1. 2 chapter Economics and Banking Better Business 4th Edition
Solomon · Poatsy · Martin
chapter
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Learning Objectives
1. What is economics, and what are the different types of economic systems? 2. What are the principles of supply and demand and the factors that affect each principle? 3. What are the various degrees of competition? 4. How do economic indicators—particularly the gross domestic product (GDP), price indices, the unemployment rate, and productivity—reflect economic health? 5. What are the four stages of the business cycle? 6. How does the government use both fiscal policy and monetary policy to control swings in the business cycle?
In this chapter, we will study:
The basics of economics, including supply and demand.
The different types of competition.
The economic indicators we hear about in the news, such as gross domestic product, unemployment, and productivity.
How business and the economy overall move in cycles.
How the government monitors economic indicators and what possible actions it uses to help stabilize the economy.
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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.
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).
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Economic Systems
Economy—system that balances available resources of a country, such as land, capital, and labor, against the wants and needs of consumers
Types of economic systems:
Planned economies
Market economies
Mixed economies
An economy is a system that balances available resources of a country, such as land, capital, and labor, against the wants and needs of consumers.
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.
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5. Types of Economic Systems
As 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 is an economic system that allows for freedom of choice and encourages private ownership of the resources required to make and provide goods and services.
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6. Determining Price: Supply and Demand
Barter
Currency
Market price
Price at which everyone who is interested can get an item with none left over
Supply
Availability of the item
Demand
Need or desire for the item
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.
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Supply
Supply—the quantity of goods or services made available for sale
Law of supply:
The amount supplied will increase as the price increases.
The amount supplied will decrease as the price decreases.
Supply curve—graph showing price and quantity supplied
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.
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Demand
Demand—the quantity of a good or service people want to buy at any given time. Demand curve—graph showing price and quantity demanded
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.
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9. Supply and Demand Curves and Eddie’s Coffee Kiosk
Important terms:
Supply curve
Demand curve
Market price
Surplus
Shortage
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.
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10. Shifts in Supply and Demand
Determinants of Supply
Technology changes
Change in resource prices
Price expectations
Number of suppliers
Price of substitute goods
Many factors affect how much of a good or service is available. The same is true for demand—the amount consumers will demand varies based on a number of determinants.
Shifts in Supply:
Technology changes—Improvements in technology enable suppliers to produce their goods or services more efficiently and with fewer costs. For example, a builder who upgrades from a hammer to a nail gun.
Changes in resource prices—An increase in resource prices increases the cost of production and reduces profits, thus lowering the incentive to supply a product. For example, an increase in the price of lumber and other building supplies can increase housing projects.
Price expectations—If prices are expected to increase in the future, the supplier may reduce supply now to supply more at a later time when prices are higher. Similarly, if prices are expected to decrease in the future, the supplier may make every attempt to deplete supplies now at the higher price.
Number of suppliers—The supply of a good or service increases as the number of competitors increases. The number of suppliers often increases in more profitable industries.
Price of substitute goods—If there are other equally comparable goods that are available at a lower price, the supply of goods will be affected. A change in any of these determinants of supply will affect the supply of a product and shift the demand curve.
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11. Shifts in Supply and Demand
Determinants of Demand
Changes in income levels
Population changes
Consumer preferences
Complementary goods
Substitute goods
Shifts in Demand:
Changes in income levels—When income increases, people are able to buy more. Conversely, when income levels decrease, most people cut back and buy fewer products.
Population changes—Vacation rentals during the “in” season vs. the “off” season; increased population increases demand for utilities and public and consumer services; demographic changes such as the aging baby boomers also affect demand for certain goods.
Consumer preferences—The demand for products can change quickly. For example, remember when people waited in line to buy a Wii system.
Complementary goods—Products or services that go with each other. For example, an iPod and iTunes
Substitute goods—Goods that can be used in place of other goods. For example, Coke for Pepsi. If one product’s demand decreases, the substitute good’s demand might increase.
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12. Degrees of Competition
Learning 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.
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13. Economic Indicators: Gross Domestic Product
Gross Domestic Product (GDP)
The broadest measure the health of any country’s economy
Includes goods that are actually produced in the country
Gross National Product (GNP)
Former system of measurement the United States used to measure the economic health
United States switched to GDP in 1991
GNP attributes earnings to the country where the company was owned, not where the company was manufactured
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 United States are counted in the U.S. GDP and not Japan’s GDP.
Until 1991, the United States 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.
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14. Economic Indicators: CPI and PPI
Inflation
Disinflation
Deflation
Consumer price index (CPI)
Purchase price index (PPI)
The health of an economy can also be measured by the level of prices.
Inflation is a rise in the general level of prices over time.
