then add them up to get the total dollar value of production. Figure 12.1 provides an example. The first column contains three product categories— goods, services, and structures—used in the NIPA. The third of these categories, structures, includes residential housing, apartments, and buildings for commercial purposes. The total number of final goods and services produced in the year is in the quantity column, and the price column shows the average price of each product. To get GDP, we simply multiply the quantity of each good by its price and then add the results, as is done in the last column of the table. Of course it is not possible to record every single good and service produced during the year, so government statisticians instead use scientific sampling techniques to estimate the quantities and prices Figure 12.1 Estimating Total Annual Output E STIMATING G ROSS D OMESTIC P RODUCT Product Automobiles Replacement tires Shoes . . .* Haircuts Income tax filings Legal advice . . .* Single family Multifamily Commercial . . .* Goods Services Structures Quantity (millions) Price (per 1 unit) Dollar value (millions) 6 10 55 . . .* 150 30 45 . . .* 3 5 1 . . .* $25,000 $60 $50 . . .* $8 $150 $200 . . .* $175,600 $300,000 $1,000,000 . . .* $150,000 $600 $2,700 . . .* $1,200 $4,500 $9,000 . . .* $525,000 $1,500,000 $1,000,000 . . .* Note: * . . . other goods, services, and structures Total GDP = $13.5 trillion Gross domestic product is the total dollar value of production within a country’s borders in a 12-month period. It can be found by multiplying all of the goods and services produced by their prices, and then adding them up. Economic Analysis How is the dollar value for each of the products on the table calculated? of the individual products. To keep the report as current as possible, they estimate GDP quarterly, or every three months, and then revise the numbers for months after that. As a result, it takes several months to discover how the economy actually performed. Some Things Are Excluded GDP is a measure of final output. This means that intermediate products— goods used to make other products already counted in GDP—are excluded. If you buy new replacement tires for your automobile, for example, the tires are counted in GDP because they were intended for final use by the customer and not combined with other parts to make a new product. However, tires on a new car are not counted separately because their value is already built into the price of the vehicle. Other goods such as flour and sugar are part of GDP if they are bought for final use by the consumer. However, if a baker buys them to make bread for sale, only the value of the bread is counted. Secondhand sales—the sales of used goods—are also excluded from GDP because no new production is created when products already in existence are transferred from one owner to another. Although the sale of a used car, house, or compact disc player may give others cash that they can use on new purchases, only the original sale is included in GDP. Nonmarket transactions—economic activities that do not generate expenditures in the market—also are excluded. For example, GDP does not take into account the value of your services when you mow your own lawn or do your own home repairs. Instead, these activities are counted only when they are done for pay outside Underground Economy Although there is no consensus on the size of the underground economy, estimates suggest that it is between 5 and 15 percent of the recorded GDP. What activities make up the underground economy intermediate products products that are components of other final products included in GDP secondhand sales sales of used goods not included in GDP nonmarket transaction economic activity not taking place in the market and, therefore, not included in GDP underground economy unreported legal and illegal activities that do not show up in GDP statistics base year year serving as point of comparison for other years in a price index or other statistical measure the home. For this reason, services that homemakers provide are excluded from GDP even though they would amount to billions of dollars annually if actually purchased in the market. Finally, transactions that occur in the underground economy—economic activities that are not reported for legal or tax collection purposes—are not counted in GDP. Some of these activities are illegal, such as those found in gambling, smuggling, prostitution, and the drug trade. Other activities are legal, such as those in flea markets, farmers’ markets, garage sales, or bake sales, but they involve cash payments, which are difficult to trace. Current GDP vs. Real GDP Because of the way it is computed, GDP can appear to increase whenever prices go up. For example, if the number of automobiles, replacement tires, and other products in Figure 12.1 stays the same from one year to the next while prices go up, GDP will go up every year. Therefore, in order to make accurate comparisons over time, GDP must be adjusted for inflation. To do so, economists use a set of constant prices in a base year—a year that serves as the basis of comparison for all CORNERED © 2004 Mike Baldwin. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. CHAPTER 12 Macroeconomic Performance 321 real GDP gross domestic product after adjustments for inflation current GDP gross domestic product measured in current prices, unadjusted for inflation GDP per capita gross domestic product on a per person basis; can be expressed in |
current or constant dollars Skills Handbook See page R56 to learn about Understanding Nominal and Real Values. other years. For example, if we compute GDP over a period of time using only prices that existed in 2000, then any increases in GDP must be due to changes in the quantity column and cannot be caused by changes in the price column. This measure is called real GDP, or GDP measured with a set of constant base year prices. In contrast, the terms GDP, current dollar GDP, nominal GDP, and current GDP all mean that the output in any given year was measured using the prices that existed in those years. Because these prices change from one year to the next, nominal or current GDP is not adjusted for inflation. When the two series are plotted together, as in Figure 12.2, you can see that real GDP grows more slowly than current GDP. The difference in growth rates occurs because current GDP reflects the distortions of inflation. The U.S. Department of Commerce uses 2000 as the base year, so the two series are equal in that year. The U.S. Department of Commerce updates the base year in fouryear increments and will eventually switch to 2004, but only after a substantial lag. Any other year would work just as well. GDP per Capita There may be times when we want to adjust GDP for population. For example, we may want to see how the economy of a country is growing over time, or how the output of one country compares to that of another. If so, we use GDP per capita, or GDP divided by the population, to get the amount of output on a per person basis. Per capita GDP can be computed on a current or constant basis. Limitations of GDP Despite GDP’s advantages, there are several limitations to keep in mind. First, by itself GDP tells us nothing about the composition of output. If GDP increases Figure 12.2 Current GDP and Real GDP C URRENT VS. R EAL GDP GDP in current dollars GDP in 2000 dollars $14,000 12,000 10,000 8,000 6,000 4,000 2,000 1960 1965 1970 1975 1980 1985 Year 1990 1995 2000 2005 2010 Source: Bureau of Economic Analysis, U.S. Department of Commerce Because prices tend to rise over time, current GDP rises faster than real GDP, which uses a constant set of prices to value the output in every year. Economic Analysis Which series is distorted by inflation? 322 UNIT 4 Macroeonomics: Performance and Stabilization &The Global Economy YOU World GDP Why should you be concerned about the size of the U.S. economy or that of other countries? A healthy U.S. economy means manufacturing and employment increase, tax revenues go up, and the standard of living improves. When the economies of other countries also do well, they are better able to purchase products that American firms export, which further improves the U.S. economy. How big is the U.S. economy, and how big is the world economy? One way to find out is to look at GDP. According to economists at the Central Intelligence Agency (CIA), the United States accounted for one out of every five dollars of output produced worldwide in 2005. The 25 countries in the European Union had a GDP only slightly lower. China, the world’s third-largest economy, produced 13.7 percent, or more than one-eighth, of total Country GDP (in billions) Percentage of World GDP United States China Japan India Germany United Kingdom France Italy Brazil European Union World $12,410 $8,182 $3,914 $3,699 $2,454 $1,869 $1,822 $1,651 $1,568 $12,180 $59,590 20.8% 13.7% 6.6% 6.2% 4.1% 3.1% 3.0% 2.8% 2.6% 20.4% 100.0% Source: www.cia.gov/cia/publication/factbook/rankorder world output. This means that GDP for the remaining countries in the world was less than half of world GDP. by $10 billion, for example, we know that production is growing and that jobs and income are generated, so we are likely to view the growth as a good thing. However, we might feel differently if we discovered that the extra output consisted of military nerve gas stockpiles rather than new libraries and parks. Second, GDP also tells little about the impact of production on the quality of life. The construction of 10,000 new homes may appear to be good for the economy. However, if the homes threaten a wildlife refuge, the value of the homes may be viewed differently. In practice, GDP does not take into account quality of life issues, so it is helpful to be aware of such matters to gain a better understanding of GDP. Finally, some GDP is produced to control activities that give us little utility or satisfaction, thus making GDP even larger. The money spent to fight crime is one example. If we had less crime, our GDP might actually be smaller because of lower government spending to control it—leaving us better off as well. A Measure of Economic Performance and Well-Being Even with these minor limitations, GDP is still our best measure of overall economic performance and well-being, because it is a measure of the voluntary transactions that take place in the market. Voluntary transactions occur only when both parties in a transaction think they are better off after they have made it than before. This is one reason why GDP is considered an indicator of our overall economic health. Changes in GDP even influence national elections. Whenever the economy is growing slowly or contracting, the political party in power usually does not fare as well as it would have during a time of economic growth. Economic growth, as measured by increases in real GDP, means that jobs are plentiful and that incomes are rising. Such economic trends often influence the decisions of voters. As a result, GDP is the single most important economic statistic compiled today. Reading Check Explaining What does GDP measure, and why is it important? CHAPTER 12 Macroeconomic Performance 323 gross national product (GNP) total dollar value of all final goods, services, and structures produced in one year with labor and property supplied by a country’s residents, regardless of where the production takes place net national product (NNP) GNP less depreciation charges for wear and tear on capital equipment national income (NI) net national product less indirect business taxes personal income (PI) total amount of income going to the consumer sector before individual income taxes are paid disposable personal income (DPI) personal income less individual income taxes GNP—The Measure of National Income capital consumption allowances. It represents the capital equipment that wore out or became obsolete during the year. MAIN Idea National income can be measured in a number of different ways National Income Economics and You Have you ever wondered about the deductions on your pay stub? Read on to find out how your net pay is part of an economic measure. Whenever business activity creates output, it generates jobs and income for someone. GDP, then, is like a two-sided coin, where one side represents output and the other side an equal amount of income. If we want to see how much output is produced, we look at one side of the coin. If we want to see how much income is generated, we look at the other side of the coin. Economists recognize one major category and several subcategories of national income. Gross National Product When economists focus on total income rather than output, they measure it with gross national product (GNP)—the dollar value of all final goods, services, and structures produced in one year with labor and property owned by a country’s residents. While GDP measures the value of all the final goods and services produced within U.S. borders, GNP measures the income of all Americans, whether the goods and services are produced in the United States or in other countries. To go from GDP to GNP, we add all payments that Americans receive from outside the United States, then subtract the payments made to all foreign-owned businesses located in the United States. The result, GNP, is the most comprehensive measure of our nation’s income. Net National Product The second measure of national income is net national product (NNP), or GNP less depreciation. Depreciation is also called The third measure in the NIPA is national income (NI). National income is the income that is left after all taxes except the corporate profits tax are subtracted from NNP. Examples of these taxes, also known as indirect business taxes, are excise taxes, property taxes, licensing fees, customs duties, and general sales taxes. Personal Income The fourth measure of the nation’s total income is personal income (PI)—the total amount of income going to consumers before individual income taxes are subtracted. To go from national to personal income, several adjustments must be made. For example, personal income would not include payments into the Social Security fund that working people make. It would include Social Security checks that retired individuals receive. Disposable Personal Income The fifth measure of income in the NIPA is disposable personal income (DPI)—the total income the consumer sector has at its disposal after personal income taxes. Although it is the smallest measure of income, it is important because it reflects the actual amount of money consumers are able to spend. At the individual level, a person’s disposable income is equal to the amount of money received from an employer after taxes and Social Security have been taken out. When you look at the pay stub that is illustrated in Figure 9.6 on page 248, the disposable personal income consists of the $586.89 net pay on the check plus the $3.20 of deductions which the individual chose to make. Reading Check Summarizing What are the different measures of national income? 324 UNIT 4 Macroeconomics: Performance and Stabilization Economic Sectors and Circular Flows MAIN Idea The production of output generates income which flows though different sectors of the economy. Economics and You Have you ever thought about your role as a consumer? Read on to find out how consumers are part of an economic model. It helps to think of the economy as consisting o |
f several different parts, or sectors. These sectors receive various components of the national income, which they then use to purchase the total output. These sectors are part of the circular flow of economic activity illustrated in Figure 12.3. Income generated by production flows to the business, government, and consumer sectors. These sectors then use the income to purchase the nation’s output. household basic unit of consumer sector consisting of all persons who occupy a house, apartment, or separate living quarters Consumer Sector The largest sector in the economy is the consumer, or household, sector. Its basic unit, the household, consists of all persons who occupy a house, apartment, or room that constitutes separate living quarters. Figure 12.3 Circular Flow of Economic Activity Personal Income Disposable Income National Income Net National Product GDP* GNP* Wages, salaries, and tips Rent Interest Dividends Proprietor’s income Corporate income taxes Retained earnings Indirect business taxes Depreciation expenditures Businesses (I) Government purchases of goods and services Government (G) Transfer payments Personal savings * GNP equals GDP in a closed economy. Personal consumption expenditures Income generated by production flows to the business, government, and consumer sectors. These sectors then use the income to purchase the nation’s output. Economic Analysis What is the difference between national income and personal income Consumer (C) See StudentWorks™ Plus or glencoe.com. Investment Sector Businesses such as this auto manufacturer that produce the nation’s output are included in the investment sector. What other sectors are part of the circular flow of economic activity? unrelated individual person living alone even though that person may have relatives living elsewhere family two or more persons living together who are related by blood, marriage, or adoption Households include related family members and all others—such as lodgers, foster children, and employees—who share the living quarters. A household also can consist of an unrelated individual—a person who lives alone even though he or she may have family living elsewhere. Finally, we have the family—a group of two or more persons related by blood, marriage, or adoption who are living together in a household. The consumer sector, shown as C in Figure 12.3, receives its income in the form of disposable personal income. This is the income that is left over after all of the depreciation, business and income taxes, and FICA payments are taken out, and after any income received in transfer payments is added back in. Investment Sector The next sector of the macro economy is the business, or investment, sector, which is labeled I in Figure 12.3. This sector is made up of proprietorships, partnerships, and corporations that are responsible for producing the nation’s output. The income of this sector comes from the retained earnings—the profits not paid out to owners— that are subtracted from NI and the depreciation or capital consumption allowances that are subtracted from GNP. Government Sector The third sector is the public sector, which includes all local, state, and federal levels of government. Shown as G in Figure 12.3, this sector receives its income from indirect business taxes, corporate income taxes, Social Security contributions, and individual income taxes. Foreign Sector The fourth sector of the macro economy is the foreign sector. Although not shown in Figure 12.3, it includes all consumers and producers outside the United States. This sector does not have a specific source of income. Instead, it represents the difference between the dollar value of goods sent abroad and that of goods purchased from abroad, identified as (X – M). If the two are reasonably close, the foreign sector appears to be small, even when large numbers of goods and services are traded. Reading Check Contrasting How do households and families differ? 326 UNIT 4 Macroeconomics: Performance and Stabilization AP Images outputexpenditure model macroeconomic model describing aggregate demand by the consumer, investment, government, and foreign sectors net exports of goods and services net expenditures by the foreign sector; equal to total exports less total imports The Output-Expenditure Model MAIN Idea The output-expenditure model is used to explain aggregate economic activity. Economics and You Have you learned in math class how to write a problem as an equation? Read on to learn how this can be done in economics. The circular flow can be represented by the output-expenditure model. This macroeconomic model shows how GDP is equal to the sum of aggregate demand by the consumer, investment, govern ment, and foreign sectors. When written as GDP = C + I + G + (X – M) the equation becomes a formal outputexpenditure model used to explain and analyze the economy’s performance. According to this model, the consumer sector spends its income on the goods and services used by households. These personal consumption expenditures include groceries, rent, and almost anything else people buy. Income that is not spent appears as personal saving, which is borrowed by the business and government sectors. The investment, or business, sector spends its income on labor, factories, equipment, inventories, and other investment goods. These expenditures include the total value of capital goods created in the economy during the year. The government sector spends its income on many categories, including national defense, income security, interest on the national debt, health care, and roads. The only major government expenditure not included in total output is transfer payments, because this money is diverted for use by others to buy goods and services. The foreign sector also buys many U.S. goods—such as tractors, airplanes, and agricultural products—and services—such as insurance—that make up our GDP. In return, it supplies products—such as Japanese cars, Korean steel, and Brazilian shoes—to U.S. consumers. For this reason, the foreign sector’s purchases are called net exports of goods and services. They are abbreviated as (X – M) to reflect the difference between exports and imports. Reading Check Describing How does the foreign sector fit into the output-expenditure model? SECTION 1 Review Vocabulary 1. Explain the significance of macroeconomics, gross domestic product, intermediate products, secondhand sales, nonmarket transactions, underground economy, base year, real GDP, current GDP, GDP per capita, gross national product, net national product, national income, personal income, disposable personal income, household, unrelated individual, family, output-expenditure model, and net exports of goods and services. Main Ideas 2. Comparing Use a graphic organizer like the one below to compare GDP and GNP. GDP plus: less: GNP 3. Stating What is the circular flow of economic activity? Critical Thinking 4. The BIG Ideas Explain why GDP is important to economists. 5. Synthesizing Information Describe the limitations of GDP. 6. Analyzing Visuals Use Figure 12.3 on page 325 to describe how your personal spending and saving contribute to the circular flow of economic activity. 7. Drawing Conclusions What would be the effects of a decline in GDP? Applying Economics 8. Gross Domestic Product What effect do you think the computer industry has had on GDP? Use examples. CHAPTER 12 Macroeconomic Performance 327 ECONOMIST Profiles in Economics John Kenneth Galbraith (1908–2006) • advocated public works funding in The Affluent Society • served as economic adviser to five presidents Galbraith attended college during the early years of the Great Depression. His experiences taught him to question accepted theories and challenge what he called “conventional wisdom.” Iconoclast Economist Shaped by his experiences during the Great Depression, John Kenneth Galbraith believed in the government’s ability to solve problems. Early in his career, he also developed a love of writing and an engaging, witty style. This turned the Harvard professor of economics into the most widely read American economist of his generation and turned his books into bestsellers. Galbraith developed a reputation as an iconoclast—a person willing to challenge accepted belief. Other economists objected to the liberal ideas Galbraith promoted. For example, in his classic The Affluent Society, Galbraith argued that Americans needed to reconsider their values. The U.S. economy had resulted in individual wealth, while public projects such as education and highways were neglected or underfunded. According to Galbraith, Americans were “artificially affluent” because corporations convinced people to buy goods they did not want or need. Government regulation of prices on certain goods would steer Americans away from spending and help them refocus on more important matters, such as attaining an education or appreciating culture. Presidential Influence Unlike most other economists, Galbraith was able to apply his economic theories in the social and political arenas. As an adviser to presidents Franklin Roosevelt, Harry Truman, John Kennedy, Lyndon Johnson, and Bill Clinton, Galbraith was a major force in directing the Democratic Party’s economic platform. Under President Roosevelt, he administered wage and price controls in the Office of Price Administration. His most direct influence, though, is reflected in President Johnson’s “war on poverty,” which incorporated many of Galbraith’s ideas, and increased funding for public works projects. Examining the Profile 1. Making Inferences Which viewpoint made Galbraith an iconoclast to other economists? 2. Drawing Conclusions How might living through the Great Depression lead to liberal economic thought? 328 UNIT 4 Macroeconomics: Performance and Stabilization Time Life Pictures/Getty Images SECTION 2 Population and Economic Growth GUIDE TO READING Section Preview Academic Vocabulary We are interested in po |
pulation because it makes up the economy’s largest sector, the consumer sector, and affects the economic performance of a nation. • residence (p. 329) • projected (p. 334) Content Vocabulary • census (p. 329) • urban population (p. 330) • population pyramid (p. 333) • dependency ratio • rural population (p. 333) (p. 330) • center of population (p. 331) • infrastructure (p. 332) • baby boom (p. 332) • demographers (p. 334) • fertility rate (p. 334) • life expectancy (p. 334) • net immigration (p. 334) Reading Strategy Identifying As you read the section, complete a graphic organizer like the one below by identifying changes in the United States in the listed categories. Rate of growth Size of household Regional change ISSUES IN THE NEWS Census Bureau Selects Sites for Census Dress Rehearsal —U.S. Census Bureau San Joaquin County, Calif., and the city of Fayetteville, N.C., and surrounding area . . . have been selected by the U.S. Census Bureau to serve in 2008 as the dress rehearsal sites for the 2010 Census. . . . San Joaquin County [is] an urban location with a multilingual population and an assortment of group quarters housing such as hospitals, college residence halls, nursing homes, prisons and facilities for the homeless. . . . The Fayetteville site [has] a mix of . . . urban, suburban and rural areas and has two military bases (Fort Bragg and Pope Air Force Base). ■ Population is important for a number of reasons. First, a country’s population is the source of its labor, one of the four factors of production. Second, the population is the primary consumer of the nation’s output and has a direct effect on how much is produced. Because of this, the size, composition, and rate of growth of a country’s population has an impact on macroeconomic performance. The Constitution of the United States requires the government to periodically take a census, an official count of all people living in the United States, including their place of residence. Because the official census occurs every 10 years, it is called the decennial census. As you can see in the news story, the U.S. Census Bureau begins making plans for the decennial census several years ahead of time. census complete count of population, including place of residence RON KUENSTLER/AP Images CHAPTER 12 Macroeconomic Performance 329 urban population those persons living in incorporated cities, towns, and villages with 2,500 or more inhabitants rural population those persons not living in urban areas Census Some census workers interview a select group of people in person. How are census data used? Population in the United States MAIN Idea The country’s population has shifted from a fast-growing, mostly rural population to a slower-growing, mostly urban one. Economics and You Have you ever wondered how we know the size of the U.S. population? Read on to learn how it is measured. One of the original uses of the census was to apportion the number of representatives that each state elects to Congress. Ever since, the census has given us a wealth of data about our nation, and we even use it to make projections into the future. Counting the Population The federal government conducted the first census in 1790. Throughout the 1800s, it created temporary agencies each decade to do the counting. In 1902, Congress permanently established the U.S. Census Bureau. Today, the Bureau works yearround, conducting monthly surveys relating to the size and other characteristics of the population. When the Census Bureau conducted the last decennial census, it used the household as its primary survey unit. In this census, about five in every six households received a “short form,” which took just a few minutes to fill out. The remaining households received a “long form,” which included more questions and served to generate a more detailed profile of the population. Bureau employees also used different methods to count special groups, such as homeless persons, who do not normally conform to the household survey unit. The Census Bureau tabulates and presents its data in a number of ways. One such classification considers the size of the urban population—people living in incorporated cities, villages, or towns with 2,500 or more inhabitants. The rural population makes up the remainder of the total, including those persons who live in sparsely populated areas along the fringes of cities. Historical Growth The population of the United States has grown considerably since colonial times. The rate of growth, however, has slowly declined. Between 1790 and 1860, the population grew at a compounded rate of about 3.0 percent a year. From the beginning of the Civil War until 1900, the average fell to 2.2 percent. From 1900 to the beginning of World War II, the rate dropped to 1.4 percent. The rate of increase declined slowly but steadily after that, and today the rate of population growth is less than 1.0 percent annually. The census also shows a steady trend toward smaller households. During colonial times, household size averaged about 5.8 people. By 1960, the average had fallen to 3.3 and today is about 2.6 people. The figures reflect a worldwide trend toward Rhoda Sidney/PhotoEdit Figure 12.4 Center of Population, 1790–2000 The center of population is the point where the country would balance if the map were flat and every person weighed the same. Economic Analysis Why has the center moved since the first census was conducted in 1790? C ENTER OF P OPULATION See StudentWorks™ Plus or glencoe.com. IOWA MISSOURI ILLINOIS INDIANA OHIO Springfield Indianapolis 1930 1910 1890 1880 1900 1920 St. Louis 1960 1950 1940 1970 1980 1990 2000 Louisville KENTUCKY Columbus 1870 1860 1850 1840 Charleston WEST VIRGINIA ARKANSAS TENNESSEE Source: U.S. Census Bureau PENNSYLVANIA Pittsburgh Baltimore 1800 1790 MD 1820 1810 DC 1830 Richmond VIRGINIA NORTH CAROLINA Mean center of population smaller families in industrialized countries. The figures also show that more individuals are living alone today than ever before. Regional Change An important population shift began in the 1970s with a migration to the western and southern parts of the United States. These regions have grown quite rapidly, while most of the older industrial areas in the North and East have grown more slowly or even lost population. As people have left the crowded, industrial Northeast for warmer, more spacious parts of the country, the population in states such as Nevada, Arizona, Colorado, Utah, Idaho, Georgia, and Florida has been increasing steadily. Another indicator of population shift is the center of population—the point where the country would balance if it could be laid flat and everyone weighed the same. In 1790, the center was 23 miles east of Baltimore, Maryland. Since then, as you can see in Figure 12.4, it has moved farther west. By the 2000 decennial census, the center of population had reached a point about 2.8 miles east of Edgar Springs, Missouri. center of population point where the country would balance if it were flat and everyone weighed the same Consequences of Growth Changes in population can distort some macroeconomic measures like GDP and GNP. As a result, both measures are often expressed on a per capita, or per person, basis. One result is GDP per capita, which is determined by dividing GDP by the population. GDP per capita is especially useful when making comparisons between countries. Population growth can have several consequences. If a nation’s population grows faster than its output, per capita output grows more slowly, and the country could CHAPTER 12 Macroeconomic Performance 331 Urban Sprawl When the population grows, it results in heavier traffic. What are other effects of population growth? Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 12—Student Web Activities for an activity about population trends. infrastructure the highways, mass transit, communications, power, water, sewerage, and other public goods needed to support a population baby boom historically high birthrate years in the United States from 1946 to 1964 end up with more mouths than it can feed. On the other hand, if a nation’s population grows too slowly, there may not be enough workers to sustain economic growth. In addition, a growing population puts more demand on resources. When a growing population shifts toward certain areas, such as cities or suburbs, it puts different pressures on existing resources. In Atlanta, Georgia, for example, urban sprawl and traffic congestion have become major problems. In heavily populated areas of Arizona, Nevada, and southern California, adequate supplies of fresh water have become concerns. Because it takes a long time to plan and construct a country’s infrastructure— the highways, levees, mass transit, communications systems, electricity, water, sewer, and other public goods needed to support a population—we need to pay attention to future population trends. If we neglect them, even modest shifts in the population can cause enormous problems in the future. Reading Check Explaining What have been the major population changes since the first census in 1790? Projected Population Trends MAIN Idea Fertility, life expectancy, and net immigration influence population trends. Economics and You Have you considered how immigration affects population growth? Read on to learn how the U.S. population is expected to change. Population trends are important to many groups. Political leaders watch population shifts to see how voting patterns may change. Community leaders are interested because changes in local population affect services such as sanitation, education, and fire protection. Businesses use census data to help determine markets for products and sales territories. Age and Gender When making its projections, the Census Bureau assumes that the aging generation of baby boomers will drive many characteristics of the population. People born durin |
g the baby boom, the high birthrate years from 1946 to 1964, make up a sizable portion of the current population. As 332 UNIT 4 Macroeconomics: Performance and Stabilization Barry Williams/Getty Images population pyramid diagram showing the breakdown of population by age and gender dependency ratio number of children and elderly people in the population for every 100 persons in the 18 to 64 working-age bracket shown in Figure 12.5, people born during this time span created a significant bulge in the population pyramid, a type of bar graph that shows the breakdown of population by age and gender. The bulge in the middle of the pyramid represents the baby boomers. A second, minor bulge represents the children born to the baby boom generation. As years pass, more births add to the bottom of the pyramid and push earlier groups upward into higher age brackets. Eventually, the baby boomers will reach their retirement years and want to collect pensions, Social Security, and Medicare benefits. Because most of these payments are transfer payments, they will place a heavy burden on the younger and relatively smaller working population. The burden becomes evident with changes in the dependency ratio—the number of children and elderly people in the population for every 100 persons in the working- age bracket of ages 18 through 64. The dependency ratio was 63.9 in 1998, but according to Census Bureau projections, it will rise to 67.5 by 2020, to 77.5 by 2030, and to 78.0 by 2040. Finally, if you compare the left side of the population pyramid with the right, you will see that women tend to outlive men. Separate population pyramids can also be created for any racial or ethnic group. Race and Ethnicity The Census Bureau also makes projections for racial and ethnic groups. In 2000, whites were the largest component of the total population. The numbers of African Americans, Hispanic Americans, Asian Americans, and Native Americans followed in that order. Differences in fertility rates, life expectancies, and immigration rates will change the racial statistics dramatically in the future. By 2050, the Asian and Hispanic Figure 12.5 Projected Distribution of the Population by Age and Gender, 2010 P OPULATION P YRAMID Male Female Age 85+ 80–84 75–79 70–74 65–69 60–64 55–59 50–54 45–49 40–44 35–39 30–34 25–29 20–24 15–19 10–14 5–9 0–4 12 10 10 12 Population (in millions) Source: U.S. Census Bureau, International Data Base. Population pyramids are one way to show the distribution of population. In this pyramid, the population is divided by age and gender. Economic Analysis To which age bracket do most males belong? Most females? Figure 12.6 Projected Change in U.S. Population by Race and Ethnic Origin, 2000–2050 P ROJECTED P OPULATION, 2000–2050 The distribution of population by race is projected to change dramatically by the year 2050. Economic Analysis Which ethnic groups are expected to increase the most? Which will decrease in proportion to the total population? t n e c r e P 90 80 70 60 50 40 30 20 10 0 2000 2010 Source: U.S. Census Bureau. White Hispanic Other races Asian American African American 2040 2050 2020 2030 Year demographer person who studies growth, density, and other characteristics of the population fertility rate number of births that 1,000 women are expected to undergo in their lifetime life expectancy average remaining life span in years for persons who attain a given age net immigration net population change after accounting for those who leave as well as enter a country portions of the population are expected to nearly double. The number of African Americans will also increase. The white non-Hispanic population is expected to remain a majority of the total population at just over 50 percent. Figure 12.6 shows how the Census Bureau projects the ethnic makeup of the U.S. population to change over the next few decades. Population Growth According to demographers—people who study the growth, density, and other characteristics of population—three major factors affect population growth. These factors are fertility, life expectancy, and net immigration levels. The fertility rate is the number of births that 1,000 women are expected to undergo in their lifetime. A fertility rate of 2,119, for example, translates to 2.119 births per woman. According to the Bureau of the Census, this rate is projected as the most likely fertility rate for the United States. That rate is barely above the replacement population rate—the rate at which the number of births in a population offsets the number of deaths and the size of the population neither increases nor decreases. This was not always the case. In the late 1800s and early 1900s, Americans tended to have large families. In the days before modern machines and appliances, the work of maintaining a home and family and earning a living was difficult and time consuming. Children were needed to do household chores, work on family farms, and bring in additional money from outside jobs. Later, as life became mechanized and fewer people lived on farms, having large families became less important. As a result, the nation’s birthrate dropped steadily throughout the last century. The second factor, life expectancy, is the average remaining life span of a person who has reached a given age. The Bureau of the Census predicts that life expectancy at birth will go from about 75.9 years today to 82.1 years by 2050. The third factor is net immigration—the overall change in population caused by 334 UNIT 4 Macroeconomics: Performance and Stabilization Skills Handbook See page R47 to learn about Making Predictions. people moving into and out of the country. The Census Bureau recently estimated a constant net immigration of about 880,000 per year. This figure is based on 1,040,000 immigrants—those entering the country— and 160,000 emigrants—those leaving the country—in the future. Taking into account these three factors, analysts expect the rate of population growth in the United States to continue to decline. The growth rate, already below 1 percent today, is likely to decrease further until the year 2050. At that time, the resident United States population is expected to be about 420 million people. Future Population Growth Most of the demographic factors examined in this section point to a population that is likely to grow more slowly in the future. While this may seem like a matter for concern, it is important to note that increases in productivity can easily offset the negative effects of declining population growth. If slightly fewer people produce significantly more on average, then total output will continue to grow. The larger concern is the age composition of the future population. As the population matures, a greater percentage of people reach retirement age. This will cause an increase in the demand for medicines, medical facilities, retirement homes, and other products that are needed for the retired and the elderly. At the same time, there may be a declining need for schools, playgrounds, and other facilities as the young become a smaller percentage of the population. These changes tend to be gradual, and their impact on the economy can be anticipated with some degree of certainty. As you learned in Chapter 2, one of the major advantages of a market economy is that it accommodates change with the least amount of disruption of daily life. Reading Check Summarizing Why is the rate of population growth declining? SECTION 2 Review Vocabulary 1. Explain the significance of census, urban population, rural population, center of population, infrastructure, baby boom, population pyramid, dependency ratio, demographers, fertility rate, life expectancy, and net immigration. Main Ideas 2. Explaining How does the rate of population growth affect economic growth? 3. Listing Use a graphic organizer like the one below to list the three most important factors that determine future population. Critical Thinking 4. The BIG Idea How can the projection of population trends help determine the direction of economic development? 5. Drawing Conclusions How will the retirement of baby boomers affect your generation? How do you think the baby boomers will feel about this? 6. Determining Cause and Effect What special demands does a high birthrate put on a nation’s economy? 7. Analyzing Visuals Look at the photograph of traffic congestion on page 332. What effect does urban sprawl have on the city of Atlanta? What could the city do to alleviate the problem? Factors Influencing Population Trends Applying Economics 8. Population Growth Search your local newspaper for articles related to population issues. Summarize the population-related problems affecting your community, and assess the local or state government’s solutions. CHAPTER 12 Macroeconomic Performance 335 CASE STUDY Falabella Flourishes Chilean Retail Giant Latin American countries have experienced tremendous population growth. Yet this alone does not guarantee business success, because it is hard to get people to buy your products when they have very little money to spend. Big-name foreign companies, such as Sears and J.C. Penney, have called it quits in Chile because of this roadblock. A domestic retail company, however, has found a highly successful way around it. Tailored to Consumers Chile’s S.A.C.I. Falabella began in 1889 as a small tailor shop and has since grown to become the largest department store chain in Chile and one of the largest in South America. Falabella’s strategy for growth is simple: find a way to satisfy consumers’ needs. In 1980, Falabella created CMR—its own credit card. Today, the CMR card, issued to more than 4 million people in Chile, Peru, Argentina, and Colombia, is the most widely used credit card in Chile. As an added incentive for frequent CMR users, Falabella offers rewards in the form of cellular phone minutes. Customers can even charge a cellular account directly to their card. F ALABELLA R EVENUE ) .0 3.5 3.0 2.5 2. |
