Teaching Assistance Manual For Economics A Contemporary Introduction 10th Edition William A. McEache

Teaching Assistance Manual For Economics A Contemporary Introduction 10th Edition William A. McEachern

Teaching Assistance Manual

Economics A Contemporary Introduction TENTH EDITION

William A. McEachern University of Connecticut

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CONTENTS Introduction ..................................................................................................................................... 1 1

The Art and Science of Economic Analysis .................................................................................... 3

2

Economic Tools and Economic Systems ........................................................................................ 6

3

Economic Decision Makers ............................................................................................................ 9

4

Demand, Supply, and Markets ...................................................................................................... 12

5

Elasticity of Demand and Supply .................................................................................................. 15

6

Consumer Choice and Demand ..................................................................................................... 18

7

Production and Cost in the Firm ................................................................................................... 21

8

Perfect Competition ....................................................................................................................... 24

9

Monopoly ...................................................................................................................................... 27

10

Monopolistic Competition and Oligopoly ..................................................................................... 30

11

Resource Markets........................................................................................................................... 33

12

Labor Markets and Labor Unions .................................................................................................. 36

13

Capital, Interest, Entrepreneurship, and Corporate Finance .......................................................... 40

14

Transaction Costs, Imperfect Information, and Behavioral Economics ........................................ 43

15

Economic Regulation and Antitrust Policy ................................................................................... 46

16

Public Goods and Public Choice ................................................................................................... 49

17

Externalities and the Environment ................................................................................................ 52

18

Income Distribution and Poverty ................................................................................................... 55

19

Introduction to Macroeconomics ................................................................................................... 58

20

Tracking the U.S. Economy .......................................................................................................... 61

21

Unemployment and Inflation ........................................................................................................ 64

22

Productivity and Growth ............................................................................................................... 67

23

Aggregate Expenditure and Aggregate Demand ........................................................................ 70

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iii

24

Aggregate Supply .......................................................................................................................... 73

25

Fiscal Policy .................................................................................................................................. 76

26

Federal Budgets and Public Policy ................................................................................................ 79

27

Money and the Financial System .................................................................................................. 82

28

Banking and the Money Supply .................................................................................................... 85

29

Monetary Theory and Policy ......................................................................................................... 88

30

Macro Policy Debate: Active or Passive? ..................................................................................... 91

31

International Trade ........................................................................................................................ 94

32

International Finance ..................................................................................................................... 97

33

Economic Development ............................................................................................................... 100 Appendix A: Classroom Presentation ......................................................................................... 103 Appendix B: Leading a Discussion.............................................................................................. 111 Appendix C: Quizzes and Exams ................................................................................................ 116 Appendix D: Special Challenges Facing the Foreign Graduate Assistant .................................. 121

Contents

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INTRODUCTION Lectures represent an effective way to provide large amounts of information, but lectures are mostly one-way communications. Since students are often reluctant to ask questions, particularly in large classes, only the looks on their faces and the results of exams provide the instructor with feedback. But this feedback is sporadic, limited, and impersonal. Thus, the instructor often has difficulty gauging how the material is being received.

One vehicle for encouraging two-way communications is to carry on more class discussion. If the class is already relatively small—say, 25 or fewer students— discussion can become a regular part of the class.

But because principles classes are often large, these classes at some institutions are broken down into small weekly sections, providing students with more individual attention, more time to discuss the material, more of an opportunity to ask questions, and a place to take quizzes.

Although many instructors might benefit from this manual, the focus here is on smaller classes, where discussion is possible. Sometimes these discussion sections are directed by graduate students, who are variously referred to as teaching assistants, graduate assistants, discussion leaders, or teaching fellows.

Whether seasoned teacher or green graduate student, however, each instructor faces many of the same challenges in the classroom. For some of you, this manual may provide new insights. For others it may simply remind you of things you already know. As Mark Twain said “None of us is smart enough to remember all we know.” To have good ideas in the classroom, we need lots of ideas. In using this manual, think of yourself as a prospector looking for a few good teaching ideas.

Each chapter number of this manual corresponds with a chapter in my hardback principles textbook (Economics: A Contemporary Introduction, Tenth Edition). The first 18 chapters of this manual correspond with the first 18 chapters of the micro paperback (Microeconomics); and the final three chapters in this manual correspond with the final three chapters of the Microeconomics. If you are using the macro paperback (Macroeconomics), Chapters 1 through 4 in this manual correspond with those same chapters in Macroeconomics; Chapters 19 through 33 of this manual go with Chapters 5 through 19 in Macroeconomics; and the final three chapters in this manual correspond with the final three chapters of the Macroeconomics. Each chapter in this manual contains (1) a brief overview, (2) a detailed outline, (3) chapter objectives and quiz material, (4) topics for class discussion, (5) warnings about trouble spots in the chapter that warrant special attention, (6) additional examples, and (7) some “What If?” questions.

The appendices to this manual provide teaching assistance on (a) presenting material, (b) generating and sustaining class discussion, (c) preparing, administering, and grading quizzes, and (d) the special challenges confronting foreign graduate assistants. Even seasoned teachers may find some of this appendix material helpful.

Don’t forget about the other components of the teaching package that could help. The Instructor’s Manual answers all end-of-chapter questions and offers chapter summaries and lecture guidance, including when to use PowerPoint slides. Also available are a Study Guide, Test Bank, downloadable PowerPoint slides, computer-assisted tutorials, on-line help, and my newsletter, The Teaching Economist. Other resources include colleagues, newspapers, periodicals, the Internet, and your daily observations of the economics all around you. Most colleges also offer some sort of teaching support through reference material, teacher counseling, and videotaping for self-appraisal. Many good books and articles have been written about college teaching. The following is a short list of references you may find helpful:

1 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

Aslanbeigui, Nahid, and Michele Naples, eds. Rethinking Economic Principles: Critical Essays on Introductory Textbooks. Chicago: Irwin, 1996.

Brookfield, Stephen D. The Skillful Teacher. San Francisco: Jossey-Bass Inc., 1990.

Byrd, Patricia, Janet Constantinides, and Martha Pennington. The Foreign Teaching Assistant’s Manual.

New York: Collier Macmillan, 1989.

Coyle, Diane. The Soulful Science: What Economists Really Do and Why It Matters. rev. ed. Princeton and Oxford: Princeton University Press, 2010.

Haskell, R. E. Transfer of Learning: Cognition, Instruction, and Reasoning. San Diego, CA: Academic Press, 2000.

Hoyt, Gail M., and Kim Marie McGoldrick, International Handbook of Teaching and Learning Economics, Cheltenham, UK and Northhampton, MA, USA: Edward Elgar, 2012.

Intrator, Sam M. Stories of the Courage to Teach: Honoring the Teacher’s Heart, San Francisco: JosseyBass Inc., 2002.

Kirk, Delaney J. Taking Back the Classroom: Tips for the College Professor on Becoming a More Effective Teacher. Des Moines, IA and Seattle, WA: Tiberius Publications, 2005.

McKeachie, Wilbert J. Teaching Tips: Strategies. Research, and Theory for College and University Teachers. 11th Ed. Boston, MA: Houghton Mifflin, 2002.

Saunders, Phillip, and William Walstad, eds. The Principles of Economics Course: A Handbook for Instructors. New York: McGraw-Hill Publishing, 1990.

Szenberg, Michael, Eminent Economists: Their Life Philosophies. Cambridge, England: Cambridge University Press, 1992.

Willingham, Daniel T. Why Don’t Students Like School: A Cognitive Scientist Answers Questions About How the Mind Works and What It Means for Your Classroom. San Francisco: Jossey-Bass Inc., 2009.

There are many of Web sites on teaching. My textbook has a home page containing a variety of resources at http://www.cengage.com/economics/mceachern. Take advantage of available resources. But experience is perhaps the best teacher. Teaching looks easier than it is. New instructors will fully understand the problems they confront only after having taught for a while. As Emerson said “The years teach us much that the days never know.”

In 1980 I began offering a teaching workshop for graduate students in the Department of Economics at the University of Connecticut. Some of the material in this manual was developed in conjunction with that workshop over the years. I thank those who contributed to the discussion over the years. I also welcome comments from all who use this manual. My e-mail address is william.mceachern@uconn.edu.

Introduction

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CHAPTER 1 THE ART AND SCIENCE OF ECONOMIC ANALYSIS This chapter introduces the problem of economics and tries to interest students. Beginning with the economic problem of scarce resources but unlimited wants, the chapter provides an overview without getting into much detail. Many terms are defined along the way, including resources, goods and services, and the economic actors in the economy. The chapter tries to show that economics is found not just in the fi nancial section of the newspaper but is very much a part of each student’s everyday life. This edition defi nes economic fluctuations in this first chapter, so this can be at least mentioned in the introductory chapters and in the micro chapters. The appendix introduces the use of graphs.

CHAPTER OUTLINE 1-1 THE ECONOMIC PROBLEM: SCARCE RESOURCES, UNLIMITED WANTS 1-1a Resources 1-1b Goods and Services 1-1c Economic Decision Makers 1-1d A Simple Circular-Flow Model 1-2 THE ART OF ECONOMIC ANALYSIS 1-2a Rational Self-Interest 1-2b Choice Requires Time and Information 1-2c Economic Analysis Is Marginal Analysis 1-2d Microeconomics and Macroeconomics 1-3 THE SCIENCE OF ECONOMIC ANALYSIS 1-3a The Role of Theory 1-3b The Scientific Method Step One: Identify the Question and Define Relevant Variables Step Two: Specify Assumptions Step Three: Formulate a Hypothesis Step Four: Test the Hypothesis 1-3c Normative Versus Positive 1-3d Economists Tell Stories 1-3e Predicting Average Behavior 1-3f Some Pitfalls of Faulty Economic Analysis The Fallacy That Association Is Causation The Fallacy of Composition The Mistake of Ignoring the Secondary Effects 1-3g If Economists Are So Smart, Why Aren’t They Rich?

CASE STUDY: College Majors and Annual Earnings 1-4 CONCLUSION APPENDIX: UNDERSTANDING GRAPHS Drawing Graphs The Slope of a Straight Line The Slope, Units of Measurement, and Marginal Analysis The Slopes of Curved Lines Line Shifts

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CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

economics, resources, labor, capital, natural resources, entrepreneurs, entrepreneurial ability, wages, interest, rent, profit, goods, services, scarcity, product market, resource market, the economic problem, the circular-flow model, microeconomics, macroeconomics, economic fluctuations, rational self-interest, marginal analysis, role of theory, other-things-constant assumption, behavioral assumption, variable, hypothesis, scientific method, positive versus normative statements, association-is-causation fallacy, fallacy of composition, and the mistake of ignoring secondary effects.

Students should also be able to: 䉴

list the steps in the scientific method and explain the role of assumptions in economic analysis.

䉴

trace through a simple circular-flow model

䉴

provide examples of the economic pitfalls.

䉴

explain why the average behavior of a large group of consumers can be predicted with greater accuracy than can the behavior of a particular consumer.

A student responsible for the appendix should be able to: 䉴

draw graphs showing a positive relation, a negative relation, no relation, and a tangency. The student should also be able to draw a line, find the value of the slope, and explain a line shift.

DISCUSSION MATERIAL ■

The chapter is a study in contrasts—beginning most fundamentally with the contrast between scarce resources and unlimited wants. Other contrasts in the chapter are goods versus services, goods versus bads, product markets versus resource markets, microeconomics versus macroeconomics, and normative versus positive. You can play on these distinctions in your presentation and discussion.

■

The chapter also develops an overall theme between economics as an art and economics as a science.

Economics is an art because it studies human decisions, not chemicals in a test tube or celestial bodies. Economics is a science because it tests hypotheses using the scientific method to discover how the economy works.

■

Students come into this course with many preconceptions about economics. Students usually fail to appreciate their own economic actions. Ask them what choices they made yesterday that could be covered in the scope of economics.

Trouble Spots While none of the ideas in this chapter is especially difficult for students, the problem is that students face so many new terms and concepts. One way to help them is to begin with the definition of economics and then pull it apart to examine scarce resources, unlimited wants, and the consequent need to make economic choices. The cause and effect of economic choice is what economics is about.

Chapter 1

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One idea your students may have trouble with is marginal analysis. Emphasize how marginal analysis cuts economic choice down to size. For example, the programming director at CBS must decide whether to replace the new situation comedy introduced last fall with another reality show. Likewise, the student must decide whether or not to attend your class today.

Give your students a feel for graphs. Go over the Chapter 1 Appendix material on graphs in class. Draw and explain curves that reflect various relationships. A step-by-step approach is a more effective tool for teaching graphs than a finished graph that appears in a book.

Additional Examples Rational self-interest — Universities and other non-profit institutions oppose any tax reform that would limit the tax-deductibility of charitable contributions. Non-profit institutions have also been concerned about a flat tax, which would eliminate deductions for charitable contributions.

Choice requires time and information — Consider the time and information needed to be a wise shopper at a grocery store, where thousands of items are sold. Considering price and quality, shoppers must decide the best buy in choosing meat, fish, detergent, soup, lettuce, popcorn, paper towels—you name it.

Theory — The role of theory is poorly understood. We use theories, or models, to simplify reality.

Consider the models in your classroom—the clock on the wall, wristwatches, maps. Ask students why these are models. When do models become less useful? (When they get too complicated).

Fallacy that association is not causation — Per pupil educational expenditures have increased sharply over the last three decades and so has the rate of imprisonment. Therefore, higher school spending leads to greater imprisonment.

Fallacy of composition — You can express your individuality by wearing the latest fashions.

Ignoring the secondary effects — The solution to unemployment is to provide everyone a guaranteed income whether or not they work.

What If? What if Adam Smith had never written The Wealth of Nations and economics had never developed as a discipline? Would we still face the economic problem of scarce resources but unlimited wants? (Yes.) Would resources be allocated less efficiently? (Not necessarily—people don’t need economists to tell them how to allocate their scarce resources.)

What if we all lived in a Garden of Eden where goods and services were abundant and provided by nature for free? What would be the role of the economist in such an economy? (Without scarcity, the economist would be out of business. But unless people lived forever, time would still be a scarce resource, just as it is in the real world.)

What if people lived forever but other resources were still scarce?

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5

CHAPTER 2 ECONOMIC TOOLS AND ECONOMIC SYSTEMS The chapter introduces students to some key ideas, such as opportunity cost, sunk cost, absolute and comparative advantage, the division of labor and gains from specialization, the production possibilities — frontier (PPF), how economic systems answer the three economic questions — — —what, how, and for whom — and differences among economic systems. All these ideas address the economic problem of scarce resources but unlimited wants. The graphs introduced in the appendix to Chapter 1 is integrated into the discussion in Chapter 2.

CHAPTER OUTLINE 2-1 CHOICE AND OPPORTUNITY COST 2-1a Opportunity Cost CASE STUDY: The Opportunity Cost of College 2-1b Opportunity Cost Is Subjective Calculating Opportunity Cost Requires Time and Information Time: The Ultimate Constraint Opportunity Cost Varies with Circumstance 2-1c Sunk Cost and Choice 2-2 COMPARATIVE ADVANTAGE, SPECIALIZATION, AND EXCHANGE 2-2a The Law of Comparative Advantage 2-2b Absolute and Comparative Advantage 2-2c Specialization and Exchange 2-2d Division of Labor and Gains from Specialization 2-3 THE ECONOMY’S PRODUCTION POSSIBILITIES 2-3a Efficiency and the Production Possibilities Frontier, or PPF 2-3b Inefficient and Unattainable Production 2-3c The Shape of the Production Possibilities Frontier 2-3d What Can Shift the Production Possibilities Frontier?

