introduction to economics

In order to study and pass  General Certificate Of Education Advanced level Economics one must grasp the basic concepts that form the foundation of the study of the subject.This material, if diligently studied shall provide all the economic concepts that are needed to understand the scope of economics.

As a student you are required to realize the importance of completing all blank spaces in your learning guide.The completed module will then constitute your powerful revision guide.You are also required to do all exercises and tests that are given in order to check your understanding and comprehension of what you are learning.

Basic Economic Ideas

economics and the economic problem

scarcity,choice and resource allocation

economics is the science which studies human behavior as a relationship between ends(unlimited wants) and scarce means(resources) which have alternative  uses . 

                                                                                   Professor Lionel Robins(1932)

 if you have challenges with understanding the difinition lets examine it step by step.As we analyse Professor Lionel Robbins's  definition of economics the following points stand out 

1- economics is a science 

2- economics studies human behavior

3-economics studies the relationship between "ends"(unlimited wants) and scarce means(scarce resources)

4-economics studies alternative use of resources

To clarify the above points and as an introduction to economics read the following study material.

Major Points of Lionel Robbins Definition of Economics

Following are the points:

1. Ends (Unlimited Wants)

Human beings have unlimited wants. They are constantly making efforts to satisfy unlimited wants with limited resources. The nature of these unlimited wants is such that if one want is satisfied another want arises. It is impossible that a person has all of his wants fulfilled. So the struggle to produce more goods or get more income continues for the whole life.

2. Means (Scarcity of Resources)

Resources are of two types, non-economic and economic resources. Non-economic resources are air, sea, water etc. These resources are unlimited in supply and are fee. Economic resources are the things and services which are limited or scarce in supply and command a non-zero price. Economics is concerned with all the natural human and man made resources that are used in the production of goods and services. These resources are also called inputs.

According to Robbins the unlimited ends and the scarce resources provide a foundation for the field of economics. Since the human wants are unlimited and the means to satisfy them are scarce or limited in supply, therefore an economic problem arises. If all the things were freely available to satisfy then unlimited human wants there would not have arisen any scarcity hence no economic goods, no need to economic and no economic problem.

3. Alternative Uses

The third important proposition of Robbins definition is the scarce resources available to satisfy human wants have alternative uses. For example if a piece of land is used for the production of sugarcane it cannot be utilized for the growth of another crop at the same time. Man therefore, has to choose the best way of utilizing the scarce resources which have alternative uses and choices are the problems confronting to the society. The choices to be made are

What goods shall be produced and in what quantity?

How the goods and services should be distributed

Summing up, the definition of economics by Robbins based on satisfaction of human wants with scarce resources which have alternative uses.


ECONOMICS AS A SOCIAL SCIENCE

The nature of economics

Economics is the scientific study of the ownership, use, and exchange of scarce resources - often shortened to the science of scarcity. Economics is regarded as a social science because it uses scientific methods to build theories that can help explain the  behaviour of individuals, groups and organisations. Economics attempts to explain economic behaviour, which arises when scarce resources are exchanged.

In terms of methodology, economists, like other social scientists, are not able to undertake controlled experiments in the way that chemists and biologists are. Hence, economists have to employ different methods, based primarily on observation and deduction and the construction of abstract models.

As the social sciences have evolved over the last 100 years, they have become increasingly specialised. This is true for economics, as witnessed by the development of many different strands of investigation including micro and macro economics, pure and applied economics, and industrial and financial economics. What links them all is the attempt to understand how and why exchange takes place, and how exchange creates benefits and costs for the participants.

The study of economics

The study of economics involves three related investigations. 

  1. Why scarce resources are exchanged?
  2. How consumers and producers behave as they interact with each other in markets, in their attempt to achieve mutually beneficial exchange?
  3. The role of government in compensating for the limitations of markets in achieving mutually beneficial exchange?

The methods used by economists

Economists use scientific observation and deduction in their investigations. To achieve this they:

Describe and measure the exchanges they observe

Economists describe changes in economic variables, and measure these changes over time. For example, economists describe and measure how interaction in markets determines the prices of such diverse products as motor cars, houses, haircuts, and computer software. Measurement in economics can take many forms, including measuring absolute and relative quantities and values. When measuring relative values it is common to use index numbers

Explain how interactions arise and create costs and benefits

Economists try to explain the effects, or results, of economic transactions. For example, economists can explain why, despite bubbles and crashes,  the long-run trend in house prices in the UK has been upwards over the last 30 years, and can identify those who have been affected positively and negatively by this increase. Of course, economists also try to explain the short-term movements in prices, and how they also have costs and benefits. 

Propose hypotheses, construct, and apply ‘models’ to test these hypotheses. 

Like all scientists, economists develop hypotheses to explain why economic behavior takes place, and then construct models to test these hypotheses. For example, economists may propose that price rises are caused by excess demand, and then attempt to construct a model of price that explains how excess demand can raise price. Economists frequently use versions of the demand and supply model to help explain events such as house price trends and movements. Economic models usually employ graphical and mathematical analysis to help explain and illustrate such economic processes.

Gather data to put into the model

Models must be tested against the real world, which means gathering statistical data about real events. In this way, a model can be improved and revised when necessary. 

Predict behavior based on these models. 

The ultimate goal of the economist is to predict future behavior. For example, by using a demand and supply model and by inputting real data about the housing market, economists can show that even a small fall in bank lending can trigger behavior that leads to a significant fall in house prices in the short run. The ultimate value of an economic model is that it can accurately predict the onset and the effect of an economic event. The better the model is, the more useful it is in helping economists make predictions. 

Economists assume that economic events and phenomena do not occur at random, but are determined by underlying and understandable causes. Unlike the pure scientist, economists cannot undertake controlled experiments, so they must test their models in different ways. Statistical analysis of actual economic data can provide a flow of information from which to build models and test hypotheses. For example, by gathering data about changes in house prices it is possible to deduce factors that cause house prices to go up or down, and by how much. Economists use index numbers to help make comparisons between countries and over time. 

Correlation analysis can help determine the strength of particular causal relationships so that strong and weak relationships can be identified. For example, it might be possible to demonstrate that, of all the factors that have contributed to falling house prices, the reduced availability of credit is the single biggest factor.

The role of the professional economist

Professional economists apply their skills of description, analysis, model building, and prediction to generate knowledge and, from this, provide advice to private firms, to governments and other organizations. 

Providing knowledge

  1. The first function of the economist is to provide information, called economic intelligence, from which decisions can be made. For firms to survive and succeed, they need to take many decisions, but each decision carries with it a risk. The professional economist can help reduce such risks by gathering and analyzing economic intelligence. This economic intelligence is only useful when it can be put into an economic model, and then applied to the decisions that need to be taken. 
  2. The second function of the professional economist is to interpret the data that has been gathered and provide informed advice to firms, organizations, and governments about the likely costs and benefits of the decisions they make.

In providing advice, the economist will always make an assessment of the other options that could have been chosen. For example, a large petrol refiner and retailer may be faced with a significant rise in the costs of crude oil – should it now raise price? After having made an assessment of all the pricing options, and having taken account of the likely response of rivals, the firm’s chief economist may advise it to hold price constant – perhaps the least ‘common sense’ answer.

To find out why, see:oligopoly

Positive and normative economics

As a social science, economics attempts to use the principles and methods of science to explain economic behavior. This involves making positive statements about the economic world.

Positive statements are those that can be verified, and are factual, such as:

‘.. House prices have fallen by 15% over the last year...’

In contrast, normative statements are based on opinion and value judgement. Statements suggesting that something ‘ought to’ happen, or that something is ‘unfair’, are normative because they are matters of opinion.

For example, ‘..the recent fall in house prices is unfair to the rich..’. 

This statement cannot be tested because it not based on anything testable. If there is an agreed definition of fairness, and it can be measured, then it might be possible to test the effect of the change in house prices on the degree of fairness experienced by a certain identifiable group of people defined as rich.  Therefore, this statement is normative, impossible to verify, and based on opinion rather than fact. 

The ceteris paribus rule

Economics is a social science, and, unlike the physical sciences, cannot engage in controlled experimentation to demonstrate how variables are connected.

In the real world, economic variables  such as price and income, are constantly changing, and this creates a problem in demonstrating the relationship between variables. For example, a fall in price is likely to lead to a rise in consumer demand if we assume nothing else changes.

Of course, for independent reasons, income could also fall while demand does not rise.  The fall in price could have been counteracted by a fall in income. The ceteris paribus rule, that all other things remain the same, is used whenever attempting to demonstrate the link between economic variables. 


please read the following definitions of economics as a social science and then complete the fill-in exercise 

Economics is categorized as a “social science” alongside anthropology, psychology and sociology.  Which makes complete sense considering that economics studies the relationships that dictate how we produce and consume goods and services within the society.   But you wouldn’t know that from the way many economists discuss economics.  Too often economists try to establish economics as an empirical science grounded in some sort of natural phenomena.

I was thinking about all of this as I was reading this piece by John Hilsenrath who was discussing Hayek’s views on this matter:

“His central grievance was the field’s long-running infatuation with scientific method and certitude. It was an impossible and misleading task for economists, he said. In their “vain search for quantitative and numerical constants,” Mr. Hayek argued, economists were constantly overlooking essential facts and misunderstanding the complexity of the social mechanisms under their microscopes.”

Hayek has this dead right even if we might have disagreed on how to apply it.  In the search for quantitative and numerical constants we often overlook just how much our economic system resembles the soft science and not the natural sciences.  And it can lead to extremely misguided thinking on certain matters.

Of course, the economy is not grounded in anything resembling the natural sciences.  There’s very little that’s “natural” about our economic system.  The economy is made up of the sum of the decisions of the people who operate within that system.  And the system exists, to a large degree, in our heads as records of accounting.   These records can be erased, created from thin air, manipulated, etc.  And the people creating those records are driven in large part by their own biases.  They react inefficiently and irrationally.  Mister Market, as Warren Buffet likes to say, is often manic.

This makes the study of economics extremely tricky because we’re dealing in uncertainties at most times.  Thankfully, we seem to be making good progress in fields like behavioral finance, but I do worry that the “science envy” of many economists continues to plague views and progress.

Economics is the study of social behavior guiding in the allocation of scarce resources to meet the unlimited needs and desires of the individual members of a given society.  

Economics seeks to understand how those individuals interact within the         social structure to address key questions about the production and exchange of goods   and services. First, how are individual needs and desires communicated         such that the correct mix of goods and services become available? Second,         how does a society provide the incentives for these individuals to participate         in the production these goods? Third, how is production organized such         that maximum-possible quantities are made available given existing resources         and production technology? Finally, given that these individuals are at         one time involved in the production process and at other times seeking         to acquire the goods that have been produced, how are trading rules and         exchange agreements established?

The above questions stress the importance of understanding the process of production. The goal here is to understand the basic features of production without getting mired in great technical detail. This is accomplished by developing a simple model that maintains the importantfeatures of what are, otherwise complex, engineering relationships. Production is about the conversion of scarce resources into desired goods and services. These resources are often referred to as the factors of production --a short list that includes: 

  •                 
  • Land (acreage            and raw materials)                    
  • Labor (unskilled, semiskilled, professional)         
  • Capital (machines, factories, transportation            equipment, and infrastructure) and            
  • Entrepreneurship (organizing the other factors of            production and risk-taking)            

This list is brief and yet complete intended to provide sufficient detail to model the input choices available to the producer. Accordingly, the combination of  Land, Labor, Capital,and Entrepreneurship will lead to the production of Apples, Wheat, Automobiles, Houses, a Freight Train, Education, or any other good or service.

However, we do live in a world of scarce resources. Scarcity refers to a physical condition where the quantity        desired of a particular resource exceeds the quantity        available in the absence of a rationing        system. Potential candidates for rationing systems include:           

  • Tradition and Culture, where the problem of allocation is addressed via social norms,customs and past history.            
  • Planning and Central Government Command, making use of complex mathematical tables to determineoutput goals and input requirements.                    
  • Voting and Political Procedures, communication about resource           allocation among individuals thorough the development of a consensus           or perhaps majority rule.         
  • Markets -- using a system of prices to act as a means                of communication about the availability of resources and the desire for those resources.             

Goods and services refer to:              

  • Final Goods and services --                 those products that are directly consumed by                individuals to satisfy their needs and wants.            
  • Intermediate or Capital Goods -- are those goods used to produce other goods.        

                       

In the case of final goods, Needs represent those        goods and services  required for human survival.        Needs are determined by nature, climate and region,        and are often finite. Human Wants or Desires refer to        everything else. Human wants are        determined by society and the culture in which an individual        lives. These wants are indeed unlimited and represent the        source of the problem facing all economic systems. 

        

We need to be careful in noting that Economics is not just about the productionof goods and services. Equally important is developing an understanding about how wants andneeds are communicated to the economic system, how to involve individuals inthe production process and provide incentives for these individuals to specialize in areas ofproduction where their talents are best used and then exchange goods with others. 

For your further reading on the introduction to economics here is more material from a different author.

 NATURE OF ECONOMICS

 DEFINITION OF ECONOMICS                                       The term economics is derived from the word “oeconomicus” by Xenophon in 431 B.C. It is derived from two words economy and science. Economy means proper utilization of resources. It means economics is the science of economy or science of proper utilization of resources. It is comprised of theories, laws, principle related to utilization of resources so as to solve the economic problems, satisfy the human wants or need and so on. However, the economics is defined in different ways by different economists. There are mainly three definitions of economics:-a. classical or wealth definition (Adam Smith)-1776 A.Db. neo-classical or welfare definition (Alfred Marshall )-1890 A.Dc. modern or scarcity and choice definition (Lionel Robbins)-1932 A.D a. classical or wealth definition (Adam Smith)-1776 A.D                                   The famous classical economist Adam smith for the firs time defined economics as “science of wealth”. The definition was given in the book “an enquiry to the nature and the causes of wealth of nations” published in 1776 A.D. the book is popularly known as “wealth of nations”. According to smith, labor is the main source of income or wealth. More wealth is accumulated only if more labor is used. Economics explains the human behavior and activities they do for wealth. This definition was based upon the assumptions of full employment, perfect competition, no governmental interventions, money just as a medium of exchange and so on.                                     This definition has following main proposition:-i. economics is science of wealth. Labor is the only source of income. there is perfect competition in product as well as labor marketiv. the government should not interfere the activities of people and business organizationsv. this definition is influenced by physiocracy and mercantilism.Criticism:-            Wealth definition has over emphasized wealth. Economics is science of human activities rather than only wealth. Adam smith considers only material things or wealth as subject matter of economics but human beings require some immaterial things like self esteem or dignity, social prestige, national identity and so on too. The immaterial things are called essential things for human satisfaction. Wealth definition is based upon the theory of subsistence wage which is known as iron law of wage. The law was against the workers and in favor of employers. Adam smith doesn’t explain about scarcityof resource and choice of best alternative for the use of resources. The problem of scarcity and choice is burning issue in the modern economics but he fails to explain about the problems of scarcity and choice. The wealth definition is based upon assumptions of full employment and perfect competition but none of these two is in existence. This definition is based upon the assumption of no intervention of government in economic activities of people and business organization but we find in every country more or less governmental intervention.b. neo-classical or welfare definition (Alfred Marshall )-1890 A.D                                 In 1890, Alfred Marshall, a famous neo-classical economist and a great contributor to micro economics defined economics as the science of material welfare. Here, the material welfare means the quantities of physical goods consumed by people. if the people are consuming large quantities of goods, they are said to have high level of welfare into two types1.       material welfare2.        immaterial welfare According to him, only the material welfare is the subject matter of economics. He assumes every person is rational and s/he uses the resources in his/her possession very properly so as to maximize their own welfare. Economics is therefore the science that studies the rational behavior revealed by the people. Major propositions of Marshall’s welfare definition are:-1. Economics is science of material welfare2. Economics is social science i.e. science of mankind3. Economics is the study of rational behavior of people revealed for maximization of material welfare. Criticisms:-This definition of economics a science of material welfare was assumed correct until the arrival of Lionel Robbins. He criticized the definition under the following aspects:-1. Classificatory activities of Marshall into material non material welfare, economics and non economic goods is only classificatory not analytical because single human cannot be material as well as non material according to the nature and purpose of work.2. Non material activities like feeling of social service, human desire also satisfy human needs. This idea has not been prioritized3. Non welfare consumption like harmful drugs, tobacco, and alcohol don’t promote social welfare but still are in the study of economics4. Economics should study about total human beings but wealth definition doesn’t study about isolated people like saints, nuns, monks etc.c. modern or scarcity and choice definition (Lionel Robbins)-1932 A.D                                 According to Lionel Robbins, economics is the science of scarcity of the resources and the choice of best alternative for their utilization. The resources are limited in supply. Each resource is usable for different purposes. The wants or need of people are unlimited. The wants differ in importance. They differ from place to place, from time to time and from person to person. Some wants are more important whereas some are not. All wants cannot be fulfilled because of insufficiency of resources. Therefore, we have to go on utilizing the resources in such a way, so that, our more wants can be fulfilled leaving no one in most important wants unfulfilled. For it, we must select best ways for the utilization of the resources. We should have the complete information of resources available, needs of the country and their importance and ways for the utilization of resources. This definition is given in 1930 A.D after WWI. During third decade of the twentieth century, the European countries were badly in need of large quantities of resources for rehabilitation, construction of infrastructures, renovation etc. they were destructed in war. This definition is both normative and positive in nature. The major propositions are:-1. there is unlimited human needs or wants2. there is scarce means of resources3. there are alternative use of resources4. there is need of choice Criticisms:         The definition is criticized in the following ways:-1. economic problems arises not only due to scarcity but due to under, miss  or over utilization of resources2. economic problems arises due to inequality too3. there is political consideration4. needs and resources may varySuperiority of Robbins definition over Marshall’s definition:-1. the definition is scientific2. the definition is universally accepted3. the definition has wide scope4. the definition has science of choiceMicroeconomics:-      The term microeconomics is derived from the word micro economy and science. The term micro is also derived from the Greek word micros which means small or tiny. Microeconomics is defined as the science of small or tiny part of the economy. It provides us the detail information of microeconomics units. The units are single consumer or consumer of a firm or an industry. A single firm or firms belonging to an industry is called worm’s eye view of an economy. In microeconomics we study about the relationships between microeconomic variables like utility, cost of purchasing, demand, supply, price, cost of production, and revenue from sale, profit or loss and so on, it is the study of behavior of consumers and firms.Scope of microeconomics:-  The scope of microeconomics means its subject matter. it means area of application too. The scopes are:-1. study of consumers behavior                   -cardinal utility theory                  – ordinal theory                  -revealed preference theory                  -cardinal behavior theory2. Study of production and cost function           Mathematically.                       Q=output (quantity)                       C=cost of production                       K=capital  Q=f (K and other inputs)  C=f (Q)          Therefore, C ∞ input3. Study of price and output determination              Profit=revenue-costMarkets = monopoly, duopoly, oligopoly, monopolistic competition and perfect competition4. Study of microeconomic distribution     Factors of production-land, labor, capital and organization     Factor wages-rent, wage, interest, profit    

Macroeconomics Macroeconomics is derived from the word macro, economy and science. The term “macro” is also derived from Greek word “macros” which means large or big. Therefore, macroeconomics can be defined as the science of large segment of the economy or economy as a whole. It provides bird’s eye view of the economy. It gives general features of the economy. It is study of features of economic problems, causes and remedies of the problems in different sectors. The sectors are divided into household sectors, government sector, foreign trade sector, business sector. In macroeconomics we study about the relationship between macro economic variables, the variables are:a) Aggregate consumptionb) Aggregate incomec) Aggregate savingd) Aggregate investmente) Aggregate demandf) Aggregate supplyg) Price levelIn macroeconomics we study about the causes and remedies of trade and payment, price instability, Inequality etc 

Scope or subject matter of macroeconomics:

Scope means the subject matter. It means the area of application…

1. Study of wage level and employment level

The macroeconomics deals with wage level and employment level. The level of employment depends upon demand for labor and supply of labor. Both of these factors depend upon wage level. There are different theories of employment like classical theory, Keynesian theory, Kaltorian theory and other modern theory2. The study of price level and output levelMacroeconomics is concerned with determination of equilibrium price level and output level. The price level means average of the prices of goods and services bought and sold in the country in a year. The level of output depends upon aggregate demand and price level. There are different theories of determination of price level and output level. Among them, Keynesian theory of effective demand is very popular. The theories are the subject matter of macroeconomics.3. The study of trade cycleMacroeconomics is concerned with trade cycle too. It explains how the economics ups and downsoccur, what are their causes, how the country can overcome fluctuation. There are different theories of trade cycle. Some of them are Schumpeter theory, Hessian theory, Calder’s theory etc.4) Study of macroeconomic distributionThe macroeconomics is the study of distribution of income, wealth or resources in the country among the people. It is the study of different theories, laws and principles of distribution of income in the form of wage, interest, profit and rent. It gives us knowledge of effects of high inequality in the distribution of income and wealth. It gives us remedies of unequal distribution and the economic problems due to the inequality