0 1.5 1.0 0.5 0 2000 2001 2002 2003 2004 2005 Year Source: Falabella R EVENUE C OMPOSITION 2% 15% 5% 9% 8% 27% 34% Source: Falabella Falabella Chile Sodimac Chile Tottus Chile CMR Chile Argentina Peru Others Diversify, Diversify Despite great success with the CMR card, the department store did not realize its potential for growth until it expanded and diversified. Falabella opened stores in neighboring Argentina and Peru, acquired a large share of ownership in The Home Depot Chile, and purchased the home improvement chain Sodimac. Building on these successes, it created a travel agency and an insurance brokerage, then built a chain of Tottus super stores called hypermarkets. To help all financial aspects of the company work together smoothly, the company added a financial division with the new Banco Falabella (Falabella Bank) . This explosive growth has nearly tripled the number of Falabella-owned stores, and they all accept the CMR card. Analyzing the Impact 1. Summarizing What services does Falabella provide? 2. Making Inferences Why has Falabella succeeded where others have failed? 336 UNIT 4 Macroeconomics: Performance and Stabilization SECTION 3 Poverty and the Distribution of Income GUIDE TO READING Section Preview In this section, you will learn about the factors that contribute to income inequality and the programs that have been implemented to reduce poverty. Content Vocabulary • poverty threshold (p. 338) • poverty guidelines (p. 338) • Lorenz curve (p. 339) • welfare (p. 342) • food stamps (p. 342) • Medicaid (p. 343) • Earned Income Tax Credit (EITC) (p. 343) • enterprise zone (p. 344) • workfare (p. 344) • negative income tax (p. 344) Academic Vocabulary • impact (p. 340) • uniform (p. 342) Reading Strategy Outlining As you read the section, complete a graphic organizer similar to the one below by outlining three explanations for a growing income gap. Income Gap —Toledo Blade ISSUES IN THE NEWS Need for Food Help Is Growing Once believed to affect only the homeless or unemployed, hunger in America has taken on a new face: the working poor. According to a new nationwide study, more than 25 million Americans seek emergency food assistance each year. In the Toledo area, nearly 297,000 visits were made by people seeking help from a local food distribution agency last year. Nearly 26 percent of those local clients had at least one adult working in the family. The study, called “Hunger in America 2006,” shows hunger has become an issue for even those with jobs. “What is really telling about this study is that such a large number of clients we’re serving have at least one adult working,” said Maura Daly, director of the study. “It’s difficult to imagine that people who have a job are coming home at the end of the day and have to make choices between food and other basic necessities like rent, utilities, or medicine.” ■ In the world today, poverty can be viewed as an indicator of macroeconomic performance. Unfortunately, about one person in eight in the United States lives in poverty despite several years of solid economic growth. As you can read in the news story, this number includes people who hold jobs but do not earn enough money to fully support their families. Governments on all levels have initiated programs to reduce poverty. Before we discuss these programs, however, we must first understand how poverty is defined and measured. Marcio Jose Sanchez/AP Images CHAPTER 12 Macroeconomic Performance 337 poverty threshold annual dollar income used to determine the number of people in poverty poverty guidelines administrative guidelines used to determine eligibility for certain federal programs Poverty MAIN Idea A portion of the U.S. population lives in poverty, and the gap in the distribution of income is widening every year. Economics and You Have you ever thought about what it would be like to be either very rich or very poor? Read on to find out how income is distributed in the United States. Poverty is a relative measure that depends on prices, the standard of living, and the incomes that others earn. What may seem like poverty to one person may seem like riches to another, so we first need to understand how poverty is defined. Defining Poverty People are classified as living in poverty if their incomes fall below a predetermined level, or threshold. The poverty threshold is the benchmark used to evaluate the income that people receive. If they have incomes below the threshold, they are considered to be in poverty even if they have supplements such as food stamps, subsidized housing, and Medicaid. The Social Security Administration developed the thresholds in 1964 using two studies done by the U.S. Department of Agriculture in the 1950s. The first study developed four alternative but nutritionally adequate food plans for individuals and families of different sizes. The least expensive food plan was then selected as the food budget that would keep people out of poverty. The second study found that families typically spend one-third of their total income on food. To obtain the threshold, the Social Security Administration simply took the least expensive food budget of the four food plans and multiplied it by three. Today the thresholds are adjusted upward every year by an amount just enough to offset increases in inflation. For administrative purposes, the poverty threshholds are then simplified to appear as poverty guidelines, or administrative guides used to determine eligibility for certain federal programs such as the Food Stamps Program and Head Start. Figure 12.7 shows the guidelines that had been established for two recent years. Figure 12.7 Poverty Guidelines The table lists the poverty guidelines for families of different sizes for two recent years. Families and households with incomes below the official poverty guidelines are eligible for certain federal programs. Economic Analysis How are the poverty guidelines used today? Persons in Family or Household 1 2 3 4 5 6 7 8 For each additional person, add Source: Federal Register 2005 $9,570 12,830 16,090 19,350 22,610 25,870 29,130 32,390 3,260 2006 $9,800 13,200 16,600 20,000 23,400 26,800 30,200 33,600 3,400 Figure 12.8 The Distribution of Income Panel A shows the rankings of all household income for two separate years. When the 2004 data are plotted in Panel B, the curve shows the cumulative income from the lowest to the highest quintiles. Because incomes are not distributed evenly among households, the Lorenz curve is not a diagonal line. Economic Analysis What percentage of income is received by the richest quintile in 1980? In 2004? A H OUSEHOLD I NCOME R ANKED BY Q UINTILES 1980 Quintiles Quintiles 2004 Cumulative Lowest fifth Second fifth Third fifth Fourth fifth Highest fifth Top 5 percent 4.2% 10.2% 16.8% 24.7% 44.1% 16.5% 3.4% 8.7% 14.7% 23.1% 50.1% 21.8% 3.4% 12.1% 26.8% 49.9% 100.0% See StudentWorks™ Plus or glencoe.com. B T HE L ORENZ C URVE 100 e 80 m o c n i 1980 2004 Equality of income 60 40 a = 3.4% 31.2% 55.9% 49.9% 20 4.2% 0 14.4% 26.8% b = 12.1% 20 Percentage of total households 80 40 60 100 Source: U.S. Census Bureau. Lorenz curve graph showing how the actual distribution of income differs from an equal distribution Distribution of Income In addition to determining the actual number of people in poverty, economists are interested in finding out how income is distributed among households. To do so, the incomes of all households are ranked from highest to lowest, and the ranking is then divided into quintiles, or fifths, for examination. Then the total amount of the nation’s income earned by each quintile is calculated. The table in Panel A of Figure 12.8 shows household income quintiles for two different years. As before, only money income is counted, while other aid such as Medicaid, food stamps, or subsidized housing is excluded. Using the most recent year in the figure as our example, the percentage of income earned by each quintile is added to the other quintiles. These incomes are plotted as a Lorenz curve. The Lorenz curve, which shows how the actual distribution of income varies from an equal distribution, appears in Panel B. To illustrate, in 2004 the 3.4 percent of total income received by the lowest quintile is plotted in Panel B as point a. This amount is added to the 8.7 percent the next quintile earns and plotted as point b. This process continues until the cumulative amounts of all quintiles are plotted. If all households received exactly the same income—so that 40 percent of the households earn 40 percent of the total income and so on—the Lorenz curve would appear as a diagonal line running from one corner of the graph to the other. Because all households do not receive the same income, however, the Lorenz curve is not a diagonal. As you can see in the figure, the distribution of income recently has become more unequal than it was in 1980. A Lorenz curve can also be shown for groups other than households. These would include Lorenz curves for individuals, families, or occupations. Reading Check Describing How were poverty thresholds developed? CHAPTER 12 Macroeconomic Performance 339 Reasons for Income Inequality MAIN Idea Lack of education and uneven distribution of wealth are among the reasons for poverty. Economics and You Have you ever considered how your education could affect your income? Read on to find out about the way income is distributed in the United States. There are at least eight, if not more, reasons why incomes vary. Education and wealth are among the most important of these reasons. Education One of the most important reasons for income inequality is the difference in individuals’ educational levels. People’s income normally goes up as they get more education. However, in the last 30 years, the gap between well-educated and poorly educated workers has widened. This has caused wages for highly skilled workers to soar, while wages for the less skilled have remained about the same. You saw p |
roof of the importance of education earlier in Figure 1.4 on page 16. This figure shows that someone who has earned a college degree makes about three times more on average than someone without a high school diploma. Likewise, someone with a college degree makes nearly twice as much as someone with a high school diploma. Wealth Income also varies because some people hold more wealth than others, and the distribution of wealth is even more unequal than the distribution of income. When wealth holders are ranked from highest to lowest, the top fifth holds about 75 percent of all the wealth in the country. The bottom two-fifths, or 40 percent of the people in the country, have less than 2 percent of the total wealth. This inequality has a dramatic impact on people’s ability to earn income. Wealthy families can send their children to expensive colleges and universities. The wealthy also can afford to set their children up in businesses where they can earn a better Personal Finance Handbook See pages R16–R19 for information on getting an education. Inequality of Income Some Americans live in mansions, while others cannot afford to pay rent and are homeless. What are the major reasons for varying incomes? 340 UNIT 4 Macroeconomics: Performance and Stabilization Joel Stettenheim/Corbis income. Even if the very wealthy choose not to work, they can make investments that will earn additional income. Tax Law Changes In recent years, Congress has changed many tax laws, reducing taxes for almost all Americans. Marginal tax rates on high incomes, however, have been reduced more than rates on lower incomes, thereby adding to the growing inequality of income. The 15 percent tax rate that applies to corporate dividend payments and capital gains, for example, is the same as the second-lowest rates that apply to the poorest Americans. This means that a millionaire who receives tens of thousands of dollars in corporate dividends pays the same percentage rate on those dividends as someone who only earns $20,000 a year. Decline of Unions As heavy manufacturing has declined in the United States, union membership has fallen, especially among less-skilled workers, adding to the growing income gap. High school graduates who once followed their parents into high-paying factory jobs can no longer do so. This leaves them to find other work, often for much less pay. More Service Jobs A structural change in the U.S. economy saw industry convert from goods production to service production. This event widened the income differential. Because wages are typically lower in service industries such as restaurants, movie theaters, and clothing stores, annual incomes also tend to be lower. Monopoly Power Another factor is the degree of monopoly power that some groups have. You learned in Chapter 8 that unions have been able to obtain higher wages for their members. Some white-collar workers—clerical, Income Gap The rising inequality of income is a worldwide phenomenon, especially for the developing countries of Asia. A major reason for this trend is the lack of jobs for the growing population. The widening income gaps have troubling results. More and more countries experience public complaints, protests, and political crises. In one year alone, China was faced with tens of thousands of protests, often in rural areas where people’s earnings are a small fraction of the average income their fellow citizens in cities and coastal regions receive. business, or professional workers who generally are salaried—also hold a degree of monopoly power. The American Medical Association, for example, has successfully limited the number of people entering the profession by restricting medical school certifications. This has been a major factor in driving up the incomes of doctors. Discrimination Discrimination also affects the distribution of income. Women may not be promoted to executive positions because male executives simply are not accustomed to women in roles of power. Some unions may deny membership to immigrants or ethnic minorities. Although workplace discrimination is illegal, it still occurs. When it does, it causes women and minority groups to be crowded into other labor markets where oversupply drives wages down. Changing Family Structure A final reason for the growing income gap concerns the changing structure of the American family. The shift from two-parent families to single-parent families and other household living arrangements tends to decrease the average family income. This and the other factors mentioned above contribute to the trend of the rich getting richer and the poor getting poorer. Reading Check Synthesizing Which factors are most important in unequal income distribution? Why? CHAPTER 12 Macroeconomic Performance 341 welfare government or private agency programs that provide general economic and social assistance to needy individuals food stamps government-issued coupons that can be exchanged for food Skills Handbook See page R48 to learn about Problems and Solutions. Antipoverty Programs MAIN Idea Since the 1960s, the government has experienced modest success with a number of anti-poverty programs. Economics and You Did you know there are programs designed to help people escape or avoid poverty? Read on to find out about these programs. Over the years, the federal government has tried a number of programs to help the needy. Most come under the general heading of welfare—economic and social assistance from the government or private agencies because of need. Reducing poverty has been difficult. As Figure 12.9 shows, even the record economic expansions of the 1980s and 1990s failed to make a significant dent in the percentage of Americans living in poverty. In fact, the proportion of the population living in poverty today is about the same as it was in the 1970s—and it might have been worse without some of the following programs. Income Assistance Programs that provide direct cash assistance to those in need fall into the category of income assistance. One such program is the Temporary Assistance for Needy Families (TANF), which began in 1997. Although provisions and benefits vary from state to state, many families qualify for modest cash payments because of the death, continuous absence, or permanent disability of a parent. More recently, Congress voted to tighten provisions of the law and toughen work standards for twoparent households. Another income assistance program is the Supplemental Security Income (SSI), which makes cash payments to blind or disabled persons or to people age 65 and older. Originally, the states administered the program, but because benefits varied so much from state to state, the federal government took it over to assure more uniform coverage. General Assistance Programs that assist poor people but do not provide direct cash assistance fall into the category of general assistance. One example is the food stamp program that serves millions of Americans. Food stamps are government-issued coupons that can be redeemed for food. They may be given or sold to eligible low-income persons. Figure 12.9 Poverty in the United States: Total Number and Rate Since the mid-1960s, the poverty rate has hovered between 10 and 15 percent of the population. In that same time span, the number of people in poverty has increased. Economic Analysis When was the poverty rate lowest? When did it reach the highest numbers? P OVERTY IN THE U NITED S TATES Number in poverty (in millions) Poverty rate (percent) 40 30 20 10 See StudentWorks™ Plus or glencoe.com. 0 1960 1965 1970 1975 1980 1990 1995 2000 2005 2010 1985 Year Source: U.S. Census Bureau Job Training Many states have introduced job training, such as this computer class, to help people out of poverty. How are such programs usually funded? For example, if a person pays 40 cents for a $1 food stamp, that person can get a dollar’s worth of food for a fraction of its cost. The program, which became law in 1964, is different from other programs because eligibility is based solely on income. Another general assistance program is Medicaid—a joint federal-state medical insurance program for low-income people. Under the program, the federal government pays a majority of health-care costs, and the state governments cover the rest of the cost. Medicaid serves millions of Americans, including children, the visually impaired, and the disabled. Social Service Programs Over the years, individual states have developed a variety of social service programs to help the needy. These include such areas as child abuse prevention, foster care, family planning, job training, child welfare, and day care. Although states control the kinds of services the programs provide, the federal Lester Lefkowitz/Corbis government may match part of the cost. To be eligible for matching funds, a state must file an annual service plan with the federal government. If the plan is approved, the state is free to select social issues it wishes to address, set the eligibility requirements for the programs, and decide how the programs are to be carried out. As a result, the range of services and the level of support may vary from state to state. Medicaid joint federal-state medical insurance program for low-income people (also see page 271) Earned Income Tax Credit (EITC) federal tax credits and cash payments for low-income workers Tax Credits Many working Americans qualify for special tax credits. The most popular is the Earned Income Tax Credit (EITC) which provides federal tax credits and even cash to low-income workers. The credit was created to partially offset the payroll tax burden on working families. The credit is applied first to federal income taxes. Lowincome workers can take the remainder of the credit in cash if the credit is larger than the taxes owed. The credit has proved to be popular, with millions of working families receiving benefits annually. CHAPTER 12 Macroeconomic Performance 343 enterprise zone area fre |
e of tax laws and other operating restrictions workfare program requiring welfare recipients to work in exchange for benefits negative income tax tax system that would make cash payments to individuals with incomes below certain levels Enterprise Zones Special enterprise zones are areas where companies can locate free of some local, state, and federal tax laws and other operating restrictions. Many enterprise zones are established in run-down or depressed areas. This benefits area residents because they can find work without worrying about transportation. Enterprise zones thus help depressed areas to grow again in several different ways. Nearly everyone agrees that a healthy and growing economy helps alleviate poverty. CAREERS Actuary The Work * Help businesses assess risks and formulate policies * Gather and analyze statistics on death, sickness, injury, disability, retirement, and property loss * Design insurance and pension plans and calculate premium rates that are high enough to cover any claims and expenses Qualifications * Strong background in mathematics, statistics, probability, finance, and business * Knowledge of economic, social, health, and legislative trends * Ability to develop and use spreadsheets, databases, and statistical analysis software * Bachelor’s degree in mathematics or statistics * Must pass a series of actuarial examinations Earnings * Median annual earnings: $76,340 Job Growth Outlook * Faster than average Source: Occupational Outlook Handbook, 2006–2007 Edition The enterprise zone concept is an attempt to focus some of that growth directly in the areas that need it most by making more employment opportunities available. Workfare Programs Because of rising welfare costs, many state and local governments require individuals who receive welfare to provide labor in exchange for benefits. Workfare is a program in which welfare recipients work for their benefits. People on workfare often assist law enforcement officials or sanitation and highway crews, work in schools or hospitals, or perform other types of community service work. Most states that have workfare programs require almost everyone except for the disabled, the elderly, and those with very young children to work. If the workfare assignments are well designed, then recipients have a valuable opportunity to learn new skills that will eventually help them get other jobs. Many welfare-to-work programs have had promising results. In some cases, companies can even earn federal tax credits when they hire workers directly from the welfare rolls. Under these circumstances, the employment is a win-win situation for both employer and employee. Negative Income Tax The negative income tax is a proposed type of tax that would make cash payments to certain groups below the poverty line. While the program is not in use today, the proposal is attractive because cash payments would take the place of existing welfare programs rather than supplementing them. Also, everyone would qualify for the program, not just working people as with the EITC. Under the negative income tax, the federal government would set an income level below which people would not have to pay taxes. Then the government would pay a certain amount of money to anyone who earned less than that amount. 344 UNIT 4 Macroeconomics: Performance and Stabilization Myrleen Ferguson Cate/PhotoEdit For example, suppose that an individual’s tax liability was computed using the following formula: taxes = (25% of income) – $8,000 Under this formula, a person with no income would have a tax of minus $8,000— which is another way of saying that the person will receive $8,000 from the government. If the person earned exactly $12,000, then the taxes would be $3,000 minus $8,000, so they would receive $5,000 for a total of $17,000 (or $5,000 from the tax formula plus the $12,000 in earned income). Under this formula, a person would have to make $32,000 before he or she actually paid any taxes. The negative income tax differs from other antipoverty programs in two respects. First, it is a market-based program designed to encourage people to work. The objective is to make the minimum payment large enough to be of some assistance, yet small enough so that people are better off working. Then, when people do go to work, the taxes they pay need to be low enough to not discourage them from working. Second, the negative income tax would be cost-effective because it would take the place of other, more costly, welfare programs. In addition, government would save on administrative costs. A Difficult Problem We might ask how the U.S. economy has done as a result of all these programs with the strong economic growth since the 1980s. The answer, unfortunately, is that poverty has been a remarkably difficult problem to solve. Economic growth is important, of course, but by itself it is not sufficient to reduce poverty. Even so, there are sound reasons to try to improve the problem of poverty. Not only would millions of Americans be better off, but everyone else in the economy would be better off as well. After all, if too many people find themselves without the capacity to earn and spend, there will be fewer people to purchase the products that our economy produces. Reading Check Summarizing What are the benefits of the EITC to a working person? SECTION 3 Review Vocabulary 1. Explain the significance of poverty threshold, poverty guidelines, Lorenz curve, welfare, food stamps, Medicaid, Earned Income Tax Credit (EITC), enterprise zone, workfare, and negative income tax. Main Ideas 2. Defining How is poverty defined? 3. Describing What are reasons for income inequality? 4. Identifying Use a graphic organizer like the one below to identify the major programs and proposals designed to alleviate the problem of poverty Alleviating the problem of poverty 1. 2. Critical Thinking 5. The BIG Idea Which of the factors that contribute to income inequality do you feel has the most impact? Explain your answer. 6. Drawing Conclusions Do you think that a workfare program is the best way to address income inequalities within our economy? Explain your answers. 7. Analyzing Visuals Look at Figure 12.9 on page 342. How do the lines for the number of people in poverty and the poverty rate compare? Why are the lines not more similar? Applying Economics 8. Distribution of Income What would happen to the Lorenz curve if nonfinancial aid such as food stamps and Medicaid were treated as income? Explain why this would occur. CHAPTER 12 Macroeconomic Performance 345 NEWSCLIP A gap in income between high- and low-paid workers has always existed. Some people argue that income inequality today is as high as before the Great Depression. The Rich Get (Much) Richer Shame on . . . us, passive witnesses to the emergence of a second Gilded Age, another Roaring Twenties, in which the fruits of economic success have gone not to the broad populace but to a slim sliver at the top. For this handful, life is a sweet mélange [mix] of megafortunes, grand houses, and massive yachts. Meanwhile, the bottom 80% endures economic stagnation. . . . Much of the recent commentary has focused on class mobility, the opportunity for individuals to move up the ladder. But trumpeting mobility as a reason for ignoring growing income inequality is a chimera [illusion]. Even if mobility is high— a questionable assertion—it is hardly a consolation for those who remain at the bottom, gazing across a growing distance at the more successful. We can debate a lot of economic data but not income inequality. Every serious study shows that the U.S. income gap has become a chasm [gulf]. Over the past 30 years, the share of income going to the highest-earning Americans has risen steadily S HARE OF H OUSEHOLD I NCOME Top 20% of households earned 50.1% of all income Next 20% earned 23.1% of all income Next 20% earned 14.7% of all income Next 20% earned 8.7% of all income Bottom 20% earned 3.4% of all income to levels not seen since shortly before the Great Depression. . . . What’s to blame for this sorry situation? Certainly globalization has taken its toll. Cheaper labor in emerging markets means relentless wage pressure on U.S. workers. Meanwhile, the fruits of American success in fast-growing services and technology remain available only to the slice of our workforce with the necessary skills. Other factors, such as an increasingly regressive tax code, have also played a role. Growing inequality helps explain why so many Americans feel so vulnerable even as the overall economy continues to expand. Moods understandably darken when many have to take second jobs and go into debt to improve their living standards. . . . Sadly, there is no magic bullet. We need to provide more education and training to fix our problem of too many low-skilled workers. We don’t need to become tax-code Robin Hoods, but we can be vigilant about tax plans . . . that widen the gulf between haves and have-nots. Finally, we can provide more protection for those at risk, such as better wage insurance to cushion the effects of globalization. —Reprinted from BusinessWeek Examining the Newsclip 1. Identifying Points of View What words and phrases can you identify in the article that help reveal the author’s point of view? 2. Detecting Bias Does the author state opinions or facts? What bias might be evident in these statements? 346 UNIT 4 Macroeconomics: Performance and Stabilization CHAPTER 12 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. National Output and Income Gross domestic product (GDP) measures the nation’s output, while gross national product (GNP) measures the nation’s income. GDP GNP • Market value of all final goods, services, and structures produced within a country’s national borders in a year • Indicator of the condition of the nation’s economy • Includes output of foreign-owned firms located in the United States • Includes only final products |
• Market value of all final goods, services, and structures produced in one year with labor and property supplied by a country's residents • Includes all payments to citizens, regardless of where the production takes place • Excludes income earned by foreign-owned resources in the country Population Governments count the population and project population trends to plan the use of resources and to prepare infrastructure. Fertility rate Life expectancy Net immigration Population growth Planning for the future Poverty People are described as living in poverty if they live below an income level called the poverty threshold. Poverty has a number of causes, and governments have established some programs to reduce it. Lack of education Lack of access to some professions Low-paying service jobs Unfavorable tax laws Lack of financial resources Decline of unions Discrimination Shift to singleparent families Poverty CHAPTER 12 Macroeconomic Performance 347 CHAPTER 12 Assessment & Activities Review Content Vocabulary Review the Main Ideas Examine the pairs of words below. Then write a sentence explaining what each pair has in common. Section 1 (pages 319–327) 1. food stamps, Medicaid the GDP. 16. Describe what goods and services are included in 2. gross national product, net national product 3. household, unrelated individuals 4. intermediate products, secondhand sales 5. underground economy, nonmarket transactions 6. workfare, welfare 7. life expectancy, dependency ratio 8. demographer, center of population 9. baby boom, population pyramid 17. Explain the connections between the various measures of income using a graphic organizer like the one below. Begin with . . . Add Subtract Equals GDP GNP NDP NI PI GNP NDP NI PI DPI Review Academic Vocabulary Identify which of the following terms correctly complete the sentences below. a. excluded b. components c. residence d. projected e. impact f. uniform 10. The Census Bureau has ____ the most likely U.S. fertility rate as 2.119 births per woman. 11. Nonmarket transactions are ____ from GDP. 12. The federal government now administers the Supplemental Security Income program to assure more ____ coverage across the nation. 13. The unequal distribution of wealth has an enormous 18. Identify the source of income for the four sectors of the economy. 19. Identify the components of GDP by decoding the formula GDP = C + I + G + (X – M). Section 2 (pages 329–335) 20. Describe the historical growth of population in the United States. 21. Identify the political and economic importance of the census. 22. Explain how the age composition of the future population might impact our economy. Section 3 (pages 337–345) ____ on people’s ability to earn income. 23. Explain what is meant by the term distribution of 14. The sectors of our economy receive various ____ of the national income, which they then use to purchase the total output. income. 24. Identify the major reasons for inequality in the distribution of income. 15. Every ten years the U.S. government takes an official count of all people, including their place of ____. 25. Explain how enterprise zones benefit residents of run-down or depressed areas. 348 UNIT 4 Macroeconomics: Performance and Stabilization Economics: Principles and Practices Web site at glencoe.com and click on Chapter 12—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Critical Thinking Math Practice 26. The BIG Idea How do the different measures of output and income allow us to assess the economy of a nation? 27. Comparing and Contrasting Which program do you think is more effective, workfare or welfare? Why? 28. Determining Cause and Effect Which of the factors affecting population growth will have the greatest impact on the United States in the next 50 years? Why? 29. Synthesizing Under what circumstances might you prefer economic security to a better standard of living? 30. Synthesizing Suppose you were told that you would earn $95,000 in 2020. Explain why this information would say little about the standard of living you might enjoy. What other information would you need before you could evaluate how well you could live in 2020? Applying Economic Concepts 31. Economic Sectors Imagine you must teach a younger class the differences among the four sectors that make up our economy. Then take the following steps: a. For one week, c lip articles from newspapers that refer to expenditures by one or more of the economic sectors. Log the expenditures in a graphic organizer similar to the one below. b. Prepare a poster or computer presentation that explains how the sectors work together. Consumer sector Investment sector Government sector Foreign sector 33. Based on the information in the table below, determine the percentage of total expenditures that consumers spend on durable goods, nondurable goods, and services. Personal Consumption Expenditures Amount (in billions) Percentage 100% Total expenditures Durable goods Motor vehicles and parts Furniture and household equipment Other Nondurable goods Food Clothing and shoes Gasoline and other energy goods Other Services Housing Household operation Transportation Medical care Recreation Other $9,081.7 1,047.6 432.3 397.7 217.6 2,687.7 1,282.4 358.4 327.4 719.5 $5,346.4 1,318.9 495.2 337.1 1,578.9 365.2 1,251.2 Thinking Like an Economist 34. In your own words, explain why greater life expectancies and declining birthrates make some entitlements like Social Security and Medicare more difficult to fund. Analyzing Visuals 32. Critical Thinking Look at Figure 12.5 on page 333. How can you use this figure to help you plan expenditures for education? Writing About Economics 35. Expository Writing Research the following topic: Is there an income gap between men’s and women’s wages? If so, is the income gap narrowing or widening? Prepare a three-page written report. Be sure to include a list of the references you used in your report. CHAPTER 12 Macroeconomic Performance 349 &The Global Economy YOU Global Fruit Take a stroll through the produce department of your local supermarket, and you will discover an amazing variety of fresh fruits. Americans are eating more fruit—in both quantity and variety—and these fresh fruits are available not only during the summer months. Produce that was once deemed “seasonal” can now be found year-round. Global Goodness Fresh fruit choices at any grocery store in the United States include the standard fare of apples, oranges, and grapes. But you also find more exotic items, such as star fruit and papaya. How do tropical fruits find their way to grocery shelves in the dead of winter? And why can we purchase a gallon of orange juice when Florida and California farmers have been hit with an early frost? We have the global economy to thank for turning the produce aisle into a perpetual smorgasbord, continuously delivering fruits from around the world. From There to Here For many fruits, the trip from field to market involves a specific process of packing and shipping. For example, bananas leave Costa Rica and other Central and South American countries F RUIT I MPORTS AND E XPORTS Exports Imports 12 10 1990 1995 2000 2005 Year Source: U.S. Department of Agriculture packed in boxes weighing about 40 pounds each. Roughly 970 boxes fit into a refrigerated cargo container, which is then placed aboard a ship. The bananas must remain at a temperature of around 57ºF to keep them from ripening while in transit. Bananas take two to seven days to reach U.S. ports. There the cargo containers full of not-yet-ripe bananas are taken to different warehouse locations around the country. Before the bananas can be sent to your local supermarket, however, they must spend some time in special “ripening rooms.” Considering this lengthy journey, bananas seem like quite a bargain at less than fifty cents per pound. From Here to There Americans not only buy fruits—we sell them, too. The United States is the world’s fifth-largest fruit producer and the largest exporter of fresh fruit. Canada is our biggest customer, importing 350 UNIT 4 Macroeconomics: Performance and Stabilization Gail Mooney/Corbis S OURCES OF F RESH F RUIT Fruit Apples Bananas Kiwi Mangoes Papaya Peaches Pears Strawberries U.S. Producers Foreign Producers Washington, New York, California, Michigan, Pennsylvania, Virginia Canada, New Zealand California Florida Florida California, South Carolina, Georgia, Michigan, Pennsylvania, New Jersey, Washington Washington, Oregon, California, Michigan, Pennsylvania, New York California, Oregon, Florida Colombia, Costa Rica, Ecuador, Guatemala, Honduras, Panama, Mexico, Nicaragua New Zealand, Chile India, South America Jamaica, Central America Chile, Canada, Mexico Chile, New Zealand, Australia, Argentina, Canada New Zealand, Mexico Source: Food and Agriculture Organization of the United Nations photo: unloading containers in U.S. port 47 percent of all U.S. fresh fruit exports. U.S. producers also export to Japan, Hong Kong, the European Union, and South Korea, among others. Yet the United States faces new competitors in the fruit trade. Mexico, China, Chile, and South Africa all impact the marketplace as they expand their reach. What Does It Mean For You? Global trade provides you with your favorite fruits throughout the year. While most U.S. fields and orchards lie dormant during winter, countries in the Southern Hemisphere are harvesting and shipping their summer crops. The worldwide competition also means lower prices for you and other fruit lovers. In addition, you now have more choices. The global exchange allows new and unusual fruits to make their way to U.S. stores for curious palates. Analyzing the Issue 1. Identifying What country is the largest buyer of U.S. fruit? 2. Analyzing What are concerns about shipping fresh fruit from other countries? 3. Applying Check out the fruit section of your local grocery store. What fruit is available because of global trade? David Maung/AP Images CHAPT |