Changes in Resource Availability Increases in the Capital Stock Technological Change Improvements in the Rules of the Game 2-3e What We Learn from the PPF 2-4 ECONOMIC SYSTEMS 2-4a Three Questions Every Economic System Must Answer What Goods and Services Are to Be Produced?

How Are Goods and Services to Be Produced?

For Whom Are Goods and Services to Be Produced 2-4b Pure Capitalism 2-4c Pure Command System 2-4d Mixed and Transitional Economies 2-4e Economies Based on Custom or Religion 2-5 CONCLUSION

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CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

opportunity cost, sunk cost, law of comparative advantage, absolute advantage, barter, division of labor, specialization of labor, production possibilities frontier (PPF), efficiency, law of increasing opportunity cost, economic growth, economic system, the three economic questions, pure capitalism, private property rights, pure command system, and mixed economies.

Students should also be able to: 䉴

explain how the specialization of labor increases efficiency.

䉴

construct the PPF and state the assumptions behind it. (Assume only two goods with resources,technology, and the rules of the game constant during the period.)

䉴

explain why the PPF is bowed out from the origin. (Some resources are not equally productive in producing each good.)

䉴

show how the PPF illustrates scarcity, opportunity cost, efficiency, economic growth, and choice.

䉴

explain how the two polar economic systems answer the three economic questions.

DISCUSSION MATERIAL ■

The chapter discusses the specialization of labor at McDonald’s. Go over this example, bringing out the efficiency gains from specialization (e.g., taking advantage of individual abilities and job preferences, accumulating job-related experience, reducing the time required to shift between tasks, and introducing labor-saving machinery). McDonald’s sells much more than burgers. You might discuss the problems that arise when one firm tries to do too many different things.

■

Some principles of economics textbooks have only a single author, but others are co-authored, and a some have three or four authors. If specialization is so efficient, why do we observe principles books that have only one author? In fact, why stop at four authors? Why not have a different author for each chapter? (The tasks of coordinating the terminology, the writing styles, the examples, the degree of difficulty, data periods, and other aspects of the book increase with the number of authors, and these higher coordination costs overwhelm the gains from specialization.)

■

The last section of the chapter considers the different types of economic systems, ranging from pure capitalism to pure command system. Suppose you open the discussion by proposing a new grading system whereby everyone would receive the average grade for the class. Ask students about the effect of such a grading scheme on their individual incentives. This can lead to a discussion about the relationship between individual incentives, the allocation system, and efficiency. Transitional economies around the world provide discussion material about comparative economic systems.

Trouble Spots Perhaps the most difficult part in the chapter is the discussion of absolute and comparative advantage using the example of ironing and typing. Review this example so you can go over it in class. Note that the only resource involved in this example is each student’s time. The example also assumes that the two individuals involved have no trouble negotiating an exchange rate for their product.

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7

Additional Examples Opportunity cost — Ask students to consider the difference in opportunity cost under these alternative situations: (1) taking a vacation during spring break versus during final exams, (2) sleeping on the bus on the ride home after your final exams versus sleeping in the library at the beginning of final exam week, and (3) watching television the night before an exam versus any other night.

Why are fire trucks cleaner than police cars? (Fire fighters have a lower opportunity cost of time on the job than do police officers, because most of the time they have little to do. Keeping the trucks clean is also used as a form of regimentation and discipline, akin to keeping ones shoes shined in the military.)

A growing proportion of graduate students at U.S. universities, particularly in technical areas such as engineering and mathematics, come from abroad. Use opportunity cost to explain this phenomenon. (The pay differential in the United States between those with an undergraduate and those with a graduate degree in, say, electrical engineering is not great enough to encourage many U.S. students to pursue graduate studies.

Foreign students have a lower opportunity cost of time because pay abroad is relatively low.)

Commercials on late night television often involve courses for tractor-trailer operator schools, beautician schools, welding schools, and the like. Why aren’t these commercials on in the morning or during prime time? (In addition to the fact that advertising rates are much lower late at night, one target of these ads is the unemployed, who are more likely to stay up late since they do not need to get up for work.)

Absolute and comparative advantage — Suppose a dentist can clean teeth in less time than a dental assistant; the dentist therefore has an absolute advantage in the task. Does this mean that the dentist, rather than the dental assistant, should clean teeth? (Not necessarily, because there are other tasks such as drilling teeth and filling cavities where the dentist has both an absolute and a comparative advantage.)

Other distinctions between absolute and comparative advantage can be drawn from (1) the lawyer who can search legal documents more quickly than can the paralegal, (2) the senator who can more quickly compose responses to constituent letters than the senator’s staff can, (3) the company executive who is a better driver than the company’s chauffeur, and (4) the professor who is faster at grading exams than her teaching assistant.

Maine’s lobster industry is another example of comparative advantage. Because Maine’s long, rocky coastline and cold ocean waters offer the ideal habitat, that state produces 80 percent of the nation’s lobster catch.

What If? What if abilities across individuals were identical? How would this affect the gains from specialization and exchange? (It would reduce these gains.)

What if scientists develop a pill that eliminates the need for sleep? What would be the effect on the economy’s PPF? (If people were willing to work more hours, the PPF would expand.)

What if robots replace workers in most manufacturing jobs? Would this expand the PPF or simply increase unemployment? (The displaced workers would move to their best alternative employment, and the economy’s PPF would expand. Because human wants are unlimited, displaced workers would produce something else in demand such as services.)

Chapter 2

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CHAPTER 3 ECONOMIC DECISION MAKERS This chapter introduces the four economic decision makers and discusses their roles in the economy.

Because students have grown up with households, firms, governments, and the rest of the world, they take them for granted. This chapter tries to take a fresh look by explaining why institutions have evolved as they have. Although households are highlighted as the most important economic units, governments actually receive the most coverage in the chapter. Government will continue to surface in both the macroeconomic and microeconomic chapters.

CHAPTER OUTLINE 3-1 THE HOUSEHOLD 3-1a The Evolution of the Household 3-1b Households Maximize Utility 3-1c Households as Resource Suppliers 3-1d Households as Demanders of Goods and Services 3-2 THE FIRM 3-2a The Evolution of the Firm 3-2b Types of Firms Sole Proprietorships Partnerships Corporations 3-2c Cooperatives Consumer Cooperatives Producer Cooperatives 3-2d Not-for-Profi t Organizations CASE STUDY: User-Generated Products 3-2e Why Does Household Production Still Exist?

No Skills or Special Resources Are Required Household Production Avoids Taxes Household Production Reduces Transaction Costs Technological Advances Increase Household Productivity 3-3 THE GOVERNMENT 3-3a The Role of Government Establishing and Enforcing the Rules of the Game Promoting Competition Regulating Natural Monopolies Providing Public Goods Dealing with Externalities A More Equal Distribution of Income Full Employment, Price Stability, and Economic Growth 3-3b Government’s Structure and Objectives Difficulty in Defining Government Objectives Voluntary Exchange Versus Coercion No Market Prices

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3-3c The Size and Growth of Government 3-3d Sources of Government Revenue 3-3e Tax Principles and Tax Incidence 3-4 THE REST OF THE WORLD 3-4a International Trade 3-4b Exchange Rates 3-4c Trade Restrictions 3-5 CONCLUSION

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

utility, households as resource suppliers, households as demanders of goods and services, evolution of the household, transfer payments, transaction costs and the emergence of the firm, cottage industry, Industrial Revolution, reasons for household production, why some firms specialize, sole proprietorship, partnership, corporation, cooperatives, not-for-profit organizations, Information Revolution, market failure, role of government (establishing and enforcing rules of the game, regulating markets, regulating natural monopolies, providing public goods, addressing externalities, redistributing income, and promoting full employment with price stability), fiscal policy, monetary policy, differences between private markets and political markets, size and growth of U.S. government, sources of U.S. government revenue, ability-to-pay and benefits-received tax principles, tax incidence, proportional taxation, progressive taxation, marginal tax rate, regressive taxation, foreign exchange, exchange rate, merchandise trade balance, balance of payments, and trade restrictions (tariffs and quotas).

Students should also be able to: 䉴

describe the four economic actors and what, if anything, each is assumed to maximize.

䉴

describe the percentage composition of federal outlays and federal revenue since 1960.

DISCUSSION MATERIAL ■

You might think of this chapter as addressing a series of questions—questions you can focus on during your discussion. Why doesn’t all production occur in the home? If firms are so efficient, why doesn’t all production occur in firms? Why doesn’t a giant firm produce everything? Why does a market economy need government?

■

Discuss the evolution of the household from a tiny factory that produced much of what was consumed to a unit that buys most goods and services.

■

Households try to maximize utility and firms try to maximize profit, but the government’s objective is more elusive. One government objective discussed in the chapter is that elected officials try to maximize the number of votes received in the next election. Discuss this and other possible government objectives, such as pursuing the public interest or bureaucrats trying to maximize their budgets. What impact would term limits have on each objective?

10

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■

The case study, entitled “User Generated Products,” discusses the growing importance of open-source software (such as Linux), Wikipedia, Facebook, Twitter, YouTube, and other products that are created and updated by users. This is a different but timely market arrangement that students should find interesting.

■

Business analysts liken a business partnership to a marriage. Partners begin with enthusiasm and optimism but the relationship often dissolves because partners can’t get along. Why don’t sole proprietorships or corporations have these same problems?

■

As a way of introducing the rest of the world as an economic decision maker, ask students about their recent purchases of foreign products; clothing, shoes, and automobiles are likely candidates. Also ask about foreign musical groups.

Trouble Spots The rationale for government often takes an entire chapter to explain in other books. In this textbook, the government section is compressed. The discussion of externalities could benefit from a brief overview in class. The introduction of the rest of the world as an economic actor is also relatively compact and could also benefit from additional class discussion.

Additional Examples As an example of various stages of production, use a lawn mower from Sears. The manufacturer that sells mowers to Sears buys components such as engines from other manufacturers. Consider the problems a household would have trying to purchase a lawn mower by contracting with all the different resource suppliers involved.

Negative externalities — A neighbor’s dog barks through the night. Litter along the highway. People in the next apartment play music loud, music that you find appalling.

Positive externalities — Neighbors beautify their houses and landscape their yards. The person next to you on the bus smells good. People in the next apartment play music loud, music that you find appealing.

What If? What if government regulations prohibited all production outside the home? What would the economy look like without firms or factories?

What if the corporate income tax was abolished? What effect would this have on the dominant type of firm in terms of sales and in terms of numbers of firms?

Economic Decision Makers © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

11

CHAPTER 4 DEMAND, SUPPLY, AND MARKETS This chapter is relatively difficult because so much analytical material comes so early in the book. Major topics include demand, supply, quantity demanded, quantity supplied, markets, equilibrium price and quantity, shifts of demand and supply, and disequilibrium. Diagrams play a central role, as they should in your presentation and discussion. Since the market is the heart of the market system, this chapter may be the most important in the book.

CHAPTER OUTLINE 4-1 DEMAND 4-1a The Law of Demand Demand, Wants, and Needs The Substitution Effect of a Price Change The Income Effect of a Price Change 4-1b The Demand Schedule and Demand Curve 4-2 SHIFTS OF THE DEMAND CURVE 4-2a Changes in Consumer Income 4-2b Changes in the Prices of Other Goods 4-2c Changes in Consumer Expectations 4-2d Changes in the Number or Composition of Consumers 4-2e Changes in Consumer Tastes 4-3 SUPPLY 4-3a The Supply Schedule and Supply Curve 4-4 SHIFTS OF THE SUPPLY CURVE 4-4a Changes in Technology 4-4b Changes in the Prices of Resources 4-4c Changes in the Prices of Other Goods 4-4d Changes in Producer Expectations 4-4e Changes in the Number of Producers 4-5 DEMAND AND SUPPLY CREATE A MARKET 4-5a Markets 4-5b Market Equilibrium 4-6 CHANGES IN EQUILIBRIUM PRICE AND QUANTITY 4-6a Shifts of the Demand Curve 4-6b Shifts of the Supply Curve 4-6c Simultaneous Shifts of Demand and Supply Curves 4-7 DISEQUILIBRIUM PRICES 4-7a Price Floors 4-7b Price Ceilings CASE STUDY: Rent Ceilings in New York City 4-8 CONCLUSION

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CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

demand, the law of demand, quantity demanded, substitution effect of a price change, income effect of a price change, money income, real income, demand curve, individual demand, market demand, a movement along the demand curve versus a shift of the demand curve, factors that can shift the demand curve, normal goods, inferior goods, substitutes, complements, tastes, supply law of supply, supply curve, quantity supplied, a m ovem ent along the supply curve versus a shift of the supply curve, factors that can shift the supply curve, transaction costs of exchange, specialized markets, equilibrium price and quantity, surplus, shortage, price floor, price ceiling, governmentcreated disequilibrium, and disequilibrium in private markets.

Students should also be able to: 䉴

describe what will cause a change in quantity demanded (a change in the price of the good) and what will cause a shift of the demand curve (changes in income, changes in the prices of related goods, and so on). Students should also be able to describe what causes a change of quantity supplied and a shift of the supply curve.

䉴

describe the market forces at work when the price is initially above the market-clearing level or below the market-clearing level.

䉴

show the effects of a price floor and price ceiling on market price and quantity. Students should be able to note the importance of the price at which the floor or ceiling is set. They should also be able to describe what nonprice allocation schemes might occur with price ceilings.

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explain how markets reduce the transaction costs of exchange. (They reduce the time and information required for choice.) Students should be able to provide examples of how markets economize on time and information.

䉴

explain the effects of the following on gold’s equilibrium price and quantity: (1) scientists discover that gold coming into contact with the body can cause cancer, (2) people lose faith in paper money and begin using gold as money, (3) a huge vein of gold ore is discovered in Texas, (4) alchemists discover how to make gold out of junk mail, (5) Starbucks develops a premium coffee called Columbian Gold that has real gold it; and (6) central banks around the world announce they are selling a major portion of their gold reserves (this, in fact, has occurred).

DISCUSSION MATERIAL ■

Your primary contribution here is to convey a feel for how markets work. Use supply-and-demand analysis to show how and why equilibrium is achieved. Then introduce a shift of supply and demand to trace through the adjustment process. Make sure that the students understand the logic behind the curves before you shift them. Ask students to explain market forces.

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When markets work well, they are usually taken for granted; but when quantity supplied does not equal quantity demanded, people notice. Discuss shortages and the kinds of nonprice mechanisms that arise to allocate products when market forces are not working or are slow to equate quantity supplied and quantity demanded. Examples might include the following: enrollment slots in classes that are very popular, concert tickets for popular musicians, parking spaces on campus, entry into trendy nightspots, and rooms in the best dormitories.

Demand, Supply, and Markets © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

13

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Sometimes sellers stay in one place and a buyer seeks them out, such as stores at the mall or any retail outlet. Other times the buyer stays in one place and sellers seek them out, such as sales representatives who call on businesses or Web sites selling products online. Can we explain these different sales approaches as a way of minimizing the transaction costs of exchange? (Often sellers seek out buyers when buyers cluster together: textbook sales representatives visit faculty offices that are located together; a roving hot dog vendor sells to customers seated at the sports stadium; customers who buy online do not have to be physically near the seller.)