Normative or positive economics

Economics is both positive and normative science. It is the study of facts as well as ideal theories and principles too. It can be explained as following:a) Positive economicsEconomics is positive science. It is the study of facts or things in reality or existence. In economics the large number of economic problems or questions like what are produced, how goods are priced and distributed, how much profit is earned by firms, what different type of resources are available, hoe the resources are utilized, who are performing different economic activities, why the economic problems are occurring, why is the country suffering from unemployment, price instability, economic instability, import dependency and so on are put and answered. There are different theories laws and principles based upon facts we study in economics. That’s why economics is called positive scienceb) Normative economics .Economics is normative science. It is the study of things ought to be. In economics, we study different ideal theories and principles. They are concerned with different economic problems. They give us ideas for overcoming of different economic problems. They are helpful to formulate proper policies and plans. They are helpful to solve the problems of unemployment, import dependency, improper allocation of resources, price and economic instability, unequal distribution of income and wealth and so on. Economics helps us to decide how much goods should be produced, hoe much they should be priced, hoe the government should control money supply, interest rate, public debt, government expenditure etc , how the consumer should allocate the money to get maximum satisfaction from the expenditure, how the firms should combine the inputs to earn maximum profit and so on. This all have ethical importance. That’s why economics is call normative science.Economics is a science or an artEconomics is both art and science. It is called a science because it is the scientific study of relationships between economic variables, behavior of consumers and firms, nature of market and economy, effect of change in one or more economic variables on the others and so on. The different theories, laws and principles are studied in economics. All of them are generalized and simplified on the basis of facts so as to make them easily understandable. Therefore, economics is said to be science.Economics is an art. The different theories, laws are explained with the help of graphs, figures, tables, charts, equations etc simplifying and generalizing them. Simplification is to make them easily understandable and generalization is to make them applicable to all economies. In order to explain theories, laws and relationships between economic variables we make some assumptions. The assumptions define the conditions for the application of theories, laws and\d the relationships. That’s why economics is an art.Importance of microeconomics:1. Important to the consumersMicroeconomics provides the ways for proper allocation of money on different goods and services so that they can get maximum utility. There are different theories of consumers behavior, the theories explain how the consumers should spend the limited money they have to maximize their satisfaction2. Important to the firms or businessmenThe firms or businessmen use the microeconomic theories of consumer behavior, production, cost, market, revenue and so on to make proper economic decisions. The microeconomics helps them to know the purchasing power of ability to pay, proper combination of inputs to maximize cost or maximize profit, effects of change in tax rates, subsidies and so on3. Important to the governmentGovernment can determine taxes, subsidies, wage level, allowances etc on the basis of effects of change in these factors on the demand for goods and services. Some goods are levied while some are subsidized. The salaries and allowances are adjusted on the basis of relationship between these variables and demand. Interest rate, exchange rate and money supply too are changed with the help of microeconomic theories.4. Important for the study of other economic science.Microeconomics helps us to study of other economic sciences like macro economics, public finance, monetary economics, labor economics, and international trade economics and so on. The theories and laws of these economic sciences are based upon micro economics theories and laws.Importance of macroeconomics1. To know the relationship between macro economics variables:The macroeconomics helps us in the study of relationship between large numbers of macro economics variables. The variables are Aggregate consumption, Aggregate income, aggregate saving, Aggregate investment, Aggregate demand, Aggregate supply, Price level2.  To know the functioning of economy     Macroeconomics helps us to know how the economy functions, how it is regulated, For it macro economics provides us the knowledge of product market, labor market, capital market, land market, international trade market etc. it in forms us the country can achieve equilibrium only if all of the markets are in equilibrium.3. To correct unfavorable balance of trade and paymentMacroeconomics provides us different theories of international trade. It provides us different remedies of import dependency and greater outflow of money from the country. The government or country may adjust custom duty, exchange rate, transaction of gold etc to promote export and to reduce import.4. To achieve high economic growth and employment levelWith the help of theories and models of economic growth and employment we can induce investment increase in income and employment opportunitiesThus, these are the importance of micro and macro economics.Read more: http://notes.tyrocity.com/nature-of-economics-class-xi-economics-hseb-notes/#ixzz4fUAAO4LJFollow us: tyrocity on Facebook


opportunity cost

What is Opportunity Cost?

The basic economic problem is the issue of scarcity. Because resources are scarce but wants are unlimited, people must make choices. This lesson showcases the most important concept in macroeconomics, which is the concept of opportunity cost. Very simply, everyone has the same amount of hours in a day, but we all make different decisions about what we do, what we choose to buy, and how we spend our time. What determines these choices? Opportunity cost does. 

Every time you make a choice, there is a certain value you place on that choice. You might not know it or think about it, but every choice has a value to you. When you choose one thing over another, you're saying to yourself, I value this more than another choice I had. 

The opportunity cost of a choice is what you gave up to get it. If you have two choices - either an apple or an orange - and you choose the apple, then your opportunity cost is the orange you could have chosen but didn't. You gave up the opportunity to take the orange in order to choose the apple. In this way, opportunity cost is the value of the opportunity lost. 

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Value: Benefits and Cost

Value has two parts to it. It has benefits as well as costs. If you choose an apple over an orange, maybe the apple costs less, but maybe you enjoy it more. So, looking at choice in terms of benefits and costs helps you make better economic decisions. To make a good economic decision, we want to choose the option with the greatest benefit to us but the lowest cost. 

Monetary Value

For example, if we graduate from college and suddenly find ourselves in the job market, there are choices to be made. Let's say that two jobs become available to us. We can either work for Company A or Company B. The job with Company A promises to pay us $20 an hour, while Company B offers to pay us only $10. Based on this information alone, of course most people would choose Company A. 

Why? Because Company A is paying a higher salary. But when you look at this kind of a choice in only dollar terms, you're only seeing it from the perspective of the benefits. Let's take that same example, but now we discover that the job for Company A requires a fancy dress suit that will cost you $1,500. You realize that the job with the higher salary may not be worth it to you. Now you're starting to think economically. You're thinking economically when you look at the value of a choice through the eyes of its benefits and costs. 

Whatever we choose, the opportunity cost is the value of the choice we could have had. The opportunity cost of working for Company A is the value of what we gave up to take the job. We gave up the value of working for Company B, so that is the opportunity cost of choosing to work for Company A. In this example, we focused more on the monetary costs. The challenge is, most people get stuck evaluating choices only in monetary terms, but there's more to the story. 

Value of Time

The value of a choice to you might be in terms of time or in terms of the enjoyment you could have experienced. When Benjamin Franklin originally explained this concept in his book, titled Advice to a Young Tradesman, he said that 'time is money.' He was trying to communicate the concept of opportunity cost by saying that what you do with your time, whether or not you are productive, can be just as important as any decision you make with money.


Opportunity Cost Examples

Here are a few examples:

Let's say you have only $100 to spend and you have two choices: you can eat at a nice restaurant or buy seven music albums instead. If you spend your $100 on buying the albums, the opportunity cost of that choice is the delicious meal you did not choose.

As I already said, this concept works for spending money, but it also works in regards to time. Let's say you only have two hours of free time. You could either go to a movie or visit the bookstore. If you choose to spend your time at the movies, the opportunity cost of this decision is the time you could have spent enjoying the bookstore.

You can apply the concept of opportunity cost to land as well. If we assume that land can either be used to produce corn, or it can be used for raising cattle to produce beef, but it cannot be used to do both at the same time, we have two choices and we must make a decision. Let's say we're already producing corn, but we want to switch to raising cattle so we can produce beef. In this case, the opportunity cost of switching from producing corn to raising cattle is the amount by which the production of corn decreases, because that's the value of our next best alternative.

Lesson Summary

To summarize what we've talked about in this lesson, scarcity creates choice, and every choice has value to us. That value can be looked at in terms of benefits and in terms of cost. Value is not always measured in financial terms but sometimes measured in terms of time or enjoyment. The opportunity cost of a choice is what must be given up in order to take an opportunity. It's not the opportunity we chose, but the value of the next best alternative we didn't choose. Every major choice has an opportunity cost, and later on, you'll learn how to calculate it.

Lesson Objectives

After you finish this lesson you'll be able to:

  • Define concepts like scarcity and opportunity cost
  • Understand the different ways economics can measure value
  • Comprehend how benefits and costs are weighted when making a choice
  • Know why opportunity cost must be viewed in comparative terms
  • How to Calculate Opportunity Cost

                                                                                                                 Chapter 1                                        /                                         Lesson 3                                                                                                                      Transcript                                                                                                                                                                                                                                                                                                                                                        

  •                                                                                                                                                                               0:12                                                                                                                                                                                                              Add to TimelineAutoplay243K views                                                        Lesson Transcript                                                                                                                                                               Instructor:                         Jon Nash                                                    

    Jon has taught Economics and Finance and has an MBA in Finance

                                                                                                                                                         Learn the formula that reveals the economic value in any major choice between two possibilities. Every choice involves tradeoffs, and opportunity cost shows you how to measure these tradeoffs.       

    Best Economical Choice?

    So now we have a choice between two alternative possibilities. We can either choose one thing or another but not both. For example, we could choose to spend our time knitting or walking but not both. How do we know what the best economical choice is? By calculating the opportunity cost of each choice.

    Opportunity cost is a relative concept, which means that you're finding out how much of one thing you can produce in comparison to another thing.

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    It's All Relative

    For example, if the two goods you're interested in are rice and wheat, then the opportunity cost of producing rice will always be in terms of wheat, and the opportunity cost of producing wheat will always be in terms of rice. The opportunity cost of choosing one possibility is the value of the possibility you gave up. It's what you sacrificed. It's not what you chose, but it's the next best alternative.

    Let's look at how to calculate opportunity cost using land as an example. In country A, we can use the same amount of scarce resources to produce two things, but we can only choose one thing at a time to produce.

    Calculation Examples

    Let's say the two things we produce are corn and beef. We can use land to either produce corn or produce beef.

    The next thing we need to know in order to calculate opportunity cost is how much corn could we produce compared to how much beef we could produce. And remember that we're using the same amount of resources, so this kind of problem really is going to give us a basis for comparing two alternative choices.

    Let's say that in Country A, we can either produce 50 tons of corn, or as an alternative, we can produce 25 tons of beef. This is our tradeoff between producing these two things. Now we have all the information we need to calculate opportunity cost, but we need to know which opportunity cost we're trying to measure based on which possibility we want to choose.

    Let's start by looking at it from the corn perspective. The opportunity cost of producing 50 tons of corn is equal to how many tons of beef we could have produced, which of course is 25 tons. Therefore, the opportunity cost is found by solving this equation:

    50 tons of corn = 25 tons of beef

    What we really want to know is how much beef we could have produced if we choose to produce 1 ton of corn, but the question gave us 50 tons. To reduce this equation down, we divide each side by 25 and this gives us:

    2 tons of corn =1 ton of beef

    And then reducing it down one more time, gives us:

    1 ton of corn = ½ ton of beef.

    That's our answer. The opportunity cost of producing a ton of corn is ½ a ton of beef.

    We only looked at this choice from one perspective. Let's look at it from the opposite perspective. If Country A can either produce 50 tons of corn or 25 tons of beef, then what is the opportunity cost to them producing 25 tons of beef? It's the value of the next best alternative, which, of course, is producing 50 tons of corn. So, in this case, our equation is as follows:

    25 tons of beef = 50 tons of corn.

    Same equation, different order. Reducing this down, we get:

    1 ton of beef = 2 tons of corn.

    So what does this mean? It means that the opportunity cost of producing one ton of beef is equal to the 2 tons of corn we could have produced instead. We sacrificed 2 tons of corn in order to produce a ton of beef.

    Why do we care about this? Because we want to know what we're good at, so ultimately we can specialize in doing this instead of doing something we're not as good at. Opportunity cost reveals the value in any decision. Why should I spend all my time producing beef if I can use the same amount of resources and produce twice as much corn? Opportunity cost just revealed this to us.

    Economics is all about getting the best results with the least amount of effort or producing a larger quantity of one thing with the same amount of resources.

    How about another example? Let's say that in one hour on a Saturday night, I can either type 3 term papers or bake 1 dozen chocolate chip cookies. What is my opportunity cost of choosing to write a term paper? My equation looks like this:

    3 term papers = 12 chocolate chip cookies

    Dividing by 3 on each side, I reduce it down to:

    1 term paper = 4 chocolate chip cookies

    So, the opportunity cost to me of choosing to write a term paper during this one hour on a Saturday night is that I would sacrifice 4 cookies.

    Lesson Summary

    You can use this method to calculate the opportunity cost for any major choice, whether it's on the level of two goods or whether it's at an economy-wide level of choosing between capital goods and consumer goods.

    The economic skill you've just learned is the building block for creating the production possibility curve.

    Lesson Objectives

    By the end of this lesson you'll be able to:


    • Make efficient economical choices by calculating opportunity cost
    • Understand how calculating oportunity costs is viewed in relative terms
    • Calculate opportunity costs by comparing relative production costs

Applying the Production Possibilities Model

Applying the Production Possibilities Model

Producers in the economy use a visual model, called the production possibilities curve, to make the most efficient production decisions and maximize output. Learn how this model reveals the tradeoffs of every production decision with the simplified example of an economy that produces only two goods.       

Production Possibilities Model

We're talking about the production possibilities model in this lesson. The classic version of the production possibilities model is the comparison between two goods that a nation can produce - either guns or butter - and it must choose between these two goods. Famous people in history have used this analogy, including William Jennings Bryan, Margaret Thatcher and even leaders in Nazi Germany. In fact, the song 'Guns Before Butter' was written in 1979 by Gang of Four about this concept.

This graph is used to show the production possibilities between two goods

The production possibilities model is a visual model of scarcity and efficiency. It simplifies the concept of how an economy can produce things using only two goods as an example. It's going to show us all the production possibilities we have between these two goods. It takes the concept of opportunity cost, which we already explored, and helps us make the best economic decision we can make, which is to say, the most efficient decision.

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Important Assumptions

There are some important assumptions we need to talk about regarding the production possibilities model. The question we're trying to answer is this: How much of each good should we produce in order to produce them in the most efficient way? For example, how many term papers and cookies should I make to get the most efficient combination? Or how much corn versus how much beef should country A produce to be the most efficient? That's where the production possibilities model comes in.

There are three important assumptions involved in using the production possibilities model:

  1. Resources are used to maximize capacity (very important).
  2. Resources are scarce.
  3. Technology remains completely constant.

We're trying to use our resources to the fullest, but we only have limited, or scarce, resources. We're also assuming, right now, that the technology we use to produce our goods isn't changing at all. So, what are we really saying? If you are producing the right combination of two goods, then you're using your resources efficiently. Why is this important? Because it reveals to us all the tradeoffs of changing our production possibilities.

Tradeoffs in Production Possibilities

We can pick any two points on a production possibilities curve and explain the tradeoffs, or opportunity cost, of producing different combinations of these two goods. For example, if our economy is producing cars and computers only, we can choose to produce many different combinations of cars and computers. Since our resources are scarce, we can't produce as much as we want, but we can produce, for example, zero cars or ten computers. We could choose instead to produce five cars and zero computers. Why are these two numbers different? Because in this example, these two activities have different production rates.

When we compare the production rates, we can speak in terms of opportunity cost, like this: If we make ten computers, we lose the opportunity to make five cars and vice versa. By reducing this fraction down, we can say the opportunity cost of producing one car is two computers. As you can see, it takes more time and resources to produce a car than it does a computer, and the production possibilities model will show us this visually.

Now, I just said we could produce zero cars and ten computers or five cars and zero computers. But there are many other production possibilities in between these two that we could choose instead. With our finite resources, we could choose to produce two cars and six computers or four cars and two computers. Then again, we could produce three cars and four computers. When you account for all the possible combinations, given the opportunity cost of one car equals two computers, you end up with a line like the one you see here, in this simple example.

Law of Increasing Opportunity Costs

This law illustrates that switching from one good to another will increase costs

Okay, time out. I want to clarify something important. Although the production possibilities model shows a straight line in this example, in the real world, the production possibilities model is a curve. As you produce more and more of one good instead of another, the opportunity cost will increase because some of the resources in an economy are only capable of producing one type of good. Which means that switching from one good to another will increase costs, and the more you switch from one good to another, the more expensive it gets. We call this the law of increasing opportunity costs, but some people call it the law of diminishing returns, which is the same thing.

For example, if an economy is producing some combination of cars and computers, and it wants to produce more cars, it will have to give up the opportunity to produce some computers, right? What happens is that each time you choose to produce additional cars, you don't get the same benefit; you don't get the same return for making that decision. Expanding your equipment so you can make more cars instead of computers becomes more and more difficult and expensive as you continue to do it. The result is that you give up more and more computers each time you add additional cars, which means opportunity cost is increasing. As you move from one side of the curve toward the other, this dynamic of increasing opportunity cost, or diminishing returns, continues to happen. It continues to happen until you reach a point somewhere in the middle where there is no benefit to producing more of one good and less of another. This is why the production possibilities curve is bowed outwards. It's bowed outwards, or shaped like a curve, because of the law of increasing opportunity costs.

Production Possibilities Curve

Here are some facts that we know to be true about all production possibilities curves. One is that any point outside the curve is not attainable. Any point outside of the curve is not a production possibility, because our resources are scarce, which means we have a capacity we won't be able to go over; a limit we can't exceed. It's our barrier of production.

The other fact we know is that any point inside the production possibilities curve is possible, but it's not efficient. The curve itself is an efficiency curve, which means it's showing us all the ways we can simultaneously produce two goods efficiently. That means any point that's inside the curve is not using all of our resources. So, if we choose to produce one car and two computers, we're producing less than our capacity. We have the resources to produce more stuff, but we choose not to.

To review, any point outside the curve is not possible, and points inside the curve are possible but not efficient. When you're a business or a firm and you're trying to maximize your profit, you're very concerned about producing at your capacity so you can earn the greatest profit. If you're an individual, you may be concerned about maximizing your income, but you're also concerned about maximizing your time, or perhaps, your enjoyment.

So, why is the production possibilities curve bowed outwards? To answer this, let's talk about what's happening when we make a move from one point on the curve to another. The curve represents the fact that there is an opportunity cost for every production possibility. If we want to switch from producing zero cars to one car, we know that we could only produce eight computers instead of ten. The opportunity cost of this switch is the value of what we gave up to get it, which in this case means we would have to give up the opportunity to produce two computers, or at least this is how we've been simplifying it.

But in reality, it can cost a lot more to reallocate resources than simply handing over the metal that was meant for computers to the car manufacturer, particularly when we shift our resources toward making only cars or only computers. If we push to make much more of one product than the other, then production is less efficient, and we have a higher opportunity cost.

Lesson Summary

To summarize what we've talked about with the production possibilities model:

  • Scarcity leads to choice, and every choice has tradeoffs, which we call opportunity costs.
  • The production possibilities curve shows the opportunity costs of producing two goods in an economy.
  • An economy that is perfectly efficient will produce on the curve instead of inside or below the curve.
  • The curve is bowed outwards because of the law of increasing opportunity costs.

Now that you know what the curve is, you'll be able to recognize situations and scenarios that can change it, and this will help you understand how a nation attempts to increase its productivity.

Lesson Objectives

Upon completing this lesson, you'll be able to:

  • Describe how the production possibilities curve works
  • Understand the role scarcity plays in production possibility
  • Analyze production quality of an economy based on a production possibilities curve analysis
  • Explain why the bow of a production possibilities curve is bowed outward
  • Determine trade-offs of various changes in production

Shifts in the Production Possibilities Curve

Shifts in the Production Possibilities Curve

In this lesson you will learn how changes inside an economy lead to changes in the production possibilities of a nation. See how different scenarios from everyday life lead to shifts in the production possibilities curve.       

Production Possibilities Frontier

The production possibilities frontier (PPF) is an economic model used to illustrate how people and nations should decide what goods to produce, how much to produce, and for whom they should produce it. It's a model and a concept that looks at only two goods at a time. For example, what combination of cars and computers should a nation produce?

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The Production Possibilities Curve

The production possibilities curve illustrates all the possible combinations of how we can produce these two goods given the constraints we have, including the fact that resources are scarce. The question we're answering in this lesson is, 'What causes the production possibilities curve to shift?'

Before we answer this, let's review some of the basic ideas about the production possibilities curve, using two types of curves. Let's say we have a production possibilities curve showing the production of two goods: cars and computers.