ER 13 Economic Instability Why It Matters Do your grandparents talk about the “good old days” when gas was 25 cents per gallon and a loaf of bread cost 10 cents? Compile a list of things that you have been purchasing for several years. Note the prices you paid in the past and those you are currently paying. What do you think accounts for the price differences? Read Chapter 13 to find out what factors can lead to economic instability. The BIG Ideas 1. Economists look at a variety of factors to assess the growth and performance of a nation’s economy. 2. The labor market, like other markets, is determined by supply and demand. During times of economic instability, people may lose their jobs and have problems finding new ones. Economics: Principles and Practices Web site at glencoe.com and click on Chapter 13—Chapter Overviews to preview chapter information. Chapter Overview Visit the 352 UNIT 4 Jack Star/PhotoLink/Getty Images SECTION 1 Business Cycles and Fluctuations GUIDE TO READING Section Preview In this section, you will learn that business cycles are the alternating increases and decreases in the level of economic activity. Content Vocabulary • business cycles (p. 353) • business fluctuation (p. 353) • recession (p. 354) • peak (p. 354) • trough (p. 354) • expansion (p. 354) • trend line (p. 354) • depression (p. 354) • depression scrip (p. 356) • leading economic indicator (p. 358) • composite index of leading economic indicators (p. 359) • econometric model (p. 359) ISSUES IN THE NEWS Economic Growth Totters Academic Vocabulary • innovation (p. 355) • series (p. 358) Reading Strategy Identifying As you read the section, complete a graphic organizer like the one below by identifying factors that can cause changes in the business cycle. Changes in the Business Cycle —Associated Press The economy has slowed to a snail’s pace, growing . . . at the slowest rate in more than three years and stirring fresh debate about the country’s financial health heading into the elections. The Commerce Department reported Friday that economic growth during the July-to-September period [of 2006] clocked in at an annual rate of just 1.6 percent, a subpar performance. . . . The fresh reading. . . disappointed economists, rattled investors and gave Republicans and Democrats plenty to argue about. Economic matters are expected to influence voters’ choices when they go to the polls Nov. 7. On Wall Street, stocks sagged. The Dow Jones industrials, which had hit new highs in recent sessions, lost 73.40 points. . . . The third quarter’s performance was the weakest since a 1.2 percent growth rate eked out in the first quarter of 2003, when a nervous nation hunkered down for the start of the Iraq war. ■ Economic growth is something that is beneficial to almost everyone. However, we cannot take economic growth for granted. Sometimes business cycles—regular ups and downs of real GDP—interrupt economic growth. Business fluctuations—the rise and fall of real GDP over time in an irregular manner—interrupt growth at other times. Slower economic growth, as you read in the news story, is always a matter of concern. Businesses lose sales, voters become unhappy, investors get nervous—and even the stock market shows its disapproval. Because of this, economists have developed elaborate forecasting models and statistical tools. After all, we all want to know where we are headed. business cycles regular increases and decreases in real GDP business fluctuations irregular increases and decreases in real GDP Richard R. Hansen/Photo Researchers, Inc CHAPTER 13 Economic Instability 353 recession decline in real GDP lasting at least two quarters peak point in time when real GDP stops expanding and begins to decline trough point in time when real GDP stops declining and begins to expand expansion period of uninterrupted growth of real GDP trend line growth path the economy would follow if it were not interrupted by alternating periods of recession and recovery depression state of the economy with large numbers of unemployed people, declining real incomes, overcapacity in manufacturing plants, and general economic hardship Business Cycles: Characteristics and Causes MAIN Idea Business cycles are marked by alternating periods of expansion and recession. Economics and You Has a slow economy ever shut down a factory in your community? Read on to learn about some possible causes. We can describe the basic features of an expansion or a recession, or the phases of the business cycle as they are sometimes called. When it comes to identifying the actual causes, though, no one theory seems to explain all past events or predict future ones because each seems to be a little different from the last. Phases of the Business Cycle The two phases of the business cycle are illustrated in Figure 13.1. The first phase is recession, a period during which real GDP—GDP measured in constant prices— declines for at least two quarters in a row, or six consecutive months. The recession begins when the economy reaches a peak— the point where real GDP stops going up. It ends when the economy reaches a trough— the turnaround point where real GDP stops going down. As soon as the declining real GDP bottoms out, the economy moves into the second phase, expansion—a period of recovery from a recession. Expansion continues until the economy reaches a new peak. When it does, the current business cycle ends and a new one begins. If periods of recession and expansion did not occur, the economy would follow a steady growth path called a trend line. As Figure 13.1 shows, the economy departs from, and then returns to, its trend line as it passes through phases of recession and expansion. To make it easier to read, recessions in figures such as this are usually shaded to separate them from periods of expansion. If a recession becomes very severe, it may turn into a depression—a state of the economy with large numbers of people out of work, acute shortages, and excess capacity in manufacturing plants. Most experts agree that the Great Depression of the 1930s was the only depression the United States experienced during the twentieth century. Changes in Investment Spending Changes in capital expenditures are thought to be one cause of business cycles. When the economy is expanding, businesses expect future sales to be high, so Figure 13.1 Business Cycles See StudentWorks™ Plus or glencoe.com. P HASES OF THE B USINESS C YCLE EXPANSION EXPANSION N O I S S E C E R Peak REAL Trough A business cycle is normally measured from peak to peak so that it includes one recession and one expansion. Peak Economic Analysis What does a trough indicate? Trough N O I S S E C E R BUSINESS CYCLE they invest heavily in capital goods. Companies may build new plants or buy new equipment to replace older equipment. At first this generates jobs and income, but after a while businesses may decide they have expanded enough. If they then cut back on their capital investments, layoffs and eventually recession may result. negative, as when high oil prices hit the United States in mid-2005. Finally, in many cases, several factors seem to work together to create a cycle. In these situations, a disturbance in one part of the economy seems to have an impact somewhere else, causing an expansion to begin or a recession to end. Innovation and Imitation Another possible cause of business cycles is an innovation that may be a new product or a new way of performing a task. When a business innovates, it often gains an edge on its competitors because costs go down or sales go up. In either case, profits increase and the business grows. If other businesses in the same industry want to remain competitive, they must copy what the innovator has done or develop something even better. The imitating companies must invest heavily to do this, and an investment boom follows. After the innovation takes hold in the industry, further investments are unnecessary, and economic activity may slow down. Monetary Policy Decisions Another possible cause of business cycles is the Federal Reserve System’s policy on interest rates. When “easy money” policies are in effect, interest rates are low and loans easy to get. Easy money encourages the private sector to borrow and invest, which stimulates the economy for a short time. Eventually the increased demand for loans causes interest rates to rise, which in turn discourages new borrowers. As borrowing and spending slow down, the level of economic activity may decline. External Shocks Another potential cause of business cycles is external shocks, such as increases in oil prices, wars, and international conflict. Some shocks drive the economy up, as when Great Britain discovered North Sea oil in the 1970s. Other shocks can be Michael Newman/PhotoEdit Reading Check Summarizing What are thought to be the causes of business cycles? CAREERS Statistician The Work * Scientifically apply mathematical principles to the collection, analysis, and presentation of numerical data * Gather and interpret data pertaining to a variety of fields, including biology, finance, economics, engineering, insurance, medicine, public health, psychology, marketing, education, scientific research, and sports * Gauge the public’s feelings on certain topics by taking samples of opinions Qualifications * Aptitude for and an interest in mathematics and computers * Knowledge in subject matter of chosen field * Strong communication skills * Bachelor’s degree in mathematics or statistics, with many private sector jobs requiring a master’s degree Earnings * Median annual earnings: $58,620 (private sector), $81,262 (government sector) Job Growth Outlook * Average Source: Occupational Outlook Handbook, 2006–2007 Edition CHAPTER 13 Economic Instability 355 depression scrip currency issued by towns, chambers of commerce, and other civic bodies during the Great Depression of the 1930s Great Depression During the height of the depression, the unemployed lined |
up in employment offices. How many people were unemployed during the Great Depression? Business Cycles in the United States MAIN Idea Business cycles have become much more moderate since the Great Depression of the 1930s. Economics and You Do you have a savings account at a bank? Read on to learn why the money in your account is insured. Economic activity in the United States followed an irregular course throughout the twentieth century. The worst downturn was the Great Depression of the 1930s. The years since World War II have taken on a special pattern of their own. The Great Depression The stock market crash on October 29, 1929, known as “Black Tuesday,” marked the beginning of the Great Depression, one of the darkest periods in American history. Between 1929 and 1933, real GDP declined nearly 50 percent, from approximately $103 billion to $55 billion. At the same time, the number of people out of work rose nearly 800 percent—from 1.6 million to 12.8 million. During the worst years of the Depression, one out of every four workers was unemployed. Even workers who had jobs suffered. The average manufacturing wage, which was 55 cents an hour in 1929, plunged to 5 cents an hour by 1933. Many banks across the country failed. Federal bank deposit insurance did not exist at the time, so depositors were not protected. To prevent panic withdrawals, the federal government declared a “bank holiday” in March 1933 and closed every bank in the country. The closure lasted for only a few days, but about one-quarter of the banks never reopened. The size of the money supply fell by one-third. Official paper currency was in such short supply that people began using depression scrip—unofficial currency that towns, counties, chambers of commerce, and other civic bodies issued. Billions of dollars of scrip were used to pay salaries for teachers, firefighters, police officers, and other municipal employees. Causes of the Great Depression An enormous gap in the distribution of income was one important cause. Poverty prevented workers from stimulating the economy by spending. The rich had the income but often used it for such nonproductive activities as stock market speculation. Easy credit also played a role. Many people borrowed heavily in the late 1920s to buy stocks. Then, as interest rates rose, it was difficult for them to repay their loans. When the crunch came, heavily indebted people had nothing to fall back on. Global economic conditions also played a part. During the 1920s, the United States had made many loans to foreign countries to help support international trade. When these loans suddenly 356 UNIT 4 Macroeconomics: Performance and Stabilization Bettmann/Corbis Recovery Wartime production during the 1940s provided an additional stimulus in the postDepression era. What other efforts led to economic recovery? were harder to get, foreign buyers purchased fewer American goods, and U.S. exports fell sharply. the same time. New unemployment programs gave some relief to people who were temporarily out of work. At the same time, high U.S. tariffs kept many countries from selling goods to the United States, leading to economic crises abroad. As world trade declined, American exports dropped even further. Recovery and Legislation The Great Depression finally ended ten years after it started, when real GDP returned to its 1929 high. The economy recovered partly because of increased government spending and partly on its own. The massive spending during World War II added another huge stimulant that further propelled the economy. The country was so shaken by the Great Depression that a number of laws were passed and agencies established from 1933 to 1940 both to protect people and to prevent another such disaster. The Social Security Act of 1935 was one of the most important and significant pieces of legislation passed during this time. To protect people during their working years, the minimum wage was established at about Because so many public stock companies went out of business, the Securities and Exchange Commission (SEC) was created to put requirements on the disclosure of financial statements by public corporations. The resulting federal regulation made stock ownership by the public much safer. Finally, the newly established Federal Deposit Insurance Corporation (FDIC) provided modest bank insurance for depositors. Such safeguards were not available earlier, when nearly one-third of the banks had failed. In all, the period from 1933 to 1940 saw the establishment of many federal institutions to make working, banking, investing, and retirement safer. The reforms of the 1930s seemed to help, and most economists today think that it would be unlikely, if not impossible, for another Great Depression to occur. Cycles After World War II Business cycles became much more moderate after World War II, with shorter recessions and longer periods of expansion. Bettmann/Corbis CHAPTER 13 Economic Instability 357 See StudentWorks™ Plus or glencoe.com. Figure 13.2 The Index of Leading Economic Indicators The index of leading economic indicators is one of the tools used to predict future economic activity. Economic Analysis How do economists use this index to predict recession? T HE I NDEX OF LEI 140 120 100 80 60 ) Occasionally, the index predicted a recession that never occurred. On average, the index turns down 9 months before a recession begins. On average, the index turns up 4 months before a recovery begins. 1965 1970 Recession years 1975 1980 1985 Year 1990 1995 2000 2005 2010 Source: The Conference Board leading economic indicator statistical series that turns down before the economy turns down, or up before the economy turns up During this time, the average length of recessions was about 10 months, while expansions averaged about 54 months. With the possible exception of the Vietnam War period, most recessions from 1965 to 1980 occurred on a fairly regular basis. After the early 1980s, recessions occurred less frequently. A record-setting peacetime expansion during the Reagan administration began in November 1982 and lasted for almost eight years. This was followed by a longer, and even more prosperous, expansion during the Clinton years from 1991 to 2001. In fact, this 10-year period of uninterrupted economic growth is the longest peacetime expansion in U.S. history. Although the Clinton expansion ended in March 2001, a new one began again in November of that year, shortly after the 9/11 terrorist attacks. Whether the latest expansion can set another record is yet to be seen, but it has already exceeded the historical 54-month average. Reading Check Inferring What impact did the Great Depression have on the United States? Forecasting Business Cycles MAIN Idea Economists use statistics and models to predict business cycles. Economics and You Would you change your post-graduation plans if you knew a recession was coming? Read on to find out how economists try to predict future recessions and expansions. Economists use several methods to predict business cycles. One uses the statistical series shown in Figure 13.2. Another makes use of macroeconomic modeling. Using Everyday Economic Statistics A change in a single statistic often indicates a change in future GDP. For example, the length of the average workweek may change just before a recession begins if people work fewer hours. This makes the measure a leading economic indicator—a statistical series that normally turns down 358 UNIT 4 Macroeconomics: Performance and Stabilization before the economy turns down or turns up before the economy turns up. However, no single series has proven completely reliable, so several individual series are combined into an overall index. This is the approach used by the composite index of leading economic indicators (LEI), a monthly statistical series that uses a combination of 10 individual indicators to forecast changes in real GDP. The composite index is shown in Figure 13.2, where the shaded areas represent recessions. The average time between a dip in the index and the onset of a recession is about nine months. The average time between a rise in the index and the start of an expansion is about four months. Using Econometric Models An econometric model is a mathematical model that uses algebraic equations to describe how the economy behaves. Most models start with the output-expenditure model we examined on page 327: GDP = C + I + G + (X – M) To see how we use it, suppose that a survey of consumers revealed that households annually spend a fixed amount of money called ‘a’, along with 95 percent of their disposable personal income, or DPI. We could express this as C = a + .95(DPI) and then substitute this equation into the output-expenditure model to get: GDP = a + .95(DPI) + I + G + (X – M) This process is repeated until each of the terms in the model is expanded and the equation is broken down into smaller and smaller components. To find GDP, forecasters put in the latest values for the variables on the right side of the equation and solve for GDP. Over time, actual changes in the economy are compared to the model’s predictions. The model is then updated by changing some of the equations. In the end, some models give reasonably good forecasts for up to nine months into the future. Reading Check Analyzing Why are short-term econometric models more accurate than long-term models? composite index of leading economic indicators (LEI) composite index of 10 economic series that move up and down in advance of changes in the overall economy; statistical series used to predict turning points in the business cycle econometric model mathematical expression used to describe how the economy is expected to perform in the future SECTION 1 Review Vocabulary 1. Explain the significance of business cycles, business fluctuation, recession, peak, trough, expansion, trend line, depression, depression scrip, leading economic indicator, composite index of leading eco |
nomic indicators, and econo metric model. Main Ideas 2. Explaining How are business cycles forecast? 3. Describing What are the two main phases of a business cycle? 4. Identifying Use a graphic organizer like the one below to identify the causes and effects of the Great Depression. Causes: The Great Depression Effects: Critical Thinking 5. The BIG Idea Why is it difficult to explain the causes of business cycles? 6. Analyzing Visuals Use Figure 13.1 on page 354 to explain how a business cycle can be compared to a roller coaster. 7. Determining Cause and Effect Assume that business inventories are falling, the average number of hours worked per week is going up, and there is an increase in the number of new building permits. What would these indicators say about the economy, and why? Applying Economics 8. Economic Security Suppose you were the head of a household. How would you plan spending for your family if you had an accurate prediction of future business cycles? Include examples in your response. CHAPTER 13 Economic Instability 359 NEWSCLIP Economists have developed a variety of tools and indicators to spot the beginnings of a recession or expansion. They also might want to take a look at one restaurant in New York that has an indicator all its own. Dog Days: A Frank Look at the Economy Corporate chiefs and economists don’t toss around the word “recession” lightly—bad for morale. But New York hot dog chain Gray’s Papaya, the 24-hour eatery frequented by bag ladies and bankers alike, isn’t bashful. Word is that the highly visible outpost on New York’s Upper West Side is about to plaster a sign for its “recession special” in its huge front windows. The last time it did that was March 2001, just as the economy was dipping into recession. The National Bureau of Economic Research, which officially calls business cycle turns, reported that March onset eight months later. Already, perhaps seeing economic clouds (and an interior “recession special” sign left over from past downturns), more Gray’s customers are asking for the dog deal ($2.75 for two franks and a drink, including tax). Anxious Times for Americans Americans are growing increasingly uneasy about the economy THE NATIONAL ECONOMY A YEAR FROM TODAY WILL BE: BETTER: THE SAME: WORSE: 6% 25% 67% Source: American Research Group, Inc. “People are getting more realistic and adjusting their expectations and budgJackie says ets,” Schwimmer, a senior vice-president at one of the city’s largest real estate brokers, in between chomps. She doesn’t see an imminent full-blown recession but concedes a pinch in the housing market. Then there’s the Wall Street guy who’d ventured uptown for his frank fix. Times are good in his neck of the woods, he admits, but he’s feeling less inclined to drop $11 on a Financial District designer salad more than twice a week. And he’d gladly trade the savory bliss of Gray’s recession special for added job security. “I love the dogs, and I love the deal,” he says, “but I hope [Gray’s Papaya is] wrong.” —Reprinted from BusinessWeek Examining the Newsclip 1. Identifying Which organization is responsible for calling turns in the business cycle? 2. Determining Cause and Effect According to the article, what do people do when they expect a recession? 360 UNIT 4 Macroeconomics: Performance and Stabilization Jenifer S. Altman SECTION 2 Inflation GUIDE TO READING Section Preview In this section, you will find out that inflation is a rise in the general level of prices that disrupts the economy. Content Vocabulary • inflation (p. 361) • deflation (p. 361) • price index (p. 362) • consumer price index (CPI) (p. 362) • market basket (p. 362) • base year (p. 362) • creeping inflation (p. 364) • hyperinflation (p. 364) • stagflation (p. 364) • producer price index (PPI) (p. 364) • implicit GDP price deflator (p. 364) • demand-pull inflation (p. 365) • cost-push inflation (p. 365) • creditor (p. 367) • debtor (p. 367) Academic Vocabulary • construction (p. 362) • recover (p. 365) Reading Strategy Illustrating As you read the section, complete a graphic organizer similar to the one below by illustrating the steps in a wage-price spiral. Higher Prices Step 2 Step 1 —The New York Times ISSUES IN THE NEWS Hyperinflation in Zimbabwe How bad is inflation in Zimbabwe? Well, consider this: at a supermarket near the center of the capital, Harare, toilet paper costs $417. No, not per roll. Four hundred seventeen Zimbabwean dollars is the value of a single two-ply sheet. A roll costs $145,750—in American currency, about 69 cents. For untold numbers of Zimbabweans, toilet paper—and bread, margarine, meat, even the once ubiquitous morning cup of tea—have become unimaginable luxuries. All are casualties of the hyperinflation that is roaring toward 1,000 percent a year, a rate usually seen only in war zones. ■ Macroeconomic instability is not limited to fluctuations in the level of national output (GDP) or national income (GNP). Changes in prices can be equally disruptive to the economy. When the general level of prices rises, the economy is experiencing inflation. A decline in the general level of prices is called deflation. Both situations are harmful to the economy and should be avoided whenever possible. Inflation in the United States has varied over the years. We may grumble when the price of gas goes up by a few cents. As you can see in the news story, though, price increases can go to extremes and turn everyday products into luxury items. inflation increase in the general level of prices of goods and services deflation decrease in the general level of prices for goods and services REUTERS/Howard Burditt CHAPTER 13 Economic Instability 361 price index statistical series used to measure changes in the price level over time consumer price index (CPI) series used to measure price changes for a representative sample of frequently used consumer items market basket representative selection of goods and services used to compile a price index base year year serving as point of comparison for other years in a price index or other statistical measure (also see page 221) Measuring Prices and Inflation MAIN Idea Several price indexes are used to measure inflation. Economics and You Have you noticed that prices for some items go up while others go down? Read on to learn how this affects the rate of inflation. To understand inflation, we must first examine how it is measured. This involves the construction of a price index—a statistical series used to measure changes in the level of prices over time. A price index can be compiled for a range of items. We will focus on the consumer price index (CPI), a statistical series that tracks monthly changes in the prices paid by urban consumers for a representative “basket” of goods and services. The Market Basket The first step we have to take is to select a market basket—a representative selection of commonly purchased goods and services. The CPI uses the prices of approximately 364 goods and services, such as those shown in Figure 13.3. While this may seem like a small number, these items are scientifically selected to represent the types of purchases that most consumers make. The next step is to find the average price of each item in the market basket. To do so, every month employees of the U.S. Census Bureau sample prices on nearly 80,000 items in stores across the country. They then add up the prices to find the total cost of the market basket. The hypothetical results of such a monthly activity are shown in Figure 13.3 for three separate periods. A base year—a year that serves as the basis of comparison for all other years, is then selected. While almost any year will do, the Bureau of Labor Statistics (BLS) in the U.S. Department of Commerce currently uses average prices as they existed from 1982 to 1984. While this is likely to be updated in the future, it is still the most popular base year used for prices today. Figure 13.3 Constructing the Consumer Price Index Item Description Price Base Period (1982–1984) Price Second Period (1998) Price Third Period (January 2006) 1 2 3 4 ..... 364 Toothpaste (7 oz.) Milk (1 gal.) Peanut butter (2-lb. jar) Lightbulb (60 watt) ..... Automobile engine tune-up Total cost of market basket Current market basket cost Base market basket cost $1.40 1.29 2.50 .45 ..... 40.00 $1,792.00 $1.49 1.29 2.65 .48 ..... 42.00 $2,925.00 $2.25 1.79 3.73 .65 ..... 84.75 $3,582.00 $1,792 $1,792 = 1.000 $2,925 $1,792 = 1.632 $3,582 $1,792 = 1.999 Index Number (%): 100 (%) 163.2 (%) 199.9 (%) Every month the Bureau of Labor Statistics reprices its market basket of commonly used consumer items and reports the results as a percentage of the cost for the base period. Economic Analysis How do we interpret a CPI of 163.2? Figure 13.4 Measuring Prices and Inflation Consumer prices have risen steadily since the mid-1960s. Inflation peaked in the early 1980s and then declined. Economic Analysis How is the CPI used to compute inflation? T HE R ATE OF I NFLATION AND THE C ONSUMER P RICE I NDEX, 1965–2006 CPI Inflation 15 10 5 1965 1970 1975 1980 1985 1990 1995 2000 2005 Recession years Year Source: Bureau of Labor Statistics ) 200% 150 100 50 0 2010 The Price Index The last step in the process is to make the numbers in the table easier to interpret by converting the dollar cost of a market basket to an index value. This is done by dividing the cost of every market basket by the base-year market basket cost. For example, the $3,582 cost for January 2006 is divided by the $1,792 base-period cost to get 1.999, or 199.9 percent. The index number for January—199.9—represents the level of prices in comparison to the baseperiod prices. In practice, all of the conversions are understood to be a percentage of the baseperiod cost even though the % sign or the word percent is not used. For example, prices in January 2006 are 199.9 percent of those in the base period, which is another way of saying that prices have nearly doubled. A |
different base year would give a different index number. However, to avoid confusion, the base year is changed only infrequently. Because so many prices are sampled all over the country, the BLS publishes specific consumer price indexes for selected cities and large urban areas, as well as one for the economy as a whole. Skills Handbook See page R54 to learn about Understanding Percentages. Measuring Inflation Now that we have the price index, we can find the percentage change in the monthly price level, which is how inflation is measured. To illustrate, suppose that the CPI in January of one year is 199.9, and it was 190.4 exactly one year earlier. To find the percentage change, we would divide the change in the CPI by the beginning value of the CPI in the following manner: (199.9-190.4) 190.4 = 9.5 190.4 = 0.05 = 5% In other words, the rate of inflation was 5 percent for the 12-month period. Figure 13.4 shows what the level of prices and the resulting inflation look like over a much longer period. The two lines are CHAPTER 13 Economic Instability 363 Hyperinflation During the 1920s, inflation in Germany reached such levels that banknotes in denominations of “100 Billionen Reichsmark” (the equivalent of 100 trillion) circulated. How is hyperinflation defined? creeping inflation relatively low rate of inflation, usually 1 to 3 percent annually hyperinflation inflation in excess of 500 percent per year stagflation period of slow economic growth coupled with inflation producer price index (PPI) index used to measure prices received by domestic producers implicit GDP price deflator index used to measure price changes in GDP shown together because the level of prices is sometimes confused with the rate of inflation, when in fact the level of prices is used to compute the inflation rate. The rate of inflation tends to change over long periods of time. In the last 20 years, the United States could be described as having creeping inflation—inflation in the range of 1 to 3 percent per year. When inflation is this low, it is generally not seen as much of a problem. However, inflation can rise to the point where it gets out of control. Hyperinflation—inflation in the range of 500 percent a year and above— does not happen very often. When it does, it is generally the last stage before a total monetary collapse. The record for hyperinflation was set in Hungary during Word War II. At that time, huge amounts of currency were printed to pay the government’s bills. By the end of the war, it was claimed that 828 octillion (828,000,000,000,000,000,000,000,000,000) pengös equaled 1 prewar pengö. An economy also may experience stagflation, a period of stagnant economic growth coupled with inflation. Stagflation was a concern in the 1970s, a time of rising prices coupled with high unemployment. Even today, some people worry that the high price of oil could cause prices to go up and economic growth to slow down. Other Price Indexes A price index can be constructed for any segment of the economy in exactly the same way. The agricultural sector, for example, constructs a separate price index for the products it buys (diesel fuel, fertilizer, and herbicides), and then compares it to the prices it gets for its products. The producer price index (PPI) is a monthly series that reports prices received by domestic producers. Prices in this series are recorded when a producer sells its output to the very first buyer. This sample consists of about 100,000 commodities, using 1982 as the base year. Although it is compiled for all commodities, it is broken down into various subcategories, including farm products, fuels, chemicals, rubber, pulp and paper, and processed foods. The implicit GDP price deflator, used to measure changes in GDP, is another series. This series is used less frequently because the figures for real GDP, or GDP already adjusted for price increases, are provided when GDP is announced. Finally, these are just a few of the many price indexes that the government maintains. Even so, the CPI is by far the most popular and the one we watch most often. Reading Check Analyzing How is a market basket used to measure the price level? 364 UNIT 4 Macroeconomics: Performance and Stabilization akg-images Causes of Inflation MAIN Idea Causes of inflation include strong demand, rising costs, and wage-price spirals, along with a growing supply of money. Economics and You Have you ever wanted something so much you did not care about the price? Read on to learn how such behavior can fuel inflation. Economists have offered several explanations for the causes of inflation. Nearly every period of inflation is due to one or more of the following causes: demand-pull inflation, cost-push inflation, wage-price spiral, or excessive monetary growth. products for manufacturers and thus cause inflation. This situation might occur, for example, when a strong national union wins a large wage contract, forcing manufacturers to raise prices to recover the increase in labor costs. Another cause of cost-push inflation could be a sudden rise in the international price of oil, which can raise the price of everything from plastics and gasoline to shipping costs and airline fares. Such an increase in prices occurred during the 1970s, when prices for crude oil went from $5 to $35 a barrel. It happened again in 2006, when the price of oil surged to over $75 a barrel. demand-pull inflation explanation that prices rise because all sectors of the economy try to buy more goods and services than the economy can produce cost-push inflation explanation that rising input costs, especially energy and organized labor, drive up the prices of products Demand-Pull According to the explanation called demand-pull inflation, all sectors in the economy try to buy more goods and services than the economy can produce. As consumers, businesses, and governments converge on stores, they cause shortages, which drives up prices. Thus prices are “pulled” up by excessive demand. This could happen, for example, if consumers decided to use their credit cards and go into debt to buy things they otherwise could not afford. Wage-Price Spiral A more neutral explanation does not blame any particular group or event for rising prices. According to this view, a selfperpetuating spiral of wages and prices becomes difficult to stop. The spiral might begin when higher prices force workers to ask for higher wages. If they get the higher wages, producers try to recover that cost with higher A similar explanation blames inflation on excessive spending by the federal government. After all, the government borrows and then spends billions of dollars, thus putting upward pressure on prices. Unlike the demand-pull explanation, however, which cites the excess demand on all sectors of the economy, this explanation holds only the federal government’s deficit spending responsible for inflation. Cost-Push The cost-push inflation explanation claims that rising input costs, especially energy and organized labor, drive up the cost of KAZ -Larry Katzman Inflation Several causes of inflation exist, but an increase in allowance would probably not have a large impact. Which explanation does the father in the cartoon use © “... but if daddy raised your allowance he’d be hurting the economy by stimulating inflation. You wouldn’t want him to do that would you?” CHAPTER 13 Economic Instability 365 Figure 13.5 The Purchasing Power of the Dollar V ALUE OF THE D OLLAR When the price level goes up, the purchasing power of the dollar goes down. When the price level rises more slowly, as it did after 1980, the value of the dollar does not decline as fast. Economic Analysis What happens to the purchasing power of the dollar during a period of inflation1.00 .90 .80 .70 .60 .50 .40 .30 .20 .10 1950 1955 1960 1965 70 19 75 19 1980 Year 1985 1990 1995 2000 2005 2010 Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 13— Student Web Activities for an activity on working with economic statistics. Source: Bureau of Labor Statistics, 2006 prices. As each side tries to improve its relative position with a larger increase than before, the rate of inflation keeps rising. Consequences of Inflation Excessive Monetary Growth The most popular explanation for inflation is excessive monetary growth. This occurs when the money supply grows faster than real GDP. According to this view, any extra money or additional credit created by the Federal Reserve System will increase someone’s purchasing power. When people spend this additional money, they cause a demand-pull effect that drives up prices. Advocates of this explanation point out that inflation cannot be maintained without a growing money supply. For example, if the price of gas goes up sharply, but the amount of money people have remains the same, then consumers will simply have to buy less of something else. While the price of gas may rise, the prices of other things will fall, leaving the overall price level unchanged. Reading Check Explaining Which explanation do you think gives the most reasonable cause of inflation? Why? MAIN Idea Inflation can reduce purchasing power, distort spending, and affect the distribution of income. Economics and You What would you do if the price of your favorite food became too high? Read on to learn how inflation changes people’s buying habits. While low levels of inflation may not be a problem, inflation can have a disruptive effect on an economy if it gets too high. Reduced Purchasing Power The most obvious effect of inflation is that the dollar buys less as prices rise, and thus it loses value over time. Figure 13.5 shows the declining value of the dollar since 1947 as inflation has eroded its purchasing power. This may not be a problem for everyone, but decreasing purchasing power can be especially hard on retired people or those with fixed incomes because their money buys a little less each month. |