Trouble Spots Because seasoned teachers are so imbued with supply and demand, they have trouble giving this a fresh feel. Students just begin to become familiar with a curve when we start shifting it on them. Shifting curves seems strange to beginning students. Students will benefit from a careful treatment of why curves shift and what effect these shifts have on equilibrium price and quantity. Also, the blackboard or whiteboard has a real advantage over diagrams in the textbook because the instructor can follow a sequential order to show the shift and the results.

Additional Examples Shortages — Ticket scalpers thrive when the posted price is below the market-clearing level. What kind of service do scalpers perform? Would society be better off or worse off if scalping was prohibited, as it is in many states? Who specifically is better off? (Those who could not have otherwise purchased a ticket.) And who is worse off? (Those quite willing to wait in line to purchase a ticket—that is, those with a relatively low opportunity cost of time.)

What If? What if goods were allocated by something other than price? What sort of rationing schemes can students devise?

What if cells in human skin converted sunlight directly into a source of energy through photosynthesis, thereby reducing the need to eat? How might the economy differ? What would happen to the market for food, clothing, and real estate in Arizona or Alaska?

What if computers were able to link consumers directly with producers (as is the case with Internet auction sites)? Would shopping malls go out of business?

Chapter 4

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CHAPTER 5 ELASTICITY OF DEMAND AND SUPPLY This chapter works through the logic and terminology of elasticity in a fairly standard way and tries to convey the importance of price elasticity to producers. The midpoint formula is the focus. Also included is a long case study on the farm problem. Most of the chapter focuses on the price elasticity of demand, but supply elasticity, as well as income elasticity and cross-price elasticity of demand are also covered.

CHAPTER OUTLINE 5-1 PRICE ELASTICITY OF DEMAND 5-1a Calculating Price Elasticity of Demand 5-1b Categories of Price Elasticity of Demand 5-1c Elasticity and Total Revenue 5-1d Price Elasticity and the Linear Demand Curve 5-1e Constant-Elasticity Demand Curves Perfectly Elastic Demand Curve Perfectly Inelastic Demand Curve Unit-Elastic Demand Curve 5-2 DETERMINANTS OF THE PRICE ELASTICITY OF DEMAND 5-2a Availability of Substitutes 5-2b Share of the Consumer’s Budget Spent on the Good 5-2c Duration of Adjustment Period 5-2d Elasticity Estimates 5-3 PRICE ELASTICITY OF SUPPLY 5-3a Constant Elasticity Supply Curves Perfectly Elastic Supply Curve Perfectly Inelastic Supply Curve Unit-Elastic Supply Curve 5-3b Determinants of Supply Elasticity 5-4 OTHER ELASTICITY MEASURES 5-4a Income Elasticity of Demand CASE STUDY: The Market for Food and the “Farm Problem” 5-4b Cross-Price Elasticity of Demand Substitutes Complements 5-5 CONCLUSION

15 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

price elasticity of demand, price elasticity formula, elastic demand, inelastic demand, unit-elastic demand, total revenue, the relationship between total revenue and price elasticity of demand, linear demand curve, price elasticity along a linear demand curve, perfectly elastic demand curve, perfectly inelastic demand curve, unit-elastic demand curve, constant-elasticity demand curve, determinants of demand elasticity (availability of substitutes, proportion of the consumer’s budget spent on the good, how narrowly the good is defined, the time period considered, and whether the good is a luxury or a necessity), price elasticity of supply, elastic supply, inelastic supply, perfectly elastic supply curve, perfectly inelastic supply curve, unit-elastic, supply curve, determinants of price elasticity of supply (how the cost of producing each additional unit changes as output increases, the time period considered), income elasticity of demand, and crossprice elasticity of demand.

Students should also be able to: 䉴

explain why demand is more elastic the more narrowly defined the good is. (The more narrowly defined the good, the more substitutes that good has.)

䉴

discuss the role of time in determining the elasticities of demand and supply. (The longer the adjustment period, the greater the price elasticities of demand and supply. Consumers have more time to find substitutes, and producers have more time to alter their rate of output.)

䉴

explain why price elasticity of demand varies along a linear demand curve that slopes downward.

䉴

show with two diagrams, one under the other, how a downward-sloping linear demand curve relates to its total revenue curve.

䉴

explain why the income elasticity of demand for some goods is negative.

DISCUSSION MATERIAL ■

Demand for some goods are more price elastic than for others. Ask students to discuss the price elasticity of demand for the following products: drugs to a drug addict, gasoline to a traveler or a cabdriver, gasoline to a joyrider, food, Chicken McNuggets, postage stamps, parking at the airport, access to a particular Web site.

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Demand is more price elastic in the long run than in the short run. Discuss the kinds of adjustments that consumers can make over time if the price of a product (such as gasoline, electricity, rent, or beef) rises sharply.

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Much advertising is aimed at fostering the belief that a particular good has no close substitutes. Discuss why producers try to present their products as unique (so demand will become less elastic, allowing producers to raise the price without experiencing much of a decline in quantity demanded).

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Consider the role of custom, or habit, in determining price elasticity of demand. (To the extent that consumers are creatures of habit, they continue to purchase a good even if its price rises.) Producers have an abiding interest in encouraging consumers to develop certain buying habits. In fact, if a firm is sold, part of the selling price reflects the value of customer buying habits. There is evidence that brand loyalty has been breaking down as evidenced by the rising share of sales accounted for by generic, or house brands. For example, the sale of generic brand cigarettes increased from only 5 percent of the market in 1984 to more than 15 percent of the market today.

In response, the Phillip Morris Company cut the price of its Marlboro brand by 20 percent. Cereal makers have also cut price because consumers were switching to generic brands.

16

Chapter 5 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

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Discuss how brand loyalty explains why TV advertisers are willing to pay more for commercials appealing to a younger crowd (those 18 to 49) than for those appealing to older viewers. (Brand loyalty is worth more to a producer, the younger the consumer, because younger consumers will buy the product for years longer).

Trouble Spots Because so much terminology is introduced, students may lose the intuitive appeal of elasticity. Simply put, price elasticity indicates how responsive buyers and sellers are to changes in the price. Exhibits throughout the chapter help keep that straight. Your job should be to emphasize the logic and intuition.

Several diagrams in this chapter should be reinforced by your step-by-step class presentations. At the chalkboard, whiteboard, PowerPoint, or other software you can build exhibits in a sequential way that cannot be done as easily in the book. In particular, Exhibit 2 shows the relation between price elasticity and total revenue for the downward-sloping linear demand curve. Better still, invites students up front to present the figures.

Additional Examples Price elasticity and the definition of the good — The more narrowly defined the good, the greater the price elasticity of demand because more substitutes exist for more narrowly defined goods. You could talk about the demand for recorded music, the demand for Rihanna’s recordings, or the demand for her downloads. Likewise, you could talk about the demand for higher education, the demand for public colleges, or the demand for a specific college (such as the college where this course is being offered).

What If? What if someone develops an engine that runs on water? What effect will this have on the market for gasoline?

What if China begins producing and exporting inexpensive but high-quality automobiles? What will happen to the price elasticity of demand for U.S. produced automobiles?

Elasticity of Demand and Supply © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

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CHAPTER 6 CONSUMER CHOICE AND DEMAND This chapter examines the underpinnings of demand, using utility analysis to explore the relationship between price and quantity demanded. Total and marginal utility are used to show how a consumer maximizes utility. The utility-maximizing conditions are laid out, and the effects of a change in price on the optimal consumption bundle are examined. The appendix explains indifference curves, budget lines, and utility maximization. The chapter underscores that consumers need not understand utility analysis in order to maximize utility (they need only behave in a manner consistent with rational self-interest). Nonetheless, economists develop utility analysis to help make predictions about consumer behavior.

CHAPTER OUTLINE 6-1 UTILITY ANALYSIS 6-1a Tastes and Preferences 6-1b The Law of Diminishing Marginal Utility 6-2 MEASURING UTILITY 6-2a Units of Utility 6-2b Utility Maximization in a World without Scarcity 6-2c Utility Maximization in a World of Scarcity 6-2d Utility-Maximizing Conditions 6-3 APPLICATIONS OF UTILITY ANALYSIS 6-3a Consumer Surplus 6-3b Market Demand and Consumer Surplus CASE STUDY: The Marginal Value of Free Medical Care 6-4 THE ROLE OF TIME IN DEMAND 6-5 CONCLUSION APPENDIX: INDIFFERENCE CURVES AND UTILITY MAXIMIZATION Consumer Preferences The Budget Line Consumer Equilibrium at the Tangency Effects of a Change in Price Income and Substitution Effects Conclusion

18 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

total and marginal utility, the law of diminishing marginal utility, utility maximization conditions, marginal valuation, consumer surplus, and deriving the market demand from individual demand.

Students should also be able to: 䉴

explain why utility maximization implies that the last dollar spent on each good yields for the consumer the same marginal utility.

䉴

indicate whether individuals would ever willingly choose a quantity where total utility is falling.

(No way.)

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determine how much of each good would be consumed if all goods and services were free. (People would consume each product to the point where the marginal utility was zero.)

䉴

explain the relationship between marginal utility and the law of demand.

Students responsible for the appendix material should be able to explain the following: 䉴

indifference curves, marginal rate of substitution, law of diminishing marginal rate of substitution, indifference map, budget line, equilibrium condition using an indifference-curve approach, effects of a change in income, effects of a change in price, the income and substitution effects of a price change.

Students responsible for the appendix material should also be able to: 䉴

draw an indifference map and discuss the properties of indifference curves. (Each indifference curve reflects a constant though unspecified level of utility; indifference curves slope downward and are bowed-in toward the origin; and indifference curves do not intersect.)

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draw the utility-maximizing condition, given the consumer’s budget constraint and the indifference map, and explain why that particular level of consumption represents maximum utility.

䉴

use indifference curve analysis to show the effects of a change in price or a change in income.

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use indifference curve analysis to show the income and substitution effects of a price change.

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use indifference curve analysis to show the effects of a change in income on the quantity of each good demanded.

DISCUSSION MATERIAL ■

Principles courses typically focus on the price as the only relevant measure of consumer cost. The final section of the chapter emphasizes the role of time in demand. Other things constant, consumers value products that involve less time more than they value products involving more time. For example, consumers value paint that dries faster, garden plants that grow faster, medicine that works quicker, and meals that require less preparation.

Consumer Choice and Demand © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

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When we look at total and marginal utility based on the consumption of two goods, we implicitly assume that the marginal utility derived from each good must be independent from the number of units of the other good consumed. You might want to discuss this limitation.

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The law of diminishing marginal utility says that marginal utility will decline sooner or later. Marginal utility sometimes increases for the first few units consumed. For example, automobile tires yield no utility until four of them are available. Point out to your students that the law of diminishing marginal utility does not claim that marginal utility will necessarily decline right away—just that it will decline eventually.

Trouble Spots In discussing utility, we must make clear that we cannot compare one person’s utility with another’s. We can examine different levels of utility only for the same person. Utility is therefore useful in examining individual demand. Demand can be derived for each individual; then these individual demand curves can be summed horizontally to derive the market demand curve. Thus, although utility comparisons across individuals are not possible, we can use utility analysis to derive market demand. We can determine that one consumer is willing to pay more for the first unit of a good than another consumer is, but we cannot infer from this that the consumer willing to pay the higher price derives more utility from the first unit of the good than does the other consumer.

Although some economists have reservations about the use of consumer surplus, particularly when market demand curve is involved, consumer surplus is a useful tool for conveying the consumer benefits of a lower price.

Additional Examples Diminishing marginal utility — As the text mentions, newspaper vending machine operators can be reasonably sure that customers will take only one copy, not the entire stack. In contrast, other types of vending machines, such as for soft drinks or candy, dispense only one unit at a time because the marginal utility of additional units is positive.

The pricing of amusement parks reflects the law of diminishing marginal utility. For example, the price of an annual pass to Disney World is not much more than twice the price of a one-week pass. The management figures that beyond two weeks a year, the marginal value of more days spent at Disney World approaches zero.

What If? What if a certain consumer is in a rut and prefers a certain kind of food regardless of what else is available?

Perhaps you know someone who eats the same thing all the time (maybe you do). In fact psychologists have shown that some people prefer the same meal on a fairly regular basis.What does this say about the law of diminishing marginal utility? (That law applies more to consumption over a short period of time, such as having additional sub sandwiches at one sitting. Some season-ticket holders apparently still enjoy sitting through 75 baseball games a season.)

Chapter 6

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CHAPTER 7 PRODUCTION AND COST IN THE FIRM This chapter is loaded with information about how firms operate in the short run and the long run. Perhaps the most important contribution of the chapter is the shape and logic of the short-run and long-run cost curves. These curves will be utilized throughout the micro section to explain the firm’s supply behavior.

The appendix develops the use of input combinations using isocosts and isoquants. If students are held responsible for the appendix material, then you should try to guide them through it.

CHAPTER OUTLINE 7-1 COST AND PROFIT 7-1a Explicit and Implicit Costs 7-1b Alternative Measures of Profit 7-2 PRODUCTION IN THE SHORT RUN 7-2a Fixed and Variable Resources 7-2b The Law of Diminishing Marginal Returns Increasing Marginal Returns Diminishing Marginal Returns 7-2c The Total and Marginal Product Curves 7-3 COSTS IN THE SHORT RUN 7-3a Total Cost and Marginal Cost in the Short Run Total Cost Marginal Cost Total and Marginal Cost Curves 7-3b Average Cost in the Short Run 7-3c The Relationship between Marginal Cost and Average Cost 7-4 COSTS IN THE LONG RUN 7-4a Economies of Scale 7-4b Diseconomies of Scale 7-4c The Long-Run Average Cost Curve CASE STUDY: Scale Economies and Diseconomies at the Movies 7-4c Economies and Diseconomies of Scale at the Firm Level 7-5 CONCLUSION APPENDIX: A CLOSER LOOK AT PRODUCTION AND COST The Production Function and Efficiency Isoquants Isocost Lines The Choice of Input Combinations The Expansion Path Summary

21 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

explicit costs, implicit costs, accounting profit, economic profit, normal profit, variable resources, fixed resources, variable cost, fixed cost, short run, long run, production function, increasing marginal returns, law of diminishing marginal returns, total and marginal product, total and marginal cost, average variable cost, average total cost, average and marginal cost curves, long-run average cost curve, economies and diseconomies of scale, constant long-run average cost, and minimum efficient scale.

Students should also be able to: 䉴

draw the marginal and average cost curves and explain how the marginal cost curve gets its shape.

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explain the relation between the marginal product curve and the marginal cost curve.

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explain why firms first experience increasing marginal returns, then diminishing marginal returns.

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explain the sources of economies of scale and diseconomies of scale.

Students responsible for the appendix should be able to explain the following: 䉴

production function, efficiency, isoquants, marginal rate of technical substitution, isocosts, optimal input combinations, and expansion path.

Students responsible for the appendix material should also be able to: 䉴

draw a family of isoquants and explain the shape of these curves.

䉴

draw an isocost line and explain its shape.

䉴

explain why isoquants slope downward, bow in toward the origin, and do not intersect.