Consumer and Capital Goods

Economists also use the PPF model to illustrate two categories of goods, both consumer goods and capital goods. So here is what that PPF curve looks like.

Every point along the curve is efficient; points outside the curve are unobtainable or inefficient

In any economy, investments into capital goods will do more to increase economic growth than investments into consumer goods will. For both of these types of curves, every point along the curve is efficient, meaning this combination of producing two goods is at our capacity. We're producing the most that we can with the least amount of costs. Movement along this curve reveals the trade-offs that are required to produce more or less of a good. We said that any point inside the curve is not efficient, and any point outside the curve is unobtainable.

The best example in history of when America's economy was inside the curve was during the Great Depression. At that time, unemployment was extremely high, and production was extremely low. But eventually, during World War II, our economy moved from inside the curve to somewhere on the curve. Now we're producing things as fast as we can, largely driven by the war, but we are on the curve. Even though we were producing a lot more, we still had a limit, a capacity that we couldn't exceed, unless something major changed. That's why any point that is outside the curve is not possible.

The production possibilities curve, whether it is showing two specific goods, such as cars and computers, or two types of goods, such as capital goods and consumer goods, shows us how much is produced, which means it's showing us a picture of output.

Shifts in the PPF Curve

So, now we can talk about shifts in the entire curve. The basic idea is that anything that causes economic output to increase or decrease will shift this curve. In any economy, the major goal that you're trying to achieve is growth, which is to say, producing increasing amounts of the goods and services that consumers demand.

An outward shift in the curve reflects growth, while an inward shift means decreasing output

Given the fact that resources are scarce, we have constraints, which is what the curve shows us. When the economy grows and all other things remain constant, we can produce more, so this will cause a shift in the production possibilities curve outward, or to the right. If the economy were to shrink, then, of course, the curve would shift to the left. When the curve shifts outward, or to the right, that means output is increasing. When the curve shifts inward, or to the left, that means output is decreasing.

Shifts in the production possibilities curve are caused by changes in these things:

•Advances in technology

•Changes in resources

•More education or training (that's what we call human capital)

•Changes in the labor force

Shifts in Technology

Let's briefly explore each one of these and see how they shift the curve. Probably what you hear about most in economics is how changes in technology affect the curve.

For example, let's say the country discovers a new technology, such as a new computer system that improves productivity. Anything that improves the productivity of workers is good. This causes output to increase, so the production possibilities curve shifts outward, or to the right. On the other hand, let's say a major war causes destruction of capital equipment in the country.  This would cause output to decrease, so in this case, the production possibilities curve shifts inward, or to the left.

Shifts in Resources

Changes in resources are also going to shift the curve - for example, if a country discovers a new energy source, like new solar panels, let's say. This causes output to increase, which shifts the production possibilities curve outwards, or to the right. On the other hand, if the country gets devastated by a major hurricane, it's not too difficult to imagine that this setback would make it more difficult to produce things. This causes output to decrease, which in turn shifts the production possibilities curve inward, or to the left.

Shifts in Education and Training

Now let's talk about education and training. When more people in the work force get educated or trained, we refer to that as human capital. Education and training increase knowledge, and knowledge tends to increase productivity, so this would shift the production possibilities curve to the right.

Shifts in Labor Force

Finally, if there was a sudden increase in the labor force, either from a population boom or, more likely, from immigration, then the production possibilities curve shifts outward, or to the right. Why is this? It's because more people working means more production possible.

This works in reverse as well. If the country experiences more unemployment, then the unemployment rate goes up. That means the labor force is shrinking, so more people are not working and not being productive. This would decrease the output of the nation, and shift the production possibilities curve inward, or to the left.

Lesson Summary

To summarize, the production possibilities frontier (PPF) is a model that helps us decide what to produce, how to produce it, and for whom to produce it.

Consumer goods are final goods that are purchased directly by consumers, while capital goods represent machinery, tools, and equipment, or anything that is used to produce consumer goods.

Shifts in the production possibilities curve are caused by things that change the output of an economy, including advances in technology, changes in resources, more education or training (that's what we call human capital) and changes in the labor force. Increases in the production possibilities curve are represented by shifts outward, or to the right, while decreases are represented by shifts inward, or to the left.

Lesson Objectives

By the end of this lesson you'll be able to:

  • Summarize the production possibilities frontier
  • Define consumer and capital goods
  • Recognize causes for shifts in the production possibilities curve
  • Portray shifts in production on a graph

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Opportunity Cost: Formula & Analysis

Opportunity Cost: Formula & Analysis

A fundamental economic analysis--whether you're running a country, a business or your personal finances--determines the opportunity costs of a decision. In this lesson, you'll learn about opportunity cost, its formula and how to calculate it.       

What Are Opportunity Costs?

Meet Lilith. She owns a small, start-up tech company that manufactures smartphones and tablets. Lilith has some important business decisions to make concerning the allocation of her company's resources over the next fiscal year. A large part of her decision-making analysis will concern calculating and assessing opportunity cost.

You can think of opportunity cost as the benefit or value you give up by picking one course of action over another. In other words, the opportunity cost of a decision is the difference between the value you receive from pursuing a course action and the value that would have received from the alternative you did not pursue. Let's look at Lilith's tech company to illustrate the concept.

Lilith can use one day to manufacture either 100 smartphones or 75 tablets. If she chooses to manufacture the phones, the opportunity cost is the difference in profits of producing 75 tablets. On the other hand, if she chooses to manufacture the 75 tablets, it costs her the difference in profits of manufacturing 100 smartphones.

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Formula

We generally want to analyze opportunity costs in terms of investment, whether it's a person or a business making that investment. We can express opportunity cost in terms of a return (or profit) on investment by using the following mathematical formula:

  • Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue

Unless the investment returns are fixed and practically guaranteed to be paid (like a U.S. Treasury bond you intend to hold to maturity), you'll have to base your calculation on the expected returns. For example, on average, the stock market may have an annual return of 8%, but that doesn't mean your stock portfolio will return 8% this year.

Now, let's apply the formula to an example. Lilith's company has a 10% return when it sells smartphones, but an 18% return when it sells tablets. Let's plug in the numbers and see what happens:

  • Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue.
  • Opportunity Cost = 18% (return on tablets) - 10% (return on cell phones)
  • Opportunity Cost = 8%

If Lilith orders the production of smartphones, she'll have to give up the opportunity to earn an extra 8%. Of course, we are assuming that there is sufficient demand for tablets to expend all Lilith's production capacity on tablets.

Capital Structure Decisions

You can use an opportunity cost analysis to help you decide how to best capitalize a business. A business's capital structure is simply how a company finances its operations. Capital structure may involve a mix of long-term debt, short-term debt, and equity (equity is the infusion of capital into a business through the sale of shares of common stock or preferred stock to investors).

What's opportunity cost have to do with a business's capital structure? If you finance your capital through debt, you have to pay it back even if you aren't making any money. Moreover, money allocated to servicing debt can't be spent on investing in the business or pursuing other investment opportunities, such as the stock and bond markets.  Let's look at an example on how a business can use opportunity cost analysis to determine whether or not obtaining an infusion of capital through debt is a smart move.

Lilith wants to make more money. She could use her company's present earnings, along with a loan, to finance the upgrade of her factory. This would help to increase her profits through better products and improved efficiency and productivity. On the other hand, she could invest her company's current earnings in the stock market.  Let's say that Lilith can obtain financing from a commercial lender sufficient to upgrade her facility, and she projects a 13% return after paying the cost of financing. Her financial advisor projects that investments in the stock market will yield an 11% return. Let's do the math.

  • Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue.
  • Opportunity Cost = 13%  (debt-financed return from renovation) - 11% (stock market return)
  • Opportunity Cost = 2%

In other words, she'll give up a 2% return if she opts to invest in the stock market instead of financing an upgrade through debt. This illustrates the power of leverage--you can make money by borrowing if your investment of the borrowed money yields a higher rate of return than the interest charged on the debt.

A Dose of Reality

Keep in mind that the calculations and analyses we have performed throughout the lesson are based on predictions and assumptions that may not hold true in the real world. For example, Lilith's factory upgrade may not yield as high of a return as she projects, and we all know that the stock market can go up or down in any given year. Consequently, realistic assumptions and projections are essential if an opportunity costs analysis is to be of any real use.

Lesson Summary

Let's review what we've learned. Opportunity cost is the benefit you forego in choosing one course of action over another. You can determine the opportunity cost of choosing one investment option over another by using the following formula:  Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue.

Opportunity cost analysis is an important tool in making business decisions, including determining the capital structure of the business. However, since opportunity cost analysis looks at the future, it's important to be very realistic about your underlying assumptions.

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Comparative Advantage: Definition and Examples

Comparative Advantage: Definition and Examples

Understand the definition of comparative advantage, using two goods as an example. This key lesson incorporates the basic foundations of economics into one foundational theory explaining what goods and services that people,and nations, should produce and for whom they should produce it.       

Comparative Advantage

In the late 1700s, the famous economist Adam Smith wrote this in the second chapter of his book The Wealth of Nations:

'It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy... What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom.'

He's observing two important principles of economics. The first one is that nations behave in the same way as individuals do: economically. Whatever is economical for people is also economical on a macroeconomic, or large, scale. The second thing he's observing is what we call the law of comparative advantage. When a person or a nation has a lower opportunity cost in the production of a good, we say they have a comparative advantage in the production of that good.

Everyone has something that they can produce at a lower opportunity cost than others. This theory teaches us that a person or a nation should specialize in the good that they have a comparative advantage in.

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Examining Opportunity Costs

So, let's explore this concept of comparative advantage using some examples from everyday life. For example, Sally can either produce 3 term papers in one hour or bake 12 chocolate chip cookies. Now let's add a second person, Adam, and talk about the same two activities, but as we'll see, Adam has different opportunity costs than Sally does. Adam is capable of producing either 8 term papers or 4 cookies in an hour. If we express both of these opportunity costs as equations, then we have:

For Sally, 3 term papers = 12 cookies.

For Adam, 8 term papers = 4 cookies.

We can ask two different questions about opportunity cost because we have two different goods. The first question we want to know is: what is the opportunity cost of producing 1 term paper? Reducing these equations down separately gives us:

For Sally, 1 term paper = 4 cookies. For Adam, 1 term paper = 0.5 cookies.

So, in this case, who has the lowest opportunity cost of producing 1 term paper? Adam does. Now, let's look at the same scenario from the opposite perspective and answer the second question: what is the opportunity cost of producing 1 cookie?

Now, I know that, in reality, no one is going to produce exactly 1 cookie unless it were a very, very big cookie, but when we reduce the equations down to 1 cookie, we can easily compare on an apples-to-apples basis (or cookie-to-cookie basis). So, let's take a look at the equations again:

For Sally, we have 12 cookies = 3 term papers.

For Adam, we have 4 cookies = 8 term papers.

Reducing these equations down gives us 1 cookie = 0.25 term papers for Sally, and for Adam 1 cookie = 2 term papers.

So, how do we decide who should produce term papers and who should be produce cookies? According to who has the lowest opportunity costs. That's what the law of comparative advantage says.

Who has the lowest opportunity cost of baking cookies? Sally does. Who has the lowest opportunity cost of producing term papers? Adam does.

So, we have two goods and two different people who have two different opportunity costs. The law of comparative advantage tells us that both of these people (Adam and Sally) will be better off if instead of both producing term papers and cookies, they decide to specialize in producing one good and trade with each other to obtain the other good.

This leads us to the conclusion that we should specialize. Individuals should specialize in the goods or services they produce. Firms and corporations should also specialize in what they have a lower opportunity cost of producing, and nations should specialize as well. Whoever has the lowest cost relative to someone else can trade with them, and everyone gains something by trading.

Absolute Advantage

Now that we've explored the law of comparative advantage, we need to make an important distinction. When a person or country has an absolute advantage, that means they can produce more of a good or service with the same amount of resources than other people or countries can. Another way to say it is they can produce it more cheaply than anybody else. This is a measure of how productive a person or country is when they produce a good or service. For example, let's say that country A can produce a ton of wheat in less time than any other nation with the same amount of resources. In this case, country A has an absolute advantage in the production of wheat.

Let's take another look at Sally and Adam, this time from the perspective of their labor productivity. As you can see, it takes Sally a 1/4 hour to produce 1 cookie, which is lower than the 1 hour that it takes Adam. Therefore, Sally is the most productive. She has an absolute advantage in the production of cookies.

In addition, it takes Sally 1 full hour to produce a term paper, while Adam can produce the same term paper in half the time - it's a 1/2 hour to produce a term paper for Adam; therefore, Adam has an absolute advantage in producing term papers.

But the theory of comparative advantage is based on lower opportunity costs, not based on absolute advantage. It is possible to have the absolute advantage in the production of two goods (in other words, you have the ability to make both goods the quickest, cheapest, and the best) and still benefit from trading with someone else who has a lower opportunity cost.

For example, let's say country A can either produce 10 cars or 10 computers. This means that  they have the exact same opportunity costs for these two goods, and we can reduce this equation down to 1 car = 1 computer. Now, if country B can produce either 4 cars or 8 computers, then their opportunity cost of producing 1 computer is equal to 1/2 a car (after we reduce that equation down).

I want you to notice something, though. On the corresponding graph, you can see that country A can produce cars and computers better, faster and cheaper than country B because their production possibility curve is outward (or to the right) of country B's production possibility curve. But look at the slope of country B's curve. It is steeper. Even though country A has an absolute advantage in the production of cars and computers, it still makes sense for them to trade with country B, who has a lower opportunity cost of producing computers. (It's 1/2 a car!) So, the law of comparative advantage leads us to the conclusion that these two countries will trade with each other - cars for computers. Country B will specialize in computers (because they have the lowest opportunity cost in this) while country A will specialize in cars.

Lesson Summary

To summarize what we've learned in this lesson, the law of comparative advantage says that a person or a nation should specialize in the good they produce at the lowest opportunity cost. Everyone has something that they can produce at a lower opportunity cost than others, and by trading with others everyone is better off.

Lesson Objectives

Once you complete this lesson, you'll understand the law of comparative advantage and how it explains which goods and services a country should produce.

                                                                                             Print Lesson

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Gains From Trade and the Benefit of Specialization

Gains From Trade and the Benefit of Specialization

Explore one of the most widely accepted ideas in economics - the idea that nations benefit from specialization and exchange, reaping gains from trade.       

Why Nations Trade

Why do nations trade goods with each other? Nations exchange goods with each other when they expect to gain from the exchange. We call that gains from trade. Adam Smith, a famous economist from the 18th century, talked about this in his book, Wealth of Nations, and so did economist David Ricardo.

The theory of comparative advantage teaches us that nations should specialize in the production of the goods in which they have the lowest opportunity cost, and trade with other nations.

The reason this works is because nations tend to have different resources, and they're not equally efficient when they are producing goods, which means they have different opportunity costs. When they have different opportunity costs of producing goods, it is possible to gain from trading. When both nations trade, they both will experience an increase in output, because they don't have to switch between one task and another. They also increase their skill level because they're doing the same task over and over again. This makes them more productive, and empowers them to produce at a level that goes beyond their production possibilities curve.

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The Benefit of Specialization

For example, let's say that the United States can produce more strawberries with the same amount of resources than Canada can. This means the U.S. has an absolute advantage in the production of strawberries. Now, my first thought about that would be, the U.S. should definitely specialize in strawberries because in this example, they are the best at it. But my perspective is nearsighted, because I'm not accounting for the concept of opportunity cost, which shows me what the U.S. would have to give up in order to specialize.

Having an absolute advantage in the production of a good doesn't always mean you have a comparative advantage.

The graph shows Canada has the lowest opportunity cost for strawberries

So let's take this idea further and see where it leads:

The U.S. can produce 20 strawberries or 80 apples while Canada can produce 15 strawberries or 5 apples. That means that the opportunity cost to the United States of producing 1 strawberry is 80/20, or 4 apples. It also means that if the U.S. specialized in strawberries, they'd have to give up 4 times as many apples to do so.

Canada's opportunity cost of producing 1 strawberry is 5/15, or 1/3 of an apple. If they decide to specialize in strawberries, they'd only have to give up only 1/3 of the amount of apples to do so.

We can also look at these opportunity costs from the opposite perspective. The opportunity cost to the U.S. of producing 1 apple is 20/80, or 1/4 of a strawberry while Canada's opportunity cost of producing 1 apple is 3 strawberries.

Here's what that looks like:

Who has the comparative advantage in strawberries? The country with the lowest opportunity cost for strawberries, which is Canada.

Who has the comparative advantage in apples? In this case, it's the U.S. because they have the lowest opportunity cost of producing apples.

Based on this information, now we can conclude that the United States should specialize in apples while Canada should specialize in strawberries.

If these two countries exchange apples and strawberries, they will both experience gains from trade. In the beginning, it looked like the U.S. should produce both goods for its own people, because it has an absolute advantage in both goods, but based on the law of comparative advantage, they both are better off if they specialize and trade. Both economies will become more productive.

Lesson Summary

To summarize what we've talked about, having an absolute advantage in the production of two goods isn't always the same as having a comparative advantage.

The theory of comparative advantage teaches us that nations should specialize in the production of the goods in which they have the lowest opportunity cost (a comparative advantage), and trade with other nations.

When nations specialize, this exchange creates gains from trade. The benefits of specialization  include a larger quantity of goods and services that can be produced, improved productivity, production beyond a nation's production possibility curve, and finally, resources that can be used more efficiently.

Lesson Objectives

Once you complete this lesson you'll be able to:

  • Understand the theory of comparative advantage
  • Explain the benefits of specialization

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Absolute Advantage in Trade: Definition and Examples

Absolute Advantage in Trade: Definition and Examples

In this lesson, you'll learn what absolute advantage is and how to easily identify it within examples of international trade. In addition, you'll learn the important difference between absolute advantage and comparative advantage.       

Absolute Advantage

In the 1700s, famous economist Adam Smith taught us that countries should find out what they can produce more efficiently (which really means cheaper, better and faster), and then specialize in what they do best while trading with other countries who are also doing what they're best at.

For example, let's say you're entering the job market and you're evaluating your options for a career. At the same time, your neighbor, Bob, is also evaluating his options. Now, you have an absolute advantage over Bob in baking cakes. Whether it's chocolate cake, vanilla cake or pineapple-upside-down cake, if both of you baked the same cakes side-by-side, you'd be the one who could bake three times as many cakes in an hour as he could. You're really good at baking cakes, and certainly better than Bob is (who's struggling to get the first cake rolling). Between the two of you, you are the best at it. In economics, we say you have an absolute advantage over your neighbor when you can produce a good more efficiently in the same amount of time.

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Theory of Comparative Advantage

When we take the same concept and apply it to the world economy, we find that some countries have an absolute advantage at producing goods. Why is that? Because resources tend to be different in different countries. One country is rich in oil, while another country has an abundance of coconuts. When resources are different, it tends to create absolute advantages.

This idea became the basis of international trade for many years. If everyone exports what they're best at, then most countries will be better off because they'll be able to produce and sell more, and they'll have access to a lot more goods and services that other countries produce more efficiently than they do. But absolute advantage is different than comparative advantage, and it's important to know the difference.

Another famous economist, David Ricardo, saw the great ideas that Adam Smith had about absolute advantage, but also saw some limitations. For example, if everyone simply does what they're best at and trades with the rest of the world, it is possible that some countries aren't best at anything (or at least maybe they haven't discovered it yet).

David Ricardo would look at the same career example that we just talked about (between you and your neighbor), and notice something very important. He would notice that not only are you better than your neighbor at baking cakes, but you have the skill to be a rocket scientist as well. In order for you to choose a career as a cake boss, designing incredible enormous cakes for weddings and special events, you'd have to give up or sacrifice the opportunity to pursue an even more profitable career - starting a company that designs rockets that take people into space for short vacations, let's say.

Economist David Ricardo taught us about opportunity cost, which is what you have to give up in order to make a choice. In your case, to choose your absolute advantage as a cake boss, you would have to give up a rocket design career worth even more to you.

This led to the theory of comparative advantage, which says that nations should specialize in producing the good in which they have the lowest opportunity cost. In the end, people would not only look at absolute advantage, but they would also consider comparative advantage when deciding what goods to produce and for whom to produce them.

Comparative vs. Absolute Advantage

Here's an important point to remember: everyone has a comparative advantage in something, but may not have an absolute advantage. You could be better than Bob at everything, but Bob may have a lower opportunity cost of becoming a cake boss, based on the fact that he isn't a rocket scientist.

When we look at international trade, we see that a nation can have an absolute advantage in the production of every good, but they will not have a comparative advantage in everything. Absolute advantage is an important first step in this process, and that's why it's very helpful to learn how to identify it.

