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2 chapter Economics and Banking Better Business 3rd EditionSolomon (Contributing Editor) · Poatsy · Martin chapter © 2014 Pearson Education, Inc.
© 2014 Pearson Education, Inc.Economics Basics Economics – the study of how individuals and businesses make decisions to best satisfy wants, needs, and desires with limited resources Microeconomics - the study of how individual businesses, households, and consumers make decisions to allocate their limited resources in the exchange of goods and services Macroeconomics - the study of behavior of the overall economy Learning Objective 1: What is economics, and what are the different types of economic systems? Economics is the study of how individuals and businesses make decisions to best satisfy wants, needs, and desires with limited resources and how efficiently and equitably resources are allocated. Microeconomics is the study of how individual businesses, households, and consumers make decisions to allocate their limited resources in the exchange of goods and services. Macroeconomics is the study of the behavior of the overall economy. Goods are products, such as books and computers, that are manufactured for sale. Services are acts, such as giving haircuts or installing a home network, that are offered for sale. Why do business managers need to be concerned with economics? Businesses need to know how much of their products and/or services to provide and what to charge. Business managers also need to be aware of the potential impact of government decisions (such as changing interest rates). © 2014 Pearson Education, Inc.
© 2014 Pearson Education, Inc.Economic Systems Economic system – the financial and social system through which a country allocated its resources (factors of production) – aka the structure for how resources are used to meet the needs of society Types of economic systems: Planned economies (Socialism and Communism) Market economies (Capitalism) Mixed economies (Blend of Market and Planned…Hybrid) Economic systems differ depending on the answers to four basic economic questions What and how much will be produced? How will it be produced? For whom will it be produced? Who owns/controls factors of production? An economic system is the system through which a country allocated its resources, which we learn are referred to as the factors of production. Economic systems can be characterized as planned economies, market economies, and mixed economies. Planned economic systems are systems in which the government has more control over what is produced, the resources to produce the goods and services, and the distribution of the goods and services. Communism and socialism are planned economic systems. Market economies give the control of economic decisions to the individual and private firms. One form of market economy is capitalism. Most modern economies in the Western world are mixed economies, which are a blend of market and planned economies. © 2014 Pearson Education, Inc.
© 2014 Pearson Education, Inc.Capitalism Capitalism An economic system in which individuals own and operate the majority of businesses that provide goods and services Commonly referred to as a FREE ENTERPISE (MARKET) SYSTEM or PURE CAPITALISM or LAISSEZ-FAIRE CAPITALISM System in which individuals are free to decide what to produce, how to produce it, and at what price to sell it Derived from Adam Smith’s laissez-faire capitalism (“Wealth of Nations,” 1776) in which a society’s best interests are served by individuals pursuing their own self-interest (called “Invisible Hand”) Creation of wealth is the concern of private individuals, not government Resources used to create wealth must be privately owned Economic freedom ensures the existence of a Free Market System Limited role of government (protection only) Pure or Laissez-faire capitalism doesn’t exist anywhere; it’s just a theory What do we have in America? © 2014 Pearson Education, Inc.
The Fundamental Rights of CapitalismThe right to own a business and keep after-tax profits The right to private property The right to free choice The right to fair competition © 2014 Pearson Education, Inc.
Types of Economic SystemsAs you see here, the various economic systems are presented on a continuum instead of as distinct categories because individual economies (that is, countries) usually include characteristics of each system. Communism is an economic system in which the government makes all the economic decisions and controls all the social services and many of the major resources required for production of goods and services. Socialism is an economic system in which the government owns or controls the most basic businesses and services so that profits can be distributed evenly among the people. Many socialist and communist countries are beginning to change their economics into free market through the practice of privatization - the conversion of government-owned production and services to privately owned, profit seeking enterprises. Capitalism an economic system that allows for freedom of choice and encourages private ownership of the resources required to make and provide goods and services. © 2014 Pearson Education, Inc.
© 2014 Pearson Education, Inc.US=Mixed Economy “ …an economy that exhibits elements of both capitalism and socialism. “ In what ways does our government “interfere” with private interests and individual freedoms? © 2014 Pearson Education, Inc.