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combine isoquant and isocost curves to indicate the combination of resources that minimizes cost for a given output or maximizes output for a given cost.

䉴

draw a firm’s long-run expansion path.

DISCUSSION MATERIAL ■

Two factors determine the shape of the short-run cost curves: fixed cost and the marginal returns to the variable resource. All the short-run cost curves can be generated based on knowledge of fixed cost and of increasing and diminishing marginal returns. Once fixed cost and marginal cost are determined, the average cost and total cost curves reflect a purely mathematical relation with fixed and marginal costs.

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The shape of the long-run cost curve is determined by economies and diseconomies of scale. Students often confuse the factors that cause increasing and diminishing marginal returns in the short run with those that cause economies and diseconomies of scale in the long run. You could use McDonald’s as an example of both phenomena. The chapter already discusses increasing and diminishing marginal returns. There is also a discussion of economies of scale in meal preparation. All you need to add is diseconomies of scale at McDonald’s. You could describe a restaurant so large that the parking lot is huge and some parking spots require a long walk. The manager has difficulty coordinating the hundreds of employees. Orders get garbled. Note that here we are talking about diseconomies of scale at the plant level, that is, at a particular location, not at the firm level.

22

Chapter 7 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

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Cost curves are key to analyzing firm behavior. You should draw the short-run cost curves and ask your students to describe the rationale behind their shapes. Make sure students understand why the marginal cost curve crosses the average variable and average total cost curves at their low points.

Trouble Spots One point of the chapter that may prove elusive for students is the switch from marginal product to marginal cost. Exhibits 2 and 3 focus on the marginal physical product at Smoother Mover, and Exhibit 4 shows the marginal cost implied by that marginal physical product. Marginal product considers the effects on total output of a one-unit change in the variable resource, but marginal cost considers the effects on total cost of a one-unit change in output.

Additional Examples Economies and diseconomies of scale — A cardboard box that is 1 foot on each side has a capacity of 1 cubic foot and requires 6 square feet of cardboard to make. The cardboard-to-volume ratio is 6 to 1. A cardboard box that is 2 feet on each side has a capacity of 8 cubic feet and requires 24 square feet of cardboard to make, yielding a cardboard-to-volume ratio of 3 to 1. Thus, a larger box holds more relative to the cardboard required. But, as we increase the size, at some point the box becomes too large to support the weight of the load, reflecting diseconomies of scale. For example, a box that is 10 feet on each side would hold 1,000 cubic feet and require only 600 square feet of cardboard. But a box that size becomes unwieldy, and the cardboard would have to be reinforced to support the weight.

What If? What if marginal returns to labor increased indefinitely? What would the typical firm look like? (One firm with little capital but many employees could supply the entire market.)

What if diseconomies of scale set in at very low levels of output relative to the size of the market? How would this affect the number of firms in the market? (There would be more firms.)

Production and Cost in the Firm © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

23

CHAPTER 8 PERFECT COMPETITION This chapter introduces the benchmark for market analysis—perfect competition. It begins with assumptions underlying perfect competition, then turns to profit maximization for the firm in the short run and the long run. The point of the chapter is that each perfectly competitive firms has no control over the market price; each can control only the amount supplied at that price. The chapter then proceeds to examine what rate of output will maximize firm profits or minimize firm losses in the short run and in the long run. According to the golden rule of profit maximization, firms choose that rate of output where marginal cost equals marginal revenue (unless the firm is better off shutting down). The last third of the chapter examines the long-run industry supply curve.

CHAPTER OUTLINE 8-1 AN INTRODUCTION TO PERFECT COMPETITION 8-1a Perfectly Competitive Market Structure 8-1b Demand Under Perfect Competition 8-2 SHORT-RUN PROFIT MAXIMIZATION 8-2a Total Revenue Minus Total Cost 8-2b Marginal Revenue Equals Marginal Cost 8-2c Economic Profit in the Short Run 8-3 MINIMIZING SHORT-RUN LOSSES 8-3a Fixed Cost and Minimizing Losses 8-3b Marginal Revenue Equals Marginal Cost 8-3c Shutting Down in the Short Run 8-4 THE FIRM AND INDUSTRY SHORT-RUN SUPPLY CURVES 8-4a The Short-Run Firm Supply Curve 8-4b The Short-Run Industry Supply Curve 8-4c Firm Supply and Industry Equilibrium 8-5 PERFECT COMPETITION IN THE LONG RUN 8-5a Zero Economic Profit in the Long Run 8-5b The Long-Run Adjustment to a Change of Demand Effects of an Increase of Demand Effects of a Decrease of Demand 8-6 THE LONG-RUN INDUSTRY SUPPLY CURVE 8-6a Constant-Cost Industries 8-6b Increasing-Cost Industries 8-7 PERFECT COMPETITION AND EFFICIENCY 8-7a Productive Efficiency: Making Stuff Right 8-7b Allocative Efficiency: Making the Right Stuff 8-7c What’s So Perfect About Perfect Competition CASE STUDY: Experimental Economics 8-8 CONCLUSION

24 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

market structure, characteristics of perfect competition, commodity price taker, fi rm demand under perfect competition, short-run profi t maximization, marginal revenue (M R), golden rule of profi t maximization, average revenue (AR), minimizing short-run losses, shutting down in the short run, firm and industry short-run supply curves, long-run equilibrium, long-run industry supply curve, constant-cost industries, increasing-cost industries, productive efficiency, allocative efficiency, producer surplus, and social welfare.

Students should also be able to: 䉴

show the firm in short-run equilibrium (1) earning economic profit, (2) minimizing economic losses, and (3) earning only a normal profit.

䉴

draw diagrams side by side showing the perfectly competitive firm and the industry in long-run equilibrium.

䉴

begin with a firm in long-run equilibrium to show the effects of an increase in market demand, assuming a constant-cost industry.

䉴

explain why perfectly competitive firms earn no economic profit in the long run. (Economic profit will attract new entrants in the long run until such profit falls to zero.)

䉴

distinguish between the long-run industry supply curves in constant-cost and in increasing-cost industries.

䉴

explain why perfectly competitive firms will not sell their product for less than the market price. (Why sell below market price when they can sell all they want at the market price?)

䉴

explain the logic of the golden rule of profit maximization. (If marginal cost is less than marginal revenue, firms can increase profits or reduce losses by expanding output. If marginal cost exceeds marginal revenue, firms can increase profits or reduce losses by reducing output.)

䉴

explain the gains from voluntary exchange (consumer surplus and producer surplus).

DISCUSSION MATERIAL ■

Discuss the assumptions underlying a perfectly competitive market and show how these assumptions relate to conclusions developed in the chapter. You might refer to the chapter’s Conclusion for a brief analysis of each assumption.

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Adam Smith’s invisible hand is best expressed by perfect competition. Firms are motivated only by their pursuit of profit, yet they act as if they cared about the efficient satisfaction of consumer desires.

Perfect Competition © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

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The chapter assumes for simplicity that all firms in an industry have the same cost curves. In reality some firms probably have cost conditions that differ from the average. If firms earn an economic loss in the short run, then some will drop out of the industry in the long run. By assuming that all firms face the same costs, the chapter does not address the question of which firms will exit and which firms will remain. In reality some firms lose more money than other firms; the biggest losers get out first.

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Once we get away from the idea that all firms are exactly alike, we can discuss more interesting market conditions. For example, some viable firms must compete with other firms that are losing money in the short run.

Trouble Spots Clearly, the most difficult section of this chapter is the development of the long-run industry supply curve.

The adjustment process to demonstrate constant costs and increasing costs is daunting since students have just been introduced to how and why firms adjust their output. Your time will be well spent if you work students through the long-run adjustment process by showing them a series of diagrams. Begin with the firm and the industry in long-run equilibrium; then introduce an increase in market demand. Trace the effects of this increase in the short run and in the long run. The adjustment process captures much of the dynamics of firm and industry behavior.

Additional Examples Increasing-cost industry — When higher education expanded in the 1960s and early 1970s, tuition rose much faster than general inflation because the supply of college faculty was relatively inelastic. Faculty salaries were bid up as a result.

Long-run adjustment process — The growth of cable and satellite TV increased the number of stations that could be delivered to homes, and the number of stations proliferated. This increased supply reduced the profits of individual stations, resulting in some bankruptcies.

What If? What if all the assumptions of perfect competition held, except the one regarding information? Suppose that not all consumers and firms have full information about prices and production processes.

What if some perfectly competitive firms decided not to maximize profits but to ensure that managers have enough leisure time to keep their golf games sharp? Would perfect competition then be inefficient? (Firms that pursue goals at the expense of profits would not survive in the long run.)

Chapter 8

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CHAPTER 9 MONOPOLY Just as the previous chapter discussed the assumptions and the logic of perfect competition, this chapter does the same for monopoly. The easiest way to introduce monopoly is by contrasting it with something the students already know—that is, perfect competition. Perhaps the most important distinction between perfect competition and monopoly is that there are no barriers to entry with perfect competition. Under monopoly, by definition, barriers block entry. Many of the important distinctions between the two market structures flow from the difference in entry barriers. The chapter also tries to bring out similarities between perfect competition and monopoly. For example, both firms try to maximize profit by producing the output rate where marginal cost equals marginal revenue.

CHAPTER OUTLINE 9-1 BARRIERS TO ENTRY 9-1a Legal Restrictions Patents and Invention Incentives Licenses and Other Entry Restrictions 9-1b Economies of Scale 9-1c Control of Essential Resources CASE STUDY: Is a Diamond Forever?

9-2 REVENUE FOR THE MONOPOLIST 9-2a Demand, Average Revenue, and Marginal Revenue 9-2b The Gain and Loss from Selling One More Unit 9-2c Revenue Schedules 9-2d Revenue Curves 9-3 THE MONOPOLIST’S COSTS AND PROFIT MAXIMIZATION 9-3a Profit Maximization Total Revenue Minus Total Cost Marginal Revenue Equals Marginal Cost Graphical Solution 9-3b Short-Run Losses and the Shutdown Decision 9-3c Long-Run Profit Maximization 9-4 MONOPOLY AND THE ALLOCATION OF RESOURCES 9-4a Price and Output under Perfect Competition 9-4b Price and Output under Monopoly 9-4c Allocative and Distributive Effects 9-5 PROBLEMS ESTIMATING THE DEADWEIGHT COST OF MONOPOLY 9-5a Why the Deadweight Loss of Monopoly Might Be Lower 9-5b Why the Deadweight Loss of Monopoly Might Be Higher

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9-6 PRICE DISCRIMINATION 9-6a Conditions for Price Discrimination 9-6b A Model of Price Discrimination 9-6c Examples of Price Discrimination 9-6d Perfect Price Discrimination: The Monopolist’s Dream 9-7 CONCLUSION

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

barriers to entry (legal restrictions, economies of scale, control of essential resources), patents, innovation, demand and marginal revenue for the monopolist, price makers, short-run profit maximization, minimizing shortrun losses and the shut-down decision, comparison of perfect competition and monopoly, deadweight loss of monopoly, why the deadweight loss of monopoly might be lower (fear of potential rivals, fear of government regulation), why the deadweight loss of monopoly might be higher (monopolists grow fat and lazy, rent-seeking activity to secure and maintain monopoly power), price discrimination, prerequisites for price discrimination (downward-sloping demand curve, at least two identifiable groups of consumers with different price elasticities of demand, ability to discriminate among groups, ability to prevent resale among groups), and perfect price discrimination.

Students should also be able to: 䉴

use diagrams to show the relationship between price elasticity of demand, marginal revenue, and total revenue. Students should also be able to explain why the monopolist will never choose to produce where demand is inelastic.

䉴

use a diagram to compare perfect competition and monopoly and explain why monopoly is less efficient than perfect competition.

䉴

explain how a price-discriminating monopolist determines what price to charge each category of customer.

䉴

use a diagram to show perfect price discrimination, identify economic profit in the diagram, and explain why this is called “the monopolist’s dream.”

䉴

explain why monopoly power does not guarantee economic profit (demand for the product may not be sufficient).

䉴

use a diagram to show a monopolist minimizing losses in the short run and explain what this firm can do in the long run to eliminate those losses. (To eliminate long-run losses, a monopolist will either change the scale of operation and advertise more to boost demand. If neither works, the firms will go out of business.)

DISCUSSION MATERIAL ■

Monopoly profit provides powerful incentives for potential rivals to enter the industry. New entrants will attempt to offer substitutes. For example, profits earned by the National Football League (NFL) prompted several upstart leagues like the United States Football League and the XFL to attempt entry. These attempts failed because the new leagues did not offer a product that was viewed as a close enough substitute. The NFL has been able to control key resources such as talented players, sports arenas, and television contracts. But monopoly profits are so enticing that new leagues will continue

28

Chapter 9 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

to enter, and one may eventually succeed. After all, the American Football League was originally an outside competitor that eventually merged with the NFL. Likewise the American Basketball Association (ABA) was absorbed by the National Basketball Association (NBA).

■

Every day the stocks of thousands of companies are bought and sold. Some of these companies are monopolies. Discuss why people would buy stocks in competitive firms, which in the long run earn only a normal rate of return, when they could buy shares in monopolies, which in the long run have the opportunity of earning economic profits. Point out that the share price of monopoly firms gets bid up until those buying such shares can expect a rate of return that is no higher than could be earned on shares of perfectly competitive firms.

Trouble Spots Diagrams will give your students the most trouble in this chapter; the most involved diagram is Exhibit 6, which summarizes profit maximization using both the marginal curves and the total curves. Carefully walk your students through the construction of this diagram. Point out that in panel (a) profit is measured by an area but in panel (b) profit is measured by the vertical distance between the total cost and total revenue curves. Identify profit maximization in each panel.

Note that Q is used in diagrams to represent market output in competitive markets and the monopolist’s output (since monopoly output is the market output). The output of a competitive firm is represented by q.

Additional Examples Monopolies — The campus bookstore once was the only source of textbooks (but Internet sites now erode that monopoly power). In many localities, government is the only provider of certain public goods such as fire protection, maintenance of the streets, and running water.

Price discrimination — The price (per quart) of a gallon of milk is less than the price of a quart of milk.

Movies charge less for matinees. Restaurants have “early bird” specials (thus, dividing customers based on when they eat).

What If? What if the government auctioned monopoly rights to the highest bidder? How much would be bid for these production rights, and what effect would this have on the profit-maximizing price and quantity? (Producers would bid up to an amount equal to the present value of the expected economic profits generated by the monopoly. The profit-maximizing price and quantity would be the same whether the firm received the right to the monopoly through an auction or was simply given the right. That’s because the price that a firm pays for monopoly rights affects fixed cost, not marginal cost.)

What if there is only one seller in a particular industry, but entry is easy? Should we call that firm a monopoly? For example, what if there is only one real estate agent in your hometown? (A single seller would not be viewed as a monopoly as long as other firms can enter the industry with ease. Evidently the real estate business in your hometown is so slow that it can support only one agent. But if business picks up or if the existing agent tries to charge more than a normal rate of return, others will enter the industry. So the existence of only one seller is a necessary, but not a sufficient, condition for monopoly.)

Monopoly

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CHAPTER 10 MONOPOLISTIC COMPETITION AND OLIGOPOLY Students have by now examined the polar cases of perfect competition and monopoly, but most firms in the economy are neither. This chapter examines monopolistic competition and oligopoly—the two market structures that reflect the majority of firms doing business today. The chapter offers several models of oligopoly, including cartels, price leadership, and game-theory models, especially the prisoner’s dilemma.