Example #1

Let's look at two more examples:

Let's say there are only two countries: country A and country B, and they produce only two goods: corn cereal and designer jeans. Here's an illustration of how much each country can produce of these two goods using only one hour of labor to produce them:


Country  Corn Cereal  Designer JeansCountry A  10  3Country B  15  4

As you can see, country B can produce more of both goods than country A. They can produce either 15 boxes of corn cereal or four pairs of jeans per hour. Country A, on the other hand, can only produce ten boxes of corn cereal or they can produce three pairs of designer jeans instead. So, what can we say about these two countries and their production possibilities?

Country B has an absolute advantage in the production of both goods (in this case, corn cereal and designer jeans). That means they have an absolute advantage because they can produce more of these goods in the same amount of time.

Example #2

Finally, let's look at another example from the perspective of labor productivity. Let's say that country A and country B can produce two goods: salmon or coconut crème pies.


Country  Salmon  Coconut Crème PiesCountry A  2 labor hours  3 labor hoursCountry B  3 labor hours  6 labor hours

As you can see, we have two countries producing two goods again; however, instead of looking at how many goods they can produce in one hour, we're looking at how long it takes to produce one good. This is what we call labor productivity. So what can we say about these two countries?

Country A is capable of catching and canning one salmon in two hours. It takes them two labor hours to produce one good. To do the same thing, it will take country B three hours instead. We can see the same pattern going on with coconut crème pies. Country A can produce one coconut crème pie in three hours of labor, while it's going to take country B six hours (or twice as long) to produce the same good.

Now that we've looked at these two production possibilities and compared the numbers for both goods, we can say that country A has an absolute advantage in the production of these two goods.

Lesson Summary

To summarize what we've learned in this lesson, Adam Smith taught us about absolute advantage - that countries should find out what they can produce more efficiently (which means cheaper, better and faster), and then specialize in what they do best while trading with other countries who are also doing what they're best at.

Because resources tend to be different in different countries, some countries have an absolute advantage over producing goods. The idea of absolute advantage is different than the theory of comparative advantage, which says that nations should specialize in producing the good in which they have the lowest opportunity cost. Everyone has a comparative advantage in something, but may not have an absolute advantage. While a nation can have an absolute advantage in the production of every good, they won't have a comparative advantage in everything.

Lesson Objectives

Once you complete this lesson you'll be able to:

  • Know what absolute advantage means
  • Understand the difference between comparative advantage and absolute advantage
  • Explain what absolute advantage tells us about what a country should focus on producing
  • Comprehend how the absolute advantage theory applies to both micro and macroecnomics

demand and supply

demand and supply

Market Demand Schedule

Demand can often drive the cost up or down for a product or service. In this lesson, you'll discover what demand is, what it looks like, and how market demand schedules are created.       

Economics

Economics is the study of how people use scarce resources in order to satisfy unlimited needs and wants. When individuals attempt to satisfy their needs and wants by purchasing a good or service, economics calls it demand. Let's talk about demand, what it looks like, and how it determines the market demand schedule.

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Demand

I don't know about you, but I love bananas. Bananas can be peeled and eaten, but they can also be used to make a variety of other desserts. For example, my favorite dessert is called bananas foster. But the point is, I am willing and able to buy bananas.

My demand for bananas would change, depending on the price of the bananas in the store. When bananas cost me 30 cents each, then I buy six of them. But, at a price of 60 cents for the same bananas, I'm only willing to buy three of them.

Quantity Demanded

Quantity demanded is the quantity of a good or service that an individual is willing and able to buy at a certain price. Now I just said that if the price of a banana is 30 cents, then the quantity of bananas I demand would be six. But I'd only want three bananas if the price went up to 60 cents. So, what does this really tell us? The quantity of a product or service demanded changes as price changes.

Demand Schedule

A demand schedule is a table that lists the quantity demanded for a good that people are willing and able to buy at all possible prices. You can use it to describe the demand for a good or service in a particular area such as your hometown, or for example, in a local grocery store. That's what the demand schedule is for. For example, the demand schedule for bananas at the supermarket might look like this:

Demand Schedule for Bananas


Cost  Supply30 cents  500 bananas week40 cents  487 bananas a week50 cents  382 bananas a week60 cents  240 bananas a week

The demand schedule shows you how the demand changes when you increase or decrease the price. As you can see from this demand schedule, when the price goes from 30 cents all the way up to 60 cents, the amount of bananas demanded goes down.

Now, the demand schedule works the same way for services. So, let's look at a demand schedule for Bob's lawn-cutting services in his neighborhood.

Demand Schedule for Bob's Low-rider Lawn Mowing


Cost  Supply$15  50 cuts per week$20  47 cuts per week$25  39 cuts per week$30  29 cuts per week$35  12 cuts per week$40  1 cut per week

As you can see, this demand schedule shows the quantity demanded at each possible price for the service that Bob performs for the neighborhood.

The Market Demand Schedule

All right, let's talk about the market demand schedule. Let's go back to bananas, because I'm thinking about that banana desert right now. There are people all over the country who want (or demand, as we say) bananas. What we want to know in economics is: how many bananas will everyone in the whole economy buy at different prices? That's where the market demand schedule comes in. What we're doing is combining all the demand schedules together, not only for the local grocery store, but all the stores everywhere in our country - wherever bananas are available for sale.

The market demand schedule is a table that lists the quantity demanded for a good or service that people throughout the whole economy are willing and able to buy at all possible prices. Let's look at a Market Demand Schedule for Bananas:

Market Demand Schedule for US Bananas


Cost  Supply30 cents  96,000 tons of bananas per week40 cents  89,000 tons of bananas per week50 cents  75,000 tons of bananas per week60 cents  51,000 tons of bananas per week

So, as you can see, instead of listing the quantities demanded each week from the local supermarket, it shows you how many tons of bananas are demanded each week across the entire economy.

Lesson Summary

In summary:

When individuals attempt to satisfy their needs and wants by purchasing a good or service, economics calls it Demand.

  • The quantity demanded is the quantity of a good or service that an individual is willing and able to buy at a certain price. The quantity demanded of a product or service changes as the price changes, and the demand schedule shows you this.
  • A demand schedule is a table that lists the quantity demanded for a good that people are willing and able to buy at all possible prices.
  • The market demand schedule is a table that lists the quantity demanded for a good or service that people throughout the whole economy are willing and able to buy at all possible prices.

Lesson Objectives

By the end of this lesson, you'll know:

  • What demand is
  • How to determine quantity demanded
  • The structure and purpose of a demand schedule

Market Supply Schedule

Market Supply Schedule

Supply and demand play big roles in the economy. In this lesson, you'll discover what supply is, how we describe it, and how market supply schedules are created.       

Economy

An economy is a system in which suppliers produce the goods and services that consumers demand. It's where consumers make choices about what to consume, and producers decide what to produce and how much of it to produce. So, let's talk about supply, what it means, what it looks like, and how we get the market supply schedule.

Supply is the relationship between the quantity of a good or service and its price. It's how much of a product or service is available for sale in a market.

The supply of bananas that nearby banana growers produce will change depending on the price of the bananas in the store. When bananas can be sold for 30 cents each, then local banana growers are willing to produce, let's say, 400 of them per week. If the price of bananas goes up to 60 cents for the same bananas, local banana growers are excited at the thought of how much profit they can make, and they're willing to supply 800 bananas instead. This is what we call quantity supplied.

Quantity supplied is often dependent on what price sellers can get.×

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Quantity Supplied

Quantity supplied is how much of a good or service sellers are willing and able to supply at a particular price. When you start to tally up all the different prices you could charge for a good or service, then you find a different quantity supply for each price. That's why we have what's called a supply schedule.

Supply Schedule

I'm not sure about you, but when I hear the words 'supply schedule,' I immediately think of some sort of calendar telling me when I'm supposed to pick up cleaning supplies or food, canned goods or something. This is not what we're talking about in macroeconomics.

A supply schedule is a table that illustrates how much of a good or service suppliers are willing and able to supply at many different prices. For example, the supply schedule for local bananas sold at the supermarket might look like this:

Supply Schedule for Bananas


Cost  Supply30 cents  500 bananas week40 cents  600 bananas a week50 cents  775 bananas a week60 cents  1000 bananas a week

The supply schedule shows you how the supply changes when you increase or decrease the price. As you can see from this supply schedule, when the price goes from 30 cents to 60 cents, the amount of bananas supplied goes up.

Now, the supply schedule works the same way for services. Let's look at a supply schedule for Bob's Low-Rider Lawn-Cutting services in the neighborhood.

Supply Schedule for Bob's Low-Rider Lawn Mowing


Cost  Supply$15  32 cuts per week$20  35 cuts per week$25  39 cuts per week$30  45 cuts per week$35  60 cuts per week$40  80 cuts per week

As you can see, this supply schedule shows the quantity supplied at each possible price for the service that Bob performs for the neighborhood. At a price of $25 per cut, Bob is willing and able to cut 39 lawns. At a price of $40 per cut, he's willing to cut 80 lawns per week. The higher the price Bob gets for his service, the more profit he can make, and the more lawns he's willing to cut. Let's just hope that, with all those bananas supplied, Bob doesn't end up running over too many banana peels in the process and going bananas.

The Market Supply Schedule

Let's talk about bananas again.  In the very first example, we looked at the local banana growers and how many bananas they were willing and able to supply to the supermarket. But, these are not the only banana growers in the economy. People are buying bananas in supermarkets all over the country, which means the supply of bananas is much larger. What we want to know in economics is: how many bananas will all the suppliers supply at different prices? That's where the market supply schedule comes in.

The market supply schedule is a table that lists the quantity supplied for a good or service that suppliers throughout the whole economy are willing and able to supply at all possible prices. Let's look at a market supply schedule for bananas:

Market Supply Schedule for U.S. Bananas


Cost  Supply30 cents  85,000 tons of bananas per week40 cents  89,000 tons of bananas per week50 cents  100,000 tons of bananas per week60 cents  130,000 tons of bananas per week

As you can see, instead of listing the quantities supplied each week from the local supermarket, it shows us how many tons of bananas suppliers are willing to supply each week across the entire economy. In reality, they're not necessarily going to sell this many, because the people buying bananas will buy fewer bananas when the price goes up, but they key is that the market supply schedule shows us the number of bananas that banana growers are willing and able to sell.

Lesson Summary

To summarize what we've talked about in this lesson:

  • Supply is the relationship between the quantity of a good or service and its price. It's how much of a product or service is available for sale in a market.
  • A supply schedule is a table that illustrates all the quantities supplied at different prices. The supply schedule shows you how the supply changes when you increase or decrease the price.
  • The market supply schedule is a table that lists the quantity supplied for a good or service that suppliers throughout the whole economy are willing and able to supply at all possible prices.

Lesson Objectives

By the end of this lesson you'll be able to:

  • Define supply
  • Illustrate quantities supplied at different prices using a supply schedule
  • Observe changes in quantity supplied at different costs
  • Analyze a market supply schedule

The Law of the Downward Sloping Demand Curve

The Law of the Downward Sloping Demand Curve

Discover the relationship between the quantity demanded and price of a good or service in a market. This lesson explains why the demand curve is downward sloping and what factors will lead to a shift in demand.       

Introduction

Economics is the study of how people use scarce resources in order to satisfy unlimited needs and wants. When people buy goods and services, we call it demand. They demand products and services. The way we describe demand at different prices is called quantity demanded.

You know this on an everyday level when you go into a grocery store. It's whether or not you want tangerines or oranges instead. It's whether or not you want one bunch of bananas or three bunches.

When people make decisions with their money as to what goods and services to buy, there is a pattern that emerges for almost every good or service in an economy, which we call the law of demand. It shows us the relationship between quantity demanded and price. You know from observing this many times that when you're in the grocery store and the price of something goes down, you tend to want to buy more of it.

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The Law of Demand

The law of demand says that, all other things equal, if the price of a good or service goes up, the demand for it will decrease, and if the price of a good or service goes down, the demand for it will increase.

How do we know this? Well, we can look at a demand schedule, which is a table illustrating the quantity demanded for a good or service at different prices. For example, the demand for bananas can be seen by looking at a demand schedule for bananas, and here it is:


Market Demand Schedule for US Bananas30 cents  96,000 tons of bananas per week40 cents  75,000 tons of bananas per week50 cents  65,000 tons of bananas per week60 cents  60,000 tons of bananas per week

As you can see, this market demand schedule tells us that if the price of bananas were 50 cents, then people would buy 65,000 tons of bananas each week. However, if the price fell to only 40 cents, then demand would increase from 65,000 to 75,000. That means consumers would be willing and able to buy 10,000 additional tons of bananas each week at this price. This dynamic is exactly the same no matter what the price is. The lower the price becomes, the more demand people have for this good. The higher the price becomes, the less demand people have for this good.

The Substitution Effect

Why does demand change this way? What makes the law of demand true?

One thing that we can observe is called the substitution effect. The substitution effect happens when the price of one good goes down enough so that it becomes cheaper than something else, and because of this decline in price, people actually change their behavior and substitute the cheaper good for something else they would normally buy. This is because people make some of their decisions based on how much products and services cost relative to other products and services. When the price of a good goes down far enough, they will substitute this cheaper product for another more expensive one.

If I'm standing in the grocery store, and I'm looking at oranges and tangerines (and let's just say I like these equally), then I might buy one container of tangerines each week. But if I come back to the same store next week and the price of the oranges has declined by 25%, then I decide to buy oranges instead of tangerines, which are now more expensive relative to the oranges. I'm willing to substitute oranges for tangerines, and that's one of the main reasons why the law of demand works.

The Demand Curve

In economics, we illustrate demand using the downward sloping demand curve, which is a graph that illustrates the relationship between price and quantity demanded for a good or service. The demand curve is a visual representation of the demand schedule, which shows quantity demanded at different prices. If we're talking about bananas, then we take the demand schedule for bananas and we use it to create the demand curve for bananas.


Market Demand Schedule for US Bananas30 cents  96,000 tons of bananas per week40 cents  75,000 tons of bananas per week50 cents  65,000 tons of bananas per week60 cents  60,000 tons of bananas per week

As you can see, the demand curve for bananas is downward sloping, just like almost every demand curve is. As price changes, we travel from one place to another on the demand curve. At a price of $0.60, we're up high on the demand curve, and at a price of $0.30, let's say, we're down at the bottom of the curve.

The downward slope of the demand curve

Now, demand for a product or service can change even if the price stays the same. It can either increase or decrease. If demand increases, then the downward sloping demand curve will increase also by shifting to the right. If demand decreases, on the other hand, then the demand curve shifts to the left.

An increase in the demand for bananas looks like this. Here's the original demand curve we already looked at, and here's a second demand curve to the right of the first one, showing the increase in demand. The entire demand curve increased by shifting to the right. Just as it goes up, demand can also go down, and here you can see the original demand curve shifting to the left.

Demand Shifters

So, let's talk about demand shifters. Variables besides price that cause a shift in demand, whether it's an increase or a decrease, are called demand shifters. Demand shifters include:

What a shift to the left looks like on a graph

If income goes up, then the demand for goods and services goes up as well. If buyers' preferences make a product more popular, then demand will increase. When there are changes in demographics, such as a larger population or an aging population, then demand is going to change. When the population size increases, there are more buyers chasing the same amount of goods, which increases demand. Likewise, as the population ages, it may need different goods and services, which will affect demand, and it shifts the demand curve. We already saw that when oranges become cheaper than tangerines, which is a substitute good, then the demand for oranges will go up. Finally, if your expectations about tomorrow change, you may change your buying behavior today. Demand is affected by expectations. For example, if you hear on television that the price of gas is going up tomorrow, you're more likely to go out today and fill up your entire tank with gas at today's prices.

Lesson Summary

Now, to summarize what we've talked about in this lesson: the law of demand says that, all other things equal, if the price of a good or service goes up, the demand for it will decrease, and if the price of a good or service goes down, the demand for it will increase.

The substitution effect happens when the price of one good goes down enough so that it becomes cheaper than something else, and because of this decline in price, people actually change their behavior and substitute the cheaper good for something else they would normally buy.

In economics, we illustrate demand using the downward sloping demand curve, which is a graph that illustrates the relationship between price and quantity demanded for a good or service. The demand curve is a visual representation of the demand schedule, which shows quantity demanded at different prices.

Variables besides price that cause a shift in demand, whether it's an increase or a decrease, are called demand shifters. When you're talking about factors that shift a demand curve, you're talking about factors that affect the buyers, who are the ones who demand the goods. The demand shifters include:

  • Income
  • Preferences
  • Demographics
  • Price of a substitute good
  • Expectations

Lesson Objectives

By the end of this lesson you'll be able to:

  • Explain the relationship between quantity demand and the price of a good
  • List concepts that instigate shifts in demand
  • Illustrate demand using a downward sloping demand curve
  • Understand the substitution effect on demand

The Upward-Sloping Supply Curve

The Upward-Sloping Supply Curve

Discover the relationship between the quantity of a good or service that is produced and its price. This lesson explains the supply side of a market, including the factors that lead to a shift in supply.       

We're talking about the upward-sloping supply curve. In order to do so, let's use cake as an example, since that's exactly what I'm wishing I was eating right at this moment.

Imagine that your next door neighbor Mandy is a cake boss. Her business, Mandy's Cake Walk, makes cakes all day long for a profit - they make chocolate cakes, vanilla cakes, and ice cream cakes. Sounds good, huh? They make fancy wedding cakes, and they also make cakes shaped like a volcano that sell in the grocery store. One time, they even made a cake in the shape of the Leaning Tower of Pisa. The challenge was that the ingredients in the cake were not as strong as the materials in the tower and the cake tower fell over on top of Bob, who owns a well-known lawn-cutting business. The only way to see that cake is by looking in your neighbor's photo album!

So let's talk about the supply of cakes and what happens to it under different circumstances - but first, a general principle. The nature of supply in almost any market is as follows:

The greater the price of a good or service is, the greater the quantity that will be supplied.

If the price of a good or service goes up, the supply for it will also go up, and if the price goes down, the supply of it will decrease. How do we know this? Because we can look at a supply schedule, which is a table that illustrates the quantity supplied for a good or service at different prices. For example, the supply for cakes throughout the whole economy can be seen by looking at the market schedule for cakes, and here it is:


Market Supply Schedule for Basic Round Cakes$15 100,000 cakes per week$20 150,000 cakes per week$25 175,000 cakes per week$30 180,000 cakes per week

As you can see, at a price of $15 per cake, cake suppliers are willing and able to supply 100,000 cakes. However, at a price of $30, they'll have a much higher profit potential and would be willing and able to supply as many as 180,000 cakes.

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The Supply Curve Comes from the Supply Schedule

In economics, we illustrate supply using the upward-sloping supply curve, which is a graph that illustrates the relationship between price and quantity supplied for a good or service. The supply curve is a visual representation of the supply schedule, which shows quantity supplied at different prices.

If we're talking about cakes, then we take the supply schedule for cakes and use it to create the supply curve for cakes. Here's the corresponding supply curve taken directly from the supply schedule. Notice that a change in price results in movement along the supply curve.

The supply curve illustrates the market supply schedule for cakes

Supply Shifters

Let's talk about supply shifters now. Factors besides price that cause a shift in supply, whether it's an increase or a decrease, are called supply shifters. The factors that lead to a shift in the supply curve are not related to the buyers of a good or service; they're related to the suppliers of the good or service, so they're mostly about the production process. Supply shifters include:

  • Prices of inputs
  • Technology
  • The number of sellers in the market
  • Returns from alternative activities
  • Seller expectations
  • Natural disasters

Let's look at an example of each one of these supply shifters using Mandy's Cake Walk.

When the price of inputs change, this generally leads to a change in supply. Last year, Mandy's Cake Walk paid $1 for a dozen eggs, which is one of the most expensive ingredients in a cake. However, this year, the price of eggs rose to $2 per dozen - a 100% increase. Since eggs are an input to the cake production process, the price of that input really matters. When the prices of inputs go up, the profit potential goes down, decreasing supply. Assuming all other things are equal, Mandy will want to produce fewer cakes when the profit potential goes down.

Now imagine that Mandy sees an online news story about the price of eggs and learns that prices are expected to go up by 20% overnight. What's she going to do when she hears this news?  Mandy grabs her purse, gets into her car, and heads over the store as quickly as possible so she can buy extra eggs before the price goes up. This is what we call seller expectations.

Mandy also has special ovens that enable her to bake two cakes per oven at the same time. But Ray, an oven salesman, shows up at Mandy's door and offers her a new and improved oven that enables her to bake five cakes per oven. Wow! This is an example of  improvements in technology. If Mandy buys the new oven, this improvement means her business can supply even more cakes to the market.