Planned Economies: Socialism and CommunismPublic Ownership of Enterprise Strong Central Government Father of Communism = Karl Marx Examples: North Korea, Cuba, Old China and USSR Socialism Government Control Key Enterprises Higher Taxes Main Goal = Social Equality © 2014 Pearson Education, Inc.
© 2014 Pearson Education, Inc.Determining Price: Supply and Demand – The Fundamental Principles of a Free Market System The Foundation of the Free Market How much can we make/sell? How much will consumers buy? At what price? Interaction of buyers & sellers Impact prices Competition Learning Objective 2: What are the principles of supply and demand and the factors that affect each principle? Historically, a system of barter was used to exchange goods and services. Through barter, people traded goods and services for other items. However, a system of barter depends upon both parties having items of equal items to exchange. This creates an inefficient and inconsistent system for commerce. Today, most economies use currency to facilitate transactions. Currency represents a unit of exchange for the transfer of goods and services and provides a consistent standard, the value of which is based on an underlying commodity, such as gold. The market price for a product or service is the price at which everyone who wants the item can get it without anyone wanting more or without any of the item being left over. Supply refers to how much of a product or service is available for purchase at any given time. The amount supplied will increase as the price increases. Demand refers to how much people want to buy at any given time. The amount demanded increases as the price decreases. Teaching Tip • Ask students if they know why eBay is a great example of supply, demand, and market price. Because bidders state the price they are willing to pay for a particular item. The price increases depending on the demand: the greater the demand, the higher the price bidders are willing to pay. Supply also affects price on eBay: if similar or identical items are available for auction, the price is kept lower. When a unique item is auctioned, prices tend to be higher because demand is higher and supply is lower. Eventually, the winning bid establishes the market price. © 2014 Pearson Education, Inc.
Supply Supply: the relationship between the price of a good and the quantity sellers are willing/able to offer Sellers tend to supply a greater quantity as the price rises. Supply curve: a graph of the supply relationship The supply curve slopes upward to the right showing that quantity supplied increases as price rises. Supply represents the quantity of goods or services available for sale. The more money a business can get for its good or service, the more of its product it is willing to supply. In economic terms, the amount supplied will increase as the price increases; also, if the price is lower, less of the product is supplied. This is known as the law of supply. A supply curve is a graph that shows the relationship between price and the quantity supplied. From the supply curve for the coffee kiosk, we can see that the quantity supplied increases with price. © 2014 Pearson Education, Inc.
Demand Demand: the relationship between the price of a good and the quantity buyers are willing and can afford to buy When price falls, consumers tend to buy more. Demand curve: a graph of the demand relationship The demand curve slopes downward showing that quantity demanded increases as price falls. Demand refers to how much of a product or a service people want to buy at any given time. People are willing to buy as much as they need, but they have limited resources (or money). Therefore, people will buy more of an item at a lower price than at a higher price. This is illustrated in the demand curve for the coffee kiosk, which quantity demanded decreases as price increases. © 2014 Pearson Education, Inc.
Supply and Demand: Determining the Market PriceForces of supply and demand drive equilibrium price The point where supply and demand intersect Market price adjusts to the equilibrium price Economists illustrate the relationship between supply and price with a supply curve like the line shown in this graph. They also illustrate the relationship between demand and price with a demand curve as shown here. As you can see, consumers’ demand increases as the price of an item falls. Meanwhile, suppliers’ interest in providing the product decreases as the price falls—this is because they would make less money. The market price is the price at which supply equals demand. If products are not offered for sale at the market price, there will be a surplus or a shortage. A surplus happens when supply exceeds demand. If Eddie sells coffee for $2, he will be willing to supply 115 cups but only 10 cups will be demanded. He will be left with a surplus of coffee. A shortage happens when demand exceeds supply. If Eddie, on the other hand, lowered the price to 50 cents, 120 cups would be demanded but only 10 cups would be available for sale, and there would be a shortage of coffee at this price. © 2014 Pearson Education, Inc.