The interdependence of oligopolistic firms leaves the door wide open for all sorts of behavior. No single oligopoly model has gained wide acceptance.

CHAPTER OUTLINE 10-1 MONOPOLISTIC COMPETITION 10-1a Product Differentiation Physical Differences Location Services Product Image 10-1b Short-Run Profit Maximization or Loss Minimization Marginal Revenue Equals Marginal Cost Maximizing Profit or Minimizing Loss in the Short Run 10-1c Zero Economic Profit in the Long Run CASE STUDY: Fast Forward to Creative Destruction 10-1d Monopolistic Competition and Perfect Competition Compared 10-2 OLIGOPOLY 10-2a Varieties of Oligopoly 10-2b Economies of Scale 10-2c The High Cost of Entry 10-2d Crowding Out the Competition 10-3 THREE APPROACHES TO OLIGOPOLY 10-3a Collusion and Cartels Differences in Average Cost Number of Firms in the Cartel New Entry Cheating OPEC’s Spotty History International Crackdowns on Cartels 10-3b Price Leadership 10-3c Game Theory Price-Setting Game Cola War Game One-Shot Versus Repeated Games Coordination Game 10-3d Comparison of Oligopoly and Perfect Competition Price Is Usually Higher under Oligopoly Higher Profits under Oligopoly 10-4 CONCLUSION

30 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

monopolistic competition, ways of differentiating products (location, accompanying services, quality, and product image), profit maximization and loss minimization under monopolistic competition, longrun equilibrium under monopolistic competition, excess capacity, comparing perfect competition with monopolistic competition, oligopoly, undifferentiated vs. differentiated oligopoly, cost of product differentiation, collusion, cartels, price leadership, game theory, prisoner’s dilemma, payoff matrix, dominant-strategy equilibrium, duopoly, Nash equilibrium, tit-for-tat, coordination games, and comparison of oligopoly and perfect competition.

Students should also be able to: 䉴

use diagrams to show a monopolistically competitive firm earning economic profit in the short run but zero economic profit in long-run equilibrium.

䉴

show the equilibrium price and quantity in a market where firms collude to form a cartel.

䉴

offer reasons why cartels tend to break down.

䉴

explain the prisoner’s dilemma and discuss it’s relevance to oligopolistic behavior.

䉴

explain why there are several competing models of oligopolistic behavior. (Because there are few firms, oligopolistic firms are interdependent and this opens the door to all sorts of possible interactions from collusion to price wars.)

DISCUSSION MATERIAL ■

An important implication of monopolistic competition is that in long-run equilibrium each fi rm earns only a normal profi t but produces less than its minimum effi cient rate. You might ask your students what sort of businesses they observe to be operating below capacity much of the time. For example, gas stations, drugstores, clothing stores, and pizza parlors could usually benefit from more business.

■

OPEC is frequently in the news, whether oil prices are rising or falling. Whatever the cartel is doing (or not doing) at the time that you cover this chapter is worth discussing.

■

The number of gas stations in the United States peaked at 226,000 just before the 1973 Arab oil embargo. That number has dropped more than half. Why the drop? (The fall in oil prices in the first half of the 1980s reduced the profit margin on each gallon sold, raising the minimum number of gallons a station had to pump to survive. Oil companies have restructured their sales efforts and as a result have pulled out of many states. Not only has the number of stations declined, but the services offered have also been reduced. More than three-quarters of the nation’s gasoline is now sold through self-service pumps. Self-service came to dominate this industry in less than a decade. Some industry observers say people prefer to pump their own gas and then pay by credit card at the pump. Gas stations in the future may have no employees. It’s worth discussing.) With a higher proportion of gas stations going to self-service, fewer offer maintenance services such as oil changes and grease jobs. This form of maintenance is now performed by chains that have sprung up, such as Jiffy Lube.

Monopolistic Competition and Oligopoly © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

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Advertising enters the chapter in several ways. Two types of advertising are distinguished (though not explicitly): (1) the type that provides consumers with information that helps them become better shoppers, such as classified ads or ads that list the specifications of the product, and (2) ads that convey little real information other than promotional puffery. You might ask the class to provide examples of each kind of ad.

Trouble Spots Students usually have trouble with the long-run adjustment process under monopolistic competition. All they see is the resulting tangency of the demand curve and the average total cost curve. They fail to realize that entry or exit of firms shifts the demand curve until remaining firms earn only a normal rate of return.

You can use the board, overheads, or the computer to show the long-run shift of demand. Or try some of the software available.

Additional Examples Monopolistic competition — Many of the professions can be viewed as monopolistically competitive. For example, this country has over 800,000 lawyers—more than enough to satisfy the prevailing demand for legal services. Consequently, many lawyers are underemployed as lawyers and go into real estate, insurance, finance, and politics.

What If? What if all advertising other than classified ads were prohibited by law? What would be the effect in the short run and the long run of such a measure? In particular, consider the effect on barriers to entry, product differentiation, and the price of goods. As an alternative to an advertising ban, consider the effects of eliminating the tax deduction that firms receive for advertising expenditures.

Chapter 10

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CHAPTER 11 RESOURCE MARKETS This chapter provides an overview of resource markets. Students are immediately presented with problems of optimal resource use under various conditions of supply and demand. The intent is to show that the basic decision about how much of a resource to supply or demand is relatively straightforward. These decisions are made every day by billions of economic actors, most who never took a course in economics. This chapter serves as an introduction to the following chapter, which examines labor.

CHAPTER OUTLINE 11-1 THE ONCE-OVER 11-1a Resource Demand 11-1b Resource Supply 11-2 THE DEMAND AND SUPPLY OF RESOURCES 11-2a The Market Demand for Resources 11-2b The Market Supply of Resources 11-3 TEMPORARY AND PERMANENT RESOURCE PRICE DIFFERENCES 11-3a Temporary Differences in Resource Prices 11-3b Permanent Differences in Resource Prices 11-4 OPPORTUNITY COST AND ECONOMIC RENT 11-4a Resource Market A: All Earnings Are Economic Rent 11-4b Resource Market B: All Earnings Are Opportunity Cost 11-4c Resource Market C: Earnings Include Both Economic Rent and Opportunity Cost 11-5 A CLOSER LOOK AT RESOURCE DEMAND 11-5a The Firm’s Demand for a Resource 11-5b Marginal Revenue Product Selling Output in Competitive Markets Selling Output with some Market Power 11-5c Marginal Resource Cost 11-5d Resource Employment to Maximize Profit or Minimize Loss 11-5e Optimal Input and Optimal Output Decisions are Equivalent 11-5f Changes in Resource Demand Changes in Other Resources Employed Changes in Technology Changes in the Demand for the Final Product 11-5g The Optimal Use of More than One Resource CASE STUDY: The McMinimum Wage 11-6 CONCLUSION

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CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

derived demand, temporary differences in resource prices, permanent differences in resource prices, the division of earnings between opportunity cost and economic rent, marginal revenue product, marginal resource cost, profit maximizing rule of resource utilization (marginal revenue product equals marginal resource cost), factors that shift the demand for a resource, and optimal resource use when more than one resource is involved.

Students should also be able to: 䉴

draw the supply and demand curves for resources, distinguish in the graph between opportunity cost and economic rent, and define each.

䉴

explain why the resource demand curve faced by a firm selling its product in a competitive market is downward sloping. (It is downward sloping because of diminishing marginal returns.)

䉴

explain why the resource demand curve for the firm selling its product with some market power is downward sloping. (It is downward sloping both because of diminishing marginal returns and the necessity to lower price to increase the quantity of output sold.)

䉴

distinguish between temporary and permanent differences in the price of resources and provide examples of each.

DISCUSSION MATERIAL ■

One way to approach resource markets is by emphasizing the importance of career choices. Students need only be reminded that their selection of college majors and their job choices after college point them toward a field that could shape their income pattern over a lifetime.

■

The salary, or wage, is clearly an important determinant of the quantity of labor supplied, but money isn’t everything. To underscore the idea, this and later chapters continue to make the point that households supply labor so as to maximize utility. To be sure, money is an important consideration, but many other factors enter the supply decision. One role that money plays is to offset the unattractive characteristics of a particular job. People must be paid more for jobs that are boring, dirty, uncomfortable, going nowhere, and of low social status. Put another way, people are willing to work for less if the job is interesting, clean, comfortable, going somewhere, and of high social status. Discuss the qualities of a job that affect the amount of labor that workers will supply at a given wage.

■

Resource markets, like product markets, operate as if by an invisible hand. You might use the analogy of a road system to discuss how people choose occupations. People try to get from one place to another using the fastest route possible. If the highway is jammed, travelers will seek alternative routes. These alternative routes will eventually fill with cars until they become just as congested as the highway. In equilibrium, the time and trouble it takes to get from point A to point B will be about the same regardless of the route chosen. Likewise, when one profession gets crowded, wages stagnate and people pursue other fields. In the long run, with all other things being constant, wages will be the same in alternative lines of work for professions requiring comparable skills.

34

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■

Reinforce the distinction between resource supply and resource demand at the firm level and at the market level. The market supply of a resource is typically upward sloping, and the market demand curve is downward sloping. The market demand curve reflects the demand for the resource in all its different uses.

Trouble Spots Exhibit 2 shows how the market price of a resource in alternative uses tends toward equality over time. This exhibit shows how, when resource markets are free to adjust, resource price differences trigger the reallocation of resources, thereby equalizing payments for similar resources. Make sure your students understand the rationale behind the shifts of resource supply.

Additional Examples Permanent price differences — Why do Canadian Football League players earn less than those in the National Football League? Why do college teachers tend to earn more than high school teachers?

Temporary price differences — Petroleum engineers earn more than mechanical engineers. Majors in finance earn more than majors in marketing. Stockbrokers earn more than insurance agents.

What If? What if everyone had identical tastes for labor and was equally talented in alternative lines of work? What would happen to the wage structure across professions?

What if the expression “an embarrassment of riches” were literally true so that people became embarrassed about earning a high salary? If high income conveyed a negative social status, what effect would this have on the salary structure we now observe?

Resource Markets © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

35

CHAPTER 12 LABOR MARKETS AND LABOR UNIONS The previous chapter focused on the demand for resources, especially labor. The first half of this chapter examines labor markets, particularly labor supply, and then brings supply and demand together to determine the market wage. The chapter begins with a careful discussion of an individual labor supply curve, with emphasis on utility maximization as well as the income and substitution effects of a higher wage.

Factors other than the wage that influence labor supply are then considered. The question of why wages differ is addressed next. Most of the presentation is verbal rather than through graphs. The second half of the chapter considers the role that labor unions play in labor markets, examining both the economic effects of unions and recent trends in union membership. Unions have been losing membership and influence for the last half century.

CHAPTER OUTLINE 12-1 LABOR SUPPLY 12-1a Labor Supply and Utility Maximization Three Uses of Time Work and Utility Utility Maximization Implications 12-1b Wages and Individual Labor Supply Substitution and Income Effects Backward-Bending Labor Supply Curve Flexibility of Hours Worked 12-1c Nonwage Determinants of Labor Supply Other Sources of Income Nonmonetary Factors The Value of Job Experience Taste for Work 12-1d Market Supply of Labor 12-2 WHY WAGES DIFFER 12-2a Differences in Training, Education, Age, and Experience 12-2b Differences in Ability CASE STUDY: Winner-Take-All Labor Markets 12-2c Differences in Risk 12-2d Geographic Differences 12-2e Discrimination 12-3 UNIONS AND COLLECTIVE BARGAINING 12-3a Types of Unions 12-3b Collective Bargaining, Mediation, and Arbitration 12-3c The Strike

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12-4 UNION WAGES AND EMPLOYMENT 12-4a Inclusive, or Industrial, Unions: Negotiating a Higher Industry Wage 12-4b Exclusive, or Craft, Unions: Reducing Labor Supply 12-4c Increasing Demand for Union Labor Increase Demand for Union-Made Goods Restrict Supply of Nonunion-Made Goods Increase Productivity of Union Labor Featherbedding 12-4d Recent Trends in Union Membership 12-5 CONCLUSION

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

market work, nonmarket work, leisure, allocating time so as to maximize utility, substitution and income effects of a higher wage on the quantity of labor supplied, the backward-bending labor supply curve, nonwage determinants of labor supply (other sources of income, job amenities, value of job experience, and tastes for work), why wages differ (differences in tastes, ability, training and education, health risk and loss-of-job risk, mobility problems, and job discrimination), winner-take-all labor markets, labor union, collective bargaining, mediation, binding arbitration, strike, inclusive (or industrial) unions, exclusive (or craft) unions, featherbedding, right-to-work states, and problems facing organized labor (unwillingness of some members to strike, competition from nonunion suppliers, industry deregulation, decline of smokestack industries, and the rise of high-tech industries).

Students should also be able to: 䉴

draw an individual labor supply curve and explain its shape.

䉴

list what factors would shift the labor supply curve.

䉴

explain how labor unions attempt to increase the demand for union labor. (They may try to increase the demand for union-made goods, restrict sales of nonunion goods, increase the productivity of union labor, and promote featherbedding.)

䉴

explain whether union wages are in fact higher than nonunion wages. (Evidence suggests that union wages are about 15 percent higher than nonunion wages, other things remaining constant.)

Ź discuss the trends in union employment. (Only 7 percent of private sector jobs are unionized versus 37 percent of public sector jobs; now most union members are public employees.)

DISCUSSION MATERIAL ■

A central assumption of the chapter is that people allocate their time across market work, nonmarket work, and leisure so as to maximize utility. To maximize utility, the last hour spent in each activity must yield the same net utility. Otherwise, an individual could increase utility by reallocating time from an activity yielding lower marginal utility to one yielding higher marginal utility. The best reference point for such a discussion is each individual student. Ask them if they are allocating time so as to maximize utility. If they are not, why not? Some may say they would like to get more sleep. Ask them why they don’t. This gets your discussion into the scarcity of time and the competing demands for time.

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37

■

Ask your students what careers they plan to pursue and why. Ask them how their college programs fit in. Some students will say they want to become lawyers, doctors, or accountants because of the higher expected income. But press them beyond that. Is income the only consideration? Ask why some plan to go into public service or the arts.

■

Although economists do not like to rely on changes in tastes to explain behavior, the tastes for certain kinds of work do seem to change over time. Adam Smith pointed out that entertainers had to be paid well because of the humiliation they subjected themselves to by performing.

■

At the turn of the 20th century, health spas and gyms were rare because most workers stayed in shape through long hours of physical labor. With many workers now using their brains instead of their bodies, the demand for places to exercise the body has increased. You might discuss whether the widespread adoption of computers will eventually reduce the demand for brainpower, too, consequently increasing the demand for mental health spas, where people can exercise their brains.

■

Students are interested in the decision to invest in human capital. Discuss the risk of investing in very specific skills. Ask your students to describe the nature of the risk. Talk about the short-run versus the long-run return on human capital investments.

■

The chapter makes the point that unions may prefer policies that raise wages by restricting supply, as is done with most craft unions, rather than by simply raising the wage and then dealing with an excess quantity of labor supplied at the above-market wage rate. Discuss how union leaders might allocate scarce union jobs among the membership. (We would expect union officials to reward those who are loyal to the union. Also, jobs might go to friends and relatives of union officials.)