Now let's say that it's been six months since Mandy has been selling cakes all over town. She's been in the newspaper and she's also been on TV. Bob, a local businessman, still remembers the time when a Leaning Tower of Pisa cake fell on him in public, and although it was something that he'd like to forget, he did taste the cake and loved it, and so did Bob's wife, Linda. With Bob's help, Linda starts a cake business and competes with Mandy. The number of people who demand cakes throughout the year hasn't changed; in fact, nothing has, except that there are now two cake suppliers instead of one, which means that the supply of cakes just went up. An increase in the number of suppliers leads to an increase in the supply.

One day, Mandy wakes up and realizes that the price of soup has risen by 50%. She's been baking cakes for a long time, but she realizes that she could be earning a much higher profit by making soup instead. This is what we call the returns from alternative activities, and it also leads to a shift in supply. Mandy will probably choose to make fewer cakes so she can make and sell soup to increase her profit. She may choose to completely give up the cake business and pursue making soup since Bob's wife Linda decided to start making cakes and compete with her. So, in the end, the supply of cakes goes down because of the return on an alternative activity, which, in this case, is soup.

Two months later, let's say, a major storm comes through town and destroys half of Mandy's cake ovens and equipment. What a terrible thing. This natural disaster decreases her ability to produce cakes, which will decrease the supply of cakes in the market, at least until Mandy can get back on track. Thankfully, Mandy had a great insurance policy to cover her business, so she's up and running again within three months.

You can begin to see now how each one of these things will affect and shift the supply curve.

Summary

To summarize what we've talked about in this lesson, the nature of supply in almost any market is as follows:

The greater the price of a good or service is, the greater the quantity that will be supplied.

If the price of a good or service goes up, the supply for it will also go up, and if the price goes down, the supply of it will decrease. This is shown by the upward-sloping supply curve, which is a graph that illustrates the relationship between price and quantity supplied for a good or service. The supply curve is a visual representation of the supply schedule, which shows quantity supplied at different prices.

Factors that lead to a shift in supply are called supply shifters, and they're related to the suppliers of the good or service, so they're all mostly about the production process. Supply shifters include:

  • Prices of inputs
  • Technology
  • The number of sellers in the market
  • Returns from alternative activities
  • Seller expectations
  • Natural disasters

Lesson Objectives

By the end of this lesson you'll understand the relationship between the quantity of a good and its price. You'll also recognize factors that contribute to supply shifts.

How to Calculate Market Equilibrium

How to Calculate Market Equilibrium

Supply and demand is an important part of macroeconomics. In this lesson, you'll learn how to calculate the equilibrium price and quantity in a market at the intersection of the supply and demand curves.       

Supply and Demand

We're talking about supply and demand, and how they interact to create the market equilibrium. The demand curve illustrates the quantities of a good or service that buyers are willing and able to buy at every price. While the supply curve, on the other hand, illustrates the quantities that sellers are willing and able to sell at every price. So, let's look at an example first from the supply perspective and then from the demand side.

A business will produce more supply if consumers will pay more for a product.×

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Market Equilibrium

I want you to imagine that right in front of you are two hats. One hat is blue, while the other hat is green. Both of these hats fit you perfectly. The blue hat represents the business owners, which we call suppliers. The green hat, on the other hand, represents the consumer who demands products and services. In order to understand market equilibrium, you have to be willing to wear one hat at a time, which means you're either wearing the hat of a supplier or a consumer. Then you can step back and see both sides of the market at the same time and understand how it works, and why it makes sense.

Now imagine that your next-door neighbor Mandy bakes cakes for a living, and the name of her business is Mandy's Cake Walk. So, put on your supplier hat as you think about this. Here's the market supply schedule for basic round cakes.

Because Mandy is in business to earn a profit, she, and every other cake business in the economy, wants to sell cakes for a high price - as high as possible. And the cake suppliers are willing and able to sell more and more and more cakes the higher the price. As you can see, suppliers want high prices, and more cakes.

Now it's time to take off your supplier's hat and put on your consumer's hat. Let's look at it from the other perspective. Here's the market demand schedule for cakes. When the price of cakes is $30, then all the consumers in the economy would be willing and able to buy 50,000 cakes. When the price goes down to $25 though, they buy 100,000. And when it drops to $20, they're willing to buy 125,000 cakes per week. They'd even buy 175,000 cakes a week if the price were as low as $15.

Market equilibrium is achieved when both buyer and seller agree on a common price.

So now we have a market - we have buyers and we have sellers. A market is where buyers and sellers meet in order to exchange, and a transaction will only take place if the price is right for both of them. Let's bring the buyers and sellers together in this market and see what the price of cakes will turn out to be given the demand that consumers have right now and the quantity that suppliers are currently willing to sell.

When the demand and supply curves are combined, at the intersection of demand and supply, we can find the market equilibrium, which is the only price where the quantity demanded equals the quantity supplied. It's the exact price at which buyers are willing to buy a product or service and sellers are willing to sell it.

Notice that in this case, the two curves intersect at a price of $20 per cake. At this price the quantity demanded and quantity supplied are totally equal. This means the market for cake is in equilibrium. Unless the demand curve shifts, or the supply curve shifts, the price of cakes should not change.

Okay, so we've talked about cakes. Let's talk about another example. The following table shows the schedule of supply and demand for coffee, per month.

By looking for the price in which demand and supply are exactly the same, we can locate the market equilibrium price. In this case, the equilibrium price is $1.25 per pound, because that's the price at which the quantity demanded (700) is equal to the quantity supplied (also 700). As you can see, we can clearly illustrate all this information using supply and demand curves that intersect at a market equilibrium price of $1.25 per pound.

When an excess of a product exists, it is called a surplus.

Surplus and Shortage

Alright, let's revisit Mandy and the market for cakes. So, here we have the quantity demanded and the quantity supplied; this is the market schedule for both. We learned from the supply and demand schedules that the equilibrium price in the cake market was $20, because this is the price at which both the seller and buyers are willing to exchange. So, now we'd like to know, what happens if the price of cakes were set by the suppliers at $25, instead of $20? I'm glad you asked!

We can see from the combined demand and supply schedule that at a price of $25 suppliers would be thrilled to bake even more cakes. Specifically, they'd be willing and able to supply 200,000 cakes. But wait a minute, look at the quantity demanded by consumers at that price! At $25 per cake, consumers wouldn't be willing to buy 200,000; they wouldn't even be willing to buy 125,000. They'd only be willing to buy 100,000.

This is what we call excess supply, otherwise known as a  surplus, and it's when the quantity supplied exceeds the quantity demanded. When a surplus exists, suppliers will lower the price until the market reaches equilibrium again. A surplus creates downward pressure on the price, which eliminates the surplus. In the market for cakes, when the price is $25 per cake, there is a surplus of 200,000 minus 100,000, which is a surplus of 100,000 cakes.

Now, what happens if the price of cakes were set by the suppliers at $15? Although consumers would be thrilled to buy cakes on sale and would buy as many as 175,000 cakes, suppliers would not make as much profit and would only be willing to supply 100,000.

If demand surpasses the supply, companies will raise prices on products.

This is what we call excess demand, otherwise known as a shortage, and it is when the quantity demanded exceeds the quantity supplied. When a shortage exists, suppliers will raise the price, and fewer consumers will choose to buy until the market reaches equilibrium again. A shortage creates upward pressure on the price, which eventually eliminates the shortage. In the cake market, when the price of cake is $15, then there is a shortage of 175,000 minus 100,000, which is equal to a shortage of 75,000 cakes.

Lesson Summary

To summarize what we've talked about in this lesson: the demand curve illustrates the quantities of a good or service that buyers are willing and able to buy at every price. The supply curve, on the other hand, illustrates the quantities that sellers are willing and able to sell at every price. When the demand and supply curves are combined, at the intersection of demand and supply we can find the market equilibrium, which is the only price where the quantity demanded equals the quantity supplied. It's the exact price at which buyers are willing to buy a product or service and sellers are willing to sell it.

A surplus exists when the quantity supplied exceeds the quantity demanded. A surplus creates downward pressure on the price, which eliminates the surplus. Finally, a shortage exists when the quantity demanded exceeds the quantity supplied. A shortage creates upward pressure on the price, which eventually eliminates the shortage.

Lesson Objectives

By the end of this lesson you'll be able to calculate market equilibrium and determine if a market is experiencing a surplus or shortage.

How Changes in Supply and Demand Affect Market Equilibrium

How Changes in Supply and Demand Affect Market Equilibrium

Learn how the equilibrium of a market changes when supply and demand curves increase and decrease and how different shifts in the curves can affect price.       

Introduction

The demand curve shifts rightward when cookie demand increases

When a market is in equilibrium, the price of a good or service tends to stay the same. Equilibrium is the price at which the quantity demanded by consumers is equal to the quantity that's supplied by suppliers. When either demand or supply changes, however, the equilibrium price and quantity will also change. That's what we're talking about in this lesson - changes in the market equilibrium.

Let's look at some examples of changes in demand and supply, including an illustration of what happens when both demand and supply increase or decrease simultaneously. Before we begin, here's a helpful list of all the possible changes to equilibrium that you'll encounter in macroeconomics:

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Overview of Changes in Equilibrium Prices


Shifts in the Demand Curve (when supply is unchanged)to the rightmeans an increase in demandcauses equilibrium to increaseto the leftmeans a decrease in demandcauses equilibrium to decrease


Shifts in the Supply Curve (when demand is unchanged)to the rightmeans an increase in supplycauses equilibrium to decreaseto the leftmeans a decrease in supplycauses equilibrium to increase

As you can see, an increase in demand causes the equilibrium price to rise. On the other hand, a decrease in demand causes the equilibrium price to fall. An increase in supply causes the equilibrium price to fall, while a decrease in supply causes the equilibrium price to rise.

Well, as it turns out, I'm thinking about chocolate chip cookies right now. For some reason, talking about macroeconomics really increases my demand for cookies. Ever since they removed the Cookie Monster from public television's 'Sesame Street,' I've noticed a remarkable decrease in the supply of cookies in my house; however, my demand for cookies has only gone up and up and up! So, let's look at an example of equilibrium in the cookie market and see what happens when things change.

Let's say the equilibrium price for a chocolate chip cookie is $3. Here's an example of the supply and demand curves, with an equilibrium price of $3, which is at the intersection of the supply and demand curves. At a price of $3, consumers will demand and suppliers will supply 5,000 cookies per year. Wow, that sounds great, doesn't it? What happens when something causes a shift in demand? Well, I'm glad you asked!

A drop in cookie demand causes the demand curve to shift to the left

When household incomes increase by 30% this year (hey, this could happen!), that means that the demand for cookies goes up. If the demand for cookies increases, then this causes a shift of the demand curve to the right. As you can see, a new equilibrium is created after the shift. The new equilibrium price is higher than the old one because demand increased. At the new equilibrium, the price for a cookie is now $5, and the quantity demanded, which is the same as the quantity supplied, is 7,500 cookies at this higher level of price.

Okay, so now, let's say that instead of increasing, household incomes decrease this year by 30%. When they do, the demand for cookies is definitely going to go down. A decrease in the demand for cookies will cause the demand curve to shift to the left, and, assuming no change in anything else, the equilibrium price will go down. The new equilibrium price is going to be $2. At this price, only 2,500 cookies will get sold in this market instead of 5,000.

So far, we've talked about what happens to the demand for cookies. Let's look at the supply side now.

There are various things that could lead to a shift in supply, but let's say that a weird blue tornado flies through the city of Chiphaven, in West Cookieland. (It's a beautiful place. I've been there - you should go there. It's a great place for vacation - the kids would love it.) Unfortunately, half of all the cookie factories are located here in Chiphaven, and the tornado picks up all the cookie factories in the air (in addition to tens of thousands of cookies, if you can imagine that) and destroys them. Thankfully, Studio 65, the nearby disco, is perfectly intact!

So, what's the effect of this event? This natural disaster is going to lead to a decrease in the supply of cookies. A decrease in the supply of cookies causes the equilibrium price to rise. The new equilibrium price is $5 a cookie, and the associated quantity has gone down to 2,500 cookies.

Let's look at this example from the opposite point of view.

When a gigantic new cookie factory is built in Chiphaven, suddenly the nearby disco is flush with tons of cookies for sale. In this example, the increase in supply causes the equilibrium price to fall to $2, and consumers are willing and able to buy a lot more cookies (7,500) at this price.

Simultaneous Changes in Demand and Supply

Now let's talk about what happens when both curves shift simultaneously.

What would happen if both the demand and the supply curves increased? Well, that would lead to a rightward shift in the demand for cookies in our previous example. Let's say that the quantity demanded rises from 5,000 cookies to 7,500 cookies, but we can't determine the new equilibrium price because we don't know how much each of the curves has shifted relative to each other. So, in this example, quantity goes up, but price is what we call ambiguous - we're not able to determine it.

A cookie supply increase causes the equilibrium price to drop

The opposite is true as well. When both the demand and supply curves shift simultaneously to the left (which means that demand and supply decreased), then we know that the quantity of cookies is going to go down. Let's say in this example that the quantity of cookies goes down from 5,000 to 2,500, but we don't know how much the equilibrium price is going to change because we can't tell, again, how much each of the curves shifted relative to each other. So in this case, quantity goes down, but price is ambiguous.

Lesson Summary

To summarize what we've talked about in this lesson, an increase in demand is illustrated by a rightward shift of the demand curve, which, all other things equal, causes the equilibrium price to rise. A decrease in demand is illustrated by a leftward shift of the demand curve, which, all other things remaining constant or equal, causes the equilibrium price to fall.

An increase in supply is illustrated by a rightward shift of the supply curve, and, all other things equal, this will cause the equilibrium price to fall. A decrease in supply is illustrated by a leftward shift of the supply curve - this will cause the equilibrium price to rise.

When both the demand and supply curves decrease at the same time, both curves are going to shift to the left, the quantity demanded goes down, and the new equilibrium price is going to either increase, decrease, or stay the same, depending on how much the curve shifted. But if the demand and supply curves both decreased by the same amount, then the new equilibrium price is going to be exactly the same - it's going to be horizontally to the left. When both the demand and the supply curves increase, both curves will shift to the right, and quantity increases, but price is ambiguous.

Lesson Objective

After this lesson you'll understand how shifts in supply and demand curves can affect market equilibrium and explain how these changes are reflected visually.

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macroeconomics

Gross Domestic Product: Using the Income and Expenditure Approaches

Gross Domestic Product: Using the Income and Expenditure Approaches

In this lesson, you will learn how economists measure gross domestic product using two different methods - the income approach and the expenditure approach.       

Measuring Total Amount of Production

On a warm sunny day a young man, Felix, is sitting on a beach overlooking the beach and the ocean. There's a slight wind blowing towards him that breaks up the heat from the sun, making this a perfect day to not be working at his job. As he sits on the bench, he takes out his wallet and looks inside, finding $300, which is the cash that he received when he took his most recent paycheck to the bank to cash it.

For the sake of a great economic illustration, let's say that Felix really loves ice cream. He loves ice cream so much that he buys a triple banana split in the morning then an hour later, he buys a milkshake as well as gelato. Every time he buys ice cream, he receives a receipt, which he adds to a pile that is beginning now to grow very tall next to the bench that he's sitting on. By the end of the day, he's spent all of the cash that he had in his wallet. It's all gone. That's right; he spent all $300 on ice cream, and he even has a gigantic pile of receipts to show for it.

Now it's 7:00 at night, and the sun's going down. All of a sudden, a young woman, Kelly, who's an economist by the way, sits down next to him. As they begin to talk with each other, Felix tells her the incredible story of how he spent everything in his wallet on ice cream, which represents his entire paycheck. Kelly, who's, by this time, quite astounded at his willingness to risk everything in an attempt to satisfy his unlimited want for ice cream, begins to think about this economically.

Kelly wants to know how much production took place in Felix's one-person economy. So, that's the question. As she thinks about it, she realizes that there are two ways she could find the answer. The first way would be to gather up all the receipts from every purchase that Felix made throughout the day - makes sense. If she adds up all the receipts of what he purchased, she will discover that he spent $300 total. Another way to say this is Felix had expenditures of $300. In addition to counting up all the receipts, Kelly realizes that she could ask Felix how much his paycheck was. So, Felix tells Kelly that he received a $300 paycheck, which he then promptly cashed and placed the money in his wallet.

As you can see from this example, you can measure the total amount of production that takes place using two different approaches. 1) By looking at how much money was spent (which we call expenditures) as well as 2) how much money was earned (which is income), and they both should be exactly the same, assuming that all the income was spent.

The economic activity of households, firms, and the government have a circular flow

Economists do the same thing that Kelly did when they examine the economy each year and estimate our total production by calculating GDP. GDP stands for gross domestic product, and it measures the total production in an economy. GDP  is the total market value of all final goods and services produced during a given time period within a nation's domestic borders. It is equal to the total income of the nation's households and also the total expenditures within the nation. Therefore, we can measure, or estimate, the total value of production from either the income side or the spending side.

So, we have two widely accepted ways to measure the total production in our economy. One is called the income approach, and the other is called the expenditure approach. The income approach measures the total income that is earned by all the households in a nation, while the expenditure approach measures the total amount of spending on goods and services that are produced within the domestic borders of the nation by households, firms, government, and even foreigners.

Both of these methods of measuring GDP are directly tied to the circular flow model for our economy in which households exchange their factors of production (such as labor) for income, and then they spend their income on the products and services that firms produce. At the same time, government receives taxes and makes purchases also within the circular flow of our economy.

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The Income Approach

Let's talk about the income approach first. The factors of production include land, labor, capital and entrepreneurship. Each of these factors of production are exchanged for a corresponding source of income; which we call rent, wages, interest, and profit. When Felix earned a paycheck, he was exchanging his factor of production - labor - for wages.

When you add up all this income, you arrive at our gross domestic product, using the income approach. In the story of Felix, remember that Kelly asked Felix how much he earned from his paycheck, which measured his income. She was using the income approach when she did this.

The Expenditure Approach

Now, let's look at the same economy but from the expenditure (or spending) side. Economic decision makers within our economy include households, firms, governments and foreigners. The spending that is directly connected with each of these decision makers is consumption, investment, government spending, and exports.

Now, when we combine all these types of spending together, we get the formula for GDP, which is: GDP = C + I + G + (X - M). Another way to say this is Gross Domestic Product = Consumption + Investment + Government Spending + (Exports - Imports). Sometimes you'll see (Exports - Imports) written as Net Exports, which simply means you are subtracting imports from exports.

When Kelly gathered up all the receipts that Felix received after purchasing all that ice cream, she used them to add up all of his expenditures. When she did that, she was using the expenditure approach.

Lesson Summary

Whether we look at gross domestic product from the income perspective or the expenditure perspective, we should arrive at exactly the same number because everything flows through the economy. Just like income and expenses needs to balance in an income statement, our nation's income and expenses should be identical.

Lesson Objectives

Once you complete this lesson you'll understand the expenditures and income approaches to calculating GDP.

and scrambled it to make a type specimen book.

Gross Domestic Product: Definition and Components

Gross Domestic Product: Definition and Components

Learn how economists measure the total production of an economy using gross domestic product (GDP). This lesson also outlines the components that make up a GDP. How do we calculate the economic value of a nation?       

Gross Domestic Product

One of the main ideas that economist John Maynard Keynes introduced is the idea that the number one driver of the economy is demand. If we can measure the economy in terms of what everyone spends, then we can estimate the level of production in our economy. We measure the economy using GDP.

GDP stands for gross domestic product. It's the official measure of the total output of goods and services in the economy. The definition of GDP is as follows: it is the total market value of all final goods and services produced during a given time period within a nation's domestic borders.

The word 'domestic' (in 'gross domestic product') means that we're only counting things that are produced within our domestic borders, whether they are produced by Americans or by foreigners. It doesn't matter. Nothing that is produced outside of our domestic borders gets counted in the GDP.

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Components of GDP

So, let's talk about the components of GDP, which come directly from the formula for GDP. The formula is as follows: GDP = C + I + G + (X - M). Another way to say this is that gross domestic product = consumption + investment + government spending + (exports - imports). Sometimes GDP is stated this way: gross domestic product = consumption + investment + government spending + net exports.

Now, consumption, which represents all of the purchases of goods and services made by households, accounts for the largest share of GDP, and it has averaged between 65% and 70% for many decades. Examples of consumption include things that consumers buy every day - things like cars, computers, rent, food, utilities and even clothes and other consumer products.

Another component is government spending, which includes federal, state and local spending on things like national defense, social security and the operational expenses of all the levels of government. Examples of investment (which is another GPD component) include the costs of building factories, regular business expenses, the construction of new homes and increases or decreases in business inventories.