Those not on fixed incomes are better able to cope. They can increase their fees or wages to keep up with inflation. 366 UNIT 4 Macroeconomics: Performance and Stabilization Distorted Spending Patterns Inflation has a tendency to make people change their spending habits. For example, when prices went up in the early 1980s, interest rates—the cost of borrowed money—also went up. This caused spending on durable goods, especially housing and automobiles, to fall dramatically. To illustrate, suppose that a couple wanted to borrow $100,000 over 20 years to buy a house. At a 7 percent interest rate, their monthly mortgage payments would be $660.12. At 14 percent, their payments would be $1,197.41. In 1981 some mortgage rates reached 18 percent, which meant a monthly payment of $1,517.32 for the same size loan! As a result of the high interest rates in that period, the homebuilding industry almost collapsed. Encouraged Speculation Inflation tempts some people to speculate heavily in an attempt to take advantage of rising prices. People who ordinarily put their money in reasonably safe investments begin buying luxury condominiums, SECTION 2 Review diamonds, and other exotic items that might be expected to increase in price. Some people actually make money on speculative ventures like this, but even speculators lose money on deals from time to time. For the average consumer, a large loss could have devastating consequences. creditor person or institution to whom money is owed debtor person who borrows and therefore owes money Distorted Distribution of Income Inflation can alter the distribution of income. During long inflationary periods, creditors, or people who lend money, are generally hurt more than debtors, or borrowers, because earlier loans are repaid later with dollars that buy less. Suppose, for example, that you borrow $100 to buy bread that costs $1 a loaf. You could buy 100 loaves of bread today. If inflation set in, and if the price level doubled by the time you paid back the loan, the lender would be able to buy only 50 loaves of bread because each loaf now would cost $2. Reading Check Identifying Why is inflation especially hard on people with fixed incomes? Vocabulary 1. Explain the significance of inflation, deflation, price Critical Thinking 4. The BIG Idea How can inflation destabilize a nation’s index, consumer price index, market basket, base year, creeping inflation, hyperinflation, producer price index, stagflation, implicit GDP price deflator, demand-pull inflation, cost-push inflation, creditor, and debtor. Main Ideas 2. Listing What are the main causes and consequences of inflation? 3. Identifying Use a graphic organizer like the one below to identify the steps in measuring inflation. Steps Details 1. 2. economy? 5. Understanding Cause and Effect In 2005 and 2006, the price of crude oil suddenly increased. What type of inflation might this development cause? Why? 6. Categorizing Information What kind of inflation might be described as “too many dollars chasing too few goods”? Why? 7. Analyzing Visuals Look at Figure 13.4 on page 363. How does the rate of inflation change during times of recessions? What might explain these changes? Applying Economics 8. Market Basket Construct a market basket of goods and services that high school students typically consume. Would it be a useful economic indicator? Explain. CHAPTER 13 Economic Instability 367 ECONOMIST Profiles in Economics Milton Friedman (1912–2006) • received the Nobel Prize for economics for his theories on economic stabilization policy • strong proponent of monetary policy A popular column in Newsweek helped Milton Friedman become one of the best-known economists. His views appealed to people: “I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it’s possible.” It’s About the Money Supply As a founder of the Chicago school of economic thought, Milton Friedman has largely defined modern monetary policy. In an era when most economists believed in fiscal policy, or government spending on public projects, Friedman disagreed. He argued that monetary policy, or controlling the supply of money in circulation, was the key to economic health and stability. Friedman’s research fundamentally changed U.S. economic policy on inflation, unemployment, and business cycles. His findings, for example, rejected the idea that high inflation helped to limit unemployment. His influential books and articles in Newsweek promoted the steadying role of the Federal Reserve in monitoring the amount of money available to individuals, households, and businesses in order to maintain the value of the dollar. Stay Off Our Backs A fervent believer in individual freedom, Friedman advocated free markets with minimal government involvement. In his book Capitalism and Freedom, he argued for a flat tax rate and the elimination of deductions, such as those for mortgage interest. Friedman also voiced opposition to such popular policies as agricultural subsidies, price controls, and the minimum wage. Friedman also wanted parents to be free to choose their children’s schools. Together with his wife Rose Director Friedman, he established the Friedman Foundation to promote the use of school vouchers in the United States. Vouchers, he thought, would improve education by forcing schools, through free market competition, to either excel or shut down. While many of Friedman’s ideas were once considered radical, some have become widely accepted. Examining the Profile 1. Contrasting How did Friedman disagree with other economists about achieving economic stability? 2. Predicting Consequences How do you think the quality of education would be affected if free market principles were applied to schools? 368 UNIT 4 Macroeconomics: Performance and Stabilization Roger Ressmeyer/Corbis SECTION 3 Unemployment GUIDE TO READING Section Preview Academic Vocabulary In this section, you will find out how unemployment is measured as well as what causes it. Content Vocabulary • civilian labor force (p. 370) • labor force (p. 370) • unemployed (p. 370) • unemployment rate (p. 370) • frictional unemployment (p. 372) • structural unemployment (p. 372) • outsourcing (p. 372) • technological unemployment (p. 372) • cyclical unemployment (p. 373) • seasonal unemployment (p. 373) • GDP gap (p. 374) • misery index (p. 374) • discomfort index (p. 374) • confined (p. 370) • fundamental (p. 372) • unfounded (p. 374) Reading Strategy Describing As you read the section, complete a graphic organizer similar to the one below by describing the different sources of unemployment. Sources of Unemployment PEOPLE IN THE NEWS Opting Out —The Atlanta Journal-Constitution Louis Myer is one of the uncounted. . . . [He volunteers at] a Stone Mountain-based nonprofit that refurbishes donated medical equipment and gives it to those who need it. Laid off in 2001 from a job as an engineer, the Atlanta native struggled in vain to catch another employer’s interest. He volunteered for a while at Habitat for Humanity. In October, he started helping out at the Stone Mountain nonprofit. It is good work, but it is not paid work. Even so, he is not counted as unemployed. . . .[T]he unemployment rate . . . does not include people who have abandoned the job search, for whatever reason. ■ Approximately half of the people in the United States belong to the labor force, and at any given time millions are without jobs. Sometimes this is because they choose not to work, as when they have quit one job to look for another. In most cases, however, people are out of work for reasons largely out of their control. Most Americans identify strongly with their work. If you were to ask someone to describe themselves, most likely they would tell you their occupation, such as a cook, a teacher, or a sales associate. Some people, such as Louis Myer in the news article, work for no pay when they cannot find another job. Coby Burns/Zuma/Corbis CHAPTER 13 Economic Instability 369 civilian labor force or labor force non-institutionalized part of the population, aged 16 and over, either working or looking for a job (also see page 204) unemployed working for less than one hour per week for pay or profit in a nonfamily-owned business, while being available and having made an effort to find a job during the past month unemployment rate percentage of people in the civilian labor force who are classified as unemployed Measuring Unemployment People are considered unemployed if they are out of work and actively seeking a job. What other factors are considered? Measuring Unemployment MAIN Idea The government takes monthly surveys to measure the unemployment rate. Economics and You Have you ever wanted a job but couldn’t find one? Read on to learn how the government measures such unemployment. To understand the severity of joblessness, we need to know how it is measured and what is overlooked. The measure of joblessness is the unemployment rate, one of the most closely watched and politically charged statistics in the economy. Civilian Labor Force The Bureau of Labor Statistics defines the civilian labor force, more commonly called the labor force, as the sum of all persons age 16 and above who are either employed or actively seeking employment. This measure excludes members of the military. Since only people able to work are included in the labor force, those persons who are confined in jail or reside in mental health facilities are also excluded. realize. In the middle of any given month, about 1,500 specialists from the Bureau of the Census begin their monthly survey of about 60,000 households in nearly 2,000 counties, covering all 50 states. Census workers are looking for the unemployed— people available for work who made a specific effort to find a job during the past month and who, during the most recent survey week, worked less than one hour for pay or profit. People are also classified as unemployed if they worked in |
a family business without pay for less than 15 hours a week. After the census workers collect their data, they turn it over to the Bureau of Labor Statistics for analysis and publication. This data is then released to the American public on a monthly basis. Unemployment Rate Unemployment is normally expressed in terms of the unemployment rate, or the individuals number of unemployed divided by the total number of persons in the civilian labor force. For example, in May 2006 the unemploy- ment rate was calculated as follows: Unemployed Persons The process of deciding if someone is able to work, willing to work, or even at work is more complicated than most people Number of unemployed persons Civilian Labor Force = 7,015,000 150,991,000 = 0.046 = 4.6% The monthly unemployment rate is expressed as a percentage of the entire labor force. Monthly changes in the unemployment rate, often as small as one-tenth of 1 percent, may seem minor even though they have a huge impact on the economy. With a civilian labor force of approximately 151 million people, a one-tenth of 1 percent rise in unemployment would mean that nearly 150,000 people had lost their jobs. This number is more than AP Images Figure 13.6 The Unemployment Rate The unemployment rate goes up sharply during a recession and then comes down slowly afterward. When the rate moves as little as 0.1 percent, approximately 151,000 workers are affected. Economic Analysis How would you characterize the unemployment rate during the period from 1990 to 2007? T HE U NEMPLOYMENT R ATE 12% 9% 6% 3 1965 1970 1975 1980 1985 Recession years Source: Bureau of Labor Statistics, 2006 1990 1995 2000 2005 2010 Year Personal Finance Handbook See pages R20–R23 for more information on getting a job. the current population of cities such as Kansas City, Kansas; Syracuse, New York; Bridgeport, Connecticut; or Savannah, Georgia. Figure 13.6 shows how much the unemployment rate can vary over time. In general, it tends to rise just before a recession begins and then continues to rise sharply during the recession. Sometimes the unemployment rate continues to rise well after the recession ends, as it did in 2003. When the rate finally starts to go back down, it may take from five to seven years for it to reach its previous low. Underemployment It might seem that a measure as comprehensive as the unemployment rate would include all of the people who are without a job. If anything, however, the unemployment rate understates employment conditions for two reasons. First, the unemployment rate does not count those too frustrated or discouraged to look for work. During recessionary periods, these labor force “dropouts” may include nearly a million people. Although they are not working and probably would like to find work, these people are not classified as unemployed because they did not actively seek a job within the previous fourweek period. Second, people are considered employed even when they only hold part-time jobs. For example, suppose a worker lost a highpaying job requiring 40 hours a week and replaced it with a minimum-wage job requiring one hour a week. Although that worker would work and earn less, he or she would still be considered employed. In other words, being employed is not the same as being fully employed. Reading Check Summarizing How do we calculate the monthly unemployment rate? CHAPTER 13 Economic Instability 371 frictional unemployment unemployment involving workers changing jobs or waiting to go to new ones structural unemployment unemployment caused by a fundamental change in the economy that reduces the demand for some workers outsourcing hiring outside firms to perform non-core operations to lower operating costs technological unemployment unemployment caused by technological developments or automation that makes some workers’ skills obsolete Sources of Unemployment MAIN Idea Unemployment is often caused by circumstances outside an individual’s control and is therefore very difficult to remedy. Economics and You Did you ever have a job and then lose it for no fault of your own? Read on to learn about the different causes of unemployment. Economists have identified several kinds of unemployment. The nature and cause of each kind affects how much the unemployment rate can be reduced. Frictional Unemployment A common type of unemployment is frictional unemployment—the situation where workers are between jobs for one reason or another. This is usually a shortterm condition, and workers suffer little economic hardship. As long as workers have the freedom to choose or change occupations, some people will always be leaving their old jobs to look for better ones. Because there are always some workers doing this, the economy will always have some frictional unemployment. Structural Unemployment A more serious type of unemployment is structural unemployment—when economic progress, a change in consumer tastes and preferences, or a fundamental change in the operations of the economy reduces the demand for workers and their skills. In the early 1900s, for example, technological and economic progress resulted in the Measuring Unemployment Some countries measure unemployment by counting the number of persons filing unemployment claims. Others count only those receiving unemployment insurance payments. This makes for relatively low unemployment rates, because some people may not be eligible for unemployment insurance. development of the automobile, which soon replaced horses and buggies and left highly skilled buggy whip makers out of work. Later, consumer tastes changed away from American-made automobiles in favor of foreign-made cars, causing considerable unemployment in Michigan, Ohio, and the industrial Northeast. More recently, outsourcing—the hiring of outside firms to perform non-core operations to lower operating costs—has become popular. Outsourcing was first used when firms found that they could have other companies perform some routine internal operations, such as the preparation of weekly paychecks. Later, improvements in technology and communications made it possible for companies to move some of their customer service operations abroad where wages are much lower. For example, if you call your telephone company or a computer software maker for customer assistance, your call is likely to be routed to an English-speaking worker in China or India rather than a U.S. office. Sometimes the government contributes to structural unemployment. Congress’s decision to close military bases in the 1990s is a prime example. Military bases are much larger than most private companies, and the impact of the base closings was concentrated in selected regions and communities. A few areas were able to attract new industry that hired some of the unemployed workers, but most workers either developed new skills or moved to other locations to find jobs. Technological Unemployment A third kind of unemployment is technological unemployment—unemployment that occurs when workers are replaced by machines or automated systems that make their skills obsolete. Technological unemployment is closely related to structural unemployment, although the technological changes are not always as broad in scale or as influential on society as cars replacing buggies. 372 UNIT 4 Macroeconomics: Performance and Stabilization &The Global Economy YOU Finding Work Overseas Unemployment can be the first step toward expanding your horizons. Can’t find a job in your area? Then look abroad. U.S. businesses are becoming increasingly global, and companies are scrambling to expand overseas. As many as 400,000 Americans relocate inter nationally each year. Some human resource specialists encourage people to travel and work abroad. This will increase the chances of being hired for management positions in the future. Many books and Web sites offer advice to Americans who want to work in other countries. Here are some tips: • Find the nearest consulate of the country in which you wish to work. The consulate is your ticket to learning about all the entry or residency requirements you’ll need to work in another country. • A nation’s main presence in a foreign country is the embassy. Embassy workers can provide information and help you find a nearby consulate office. • Different countries require dif- ferent documentation for a visa or work permit. These often include a valid passport, a statewide criminal history record check, and a medical certificate. One example is the reduced need for bank tellers by commercial banks because of the increased use of automated teller machines. Another example would be the introduction of word processing programs whose spell-checking, formatting, and text manipulation functions have greatly reduced the demand for typists. Cyclical Unemployment A fourth kind of unemployment is cyclical unemployment—unemployment directly related to swings in the business cycle. During a recession, for example, many people put off buying durable goods such as automobiles and refrigerators. As a result, some industries must lay off workers until the economy recovers. If we look at Figure 13.6 on page 371, we can see that the unemployment rate rose dramatically whenever the economy was in recession. During the 2001 recession, more than 2 million jobs were lost. Laid-off workers may eventually get their jobs back when the economy improves, but it usually takes several years of economic growth before the unemployment rate returns to where it was before the recession. In the meantime, the pain of unemployment is a fact of life for those who are out of work. Seasonal Unemployment Finally, a fifth kind of unemployment is seasonal unemployment—unemployment resulting from seasonal changes in the weather or in the demand for certain products or jobs. Many carpenters and builders, for example, have less work in the winter because some tasks, such as replacing a roof or digging a foundation, are harder to do during cold weather |
. Department store sales clerks often lose their jobs after the December holiday season is over. The difference between seasonal and cyclical unemployment relates to the period of measurement. Cyclical unemployment takes place over the course of the business cycle, which may last three to five years. Seasonal unemployment takes place every year, regardless of the general health of the economy. Reading Check Interpreting Which categories of unemployment do you think are the most troublesome for the U.S. economy? Why? cyclical unemployment unemployment directly related to swings in the business cycle seasonal unemployment unemployment caused by annual changes in the weather or other conditions that reduce the demand for jobs Karen Huntt/Corbis CHAPTER 13 Economic Instability 373 Figure 13.7 Measuring Consumer Discomfort The misery index is an unofficial measure of consumer discomfort that is compiled by adding the monthly inflation and unemployment rates. Economic Analysis When did the misery index reach its highest point? See StudentWorks™ Plus or glencoe.com. T HE M ISERY I NDEX 25% 20% 15% 10% 5 1965 1970 1975 1980 1985 Recession years Source: Bureau of Labor Statistics, 2006 1990 1995 2000 2005 2010 Year GDP gap difference between what the economy can and does produce misery index or discomfort index unofficial statistic that is the sum of the monthly inflation and unemployment rates Costs of Instability MAIN Idea Unemployment can cause uncertainty, political instability, and social problems. Economics and You What would you do if you wanted a job but could not find one? Read on to learn about the costs of unemployment. Recession, inflation, and unemployment are all forms of instability that hinder economic growth. These problems can occur separately or at the same time. Fears about these conditions are not unfounded, because economic instability carries enormous costs that can be measured in economic as well as human terms. GDP Gap One measure of the economic cost of unemployment is the GDP gap—the difference between the actual GDP and the potential GDP that could be produced if all resources were fully employed. In other words, the gap is a type of opportunity cost—a measure of output not produced because of unemployed resources. If we were to illustrate the gap with a production possibilities curve, the amount that could be produced would be any point on the frontier. The amount actually produced would be represented by a point inside the frontier. The distance between the two would be the GDP gap. In a more dynamic sense, the business cycle may cause the size of this gap to vary over time. The scale of GDP is such that if GDP declines even a fraction of a percentage point, the amount of lost production and income could be enormous. For example, suppose that an economy with a $13.5-trillion-dollar GDP declines by just one-tenth of one percent. This translates into $13.5 billion in lost output. Misery Index Figure 13.7 shows the misery index, sometimes called the discomfort index— the sum of the monthly inflation and 374 UNIT 4 Macroeconomics: Performance and Stabilization unemployment rates. As the figure shows, the index usually reaches a peak either during or immediately following a recession. Although it is not an official government statistic, the misery index provides a reasonable measurement of consumer suffering during periods of high inflation and high unemployment. Uncertainty When the economy is unstable, a great deal of uncertainty exists. Workers may not buy something because of concern over their jobs. This uncertainty translates into many consumer purchases that are not made, causing unemployment to rise as jobs are lost. Workers are not the only ones affected by uncertainty. The owner of a business that is producing at capacity may decide against an expansion even though new orders are arriving daily. Instead, the producer may try to raise prices, which increases inflation. Even the government may decide to spend less on schools and roads if it is not sure of its revenues. Political Instability Politicians also suffer the consequences of economic instability. When times are hard, voters are dissatisfied and incumbents often voted out of office. For example, many experts agree that Bill Clinton’s victory over President George Bush in 1992 was due in part to the 1991 recession. If too much economic instability exists, as during the Great Depression of the 1930s, some voters are willing to vote for radical change. As a result, economic stability adds to the political stability of our nation. Crime, Poverty, and Family Instability Recession, inflation, and unemployment can also lead to higher rates of crime and poverty. They can contribute to problems such as fights and divorce when individuals and families face uncertainty because lost jobs and income make it difficult to pay the bills. Thus all of us have a stake in reducing economic instability. Reading Check Identifying What makes the GDP gap a type of opportunity cost? SECTION 3 Review Vocabulary 1. Explain the significance of civilian labor force, unem- Critical Thinking 5. The BIG Idea Why is structural unemployment a ployed, unemployment rate, frictional unemployment, structural unemployment, outsourcing, technological unemployment, cyclical unemployment, seasonal unemployment, GDP gap, misery index, and discomfort index. more difficult problem for the economy and for individual workers than other types of unemployment? 6. Drawing Inferences What factors make it difficult to determine the unemployment rate? Main Ideas 2. Explaining How do economists measure the economic 7. Categorizing Information List three reasons why a person may become discouraged from finding a job. cost of instability? 3. Defining What is frictional unemployment? 4. Identifying Use a graphic organizer like the one below to identify the people who are considered unemployed and those excluded from the civilian labor force. Unemployed: Excluded from the labor force: 8. Analyzing Visuals Look at Figure 13.6 on page 371 and Figure 13.7 on page 374. How do the line graphs compare? Applying Economics 9. Employment Give examples of individuals caught in each of the five types of unemployment. Find new examples. CHAPTER 13 Economic Instability 375 CASE STUDY Resale Universe Winmark Wins Customers Everyone loves a bargain, especially during times of economic instability. That’s what Winmark counted on when it incorporated its business model in 1988. Winmark Corp. is the parent company of four buy-selltrade franchises: Play It Again Sports, Plato’s Closet, Music Go Round, and Once Upon A Child. In 2006 these franchises numbered more than 800. Bargain Hunter’s Paradise If purchased new at a mall, clothing from such top brands as Abercrombie & Fitch, Juicy Couture, Seven for All Mankind, and Baby Phat come with hefty price tags. But astute customers who comb the racks and shelves of Winmark’s resale universe find the same high-end brands at nearly 70 percent off retail price. The average clothing price at Plato’s Closet, for example, is about $10. The resale concept has turned many teens into consignment gurus. They sell their old threads, buy new ones at the lower prices, and count their savings, because they beat even mall sales by a wide margin. Plato’s Closet buys and sells only “gently used” merchandise, meaning it must be in style and in great condition. The same holds true for Play It Again Sports and Music Go Round, W INMARK C ORP* 2005 Total Revenues: $26.42 million Profits: 2.51 million Employees: 102 Source: finapps.forbes.com * Figures for Winmark corporate headquarters where customers can find new and almost-new sports and music equipment, from hockey skates and treadmills to amplifiers and saxophones. Footing the Bill Winmark receives a percentage of the profits from its franchises, but the corporation makes most of its money by providing services to the entrepreneurs who run the individual resale stores. It helps owners set up shop, advertise, and gather inventory. Winmark also leases technology to small businesses. On top of that, in 2005 the company launched a new division called Wirth Business Credit, which provides financing to small businesses. With just over 100 employees, the parent company posted profits of roughly $2.5 million in 2005. Analyzing the Impact 1. Summarizing How does Winmark Corporation’s business model enable it to profit from its franchises? 2. Drawing Conclusions How do you think economic instability impacts resale shops? 376 UNIT 4 Macroeconomics: Performance and Stabilization The McGraw-Hill Companies CHAPTER 13 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Business Cycles Economic growth is typically marked by periods of recession followed by periods of expansion. A business cycle is the period from the beginning of one recession to the beginning of the next. B USINESS C YCLES N O I S S E C E R Peak EXPANSION EXPANSION Peak REAL Trough N O I S S E C E R Trough BUSINESS CYCLE Inflation The economy faces inflation when the general level of prices increases. If excessive, inflation can have a disruptive effect on the economy. Demand-pull Cost-push Wage-price spiral Excessive monetary growth Inflation Reduced purchasing power Distorted spending patterns Encouraged speculation Distorted distribution of income Unemployment The unemployment rate includes those individuals who are actively looking for a job but work less than one hour a week for pay or profit. It does not include people who are underemployed, working part-time, or have given up the job search. Frictional Structural Sources of Unemployment Seasonal Technological Cyclical CHAPTER 13 Economic Instability 377 CHAPTER 13 Assessment & Activities Review Content Vocabulary Review the Main Ideas Write the letter of the key term that best matches each definition below. g. trough inflation a. trend line b. cyclical unemployment h. |
c. unemployed d. base year e. civilian labor force f. peak i. market basket j. consumer price index k. structural unemployment l. recession Section 1 (pages 353–359) 20. Explain the difference between a depression and a recession. 21. Describe the effects of the Great Depression. 22. Discuss how econometric models describe the behavior of the economy. Section 2 (pages 361–367) 23. Explain the difference between the price level and the 1. marks the beginning of a recession rate of inflation. 2. representative selection of commonly purchased goods 24. Identify three major price indexes. 3. point of comparison for other years in statistical 25. Identify four ways inflation destabilizes the economy measures using a graphic organizer like the one below. 4. caused by a shift in demand or a change in the way the economy operates 5. caused by periodic swings in business activity 6. used to measure price changes for a market basket of consumer items Destabilizing effects of inflation 7. growth path in absence of recession or expansion Section 3 (pages 369–375) 8. measured by changes in the CPI 9. lowest point of the business cycle 10. works less than one hour per week for pay or profit 11. real GDP declines for two consecutive quarters 12. all persons aged 16 or older who are working or actively seeking a job 26. Describe the five major kinds of unemployment by using a graphic organizer like the one below. UNEMPLOYMENT Description Example Type Frictional Structural Cyclical Technological Seasonal Review Academic Vocabulary Use each of the following terms in a sentence that relates to either inflation or unemployment. 13. innovation 14. series 15. construction 16. recover 17. confined 18. fundamental 19. unfounded 27. Describe the costs and benefits of outsourcing. 28. Identify the political costs of economic instability. Critical Thinking 29. The BIG Idea Why do leading economic indicators and econometric models not provide long-term predictions of economic behavior? 378 UNIT 4 Macroeconomics: Performance and Stabilization Economics: Principles and Practices Web site at glencoe.com and click on Chapter 13—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the 30. Determining Cause and Effect How would a 10 percent inflation rate affect both lenders and borrowers? Why? 31. Drawing Conclusions Which type of unemployment do you think is the most troublesome for the U.S. economy? Why? 32. Comparing and Contrasting What are the similarities and differences between the CPI and the PPI? 36. Inflation Explain why inflation cannot take place without an expansion of the money supply. 37. Misery Index How might the psychological strains that many people feel during difficult economic times help prolong an economic downturn? Provide at least one example with your answer. 33. Synthesizing Information Describe structural and Math Practice technological unemployment and give an example of each. Why are these kinds of unemployment serious problems for an economy? Applying Economic Concepts 34. Inflation Go to the Minneapolis Fed’s site at http://www. minneapolisfed.org/ and click on “Inflation Calculator.” Follow the directions to find the adjusted prices for the items listed in the chart below. Then use the Internet or other sources to find the current price for each item. Write a paragraph on the topic: “Were the ‘good old days’ really all that good?” 38. Look at Figure 13.3 on page 362. Then find current prices for the first four items on the list. Use the equation on page 363 to determine the percentage change in prices since 1998. Analyzing Visuals 39. Look at Figure 13.6 on page 371. What was the lowest unempoyment rate immediately before the 1991 recession, and when was it recorded? How long did it take for the unemployment rate to reach this previous low? Item Year and Price Price Adjusted for Inflation Today’s Price Interpreting Cartoons Teacher’s starting salary (Richmond, VA) 2-bdrm apartment with den; gas for heating/cooking included (Richmond, VA) Gallon of gas Minimum wage Tuition/room and board at Longwood Univ. (VA) 1969 $6,500 1969 $147.50 1969 $0.25 1978 $2.65 1968 $550 per semester 35. Recession If we were to enter a period of recession, what would likely happen to the unemployment rate? The inflation rate? The poverty rate? Explain your answers. 40. Critical Thinking How does the cartoon below relate to what you have learned in this chapter Copyright 2006, Jeff Parker/Cagle Cartoons INC. CHAPTER 13 Economic Instability 379 DEBATES IN ECONOMICS Should the Trade Embargo on Cuba Be Lifted? $ T hree years after Fidel Castro took power in Cuba and installed a Communist regime, the U.S. government initiated a trade embargo against the nation. The embargo was intended to put economic pressure on the Cuban government. Today the embargo is still in effect— one of the longest trade embargos in modern history. Opponents on each side of the issue debate its effectiveness. Who is right? As you read the selections, ask yourself: Should the trade embargo on Cuba be lifted or remain in place? PRO A HALF-CENTURY OF FAILURE For almost half a century, the U.S. government has tried to isolate Cuba economically in an effort to undermine the [Communist] regime [of Fidel Castro] and deprive it of resources. Since 1960, Americans have been barred from trading with, investing in, or traveling to Cuba. . . . As a foreign policy tool, the embargo actually enhances Castro’s standing by giving him a handy excuse for the failures of his homegrown Caribbean socialism. . . . If the embargo were lifted, the Cuban people would be a bit less deprived and Castro would have no one else to blame for the shortages and stagnation that will persist without real market reforms. . . . Many of the dollars Cubans could earn from U.S. tourists would come back to the United States to buy American products, especially farm goods. In 2000, Congress approved a modest opening of the embargo. The Trade Sanctions Reform and Export Enhancement Act of 2000 allows cash-only sales to Cuba of U.S. farm products and medical supplies. The results of this opening have been quite amazing. Since 2000, total sales of farm products to Cuba have increased from virtually zero to $380 million. . . . —Daniel Griswold, Professor of Law and Economics, Columbia University P OTENTIAL A GRICULTURAL E XPORTS TO C UBA, T OP T EN S TATES s e t a t S Missouri Nebraska Minnesota Mississippi Illinois Texas Louisiana Iowa California Arkansas 0 50 100 Millions of dollars 150 200 Source: Cuba Policy Foundation 380 UNIT 4 Macroeconomics: Performance and Stabilization Stephen Ferry/Liaison/Getty Images CON SUBSIDIZE COMMUNIST CUBA? At the end of July [2002], the U.S. House of Representatives voted on two amendments, each approved by 95 vote margins, to end restrictions on travel and lift restrictions on financing exports to Cuba. . . . While the White House has threatened to veto any legislation that would “bolster the Cuban dictatorship,” the anti-Embargo lobby argues that U.S. tourism will benefit Cubans without strengthening Castro, and that trade with Havana will mean substantial American profits. These arguments are misguided at best and disingenuous at worst. Fidel Castro is broke, and at issue is not trade, but extending American export credit and export insurance to his regime, both of which are funded by American taxpayers. Since [2006], American companies are allowed to ‘trade’ with Castro’s government on a cash and carry basis. But when Castro defaults on his purchases, under the proposed policy American taxpayers will have the burden of picking up his tab. . . . France, Spain, Italy and Venezuela have suspended official credits to Castro’s Cuba—not because of the Cuban communities in those nations—but because Cuba has failed to make payments on its debt, including debt incurred on agricultural purchases. . . . Havana owes billions of dollars to western banks and former socialist countries. —Frank Calzon, executive director of Center for a Free Cuba C UBA’S I NTERNATIONAL D EBT ) 25 20 15 10 5 0 Russia Europe Japan Country Argentina Others Source: U.S. Department of State Analyzing the Issue 1. Summarizing What argument does Griswold use to support his argument that the embargo should be lifted? 2. Analyzing Review Calzon’s argument. Do you agree with him that trade with Cuba would be a misguided policy? 3. Deciding With which opinion do you agree? Explain your reasoning. CHAPTER 13 Economic Instability 381 Stephen Ferry/Liaison/Getty Images CHAPTER 14 Money, Banking, and the Fed Why It Matters Congratulations, you have just been hired by the federal government to completely redesign our money. Before getting started on your design, think about how we use money. Working with a partner, create a design for the new bills and coins. Share your finished product with the class and explain why your money will serve the same purpose(s) as our existing money. Read Chapter 14 to learn more about our monetary system and how the government works to promote economic stability and growth. The BIG Idea Governments strive for a balance between the costs and benefits of their economic policies to promote economic stability and growth. Our modern banking system allows you to access your money anywhere in the world. 382 UNIT 4 Corbis Economics: Principles and Practices Web site at glencoe.com and click on Chapter 14—Chapter Overviews to preview chapter information. Chapter Overview Visit the SECTION 1 The Evolution, Functions, and Characteristics of Money GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that money functions as a medium of exchange, a measure of value, and a store of value. Content Vocabulary • Federal Reserve System (Fed) (p. 383) • Federal Reserve notes (p. 383) • barter economy (p. 384) • specie (p. 385) • monetary unit (p. 386) • medium of exchange (p. 387) • measure of value (p. 387) • store of value (p. 387) • demand deposit |
accounts • commodity money (DDAs) (p. 388) (p. 384) • fiat money (p. 384) • M1 (p. 388) • M2 (p. 388) • revolution (p. 385) • converted (p. 387) Reading Strategy Describing As you read the section, complete a graphic organizer similar to the one below that describes the characteristics of money. Characteristics of money PRODUCTS IN THE NEWS Early Money —www.ptma.org Before there was money as we know it, there was barter. People in early societies developed forms of proto-money—the use of commodities that everyone agreed to accept in trade. Aztecs used cacao beans. Norwegians once used butter. The early U.S. colonists used tobacco leaves and animal hides (settlers traded deer hides—the origin of our modern word for money: “bucks”). Some items, such as arrowheads, salt, and animal hides, were useful in and of themselves. Gradually, however, people began exchanging items that had no intrinsic value, but which had only agreed-upon or symbolic value. An example is the cowrie shell. Cowrie shells are found on an island off the coast of India. They have been widely used as currency in China, India, Thailand, and in West Africa. ■ It may seem odd that people once used tobacco or shells as a form of money. Frequently, people used things that were easily available and valued by others as a form of money. As a result money came in a variety of forms, shapes, and sizes. The use of money developed because it makes life easier for people and serves everyone’s best interests. In fact, over time money has become a social convention, much like the general acceptance of laws and government. Today most of our money is issued by the Federal Reserve System (Fed), the privately owned, publicly controlled central bank of the United States. It issues paper currency known as Federal Reserve notes, a key part of our money supply. Federal Reserve System (Fed) privately owned, publicly controlled central bank of the United States Federal Reserve note paper currency issued by the Fed in use today Michael Freeman/IPNstock CHAPTER 14 Money, Banking, and the Fed 383 barter economy moneyless economy that relies on trade or barter commodity money money that has an alternative use as an economic good fiat money money by government decree Barter Economy As the cartoon shows, trading in a barter economy can be difficult for those wanting to exchange goods for products they may use. How does money function as a medium of exchange . The Evolution of Money MAIN Idea People invented money to make life easier. Economics and You Have you ever tried to trade for something with your friends? Read on to learn how societies began using money to make exchange easier. Take a moment to think what life would be like in a barter economy, a moneyless economy that relies on trade. Without money, the exchange of goods and services would be more difficult because the products some people have to offer are not always acceptable or easy to divide for payment. For example, how could a farmer with a pail of milk obtain a pair of shoes if the cobbler wanted a basket of fish? Unless there is a “mutual coincidence of wants”— where two people want exactly what the other has and are willing to trade what they have for it—it is difficult for trade to take place. Life is simpler in an economy with money. The farmer sells the milk for cash and then exchanges the cash for shoes. The cobbler takes the cash and looks for some- one selling fish. Money, as it turns out, makes life easier for everybody in ways we may have never considered. Money in Primitive Societies Tea leaves compressed into “bricks” comprised money in ancient China, and compressed cheese was used in early Russian trade. In early colonial America, corn and even animal pelts were used as a form of money. Today, this money would be classified as commodity money—money that has an alternative use as an economic good, or commodity. For example, the compressed tea leaves could be used to make tea when not needed for trade. Other items became fiat money—money by government decree—such as tiny metallic coins used in Asia Minor in the seventh century b.c. These coins served as money because the government said they were money. Money in Colonial America The money used by early settlers in the American colonies was similar to that found in early societies. Some of it consisted of commodity money, and some was fiat money. Many products—including corn, hemp, gunpowder, and musket balls—served as commodity money. They could be used to settle debts and make purchases. At the same time, colonists could consume these products if necessary. A commonly accepted commodity money was tobacco, for which the governor of colonial Virginia set a value of three English shillings per pound in 1618. Two years later, colonists used some of this money to bring wives to the colonies. Other colonies established fiat monies. For example, in 384 UNIT 4 Macroeconomics: Performance and Stabilization www.CartoonStock.com Specie Immigrants brought coins made of gold and silver, such as the Austrian taler on the left and the Spanish peso on the right. These coins were used throughout the colonies. Why were such coins desirable? 1637 Massachusetts established a monetary value for wampum—a form of currency the Wampanoag Native Americans made out of white and purple mussel shells. The Wampanoag and the settlers used these shells in trade. White shells were more plentiful than purple ones, so one English penny was made equal to six white or three purple shells. Early Paper Currency As time passed, Americans used other forms of money. In some cases, state laws allowed individuals to print their own paper currency. Usually backed by gold and silver deposits in banks, it served as currency for the immediate area. States even printed money in the form of taxanticipation notes and used them to pay salaries, buy supplies, and meet other expenditures until they received taxes and redeemed the notes. The Continental Congress issued paper money to finance the Revolutionary War. In 1775 it printed Continental dollars, a form of fiat paper currency with no gold or silver backing. By the end of the war, nearly one-quarter billion Continental dollars had been printed—a volume so large that it was virtually worthless by the end of the revolution. (l) imagebroker/Alamy, (r) akg-images/Gilles Mermet specie money in the form of gold or silver coins Specie in the Colonies Colonists also used modest amounts of specie—or money in the form of silver or gold coins. These included English shillings, Austrian talers, and various European coins that immigrants had brought to the colonies. Coins were the most desirable form of money, not only because of their mineral content, but because they were in limited supply. By 1776 only $12 million in specie circulated in the colonies, compared to nearly $500 million in paper currency. The most popular coin in the colonies was the Spanish peso that came to America through trade and piracy. Long before the American Revolution had begun, the Spanish were mining silver in Mexico. They melted the silver into bullion—ingots or bars of precious metals—or minted it into coins for shipment to Spain. When the Spanish treasure ships stopped in the West Indies to buy fresh provisions, however, they often became victims of Caribbean pirates who spent their stolen treasure in America’s southern colonies. The “triangular trade” between the colonies, Africa, and the Caribbean brought more pesos to America. Traders took molasses and pesos from the Caribbean to the colonies. There they sold the molasses to be made into rum and spent their pesos on other goods. The rum was shipped to CHAPTER 14 Money, Banking, and the Fed 385 monetary unit standard unit of currency in a country’s money supply Dollars Today’s money is available in both bills and coins. Why was the dollar divided into tenths? Africa, where it was traded for enslaved Africans. The enslaved Africans were taken to the Caribbean to be sold for pesos and more molasses. The trade cycle started anew when molasses and pesos were taken to the colonies. From “Talers” to “Dollars” Pesos were known as “pieces of eight,” because they were divided into eight subparts known as “bits.” Because the pesos resembled the Austrian talers, they were nicknamed “talers,” which sounds similar to the word dollars. This term became so popular that the dollar became the basic monetary unit, or standard unit of currency, in the U.S. money system. Rather than divide the dollar into eighths as the Spanish had done with the peso, it was decided to divide it into tenths, which was easier to understand. Still, some of the terminology associated with the Spanish peso remains, as when people sometimes call a 25-cent coin—one quarter of a dollar—“two bits.” Reading Check Describing What kind of money was used in colonial America? Characteristics and Functions of Money MAIN Idea Anything can be used as money as long as it is portable, durable, divisible, and limited in supply. Economics and You When you go shopping, you carry your money with you. Read on to learn how this feature of money is helpful to us. The study of early money is useful because it helps us understand the characteristics that give money its value. In fact, any substance can serve as money if it possesses four main characteristics. Characteristics of Money First, money must be portable, or easily transferred from one person to another, to make the exchange of money for products easier. Most money in early societies was very portable—including shells, wampum, tobacco, and compressed blocks of tea. Second, money must also be reasonably durable so it does not deteriorate when it is handled. Most colonial money was quite durable, especially monies like musket balls and wampum. Even the fiat paper money of the colonial period was durable in the sense that it could be easily replaced by new bills when old ones became worn. Third, money should be easily divisible in |