■

For a useful chalkboard exercise, begin with two competitive labor markets side by side. If labor is free to move from sector to sector, the equilibrium wage in the long run will be the same in both sectors, as shown in Exhibit 2 of the previous chapter. Label one of the markets as the union sector and the other as the nonunion sector. Now show the effects of reducing the supply of labor in the union sector and increasing the supply of labor in the nonunion sector. This exercise should demonstrate how labor supply restrictions raise the union wages above nonunion wages.

■

Some argue that the shift of employment from the goods-producing sector to the service-producing sector has reduced union employment because the service sector has not traditionally been the source of new membership. But one of the bright spots for the labor movement has been government employment—largely in the service sector. In fact, schoolteachers are among the most unionized of workers. Government unions impose special problems for the economy because government is usually the only provider of certain goods and services, and government workers also vote for those who offer them the best deal.

■

Discuss with the class how unions can affect wage levels and employee benefits in the economy, even though only about one in eight workers belongs to a union. Point out that many nonunion employers, to avoid unionization, are more sensitive to employee welfare.

Trouble Spots The section on why wages differ offers no diagrams. Students might benefit if you graph the market for labor to show the effects of the differences discussed in the chapter. For example, you could draw the market for tree surgeons alongside the market for brain surgeons.

Chapter 12

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Additional Examples Taste, ability, and the supply of labor — Those who like working on cars become auto mechanics.

Creative people pursue the arts, literature, or even marketing. Those who are physically strong may go into construction or the moving business. Such a list is endless.

Backward-bending labor supply curve — Typically, professors at more prestigious institutions earn more but teach less than those at other institutions (the reduced teaching load is to allow more time for research).

Featherbedding — When modern containerization offered the ability to unload ships easily, the Longshoremen’s Union prevented the adoption of this technology until an agreement was reached providing existing union members with a guaranteed annual income whether or not they worked.

Some truck drivers who deliver the New York Daily News reportedly earn more than $100,000 a year. The union contract allows these drivers many opportunities for overtime, even when some other company drivers are not fully employed. The newspaper claims it could deliver the paper with one-third fewer drivers.

The union staffing requirements also call for 14 workers per printing press even though the job could be done with half that number. The paper has threatened to fold unless it gets relief from restrictive work rules.

What If? What if government passes a law that says the wage must be equal in all occupations?

What would be the effect of such a measure on labor markets, education, career choices, hours worked, and the like?

What if all workers were required to belong to a union? Would this increase or decrease union wages?

What would be the effect on the economy’s unemployment rate?

What if unions were outlawed? What would happen to the average wage level in the economy and the economy’s rate of unemployment?

Labor Markets and Labor Unions © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

39

CHAPTER 13 CAPITAL, INTEREST, ENTERPRENEURSHIP, AND CORPORATE FINANCE Thus far the discussion of resources has focused primarily on labor. But the return to human resources depends in part on the amount and quality of other resources employed. This chapter discusses capital, interest, and entrepreneurship. The role of time plays an important part in this chapter. The chapter shows why production cannot occur without the prior saving. In discussing capital, the rate of time preference is fundamental. A new section with this edition looks at entrepreneurship and economic profit. The final section considers corporate finance.

CHAPTER OUTLINE 13-1 THE ROLE OF TIME IN CONSUMPTION AND PRODUCTION 13-1a Production, Saving, and Time 13-1b Consumption, Saving, and Time 13-1c Optimal Investment CASE STUDY: The Value of a Good Idea—Intellectual Property 13-2 THE MARKET FOR LOANABLE FUNDS 13-2a Demand for Loanable Funds 13-2b Supply of Loanable Funds 13-2c Market Interest Rate 13-3 WHY INTEREST RATES DIFFER 13-3a Risk 13-3b Duration of the Loan 13-3c Administration Cost 13-3d Tax Treatment 13-4 PRESENT VALUE AND DISCOUNTING 13-4a Present Value of Payment OneYear Hence 13-4b Present Value for Payments in Later Years 13-4c Present Value of an Income Stream 13-4d Present Value of an Annuity 13-5 ENTREPRENEURSHIP 13-5a Role of the Entrepreneur 13-5b Entrepreneurs Drive the Economy Forward New Products Improve Existing Products New Production Methods New Ways of Doing Business 13-5c Who Are Not Entrepreneurs Corporate Inventors Managers Stockholders

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13-6 CORPORATE FINANCE 13-6a Corporate Stock and Retained Earnings 13-6b Corporate Bonds 13-6c Securities Exchanges 13-7 CONCLUSION

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

positive rate of time preference, interest rate, expected rate of return on capital, intellectual property, demand for loanable funds, supply of loanable funds, loanable funds markets, prime rate of interest, collateral, term structure of interest rates, present value, discounting, annuity, corporate stock, dividends, retained earnings, bonds, securities markets, and initial public offerings (IPO).

Students should also be able to: 䉴

explain why production requires savings. (Production takes time--time during which workers and other resource suppliers need goods and services to survive. These goods and services must be purchased with savings.) Note that “savings” is a stock measure, reflecting accumulation over time of past “saving.” “Saving” is a flow measure, reflecting the amount saved in a particular period, such as saving per year.

䉴

describe the conditions for optimal capital use.

䉴

explain why a firm’s optimal investment decision does not depend on whether the funds are on hand or on whether the firm must borrow the funds at the market rate of interest.

䉴

explain why several interest rates usually exist at the same time. (There could be differences in risk, in the duration of the loan, in the cost of loan administration, and in the tax treatment of interest.)

䉴

explain what separates entrepreneurship from the other factors of production. What’s unique about the resource supplied by an entrepreneur?

DISCUSSION MATERIAL ■

Students are perhaps most interested in the decision to invest in human capital. Discuss the risk of investing in very specific skills. Ask your students to describe the nature of the risk. Talk about the short-run versus the long-run return on human capital investments.

■

The effects of discounting are powerful and usually impress students. Consider a million-dollar lottery that is paid off in 30 annual installments of $33,333. Given a discount rate of 8 percent, the present value of receiving $33,333 every year forever after Year 30 is only $41,406. If you sim ply sum m ed $33,333 forever the am ount w ould be infinite. D iscuss present value and discounting and describe how the principle is behind the insurance industry.

As a wilder example, conider this: $1 deposited in a bank account earning 5 percent interest would accumulate to about $4 billion in 500 years. Albert Einstein said “The most powerful force in the universe is compound interest.” *Ask students to name some entrepreneurs and identify the unique contribution of each.

Capital, Interest, Entrepreneurship, and Corporate Finance © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

41

Trouble Spots The supply and demand curves for loanable funds presented in this chapter focus on determining the market rate of interest, other things constant. Present the market for loanable funds; then show the effects on the market interest rate of various possible events, such as a technological breakthrough affecting much of production or an increase in the rate of time preference.

Another trouble spot is likely to be discounting and present value. Work through some problems with your students.

Additional Examples Present consumption is valued more than future consumption — The attraction of fast food is based on the promise of early availability. Some sellers even provide a free meal if your food is not ready within a specified time. Many retailers promote the early availability of their products, from one-hour dry cleaners to Lenscrafters, where your glasses are ready “in about an hour.”

Ability to capitalize on expected profits — A share of common stock represents a claim on the future earnings of the firm. The price of a share is nothing more than the present value of the discounted stream of expected profits. Because future profits are uncertain, people are gambling when they buy and sell stock.

Any event that affects future profitability, such as a tax change or a change in the cost of resources, affects the share price.

What If? What if people valued future consumption more than present consumption, other things being constant?

What would this do to interest rates? What about the way producers promote their products?

What if people expected deflation; that is, what if they expected the average price level to fall over the course of the next five or ten years? Would people then be willing to lend their savings even if the rate of interest was negative? (No, because they could always end up with more simply by stuffing their savings under a mattress.)

Chapter 13

42 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER 14 TRANSACTION COSTS, IMPERFECT INFORMATION, AND BEHAVIORAL ECONOMICS The first part of the chapter draws on Ronald Coase’s work on the firm to show that transaction costs can help explain why production occurs in the hierarchical relation of firms rather than through market exchange. Also examined in the first part of the chapter are the boundaries of the firm and its optimal scope. The second half of the chapter focuses on problems of imperfect information, asymmetric information—problems such as optimal search, the winner’s curse, the lemon problem, adverse selection, principal-agent problems, and moral hazard--and behavioral economics. There are many examples. Thus, most of the chapter addresses contemporary issues in microeconomics.

CHAPTER OUTLINE 14-1 RATIONALE FOR THE FIRM AND ITS SCOPE OF OPERATION 14-1a The Firm Reduces Transaction Costs 14-1b The Boundaries of the Firm Bounded Rationality of the Manager Minimum Efficient Scale Easily Observable Quality Many Suppliers 14-1c Economies of Scope 14-2 MARKET BEHAVIOR WITH IMPERFECT INFORMATION 14-2a Optimal Search with Imperfect Information Marginal Cost of Search Marginal Benefit of Search Optimal Search Implications 14-2b The Winner’s Curse 14-3 ASYMMETRIC INFORMATION IN PRODUCT MARKETS 14-3a Hidden Characteristics: Adverse Selection 14-3b Hidden Actions: The Principal-Agent Problem 14-3c Asymmetric Information in Insurance Markets 14-3d Coping with Asymmetric Information 14-4 ASYMMETRIC INFORMATION IN LABOR MARKETS 14-4a Adverse Selection in Labor Markets 14-4b Signaling and Screening 14-5 BEHAVIORAL ECONOMICS 15-5a Unbounded Rationality 15-5b Unbounded Willpower CASE STUDY: Self Control: Just Don’t Do It! 15-5c Neuroeconomics 14-6 CONCLUSION

43 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

vertical in teg ratio n , b o u n d ed ratio n ality, o u tso u rcin g , co re co m p eten cy, eco n o m ies of scope, optimal search with imperfect information, the winner’s curse, asymmetric information, the “lemon” problem, principal, agent, the principal-agent problem, hidden characteristics, adverse selection, moral hazard, efficiency wage theory signaling, screening, behavioral economics, and neuroeconomics.

Students should also be able to: 䉴

explain why, according to Coase, firms exist (firms minimize the transaction costs of exchange).

䉴

discuss factors affecting the efficient scope of the firm.

䉴

discuss problems that arise when market participants do not know all they would like to know about the product in question, especially if one side of the market knows more than the other side of the market.

DISCUSSION MATERIAL ■

The degree of vertical integration depends on a variety of factors. Often the rationale for integrating backward is so that producers can offer consumers a guarantee about the quality of ingredients or components. Discuss the rationales for vertical integration. For example, U.S. suppliers of toys from China faced problems because the toys contained hazardous materials.

■

There are a number of fascinating problems that arise from limited information or asymmetric information. You should try to discuss some of these problems. For example, utilize the material on optimal search theory to discuss how students make major purchases such as computers, cars, and housing.

Discuss how insurance companies and lenders try to cope with asymmetric information.

Trouble Spots The rationale for the firm offered by Coase is entirely verbal and will require the student’s concentration.

Coase makes the point that the firm emerges as the least-cost producer when the transaction costs of using the market exceed the costs of coordinating resources within the firm. Thus, the firm minimizes the sum of transaction costs and production costs. See if you can convey this rationale for the firm to your students.

Ask a student to explain the point.

Chapter 14

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Additional Examples Vertical integration — A dairy opens its own ice-cream stand. A shoe manufacturer tans its own leather. The grocery store sells its own “house” brand. Roche-Bobois, makers of high-end contemporary furniture, operates its own marble quarries in Italy. 7-Eleven convenience stores grind their own coffee.

Winner’s curse — ESPN and CBS claim they overbid for the rights to broadcast professional baseball and they are not about to do it again. They paid $1.5 billion for a four-year contract. For ESPN the opportunity cost of showing Sunday night baseball games jumped when it bought rights to Sunday night football games, which attract four times as many viewers as baseball games.

What If? What if it became illegal to ask certain questions on applications for a mortgage, for a job, or for an insurance policy? For example, what if questions about income, health, or drug use could not be asked? How would these restrictions affect the efficiency of the market?

Transaction Costs, Imperfect Information, and Behavioral Economics © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

45

CHAPTER 15 ECONOMIC REGULATION AND ANTITRUST POLICY This chapter introduces major policy questions about government regulation and provides some fl avor of current issues in regulation, deregulation, and antitrust policy. Perhaps the most fundamental question raised in the chapter is the rationale for government intervention in business. Is government intervention in the public interest or is it in the special interest of producers? A case study examines some high profile antitrust cases in the technology sector. Antitrust legislation and the competitive trend in the U.S. economy are also discussed.

CHAPTER OUTLINE 15-1 TYPES OF GOVERNMENT REGULATION 15-2 REGULATING A NATURAL MONOPOLY 15-2a Unregulated Profit Maximization 15-2b Setting Price Equal to Marginal Cost 15-2c Subsidizing the Natural Monopolist 15-2d Setting Price Equal to Average Cost 15-2e The Regulatory Dilemma 15-3 ALTERNATIVE THEORIES OF ECONOMIC REGULATION 15-3a Producers’ Special Interest in Economic Regulation 15-4 ANTITRUST LAW AND ENFORCEMENT 15-4a Origins of Antitrust Policy Sherman Antitrust Act of 1890 Clayton Act of 1914 Federal Trade Commission Act of 1914 15-4b Antitrust Enforcement 15-4c Per-Se Illegality and the Rule of Reason 15-4d Mergers and Public Policy 15-4e Merger Waves 15-5 COMPETITIVE TRENDS IN THE U.S. ECONOMY 15-5a Competition over Time CASE STUDY: Microsoft on Trial 15-5b Recent Competitive Trends 15-5c Problems with Antitrust Policy Competition May Not Require That Many Firms Antitrust Abuses Growth of International Markets Bailing out Troubled Industries 15-6 CONCLUSION

46 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

market power, social regulation, economic regulation, antitrust policy, public utilities, government alternatives in dealing with natural monopoly (do nothing, public ownership, and regulation), the regulatory dilemma (set price equal to marginal cost and make up the firm’s loss or set price equal to average cost and forgo some social welfare), theories of economic regulation (public interest theory versus special interest, or capture, theory), capture theory of regulation, trusts, S herm an A ntitrust A ct, Clayton A ct, tying contracts, exclusive dealing, interlocking directorates, Federal Trade Commission Act, consent decree, predatory pricing, per se illegality versus the rule of reason, vertical mergers, horizontal mergers, conglomerate mergers, and the Herfindahl-Hirschman Index (HHI).

Students should also be able to: 䉴

describe the competitive trend in the U.S. economy since 1939 and explain the reasons for this trend.

䉴

explain why regulation may be more in accord with producer interests than consumer interests.

DISCUSSION MATERIAL ■

As noted, one issue ripe for discussion is the objective of government regulation of business. Is regulation for the most part in the public interest or is it in the special interest? Put another way, is regulation in the consumer interest or in the producer interest? Consumers do not specialize in demanding any particular product, but producers specialize in supplying a particular product or line of products; the debate of public policy concerning a particular product tends to be dominated by producer interests.

Discuss this basic asymmetry. The chapter examines haircuts, but you could consider other products, such as fast-food restaurants or auto-repair garages.

■

The scarce resource in the airline industry appears to be landing slots and gaates at the major airports. Discuss why major airlines may not be in favor of airport expansions.