Degrees of CompetitionPure competition A) a market situation in which there are A LOT of buyers along with a relatively large number of sellers; B) Sellers have NO control over price (market determines price, Supply and Demand); C) Identical products with NO differentiation (cotton, wheat?) Oligopoly A) a market (or industry) situation in which there are FEW sellers; B) Strong barriers to entry (for seller, it’s hard to enter into market); C) Similar products (cereal, cars, airlines); D) relatively higher prices for consumers Monopolistic competition A) a market situation in which there are many buyers along with a relatively large number of sellers; B) Sellers look for a COMPETITIVE ADVANTAGE by promoting PRODUCT DIFFERENTIAION (real or perceived differences by consumers with sellers’ products); C) Seller retains some control over price Monopoly A) a market (or industry) with only one seller, and there are barriers to keep other firms from entering the industry; B) Seller has complete control over price; C) Illegal; D) Some legal exceptions – NATURAL MONOPOLY and LIMITED MONOPOLY © 2014 Pearson Education, Inc.
Degrees of CompetitionLearning Objective 3: What are the various degrees of competition? A monopoly is a form of competition in which there is only one provider of a service or product, and no substitutes for the product exist. There are very few monopolies. A duopoly occurs when two sellers exist, although the term may also be used when two large firms dominate the market. An oligopoly is a form of competition in which only a few sellers exist; it typically occurs in industries that require a high investment to enter. The cellular phone industry is a good example. Monopolistic competition is a form of competition in which there are many buyers and sellers, little differentiation between the products themselves, but there is a perceived difference among consumers who thereby favor one product offering over another. Monopolistic competition is very widespread and describes most retailers. Perfect competition is a form of competition in which there are many buyers and sellers of products that are virtually identical, and any seller can easily enter and exit the market. Good examples of perfect competition include agricultural products such as fruit, grains, and milk. © 2014 Pearson Education, Inc.
Economic Indicators: Measuring Economic PerformanceGross domestic product (GDP) The total dollar value of all goods & services produced within a country’s borders during a one-year period Real GDP (RGD) – GDP that adjusts for inflation Nominal GDP (NGDP) – GDP measured in current year’s prices Inflation A general rise in the level of prices Productivity The average level of output per worker per hour Unemployment rate The percentage of a nation’s labor force unemployed at any time Learning Objective 4: How do economic indicators—particularly the gross domestic product (GDP), price indices, the unemployment rate, and productivity—reflect economic health? Here we switch from discussing the economic environment to talking about how we understand how an economy is performing, through economic indicators. The broadest measure of the health of any country’s economy is the gross domestic product, or GDP. The GDP measures economic activity—that is, the overall market value of final goods and services produced in a country in a year. It is important to note that only those goods that are actually produced in the country are counted in the country’s GDP. If the products are made abroad by a U.S. company, they count in that country’s GDP (but they count in the U.S. gross national product, a different measure). For example, Toshiba, a Tokyo-based company, has a plant in Tennessee therefore the value of their products that are produced in the U.S. are counted in the U.S. GDP and not Japan’s GDP Until 1991, the US used gross national product (GNP) to measure the economy. GNP measures the U.S. income resulting from production, whereas the GDP measures production in the United States, regardless of country of ownership. How does GDP influence business? When the GDP goes up, the indication is that the economy is in a positive state. A downward moving GDP indicates problems with the economy. Business owners use GDP data to forecast sales and adjust production and investment in inventory. © 2014 Pearson Education, Inc.
© 2014 Pearson Education, Inc.RGDP vs. NGDP Year Product Price Q 2012 Chips $1 5 2013 Chips $2 10 2012 Beer $3 4 2013 Beer $4 6 •NGDP2012? NGDP2013? • RGDP2012? RGDP2013? Productivity measures the quantity of goods and services that human and physical resources can produce in a given time period. Productivity is an indicator of a business’s health. An increase in productivity indicates that workers are producing more goods or services in the same amount of time. Why is it important to measure and track productivity? Higher productivity numbers often result in lower costs and prices. Increasing productivity means that the existing resources are producing more, which generates more income and profitability. Companies can reinvest the economic benefits of productivity growth by increasing wages and improving working conditions, by reducing prices for customers, by increasing shareholder value, and by increasing tax revenue to the government, thus improving GDP. Overall productivity is an important economic indicator of the economy’s health. © 2014 Pearson Education, Inc.