to smaller units so that people can use only as much as they need for a transaction. Most early money was highly divisible. The blocks of tea or cheese were cut with a knife. Bundles of tobacco leaves could easily be broken apart. Even Spanish pesos were cut with a knife into eights to make “bits” for payment. Finally, if something is to serve as money, it must be available, but only in limited supply. Stones used as money on the Yap Islands, for example, were carried in open canoes from other islands 400 miles away. Because navigation was uncertain and the weather was unpredictable, only one canoe in 20 completed the round-trip, resulting in a limited supply of stone money. 386 UNIT 4 Macroeconomics: Performance and Stabilization The McGraw-Hill Companies &The Global Economy YOU The Euro Go to any U.S. coin shop, and you can buy German marks, French francs, Italian lira, and Greek drachmas— often a whole bag of coins—for just a few bucks. Why so cheap? Because those coins have been replaced by the euro, they are now virtually worthless. In January 2002, most European Union (EU) nations replaced their own money with the euro. A historic milestone in the process of European integration, the euro has created a new monetary reality for 300 million Europeans. A generation ago, few would have believed this possible. People take their money personally. It usually includes national symbols, heroic figures, or government leaders. So how did the EU countries agree on a single type of currency? The fact is, they didn’t. The euro bills depict stylized buildings from different architectural periods. The coins, however, are unique for each country. While one side of the coins is the same, the other side reflects the country from which it originated. medium of exchange money or other substance generally accepted as payment for goods and services measure of value a function of money that allows it to serve as a common way to express value store of value a function of money that allows people to preserve value for future use Money, like almost everything else, loses its value whenever there is too much of it. This was a major problem for most types of commodity money. In Virginia, the price of tobacco went from 36 pennies a pound to 1 penny a pound after every-one started growing their own money. Wampum even lost its value when settlers used industrial dyes to turn white shells into purple— thereby doubling their value. Functions of Money Any substance that is portable, durable, divisible, and limited in supply can serve as money. If it does, it will serve three roles in the economy. Money is a medium of exchange— something accepted by all parties as payment for goods and services. Throughout history, societies have used many materials as a medium of exchange, including gold, silver, and even salt. In ancient Rome, salt was so valuable that each soldier received an annual salt payment called a “salarium.” The modern term for an annual income— salary—is based on this Latin term. The second function of money is to serve as a measure of value—a common measuring stick that can be used to express worth in terms that most individuals understand. This is what we observe whenever we see a price tag on something—a value that we can use to make comparisons with other products. In the United States, our measure of value is expressed in dollars and cents. Third, money serves as a store of value— the quality that allows purchasing power to be saved until needed. For example, goods or services can be converted into money, which is easily stored until needed. This feature of money allows a period of time to pass between earning and spending an income. Modern Money Today we have several different types of money. Some of it is in the form of Federal Reserve notes and some in the form of The McGraw-Hill Companies CHAPTER 14 Money, Banking, and the Fed 387 demand deposit account (DDA) account from which funds can be removed by writing a check and without having to gain prior approval from the depository institution M1 component of the money supply relating to money’s role as a medium of exchange M2 component of the money supply relating to money’s role as a store of value Skills Handbook See page R46 to learn about Drawing Conclusions. metallic coins issued by the U.S. Bureau of the Mint. Other forms of money include demand deposit accounts (DDAs), or funds deposited in a bank that can be accessed by writing a check and without having to secure prior approval of the institution. Because of this, the Fed uses different definitions for the money supply. The first is M1, which includes coins and currency, traveler’s checks, DDAs, and checking accounts held at other depository institutions. This definition of the money supply relates to money’s function as a medium of exchange. A broader definition is M2, which includes M1 along with savings deposits, time deposits, and money market funds—all of which relate to money’s function as a store of value. While our modern money may seem to be quite different from earlier forms of money, it shares the fundamental characteristics and functions of money. Modern money is portable. Our currency is lightweight, convenient, and can be easily transferred from one person to another. The same applies to the use of checks. Modern money is reasonably durable. Metallic coins last about 20 years under normal use. Paper currency is also reasonably durable, with a $1 bill lasting about 18 months in circulation. The introduction of the Sacagawea dollar coin was part of an attempt to make the money supply even more durable by replacing the $1 bill, a low-denomination currency, with longerlasting coins. Modern money is divisible. The penny, which is the smallest denomination of coin, is small enough for almost any purchase. In addition, people can write checks for the exact amount of a purchase. If anything, modern money has an uneven track record when it comes to limited availability and stability in value. The money supply often grew at a rate of 10 to 12 percent a year in the 1970s, which contributed greatly to the inflation of the early 1980s. It has slowed considerably since then, which has led to a period of price stability. Reading Check Explaining How does modern money reflect the functions and characteristics of money? SECTION 1 Review Vocabulary 1. Explain the significance of Federal Reserve System (Fed), Critical Thinking 4. The BIG Idea How does money advance the exchange Federal Reserve note, barter economy, commodity money, fiat money, specie, monetary unit, medium of exchange, measure of value, store of value, demand deposit account (DDA), M1, and M2. Main Ideas 2. Explaining Why was the “dollar” adopted as the basic monetary unit of the United States? 3. Identifying Use a graphic organizer like the one below to identify the functions of money. Functions of Money of goods and services? 5. Inferring Why would some people be more willing to accept commodity money rather than fiat money? 6. Drawing Conclusions Why did the use of money replace the barter system? 7. Analyzing Visuals Study the cartoon on page 384. How does this cartoon spotlight the basic problem of a barter economy? Applying Economics 8. Functions of Money Create a list of the ways you have used money during the last week. Write the actions on a piece of paper. Next to each, identify which of the functions of money your actions illustrated. 388 UNIT 4 Macroeconomics: Performance and Stabilization CASE STUDY Keep the Change Thinking Outside the Bank When you think of banks, you probably see an unimaginative, conservative industry. Most banks offer very similar services and interest rates on loans, savings accounts, and certificates of deposit. So how can a bank differentiate itself to attract new customers? “Keep the Change” Bank of America came up with a plan and in 2005 launched a new program called “Keep the Change.” The bank tallies each purchase its customers make with their debit cards and rounds it up to the next higher dollar. The bank then transfers the difference, or “change,” into the Bank of America savings accounts of customers. To sweeten the pot, the bank matches the first three months of savings at 100 percent and each month H OW IT W ORKS Go into a store, buy a cup of coffee for $1.50 Pay for it with your Keep the Change debit card, B of A rounds it off to $2 B of A transfers $.50 from your checking to your savings account, matching 5% of the annual total up to $250 thereafter at 5 percent, up to a yearly total of $250. The bank’s contributions are made annually, but customers can still watch their money grow with interest on a daily basis. I T A DDS U P! Daily Purchases Purchase Price Amount Transferred to Savings CD: Latte: Burger: Total: $9.63 $3.80 $2.29 $15.72 $.37 $.20 $.71 $1.28 Don’t Even Think About Saving How did Bank of America come up with such a new idea in an industry not known for innovation? In early 2004, the bank hired researchers to study people’s banking and spending habits. They found that some people rounded up their payments to make balancing their checkbooks easier and quicker. They also saw purchasing behaviors that reinforced the stereotype that Americans are big spenders but not big savers. The “Keep the Change” program takes the responsibility for saving out of customers’ hands while it rewards spending. Even so, it’s still money in the bank. Instead of tossing change into a jar each night, 2.5 million new Bank of America customers allow the bank to slip their change into an interestbearing savings account. Analyzing the Impact 1. Summarizing Why did Bank of America introduce its “Keep the Change” program? 2. Drawing Conclusions How much money would a person save per month and per year if making a weekly purchase of the items in the table? CHAPTER 14 Money, Banking, and the Fed 389 SECTION 2 The Development of Modern Banking GUIDE TO READING Section Preview Academic Vocabulary In this section, you will |
learn that many different types of money have been used throughout American history, and fiat money is used today. • clauses (p. 391) • initially (p. 395) Content Vocabulary • state bank (p. 391) • legal tender (p. 392) • national bank (p. 392) • national currency (p. 392) • gold certificate (p. 393) • silver certificate (p. 393) • central bank (p. 394) • bank run (p. 395) • bank holiday (p. 395) • fractional reserve system (p. 396) • legal reserves (p. 396) • reserve requirement (p. 396) • member bank reserve (MBR) (p. 396) • excess reserves (p. 396) Reading Strategy Listing As you read the section, complete a time line similar to the one below by listing major events in U.S. monetary history in the appropriate spaces. 1860 1880 1900 1920 1940 1862 1900 1886 1861 Gold certificates issues 1934 —Bureau of Engraving and Printing PRODUCTS IN THE NEWS New $10 Bills On March 2, 2006, the Federal Reserve banks issued a redesigned Series 2004 $10 note to the public through commercial banks. The notes will begin circulating immediately in the United States, and will then be introduced in other countries. . . . New money designs are being issued as part of an ongoing effort to stay ahead of counterfeiting, and to protect the economy and the hard-earned money of U.S. currency users. The new series began with the introduction of the $20 note on October 9, 2003, and continued with the $50 note issued on September 28, 2004. ■ Creating and maintaining a dependable money supply is more difficult than most people think. Over the years, the United States has experimented with different kinds of money with varying success. Early attempts included coins made of gold and silver, as well as paper currency backed by gold and silver. Today some of our money circulates as paper currency, but most of it exists in the form of electronic bookkeeping entries. Neither is backed by gold or silver. Instead, we have a managed money supply that is accepted by everyone simply because people have faith in it. Managing this money supply takes an enormous amount of work. As you read in the news story, we even have to make it difficult for others to copy money so that it stays in limited supply—lest it go the way of the Continental dollar. 390 UNIT 4 Macroeconomics: Performance and Stabilization The McGraw-Hill Companies The Development of Banking in America MAIN Idea The United States experimented with many different kinds of money before it created the Federal Reserve System. Economics and You Have you ever wondered why the dollar bill is green? Read on to learn why the government decided to print our money this way. Banking in the United States has gone through many changes. At one time, banking was virtually unregulated. This led to abuses, and problems with the money supply eventually required the intervention of government. Privately Issued Bank Notes During the Revolutionary War, nearly 250 million Continental dollars were printed. By the end of the Revolution, Continental currency had become worthless, and people did not trust the government to issue anything except coins. Accordingly, Article 1, Section 8, of the United States Constitution states: The Congress shall have the power To coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures; To provide for the punishment of counterfeiting the securities and current coin of the United States; . . . To make all laws which shall be necessary and proper for carrying into execution the foregoing powers, and all other powers vested by this Constitution in the government of the United States, or in any department or officer thereof. Article 1, Section 10, further states: No State shall . . . coin money; emit bills of credit; make anything but gold and silver coin a tender in payment of debts. . . . Because of these clauses, the federal government did not print paper currency until the Civil War. Instead, the printing, The Library of Congress distribution, and regulation of the paper money supply were left to the discretion of privately owned banks. state bank bank that receives its charter from the state in which it operates Growth of State Banking Banking became popular after the Revolution because the new Constitution allowed private banks to issue paper currency. By 1811 the country had about 100 state banks. A state bank is a bank that receives its operating charter from a state government. Banks issued their own currency by printing their notes at local printing shops. The banks then put these notes in circulation with the assurance that people could exchange them for gold or silver if they ever lost faith in the bank or its currency. At first, most banks printed only the amount of currency they could reasonably back with their gold and silver reserves. Others, however, were not as honest and printed large amounts of currency in remote areas to make it difficult for people to redeem their currency. Problems With Currency Even when banks were honest, problems with their currency arose. First, each bank issued its own currency in different sizes, Money Paper currency such as this Continental dollar helped finance the Revolutionary War. Why did the federal government stop printing paper currency? CHAPTER 14 Money, Banking, and the Fed 391 Private Bank Notes After the Revolutionary War, private banks issued their own currencies. What were the major problems with such currencies? legal tender fiat currency that must be accepted for payment by decree of the government national bank commercial bank chartered by the National Banking System national currency currency backed by government bonds and issued by commercial banks in the National Banking System colors, and denominations. As a result, hundreds of different kinds of notes could be in circulation in any given city. Second, banks were tempted to issue too many notes because they could print more money whenever they wanted. Third, counterfeiting became a major problem. With so many different types of notes in circulation, many counterfeiters did not even bother to copy other notes. Instead, they just made up new ones. By the time of the Civil War, more than 1,600 banks were issuing more than 10,000 different kinds of paper currency. Each bank was supposed to have backing for its notes in the form of gold or silver, but this was seldom the case. As a result, when people tried to buy something, merchants would often check their notes against the latest listing of good and bad currencies before deciding which ones they would accept in payment. The paper currency component of the nation’s money supply was badly in need of an overhaul. Politically powerful local bankers, however, resisted change until an event came along that would change commercial banking in the United States forever—the Civil War. Greenbacks When the Civil War erupted, both the Union and the Confederacy needed to raise enormous sums to finance the war. Congress tried to borrow money by selling bonds, but this did not raise as much money as the federal government needed. As a result, Congress decided to print paper currency for the first time since the Constitution was adopted. In 1861 Congress authorized the printing of $60 million in the new currency. Although this currency had no gold or silver backing, it was declared legal tender— fiat currency that must be accepted in payment for debts. These new notes were soon dubbed “greenbacks” because the reverse sides of the notes were printed with green ink. The green backs distinguished the new notes from the state notes already in circulation, because these were usually blank on the back. The National Banking System As the war dragged on, people feared that the greenbacks—like the Continental dollars used almost a century earlier to finance the Revolutionary War—might become worthless. When the greenbacks did lose some of their value, people avoided using them, forcing Congress to find another way to pay for the war. In 1863 Congress enacted the National Currency Act, which created a National Banking System (NBS) made up of national banks. A national bank is a privately owned bank that receives its operating charter from the federal government. These banks issued their own notes called national currency that were backed with 392 UNIT 4 Macroeconomics: Performance and Stabilization Courtesy of the Federal Reserve Bank of San Francisco bonds that the banks bought from the federal government. The government hoped that rigorous bank inspections and other high standards would give people confidence in the new banking system and its currency. The new system also would help the government because banks that joined the NBS would buy the bonds that helped supply the government with funds needed to finance the Civil War. Initially, only a few state-chartered banks joined the system because it was easier for them to print their money at local printers. Finally, in 1865 the federal government forced state banks to become part of the National Banking System by placing a 10 percent tax on all privately issued bank notes. Because state-chartered banks could not afford the tax, they withdrew their notes, leaving only the greenbacks and currency issued by the NBS in circulation. As a result of the need to finance the Civil War, the makeup of the paper component of the money supply shifted from being entirely privately issued to being entirely publicly issued. Other Federal Currencies The 10 percent tax greatly simplified the money supply by causing the removal of more than 10,000 different sizes and denominations of state bank notes. Before long, however, new types of federal currency appeared. In the same year the NBS was created, the government issued gold certificates— paper currency backed by gold placed on deposit with the United States Treasury. At first, these certificates were printed in large denominations for use exclusively by banks, but by 1882 they were also issued in smaller denominatio |
ns for use by the general public. In 1878 the government introduced silver certificates—paper currency backed by silver dollars and bullion placed on reserve with the Treasury. The government was already minting silver dollar coins, but their bulky size made them inconvenient. RubberBall/SuperStock When silver dollars were used as backing, the certificates became more popular and increased the demand for silver. This appeased both the silver miners and the public who wanted an alternative to the bulky silver dollars. Reading Check Explaining Why did the govern- ment issue greenbacks in 1861? gold certificate paper currency backed by gold and issued between 1863 and 1934 silver certificate paper currency backed by, and redeemable for, silver from 1878 to 1968 CAREERS Bank Teller The Work * Handle a wide range of banking transactions, including cashing checks, accepting deposits and loan payments, and processing withdrawals * Sell savings bonds and traveler’s checks, and handle foreign currencies or commercial accounts * Explain to customers the various types of accounts and financial services the bank offers Qualifications * Solid computer, numerical, clerical, and communication skills * Consistent attention to detail * Must enjoy public contact, feel comfortable handling large amounts of money, and should be discreet and trustworthy * High school diploma Earnings * Median annual earnings: $21,120 Job Growth Outlook * Slower than average Source: Occupational Outlook Handbook, 2006–2007 Edition CHAPTER 14 Money, Banking, and the Fed 393 The Creation of the Fed MAIN Idea The Federal Reserve System is the nation’s central bank. Economics and You Have you ever wondered where the money you might borrow to buy a car comes from? Read on to learn how banks generate these funds. By the turn of the twentieth century, the banking system was showing signs of strain. First, the National Banking System, designed primarily to help the federal government finance the Civil War, was having difficulty providing enough currency for the growing nation. Second, checking accounts were becoming more popular, and the banking system was not designed to deal with this new method of payment. Third, even minor recessions were causing major problems for banks and other lending institutions. The Federal Reserve System Reform came in 1913 when Congress created the Federal Reserve System, or Fed, as the nation’s central bank. A central bank is a bank that can lend to other banks in times of need. To ensure membership in the Fed, all national banks were required, and all statechartered banks were eligible, to become “members”—or part owners—of the Fed. Because the Fed was organized as a corporation, any bank that joined had to purchase shares of stock in the system, just as a private individual purchases shares in a regular corporation. As a result, privately owned banks, not the government, own the Federal Reserve System. The Fed issued its own currency, called Federal Reserve notes, which eventually replaced all other types of federal currency. Because the Fed had the resources to lend to other banks during periods of difficulty, the Fed became the nation’s first true central bank. Banking in the Great Depression Despite the creation of the Fed, many banks were only marginally sound during the 1920s. Part of the reason was an overexpansion of banking between the Civil War and 1921, when the total number of banks exceeded 31,000. Although some consolidation occurred between 1921 and 1929, the banking industry was overextended when the Great Depression began in 1929. central bank bank that can lend money to other banks in times of need The Great Depression When depositors became concerned about the safety of their money, they often started bank runs, such as this on on the Federal American Bank. Why did bank runs occur? 394 UNIT 4 Macroeconomics: Performance and Stabilization Hulton-Deutsch Collection/Corbis Figure 14.1 State and National Banks The number of banks in the United States grew rapidly after 1880 and peaked in 1921. A period of mergers and consolidations took place from 1921 to 1929, after which the Great Depression took its toll. The number of banks remained relatively constant from 1933 to 1985, when another wave of mergers took place. Economic Analysis What can you infer about the ratio of state banks to national banks? See StudentWorks™ Plus or glencoe.com. As Figure 14.1 shows, a staggering number of bank failures occurred during the 1930s. At the start of the Depression, about 25,500 banks existed—none of which had deposit insurance for their customers. As a result, concern about the safety of bank deposits often caused a bank run—a rush by depositors to withdraw their funds from a bank before it failed. This made the situation worse, causing more banks to fail. On March 5, 1933, President Roosevelt announced a bank holiday—a brief period during which every bank in the country was required to close. Several days later, after Congress passed legislation to strengthen the banking industry, most banks were allowed to reopen. Still, the Great Depression took its toll, and by 1934 more than 10,000 banks had closed or merged with stronger banks. Federal Deposit Insurance When banks failed during the Great Depression, depositors lost all their savings. The Banking Act of 1933, also known as the Glass-Steagall Act, was passed to strengthen the banking industry. The act also created the Federal Deposit Insurance Corporation (FDIC), which initially insured customer deposits to a maximum of $2,500 in the event of a bank failure. The insurance did little for those who lost their savings before 1934, but it has provided a sense of security in banking bank run sudden rush by depositors to withdraw all deposited funds, generally in anticipation of bank failure or closure bank holiday brief period during which all banks or depos i tory institutions are closed to prevent bank runs CHAPTER 14 Money, Banking, and the Fed 395 Figure 14.2 Fractional Reserves and the Money Supply With a 20 percent reserve requirement, a $1,000 cash deposit will result in a fivefold expansion of the money supply. Economic Analysis If the initial reserves were $2,000, how large could the money supply get? fractional reserve system system requiring financial institutions to set aside a fraction of their deposits in the form of reserves legal reserves currency and deposits used to meet the reserve requirement reserve requirement formula used to compute the amount of a depository institution’s required reserves member bank reserve (MBR) reserves kept by member banks at the Fed to satisfy reserve requirements excess reserves financial institution’s cash, currency, and reserves not needed for reserve requirements ever since. After the FDIC was created, people worried less about the safety of their deposits, reducing the number of runs on banks. If a bank is in danger of collapse today, the FDIC can seize the bank and either sell it to a stronger one or liquidate it and pay off the depositors. If it is sold, the sale is done in secrecy to prevent panic withdrawals or to keep shareholders from selling their worthless stock to unsuspecting investors. Either way, depositors today have little to fear because they are now covered up to the current $100,000 FDIC insurance limit per customer per bank. If an account holds more than this amount, the depositor may go to court and sue the bank’s owners to recover the rest. Fractional Reserves and Deposit Expansion The growing popularity of checking accounts in the last century led to the refinement of another important banking practice, the use of fractional bank reserves. Under a fractional reserve system, banks are required to keep only a portion of their total deposits in the form of legal reserves. Legal reserves consist of coins and currency that banks hold in their vaults, plus deposits at the Fed. The size of the reserves are determined by a reserve requirement, the percentage of every deposit that must be set aside as legal reserves. The result is a money supply that is several times larger than the total reserves of the banking system. To see how this works, let us assume that on Monday, a depositor named Kim opens a demand deposit account (DDA) by depositing $1,000 in a bank that is subject to a 20 percent reserve requirement. We will also assume that no one else has any money, so the size of the entire money supply is also $1,000. Figure 14.2 illustrates the monetary expansion process that takes place under these conditions. Because of the 20 percent reserve requirement, $200 of Kim’s deposit must be set aside as a reserve in the form of vault cash or in a member bank reserve (MBR)— a deposit a member bank keeps at the Fed to satisfy reserve requirements. The remaining $800 of excess reserves—legal reserves beyond the reserve requirement—represents the bank’s lending power and can be loaned out. At the end of Monday the total money supply in the hands of the public amounts to Kim’s $1,000 checking account. On Tuesday, the bank lends its $800 excess reserves to Bill. Bill decides to take the loan in the form of a DDA so that the 396 UNIT 4 Macroeconomics: Performance and Stabilization Personal Finance Handbook See pages R14– R15 to learn more about loans. cash never leaves the bank. Even so, the bank treats the new DDA as a new deposit, so 20 percent, or $160, must be set aside as a reserve. This leaves $640 of excess reserves to be lent to someone else. By the end of Tuesday, the total money supply in the hands of the public amounts to $1,800—the sum of Kim’s and Bill’s DDAs. On Wednesday, Maria enters the bank and borrows the $640 excess reserves. If she takes the loan in the form of a DDA, the bank treats it as a new $640 deposit, 20 percent of which must be set aside as a required reserve, leaving $512 of excess reserves. By the end of the day, the money supply in the hands of the public (DDAs and cash) has grown to $2 |
,440—the sum of the DDAs owned by Kim, Bill, and Maria. The $2,440 result would be exactly the same if Maria had borrowed the bank’s $640 excess reserves in cash. Had she done so, the money supply in the hands of the public would have consisted of the $1,800 in Kim’s and Bill’s checking accounts, plus Maria’s $640. However, the money expansion process will now come to a temporary halt until the $640 cash returns to the bank as a deposit. If Maria spends the money, and if the person who receives it opens a new deposit account so that additional excess reserves are created, the expansion process can resume. This expansion will continue as long as the bank has excess reserves to lend and as long as lenders deposit part or all of that money. In fact, as long as every dollar of DDAs is backed by 20 cents of legal reserves, the total amount of DDAs would be: Total MBRs Reserve Requirement = $1,000 .20 = $5,000 Some people will use cash, of course, so the DDA component of the money supply may never reach $5,000. Even so, it is clear that fractional reserve banking allows the DDA component of the money supply to grow several times larger than the total amount of member bank reserves. Reading Check Describing What is the purpose of the FDIC? SECTION 2 Review Vocabulary 1. Explain the significance of state bank, legal tender, Critical Thinking 4. The BIG Idea Why did the United States move to national bank, national currency, gold certificate, silver certificate, central bank, bank run, bank holiday, fractional reserve system, legal reserves, reserve requirement, member bank reserve (MBR), and excess reserves. Main Ideas 2. Describing How did experiences during and after the Revolutionary War affect banking in the United States? 3. Listing Use a graphic organizer like the one below to list the reasons for creating the Federal Reserve System. a single national currency in the 1860s? 5. Synthesizing How does the system of fractional reserves “create” money? 6. Making Comparisons How do the operations of a central bank like the Fed compare to the operations of a normal bank? 7. Analyzing Visuals Examine the photo on page 394. What weaknesses in the banking system led to the actions pictured in this photo? Reasons for Creating the Federal Reserve System Applying Economics 8. National and State Banks Interview the branch managers of different banks in your locality. Ask whether the bank is a national bank or a state bank and how that designation affects the bank’s operation and relationship with the Fed. CHAPTER 14 Money, Banking, and the Fed 397 Profiles in Economics ECONOMIST When his high school did not offer calculus, Ben Bernanke taught it to himself—not an unusual feat for the student with the highest SAT score in his state that year. Bernanke went on to major in economics at Harvard and MIT because he thought it combined math and people. Ben S. Bernanke (1953– ) • distinguished academic career as an economics professor • sworn in as chairman of the Federal Reserve Board in 2006 Maestro of the Economy Before becoming the second most powerful man in America (after the president), Ben S. Bernanke was professor of Economics and Public Affairs at Princeton University. As chair of the Fed, Bernanke now is responsible for U.S. monetary policy. His tenure follows that of Alan Greenspan, Fed chair from 1987 to 2006, who is credited with presiding over the period of greatest economic growth in U.S. history. These are large shoes to fill. Bernanke’s academic career, with a focus on monetary policy, prepared him well for the task. Clear Talk, Clear Target Unlike Greenspan, who was known to be vague when reporting his monetary decisions to Congress, Bernanke promotes transparency and straightforward communication. He believes that “as public servants whose policy actions affect the lives of every citizen, central bankers have a basic responsibility” to clearly state reasons for any Fed action. “Fedspeak,” as U.S. media and financial markets called earlier central bank talk, was out. Even so, Bernanke learned to be careful about what he says in public. When he mentioned offhand at a dinner party that rising inflation concerned him, the stock market dropped 250 points in two days. Such is the power of the Fed chair’s words. Besides his transparency, Bernanke differs from Greenspan in how he looks at inflation. Rather than relying on hunches, Bernanke wants to base Fed policy on analysis of economic data and predetermined inflation targets. The Fed can then adjust monetary policy to meet those targets. It is a strategy he advocated several years before his appointment, when he wrote that “the Fed needs an approach that consolidates the gains of the Greenspan years and ensures that those successful policies will continue.” Examining the Profile 1. Contrasting How does Bernanke differ from his predecessor Greenspan? 2. Making Inferences What effect would a more transparent monetary policy have on financial markets? 398 UNIT 4 Macroeconomics: Performance and Stabilization AP Images/Stephen Chernin SECTION 3 The Federal Reserve System and Monetary Policy GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn how the Federal Reserve System is organized and conducts monetary policy. • aspects (p. 401) • functions (p. 401) Content Vocabulary • member bank (p. 400) • monetary policy (p. 402) • interest rate (p. 402) • easy money policy (p. 402) • tight money policy (p. 402) • open market operations (p. 403) • discount rate (p. 404) • prime rate (p. 404) • quantity theory of money (p. 405) • currency (p. 406) • coins (p. 406) • bank holding companies (p. 407) • Regulation Z (p. 407) PEOPLE IN THE NEWS Fed Raises Rates Reading Strategy Describing As you read this section, complete a graphic organizer similar to the one below by describing the features of the Federal Reserve System. The Federal Reserve System —Associated Press The Federal Reserve, in the last major piece of business for retiring chairman Alan Greenspan, pushed borrowing costs to the highest point in nearly five years Tuesday and hinted that another rate increase was possible. Shortly after the Fed’s rate announcement, the Senate [approved] Ben Bernanke’s nomination to be the 14th chairman of the central bank. Bernanke, 52, will be sworn in as Fed chief Wednesday morning in a private ceremony at the Fed’s marble headquarters. At Greenspan’s final meeting, the Fed boosted the federal funds rate . . . to 4.50 percent. . . . In response, commercial banks raised their prime lending rates . . . by a corresponding amount to 7.50 percent. ■ The U.S. economy reached a milestone in early 2006 when Alan Greenspan ended his tenure of over 18 years as Chairman of the Federal Reserve System’s Board of Governors. This position is important because the Fed Chair has immense influence over the economy. The new chairman is Ben Bernanke. As the head of the Fed, he has an unusual degree of independence. Along with other Fed officials and without the approval of elected officials, he can change interest rates to try to speed up the economy when it is growing too slowly, or try to slow it down when it is growing too fast. Like his predecessor, the new chairman will be especially concerned about economic instability, recessions, and inflation. Getty Images CHAPTER 14 Money, Banking, and the Fed 399 member bank bank belonging to the Federal Reserve System Skills Handbook See page R51 to learn about Using Tables and Charts. Structure of the Fed MAIN Idea The Fed is organized as a corporation, owned by its member banks, and directed by a government-appointed board. Economics and You Does your local school board have advisory committees to help with board decisions? Read on to find out about similar advisory committees for the Fed. The main components of the Fed, shown in Figure 14.3, have remained practically unchanged since the Great Depression. Private Ownership One of the unique features of the Fed is that it is privately owned by its member banks. A member bank is a commercial bank that is a member of, and holds shares of stock in, the Fed. National banks—those chartered by the national government— must belong to the Fed. State banks—those receiving their charters from state governments—have the choice to belong or not. The original decision to make the Fed a stock corporation was a matter of necessity because the government did not have enough money to set up a new banking system. Instead, banks were required to purchase shares when they joined. This made the banks part-owners of the Fed, just as someone might own shares in IBM or Ford Motor Company. Private individuals are not allowed to buy shares in the Fed, although they become indirect owners by buying shares of stock in a Fed-member bank. Board of Governors The Fed is directed by a seven-member Board of Governors. Each member is appointed by the president of the United Figure 14.3 Structure of the Federal Reserve System The Board of Governors supervises the Federal Reserve System. The FOMC has primary responsibility for monetary policy. Three advisory councils provide direct advice to the Board on a regular basis. The district banks are located throughout the nation near the institutions they serve. Member banks contribute a small amount of funds and receive stock ownership shares in return. Economic Analysis What functions does the Board of Governors perform? See StudentWorks™ Plus or glencoe.com. States and approved by the Senate to serve a 14-year term of office. The appointments are staggered, so that one appointment becomes vacant every two years. In addition, care is taken to appoint people who will govern the Fed in the public interest. Because of this, it is often said that the Fed is “privately owned, but publicly controlled.” The Board is primarily a regulatory and supervisory agency. It sets general policies for its member banks to follow and regulates certain aspects of state-chartered member banks’ |