■

Airline deregulation resulted in lower prices. In fact, between some cities, airfares fell below bus fares.

Consequently, the demand for bus trips dropped to the point where Trailways sold its equipment to Greyhound. Declining demand for bus service forced Greyhound to cut drivers’ pay, which resulted in a bitter strike by Greyhound bus drivers.

■

Professor William Shepherd credits antitrust activity with much of the increase in competition among U.S. firms between 1958 and 2000. Antitrust activity seems less relevant today because many markets have become global. There may also be too much emphasis on the competitive model. Joseph Schumpeter argued that competition is a dynamic process and a policy aimed at increasing the number of firms may not best serve the needs of consumers (because many firms may be operating with excess capacity).

■

Some economists think that the possibility of treble damages provides firms that have been harmed by the anticompetitive practices of other firms with a powerful incentive to claim violations of antitrust laws. Discuss why treble damages increase the incentives for alleging antitrust violations.

Economic Regulation and Antitrust Policy © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

47

■

At present there are no international laws prohibiting cartels or price fixing. As a result, global cartels exist in oil, tin, and some other products. Should the United Nations or some other international body prohibit such efforts to restrict international competition? What would be the problems of policing international laws? Lately major economies have been cooperating in enforcing their national antitrust laws, as noted in the chapter.

Trouble Spots Students will have difficulty keeping all the antitrust laws straight. There are so many major and minor laws, plus several possible violations under each law, that students are bound to twist them around. Make clear to your students the level of detail you expect of them. A chronological review of the major laws would help. As always, try to make the objectives of your course as transparent and possible. Allow students to “see right through you.”

Additional Examples Regulation — Many professions are licensed and otherwise regulated at the state level. Plumbers, electricians, physicians, lawyers, insurance representatives, real estate agents, bug exterminators, schoolteachers— the list goes on and on. You might discuss the public-interest versus the private-interest rationale for such regulations. Ask how consumers would benefit from laws requiring certain trades to be licensed. Why would producers prefer these restrictions? (They restrict entry, thus reducing competition in the profession.)

Deregulation — The banking industry, once a sleepy business well insulated by government regulations, has become more dynamic as a result of the deregulation measures introduced in the early 1980s. Interestrate competition among banks is only one result of deregulation. It is thought that deregulation of banking was one reason for the failure of thousands of savings and loan institutions. Why might some firms fail after deregulation? In light of the financial crisis of 2008 and the severe recession, Congress and the president enacted more regulations of financial institutions.

What If? What if the U.S. government promoted cartels as governments do in some other countries around the world? Would U.S. firms be better able to compete on the world market if they faced global competition as a unified industry with agreed-upon prices and common goals? (Observers argue that the Japanese industries that are cartelized are the least competitive in world markets.)

Chapter 15

48 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER 16 PUBLIC GOODS AND PUBLIC CHOICE The role of government has been discussed throughout the book. This chapter puts government centerstage, beginning with an analysis of public goods using a simple matrix to lay out four combinations of the public-private spectrum. The public choice section follows a natural progression beginning with representative democracy and the problems that arise from the combination of intense producer interests coupled with rational ignorance by most voters. The public choice section is really about the agency problems that arise in government. The first such problem is that voters, as principals, must delegate decisions to their agents, elected officials. But elected officials, in turn, may have a principal-agency problem of their own because they must delegate the execution of their decisions to bureaucrats, who may pursue their own agendas. Thus, voters may be two steps removed from actual decisions about public goods and services.

CHAPTER OUTLINE 16-1 PUBLIC GOODS 16-1a Private Goods, Public Goods, and In Between 16-1b Optimal Provision of Public Goods 16-1c Paying for Public Goods 16-2 PUBLIC CHOICE IN REPRESENTATIVE DEMOCRACY 16-2a Median-Voter Model 16-2b Special Interest and Rational Ignorance 16-2c Distribution of Benefits and Costs CASE STUDY: Farm Subsidies 16-2d Rent Seeking 16-2e The Underground Economy 16-3 BUREAUCRACY AND REPRESENTATIVE DEMOCRACY 16-3a Ownership and Funding of Bureaus 16-3b Ownership and Organizational Behavior 16-3c Bureaucratic Objectives 16-3d Private Versus Public Production 16-4 CONCLUSION

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

public goods, natural monopolies, open-access goods, private goods, optimal provision of public goods, representative democracy, median-voter model, rational ignorance, traditional public-goods legislation, special-interest legislation, populist legislation, competing-interest legislation, bureaus, rent seeking, pork-barrel spending, political action committees, underground economy, bureaus, and private versus public production of public goods and services.

49 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

Students should also be able to: 䉴

explain why we might expect resources to be used more efficiently in private firms than in public bureaus.

䉴

explain why elected officials may be inclined to favor producer groups over consumer groups in making public choices.

䉴

explain why a public choice to finance particular goods or services does not necessarily imply public production.

䉴

discuss which types of public goods and services should be produced by the government bureaus and which types could be produced by private firms.

䉴

explain why in majority rule the outcome often will be that preferred by the median voter.

DISCUSSION MATERIAL ■

William Niskanen has argued that bureaucrats attempt to maximize the bureau’s budget and that they may do this by offering the legislature an all-or-none package of public goods and services in return for a budget appropriation. If legislators try to cut the budget, then bureaucrats make these cuts as painful as possible. (Cut the school budget and there go the band uniforms or kindergarten.) Discuss how realistic Niskanen’s budget theory is. Can legislators be forced to accept the budget as is?

■

The tendency is to turn problems of market failure over to the government. But representative democracy has failings of its own, so we should not always expect government to perform better than the private sector. The ability of the state to back up public choices with force should also make us especially wary of conveying powers to government. At least in private markets, nobody is forced to participate in market exchange. Discuss the differences between public and private choices and the tendency to turn to government as the final solution.

■

Some view it as cynical to attribute selfish motives to public servants, but economists make no secret of the assumption that people, by and large, pursue their self-interests. In the private sector, however, the pursuit of self-interest tends to promote the general good. This, of course, is the point of Adam Smith’s “invisible hand.” There is no real analogue to the invisible hand in the public sector. The closest parallel is that elected officials try to maximize their political support, and to do this they must provide the bundle of goods and services most preferred by constituents. But as we have seen, there is a lot of slip twixt the voting booth and the provisions of public goods.

■

The chapter explains the principal-agent problem with government. Voters delegate decisions to elected officials who delegate to government employees, or bureaucrats. But government officials may, in turn, delegate choices to for-profit firms. So the voter may be three steps removed from the organization actually providing the public good. For example, public roads are usually built by construction companies hires by government bureaus.

50

Chapter 16 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

Trouble Spots Because this chapter is largely narrative, the students should have little trouble following it. However, the diagram of public goods is new to students. Students are often overwhelmed by the mechanics of a new exhibit and tend to miss the point. Take the time to present this exhibits carefully. Make sure students know why individual demand curves for a private good are added horizontally to get the total demand, while individual demand curves for a public good are added vertically to get the total demand.

What If? What if tastes were such that people specialized in consuming particular goods? For example, suppose that some people ate nothing but pizza and others ate only chicken. Would this affect the asymmetry that arises from the combination of intense producer interests and rational ignorance by consumer-voters? (Yes, to some extent, it would.)

Public Goods and Public Choice © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

51

CHAPTER 17 EXTERNALITIES AND THE ENVIRONMENT The central point of this chapter is that negative externalities arise not so much from the greed or shortsightedness of producers and consumers as from the lack of well-defined property rights to the air, water, land, and other open-access resources. As long as a resource is free, that resource will be used to the point where the marginal value of additional use is zero. The way to resolve this common pool problem is either to assign property rights or to introduce regulations that restrict use to the level consistent with maximizing social welfare. Students should find this chapter interesting since many of the topics, such as the destruction of the tropical rain forests, climate change, and the oil spill in the Gulf of Mexico, are very much in the news and tie in with students’ environmental concerns. The first half of the chapter deals with the theory of externalities; the second half with U.S. environmental policy. Although positive externalities are discussed at the end of the chapter, most of the chapter deals with negative externalities.

CHAPTER OUTLINE 17-1 EXTERNALITIES AND THE COMMON-POOL PROBLEM 17-1a Renewable Resources 17-1b Resolving the Common-Pool Problem 17-2 OPTIMAL LEVEL OF POLLUTION 17-2a External Costs with Fixed Technology 17-2b External Costs with Variable Technology CASE STUDY: The Lungs of the Planet 17-2c The Coase Theorem 17-2d Markets for Pollution Rights 17-2e Pollutions Rights and Public Choice 17-3 ENVIRONMENTAL PROTECTION 17-3a Air Pollution 17-3b Water Pollution 17-3c Hazardous Waste and the Superfund 17-3d Solid Waste: “Paper or Plastic?”

17-4 POSITIVE EXTERNALITIES 17-5 CONCLUSION

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

negative externalities, positive externalities, private property rights, exhaustible resources, renewable resources, the common-pool problem, marginal social cost, market failure, marginal social benefit, external costs with fixed technology, external costs with variable technology, the Coase theorem, the market for pollution rights, effluent fees, command-and-control environmental regulations versus economic efficiency approach, recycling, and the U.S. Environmental Protection Agency.

52 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

Students should also be able to: 䉴

explain and show graphically why the market outcome in the presence of negative externalities results in a greater than optimal rate of output.

䉴

explain and show graphically why the market outcome in the presence of positive externalities results in a less than optimal rate of output.

䉴

describe the optimal output conditions (marginal social benefit equals marginal social cost).

䉴

indicate ways of resolving the common-pool problem.

䉴

describe the progress in the United States since 1970 in addressing problems of air pollution, water pollution, and solid waste disposal.

DISCUSSION MATERIAL ■

The revolution in Eastern Europe uncovered deplorable environmental conditions in many of these countries. In Poland, for example, half of the bodies of water were reportedly too polluted even for industrial use. What had been East Germany has been called an environmental disaster area. Apparently, pressure to meet the targets of central planning made policy makers ignore the health and safety of the citizens.

■

In regions where land contours and air patterns trap air pollution, such as the Los Angeles basin, the jurisdiction is under more pressure to clean the air than in areas such as New York City, where winds carry off much of the smog to other jurisdictions, especially Connecticut.

■

The chapter notes that some firms, such as Delta Airlines, and some celebrities, such as the band Coldplay are trying to become carbon neutral. Discuss what this means and why some producers are making a point of becoming more environmentally sensitive.

Externalities and the Environment © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

53

Trouble Spots Class time can be spent most productively by reviewing the exhibits in this chapter. None of the exhibits is especially complicated when compared to others in the book, but they are relatively more difficult than the descriptive material of the chapter.

Additional Examples Congestion costs — Boston’s Logan Airport once charged planes a landing fee based on weight. This meant that small planes paid only a tiny fraction of the landing fees paid by large airlines. The problem was that small planes were congesting the airport, especially during peak travel periods. The airport increased landing fees on small planes from $25 to over $100. As a result, private aircraft traffic fell by 30 percent.

Total passengers using the airport actually increased because larger aircraft filled the landing spots vacated by smaller aircraft.

Toxic waste sites — Perhaps the most well-known toxic waste site in U.S. history occurred in Love Canal, located in Niagara, New York. The former canal was used to dispose of chemical wastes. After the toxic dumping, the site was covered with earth and clay and given to the city for a school and playground. Homes were built on land surrounding the site. All of this occurred long before there was public concern about ground pollution. After reports of illness and of discolored basements, New York State in 1978 declared the area unsafe.

Water pollution — Until recently, Boston was one of the few major cities without a modern sewage treatment system, and Boston Harbor was one of the most polluted bodies of water in the nation. Residents there spent more than $6 billion cleaning up the harbor. To fund the cleanup, annual water bills for Boston residents were expected to increase on average from $300 to more than $1,100.

What If? What if the national income accounts fully reflected the effects of negative externalities? Would this make it easier to introduce appropriate regulations?

What if people had to carry around with them all the garbage they generated and could dispose of it only weekly? What would happen to such things as packaging, newspapers, clothing styles, and, more generally, the amount of garbage generated?

Chapter 17

54 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER 18 INCOME DISTRIBUTION AND POVERTY This chapter examines the U.S. distribution of income, the U.S. incidence of poverty over time by demographic groups, poverty programs, and welfare reform. The chapter is relatively long and is packed with institutional detail about poverty programs and poverty rates among various groups since 1959, when consistent poverty statistics first became available. Stick with the major themes of the chapter and get into details only selectively. Concentrate on the overall trends, such as the declining rate of poverty among the elderly (because of Medicare and Social Security) and the growing feminization of poverty (with the consequent problem of poverty among children).

CHAPTER OUTLINE 18-1 THE DISTRIBUTION OF HOUSEHOLD INCOME 18-1a Income Distribution by Quintile 18-1b The Lorenz Curve 18-1c Why Incomes Differ?

18-1d A College Education Pays More CASE STUDY: Marital Sorting and Income Inequality 18-1e Problems with Distributional Benchmarks 18-2 REDISTRIBUTION PROGRAMS 18-2a Official Poverty Level 18-2b Programs to Help the Poor Social Insurance Income Assistance 18-3 WHO ARE THE POOR? 18-3a Poverty and Age 18-3b Poverty and Public Choice 18-3c The Feminization of Poverty 18-3d Poverty and Discrimination 18-3e Affirmative Action 18-4 UNINTENDED CONSEQUENCES OF INCOME ASSISTANCE 18-5 WELFARE REFORM 18-5a Recent Reforms 18-5b Welfare Rolls Have Declined 18-6 CONCLUSION

55 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

distribution of income across households, Lorenz curve, median income, median wage, offi cial poverty level, Social Security, Medicare, Medicaid, Temporary Assistance for Needy Families (TANF), SNAP (food vouchers), social insurance versus income assistance programs, means-tested programs, affirmative action, unintended consequences of welfare programs, and reforms in the welfare system.

Students should also be able to: 䉴

explain the relations between income and education and between income and the age of the householder.

䉴

discuss major trends in poverty rates among U.S. demographic groups since 1959. They should be able to identify the group that has shown the most improvement. (The rate of poverty among all groups has decreased since 1959, but the greatest improvement has been among the elderly.) Students should also be able to identify the group where the number of poor has increased the most.

DISCUSSION MATERIAL ■

The chapter discusses some unintended consequences of income assistance programs. High marginal tax rates among transfer recipients reduce the incentives to find work and to get off welfare. Discuss whether welfare causes dependence.

■

In the last 50 years, the elderly have experienced the most dramatic reduction in poverty. Discuss why the elderly have been so successful. Contrast the elderly with, say, children, in terms of political clout.

■

Why are incentive effects of less concern when considering transfers to the elderly as opposed to, say, transfers to young males or young females? (Aid to the elderly will not make people become old to receive aid, but aid to unemployed youth or to unmarried mothers could, at the margin, affect the incentives to remain unemployed or to become a single mother.)

■

Discuss the various ways that racial discrimination could affect household income. (Quality of schooling, choice of neighborhoods, job opportunities.)

■

One possible solution to problems of poverty is to force an absent father to assume greater financial responsibility for his children. Discuss why this approach has met with only limited success. (Many welfare mothers are unmarried and the father is not around. Since paternal income is usually subtracted from welfare benefits, mothers have little financial incentive to see that the father pays support.)