© 2014 Pearson Education, Inc.Business Cycle The state of the economy changes over time - Peak - Recession - Trough - Expansion/ Recovery Learning Objective 5: What are the four stages of the business cycle? The four stages of the business cycle include: 1. Peak: This occurs when the economy is at its most robust point. The peak occurs when an expansion ends and a recession begins. 2. Recession: By definition, a recession is a decline in the GDP for two or more successive quarters of a year. In recessionary times, corporate profits decline, unemployment increases, and the stock market reacts with large selling sessions that result in decreasing stock prices. The most recent recession began in 2007 and ended it It was evidenced by an increase in unemployment and a decrease in housing prices. A very severe or long recession is a depression. Depressions are usually associated with falling prices (deflation). After the onset of the Great Depression of 1929, the government used policies to control the economy to avoid another such depression. 3. Trough: A trough occurs when the recession hits bottom and the economy begins to expand again. 4. Expansion or recovery: Eventually, after a recession or even a depression the economy hits a trough and begins to grow again and therefore enters into an expansionary or recovery phase. Eventually, the recovery will hit a peak, and the cycle begins again. The government manages swings in the business cycle through fiscal policy, in which the government determines the appropriate level of taxes and spending, and through monetary policy, in which the government manages the supply of money. © 2014 Pearson Education, Inc.
Managing The Economy Through Fiscal and Monetary PolicyFiscal Policy – Government efforts to influence the economy: Taxation Taxes, Economy Government Spending Gov’t Spending, Economy Controlled by Congress/Budget Process Monetary Policy – Federal Reserve actions to shape the economy: Supply of Money Money Supply, Economy Influencing Interest Rates Interest Rates, Economy Controlled by Fed © 2014 Pearson Education, Inc.
© 2014 Pearson Education, Inc.Fiscal Policy Fiscal policy relates to government management of revenues (taxes) and spending The federal government budget outlines Revenue and Expenses (i.e. Gov’t Spending) When Tax Revenue is higher than Gov’t Spending, there is a budget surplus When Gov’t Spending is higher than Tax Revenue, the government incurs a budget deficit (FEDERAL DEFICIT) The sum of all the money borrowed is the federal debt (NATIONAL DEBT) What is our current National Debt? Learning Objective 6: How does the government use both fiscal policy and monetary policy to control swings in the business cycle? To smooth out the swings in the business cycle, the government influences the economy through its fiscal policy, in which the government determines the appropriate level of taxes and spending. Why does the government increase taxes? It slows the growth of businesses and the economy by reducing the amount of money in the system. This slows inflation. Why does the government decrease taxes? A tax cut can help stimulate the economy, but the amount of money entering into the system depends on how much of the reduction in taxes consumers spend and how much they save. Money put into savings does not help stimulate the economy immediately. How does government spending help stimulate the economy? To stimulate the economy, the government uses another form of fiscal policy: government spending. The government spends money on a wide variety of projects, such as infrastructure improvements and those that benefit the military, education, and health care. Government spending increases cash flow to the economy faster than decreasing taxes since it’s an immediate injection of funds into the system. Often, government spending creates additional jobs, which also helps stimulate the economy. © 2014 Pearson Education, Inc.
Monetary Policy and the Federal Reserve System“Fed” - central banking system in the U.S. - Independent government agency - 12 regional Federal Reserve Banks Board of Governors Federal Open Market Committee (FOMC) sets policies of the Fed, including monetary policies The Federal Reserve System (the Fed) is the central banking system in the United States. It was created by Congress to be an independent governmental entity. It includes 12 regional Federal Reserve Banks and a Board of Governors based in Washington, D.C. The Fed also includes the Federal Open Market Committee, which sets the policies of the Fed, including monetary policies. The Fed manages the country’s money supply through its monetary policy to control inflation. It accomplishes this by: Changing certain interest rates. Buying and selling government securities. Trading in foreign exchange markets. The Federal Reserve Banks carry out most of the activities of the Fed. © 2014 Pearson Education, Inc.