operations. It helps make policies that affect the level of interest rates and the general availability of credit. Finally, it reports annually to Congress and puts out a monthly bulletin that covers national and international monetary matters. District Banks The Fed was originally intended to operate as a system of 12 independent and equally powerful banks. Each reserve bank was responsible for a district, and some Federal Reserve notes today still have the district bank’s name in the seal to the left of the portrait. More recently, advances in technology have minimized the need for a regional structure, so the new Fed seal on our currency does not incorporate any mention of the district banks. Today the 12 Federal Reserve district banks and their branches are strategically located to be near the institutions they serve. The district banks provide many of the same functions for banks and depository institutions that banks provide for us. For example, the district banks accept deposits from, and make loans to, privately owned banks and thrift institutions. Federal Open Market Committee The Federal Open Market Committee (FOMC) makes decisions about the level of interest rates. It has 12 voting members: seven members from the Board of Governors, the president of the New York The Fed When the Federal Reserve was first established in 1913, the individual states fought over the right to have one of the 12 district banks placed in their state. One state, however, was more equal than all the others and got two banks. One bank is located in St. Louis and the other bank is located in Kansas City—but both are located in the state of Missouri. It turns out that a powerful senator by the name of James A. Reed would not let the bill creating the Fed pass the Senate unless his state got two district banks. district Fed, and four district Federal Reserve bank presidents who serve oneyear rotating terms. The FOMC meets eight times a year to review the economy and to evaluate factors such as trends in construction, wages, prices, employment, production, and consumer spending. Its decisions have a direct impact on the cost and availability of credit. While decisions are made in private, they are announced almost immediately. The FOMC is the Fed’s primary monetary policy-making body. Advisory Committees Three advisory committees advise the Board of Governors. The Federal Advisory Council consists of one representative from each of the 12 district banks. It provides advice to the Federal Reserve on matters concerning the overall health of the economy. The Consumer Advisory Council’s 30 members meet with the Board three times a year to advise on consumer credit laws. Members include educators, consumer legal specialists, and representatives from consumer and financial industry groups. The third advisory group is the Thrift Institutions Advisory Council, with representatives from savings and loan associations, savings banks, and credit unions. It meets with the Board three times a year to advise on matters pertaining to the Savings and Loan industry. Reading Check Explaining What is the purpose of the Federal Open Market Committee? CHAPTER 14 Money, Banking, and the Fed 401 monetary policy actions by the Federal Reserve System to expand or contract the money supply in order to affect the cost and availability of credit interest rate the price of credit to a borrower easy money policy monetary policy that results in lower interest rates and greater access to credit tight money policy monetary policy that results in higher interest rates and restricted access to credit Conducting Monetary Policy MAIN Idea Monetary policy involves expanding and contracting the money supply to change the level of interest rates. Economics and You Have you noticed that prices for some items go up faster than those for others? Read on to learn that inflation is one of the Fed’s main concerns. One of the most important functions of the Fed is to conduct monetary policy— changes in the money supply in order to affect the availability and cost of credit. This in turn influences economic activity. How Monetary Policy Works Monetary policy is based on the mechanism of supply and demand. Figure 14.4 shows that the demand curve for money has the usual shape, which illustrates that more money will be demanded when the interest rate, or the price of credit to a borrower, is low. However, the supply curve does not have its usual shape. Instead, its vertical slope indicates that the supply of money is fixed at any given time. When the Fed conducts its monetary policy, it changes interest rates by changing the size of the money supply. Under an easy money policy, the Fed expands the money supply, causing interest rates to fall. Such a policy stimulates the economy because people borrow more at lower interest rates. This is illustrated in Panel A, where a larger money supply lowers the rate from 10 to 8 percent. Under a tight money policy, the Fed restricts the size of the money supply. This is shown in Panel B, where a contraction of the money supply drives the cost of borrowing up from 10 to 12 percent. This tends to slow economic growth because higher interest rates normally encourage everyone to borrow and spend less. The Fed can use three major tools to conduct monetary policy. Each tool works in a different way to change the amount of excess reserves—the amount of money a bank can lend to others. Figure 14.4 Short-Run Impact of Monetary Policy B M ONETARY C ONTRACTION S1 S 12% 10 Quantity of money In the short run, monetary policy impacts interest rates, or the price of credit. When the money supply expands, the price of credit goes down. When the money supply contracts, the price of credit goes up. Economic Analysis Why is the supply curve of money shown as a vertical line? Figure 14.5 The Reserve Requirement as a Tool of Monetary Policy The Fed can control the size of the money supply by changing the reserve requirement. A low requirement, such as 10 percent, can be used to expand the money supply. A higher requirement, such as 40 percent, has the opposite effect. Economic Analysis What would be the size of the money supply if the Fed set the reserve requirement at 25 percent? See StudentWorks™ Plus or glencoe.com. A M ONETARY E XPANSION (10% Reserve Requirement) B MONETARY CONTRACTION (40% Reserve Requirement) Additions to money supply Existing money supply Initial deposit $1,000 $900 $1,000 $810 $900 $1,000 Monday Tuesday Wednesday Nth Day $10,000 2,710 1,900 1,000 0 Additions to money supply Existing money supply Initial deposit $1,000 $600 $360 $600 $1,000 $1,000 Monday Tuesday Wednesday Nth Day $2,500 1,960 1,600 1,000 0 open market operations sales or purchases of U.S. government securities by the Fed Reserve Requirement The first tool of monetary policy is the reserve requirement. Within limits that Congress sets, the Fed can change this requirement for all checking, time, and savings accounts. For instance, in Figure 14.2 on page 396 we assumed that a 20 percent reserve requirement applied to the DDAs held by Bill, Maria, and other depositors. In the figure, an initial deposit of $1,000 could expand to as much as $5,000 in total bank deposits. However, the Fed could also lower the reserve requirement to 10 percent or increase it to 40 percent. Figure 14.5 shows the results of such changes with the same initial deposit of $1,000. In Panel A, the 10 percent reserve requirement means that $900 of excess reserves could be lent out on the second day, $810 on the third day, and so on. Excess reserves are available until the DDAs reach a maximum of: Total MBRs Reserve Requirement = $1,000 .10 = $10,000 In Panel B, the reserve requirement increases to 40 percent. The result is that $600 of excess reserves are available for the first loan, $360 of excess reserves are available for the second loan, and so on until $2,500 of DDAs are generated. Historically, the Fed has been reluctant to use the reserve requirement as a policy tool, in part because other monetary policy tools work better. Even so, the reserve requirement can be powerful should the Fed decide to use it. Open Market Operations The second tool of monetary policy is open market operations—the buying and selling of government securities in financial markets. This method is the Fed’s most popular tool and allows the Fed to influence short-term interest rates. Suppose the Fed wants to expand the money supply. All it has to do is buy a bond from an investor and pay for it with a check drawn on itself or an equivalent amount of cash. When the money is put in a bank, the CHAPTER 14 Money, Banking, and the Fed 403 discount rate interest rate that the Federal Reserve System charges on loans to the nation’s financial institutions prime rate lowest rate of interest rate that banks charge their best customers bank will have additional excess reserves and the loan expansion process can begin. The result is that whenever the Fed buys government securities, excess reserves are created and the money supply expands. Suppose the Fed were to sell some of its government securities. When a buyer takes money out of the banking system to pay for the securities, member bank reserves go down, forcing the money supply to contract. A smaller money supply, as we saw in Panel B of Figure 14.4, raises the interest rate. In the end, whenever the Fed sells government securities, excess reserves contract and the money supply contracts. In practice, every day the Fed buys and sells billions of dollars of government securities through dealers. The Fed pays for the securities by writing checks drawn on itself. The dealers deposit the checks in their banks—thereby creating excess reserves. If the Fed sells securities, it accepts checks from the dealers, which reduces both dealers’ bank deposits and member banks’ reserves. The Federal Open Market Committee (FOMC) is the part of the Fed that conducts open-market operations. Normally th |
e Discount Rate The Fed monitors consumer behavior so it knows when to adjust the money supply with tools such as the discount rate and open market operations. Why do changes in the discount rate affect the prime rate and most other interest rates The leading economic indicator the Fed watches to know when to raise interest rates is you. FOMC decides whether interest rates are too high, too low, or just right. After the committee votes to set targets, officials at the trading desk take over. The trading desk at the Fed’s New York district bank is the physical location where the daily buying and selling actually occurs. It is permanently located in New York to be close to the nation’s major financial markets. Discount Rate As a central bank, the Fed makes loans to other depository institutions. The discount rate—the interest the Fed charges on loans to financial institutions—is the third major tool of monetary policy. Only financial institutions can borrow from the Fed; private individuals and companies are not allowed to do so. The discount rate is the price of credit for an institution that borrows from the Fed. If the discount rate goes up, fewer banks will want to borrow from the Fed, and banks will have fewer excess reserves available to loan out. If the Fed wants to expand the money supply, it might lower the rate to encourage additional borrowing, thus increasing excess reserves. A bank may want to borrow from the Fed if it has an unexpected drop in its required reserves. A bank could also have high seasonal demands for loans. For example, a bank in an agricultural area might face a heavy loan demand during the planting season. In either case, a shortterm loan from the Fed could restore its reserves. Effects on Other Interest Rates While the Fed directly sets only one interest rate—the discount rate—its monetary policy actions influence other interest rates. For example, changes can directly affect the prime rate—the lowest rate of interest commercial banks charge their best customers. At many large banks, the prime rate is linked to other interest rates, so the banks usually adjust 404 UNIT 4 Macroeconomics: Performance and Stabilization REAL LIFE ADVENTURES © 2004 GarLanco. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. Figure 14.6 Monetary Policy Tools The key to understanding monetary policy is to see how the excess reserves in the system are affected. Economic Analysis How does the Fed use the reserve requirement to affect the money supply? their prime rate up or down whenever the Fed changes the discount rate. slowly, though, and the unemployment rate took unusually long to recover. Changes in monetary policy spill over to almost all other interest rates as well. Any tightening of the money supply will affect the interest rate on home mortgages, savings bonds, certificates of deposits, and even Treasury bills and bonds. Monetary Policy Dilemmas The impact of monetary policy on the economy is complex. The problem is that we never know for sure how long it will take for a particular policy to take effect. As a result, it is often difficult for the Fed to please everyone. For example, some people blamed the 2001 recession on the Fed’s tight money policy of 2000. The Fed was worried about inflation and raised interest rates to slow the economy. When the economy went into recession in 2001, the Fed acted quickly to reverse itself and lower interest rates to stimulate GDP. The economy responded In the long run, the money supply also affects the general price level. If the money supply were to expand for a prolonged period of time, we would have too many dollars chasing too few goods, and demandpull inflation would result. This is the basis for the quantity theory of money, and it often has been observed in history. When the Spanish brought gold and silver back to Spain from the Americas in the 1700s, the increase in the money supply started an inflation that lasted for 100 years. During the Revolutionary War, the economy suffered severe inflation when the Continental Congress issued $250 million of currency. The country saw similar effects during the Civil War when the Union printed nearly $500 million of greenbacks. As a result, the Fed normally proceeds with a great deal of caution. Reading Check Examining Why does the Fed use open market operations? quantity theory of money hypothesis that the supply of money directly affects the price level over the long run CHAPTER 14 Money, Banking, and the Fed 405 currency paper component of the money supply, today consisting of Federal Reserve notes coins metallic forms of money such as pennies, nickels, dimes, and quarters Other Fed Responsibilities MAIN Idea As the nation’s central bank, the Fed is responsible for most aspects of banking and the payments system. Economics and You Have you ever bought anything on credit and seen the loan information disclosed to you by the merchant? Read to learn how the Fed helped provide this information. The Federal Reserve has other responsibilities as well. These include maintaining the money supply and the payments system, regulating and supervising banks, preparing consumer legislation, and serving as the federal government’s bank. Money Today’s bills are printed on large sheets of paper. They undergo exten sive inspection before being cut up for circulation. What are other Fed responsibilities? Maintaining the Money Supply Today’s currency, the paper component of the money supply, is made up of Federal Reserve notes that are printed by the U.S. Bureau of Engraving and Printing. This currency, issued in amounts of $1, $2, $5, $10, $20, $50, and $100, is distributed to the Fed’s district banks for storage until it is needed by the public. The Bureau of the Mint produces coins— metallic forms of money—such as pennies, nickels, dimes, quarters, and the new presidential dollar coin. After the coins are minted, they are shipped to the Fed district banks for storage. When member banks need additional coins or currency, they contact the Fed to fulfill their needs. When banks come across coins or currency that are mutilated or cannot be used for other reasons, they return them to the Fed for replacement. The Fed then destroys the old money so that it cannot be put back into circulation. Maintaining the Payments System The payments system involves more than the money supply. It also covers the electronic transfer of funds between businesses, state and local governments, financial institutions, and foreign central banks. In addition, specialized operations called clearinghouses process the billions of checks that are written every year. The Fed works with all of these agencies to ensure the payments system operates smoothly. Next to cash, checks are the most popular form of payment in the United States. A 2003 law, however, has changed the way checks are processed. Whereas checks used to be returned to the person who originally wrote them, now only electronic images of the checks are returned to the issuer. Online banking is another major innovation in the banking system. Now that people can open an account anywhere in the country using the Internet, the Fed is designing new procedures to make sure that no abuses occur. Regulating and Supervising Banks The Fed is responsible for establishing specific guidelines that govern banking behavior. It also has the responsibility for monitoring, inspecting, and examining various banking agencies to verify that they comply with existing banking laws. Paul Conklin/PhotoEdit As a result, the Fed is charged with watching over foreign branches of its own member banks, as well as U.S. branches of foreign-owned banks. The Fed also has jurisdiction over many activities of state banks. This includes the operations of bank holding companies—firms that own and control one or more banks. Preparing Consumer Legislation The Fed is responsible for implementing some consumer legislation, such as the federal Truth in Lending Act, which requires sellers to make complete and accurate disclosures to people who buy on credit. Under Regulation Z, the Fed has the authority to extend truth-in-lending disclosures to millions of individuals who borrow from retail stores, automobile dealers, banks, and lending institutions. If you buy furniture or a car on credit, for example, you will discover that the seller must explain several items before you make the purchase. These items include the size of the down payment, the number and size of the monthly payments, and the total amount of interest over the life of the loan. All of the disclosures that the seller makes were determined by the Fed. bank holding company company that owns and controls one or more banks Regulation Z provision extending truth-in-lending disclosures to consumers Acting as the Government’s Bank A final Fed function is the range of financial services it provides to the federal government and its agencies. For example, the Fed conducts nationwide auctions of Treasury securities. It also issues, services, and redeems these securities on behalf of the Treasury. In the process, it maintains numerous demand depos it accounts for the Treasury. The Fed also maintains accounts for the government. In fact, any check written to the U.S. Treasury is deposited in the Fed. Any federal agency check, such as a monthly Social Security payment, comes from accounts held at the Fed. In essence, the Fed serves as the government’s bank. Reading Check Summarizing How does the Fed regulate banks? SECTION 3 Review Vocabulary 1. Explain the significance of member bank, monetary policy, interest rate, easy money policy, tight money policy, open market operations, discount rate, prime rate, quantity theory of money, currency, coins, bank holding companies, and Regulation Z. Main Ideas 2. Listing What are the components of the Federal Reserve System? 3. Describing What are the additional responsibilities the Fed has beyond monetary policy? 4. Ide |
ntifying Use a graphic organizer like the one below to identify the tools of monetary policy. Tools of Monetary Policy Critical Thinking 5. The BIG Idea Why and how does the Fed conduct monetary policy? 6. Contrasting How do “tight money” and “easy money” impact the economy? 7. Drawing Conclusions What are the advantages of having the Fed oversee the U.S. banking system? 8. Analyzing Visuals Look at Figure 14.4 on page 402. What would happen if supply shifted to the right? To the left? Why? Applying Economics 9. Truth-in-Lending Laws Visit any local store that sells goods on credit, such as appliances, cars, or furniture. Ask the owner or manager about the type of information that the store is required to disclose when the sale is made. Obtain copies of the disclosure forms and share the disclosure details with your classmates. CHAPTER 14 Money, Banking, and the Fed 407 NEWSCLIP As head of the Federal Open Market Committee (FOMC), the Fed chair monitors a number of economic indicators to help him make decisions on monetary policy. One of these indicators is the rate of inflation. The chairman also likes to watch something new these days: inflation expectations. Inflation: What You Foresee Is What You Get What . . . are inflation expectations, anyway? You won’t find the term in any of the major economic data releases put out by the government. Yet whether inflation expectations are rising or falling may turn out to be a critical factor in determining how far and how fast the Federal Reserve raises interest rates. That, at least, is the new line coming out of the Fed these days. Inflation expectations—a bit of a touchy-feely concept—represent the beliefs of consumers, investors, corporate execs, and economists about how fast prices will rise in the future. To new Fed Chairman Ben S. Bernanke, inflation expectations are a key indicator. If people believe inflation will stay low, the Fed can afford to relax a bit. But if the masses start anticipating faster inflation, the odds are greater that the Fed will need to hit them with higher rates even if actual price hikes remain moderate. . . . How are beliefs about future inflation measured? One way is to ask economists what they think is U NIVERSIT Y OF M ICHIGAN I NFLATION E XPEC TATION n o i t a fl 12% 10 8 6 4 2 0 1978 1986 1996 2006 Year going to happen. According to the Philadelphia Fed’s Survey of Professional Forecasters, economists expect consumer inflation to average 2.5% over the next 10 years, only a tad above their 2.45% forecast of a year earlier. That’s not very worrisome. Another way to judge expectations is to look at the behavior of investors—in particular, the people who buy [s]ecurities . . . which are indexed to inflation to give investors a fixed real return. . . . The danger, of course, is that expectations about future prices might jump, forcing the Fed to raise rates sharply to maintain its credibility as an inflation fighter. That’s what happened in the 1970s, when the public’s lack of faith in the Fed’s inflation-fighting resolve sent prices—and expectations of future inflation—spiraling out of control after the oil shock. Contrast that with [the situation] today. The Fed has built credi bility by both aggressively fighting inflation and communicating its commitment to price stability. As a result, even as energy prices skyrocketed in recent years, inflation expectations hardly budged, and non-energy inflation stayed relatively low. —Reprinted from BusinessWeek Examining the Newsclip 1. Defining How does the author of the article define inflation expectations? 2. Analyzing Why are inflation expectations important to the Fed? Source: Survey Research Center: University of Michigan 408 UNIT 4 Macroeconomics: Performance and Stabilization CHAPTER 14 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Money People began using money because it made buying and selling easier than barter. Money Characteristics Functions Portable Durable Divisible Limited supply Medium of exchange Measure of value Store of value Development of Modern Banking Problems with the money supply before 1914 led to the creation of the Federal Reserve System. 1861 Congress authorizes the printing of greenbacks 1913 Congress creates the Federal Reserve System (the Fed) as the nation’s first true central bank 1934 More than 10,000 banks close or merge with stronger partners 1862 $150 million of federal currency with no gold or silver backing is authorized 1929 About 25,500 banks exist 1933 Glass-Steagall Act passes, creating the FDIC 1990 Wave of merger activity begins 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Monetary Policy The Federal Reserve System has three main policy tools at its disposal. It uses these tools to affect the money supply and interest rates. S UMMARY OF M ONETARY P OLICY T OOLS Tool Fed Action Effect on Excess Reserves Money Supply Reserve requirement Lower Raise Frees excess reserves because fewer are needed to back existing deposits in the system. More reserves are required to back existing deposits. Excess reserves contract. Open market operations Discount rate Buy securities Checks written by the Fed add to reserves in the banking system. Sell securities Checks written by buyers are subtracted from bank reserves. Excess reserves in the system contract. Lower Raise Additional reserves can be obtained at lower cost. Excess reserves expand. Additional reserves through borrowing are now more expensive. Excess reserves are not added. Expands Contracts Expands Contracts Expands Contracts CHAPTER 14 Money, Banking, and the Fed 409 CHAPTER 14 Assessment & Activities Review Content Vocabulary Review the Main Ideas Write the key term that best completes the following sentences. Section 1 (pages 383–388) 15. Describe the characteristics of money. a. fiat money b. central bank c. Regulation Z d. easy money policy e. excess reserves f. M1 g. barter economy h. open market operations 16. Explain why trade was difficult in a barter system. 17. Identify and provide examples of the types of money used in different periods of American history by using a graphic organizer like the one below. 1. The Fed serves as the _____ of the United States. Time period Type of money Example(s) History of American Money 2. A(n) _____ would expand the money supply and tend to lower interest rates. 3. In a _____ people rely on trade to obtain goods and services. 4. If a bank has _____ , it is able to make additional loans to customers. 5. The most popular and effective tool of monetary policy is that of _____. 6. _____ is money that must be accepted by government decree. 7. _____ is the component of the money supply that acts as a medium of exchange. 8. _____ gives the Fed the authority to extend truth-in- lending disclosures to consumers. Review Academic Vocabulary 18. Compare M1 and M2. Section 2 (pages 390–397) 19. Identify the problems that existed with pre–Civil War currency. 20. Explain why the National Banking System was created during the Civil War. 21. Explain why the U.S. government created the Federal Deposit Insurance Corporation. Section 3 (pages 399–407) 22. Describe the role of the Board of Governors of the Fed. 23. Explain why member banks borrow from the Fed. 24. Describe the three major tools of monetary policy available to the Fed. Match the terms on the left with their synonyms on the right. 25. Discuss how the reserve requirement allows the money supply to expand. 9. aspect 10. clause 11. converted 12. function 13. initially 14. revolution a. major change, transformation b. altered, revised c. stipulation, provision d. originally, in the beginning e. situation, condition f. purpose, duty Critical Thinking 26. The BIG Idea How does regulating the U.S. banking system reflect our concern about balancing monetary policies with a free enterprise economy? 27. Making Inferences How did the popularity of checking accounts lead to the expansion of a fractional reserve system? 410 UNIT 4 Macroeconomics: Performance and Stabilization 28. Determining Cause and Effect At times, someone with a good credit rating may not be able to get a loan. When this happens, the potential customer may be told to try again in the near future. What does this tell you about the bank’s reserves? How should the customer react to a situation like this? 29. Predicting Our money supply, as well as the different forms of money and ways to hold it, has changed considerably over the years. Describe one or two ways you think American money might change even more in the future. 30. Determining Cause and Effect Why do business cycles make it difficult to time monetary policy? 31. Drawing Conclusions Defend or refute the following statement: The independence of the Federal Reserve System is essential to the health of the economy. 32. Evaluating The FDIC insures deposits up to $100,000. What would you do if you had $400,000 you wanted to deposit and insure? Thinking Like an Economist 33. You have been invited to speak to your school’s PTA to explain how actions of the Federal Reserve impact the economy and individuals. Prepare a chart like the one below to illustrate your presentation. Economics: Principles and Practices Web site at glencoe.com and click on Chapter 14—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Interpreting Cartoons 34. Critical Thinking What point is the cartoonist making about the relationship between the Chairman of the Board of Governors of the Federal Reserve and the performance of the stock market Applying Economic Concepts 35. Fractional Bank Reserves Your local bank is required to keep its reserves in the form of vault cash and member deposits with the Fed. Why do you suppose that other assets, such as common stocks or real estate, are not suitable reserves? 36. Barter Assume that you live in a barter society. Compile a list of 10 items that you use frequently, and |
then identify alternative goods of comparable worth that you would be willing to trade for them. Analyzing Visuals 37. Look at Figure 14.5 on page 403. How do the differences in the panels reflect the expansion or contraction of the money supply? Michael Ramirez/Copley News Service CHAPTER 14 Money, Banking, and the Fed 411 CHAPTER 15 Economic Stabilization Policies Why It Matters Do you remember Hurricane Katrina or the invasion of Iraq and the subsequent war? How did these events—along with growing demand—affect gasoline prices? Did the higher gasoline prices change the spending habits of you and your friends? How and why? Conduct a simple survey of your friends and family to find out how higher prices impacted their lives. Present the survey to your class. Read Chapter 15 to learn what the government might do to stabilize the economy. The BIG Idea Governments strive for a balance between the costs and benefits of their economic policies to promote economic stability and growth. A busy lunch hour at Times Square in New York City indicates a stable, growing economy. Economics: Principles and Practices Web site at glencoe.com and click on Chapter 15—Chapter Overviews to preview chapter information. Chapter Overview Visit the 412 UNIT 4 Jon Arnold Images/SuperStock SECTION 1 Macroeconomic Equilibrium GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that macroeconomic equilibrium takes place at the intersection of aggregate demand and aggregate supply. • framework (p. 416) • unduly (p. 417) Reading Strategy Content Vocabulary • macroeconomics (p. 413) • equilibrium price (p. 414) • aggregate supply (p. 414) • aggregate supply curve (p. 414) • aggregate demand (p. 415) • aggregate demand curve (p. 415) • macroeconomic equilibrium (p. 416) Listing As you read the section, complete a graphic organizer similar to the one below by listing at least three factors that could lower production costs and lead to an increase in aggregate supply. Effect: Increase in aggregate supply ISSUES IN THE NEWS This Porridge Looks a Little Too Warm —BusinessWeek Goldilocks lives. The economic scenario, that is. Those who believe in her think the economy this year will be not too hot, not too cold, but just right. Currently, it’s the view most widely held by economists, investors, and Wall Street pros. So, the tale goes, after the unusually warm winter heated up the economy in the first quarter, growth will cool down to a pace of about 3%. . . . [T]wo things are happening right now that are affect- ing both manufacturing and the economy. One, businesses are rushing to expand their operations in the face of strong demand and insufficient production capacity. And two, because factory output is growing . . . manufacturing operating rates have risen sharply during the past year. The only way to know for sure . . . is to watch the economy and the data. ■ “Not too hot, not too cold, but just right.” According to the news story above, the concept of equilibrium seems to be alive and well. In literature as well as in life, we seem to like things best when they can achieve a reasonable balance. The economy is no exception. When we deal with macroeconomics, the part of economics concerned with the economy as a whole and decision making by large units, we also seek a balance. To do so, we can use a set of “tools” already familiar to us—supply and demand—to find out just where the balance is. macroeconomics part of economics that deals with the economy as a whole (also see page 197) David Grossman/The Image Works CHAPTER 15 Economic Stabilization Policies 413 equilibrium price price where quantity supplied equals quantity demanded (also see page 149) aggregate supply the total value of all goods and services that all firms would produce in a specific period of time at various price levels aggregate supply curve hypothetical curve showing different levels of real GDP that would be produced at various price levels Aggregate Supply and Demand MAIN Idea Aggregate supply and demand help us study supply and demand for the economy as a whole. Economics and You In your English classes, you might study a part of a novel in depth to understand the whole book better. Read on to learn about a similar approach in economics. When we study markets, we often use the tools of supply and demand to show how the equilibrium price and quantity of output are determined. When we study the economy as a whole, we can use these tools in much the same way. Aggregate Supply You learned in Chapter 5 that supply is the amount of a particular product offered for sale at all possible prices. When it comes to the economy as a whole, economists like to look at aggregate supply, the total value of goods and services that all firms would produce in a specific period of time at various price levels. If the period was exactly one year, and if all production took place within a country’s borders, then aggregate supply would be the same as GDP. The concept of aggregate supply assumes that the money supply is fixed and that a given price level prevails. If prices should change, however, then individual firms would respond by adjusting their output to produce a slightly different level of GDP. If it were somehow possible to keep adjusting the price level to observe how total output changed, we could then construct an aggregate supply curve, which shows the amount of real GDP that would be produced at various price levels. Figure 15.1 shows how an aggregate supply curve for the whole economy might look. Like the supply curve of an individual firm or the market supply curve, it is shown as upward sloping as you move from left to right. To distinguish the aggregate supply curve from other supply curves, it is labeled AS. In Figure 15.1, note that the vertical axis of the graph is labeled ‘Price level’ rather than just ‘Price’, as you have seen in earlier chapters. The price level includes the price of everything produced in the economy. In contrast, the word price would indicate the cost of only a single good or service. Economists often use an aggregate measure like the price level rather than a single price. Aggregate measures help them better explain changes in the economy. Figure 15.1 The Aggregate Supply Curve C HANGE IN A GGREGATE S UPPLY The aggregate supply curve shows the amount of real GDP that would be produced at various price levels. An increase in aggregate supply occurs when production costs decrease for all individual producers. When economists use 2 curves to show changes in aggregate supply, they label the first curve AS0 and the second AS1. Economic Analysis What causes a decrease in aggregate supply See StudentWorks™ Plus or glencoe.com. AS0 AS1 Increase Decrease Real GDP Figure 15.2 The Aggregate Demand Curve C HANGE IN A GGREGATE D EMAND See StudentWorks™ Plus or glencoe.com. Increase Decrease The aggregate demand curve shows the amount of real GDP the economy would demand at all possible price levels. Aggregate demand, like aggregate supply, can either increase or decrease. When economists use two curves to show changes in aggregate demand, they label the first curve AD0 and the second AD1. Economic Analysis What causes the aggregate demand curve to shift? AD0 AD1 Real GDP aggregate demand the total value of goods and services demanded at all different price levels aggregate demand curve hypothetical curve showing different levels of real GDP that would be purchased at various price levels Finally, note that the horizontal axis is labeled ‘Real GDP’. This is because we want to know the value of all goods and services produced, not just the output of a single product. While there are some other differences between the supply curve of a single product and aggregate supply, the two curves are otherwise fairly similar. Changes in Aggregate Supply Aggregate supply, like the supply of an individual firm, can increase or decrease. Many increases in aggregate supply are tied to the cost of production for an individual firm. For example, if the price of energy should suddenly go down, most if not all firms will be able to produce a little more output, and real GDP will go up. Since this increase in output would happen at all price levels, the increase shows as a shift of the original aggregate supply curve AS0 to the right, and the new aggregate supply curve AS1. Factors that increase the cost of production for individual firms tend to decrease aggregate supply. These factors include higher oil prices, higher interest rates, and lower labor productivity. Any increase in cost that causes individual firms to offer fewer goods and services for sale at each and every price would shift the aggregate supply curve to the left. Aggregate Demand In Chapter 4 you learned that demand is the desire, ability, and willingness to purchase a product. If it were possible to add up everyone’s demand for every good and service in the economy, we would have a measure of aggregate, or total, demand. Accordingly, economists call this concept aggregate demand, the total value of all goods and services demanded at different price levels. Aggregate demand is labeled AD to keep it separate from other demand curves. It is a summary measure of all demand in the economy. Like aggregate supply, it can be represented as a graph, and it can either increase or decrease. The aggregate demand curve appears in Figure 15.2 and shows the amount of total output, measured in terms of real GDP, that would be purchased at every possible price level. This curve is labeled AD and represents the sum of all consumer, business, government, and net foreign demands CHAPTER 15 Economic Stabilization Policies 415 &The Global Economy YOU Banking on the Future PERSONAL SAVINGS RATE When consumers save less and spend more, the aggregate demand curve shifts to the right. This has been the case recently in the United States, where seemingly tireless consumers shop online, in the mall, and at ever |