Exports include goods and services that are produced within our borders but sold in other countries. Since money flows into our economy when we sell products and services to foreigners, exports add to our GDP. Imports, on the other hand, are goods and services that are consumed within our country but produced in other countries. Because money flows out from our country to purchase these goods and services, imports subtract from GDP.

Lesson Summary

Now, let's review the key points we talked about. GDP is the total market value of all final goods and services produced during a given time period within a nation's domestic borders. The formula for GDP is as follows: GDP = C + I + G + (X - M). Another way to say this is that gross domestic product = consumption + investment + government spending + (exports - imports). Notice that everything in the formula adds to GDP except for imports. Consumption, which represents all of the purchases of goods and services made by households, accounts for the largest share of GDP, about two-thirds.

Lesson Objectives

In this lesson we'll learn what Gross Domestic Product is and analyze its various components.

Gross Domestic Product: Items Excluded from National Production

Gross Domestic Product: Items Excluded from National Production

In this lesson, you'll gain a better understanding of what the gross domestic product is by exploring things that are excluded from it. Why do we count some items in the GDP but not others?       

Gross Domestic Product (GDP)

We're talking about a nation's GDP, and it's important to understand not only what's included in the GDP, but also what's not included in the GDP. GDP stands for gross domestic product and represents the total production of a nation within its domestic borders.

We know from the formula of GDP that gross domestic product = consumption + investment + government purchases + (exports - imports). However, there are some transactions that take place every day that don't get counted in the GDP. Let's talk about what's not included in the GDP and then look at some examples.

Basically, in order for something to be included in our GDP, it has to be something that is actually produced. It has to be something that isn't used to produce something else. It has to be produced here and not somewhere else, and it also has to be legal.

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What's Not Included in the GDP

So here is a list of things that are not included:

  • Sales of goods that were produced outside our domestic borders
  • Sales of used goods
  • Illegal sales of goods and services (which we call the black market)
  • Transfer payments made by the government
  • Intermediate goods that are used to produce other final goods

Let's say that Kelly, an economist-turned-opera singer, has been invited to sing in the United Kingdom. At the same time, an American computer company produces and sells all their computers in Germany, while a German company produces and sells all its cars here inside the borders of America. Economists need to know what gets counted and what doesn't.

Only goods and services produced domestically are included within the GDP. That means that goods produced by Americans outside the U.S. will not be counted as part of the GDP. When a singer from the United States holds a concert abroad, this isn't counted. On the other hand, goods and services produced and sold by foreigners within our domestic borders are counted in the GDP. When a famous British singer tours throughout the United States or a foreign car company produces and sells cars here in the U.S., this production does get counted.

If a foreign company produces and sells goods or services in the U.S., it is counted in the GDP

No used goods are included. When Jennifer purchases a lawnmower from her father, or Megan resells a book she received from her father, these transactions are not counted in the GDP. Only newly produced goods - including those that increase inventories - are counted in GDP. Sales of used goods and sales from inventories of goods that were produced in previous years are excluded.

Only goods that are produced and sold legally, in addition, are included within our GDP. That means that goods produced illegally are not counted. If there's a transaction that you see taking place in a parking lot with two cars and somebody's selling stereos, that's not going to be counted in the GDP.

Governments spend money in the economy, but they also send transfer payments to individuals. Transfer payments are not counted. An everyday example of a transfer payment would be a welfare check received by a household. When calculating GDP, transfer payments are excluded because nothing gets produced. Money is simply transferred from one group to another.

Final and Intermediate Goods

Let's talk about final and intermediate goods. Gross domestic product measures the total market value of all final goods and services produced within the domestic borders of a nation. The key word here is 'final.' Final goods include anything that is purchased directly by consumers in the marketplace. For example, a computer sold at a retail store is a final good. A new car that a consumer purchases is considered a final good.

If a good is used as an input, however, to produce another good, it's considered an intermediate good. For example, the plastic used to produce some laptop computers is an intermediate good. The steel that is used to produce cars which are sold at the dealership is also an intermediate good. Because they are not final goods, they're not counted in the GDP of a nation.

Intermediate goods, such as the plastic used to produce some laptops, are not included in the GDP

Let's say that you're a retailer that sells women's clothing. As you walk through your clothing store, you notice that most of the clothing is made from cotton that is turned into fabric. The clothing you sell would be included in GDP, but the raw materials that went into the product (in this case, cotton) would not. If the cost of the fabric was included in the GDP, the real market value of the good would be exaggerated because the cost of this material is already included in the price of the final product.

Another example of a final good is a newly constructed home. Homes are made up of many different kinds of intermediate goods. The wood that is used to produce the frame, the brick that's sometimes on the outside of the home, as well as the tile or carpeting that's probably installed inside the home - these are all examples of intermediate goods. The prices of these inputs are reflected in the price of the new home, which is the final good.

Lesson Summary

So let's review. Here is a list of items that are not included in the GDP:

  • Sales of goods that were produced outside our domestic borders
  • Sales of used goods
  • Illegal sales of goods and services (which we call the black market)
  • Transfer payments made by the government
  • Intermediate goods that are used to produce other final goods

Lesson Objectives

By the end of this lesson you'll have a better understanding of what GDP is by knowing which items are excluded from it.

Consumer Price Index: Measuring the Cost of Living and Inflation

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Consumer Price Index: Measuring the Cost of Living and Inflation

In this lesson, you'll learn what the Consumer Price Index is and how it measures changes in the level of prices in an economy. You'll also learn about the important economic concepts of inflation and deflation. Why do prices always seem to be going up?       

Introduction

In the economy, there is a circular flow of money, factors of production, and goods and services. For example, when Dave works for Mandy's Cake Walk as a cake decorator, he earns an income he can spend on goods and services. During the year, Dave spends his income on a wide variety of products and services. When Dave goes to the store, he takes $100 with him, and he buys a regular basket of items that he needs throughout the year. Let's say he buys eggs, milk, cereal, bread, a pound of ground beef, celery, and orange juice. He also buys gas for his car, pays a utility bill, and makes a monthly payment for shelter throughout the year. This year, Dave buys a used car, takes a vacation by airplane, and also goes to the doctor. All of these expenses are incorporated into the Consumer Price Index each year and measured across the entire economy.

There is a circular flow of money, where people work, earn income and purchase goods and services

Why is this important? Because next year, when Dave goes to the store and spends the same $100, he notices that his $100 does not buy the same amount of stuff. This is because the prices of goods and services tend to go up over time. Dave's cost of living has increased, not only when he goes to the store, but also when it costs more to fill up his gas tank and when it costs more to take a vacation. Inflation is one of the most important concepts you can possibly understand in macroeconomics, and it affects each and every one of us.

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Why Do Prices Rise?

Why do prices rise? One reason is changes in supply and demand. For example, when demand for products and services increases, suppliers will raise their prices in response. Likewise, when the Organization of Petroleum Exporting Countries (OPEC) decides to reduce the supply of oil, then, if nothing else changes, the price of oil (and therefore gasoline) will rise. Another reason that prices tend to rise is because the supply of money in an economy increases. This makes the value of each dollar worth less. The effect of a falling dollar is rising prices.

Inflation and Deflation

Let's take a look at inflation through the eyes of an economist. Inflation is a sustained increase in the average level of prices in the economy. The opposite of inflation is deflation, which is a sustained decrease in the level of prices in an economy. The inflation rate is the rate at which prices are increasing, usually on an annual basis. The inflation rate is a widely watched report released by the Bureau of Labor Statistics. In the 1970s, the U.S. experienced a dramatic increase in the rate of inflation that led to a major economic challenge, especially for business owners, who encountered extremely high rates on bank loans.

Economists measure inflation, or changes in the level of prices, using a price index. The Consumer Price Index is an index measuring the level of prices in the economy and comparing them to previous years in order to gauge the level of inflation in an economy. The Consumer Price Index reveals to us the capacity of our money to buy goods and services, which we call purchasing power. Purchasing power represents the amount of goods and services that $1 will buy. When prices go up that means the purchasing power of money has gone down.

The consumer price index compares a particular year to a base year and determines the inflation rate

Here's an example. An index is a number that starts at 100 in a certain year, which we call the base year. It changes over time in comparison with the base year and can be easily converted into a percentage since the base year starts at 100. For example, if the Consumer Price Index is said to start at 100 in the year 2010 and then the index increases to 103 in 2011, we can quickly calculate that prices in our economy have risen by 3 divided by 100, which is 3%. That means the inflation rate is 3% and that $1 will buy 3% fewer goods and services than it did at the end of the previous year.

Real Terms vs. Nominal Terms

Economic statistics are numbers that describe changes in the economy. They can be presented in two different ways - either as an original number or as a number that is adjusted for the cost of living, or inflation, which measures changes in the price level. Statistics that are presented to us in nominal terms show us the actual numbers before adjusting for changes in the level of prices. Statistics presented in real terms, however, show us numbers that already reflect changes in the price level and are, therefore, after inflation. Because of this adjustment, real data show us what something is worth in terms of its real purchasing power.

Here's an example: your neighbor, Bob, owns a lawn service. Bob's nominal income rises by 3% this year; the inflation rate, however, is 4%. What does that mean? That means that prices in the economy rose by more than Bob's income did. When he goes to spend his income, he'll find that he can't buy the same amount of goods and services that he could last year, even though in dollar terms his income went up. The formula for calculating this change of income in real terms is real = nominal minus inflation. This is when you're dealing with percentages. This formula works for any type of increase, whether it's income or interest rates, or GDP. So, in this example, Bob's real change in income is equal to his nominal change minus the rate of inflation, which would be 3% minus 4% = -1%. His real change in income was -1%.

A change in income expressed in real terms would be equal to the nominal change minus inflation

Looking at this scenario a different way, if Bob's nominal income rises by 3%, while his real income fell by 1%, then that means that prices in the economy rose by 4%. We can calculate this number by subtracting -1% from 3%, which give us 3% minus - 1% = 4%. We're just moving that formula around.

Let's look at one more example using interest rates instead of income. When the nominal interest rate on a bank checking account is 1% and the rate of inflation is 2%, the real interest rate would be 1% minus 2%, which would be -1%.

Summary

To summarize what we've talked about in this lesson, inflation is a sustained increase in the price level. The inflation rate is the rate at which inflation is changing, usually reported on an annual basis. The inflation rate is taken from The Consumer Price Index. The Consumer Price Index is an index measuring changes in the level of prices in the economy. It reveals the purchasing power of money, or the amount of goods and services that $1 will buy.

Statistics that are presented to us in nominal terms show us actual numbers before adjusting for changes in the level of prices, while statistics that are presented in real terms show us numbers that have been adjusted for inflation. Real data show us what something is worth in terms of its real purchasing power.

Lesson Objectives

Once you've completed this lesson, you'll be able to use the Consumer Price Index to:

  • Determine inflation rates
  • Observe changes in purchasing power
  • Understand the differences between data given in real terms and data given in nominal terms
  • Calculate real income

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The GDP Deflator and Consumer Price Index

The GDP Deflator and Consumer Price Index

Have you ever wondered how inflation is measured? This lesson will compare and contrast two of the indicators used to measure inflation - the consumer price index and the GDP deflator.       

GDP Deflator & Consumer Price Index

Economists measure inflation, or changes in the price level, using a price index. The consumer price index (CPI) is an index measuring the level of prices in the economy and comparing them to previous years in order to gauge the level of inflation inside the economy. It's based on a fixed basket of goods that an average person buys each year.

For example, according to this table showing changes in the consumer price index over a 4-year period, the index changed from 100 to 103 between years one and two. That means that prices increased by 3%. The value of an index is that you can easily compare prices across different years, but the consumer price index is not the only indicator that economists have to measure changes in the average level of prices. They also use what's called The GDP deflator.

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The Formula

Remember that  GDP, or the gross domestic product, is the market value of all final goods and services produced within a country's domestic borders, and it's usually quoted on an annual basis.

The GDP deflator is a number, similar to the consumer price index, that we can use to deflate, or adjust downward, the gross domestic product and thereby remove the effect of rising prices. What we want to know is how much did our economy really grow because of increased production? We don't want to count increases in prices, and when we use the GDP deflator, we can adjust nominal GDP for inflation.

The formula for the GDP deflator is nominal GDP divided by real GDP

So, the formula for the GDP deflator is nominal GDP / real GDP. For example, if nominal GDP in year one is recorded as $2.2 trillion and the real GDP in the same year is $1 trillion, then the GDP deflator would be 2.2 / 1 = 1.2. We can turn this number into an index by multiplying by 100. In this case, we'd get 120, which we can now compare to another year, so we can find out how much prices rose. If this year's GDP deflator is 1.2 and last year's GDP deflator was 1, then that means prices rose by 20%.

GDP Deflator vs. Consumer Price Index

I said that the consumer price index represents a fixed basket of goods and services that is compared year by year, but the basket never changes. In reality, though, people's tastes and behaviors do change over time, which means that in real life an average person's basket of goods also changes, but the consumer price index assumes no change in the basket of goods.

For example, let's say the consumer price index reflects a basket of goods, including 14% food, 30% housing, and 10% energy, with everything in the basket totaling 100%, of course. This basket is supposed to represent the average person's buying patterns within the economy, so it's a good benchmark for spending. This same basket of goods is used to compare changes in price every single year - even for decades. So, what if the price of energy increased dramatically and people only buy half as much gas? Then, the real basket that the average person buys would be different from the assumed, fixed basket of goods that the government deals with. This poses a challenge to economists, which leads us to favor the GDP deflator.

Unlike the GDP deflator, the consumer price index represents a fixed basket of goods and services

The GDP deflator is a more accurate indicator of inflation because it includes all the goods and services in the economy, so it doesn't have this limitation of a fixed basket of goods. The GDP deflator is considered by economists to be the best measure of changes in the price level of a nation's gross domestic product. However, the CPI continues to be released, and it might even be easier for consumers to understand.

Lesson Summary

Let's summarize what we've talked about in this lesson. The consumer price index is an index measuring the level of prices in the economy and comparing them to previous years in order to gauge the level of inflation inside the economy.

But economists also use what's called the GDP deflator. The formula for the GDP deflator is as follows: GDP deflator = nominal GDP / real GDP. The GDP deflator is considered by economists to be the best measure of changes in the price level of a nation's gross domestic product and more accurate than the consumer price index because it doesn't depend on a fixed basket of goods like the consumer price index does.

Consumer Price Index and the Substitution Bias

Consumer Price Index and the Substitution Bias

In this lesson you'll learn about the Consumer Price Index and how it is measured. You'll also learn why many economists believe that the Consumer Price Index overstates inflation.       

Estimating Prices

I want you to imagine now that you're entering a grocery store, and as you walk in, you happen to look down at the grocery shopping list that you scribbled on a piece of paper before you left home. Now, I certainly would hate for you to look at my list because, truth be told, it's hard to read my writing. It kind of looks like a doctor's writing. But we're assuming that in your case, everything is nice and neat. On your shopping list are things like bread, spinach, and tangerines.

Now, although you didn't write this on your list, you have a certain brand of bread you always buy. You tend to choose the same brand of spinach as well. You also tend to buy tangerines each week, but you also like oranges just as much. Well, the prices for goods change over time. If the price of oranges goes down far enough, even though you wrote 'tangerines' on your shopping list, you'd be willing to buy oranges instead. This truth makes it difficult for economists and the government to estimate how much prices are going up. Let's talk about why.

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Inflation

Inflation refers to a sustained increase in the level of prices in an economy. When the government reports that inflation was 3% this year, let's say, then that means that prices, on average, increased by 3% across the economy. It also means that a $1 bill in your pocket is worth 3% less than it was last year, because when prices go up, you're not able to afford the same amount of goods and services that you could before.

Consumer Price Index

One of the ways the government measures inflation is by creating a benchmark each year of the prices that consumers pay for stuff. It's called the Consumer Price Index.

The Consumer Price Index, or CPI for short, represents a fixed basket of goods whose prices the Bureau of Labor Statistics measure each year. Tens of thousands of prices go into the creation of the Consumer Price Index, but at the end of the day (well, in the morning also), they're estimating what they think people are buying across the nation. Once they come up with an estimate of the basket of goods that an average citizen buys, they keep this basket and check the prices of the stuff in this basket each and every year.

The Substitution Bias

However, a weakness exists in this index that economists have come to recognize. We call it the substitution bias.

The substitution bias is a weakness in the Consumer Price Index that overstates inflation because it does not account for the substitution effect, when consumers choose to substitute one good for another after its price becomes cheaper than the good they normally buy.

The Law of Demand

To explain this effect, you have to revisit one of the basic foundations of economics, the law of demand.

According to the law of demand, all other things equal, if the price of a good or service goes up, the demand for it will decrease, and the opposite is also true. If the price of a good or service goes down, the demand for it will increase. This is what makes the demand curve downward-sloping.

A graph of the demand curve

The Substitution Effect

When you're standing in the grocery store looking at oranges and tangerines, and you choose to buy more affordable oranges instead of the tangerines you usually buy, this is because of the substitution effect.

The substitution effect happens when the price of one good goes down enough so that it becomes cheaper than something else, and because of this decline in price, people actually change their behavior and substitute the cheaper good for something else they would normally buy. We make some of our decisions based on how much products and services cost relative to other products and services. When the price of a good goes down far enough, we will likely substitute a cheaper product for another, more expensive one.

Because people substitute goods when prices change, that means they change what's in their basket, and if they change what's in their basket to something cheaper, then the basket that the government uses to measure inflation is still using the more expensive goods, so that's why it tends to overstate inflation. If we were talking about your basket of goods that you tend to buy at the grocery store you like, then your fixed basket of goods would have bread, spinach and tangerines in it. But once the price of oranges falls enough relative to tangerines, you change your behavior and buy oranges instead, which are cheaper. (The audio track contains a misstatement here. This transcript is correct.)

In reality, though, the Bureau of Labor Statistics knows about this, and they've made some adjustments over time, but many economists still estimate that the real rate of inflation is lower than what is reported.

Lesson Summary

To summarize what we've talked about, the Consumer Price Index, or CPI for short, represents a fixed basket of goods whose prices the Bureau of Labor Statistics measures on an on-going basis each year.

However, a weakness exists in this index, which economists have come to recognize.

The substitution bias is a weakness in the Consumer Price Index that overstates inflation because it does not account for the substitution effect, when consumers choose to substitute one good for another after its price becomes cheaper than the good they normally buy.

Lesson Objectives

Once you complete this lesson you'll understand why the substitution bias occurs in the Consumer Price Index.

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Gross Domestic Product: Nominal vs. Real GDP

Gross Domestic Product: Nominal vs. Real GDP

Watch this video and you'll learn the difference between nominal GDP and real GDP with the help of a memorable story about a competition between twin brothers.       

Measuring the Total Output of an Economy

Please go with me to a planet far, far away by the name of Econoland. On this planet are three countries: the nations of Macro, Micro, and Eden. In this lesson, you'll learn the difference between real GDP and nominal GDP. Why does this matter? Because, as you'll find out, real GDP tells us how much a country really grew after adjusting for inflation.

You'll do this by following a lifelong drama of competition that develops between two identical twins, Arnold and Danny, who were born in the nation of Eden. These boys have great aspirations growing up. As toddlers, they accidentally solve the Rubik's Cube in sixty seconds, and by age ten, they attend their first Tony Robbins success seminar, walking on hot coals, of course. At age fifteen, the twins open up competing hot dog stands in New York City - right across the street from each other - and Arnold loses a bet with his twin brother that costs him his hot dog stand as well as his pride.

Well, eventually Arnold and Danny become presidents of the nations of Macro and Micro, respectively. Let's first see how these twins made it into the highest positions of the land, but more importantly, watch what happens when they compare the nominal GDP of their two nations. Then we'll introduce a superior way to compare the output of an economy.

As the years roll on, both young men grow in their success, rising to the top of every company and organization they work for. After twenty years, Arnold and Danny find themselves in the highest position possible in the nations they live in - Arnold is the president of the nation of Macro, and Danny's the prime minister of the nation of Micro!

On New Year's Eve, they happen to run into each other while attending a royal party hosted by the King of Eden - the twins discover that they are by accident attempting to court the same woman. Helen is her name, and she also just happens to be the king's daughter! After greeting each other politely, their competitive nature gets the best of them, and Arnold begins to discuss the biggest challenge they've ever been involved in, with an even bigger reward.

Here's the challenge: whoever's economy has a higher gross domestic product at the end of the year gets to take over half of the other person's land and marry the king's daughter. Gross domestic product is the total market value of goods and services produced within the domestic borders of a nation during the year.

On New Year's Eve, the two of them meet up at the royal party, dressed in their absolute best outfit in preparation for the opportunity to ask the king's daughter to marry him. Arnold announces that his gross domestic product (or nominal GDP) is $1.5 trillion, while Danny's is $1.75 trillion. Once again, just like with the hot dog stand, it looks like Danny is the winner, but the king knows different because the king understands the difference between nominal GDP and real GDP.