Why is measurement of the money supply important?Monetary Policy Monetary policy relates to managing the supply of money The money supply is the combined amount of money available within an economy, but there are different components to the money supply M-1: Currency, traveler’s checks, and checking accounts M-2: M-1 along with the available money for banks to lend out, such as savings deposits, money market accounts, and certificates of deposit (CDs) less than $100,000 M-3: M-2 plus less liquid funds Why is measurement of the money supply important? Money supply is the combined amount of money available within the economy, but there are different ways to measure money supply: M-1 is readily available money such as cash and checking accounts. M-2 is M-1 plus money available to banks to lend out, including savings deposits, money market accounts, and small certificates of deposit. M-3 is M-2 plus less available money, including large certificates of deposit, large institutional money market accounts, and U.S. money deposited in foreign banks. Why is measurement of the money supply important? Money has a direct effect on the economy since the more money we have, the more we tend to spend. When we as consumers spend more, businesses do better. Demands for resources, labor, and capital increase due to the stimulated business activity, and, in general, the economy improves. But when the money supply continues to expand and demand is high, prices will rise. Inflation results from an increase in overall prices. © 2014 Pearson Education, Inc.
Managing the Money Supply: Reserve Requirementthe minimum amount of money banks must hold in reserve to cover deposits set by the Fed Decrease in reserve requirement More money for lending Stimulates the economy The reserve requirement, determined by the Federal Reserve Bank, is the minimum amount of money banks must hold in reserve to cover deposits. Banks retain a reserve that is sufficient to cover any demands by their customers for funds on any given day. The Fed rarely uses the reserve requirement as a means of monetary policy. They can increase or decrease the reserve requirement to ease or tighten the money supply, respectively. © 2014 Pearson Education, Inc.
Managing the Money Supply: Discount RateDiscount Rate - Interest rate charged to banks that borrow emergency funds from the Federal Reserve Bank Fed Funds Rate - Interest rate that banks charge other banks when they borrow funds overnight from one another Decrease in discount rate More money for lending at lower rates Stimulates the economy The Federal Reserve Bank is the bank’s banker. Occasionally, commercial banks have unexpected needs for funds and turn to the Federal Reserve Bank for short-term loans. When these banks borrow money from the Fed, they are charged an interest rate called the discount rate. By lowering the discount rate, commercial banks are encouraged to obtain additional reserves by borrowing funds from the Fed. The commercial banks then lend to businesses, thereby stimulating the economy. If the economy is too robust, the Fed can increase the discount rate, which discourages banks from borrowing additional reserves. Businesses are then discouraged from borrowing because of the higher interest rates. The Fed Funds rate is the interest rate that banks charge other banks when they borrow funds overnight from one another. The Fed does not control the Fed Funds rate directly. To decrease the Federal Funds rate, the Fed will buy bonds in the open market. Buying securities from banks increases the banks’ excess reserves, making money supply more available, which decreases the Federal Funds rate and helps stimulate the economy. © 2014 Pearson Education, Inc.
Managing the Money Supply: Open Market OperationsOpen market operations - Primary, and most influential, tool the Fed uses to alter the money supply - Consists of buying and selling U.S. Treasury and federal agency bonds in the “open market” The primary tool the Fed uses in its monetary policy is open market operations, buying and selling U.S. Treasury and federal agency bonds in the “open market.” The Fed does not place transactions with any particular security dealer; rather, the securities dealers compete in an open market. When the Fed buys or sells U.S. securities, it is changing the level of reserves in the banking system. When the Fed buys securities, it adds reserves to the system; money is said to be “easy,” and interest rates drop. Lower interest rates help stimulate the economy by decreasing the desire to save and increasing the demand for loans such as home mortgages. When the Fed sells government bonds, it decreases the amount of reserves in the system, causing interest rates to increase. Open market operations are probably the most influential tools the Fed can use to alter money supply. Fed buys securities through OMO More money for lending Stimulates the economy © 2014 Pearson Education, Inc.
© 2014 Pearson Education, Inc.
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