y stop in between. In a country where the minimum wage is $5.15 per hour—compared to Mexico’s $4.36 per day—one would think Americans could afford to sock away substantial savings. Instead, we are spending our money at an astonishing rate. Why are Americans not saving more? Given the dismal outlook for Social Security, shaky pension plans, and rising interest rates, they should be more concerned than ever about their economic future. Despite these issues, the U.S. personal savings rate dipped lower in 2005 than it has since 1933, during the Great Depression. That year it reached negative 0.4 percent. United States United Kingdom Australia Japan Germany 28% 24 20 16 12 8 4 0 –4 t n e c r e P 1996 1998 2000 2002 2004 2006 Year Source: St. Louis Federal Reserve Compared with personal savings rates from around the globe, those of Americans are well below the international average. macroeconomic equilibrium level of real GDP consistent with a given price level and marked by the intersection of aggregate supply and aggregate demand at various price levels. It slopes downward and to the right like the individual and the market demand curves. Macroeconomic Equilibrium Changes in Aggregate Demand Aggregate demand can increase or decrease depending on certain factors. For example, if consumers decide to spend more and save less, the increase in consumer spending also increases aggregate demand, shifting the original aggregate demand curve AD0 to the right to form the new aggregate demand curve AD1. A decrease in aggregate demand can occur if the same factors act in an opposite manner. If people were to save more and spend less, the aggregate demand curve would shift to the left. Higher taxes and lower transfer payments could also reduce aggregate spending. Such decisions shift the aggregate demand curve to the left because all sectors of the economy collectively buy less GDP at all price levels. Reading Check Comparing How do AS and AD compare to individual supply and demand? MAIN Idea Macroeconomic equilibrium is reached when the level of real GDP is consistent with a given price level. Economics and You You learned earlier about the equilibrium price. Read on to learn how this concept applies to the economy as a whole. Aggregate supply and demand curves are useful concepts because they provide a framework to help us analyze the impact of economic policy proposals on economic growth and price stability. They also can give us an idea of the way and direction in which things will change. They do not provide us with exact predictions, however. Even so, they are useful when we analyze macroeconomic issues. Macroeconomic equilibrium, for example, is the point at which the level of real GDP is consistent with a given price level. It is determined by the intersection of the aggregate supply and demand curves. 416 UNIT 4 Macroeconomics: Performance and Stabilization This equilibrium is shown in Figure 15.3. In this figure, quantity Q is the level of real GDP that is consistent with price level P, or where the aggregate supply curve AS and the aggregate demand curve AD intersect. This equilibrium represents a specific situation at a particular point in time and could change if either AS or AD changes. For example, if a new government policy caused the aggregate demand curve AD to shift to the right, the new equilibrium would take place at a higher level of real GDP and a higher price level. This is one of the dilemmas facing economic policy makers—how to make real GDP grow without unduly increasing the price level and thereby the rate of inflation. As you will see in the next section, we can use aggregate supply and demand to analyze the impact of fiscal and monetary policies, two of the major ways of affecting the level of output and real GDP. Reading Check Explaining How does the macro- economic equilibrium work? How is it used? Figure 15.3 The Economy in Equilibrium The economy is at equilibrium when the quantity of real GDP demanded is equal to the real GDP supplied. Economic Analysis What happens to the price level when output increases? M ACROECONOMIC E QUILIBRIUM AS AD Q Real GDP SECTION 1 Review Vocabulary 1. Explain the significance of macroeconomics, equilibrium price, aggregate supply, aggregate supply curve, aggregate demand, aggregate demand curve, and macro economic equilibrium. Main Ideas 2. Identifying Use a graphic organizer like the one below to identify the factors that might cause aggregate supply to increase and aggregate demand to decrease. Aggregate Supply Aggregate Demand 3. Explaining Why is macroeconomic equilibrium important? Critical Thinking 4. The BIG Idea How do aggregate supply and aggregate demand help economic policy makers? 5. Drawing Conclusions How is it possible for an economy to grow without a general increase in price levels? 6. Analyzing Information What kind of effect would higher taxes have on aggregate supply? Explain. 7. Analyzing Visuals Look at Figure 15.3 on this page. What would happen to the price level if AD decreased? Applying Economics 8. Aggregate Supply and Demand Search your local newspaper for articles relating to the impact of changing gasoline prices. Summarize the articles and answer the following question: “How do changing gasoline prices impact AS and AD?” Explain your answer. CHAPTER 15 Economic Stabilization Policies 417 NEWSCLIP Aggregate demand and aggregate supply are becoming global concepts. When demand for a product drops in one country, producers often look for markets in other countries to take up the slack. Asian automakers did just that when demand for Japanese cars decreased in Japan. Asia’s Automakers Think Globally The global market may be becoming increasingly competitive, but Japan’s and Korea’s top automakers are hitting new production records and expanding outside their domestic markets at a rapid pace. Faced with stagnant demand in their home countries and a need to reduce foreign exchange risks, the big automakers in both countries are rapidly expanding production overseas and shearing off market shares from the foreign incumbents. So far, the big three Japanese companies— Toyota Motor Corp., Honda Motor Co. Ltd., and Nissan Motor Co. Ltd.—are enjoying successes as their tight controls on costs and mostly competitive product lineups enable them to take market share from overseas rivals. . . . Over the past decade, Japanese automakers have been setting up and expanding production facilities overseas. . . . In comparison, Hyundai and its W ORLD A UTOMOBILE S ALES 4.3% 1% 6.5% 32.2% 56.9% Japanese automakers U.S. automakers European automakers Korean automakers Others Source: Autodata Corp. subsidiary Kia are late starters in their localization plans in the U.S. and Europe. But . . . all five autom a k e r s ’ prospects for further expansion in North America look promising. In the current high gasoline price environment, their product mixes look to be in tune with customer shifts, with more fuelefficient cars becoming popular. . . . Success in the U.S. carries some risks. . . . The impact of a sudden change in purchasing habits by American auto buyers on these companies’ earnings and cash flow could be amplified because of this heavy dependence. . . . The Japanese domestic market remains flat, however. Although the economy is recovering, weak demand is unlikely to be reversed. With a rapidly aging population, long-term growth prospects in Japan are very limited. —Reprinted from BusinessWeek Examining the Newsclip 1. Determining Cause and Effect According to the article, what is causing demand for Japanese and other Asian autos to increase in the United States? 2. Analyzing Why is demand for Japanese cars decreasing in Japan? 418 UNIT 4 Macroeconomics: Performance and Stabilization Jim West/Alamy Images SECTION 2 Stabilization Policies GUIDE TO READING Section Preview In this section, you will learn how government can promote economic growth through economic policies. Content Vocabulary • Medicare (p. 419) • fiscal policy (p. 420) • Keynesian • entitlements (p. 422) • unemployment insurance (p. 422) economics (p. 420) • supply-side policies Academic Vocabulary • unstable (p. 420) • explicit (p. 427) Reading Strategy Describing As you read the section, complete graphic organizers similar to the ones below by describing the role of government under demand-side and supply-side policies. Demand-side policies Supply-side policies —www.cato.org • multiplier (p. 420) • accelerator (p. 420) • automatic stabilizer (p. 422) (p. 423) • deregulation (p. 424) • monetarism (p. 426) • wage-price controls (p. 427) ISSUES IN THE NEWS Time for “Wise and Frugal” Federal spending has increased 45 percent in the past five years; the government has run deficits in thirty-three of the past thirty-seven years; the costs of programs for the elderly are set to balloon and impose huge burdens on coming generations of young workers. Clearly, policymakers are failing to run a “wise and frugal government,” as Thomas Jefferson advised in his first inaugural address. A key problem is that federal budget rules stack the deck in favor of continual program expansion. The costly Medicare drug bill and the explosion in pork spending illustrate how a lack of structural controls leads to an undisciplined scramble to spend, spend, spend. ■ Whenever the government spends money on Medicare, the federal program that provides health-care expenditures for the elderly, it shifts the aggregate demand curve to the right. As you read in the news story above, it costs the government more money—and it puts an upward pressure on the price level. Medicare expenditures are important to those who benefit from them, since economic security is one of the seven major economic goals. Still, policy makers must often choose among a number of competing economic policies. Finding the proper balance between them is an important part of stabilization policy. Medicare federal health-care program for senior citizen |
s, regardless of income (also see page 235) Mark Reinstein/Jupiter Images CHAPTER 15 Economic Stabilization Policies 419 fiscal policy use of government spending and revenue col lection measures to influence the economy Keynesian economics government spending and taxation policies suggested by John Maynard Keynes to stimulate the economy multiplier magnified change in overall spending caused by a change in investment spending Demand-Side Policies MAIN Idea Demand-side policies are designed to affect total demand through taxing, government spending, and automatic stabilizers. Economics and You You learned earlier that government implements policies to help people. Read on to learn how it uses policies to affect the economy. Demand-side policies are designed to increase or decrease total demand in the economy. These policies try to shift the aggregate demand curve to the right or the left. One approach to changing demand is known as fiscal policy—the federal government’s attempt to influence or stabilize the economy through taxing and government spending. Government Spending During the Great Depression, the government funded public works, such as the construction of Hoover Dam shown below, to stabilize the economy. Which economist made fiscal policy popular? Fiscal policies are derived from Keynesian economics, an economic policy approach designed to lower unemployment by stimulating aggregate demand. John Maynard Keynes put forth these theories in 1936, and they dominated the thinking of economists until the 1970s. Keynesian Economics Keynes provided the basic framework by using the output-expenditure model, GDP = C + I + G + F. According to this model, any change in GDP on the left side of the equation could be traced to changes on the right side of the equation. The question was: which of the four components caused the instability? According to Keynes, the net impact of the foreign sector (F) was so small that it could be ignored. The government sector (G) was not the problem either, because its expenditures were normally stable over time. According to Keynes, spending by the consumer sector (C), was the most stable of all. It appeared that the business, or investment, sector (I) was to blame for the instability. In Keynes’s theory, spending by the investment sector was not only unstable but had a magnified effect on other spending. If investment spending declined by $50 billion, for example, many workers would lose their jobs. These workers in turn would spend less and pay fewer taxes. Soon, the amount of spending by all sectors in the economy would be down by more in investment. initial decline than the This effect is called the multiplier. It says that a change in investment spending will have a magnified effect on total spending. The multiplier is believed to be about 2 in today’s economy. Thus, if investment spending goes down by $50 billion, the decline in overall spending could reach $100 billion. The multiplier also works in the other direction. An increase in spending by $50 billion would increase overall spending by twice that amount. US Dept. of the Interior Bureau of Reclamation/Lower Colorado Region Public Works The federal government continues to fund large-scale public works projects, such as the Hyperion water treatment facility in Los Angeles. How does public spending offest the loss of business spending? accelerator change in investment spending caused by a change in overall spending Conditions are likely to be made even worse by the accelerator—the change in investment spending caused by a change in total spending. After a decline in overall spending begins, investors tend to become cautious, causing investment spending to be reduced even further. Before long, the economy is trapped in a downward spiral. The combined multiplier-accelerator effect is important because it contributes to the instability of GDP. Role of Government Keynes argued that only the government was big enough to step in and offset changes in investment-sector spending. The government could take a direct role in the economy and undertake its own spending to offset the decline in spending by businesses. The government could also play an indirect role by lowering taxes and enacting other measures to encourage businesses and consumers to spend more. Suppose the government wanted to take direct steps quickly to offset a $50 billion decline in business spending. To do this, it could spend $10 billion to build a dam, give $20 billion in grants to cities to fix up poor neighborhoods, and spend another $20 billion in other ways. By adding up individual programs, government spending would replace the $50 billion that businesses do not spend. Thus, the overall sum of C + I + G + F would remain unchanged. Instead of spending the $50 billion, the government could affect the economy indirectly by reducing tax rates to give investors and consumers more purchasing power. If they spent the $50 billion not collected in taxes, investors and consumers would offset the initial decline in investment spending. Again, there would be no change in the sum of C + I + G + F. Either way, the government would run the risk of a short-term federal deficit. In Keynes’s view, the deficit was unfortunate but necessary to stop further declines in economic activity. When the economy recovered, tax collections would rise, the government would run a surplus, and the debt could be paid back. The justification for temporary federal deficits was one of the lasting contributions of Keynesian economics and a major departure from the economic thinking of the time. Tom Carroll/IndexStock CHAPTER 15 Economic Stabilization Policies 421 Figure 15.4 Fiscal Policy and Aggregate Demand Fiscal policies are designed to affect aggregate demand. Increases in government spending or tax reductions increase aggregate demand. As a result, the economy moves from a to b. Economic Analysis Which point on the graph represents the lowest aggregate demand? T HE A GGREGATE D EMAND C URVE AS P1 P0 b a Q1 Q0 Real GDP AD0 AD1 automatic stabilizer program that automatically provides benefits to offset a change in people’s incomes entitlement broad social program that uses established eligibility requirements to provide health, nutritional, or income supplements to individuals (also see page 283) unemployment insurance government program pro viding payments to unemployed workers Automatic Stabilizers Another key component of fiscal policy is the role of automatic stabilizers, programs that automatically trigger benefits if changes in the economy threaten income. The benefits are automatic because they were approved in prior legislation. Most entitlements—broad social programs that use established eligibility requirements to provide health, nutritional, or income supplements—function as automatic stabilizers. These progams provide some financial assistance to people who lose a job, are injured on the job and receive medical benefits, or are forced to retire because of age or health. One such entitlement program is unemployment insurance—insurance that workers who lose their jobs through no fault of their own can collect from individual states for a limited amount of time. This insurance cannot be collected by people who are fired because of mis conduct or who quit their jobs without good reason. Another important automatic stabilizer is the progressive income tax. For example, if someone loses his or her job or ends up working fewer hours because of cutbacks, that person will earn less. If the reduction in income is significant, that person is likely to fall into a lower tax bracket, which cushions the decline in income. Fiscal Policy and Aggregate Demand We can illustrate the impact of such fiscal policies with the aggregate demand curve AD. Figure 15.4 shows a single aggregate supply curve and two aggregate demand curves. When aggregate demand is weak, the economy would be at point a, where AD0 intersects AS. Increases in government spending or tax reductions could shift aggregate demand to AD1 and move the economy to point b, where both real GDP and the price level are higher. Because aggregate demand basically is the sum of C + I + G + F, it makes little difference which sector provides the stimulus. As long as government policies cause the spending of one sector to expand, AD will shift to the right. Limitations of Fiscal Policy Keynes envisioned the role of government spending as a counterbalance to changes in investment spending. Ideally, the government would increase its spending to offset declines in business spending, and conversely government would decrease spending whenever business spending recovered. In practice, however, the federal government generally has not been able to limit or reduce spending. As a result, the most effective fiscal policies to counter business cycles are the automatic stabilizers. The advantage of the stabilizers is the speed at which they can be implemented because the legislation is already approved. Reading Check Analyzing Why are Keynes’s ideas important in the study of economics? 422 UNIT 4 Macroeconomics: Performance and Stabilization supply-side policies economic policies designed to stimulate the economy by increasing production Supply-Side Policies MAIN Idea Supply-side economics focuses on policies that increase production through less government and lower taxes. Economics and You If you and your family had to pay less in taxes, would you spend or save the extra money? Read on to find out what supplysiders think. the 1980s, supply-side policies became the hallmark of President Ronald Reagan’s administration. The differences between supply-side policies and demand-side policies are smaller than most people realize. Both policies, which are summarized in Figure 15.5, have the same goal: increasing production and decreasing unemployment without increasing inflation. Supply-side policies are policies designed to stimulate output and lower unemploy |
ment by increasing production rather than by stimulating demand. The supply-side view gained support in the late 1970s because demand-side policies did not seem to be controlling the nation’s growing unemployment and inflation. In Smaller Role for Government A key goal for supply-siders is reducing government’s role in the economy. One way to do this is to reduce the number of federal agencies. Another way is to spend less at the federal level. Yet another way is to lessen the government’s role by relaxing Figure 15.5 Comparing Supply-Side and Demand-Side Policies S UPPLY-S IDE P OLICIES Stimulate production (supply) to spur output Cut taxes and government regulations to increase incentives for businesses and individuals Businesses invest and expand, creating jobs; people work, save, and spend more Increasing investment and productivity lead to increasing output D EMAND-S IDE P OLICIES Stimulate consumption of goods and services (demand) to spur output Cut taxes or increase federal spending to put money into people’s hands With more money, people buy more Businesses increase output to meet growing demand With output increasing, economy grows and unemployment goes down Supply-side policies and demand-side policies have the same goal: continuous and stable economic growth without price inflation. Economic Analysis How does the role of the government differ under supply-side and demand-side policies? See StudentWorks™ Plus or glencoe.com. Figure 15.6 Tax Rates and Tax Receipts The Laffer curve is a hypothetical relationship between federal income tax rates and tax revenues. Panel A illustrates the argument that lower individual income tax rates would generate higher tax collections, as shown in the movement from a to b. Panel B shows that federal tax revenues declined after individual income tax rates were reduced in 2001. Economic Analysis How does personal income in 2000 and 2005 compare to individual income tax receipts during the same years? A T HE L AFFER C URVE B T AX R ECEIPTS ) 1.2 $1.0 0 According to Laffer, lower tax rates produced higher revenues . . . b a . . . because high tax rates slowed economic growth Tax rates (percent of income) 100 Year 2000 2001 2002 2003 2004 2005 Personal income (in billions) Individual income tax receipts (in billions) $8,430 $1,004 8,724 8,882 9,164 9,731 10,239 994 858 794 809 927 Source: Economic Report of the President deregulation relaxation or removal of government regu lations on business activities or removing government regulations that restrict the activities of firms in certain industries—a process called deregulation. Deregulation is a major objective of supply-siders. The policy has been popular among politicians ever since President Reagan deregulated the savings and loan industry in the 1980s. Since then, the American economy has seen a flood of deregulation ranging from airlines and banking to telecommunications and interstate trucking. Lower Federal Taxes Supply-siders also target the federal tax burden on individuals and businesses. They believe that if taxes are too high, people will not want to work as much, and businesses will therefore produce less. Lower tax rates, they argue, allow individuals to keep more of the money they earn, which encourages them to work harder. This would give workers more money to spend in the long run. Government revenues would also increase, as additional business activity leads to greater production, resulting in greater tax collections. During the 1980s, somewhat optimistic supply-siders argued that lower individual income tax rates would stimulate the economy so much that the government could collect even more taxes than before. This idea of increased tax revenue was formalized in the Laffer curve—a hypothetical relationship between federal income tax rates and tax revenues. The Laffer curve shown in Panel A of Figure 15.6 illustrates the expected gain in tax revenues when taxes were reduced from point a to point b. This proposition was the basis for President Reagan’s 1981 tax cut, which reduced the tax rates for individual income taxes 25 percent over a three-year period. The Laffer curve was popular at the time because it gave people a seemingly sound reason to have lower marginal tax brackets. 424 UNIT 4 Macroeconomics: Performance and Stabilization When President George W. Bush was elected in 2000, he also made individual income tax cuts one of his highest priorities. The first round of his proposed tax cuts was passed in 2001, and several extensions followed in subsequent years. However, as Panel B in Figure 15.6 shows, individual income tax receipts generally declined from 2000 to 2004, even though personal income rose in each of those years. Unfortunately, the increased tax revenue collections predicted by the Laffer curve never materialized, although it is highly likely that the increase in personal income worked to stimulate economic growth. Impact of Supply-Side Policies The aggregate supply and demand curves can illustrate the impact of supplyside policies. As Figure 15.7 shows, when aggregate supply is low, the economy is at point a. This is the point where the original aggregate demand curve AS0 intersects with the aggregate demand curve AD. If supply-side policies were successful, more would be produced at every price level. The aggregate supply curve would then shift to AS1, and the point of macroeconomic equilibrium would move to b. As long as there was no corresponding change in aggregate demand, real output would grow, and the price level would come down. Limitations of Supply-Side Policies One limitation of supply-side policies is a lack of enough experience with them to know how they affect the economy. Even aggregate supply and aggregate demand are largely conceptual, making it difficult to predict the exact consequence of any particular supply-side policy. In the case of the Laffer curve, total personal income tax collections, when adjusted for inflation, actually declined after the implementation of President Reagan’s 1981 tax reductions. They declined again after the Bush tax cuts of 2001. The result was that one of the main foundations of the supply-side school—that tax cuts would lead to higher tax revenues—proved to be false. Even so, policies that promote productivity, reduce unnecessary paperwork, or otherwise stimulate the economy to grow to its maximum potential are certainly worthwhile. Almost everyone, including demand-siders, favors these policies. Finally, we should note that supply-side economic policies are designed to promote economic growth rather than to remedy economic instability. Many economists believe that supply-side policies during both the Reagan and the Bush presidencies weakened the automatic stabilizers by making the federal tax structure less progressive and by reducing many “safety net” programs. Both actions may have stimulated growth. However, neither was designed to add to short-term economic stability. Reading Check Interpreting What are the main goals of supply-side economists? Figure 15.7 Supply-Side Policies and Aggregate Supply T HE A GGREGATE S UPPLY C URVE AS0 AS1 P1 P0 a b Q1 Q0 Real GDP AD Supply-side policies are designed to increase aggregate supply through decreased government spending and involvement as well as lower taxes. Economic Analysis What happens to the price level when the aggregate supply curve shifts to the right? Money Supply and Interest Rates When the Fed decreases interest rates, more money becomes available to grow the economy. What is the short-run impact of lower interest rates? MCCOY © 2001 Glen McCoy. Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. Monetary Policies MAIN Idea Monetarist policies seek steady economic growth by controlling the money supply. Economics and You Neither demand-siders nor supply-siders consider the money supply. Read on to learn why monetarists disagree with both. Both demand-side policies and supplyside policies are concerned with stimulating production and employment. Neither assigns much importance to the money supply. An approach called monetarism, however, places primary importance on the role of money in the economy. Monetarists believe that fluctuations in the money supply can be a destabilizing element that leads to unemployment and inflation. Therefore, they favor policies that lead to stable, long-term monetary growth at levels low enough to control inflation. Short-Run Impacts monetarism school of thought stressing the importance of stable monetary growth to control inflation and stimulate long-term economic growth Skills Handbook See page R52 to learn about Sequencing Events. policy can raise interest rates. Higher interest rates might be desirable if the economy is growing too fast and prices are rising. The higher interest rates would slow consumer and business borrowing, leading to a decrease in aggregate demand. As a result, the aggregate demand curve would shift to the left, lowering both the price level and real GDP. If the economy is growing too slowly, an expansionary policy can increase the money supply and lower interest rates. This would reduce the cost of consumer and business borrowing and increase aggregate demand. The aggregate demand curve would then shift to the right, causing real GDP and the price level to increase. In the short run, monetary policy affects interest rates. Changes in the level of interest rates can have a significant impact on the demand for real GDP. In the longer run, however, monetary policy can have very different results. Long Run Impacts Expansionary monetary policy, with a larger money supply, can lower interest rates. At the same time, it could also increase the possibility of future inflation, as past events have shown. During the Revolutionary War, so much money was printed that prices rose dramatically, and the Continental dollar soon became worthless. Prices also increased significantly during the Civil War when too m |
any greenbacks were printed. Finally, excessive monetary growth allowed by the Fed to help the government finance the Vietnam War resulted in the inflation of the 1970s. The money supply can grow over time, but how fast should it be allowed to grow? According to the monetarists, it should grow at a slow but steady rate. Specifically, the rates of growth of real GDP and productivity would determine the rate at which the money supply grows. A monetary policy in which the money supply is tightened is called a contractionary monetary policy. In the short run, this For example, with real GDP growing by 3 percent and productivity growing by 1 percent, the money supply could be allowed 426 UNIT 4 Macroeconomics: Performance and Stabilization MCCOY © 2001 Glen McCoy.Reprinted with permission of UNIVERSAL PRESS SYNDICATE. All rights reserved. wage-price controls policies and regulations making it illegal for firms to give raises or raise prices without government permission to grow at about 4 percent without causing inflation. At this rate, there would be just enough extra money each year to buy the additional goods and services the economy produces. This approach to inflation control is in sharp contrast to approaches that other administrations tried earlier. In the early 1970s, for example, President Richard Nixon attempted to stop inflation by imposing wage-price controls—regulations that make it illegal for businesses to give workers raises or to raise prices without the explicit permission of the government. Most monetarists at the time said the controls would not work. Events soon proved them correct, as prices rose despite the legislated controls. Use of Monetary Policy Economists have discovered that timing can be difficult when it comes to implementing monetary policy. An expansionary monetary policy may affect the economy right away—or several years later. The same thing is true for a contractionary monetary policy. In either case, the desired changes may happen immediately or only after a lag. For this reason, monetarists argue that changes in the money supply should be gradual so that they do not destabilize the economy. Because of these lags, monetary policy does not seem to be very effective in reducing short-term unemployment. For example, when the Fed aggressively lowered interest rates in 2001 to move the economy out of the recession, it took several years for the unemployment rate to come down. In the end, most monetarists argue that monetary policy can be used to maintain long-term price stability. However, it must be used with caution because its short-run impacts are uncertain. Reading Check Summarizing What problems are associated with expansionist monetary policy? SECTION 2 Review Vocabulary 1. Explain the significance of Medicare, fiscal policy, Critical Thinking 5. The BIG Idea How do supply-side economists and Keynesian economics, multiplier, accelerator, automatic stabilizer, entitlements, unemployment insurance, supply-side policies, deregulation, monetarism, and wage-price controls. Main Ideas 2. Listing What are the assumptions of supply-siders? 3. Explaining What problems exist for monetary policy? 4. Identifying Use a graphic organizer like the one below to identify the tools of demand-side policies. demand-side economists differ with regard to the role of government in the economy? 6. Drawing Conclusions Do you agree with the opinion that fiscal policy is ineffective? Explain your reasons for agreeing or disagreeing. 7. Analyzing Information According to monetarists, how do fluctuations in the money supply affect the economy? 8. Analyzing Visuals Look at the photo on page 420. How does it reflect the views of John Maynard Keynes on the role of government in the economy? Tools of demand-side policies Applying Economics 9. Deregulation Identify an industry in your state that has been or is being deregulated. Why did legislators make the decision to deregulate the industry? Did deregulation have the expected benefits? Were there any unanticipated costs? Explain. CHAPTER 15 Economic Stabilization Policies 427 ECONOMIST Profiles in Economics John Maynard Keynes (1883–1946) • his “Keynesian economics” caused governments to implement fiscal policy • instrumental in the planning of the World Bank The Long Run During the Great Depression of the 1930s, government leaders desperately sought solutions to widespread unemployment and poverty. Yet they remained reluctant to “unbalance” the budget by using federal money to help the nation’s people directly. Instead, they believed that laissez-faire policies would allow the market to correct itself in the long run. Enter Keynes A brilliant intellectual, John Maynard Keynes established a reputation for straight talking and insightful critique early in his career. He served as an adviser to the British Treasury and as a British representative at the World War I peace conference at Versailles. He correctly predicted that the high reparations imposed on Germany after World War I would lead to another war. As an economist, Keynes was not impressed with perfectly balanced budgets. In fact, he considered balanced budgets—when that meant government inaction— to be disastrous if a nation’s consumer and business sectors had no money to spend or invest to create jobs. In his masterpiece, The General Theory of Employment, Interest, and Money (1936), Keynes argued that governments should spend money—and even take on debt—to help correct an economic recession or depression. They should then save money during an overly successful period to prevent inflation. To Keynes, it did not help anyone to wait for the long run because “in the long run we are all dead.” His theories were revolutionary, and they provided much needed insight into the workings of a depression-era economy. Soon, the label Keynesian economics stood for any government spending or taxing policies designed to stimulate the private sector. Examining the Profile 1. Analyzing Information Why were government leaders reluctant to help people during the Great Depression? 2. Summarizing Information What is the basic premise of Keynesian economics? John Maynard Keynes is widely regarded as the most influential economist of the twentieth century. His theories led the U.S. government to take an active role in preventing economic instability that could lead to widespread joblessness. 428 UNIT 4 Macroeconomics: Performance and Stabilization Getty Images SECTION 3 Economics and Politics GUIDE TO READING Section Preview Reading Strategy In this section, you will learn that economic policies change as time and circumstances change. Identifying As you read the section, complete a graphic organizer similar to the one below by identifying the different kinds of fiscal policy. Content Vocabulary • monetary policy (p. 431) • baby boomers (p. 432) • Council of Economic Advisers (p. 433) Academic Vocabulary • ideology (p. 431) • advocates (p. 433) Fiscal policy ISSUES IN THE NEWS Enthusiastic Capitalism American culture is today, as ever, uniquely suited for growth, innovation, and advancement. The most obvious bedrock of success is entrepreneurial spirit. The U.S. has the most risk-taking, most laissez-faire, least regulated economy in the advanced Western world. America is heartily disdained by its coddled and controlled European cousins for its cowboy capitalism. But it is precisely America’s tolerance for creative destruction—industries failing, others rising, workers changing jobs and cities and skills with an [enthusiasm] and [casualness] that Europeans find astonishing—that keeps its economy churning and advancing. . . . The mistake of the Soviets, Japanese, and so many others was to assume that creativity could be achieved with enough government planning and funding. . . . ■ —TIME As we look at the economic history of the United States, it is clear that times are better than ever. Inflation is largely under control, and the economy is larger and more productive than ever. Recessions still occur, of course, but business cycles have generally turned into fluctuations, and economic expansions are longer than ever. Major domestic or even international events can temporarily interrupt the economy, but capitalistic market economies have a remarkable ability to cope with adversity. If anything, the task before us is to manage our prosperity in a way that both improves our economic health and benefits everyone. Lon C. Diehl/PhotoEdit CHAPTER 15 Economic Stabilization Policies 429 Changing Nature of Economic Policy MAIN Idea The government can influence the economy with discretionary, passive, or structural fiscal policies. Economics and You Today, major recessions are rare in the United States. Read on to learn how this has affected government policies. Fiscal policies are government attempts to influence the economy through taxing and spending actions. This may involve ways to speed up the economy with tax cuts or with additional federal spending. It may also include government efforts to slow the economy down by either increasing taxes or reducing spending. Types of Fiscal Policy Several different kinds of spending and taxing policies exist. These fiscal policies can be either discretionary, passive, or structural. Discretionary fiscal policy is policy that someone must choose to implement. It requires an action by Congress, the president, or an agency of government to take effect. One example is a federal expenditure to build a highway or renovate a downtown area in order to offset a decline in business spending. As you read in Chapter 10, about one-third of all federal spending is discretionary rather than mandatory. Early Practitioner While John Maynard Keynes was widely credited as the first person to advocate fiscal policy to stimulate the economy in the mid-1930s, President Franklin D. Roosevelt preceded him by several years. When Roosevelt took office on March 4, 1933, the U.S. economy was suffering from its worst d |
epression. With little economic theory to guide him, Roosevelt introduced 15 new bills during his first 100 days in office, some of which poured billions of dollars into state-run welfare and public-works programs. Roosevelt’s aggressive use of discretionary fiscal policy was instrumental in helping the economy out of the Great Depression. Passive fiscal policies do not require new or special action to go into effect. Instead, the policies react automatically when the economy changes. Examples of passive fiscal policies include unemployment insurance and Social Security benefits. In fact, most of the automatic stabilizers you learned about earlier are examples of passive fiscal policies. Finally, structural fiscal policies are policies designed to strengthen the economy over a longer period of time. Examples include reforms of popular programs such as Social Security and welfare in order to make the programs financially secure and more effective in the long run. Most of the supply-side policies, which advocate a smaller role for government and lower taxes, are structural fiscal policies. Decline of Discretionary Fiscal Policy At one time, discretionary fiscal policies were the most popular economic policies. In the 1940s, massive government spending for World War II helped pull the economy out of the Great Depression. Both President Kennedy, in the early 1960s, and later President Reagan, in the early 1980s, used large tax cuts to get a sluggish economy moving again. However, for several reasons discretionary fiscal policy is used less today. The first reason relates to the various lags that inevitably occur between recognizing that there is a problem and actually doing something about it. Suppose, for example, that the problem is a potential recession, and that the ideal remedy would be to spend $50 billion on roads and highways. Policy makers first face a recognition lag because it normally takes several months to confirm that a recession is actually taking place. A legislative lag would follow because it may take a year or more for Congress to pass laws authorizing expenditures. This would be followed by an implementation lag because it often takes several more years to build the highways 430 UNIT 4 Macroeconomics: Performance and Stabilization and pump the money into the economy. In the end, the recession—which historically lasts for less than a year—will be over by the time the spending begins to stimulate the economy. The second reason for the decline of discretionary fiscal policy is the gridlock that can occur when the political parties in Congress oppose each other’s views on the budget. In both 1995 and 1996, for example, Congress shut down the federal government when Republicans and Democrats could not agree on the federal budget. Ideology is the third reason. President Bush’s tax cuts, for example, were based on the belief the American economy needed a structural change. As a result, in 2001 Bush proposed tax cuts that would extend to the year 2010 and beyond. Thus, the preference for structural policies has displaced the use of discretionary ones. Rise of Monetary Policy The declining use of discretionary fiscal policy left a void filled by the Federal Reserve System, which has the responsibility for conducting monetary policy. As you learned earlier, monetary policy involves changing the amount and availability of credit in order to influence interest rates. Such a situation occurred during the recession of 2001. That recession was so mild and so short—lasting about eight months—that policymakers altogether ignored discretionary fiscal policy. In addition, Congress was preoccupied with a response to the terrorist attacks on September 11. On the other hand, the Fed was actively lowering the discount rate on an almost monthly basis in order to stimulate the economy. The policy worked, and the Fed took much of the credit for the short duration and mild impact of the recession. Of course, even the Fed is not above criticism. For example, the Fed’s efforts to prevent inflation by raising interest rates in 2000 may have contributed to the 2001 slowdown. Even so, most members of Comstock Images/PictureQuest Inc Congress believe that the power to create money and to manage the money supply should remain with an independent agency rather than with elected officials. Reading Check Summarizing Why is discretion- ary fiscal policy used less and less frequently? monetary policy actions by the Federal Reserve System to expand or contract the money supply in order to affect the cost and availability of credit (also see page 400) CAREERS Credit Manager The Work * Manage the preparation of financial reports * Oversee a firm’s granting of credit by establishing credit-rating criteria, determining credit ceilings, and monitoring the collections of past-due accounts * Solicit business, authorize loans, and direct the investment of funds Qualifications * Ability to analyze detailed information and draw conclusions * Excellent communication skills to explain complex financial data * Expertise on government appropriations, budgeting, tax laws, and regulations * Knowledge about global trade, changes in federal and state laws, and new financial instruments * Bachelor’s degree in business, finance, accounting, or a related field, with many positions requiring a master’s degree in business administration, economics, finance, or risk management Earnings * Median annual earnings: $81,880 Job Growth Outlook * Average Source: Occupational Outlook Handbook, 2006–2007 Edition CHAPTER 15 Economic Stabilization Policies 431 Differing Opinions Economists have different ideas about economic policies, although they don’t come to blows as in the cartoon. Why do economists differ? baby boomers people born in the United States during the historically high birthrate years from 1946 to 1964 Skills Handbook See page R41 to learn about Evaluating Information. concerned largely with the economic consequences of what they do. Most of the major debates in Congress are over spending, taxes, and other budgetary matters. Why Economists Differ Economists who choose one policy over another normally do so because they think that some problems are more critical than others. For example, one economist might think that unemployment is the crucial issue, while another believes that inflation is. Yet if we surveyed all economists on the best way to deal with one specific problem, their recommendations would be much more consistent. Another reason economists differ is that most economic theories are a product of the times. The unemployment and other problems that occurred during the Great Depression influenced a generation of demand-side economists. Because the government sector was so small during the 1930s, supply-side policies designed to make government’s role even smaller probably would not have helped much then. Later, from the 1960s through 1980s, the monetarists gained influence because of the slow decline of discretionary fiscal policy. Then, by the 1980s, the ideological rejection of “big government” created a generation of supply-siders who thought that the key to economic growth was a smaller government. By 2010 and beyond, the large population of retired baby boomers, who were born between 1946 and 1964, will have its own unique problems. The problems facing this group may well prompt another generation of economists to focus on a whole new set of issues. In the end, then, the views of economists are very much affected by the problems of the current moment. Council of Economic Advisers Generally, economists and politicians work together fairly closely. To help keep track of the economy, the president has Economics and Politics Today MAIN Idea Current conditions shape the views of economists and policy makers. Economics and You Have you ever perceived an issue to be a certain way and then found out later that it was completely different? Read on to learn why economists’ views change as well. Choosing which economic policies will work best is difficult. When economists offer proposals that sometimes seem contradictory, it makes choosing even more difficult. These differences of opinions among economists, however, are smaller than most people realize. Economic Politics In the 1800s, the science of economics was known as “political economics.” After a while, economists broke away from the political theorists and tried to establish economics as a science in its own right. In recent years, the two fields have merged again. This time, however, they have done so in a way better described as “economic politics.” Today, politicians are 432 UNIT 4 Macroeconomics: Performance and Stabilization Tribune Media Services, Inc. All Rights Reserved. Reprinted with Permission. Council of Economic Advisers, a threemember group that reports on economic developments and proposes strategies. The economists are the advisers, while the politicians direct or implement the policies. In its role as “the president’s intelligence arm in the war against the business cycle,” the council gathers information and makes recommendations. The president listens to the economists’ advice but may not be willing or able to follow it. For example, if the president advocates a balanced budget, the economic advisers may recommend raising taxes to achieve this goal. If one of the president’s campaign pledges was not to raise taxes, however, the president might reject the advisers’ suggestion and let a deficit develop. Increased Public Understanding Despite disagreeing on some points, economists have had considerable success with the description, analysis, and explanation of economic activity. They have developed many statistical measures of the economy’s performance. Economists also have constructed models that are helpful with economic analysis and explanation. All of these tools are necessary if we are to understand the opportunity costs of the trade-offs we must make when we select on |