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Removing the Effects of Rising Prices

Because of the huge reward at stake, the twins agree to defer to the King of Eden, who first begins by asking them what their inflation rate was in the nation that they're in over the past year. Arnold says inflation was 0% in his nation, while Danny says 5%.

'Aha!' says the king. After reviewing all of the economic statistics, the king makes adjustments to Danny's gross domestic product numbers by measuring the market value of goods and services produced at the prices that were available in a previous year, thereby removing the effect of rising prices, or what we call inflation.

Nominal vs. Real GDP

Nominal gross domestic product, or nominal GDP, is the total market value of goods and services produced, measured in current dollars. It represents 'current quantities at current prices.'

On the other hand, real gross domestic product, or real GDP, is the total market value of goods and services produced, measured in constant dollars. What that means is it represents 'current quantities at past prices.'

When he's all done with his adjustments (the king, I'm talking about), he tells the twins that Arnold's real GDP was $1.5 trillion, and although Danny's nominal GDP was $1.75 trillion (higher than the other one was), his real GDP was only $1.49999999999 trillion. Feeling very wounded, quite shocked, but mostly astonished that his twin brother just beat him by about a penny and gained half of his land and the king's daughter, he storms out of the party, climbs in his Rolls Royce, and heads for the hills.

A month later, the entire nation of Eden joins their king in celebrating the wedding of the king's daughter to President Arnold, and Danny shows up to give his brother love and support, and everyone lives happily ever after.

Two Reasons That Economic Output Can Increase

Okay, so whenever we compare the gross domestic product of a nation from one year to the next, we're trying to find out what economic output was, but we have to realize that GDP can go up for two reasons.

Firstly, it can go up because a nation actually produced more goods and services. Secondly, it can go up simply because prices for goods and services have increased - inflation, in other words. Think about this for a minute. If a nation produced $500 in nominal GDP in one year and then produced $1,000 in nominal GDP the next year, but the price level doubled (or increased by 100%), then the nominal GDP may look great, but the people in the land are no better off than they were in the first year. The country simply produced the same amount of stuff, but the stuff was twice as expensive.

By using real GDP, we discover how much a nation's output really grew. Danny's economy had nominal growth but no real growth. That's why the King of Eden gave the winnings to Arnold. What's the real lesson we've learned here? Find out how much the economy really grew!

Lesson Summary

Okay, it's time to review. Gross domestic product, or GDP, is the total market value of goods and services produced within the domestic borders of a nation during the year. Nominal gross domestic product, or nominal GDP, is the total market value of goods and services produced, measured in current dollars. It represents 'current quantities at current prices.' On the other hand, real gross domestic product, or real GDP, is the total market value of goods and services produced, but, listen to this, measured in constant dollars. It represents 'current quantities at past prices,' so it removes the effect of inflation.

Using nominal GDP creates a false impression of the amount of output taking place in a nation from one year to the next. How do we account for this? We adjust the nation's nominal GDP by any increase in the price level that took place. In other words, we adjust GDP for inflation. Economists call the new adjusted number real GDP because it tells us how much production really increased from one year to the next.

Lesson Objectives

After viewing this lesson, you'll be able to:

  • Explain the difference between real and nominal GDP
  • Recall factors that contribute to an increase in economic activity
  • Understand the shortcomings of nominal GDP

Gross Domestic Product: How to Calculate Real GDP

Gross Domestic Product: How to Calculate Real GDP

Learn how to adjust economic output for inflation using real GDP. This calculation enables economists to remove the effect of rising prices and more accurately compare economic output from multiple years.       

Economic Output

I want you to go with me to Econoworld, where at this very moment, President Arnold is sitting in his Oval Office while he's taking a break. He asked his assistant for two things to be brought up, and now he's enjoying them both: high-quality headphones that he can use to listen to the brand-new music download that he's purchased online and some cheesecake to go with it. The nation of Macro produces only two goods - music downloads and cheesecake. That's it. That's all they eat and all they do, all day.

Just before the president finishes his cheesecake, he is interrupted by his chief economist, who brings in the newly-completed Economic Report of the President. This is good stuff; a very good read. As a matter of fact, it's filled with economic statistics and a proposed budget for the entire economy. Also contained within the report is information on the economic output of the nation for the years 2011 and 2012. With the help of the Council of Economic Advisors, every president publishes this report annually, which contains an overview of the nation's economic progress.

Let's open up the book and take a closer look at economic output in the nation of Macro.

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Comparing Nominal and Real GDP

Nominal gross domestic product is the total market value of goods and services produced, measured in current dollars. It represents current quantities at current prices. On the other hand, real gross domestic product is the total market value of goods and services produced, measured in constant dollars. It represents current quantities at past prices.

As you can see, the price of music downloads increased from $1 to $2, while the price of cheesecake, if you notice, went up by 20%.

At these prices, the nation produced 100 downloads the first year and 150 the second year. Cheesecake was another story. I'm told that the majority of the 20 cheesecakes produced in 2011 were made for President Arnold. Notice that in 2012, the quantity of cheesecakes produced dropped to 15. That's because the prez had a cholesterol scare and had to cut back on the cake. Whenever he wanted that piece of cheesecake, he valiantly resisted and instead listened to a download of his favorite classic song, 'Cut the Cake,' by Average White Band.

What we want to know is how much did the nation really grow between these two years?

First, I'll show you how to calculate nominal GDP. Then, we'll adjust it for inflation to get real GDP, which removes the effect of rising prices and enables us to make an apples-to-apples comparison. The prices and quantities of these two goods are listed below for the years 2011 and 2012.

How to Calculate Nominal GDP

By definition, GDP is the total market value of goods and services produced. Since market value = price * quantity, it means we multiply the price times the quantity for all goods in the economy and add them up for every year we're looking at. Nominal GDP represents current quantities at current prices, so we use the 2011 prices for the 2011 nominal GDP, and we use the 2012 prices for the 2012 nominal GDP.

We're going to make 2011 what economists call 'the base year,' which means that it's the year we will compare 2012 to. In the base year, nominal GDP and real GDP are always going to be the same.

To get the nominal GDP in the first year, we use the prices for that year, as follows:

Nominal GDP in 2011 = (Price of downloads in 2011 * Quantity of downloads in 2011) + (Price of cheesecake in 2011 * Quantity of cheesecake in 2011)

So plugging in the numbers here, we have ($1.00 * 100) for the downloads, and then we have ($10.00 * 20) for the cheesecake, which equals $100 + $200, for a total of $300. So that was the nominal GDP in 2011.

Next, we calculate the nominal GDP in 2012, as follows. We have the same formula, but we're using different information this time for 2012.

($2.00 * 150 downloads) + ($12.00 * 15 cheesecakes), which equals $300 + $180, for a total of $480. So that's our nominal GDP in 2012. So we have $300 nominal GDP in 2011 and $480 in nominal GDP in 2012.

As we quickly compare the nominal GDPs from these years, it appears that economic output went up substantially, from $300 to $480, right?

How to Calculate Real GDP

Now, let's calculate real GDP in both years, which will enable us to adjust for inflation and compare apples to apples. Remember that real GDP represents current quantities at past prices. However, real GDP in the base year is always the same as the nominal GDP in the base year because that's the year that the other year is being compared to. So here's the formula for real GDP in 2011:

Real GDP in 2011 = (Price of downloads in 2011 * Quantity of downloads in 2011) + (Price of cheesecake in 2011 * Quantity of cheesecake in 2011)

Plugging in the numbers, we have ($1.00 * 100) + ($10.00 * 20), which equals $100 + $200, for a total of $300. Remember, I said that the nominal GDP and the real GDP are going to be the same in the base year, so this is what we found.

To calculate real GDP in 2012, we're going to use the quantities produced in 2012 but the prices in 2011. Why? It's the current quantities at past prices (that's what real GDP means) and the base year is 2011. If the base year was another year before that, then we'd use that year instead. We always replace the current year prices with the base year prices because prices have changed, and we're trying to remove the effect of this change in prices. In essence, what we're saying is, 'How much output would we have ended the year with if the nation produced the amount of stuff it produced in 2012 but sold it at 2011 prices?' Here's what the calculations for 2012 real GDP look like:

Real GDP in 2012 = (Price of downloads in 2011 * Quantity of downloads in 2012) + (Price of cheesecake in 2011 * Quantity of cheesecake in 2012)

This equals ($1.00 * 150) + ($10.00 * 15), and that is $150 + $150, for a total of $300.

Drawing Conclusions

Now we have all the information we need to make an informed judgment about how much the economy really grew.

Although nominal GDP says that Macro's economic output was $480 during 2012, after adjusting for inflation, economic output was only $300, which is exactly the same output as the year before. Economists would say it this way: 'There was no real growth in the nation of Macro between 2011 and 2012.'

So, what did we learn?

Gross domestic product can increase for two reasons: because quantity increased or because prices increased. What we want to know is how much more did we really produce, and real GDP tells us what we want to know by removing the effect of rising prices.

Lesson Summary

Let's summarize the key points from this lesson. Gross domestic product is the total market value of goods and services produced within the domestic borders of a nation during the year.

Nominal gross domestic product is the total market value of goods and services produced, measured in current dollars. It represents current quantities at current prices.

By definition, GDP is the total market value of goods and services produced. Since market value = price * quantity, it means that we multiply the price times the quantity for all goods in the economy and add them up for every year that we're looking at.

The major drawback of using nominal GDP is that it creates a false impression of the amount of output taking place in a nation from one year to the next due to the change in prices.

On the other hand, real gross domestic product is the total market value of goods and services produced, measured in constant dollars. It represents current quantities at past prices.

How do we account for this? We adjust a nation's nominal GDP by any increase in the price level that took place. In other words, we adjust GDP for inflation. Economists call the new adjusted number 'real GDP' because it tells us how much production really increased from one year to the next.

To calculate real GDP in a certain year, multiply the quantities of goods produced in that year by the prices for those goods in the base year.

Lesson Objectives

After watching this lesson, you should be able to:

  • Compare and contrast nominal and real gross domestic product
  • Calculate nominal and real gross domestic product

How to Calculate Real GDP Growth Rates

How to Calculate Real GDP Growth Rates

How can you tell how much the economy is really growing from year to year? In this lesson, you'll discover the formulas economists use to calculate real GDP growth rates and draw conclusions about real economic growth.       

Real GDP Growth Rates

Let's talk about real GDP growth rates and then look at two examples.

GDP growth rates are kind of like the speedometer on a sports car. Just imagine that Bob, from the town of Ceelo, has done quite well in his lawn business. He just left the mall, where he bought some new designer jeans, and he's driving a new sports car, let's say. The speedometer on Bob's car is going to show how fast he's going at any given time. Now, let's say that Bob is on the city street, where he's traveling at 40 miles an hour. Well, then he enters the expressway, where his speed increases to 60 miles per hour.

When Bob went from the city street to the expressway, he accelerated from 40 mph to 60 mph, which is a 50% increase. Economists basically talk about the same thing when they calculate nominal GDP growth rates to determine how fast the economy accelerated or slowed. Nominal GDP growth measures the actual growth rate from one year to the next. The only major difference is that instead of the 50% rates you can get by using a car as an example, you tend to get much smaller growth rates for major economies, like 2% or 6%.

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GDP Growth Rate Formula

In order to calculate the growth rate of nominal GDP, we need two nominal numbers in two different years, year 1 and year 2. Here's the formula for calculating GDP growth rates:

(GDP in year 2 / GDP in year 1) - 1

For example, let's suppose that in year 1, which is our base year, the total production in the economy was $16,000. That's our nominal GDP, and it represents current production at current prices. In year 2, the total production (or nominal GDP) was $16,820. So we see that production went up. By how much? Well, let's calculate the growth rate of nominal GDP. When you do the numbers, it works out like this:

($16,820 / $16,000) - 1, which equals 5.1%. That means from year 1 to year 2, nominal GDP in this economy of two goods has increased by 5.1%.

Now imagine that Bob is on the expressway, but it's totally covered with ice. Have you ever driven a car on ice during the wintertime in a cold place? I know I have! Bob's speedometer says he's going 60 miles per hour, but a police radar gun (like the ones they use during the baseball games) says that he's only going 40 miles per hour. When you're trying to go fast on the ice, your tires are doing some spinning underneath you as you drive. The ice is very slippery, and the car tires don't have the same amount of traction on the ice as they do on the regular pavement during summertime, let's say.

Economists recognize that some of the increase in nominal GDP may have been due to a sustained increase in prices, which we call inflation. Inflation is a lot like driving on ice. It makes you feel like you're just spinning your wheels - and hey, let's hope you're not on thin ice! When you think the economy is growing by 6%, it may really be only growing by 3% after inflation.

Inflation subtracts from nominal GDP growth. For this reason, we use real GDP growth rates to remove the effects of rising prices. This process will allow us to draw some conclusions afterwards, and it's what helps fiscal policy leaders and monetary policy leaders interpret the trends in the economy so they can create policies that will promote economic growth.

Nominal GDP growth is like the speedometer in the car when you're driving on ice. It says that you're going faster than you really are. On the other hand, real GDP growth is like the radar gun held by the police, and it measures how fast you're really going. I mean, come on, let's be real. Keepin' it real in Ceelo! Hey, that was a Top 20 radio hit last year, I think.

Good news! We can use the same formula to calculate both nominal and real GDP growth rates. The formula is:

(GDP in year 2 / GDP in year 1) - 1

Let's say that in year 1, which is the base year, real GDP was $16,000. In year 2, real GDP was $16,400. Now we can calculate the growth rate in real GDP because we have two years of data. The growth rate is simply ($16,400 / $16,000) - 1 = 2.5%.

Conclusions About the Economy

Okay, it's time to draw some important conclusions about the economy. Using the examples that we used here, nominal GDP increased. By how much? 5.1%. Real GDP increased as well. How much did it increase? By 2.5%.

So what initially looks like a 5.1% growth in the economy really turns out to be only 2.5% growth after you factor in the effect of inflation (or the increase in prices between these two years). Hey, if you're driving on ice, you can't always trust the speedometer. See what the radar gun says. That's what real GDP is all about. Did the economy really grow?

Nominal GDP

It's time for one more example and another table of economic data. First, let's look at nominal GDP. Nominal GDP in year 1 was $16,000. Nominal GDP in year 2 was $19,320. The growth rate in nominal GDP was ($19,320 / $16,000) - 1, which equals 20.8%. So we see that in nominal terms, the economy grew quite a bit. But some of that growth could have been the result of rising prices, so we want to remove the effects of inflation by using real GDP.

Real GDP

The real GDP in year 1 was the same as the nominal GDP because year 1 is the base year. So this is $16,000. The real GDP in year 2 was $15,500. Therefore, the growth rate in real GDP is ($15,500 / $16,000) - 1, which is equal to -3.1%. What conclusions can we draw about the economy between years 1 and 2? Nominal GDP increased, while real GDP decreased. The economy was in recession.

These are some of the most common observations that economists make, and now you're familiar with real GDP growth rates.

Lesson Summary

To summarize what we've learned in this lesson, economists use two terms to describe GDP growth rates before and after inflation. One is nominal GDP growth and the other is real GDP growth. Nominal GDP growth is just the actual rate of growth from one year to the next.

If you have actual numbers for nominal GDP, it is very useful to look at how much they've changed from one year to another. This is how you determine whether the economy is accelerating or slowing down. Real GDP growth removes the effects of inflation so you can find out if the economy really grew or not.

This allows economists to draw some important conclusions about how much the economy grew. It's what helps fiscal policy leaders and monetary policy leaders interpret the trends in the economy so they can create policies that will promote growth.

In order to calculate growth rates, we need two numbers in two different years. The general formula for calculating GDP growth rates is as follows:

(GDP in year 2 / GDP in year 1) - 1

Learning Outcome

After watching this lesson, you should be able to calculate growth rates of real GDP and nominal GDP and interpret GDP growth rates to identify economic expansion and recession.

Defining and Measuring the Unemployment Rate

Defining and Measuring the Unemployment Rate

You've probably heard about the unemployment rate, especially given how high it was in the 2008 recession. Find out how economists define unemployment, what the unemployment rate is, and how to calculate it in this lesson.       

What is Unemployment?

Let's talk about who's considered unemployed, how we measure the labor force, and how we calculate the unemployment rate (with the help of some real-world examples).

The Bureau of Labor Statistics defines a person as unemployed if they are is not working but are willing and able to work. More precisely, unemployment is when the labor force is seeking employment but cannot find it. Unemployment is a cost to the economy in terms of the deficiency in production. In other words, when people don't have jobs those employees aren't able to produce, and therefore the economy produces less. The number of unemployed persons includes people age 16 and older who are without a job but looking for work. The number of people out of work is the focus of this lesson; however, in order to accurately measure this, we need to define the labor force and talk about who's included in it.

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Who's Included in the Labor Force?

The labor force includes the total number of people who are working or unemployed. It's an important measurement of who is willing and able to work. For example, when Melanie loses her job at the local jewelry store, she scans the newspapers and internet job sites for job postings; however, Melanie's sister Hannah still works at the jewelry store. Both Melanie and Hannah would be counted in the labor force - it's both people who are working and people who are unemployed.

Who's Not Included in the Labor Force?

We've talked about who's included; let's talk about who's not included. Some people are not counted in the labor force.

Melanie's daughter Melinda goes to college full-time. Full-time college students are neither employed nor unemployed, and so they are not included in the labor force.

Another example: Melanie's cousin Marvin lost his job at the auto plant. He was looking for work for nine months but finally gave up and is no longer seeking a job, even though he's willing to work. Marvin is what we call a discouraged worker. Discouraged workers are not included in the labor force even though they're able to work because they're not looking for work. They really want a job, but they've given up on the whole job search process, and because of this, they don't get counted in the unemployment statistics. Why is this important? If discouraged workers were included in the unemployment rate, it would be a lot higher. Economists believe that the unemployment rate underestimates the level of unemployment in the economy.

Finally, if we want to know how much of the population is participating in the labor force, we have a number for that. The labor force participation rate is the percentage of the population that is in the labor force. The formula is as follows: labor force participation rate = labor force / adult population. We can use this information to measure unemployment and draw some important conclusions as well. The way we measure unemployment is by calculating the unemployment rate.

Using this formula will allow you to calculate the labor force participation rate.

How To Measure Unemployment

The unemployment rate is the percentage of the labor force that is unemployed. It's reported by the Department of Labor on the first Friday of each month. It's one of the most widely followed economic indicators, and it frequently affects the direction of investment markets. During the Great Depression, the unemployment rate surged as high as 25%. That means one out of every four people were willing and able to work but could not find work! A recession in 2008 was the worst since the Great Depression (because the unemployment rate was higher for longer than any other time since the Great Depression), and during this time the unemployment rate peaked at 10.2%.

Let's find out how this rate is calculated, and we'll start in a small town, far, far away. To calculate the unemployment rate, you need to know two things: first, you need to know the number of unemployed persons, and second, you need to know the number of people that are in the labor force. The unemployment rate represents the number of unemployed persons as a percentage of the labor force.

So let's calculate the unemployment rate in the small town of Ceelo. As you can see, here are the statistics from the town government regarding the labor market in the town of Ceelo. In 2010, 80 adults lived in Ceelo, of which 40 had a job. Then a lot of residents talked to their friends around the country, and another 80 adults moved to town. In 2011, there were 160 adults, 90 of whom had jobs.

Calculating the Unemployment Rate

The formula for calculating the unemployment rate is unemployment rate = number of unemployed persons / labor force. Remember that the labor force includes those who are employed and those who are unemployed.

So let's start with 2010. In 2010, Ceelo had a labor force of 40 + 10, which is 50 workers. When we plug in the 10 unemployed people into the formula, we get 10 / 50 = 20%. So that's the unemployment rate for 2010 in the town of Ceelo. If the unemployment rate is 20%, that doesn't mean that 20% of the adult population is unemployed. It means that (10/50), or 20% of the labor force, is unemployed -  a very important distinction. Another way to say this is that (40/50), or 80% of the labor force, is employed.

In the following year, 2011, Ceelo had a labor force of 90 + 10, or 100, workers. That's the labor force. That means the unemployment rate was 10 / 100 = 10%. This means that 90% of the labor force is employed during that year.

The formula for calculating the unemployment rate

Now we can draw a conclusion about the trends in the labor force in the small town of Ceelo. From 2010 to 2011, the population increased and the labor force grew, while the unemployment rate fell from 20% down to 10%.

But what if we want to know how much of Ceelo's population is willing and able to work? Then we'd use the labor force participation rate. Remember, the labor force participation rate is the percentage of the population that is in the labor force. The formula is labor force participation rate = labor force / adult population.