A decrease in the rate of inflation is disinflation.
A continuous decrease in prices over time is deflation.
The consumer price index, or CPI, is a benchmark used to track changes in prices over time. The CPI measures price changes by creating a “market basket” of a specified set of goods and services that represent the average buying pattern of urban households. Changes in the CPI are tracked from month to month.
What types of products are included in the “market basket” for the CPI?
Clothing
Housing
Food and beverages
Recreation
Medical care
Education
Communication
Transportation
Other goods and services such as cigarettes, haircuts, and funeral services
The producer price index, or PPI, tracks prices of goods businesses use to create products or services, such as raw materials, product components that require further processing, and finished goods sold to retailers.
Why are these price indices so important? Both of these measure purchasing power and can help businesses make decisions. When prices to consumers are going up (as evidenced by an increase in the CPI), businesses may need to consider increasing pay to employees to allow their employees to maintain their standard of living. Additionally, an increase in the PPI can foreshadow an increase in prices to consumer as manufacturers will eventually pass along increases in costs to consumers in the form of higher prices.
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15. Economic Indicators: Unemployment
Unemployment rate
The number of workers who are not working and who are actively looking for work
Types of unemployment
- Frictional unemployment
Structural unemployment
Cyclical unemployment
Seasonal unemployment
The unemployment rate measures the number of workers who are at least 16 years old who are not working and who have been trying to find a job within the past four weeks and still haven’t found one.
Unemployment can have many causes. This is reflected in the four types of unemployment.
Frictional unemployment measures temporary unemployment in which workers move among jobs, careers, and locations.
Structural unemployment measures permanent unemployment associated when an industry changes in such a way that jobs are terminated completely.
Cyclical unemployment measures unemployment caused by lack of demand for those who want to work. This generally follows the economy.
Seasonal unemployment measures those out of work during the off-season, such as those employed in snow- or beach-related industries, agriculture, and/or holiday activities.
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16. Economic Indicators: Productivity
Measurement of the quantity of goods and services that human and physical resources can produce in a given period of time
Why is it important to measure and track productivity?
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.
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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.
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Fiscal Policy
Fiscal policy relates to government management of revenues (taxes) and spending
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 because it’s an immediate injection of funds into the system. Often, government spending creates additional jobs, which also helps stimulate the economy.
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19. Monetary Policy and the Federal Reserve System
The Federal Reserve System, “the Fed”, is the central banking system in the United States.
Independent government agency
Twelve 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.
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20. 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?
The 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 because 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.
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21. Managing the Money Supply: Reserve Requirement
The 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.
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22. Managing the Money Supply: Discount Rate
Discount 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.
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23. Managing the Money Supply: Open Market Operations
Open 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
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Chapter Summary
1. What is economics, and what are the different types of economic systems? 2. What are the principles of supply and demand and the factors that affect each principle? 3. What are the various degrees of competition? 4. How do economic indicators, particularly the gross domestic product (GDP), price indices, the unemployment rate, and productivity, reflect economic health? 5. What are the four stages of the business cycle? 6. How does the government use both fiscal policy and monetary policy to control swings in the business cycle?
Chapter Summary
What is economics, and what are the different types of economic systems? Economics is how individuals and businesses make decisions to satisfy needs and desires with limited resources. There are different types of economic systems: planned, market, and mixed.
What are the principles of supply and demand and the factors that affect each principle? Supply refers to how much of a product is available. Demand refers to how much people want to buy.
What are the various degrees of competition? The degrees of competition are monopoly, duopoly, oligopoly, monopolistic competition, and perfect competition. In a monopoly, there is just one seller providing the product. In a market where there are two sellers, a duopoly exists. Supplies may increase with an oligopoly, in which a few sellers exist. Monopolistic competition allows for many sellers, increasing the supply. Similarly, there are many sellers in perfect competition, which also increases the supply of a product or service.
How do economic indicators, particularly the gross domestic product (GDP), price indices, the unemployment rate, and productivity, reflect economic health? GDP measures the overall market value of final goods and services produced in a country in a year. CPI and PPI track changes in prices over time and are indicators of inflation or deflation. The unemployment rate is watched as an indicator of how productive the workforce is. Increasing productivity means that the existing resources are producing more, which generates more income and more profitability.
What are the four stages of the business cycle? The four stages are peak, recession, trough, and expansion/recovery.
How does the government use both fiscal policy and monetary policy to control swings in the business cycle? The government’s fiscal policy determines the appropriate level of taxes and government spending. The government’s monetary policy manages the money supply to control inflation. The Federal Reserve System is responsible for the monetary policy and uses open market operations, changes in the discount rate, and manipulations of the reserve requirements to help keep the economy from experiencing severe negative or positive swings.
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