e policy over another. In the process, economists have helped the American people become more aware of the workings of the economy. This awareness has benefited everyone, from the student just starting out to the politician who must answer to the voters. Today economists know enough about the economy to prevent a depression like the one in the 1930s. It is doubtful that economists know enough—or can persuade others that they know enough—to avoid minor recessions. Even so, they can devise policies to stimulate growth, help disadvantaged groups when unemployment rises or inflation strikes, and generally make the American economy more successful. Reading Check Interpreting What is the role of the Council of Economic Advisers? Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 15— Student Web Activities for an activity on the Council of Economic Advisers. Council of Economic Advisers three-member group that devises strategies and advises the president of the United States on economic matters SECTION 3 Review Vocabulary 1. Explain the significance of monetary policy, baby boomers, and Council of Economic Advisers. Main Ideas 2. Explaining Why have structural fiscal policies replaced discretionary fiscal policies? 3. Describing What actions did the Fed take in response to the recession of 2001? 4. Describing Use a graphic organizer like the one below to describe the different types of fiscal policy. Types of Fiscal Policy Type Description Example Discretionary Passive Structural Critical Thinking 5. The BIG Idea Why do economists have differing views over which policy is most effective in producing stability and economic growth? 6. Drawing Conclusions Why do some people blame the Fed for the recession of 2001? 7. Analyzing Information Why might monetary and fiscal policy conflict during an election year? 8. Analyzing Visuals Look at the cartoon on the previous page. Why do you think economists care so strongly about their views? Applying Economics 9. Fiscal and Monetary Policy Suppose that Congress passes a massive tax cut during an election year even though inflation is very high. What actions might the Fed take in response? Explain your answer. CHAPTER 15 Economic Stabilization Policies 433 CASE STUDY Best Buy Gets Better Too Big, Too Fast In 1996 Best Buy found itself in a predicament. Despite astounding growth over a three-year period, the company had not changed the way it did business. As a result, its stock tumbled and profits dwindled. The company switched gears, opting for a smaller array of products, a new pricing strategy, and new store layouts. Customer Focus In addition, Best Buy turned to a business model called Customer Insight that determined the lifestyles of its most profitable customers. The five segments Best Buy identified include wealthy professionals desiring the best technology products, young males seeking the latest technology and accessories, fathers looking for technology to improve entertainment, mothers on the lookout for gadgets to enrich their children, and smallbusiness owners who use technology to increase their profits. Best Buy began targeting these groups, increasing revenues from $7.8 million in 1997 to more than $30 million in 2006. B EST B UY R EVENUES, 1997–2006 r a e Y 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 0 5 10 15 20 Millions of Dollars 25 $30 Source: Best Buy annual reports Geek Squad Best Buy still faced strong competition from other technology retailers such as Circuit City. Enter, the Geek Squad. This army of 2,500 “agents” provides emergency services 24 hours a day, seven days a week, 525,600 minutes a year to fix computers, printers, and networks for individual customers and businesses alike. The ability to provide full technology service and support for the products sold in stores helped Best Buy win back customers and shareholders. Analyzing the Impact 1. Summarizing What is Customer Insight, and how did it help change the way Best Buy does business? 2. Drawing Conclusions How did Best Buy differentiate itself from other technology retailers? 434 UNIT 4 Macroeconomics: Performance and Stabilization Getty Images CHAPTER 15 Visual Summary Study anywhere, anytime! Download quizzes and flash cards to your PDA from glencoe.com. Aggregate Supply and Demand In order to understand the economy as a whole, we need to study aggregate supply and demand. The economy reaches macroeconomic equilibrium when aggregate supply and demand are equal at a given price level. M ACROECONOMIC E QUILIBRIUM AS AD Q Real GDP Stabilization Policies The government can pursue three different policies to stabilize and grow the economy. Demand-Side Policies Supply-Side Policies Monetary Policies • Stimulate consumption of goods and services (demand) • Introduced by John Maynard Keynes • Government’s role is to offset changes in investment-sector spending • Includes automatic stabilizers • Stimulate production of goods and services (supply) • Smaller role for government • Lower taxes • Difficult to predict results • Focuses on money supply • Money supply to grow at a steady rate to match growth of real GDP and production • Difficult to time policy Influences on Economic Policies Several factors influence economic policies. Demand-side policies (preferred during recessions) Supply-side policies (favored to combat “big government”) Strategies devised by Council of Economic Advisers Influences on Economic Policy Rise of monetary policies with decline of discretionary spending Policies and ideology CHAPTER 15 Economic Stabilization Policies 435 CHAPTER 15 Assessment & Activities Review Content Vocabulary Use all of the terms below to write a paragraph about government policies to stabilize the economy. 22. Identify the factors influencing the increase or decrease of aggregate supply and aggregate demand by using a graphic organizer like the one below. 1. aggregate supply 2. supply-side policies 3. fiscal policy 4. aggregate demand 5. monetarism 6. automatic stabilizer 7. deregulation 8. accelerator Aggregate Supply (AS) and Aggregate Demand (AD) Factors that increase AS Factors that decrease AS Factors that increase AD Factors that decrease AD Section 2 (pages 419–427) 23. Identify which component of GDP Keynes labeled 9. macroeconomic equilibrium as the cause of instability. 10. monetary policy 11. wage-price controls 12. Keynesian economics Review Academic Vocabulary Use the words below to construct three sentences that summarize the goals of demand-side, supply-side, and monetarist economic policies. 13. unduly 14. framework 15. unstable 16. explicit 17. ideology 18. advocates 24. Discuss the effects of the multiplier and the accelerator. 25. Describe how monetarists determine the proper growth rate for the money supply. 26. Explain how supply-siders would reduce the govern- ment’s role in the economy. Section 3 (pages 429–433) 27. Discuss the difficulty of using discretionary fiscal policy. 28. Explain why new problems will arise in the economy, even as old ones are solved. 29. State an example of how politics sometimes overrides economic policies. 30. Describe how economists sometimes differ in their views about the economy. Review the Main Ideas Section 1 (pages 413–417) Critical Thinking 19. Describe the circumstances under which prices are 31. The BIG Idea Why and how could monetary policy consistent with a given level of real GDP. be destabilizing? 20. Explain the difference between the supply curve 32. Contrasting How do aggregate supply and demand of a firm and the aggregate supply curve. differ from simple supply and demand? 21. State the major dilemma that faces economic policy 33. Comparing What are the limitations of demand-side, makers. supply-side, and monetarist economic policies? 436 UNIT 4 Macroeconomics: Performance and Stabilization 34. Analyzing Information How do the events of the 1980s and the early 2000s support or disprove the central supply-side position about the relationship between taxes, economic growth, and tax revenues? Provide examples in your answer. 35. Drawing Conclusions Why are the automatic stabilizers effective fiscal policies that counter business cycles? 36. Contrasting Compare the use of discretionary fiscal policy and monetary policy to offset the effects of a short recession. Which policy would you choose? Include reasons to support your choice. Analyzing Visuals 37. Synthesizing Look at Figure 15.4 on page 422. Use what you have learned to explain what policies might make the demand curve shift. What effect does this have on aggregate supply? Applying Economic Concepts 38. Monetary Policy At one time or another, some presidents have complained about the independence that the Fed enjoys when it conducts monetary policy. Do you think this independence is beneficial and should be maintained, or would you prefer that elected officials have more control over monetary policy? Support your answer. 39. Fiscal Policy Which fiscal policy do you think the government would use in each of the scenarios described in the table below? Explain your answers. Scenario Fiscal Policy Explanation Inflation is rising and real GDP is growing strongly GDP is down and the unemployment rate has increased by 10 percent Economics: Principles and Practices Web site at glencoe.com and click on Chapter 15—Self-Check Quizzes to prepare for the chapter test. Self-Check Quiz Visit the Interpreting Cartoons 40. Look at the cartoon below. What is the topic of the cartoon? What point is the cartoonist making about the impact of tax cuts and the war in Iraq? How does the cartoonist illustrate this point Thinking Like an Economist 41. Like demand-side and supply-side policies, monetary policies are designed to promote stable economic growth. The three approaches differ on what should be done to achieve this goal. Assume that real GDP growth was negative during the last quarter. Using Figure 15.5 as an example, construct a |
similar chart listing the policies that monetarists would follow to help the economy. Writing About Economics 42. Expository Writing Some economists favor policies that stimulate demand, while others favor those that stimulate the supply of goods and services. Still other economists prefer policies based on the growth of the money supply. With which group of economists do you agree? Write a two-page paper outlining the policies and the reason for your choice. Copyright RJ Matson and CagleCartoons.com 2006. All rights reserved. CHAPTER 15 Economic Stabilization Policies 437 The Global Economy UNIT 5 CHAPTER 16 International Trade CHAPTER 17 Developing Countries CHAPTER 18 Global Economic Challenges This Japanese-owned Honda manufacturing plant in Marysville, Ohio, reflects increasingly global markets and production. 438 UNIT 5 AP Images AP Images CHAPTER 16 International Trade Why It Matters You and a classmate are planning to open a lawn-service business. You will each contribute $200 toward the purchase of a mower, gas can, trimmer, and other materials for the business. Now it is time to get organized. Work with a classmate and make a list of the different “jobs” associated with your lawn-service business. What criteria will you use to divide up these jobs? Why? Read Chapter 16 to find out how nations make decisions about what to produce and trade with other nations. The BIG Idea Trade and specialization lead to economic growth for individuals, regions, and nations. International trade allows us to purchase items produced in any country, such as the items from Africa and the Caribbean in a store in Syracuse, New York. 440 UNIT 5 Syracuse Newspapers/Michelle Gabel/The Image Works Economics: Principles and Practices Web site at glencoe.com and click on Chapter 16—Chapter Overviews to preview chapter information. Chapter Overview Visit the SECTION 1 Absolute and Comparative Advantage GUIDE TO READING Section Preview Reading Strategy In this section, you will learn that comparative advantage is the basis for international trade. Content Vocabulary Defining As you read the section, complete graphic organizers similar to the ones below by defining each term and providing an example of each. • exports (p. 442) • imports (p. 442) • absolute advantage • comparative advantage • production possibilities frontier (p. 444) (p. 443) (p. 444) • opportunity cost (p. 444) Academic Vocabulary • volume (p. 443) • enabled (p. 444) Absolute advantage Comparative advantage Definition Definition Example Example —BusinessWeek ISSUES IN THE NEWS Russia: Shoppers Gone Wild It’s midday on Saturday, and the Mega-1 mall in southern Moscow is packed. Shoppers have come to stock up on groceries at the mall’s French-owned Auchan hypermarket, buy furniture at Swedish retailer IKEA, and browse dozens of boutiques selling everything from Yves Rocher cosmetics to Calvin Klein underwear. Although crammed with expensive Western merchandise, Mega has been a hit since it opened its doors in December, 2002. Last year it was the world’s most frequented shopping center, with 52 million visitors. Down the road at the Rolf car dealership, Oxana Starostina is filling in registration forms for her new Mitsubishi Lancer, purchased with $20,000 in cash. She and her husband, Maxim, saved the money from their small construction supply business. . . . [F]or many multinationals from the U.S., Europe, and Asia, the consumer boom, not oil and gas, is the investment story to watch. ■ Nations trade for the same reasons that individuals do—because they believe that the products they receive are worth more than the products they give up. International trade is partially responsible for the incredible variety of goods and services both we and the shoppers in the news story consume. For example, we purchase clothing made in China, oil from the Middle East, bananas from Honduras, and coffee beans from Colombia and Brazil. We consume a service when we vacation in the Caribbean or in Europe. The shoppers in Moscow are doing the same thing: enjoying the goods produced in France, Sweden, and Japan. Oleg Nikishin/Pressphotos CHAPTER 16 International Trade 441 exports the goods and services that a nation sells to other nations imports the goods and services that a nation buys from other nations Why Nations Trade MAIN Idea Trade allows nations to specialize in some products and then trade them for goods and services that are more expensive to produce. Economics and You When you were young, did you ever trade toys, cards, or candy with your friends? Read on to learn about international trade. Some trade takes place because countries lack goods at home. Figure 16.1 shows some essential raw materials used in the United States that come from abroad. Specialization A more important reason for trade— whether among people, states, or countries—is specialization. When people specialize, they produce the things they do best and exchange those products for the things that other people do best. States also specialize. For example, New York is a financial center for stocks and bonds, while automobiles are a major industry in Michigan. Texas is known for oil and cattle, while Florida and California are famous for citrus fruit. Countries specialize in different goods and services in much the same way. If you want to find out what a country specializes in, look at its exports—the goods and services that it produces and sells to other nations. If you want to see what a country would like to have but does not produce as efficiently, look at its imports—the goods and services that one country buys from other countries. Extent of Trade International trade is important to all nations, even a country as large as the United States. Most of the products that Figure 16.1 American Dependence on Trade Raw Material Imports as a Percent of Consumption Primary Foreign Sources Use of Raw Materials Industrial diamonds Bauxite Columbium Mica (sheet) Strontium Tin Tantalum Barite Cobalt Chromium 100 100 100 100 100 88 80 79 76 72 South Africa, Australia, Democratic Republic of the Congo, Botswana Industrial cutting tools, oil well drills Jamaica, Guinea, Brazil, Guyana Anything made of aluminum Brazil, Canada, Thailand Rocket structures and heat radiation shields India, Belgium, France Electrical insulation, ceramics Mexico, Spain Flares, fireworks Peru, China, Bolivia, Indonesia Cans and containers, electrical components Thailand, Germany, Brazil Surgical instruments, missile parts China, India Filler for gas and oil well drilling fluids, paint, plastics Democratic Republic of the Congo, Zambia, Canada High-temperature jet fighter engines South Africa, Zimbabwe, Turkey Chrome, ball bearings, trim on appliances and cars Sources: Statistical Abstract of the United States; U.S. Geological Survey International trade is the primary means by which nations, including the United States, obtain many essential materials. Economic Analysis How does the lack of certain raw materials force nations to become more interdependent? Figure 16.2 U.S. Merchandise Trade by Area The United States exports merchandise (goods) all over the world. The biggest trade imbalance is with China, followed by the OPEC members. Economic Analysis Which single area of the world trades the most with the United States? Canada United Kingdom $138 $210 $38 $49 China Japan $118 $237 $53 $137 United States Imports Exports Trade Deficit $ Billions % GDP $1,645 $883 $762 13.2% 7.1% 6.1% $118 $168 $261 $421 Mexico Rest of the World In billions of dollars Source: Economic Report of the President, 2006 Euro currency area Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain $226 $133 $120 $29 OPEC Members Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, Venezuela absolute advantage country’s ability to produce more of a given product than another country can produce countries exchange are goods. However, trade in services such as banking and insurance is increasing. Figure 16.2 shows the patterns of merchandise trade for the United States with the rest of the world. The import of goods alone amounts to $1,645 billion, or about $5,500 per person. The numbers in the figure would be even larger if we included the value of services. In the end, international trade is much more than a way to obtain exotic products. The sheer volume of trade between nations with such different geographic, political, and religious characteristics is proof that trade is beneficial. Reading Check Explaining Why is specialization a good idea in trade? The Basis for Trade MAIN Idea Trade works best when countries focus on those products they can produce best. Economics and You Have you ever bought anything, such as clothing or a meal, that you could have made yourself? Read on to learn how this action relates to international trade. It may be cheaper for a country to import a product than to manufacture it. The difference between absolute and comparative advantage makes this clear. Absolute Advantage A country has an absolute advantage when it can produce more of a product than another country. For example, assume CHAPTER 16 International Trade 443 Figure 16.3 The Gains From Trade A Total Output Before Specializing Total Output After Specializing Alpha Beta Alpha Beta Coffee 20 Cashews 4 + + 5 1 = = 25 5 Coffee 40 Cashews 0 + + 0 6 = = 40 6 B A LPHA a’ 40 After specialization e e ff o C 30 20 10 0 Before specialization a Alpha’s opportunity cost of production: 8 cashews = 40 coffee, or 1 cashew = 5 coffee 2 6 4 Cashew nuts 8 10 (Coffee and nuts measured in pounds) See StudentWorks™ Plus or glencoe.com. If Alpha and Beta each specializes in the product it can produce relatively more efficiently, total output for both countries goes up. After specialization, each country would trade its surplus production with its neighbor. Economic Analysis Does Alpha or Beta have a comparative adv |
antage in the production of coffee? C B ETA 40 30 e e ff o C 20 10 0 Beta’s opportunity cost of production: 6 cashews = 6 coffee, or 1 cashew = 1 coffee Before specialization b 2 After specialization b’ 68 4 Cashew nuts 10 production possibilities frontier diagram showing the maximum combinations of goods and/or services an economy can produce when all resources are fully employed (also see page 21) comparative advantage country’s ability to produce a given product relatively more efficiently than another country by doing it at a lower opportunity cost opportunity cost cost of the nextbest alternative use of money, time, or resources when making a choice (also see page 20) the hypothetical case of two countries— Alpha and Beta—which are the same size in terms of area, population, and capital stock. Only their climate and soil fertilities differ. In each country, only two crops can be grown—coffee and cashew nuts. In Figure 16.3 you see an illustration of the production possibilities frontiers for Alpha and Beta. Note that if both countries devote all of their efforts to producing coffee, Alpha could produce 40 million pounds and Beta six million—giving Alpha an absolute advantage in the coffee production. If both countries concentrate on producing cashew nuts, Alpha could produce eight million pounds and Beta six million. Alpha, then, also has an absolute advantage in the production of cashew nuts because it can produce more than Beta. For years, people thought that absolute advantage was the basis for trade because it enabled a country to produce enough of a good to consume domestically while leaving some for export. However, the concept of absolute advantage did not explain how two countries could benefit from an exchange in which a country with a large output like Alpha traded with a country with a smaller output like Beta. Comparative Advantage Even when one country enjoys an absolute advantage in the production of all goods, as in the case of Alpha above, trade between it and another country is still beneficial. This happens whenever a country has a comparative advantage—the ability to produce a product relatively more efficiently, or at a lower opportunity cost. To illustrate, because Alpha can produce either 40 pounds of coffee or 8 pounds of cashew nuts, the opportunity cost of 444 UNIT 5 The Global Economy producing 1 pound of cashew nuts is 5 pounds of coffee (40 pounds of coffee divided by 8). At the same time, Beta’s opportunity cost of producing 1 pound of cashew nuts is 1 pound of coffee (6 pounds of coffee divided by 6). Beta is the lowercost producer of cashew nuts because its opportunity cost of producing 1 pound of nuts is 1 pound of coffee—whereas Alpha would have to give up 5 pounds of coffee to produce the same amount of cashews. If Beta has a comparative advantage in producing cashews, then Alpha must have a comparative advantage in coffee production. Indeed, if we try to find each country’s opportunity cost of producing coffee, we would see that Alpha’s opportunity cost of producing 1 pound of coffee is 1/5 of a pound of cashews (8 pounds of cashews divided by 40). Using the same computations, Beta’s opportunity cost is 1 pound of cashews (6 pounds of cashews divided by 6). Alpha, then, has a comparative advantage in coffee production, because its opportunity cost of production is lower than Beta’s. The Gains from Trade The concept of comparative advantage is based on the assumption that everyone will be better off specializing in the products they produce best. This applies to individuals, companies, states, and regions as well as to nations. If we look at the final result of trade between Alpha and Beta, we can see that specialization and trade increased the total world output. Without trade, both countries together produced 25 coffee and 5 cashews. After trade, total world output grew to 40 coffee and 6 cashews. This explains why countries such as the United States and Colombia trade. The United States has the necessary resources to produce farm equipment efficiently, while Colombia has the resources to produce coffee efficiently. Because each country has a comparative advantage in a product the other country wants, trade will be beneficial to both. Reading Check Summarizing Why is it beneficial for a country to trade with another when it has comparative advantage? Student Web Activity Visit the Economics: Principles and Practices Web site at glencoe.com and click on Chapter 16— Student Web Activities for an activity on international trade agreements. Skills Handbook See page R43 to learn about Comparing and Contrasting. SECTION 1 Review Vocabulary 1. Explain the significance of exports, imports, absolute Critical Thinking 5. The BIG Idea What does the theory of comparative advantage, and comparative advantage. advantage suggest that countries should do? Main Ideas 2. Listing Use a graphic organizer like the one below to list the reasons that nations trade with one another. Why Nations Trade 6. Contrasting How do comparative advantage and absolute advantage differ? Use examples to support your comparison. 7. Predicting Suppose a nation has a great deal of human capital but few natural resources. In what kinds of products might the nation specialize? 8. Analyzing Visuals Look at Figure 16.3 on page 444. What would happen to total output if Alpha preferred growing cashew nuts and Beta specialized in coffee? 3. Describing How do specialization and trade benefit Applying Economics both trading partners? 4. Explaining Why does total world output increase as countries specialize to engage in trade? 9. Comparative Advantage Do you know of a product for which your state has a comparative advantage? Explain how this might affect trade with another state. CHAPTER 16 International Trade 445 CASE STUDY Virgin Group Unlimited Advantage The theory of comparative advantage has led many companies to narrow their product lines. Richard Branson, founder of Virgin Group, did just the opposite. He decided to expand into a wide range of products in an even wider geographic area. Rather than building one large corporation with many divisions, though, Branson decided to create many individual companies united under the Virgin brand. The result: companies located on most continents, selling everything from train rides and low-cost flights to music, mobile phones, and luxury vacations. Virgin’s Success 1968 Company begins 1970 1971 1973 1984 1987 1991 1993 1999 2000 Start of mail order record sales Opens first record shop Virgin record label launched Virgin Atlantic Airways opens Virgin Records America founded Virgin Publishing Company founded Virgin Radio begins Virgin Mobile launched Virgin Cars Produced 2002 Virgin Credit Card established Source: www.virgin.com Finding Niche Markets Virgin traces its origins back to 1968 published the first issue of Student Magazine for his university. Shortly after, he expanded into mail-order record sales and record shops. He also launched his own record label, signing such artists as Phil Collins and Boy George. For over a decade, Branson limited his business ventures to 446 UNIT 5 The Global Economy Daniel Berehulak/Getty Images those related to music. During the 1980s, Branson decided to begin his expansion into other products and worldwide markets. His business plan was to find markets that are either underserved or lack competition. First steps included Virgin Atlantic Air Cargo and a luxury hotel in Spain. Success Story Today, Virgin Group has about 200 companies on most continents. Some provide their everyday customers with affordable vacations. Others cater to a more exclusive crowd, such as a luxury game resort in Africa and a motorcycle limousine service that can skirt London traffic jams. His latest venture will take vacationers into space. Branson’s formula for success is apparently working. In 2005 the Virgin Group reported revenues of about $8 billion. Analyzing the Impact 1. Recalling How does the organization of Virgin Group differ from that of most other corporations? 2. Drawing Conclusions How did Branson’s business plan allow him to use comparative advantage? SECTION 2 Barriers to International Trade GUIDE TO READING Section Preview Academic Vocabulary In this section, you will learn that nations use tariffs and quotas to protect special interests, while the free trade movement tries to eliminate trade barriers. • imposed (p. 448) • justify (p. 450) Reading Strategy Describing As you read the section, complete a graphic organizer similar to the one below by describing the arguments of protectionists and free traders. Protectionists Free Traders Content Vocabulary • tariff (p. 448) • quota (p. 448) • protective tariff (p. 448) • revenue tariff (p. 448) • protectionists (p. 450) • free traders (p. 450) • infant industries argument (p. 450) • balance of payments (p. 452) • most favored nation clause (p. 453) • World Trade Organization (WTO) (p. 453) • North American Free Trade Agreement (NAFTA) (p. 454) ISSUES IN THE NEWS China Economic Ties Under Scrutiny —www.usinfo.state.gov U.S. Commerce Secretary Carlos Gutierrez warns that the United States might be forced to reassess its economic relationship with China if Beijing fails to address economic frictions between the two countries quickly and effectively. . . . He said that China maintains a range of nontariff barriers that, in combination with other policies, prevent the United States from achieving balanced trade with that country. . . . He said that “with a stroke of a pen” China could open critical closed sectors to competition from abroad. “Progress would greatly strengthen those of us who oppose protectionist policies,” Gutierrez said. But if the Chinese government refuses or fails to act quickly, the U.S. Congress might “go down a path that none of us want,” that is “build protectionist barriers around the U.S. market,” he said. ■ While free markets and international trade can bring many benefits |
, some people still object, because trade can displace selected industries and groups of workers. When these people object to trade, they look for ways to prevent it, or to at least slow the rate of growth. Because of the wealth that a market economy can generate, China has decided to join the community of nations committed to markets and trade. China is still new at this, however, and as you read in the news story, it is trying to protect some sectors of the economy while opening up to trade. Owaki/Kulla/Corbis CHAPTER 16 International Trade 447 tariff tax placed on an imported product quota limit on the amount of a good that is allowed into a country protective tariff tax on an imported product designed to protect less-efficient domestic producers revenue tariff tax placed on imported goods to raise revenue Tariffs In 2002 a temporary tariff on steel imports protected the jobs of steelworkers such as this one. What is the name of this kind of tariff? Restricting International Trade MAIN Idea Tariffs and quotas are the main ways to restrict international trade. Economics and You Have you noticed where your clothes, electronics, or home appliances are made? Read on to find out about ways to restrict imports of such goods. Historically, trade has been restricted in two major ways. One is through a tariff—a tax placed on imports to increase their price in the domestic market. The other is with a quota—a limit placed on the quantities of a product that can be imported. Tariffs Governments generally levy two kinds of tariffs—protective tariffs and revenue tariffs. A protective tariff is a tariff that is high enough to protect less-efficient domestic industries. Suppose, for example, that it costs $1 to produce a mechanical pencil in the United States, while the same product can be imported for 35 cents from another country. If a tariff of 95 cents is placed on each imported pencil, the cost for these imports climbs to $1.30 per pencil—more than the cost of the American-made one. The result of the tariff is that a domestic industry is protected from being undersold by a foreign one. The revenue tariff is a tariff that is high enough to generate revenue for the government without actually prohibiting imports. If the tariff on imported mechanical pencils were 40 cents, the price of the imports would be 75 cents, or 25 cents less than the American-made ones. As long as the two products are identical, consumers would prefer the imported one because it is less expensive, so the tariff would raise revenue rather than protect domestic producers from foreign competition. Traditionally, tariffs were used more for revenues than for protection. Before the Civil War, tariffs were the chief source of revenue for the federal government. From the Civil War to 1913, tariffs provided about one-half of the government’s total revenue. After the federal income tax became law in 1913, the government had a new and more lucrative source of revenue. Since then tariffs—also called customs duties—have accounted for only a small portion of total government revenue, as shown in Figure 9.3 on page 239. In practice, a tariff achieves a little bit of both goals—it gives some protection and it raises some revenue. In 2002, for example, the Bush administration imposed a 30 percent temporary tariff on foreign steel imports to protect the domestic steel industry. The tariff raised some revenue and preserved some jobs during an election year, but it also raised the price of domestic steel by 20 to 30 percent—and hence the cost of goods to U.S. consumers. Quotas Foreign goods sometimes cost so little that even a high tariff on them might not protect the domestic market. In 448 UNIT 5 The Global Economy Daniel Boschung/zefa/Corbis such cases, the government can use a quota to keep foreign goods out of the country. Quotas can even be set as low as zero to keep a product from ever entering the country. More typically, quotas are used to reduce the total supply of a product to keep prices high for domestic producers. In 1981, for example, domestic automobile producers faced intense competition from lower-priced Japanese imports. Rather than lower their own prices, domestic manufacturers wanted President Ronald Reagan to establish import quotas on Japanese cars. The Reagan administration agreed. As a result, Americans had fewer cars from which to choose, and the prices of all cars were higher than they otherwise would have been. More recently, the threat of a quota has been used as a way to persuade other nations to change their trade policies. For example, the United States became concerned when the low prices China charged for its exports of textiles created problems for the domestic textile industry. In order to make China raise prices, in 2005 the government threatened China with quotas on these textiles. While it may seem odd to have the U.S. government pursue policies that would raise the cost of products to American citizens, the real purpose of a quota is to protect domestic industries and the jobs in those industries. Other Barriers Tariffs and quotas are not the only barriers to trade. Many imported foods are subject to health inspections that are far more rigorous than those given to domestic foods. For years this tactic was used to keep beef from Argentina out of the United States. Another method is to require a license to import. If the government is slow to grant the license, or if the license fees are too high, international trade is restricted. Other nations also use health issues to restrict trade. Several European countries, for example, refuse to import genetically altered crops grown in the United States. Delcia Lopez/San Antonio Express-News/ZUMA Press Nationalism and culture often play a role in these debates. Europeans frequently claim that they prefer regional and traditional foods to genetically altered ones. While these may or may not be legitimate arguments, they do restrict trade. Reading Check Comparing How do tariffs and quotas differ? CAREERS Customs Inspector The Work * Inspect cargo, baggage, and articles worn or carried by people, vessels, vehicles, trains, and aircraft entering or leaving the United States * Examine, count, measure, weigh, gauge, and sample commercial and noncommercial cargoes entering and leaving the United States * Seize prohibited or smuggled articles and intercept contraband * Apprehend, search, detain, and arrest violators of U.S. laws Qualifications * Must be a U.S. citizen between 21 and 36 years of age when hired * Possess a valid driver’s license and pass a civil service exam * Must pass a background investigation, meet certain health requirements, and undergo a drug screening test * Bachelor’s degree and one year of related work experience Earnings * Starting annual salary: $35,100 Job Growth Outlook * Average Source: Occupational Outlook Handbook, 2006–2007 Edition CHAPTER 16 International Trade 449 Arguments for Protection MAIN Idea Protectionists disagree with free traders over the best way to protect a country’s independence, industries, and workers. Economics and You What might you be willing to do to ensure the well-being of your family? Read on to learn why protectionists want to limit international trade. Freer international trade has been a subject of debate for many years. Protectionists are people who favor trade barriers to protect domestic industries. Other people, known as free traders, prefer fewer or even no trade restrictions. The debate between the two groups usually centers on the six arguments for protection discussed below. Aiding National Defense The first argument for trade barriers centers on national defense. Protectionists argue that without trade barriers, a country could become so specialized that it would end up becoming too dependent on other countries. During wartime, protectionists argue, a country might not be able to get critical supplies such as oil and weapons. As a result, some smaller countries such as Israel and South Africa have developed large armaments industries to prepare for such crises. They want to be sure they will have a domestic supply should hostilities break out or other countries impose economic sanctions such as boycotts. Free traders admit that national security is a compelling argument for trade barriers. They believe, however, that the advantages of having a reliable source of domestic supply must be weighed against the disadvantages that the supply will be smaller and possibly less efficient than it would be with free trade. The political problem of deciding which industries are critical to national defense and which are not must also be considered. At one time, the steel, automobile, ceramic, and electronics industries all have argued that they are critical to national defense and so should receive some protection. Promoting Infant Industries The infant industries argument—that new or emerging industries should be protected from foreign compe tition—is also used to justify trade barriers. Protectionists claim that some industries need to gain protectionist person who wants to protect domestic producers against foreign competition with tariffs, quotas, and other trade barriers free trader person who favors fewer or even no trade restrictions infant industries argument argument that new and emerg ing industries should be protected from foreign competition until they are strong enough to compete Protecting Industries While Harley-Davidson was not a new industry at the time, trade protection in the 1980s helped it to retool and become a worldwide competitor. Why do protectionists believe that new industries need protection? Lon C. Diehl/Photo Edit strength and experience before they can compete against established industries in other countries. Trade barriers, they argue, would give them the time they need to develop. Many people are willing to accept the infant industries argument, but only if protection will eventually be removed so that |
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