If we want to know what the labor force participation rate was in 2010, here it is in Ceelo: 50 people in the labor force / 80 people in the adult population = 5/8 x 100, which is about 63%. The labor force participation rate for 2011 would be 100 people in the labor force / 160 people in the adult population = 10/16 x 100, which is also about 63% - the same as it was in 2010.

Here's a challenge for you: what if the unemployment rate rose, let's say, from 5% to 7%, but at the same time there were more people employed in the economy? How could that scenario happen? Remember that the unemployment rate is a percentage calculated from two numbers, the number of unemployed people and the labor force. The labor force includes people of working age, which is increasing over time whenever the population grows. So increases in population are making the labor force get larger, and that means the economy needs new jobs just to keep up with the increase in population. Sometimes more people are getting jobs, but not enough to keep up with the population. When the unemployment rate rises but more people are employed, that means that the population grew faster than employment did.

Lesson Summary

Let's review the basic formulas we've learned in this lesson. Unemployment is when the labor force is seeking employment but cannot find it. The labor force includes the total number of people who are working or unemployed. It's an important measurement of who is willing and able to work. Groups not included in the labor force are full-time college students and discouraged workers. Discouraged workers are not included in the labor force, even though they're able to work, because they're not looking for work. If discouraged workers were counted, the unemployment rate would be much higher; therefore, many economists believe that the unemployment rate underestimates the level of unemployment.

The unemployment rate represents the number of unemployed persons as a percentage of the labor force. To calculate it, you need to know two things: the number of unemployed persons and the number of people in the labor force. Here's the formula for calculating it: unemployment rate = number of unemployed persons / labor force. Finally, the labor force participation rate is the percentage of the population that is in the labor force. The formula is labor force participation rate = labor force / adult population.

Lesson Objectives

Once you complete this lesson you'll be able to:

  • Define unemployment
  • Understand which items are not included in the labor force
  • Calculate the unemployment rate
  • Figure out the labor force participation rate

Three Types of Unemployment: Cyclical, Frictional & Structural

Three Types of Unemployment: Cyclical, Frictional & Structural

If you've ever lost your job after the holiday season, you've experienced at least one type of unemployment. In this lesson, explore the three types of unemployment including cyclical, frictional, and structural using real-world examples.       

Types of Unemployment

There are three major types of unemployment including cyclical, frictional, and structural. Let's take a look at each one of them through the eyes of workers in the town of Ceelo. As a matter of fact, I'd like to introduce you to a few of them and then find out what type of unemployment they're experiencing.

Cindy just graduated from college, and she's looking for work by scanning job sites, reading newspaper listings and attending job fairs. Good for you, Cindy. Cindy's dad, Matt, is a manufacturing worker in Ceelo who loves to pull levers and wear hard hats. Matt's Uncle Fred works as a temporary Santa Claus each holiday season; in particular, he loves to work at commodities trading firms on Wall Street. Fred's brother Frohm is a high school gym teacher who is desperately trying to teach kickboxing to the school's guinea pigs with the help of students. He was hired as a second gym teacher last year.

Okay, so this is the town of Ceelo, and these are the workers we're talking about. Now, let's talk about the economy.

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Cyclical Unemployment

Over time, the economy experiences many ups and downs. That's what we call cyclical unemployment because it goes in cycles. Cyclical unemployment occurs because of these cycles. When the economy enters a recession, many of the jobs lost are considered cyclical unemployment.

For example, during the Great Depression, the unemployment rate surged as high as 25%. That means one out of four people were willing and able to work, but could not find work! Most of this unemployment was considered cyclical unemployment. Eventually, unemployment came down again. As you can see, at least part of unemployment can be explained by looking at the cycles, or the ups and downs of the economy.

Frictional Unemployment

Frictional unemployment occurs because of the normal turnover in the labor market and the time it takes for workers to find new jobs. Throughout the course of the year in the labor market, some workers change jobs. When they do, it takes time to match up potential employees with new employers. Even if there are enough workers to satisfy every job opening, it takes time for workers to learn about these new job opportunities, and for them to be considered, interviewed and hired.

When Cindy graduates from college, she begins looking for work. Let's say it takes her four months to land a new job. During this time, she is frictionally unemployed.

Structural Unemployment

Let's talk about structural unemployment occurs because of an absence of demand for a certain type of worker. This typically happens when there are mismatches between the skills employers want and the skills workers have.  Major advances in technology, as well as finding lower costs of labor overseas, lead to this type of unemployment.

When workers lose jobs because their skills are obsolete or because their jobs are transferred to other countries, they are structurally unemployed. It's structural unemployment because the structure of the economy has changed, not because of the regular ups and downs of it.

For example, Matt loses his job because the manufacturing company he worked for in Ceelo moves overseas, and some of the factory workers left at home are not needed because of new high-tech gear that was recently installed. So, Matt becomes structurally unemployed.  Most of the new jobs require a college degree or new skills, so Matt decides to go back to school. It's a very common example of what's happened in the economy, especially during challenging times.

One type of structural unemployment is seasonal unemployment.  Seasonal unemployment happens when the structure of the economy changes from month to month. Some jobs close down because the seasons change. Here are some examples:

Fred takes a job every December dressing up as a Santa Claus and attending parties on Wall Street. Once Christmas is over, Fred's Santa Claus job, of course, disappears as quickly as the salmon he enjoyed at the party. This is an example of seasonal unemployment.

Another example is Fred's brother Frohm. Frohm is a high school gym teacher in the town of Ceelo. Because of the school's schedule, he is unemployed during the summer months; however, he remains fully dedicated to the school's guinea pigs in the meantime. This is an example of seasonal unemployment.

Lesson Summary

Let's summarize what we talked about in this lesson. There are three main types of unemployment: cyclical, frictional and structural.

Cyclical unemployment occurs because of the ups and downs of the economy over time. When the economy enters a recession, many of the jobs lost are considered cyclical unemployment. Frictional unemployment occurs because of the normal turnover in the labor market and the time it takes for workers to find new jobs.

Structural unemployment occurs because of an absence of demand for a certain type of worker. This typically happens when there are mismatches between the skills employers want and the skills that workers have. Seasonal unemployment is a type of structural unemployment that happens when the structure of the economy changes from month to month. Some jobs close down because the seasons change. When workers lose their jobs because of this, it's considered seasonal unemployment.

Lesson Objectives

Once you finish this lesson you'll understand the fundamental differences between cyclical, structual, and seasonal unemployment.

                                                                                             Print Lesson

Natural Rate of Unemployment: Definition and Formula

Natural Rate of Unemployment: Definition and Formula

Explore the natural level of employment through the eyes of the Classical School and Keynesian economics, including fiscal policies that may reduce it.       

Introduction

We're talking about the natural rate of unemployment. There are some important terms and definitions regarding the labor market that you need to know in economics.

Just imagine we find ourselves in the little town of Ceelo - quite a breathtaking place, if you ask me. Within the town of Ceelo, we find that Cindy just graduated from college, and she's actively looking for work. Cindy is frictionally unemployed, meaning that her decision is part of the normal turnover that happens in a healthy job market.

The natural level of employment occurs when the labor market is in equilibrium

Now Cindy's dad, Matt, has lost his job because he no longer has the skills necessary to perform his job at the factory since they replaced all the machinery with high-tech gear and also moved a lot of the factory overseas. In addition, Matt's Uncle Fred works seasonally as a Santa Claus for Christmas parties on Wall Street and loves to eat salmon from the buffet, but he's not working since the holidays have long since passed. Matt and Fred are what we call structurally unemployed.

Matt's Uncle Fred has a brother named Frohm, and Frohm has lost his job as a high school gym teacher because of an economic slowdown. Things were going well, but when the economy slowed down, the school had to lay him off, so he's now unemployed. This is an example of cyclical unemployment. Frohm is cyclically unemployed.

Now, what we want to do is take the concept of supply and demand and apply it to the labor market.

When the labor market is in equilibrium, employment is at what economists consider the natural level of employment. That means employment is at a level at which the quantity of labor demanded equals the quantity supplied.

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Classical Theory of Unemployment

So, let's talk about the classical theory of unemployment for a minute. In theory, the labor markets should be very quickly moving and efficient, which should lead supply and demand into equilibrium most of the time, and everyone should have a job that wants one. Right? This is the view of the classical theory of unemployment. Classical economists believe that unemployment must be due to some interference in the labor markets, such as regulations, which they believe should be removed.

In reality, Cindy, Matt, Fred, and Frohm are unemployed for one reason or another. Even if the economy is operating at an equilibrium level, there will still be some unemployment. Specifically, there will be frictional and structural unemployment, but no cyclical unemployment. That means that when the economy is at the natural rate of unemployment, Cindy, Fred, and Matt may be unemployed, but Frohm will still have his job. Therefore, most economists believe that over the long term, an unemployment rate of zero is unobtainable.

The rate of unemployment consistent with the natural level of employment is called the natural rate of unemployment. Economists also describe an economy at this natural rate as the full employment level of output. Now, because it's a theoretical concept, it's not possible to measure the natural rate, so economists have to estimate it.

Structural and frictional unemployment still occurs at the natural rate of unemployment

Now, most of us, when we hear this, would think the natural rate is zero because we assume that the goal of government leaders is to remove unemployment so that everyone has a job who wants one. However, economists suggest that the natural rate of unemployment is between four and six percent. In our example, Cindy, her dad Matt, and his Uncle Fred are unemployed for reasons not caused by a recession.

The ups and downs of the economy - the expansions and contractions in real GDP  - that we continue to experience over time will bring the employment level above or below the natural rate. For example, when the economy experiences a recession, additional unemployment is generated, which we call cyclical unemployment, or unemployment that's directly caused by an economic slowdown (hey, remember Frohm?). However, as firms and employees adjust their expectations to the ups and the downs, the economy generally moves back towards a natural level where there is no cyclical unemployment but only frictional and structural.

When the economy is growing rapidly, the actual unemployment rate is usually below the natural rate of unemployment. On the other hand, when it is growing very slowly, actual unemployment tends to be above the natural rate.

As it turns out, inflation is closely tied to this concept. The Federal Reserve tends to define the natural rate of unemployment as the rate of unemployment at which there is no tendency for inflation to accelerate or decelerate - in other words, where inflation is fairly stable and doesn't change from year to year. We can infer from this definition that when actual unemployment is below the natural rate, the likely result would be higher inflation.

Reducing the Natural Rate of Unemployment

Let's talk more about structural unemployment (which, in the previous example, would be Matt and Fred in the town of Ceelo). Structural unemployment can be caused by a mismatch between available jobs and workers' skills, as well as by a mismatch of location or challenges with the flow of information about jobs. Seasonal unemployment is also considered structural (remember, this is Fred, the Santa Claus who loves salmon).

Actual unemployment typically falls below the natural rate if there is rapid economic growth

According to economists at the Federal Reserve Bank of New York, the dominant type of unemployment that was prevalent during the 1991 and 2001 recessions was structural. They determined this by measuring the number of layoffs, then watching to see if those jobs were recovered after the recession. While some of them were recovered (cyclical unemployment of course), many were not.

In response to these causes of structural unemployment, there are certain fiscal policies that could lead to a reduction in the natural rate of unemployment - for example, providing additional job training programs to workers who are less skilled. When you help workers get better job training for the kind of jobs that are available, they improve their skills and gain knowledge that will help them qualify for these new jobs, and that's going to reduce unemployment.

So, that's an example of a fiscal policy that would help reduce the natural rate of unemployment.

Lesson Summary

So, let's summarize what we've talked about.

When the labor market is in equilibrium, employment is at what economists consider the natural level of employment. That means employment is at a level at which the quantity of labor demanded equals the quantity supplied.

Although the Classical School of economics believes that everyone can have a job who wants one, most economists believe that over the long term, an unemployment rate of zero is unobtainable.

The rate of unemployment consistent with the natural level is called the natural rate of unemployment. Economists describe an economy at this natural rate as the full employment level of output. The Federal Reserve tends to define it as the rate of unemployment at which there is no tendency for inflation to accelerate or decelerate. When actual unemployment is below the natural rate, however, the likely result is going to be higher inflation. Economists suggest that the natural rate of unemployment is between four and six percent. There are certain fiscal policies that could lead to a reduction in this natural rate of unemployment, such as providing additional job training programs to workers who are less skilled.

Lesson Objectives

By the end of this lesson you'll be able to:

  • Differentiate between structural, frictional, and cyclical unemployment
  • Explain the classical theory of unemployment
  • Predict what will happen if actual unemployment is below natural rate
  • Recall fiscal policies that could reduce the natural rate of unemployment
  • Understand how the Federal Reserve describes the natural rate of unemployment

ever since the 1500s, when an unknown printer took a galley of type and scrambled it to make a type specimen book.

Minimum Wage and its Effects on Employment

Minimum Wage and its Effects on Employment

There are times when the labor market is perfectly balanced between what employers are willing to pay and what workers want in a job. In this lesson, find out what happens to the labor market when governments intervene, imposing a minimum wage.       

Supply and Demand in the Labor Market

The point where labor supply and demand meet creates market equilibrium

In this lesson, we're talking about the resource market, where workers exchange their human capital with firms for wages. Firms must have labor to produce the goods and services that they sell. For example, Bob's lawn-cutting business needs workers to help him mow as many lawns as possible throughout the neighborhood. At the same time Margie's cake business needs workers to help create, decorate and deliver her unique prize-winning cakes that generate smiles all across the land. In the resource market, firms become the demanders, and workers become the suppliers.

In the labor market, supply and demand forces are at work just like they are in the product market. When the supply of labor is equal to the demand for labor, the market is in equilibrium at the intersection between the supply and demand curves.

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The Minimum Wage

When the labor market is in equilibrium, that means that wages are currently at the market rate, or the going rate that firms are willing to pay and workers are willing to agree to when they take on new jobs. In this example, let's say that 50 workers are willing and able to accept jobs that pay $5 per hour.

So what happens when governments intervene in this market with minimum wages? Let's find out.

Governments often impose a minimum wage to raise the wages of workers who are earning very little. A minimum wage is very similar to a price floor because it is set above the market wage.

Increasing the minimum wage causes a drop in labor demand

According to this illustration of the labor market, the equilibrium wage is at $5, while the quantity of workers at that wage is at 50. Right now, the labor market has found its equilibrium, and it's in balance. However, the government, concerned about unskilled workers, decides to impose a minimum wage of $7, instead of $5, in an attempt to help those workers who are having trouble paying the bills.

So what happens? The labor market actually loses jobs. At a price of $7, firms only demand and hire  40 employees, while workers, of course, would love to earn a higher wage, and there are 60 workers willing and able to take jobs at this minimum wage.

So in this case, the quantity of labor demanded goes down, while the quantity of labor supplied goes up. Since there are 60 workers looking for jobs, but firms only hire 40, that means there is a surplus of 20 workers. The surplus is unemployment. We just saw that a minimum wage set above the market wage will increase unemployment, in this case, by 20 workers.

So why do governments impose minimum wages if they understand the economics of that decision? Some economists argue that when it comes to unskilled workers, the firms will need these workers regardless of the wage, and so the firms will simply take everyone at a higher wage and raise the prices of their products if necessary.

Lesson Summary

The surplus of 20 workers results in unemployment

Let's summarize what we've talked about in this lesson. When the supply of labor is equal to the demand for labor, the market is in equilibrium, at the intersection between the supply and demand curves. When the labor market is in equilibrium, that means that wages are currently at the market rate.

Governments often impose a minimum wage to raise the wages of workers who are earning very little. A minimum wage is very similar to a price floor, because it is set above the market wage. When minimum wages are imposed, unemployment increases.

Why do governments impose minimum wages if they understand the economics of that decision? Some economists argue that firms need unskilled workers and will simply pay them a higher wage while raising the price of their products.

Lesson Objectives

Once you complete this lesson you'll be able to:

  • Recognize when a market is in equilibrium
  • Analyze supply and demand curves to determine if wages are at market rates
  • Define minimum wage
  • Understand why unemployment increases when minimum wages are imposed
  • Explain how businesses often counteract higher wages

Measuring the Costs of Unemployment

Measuring the Costs of Unemployment

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Measuring the Costs of Unemployment

Measuring the Costs of Unemployment

Unemployment has serious effects on individuals, businesses, governments, and the economy in general. In this lesson, you'll learn how the costs of unemployment impose on each of these. We'll also take a look at Okun's law.       

Unemployment Affects Everyone

The vast majority of people in modern economies rely upon trading their labor in exchange for the money they need to obtain food, shelter, and other necessities of life. In other words, most people work for others to make a living. If you're unemployed (or without a job), you don't have money for rent, groceries, transportation, health care, and other essentials of daily living. But that's not all. The negative effect of a high rate of unemployment reaches well beyond the personal financial consequences for unemployed people. Let's take a look at different ways to measure the true cost of unemployment.

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Individual Costs

An unemployed person incurs many different economic and non-economic costs. Economically, unemployed people will often suffer a reduction in their standard of living as unemployment benefits often do not come close to replacing past income, and many unemployed people have inadequate savings to withstand even a few weeks of unemployment without defaulting on their financial obligations, such as mortgages, car loans, and credit cards. If you live paycheck-to-paycheck, missing one paycheck is all that is needed for financial ruin. Non-economic costs include the mental and emotional stress that can actually adversely affect your health.

Social Costs

Long periods of high unemployment can adversely affect an entire society. Unemployment may cause crime to increase. People may be less willing to volunteer and contribute to charities because they fear they may suffer unemployment. There may also be calls to restrict free trade and immigration in an effort to insulate the country from perceived threats that may cause a loss of even more jobs creating an 'us vs. them' mentality.

Business Costs

Unemployment costs businesses as well. The United States is a consumer-driven economy, which means most businesses make their money from the goods and services they sell to other people. Most consumers get the money to buy stuff from working. If too many people are unemployed, there's a decrease in demand. A decrease in demand means a company doesn't make money and may even have to lay off employees. These laid-off employees now don't have the money to buy goods and services from businesses, resulting in further reduction in demand, and the cycle may continue.

Also, keep in mind that unemployment benefits are funded through taxes assessed on employers. A high rate of sustained unemployment may increase the tax burden on businesses, which cuts into profits and investment, including hiring more people.

Governmental Costs

Unemployment imposes tangible costs on governments as well. The more people are unemployed, the more the state and federal governments must pay out money in unemployment insurance benefits, Medicaid, food stamps, and other social insurance programs. This extra spending either takes way from other government investments, such as defense, infrastructure, and scientific research; adds to governmental debt; or both. Moreover, people that aren't earning paychecks don't have an income to tax. Likewise, people that don't have a paycheck don't buy as much stuff subject to sales tax. This causes a decline in federal and state revenue and exasperates the fiscal problems.

Unemployment, GDP, & Okun's Law

It should not come to a surprise to you by now that a prolonged high rate of unemployment can have broad implications for our economy. In fact, economist Arthur Okun discovered a statistical relationship between employment and a country's gross national product (GNP). GNP was an older measure of the size of economic production in a country in terms of the monetary value of what its citizens produce, regardless of whether the income is generated within the country's borders. GNP has now been displaced by gross domestic product (GDP), which is the aggregate of all value of all the goods and services produced within a country during a specific period of time.

Okun's law holds that there is a positive relationship between GNP and employment. This means that a country's national economic production goes up when employment goes up. On the other hand, there's a negative relationship between unemployment and GNP; when unemployment increases, GNP goes down. This makes sense because productivity is tied to a significant degree to people working on producing goods and services. If less people are producing, then less stuff is produced.

Okun's law has evolved over the years. An earlier version of the law holds that when GNP increases by three percent, unemployment decreases by one percent. This law only works when the unemployment rate drops somewhere between three and seven and one-half percent. Another version looks at the relationship between unemployment and GDP and finds that a one percent increase in unemployment will result in a two percent drop in the GDP.

You should note that while the general idea behind Okun's law applies to economies outside the United States, the effect of unemployment on GDP will be different. This is because the nature of labor markets are different from country to country.

Lesson Summary

Let's review what we've learned. A prolonged rate of high unemployment is costly not only to individuals but also to businesses, government, and society in general. Unemployed individuals may suffer a reduction in their standard of living and be plagued by mental and emotional stress. Businesses suffer a reduction in demand, which means less sales and may result in further unemployment. Government expenses increase while its revenue goes down. Society may become less civil with increases in crime, less charitable acts, and a general 'us vs. them' mentality towards trade and immigration.

Okun's law is useful in understanding how unemployment can be costly to a country's GDP. Okun's law demonstrates a statistical correlation between a country's GDP and its unemployment rate. According to Okun's law, a one percent increase in unemployment in the United States labor market will result in a two percent drop in US GDP.