How might efforts to garnish wages for child support lead to higher unemployment among the affected group?

56

Chapter 18 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

Trouble Spots Students may get lost in working through the section about who the poor are because several demographic groups are examined. Poverty rates are identified based on the age and gender of the head of the household.

Try to cut through the statistical thicket by reminding your students that the poorest families are those where nobody is employed; this is more likely when the household head is young and female. Also use Exhibit 5 to summarize the growth in federal redistribution programs in the last half century.

Additional Examples The chapter already contains abundant examples.

What If? What if every family in the United States was provided a guaranteed income of $50,000 per year? What would be the effect on the extent of poverty, work incentives, and gross domestic product?

Income Distribution and Poverty © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

57

CHAPTER 19 INTRODUCTION TO MACROECONOMICS This chapter introduces macroeconomics in a way that makes the macroeconomy seem natural and familiar, not contrived and strange. As a way of explaining the subject in a natural way, the economy is compared to the human body and parallels are drawn. The chapter introduces aggregate demand, aggregate supply, and macroeconomic equilibrium. Demand-side economics is distinguished from supply-side economics. The chapter also conveys how difficult it is to test macroeconomic theories and offers a short macroeconomic history of the United States.

CHAPTER OUTLINE 19-1 THE NATIONAL ECONOMY 19-1a What’s Special about the National Economy?

19-1b The Human Body and the U.S. Economy Flow and Stock Variables Testing New Theories 19-1c Knowledge and Performance 19-2 ECONOMIC FLUCTUATIONS AND GROWTH 19-2a U.S. Economic Fluctuations 19-2b Leading Economic Indicators 19-3 AGGREGATE DEMAND AND AGGREGATE SUPPLY 19-3a Aggregate Output and the Price Level 19-3b Aggregate Demand Curve 19-3c Aggregate Supply Curve 19-3d Equilibrium 19-4 BRIEF HISTORY OF THE U.S. ECONOMY 19-4a The Great Depression and Before 19-4b The Age of Keynes: After the Great Depression to the Early 1970s 19-4c Stagfl ation: 1973-1975 and 1979-1980 19-4d Relatively Normal Times: 1980 to 2007 19-4e The Great Recession of 2007–2009 and Beyond CASE STUDY: U.S. Economic Growth Since 1929 19-5 CONCLUSION

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CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

the economy, gross domestic product (GDP), gross world product, the national economy, why macroeconomics focuses on the national economy, stocks and flows, mercantilism, role of expectations, economic fluctuations and the business cycle, expansions, contraction, depression, recession, inflation, leading economic indicators, coincident economic indicators, lagging economic indicators, aggregate output, aggregate demand curve, price level, aggregate supply curve, real gross domestic product (real GDP), equilibrium level of price and aggregate output, the Great Depression, federal budget deficit, demandside economics, stagflation, supply-side economics, federal debt, and real GDP per capita.

䉴

only two analytical tools are introduced in this chapter—aggregate supply and aggregate demand.

Students should be able to explain what these curves mean; what is measured on each axis; roughly, what explains the shape of each curve; and how shifts of these curves can be used to describe the (1) Great Depression, (2) the U.S. economy’s recovery from that Depression, (3) stagflation, (4) supply-side economics, and (5) the Great Recession of 2007–2009.

Students should also be able to: 䉴

explain what the business cycle is and approximately how long each phase lasts on average. (Since World War II, recessions have averaged about a year, and expansions about four years.) Also students should explain why, since World War II, recessions have been shorter and expansions longer.

䉴

explain what the three types of economic indicators are and provide examples.

䉴

explain why macroeconomic theory is so elusive. (It’s hard to grasp what’s going on with the entire economy. We can’t run experiments. Each national economy is unique, so comparisons are tricky.)

Students should also be able to explain why major economic events often cause us to revise our theories and why the study of macroeconomics is important.

DISCUSSION MATERIAL ■

The chapter presents many reasons why the national economy differs from state or regional economies. You might discuss these reasons (nations often differ in language, culture, communication and transportation systems; monetary and tax systems; customs and conventions of the marketplace, and rules of the game for conducting economic activity). Ask students about their own experiences with crossing international borders and how this contrasts with crossing state lines.

■

You might discuss similarities and differences between studying the economy and studying medicine.

Point out why medical researchers have an opportunity to be luckier than macroeconomic researchers.

■

Explain where the U.S. economy currently is in terms of the business cycle. Also, say where your state is in terms of the business cycle. Some states get hit harder than the national average in terms of unemployment. *In response to the recent recession, the federal government has tried to stimulate aggregate demand.

Discuss the impact of this on the economy and on the federal deficit.

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Trouble Spots The natural tendency for students, when they see aggregate demand and aggregate supply curves, is to view them like other demand and supply curves. While this familiarity helps introduce these new tools, you should warn students that the shape of the aggregate curves is not based on the same forces that shape curves for individual markets.

Additional Examples Flows and stocks — The rate of snowfall is a flow variable and is measured in inches per hour; the accumulation of snow is a stock, measured by total snowfall. Calorie consumption per day is a flow; body weight is a stock. Pounds gained or lost per month would be a flow variable.

Medical/economics analogy — Maladies that afflict the body and the economy are often described in similar terms. For example, both a person and the economy experience growth or can suffer from depression.

What If? What if there were never problems of unemployment, inflation, or poor economic growth? What would be the role of macroeconomic theory in such an economy? (If the economy remained healthy, we would have less need to understand how it works; but we may still want to know, just as we may want to learn about astronomy, even though our knowledge of astronomy does not influence celestial movements.)

What if the problem of stagflation in the middle and late 1970s had not occurred? What would be the dominant macroeconomic theory today? (It would probably be more Keynesian than it already is.)

What if the 13 original U.S. colonies were still British colonies? Could we speak of the colonial economy, or would these colonies be part of the British economy? (The Atlantic Ocean gets into the act.)

Chapter 19

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CHAPTER 20 TRACKING THE U.S. ECONOMY This chapter discusses the economy’s scorecard, using the national income accounts to track economic activity. By focusing on the value of fi nal goods and services, the national income accounts the value of apples and oranges. Alternative ways of measuring GDP are the income approach and the expenditure approach. The circular fl ow of income and expenditure is used as an organizing tool, helping explain the relationship between income and spending. The bottom half of the circular fl ow represents income and the upper half, expenditure. The chapter also points out the limitations of national income accounts and how to adjust for changes in the price level over time. The consumer price index focuses on the price of a given basket of goods over time. The GDP price index considers changes in price of all goods and services produced. Only two measures of income are emphasized in the body of the chapter—GDP and disposable income. The Appendix offers more detail on national income and personal income.

CHAPTER OUTLINE 20-1 THE PRODUCT OF A NATION 20-1a National Income Accounts 20-1b GDP Based on the Expenditure Approach 20-1c Composition of Aggregate Expenditure 20-1d GDP Based on the Income Approach 20-2 CIRCULAR FLOW OF INCOME AND EXPENDITURE 20-2a Income Half of the Circular Flow 20-2b Expenditure Half of the Circular Flow 20-2c Leakages Equal Injections 20-3 LIMITATIONS OF NATIONAL INCOME ACCOUNTING 20-3a Some Production Is Not Included in GDP 20-3b Leisure, Quality, and Variety 20-3c What’s Gross About Gross Domestic Product?

20-3d GDP Does Not Reflect All Costs 20-3e GDP and Economic Welfare 20-4 ACCOUNTING FOR PRICE CHANGES 20-4a Price Indexes 20-4b Consumer Price Index 20-4c Problems with the CPI CASE STUDY: Price Check on Aisle 2 20-4d The GDP Price Index 20-4e Moving from Fixed Weights to Chain Weights 20-5 CONCLUSION

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APPENDIX: NATIONAL INCOME ACCOUNTS National Income Personal and Disposable Income Summary of National Income Accounts Summary Income Statement of the Economy

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

expenditure approach to GDP, income approach to GDP, final goods and services, intermediate goods and services, consumption, investment, physical capital, residential construction, inventories, government purchases, net exports, aggregate expenditure, aggregate income, value added, double counting, the circular flow of income and spending, net taxes (NT), financial markets, leakages and injections, the underground economy, depreciation, net domestic product, nominal GDP versus real GDP, base year, disposable income (DI), consumer price index (CPI), GDP price index, and fixed weights versus chain weights.

Students should also be able to: 䉴

explain why economic activity is measured as a flow rather than as a stock.

䉴

describe two ways of measuring GDP and explain why they are equivalent. (The expenditure approach and the income approach are equivalent because every dollar spent represents a dollar of income to some resource owner.)

䉴

explain why GDP calculations ignore intermediate goods. (They are ignored so as to avoid double counting.)

䉴

identify the components of aggregate expenditure. (The components are consumption, investment, government purchases, and net exports.)

䉴

explain the difference between the nominal value and real value of national output.

䉴

explain the difference between the CPI and the GDP price index. (The CPI reflects the price of a given basket of goods and services. The GDP price index is a comprehensive measure of all goods and services included in gross domestic output.)

If students are responsible for the appendix, they should be able to convert GDP to net domestic product, work their way down to national income, personal income, and disposable income, and show the steps in between.

DISCUSSION MATERIAL ■

The temptation is to present the national income accounts in all their glorious detail, but what would benefit students more is an intuitive understanding of the big picture. Perhaps you should begin with a discussion about why we want to know about the income and output for the entire economy. Then explain the two ways of computing GDP and show how they are equivalent. The level of detail of the discussions in your sections will depend on whether students are responsible for the appendix material.

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■

The national income accounts fail to capture fully any changes in quality or variety over time. Ask students to discuss recent changes in the quality and variety of products.

■

The national income accounts measure production, spending, and income; but these accounts were not designed to measure economic welfare. Discuss aspects of economic welfare ignored in GDP calculations. (GDP fails to account for changes in leisure, negative externalities, or the distribution of income.)

■

The discussion material that follows is based on topics covered in the Appendix. Under national income accounting, home ownership is treated as a tiny business renting the home to itself. Consider the implications of this approach: Spending for new homes is counted as investment; the estimated rental value of owner-occupied housing minus expenses, such as interest, taxes, and depreciation, is considered part of personal income. Viewing the household as a tiny firm seems reasonable when you realize that the most valuable real asset that most families own is their home. Home improvement decisions are often based on their effect on the market value of the home.

Trouble Spots The danger in a chapter like this one is that the student can drown in all the details. Make sure students understand the rationale for and the idea behind the national income accounts before you try to provide details.

Additional Examples Value added — The book traces through value added in making a wooden desk. You could present a similar value-added problem for a loaf of bread. Begin with wheat that is sold by the farmer to the miller for 50 cents. The wheat is milled and sold for 80 cents to the baker, who bakes it into a loaf of bread sold to the consumer for $2.

Double counting — As a way of underscoring why we want to avoid double counting, consider a desk manufacturer who cuts and mills lumber from a company-owned forest. Compare this with the example in the chapter that traces the various production stages of a desk. In each case the contribution to GDP is the retail price of the desk. Yet if the dollar value of all sales was simply added up, the example in the book would have a greater sum than if the manufacturer produced the desk from raw timber.

What If? What if there was a shift of production from the firm to the household? What would happen to GDP? (It would fall.)

What if McDonald’s started raising its own lettuce rather than purchasing it? What would happen to GDP? (Nothing much.)

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CHAPTER 21 UNEMPLOYMENT AND INFLATION If the economy always operated smoothly, there would be less need to understand how it works. The intent of the chapter is to show two things that can go wrong with the economy, thereby providing the rationale for studying macroeconomics. Four types of unemployment are discussed—frictional, structural, seasonal, and cyclical. The composition and duration of unemployment along with the impact of unemployment insurance are also examined. Inflation, hyperinflation, deflation, disinflation (a reduction in the rate of inflation), and changes in relative prices are covered in the second half of the chapter. The chapter emphasizes the economic and social costs of unemployment and inflation.

CHAPTER OUTLINE 21-1 UNEMPLOYMENT 21-1a Measuring Unemployment 21-1b Labor Force Participation Rate 21-1c Unemployment Over Time 21-1d Duration of Unemployment 21-1e Unemployment in Various Groups 21-1f Unemployment Varies Across Occupations and Regions 21-1g International Comparisons of Unemployment 21-1h Sources of Unemployment Frictional Unemployment Seasonal Unemployment Structural Unemployment Cyclical Unemployment 21-2 OTHER UNEMPLOYMENT ISSUES 21-2a Duration of Unemployment 21-2b The Meaning of Full Employment 21-2c Unemployment Compensation 21-2d Problems with Official Unemployment Figures 21-3 INFLATION: ITS MEASURES AND SOURCES CASE STUDY: Hyperinflation in Zimbabwe 21-3a Two Sources of Inflation 21-3b A Historical Look at Inflation and the Price Level 21-3c Inflation Across Metropolitan Areas 21-3d International Comparisons of Inflation 21-4 EFFECTS OF INFLATION 21-4a Anticipated Versus Unanticipated Infl ation 21-4b The Transaction Costs of Variable Infl ation 21-4c Inflation Obscures Relative Price Changes 21-4d Inflation and Interest Rates 21-4e Why Is Inflation So Unpopular?

21-4 CONCLUSION

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CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

labor force; unemployment rate; discouraged workers; labor force participation rate; frictional, structural, seasonal, and cyclical unemployment; long-term unemployed; full employment; unemployment benefits, underemployment, inflation; deflation; disinflation; hyperinflation; demand-pull inflation; cost-push inflation; interest rate; real interest rate; nominal interest rate; and COLA.

Students should also be able to: 䉴

distinguish between those who are unemployed and those who are not working.

䉴

describe the record of U.S. unemployment and inflation during the last century, as well as costs of unemployment and inflation.

䉴

explain why unanticipated inflation creates more problems than anticipated inflation.

䉴

explain why hyperinflation reduces productivity. (People must spend more time on money matters— time robbed from leisure and from the production of goods and services.)

DISCUSSION MATERIAL ■

The chapter notes that unemployment occurs even in a healthy economy. Discuss the source of unemployment in a healthy economy.

■

“Rosie the Riveter” earns a take-home pay of $400 per week. She loses her job, and her unemployment benefits amount to $300 per week. Discuss how unemployment insurance affects her incentives to find another job. Unemployment benefits are taxed as personal income; though most people with low income have no personal income tax liability. How does this influence her incentives to get back to work? During the recent recession, unemployment benefits extended to 99 weeks in some states.

■

The chapter emphasizes that on the other side of every higher price is higher nominal income to some resource supplier. Thus, when viewed as a rise in nominal income, inflation is not so bad. Discuss the two sides of inflation.

■

The chapter notes the distinction between anticipated and unanticipated inflation. Point out that if inflation went up 2 percent per year with great regularity and if the prices of all goods increased by the same amount, then inflation would cause few problems. But if inflation is unpredictable and if price changes differ across products, then inflation makes planning more difficult and creates winners and losers arbitrarily. Discuss differences between anticipated and unanticipated inflation.

■

During the Great Depression, the U.S. economy experienced severe deflation, with the price level falling by about one-third between 1930 and 1933. Discuss how deflation is the flip side of inflation and why deflation can cause problems as well. (With deflation, people defer making major purchases because they are waiting for prices to decline further. This reduces aggregate demand and increases unemployment.)

■

Discuss in what ways people’s expectations of higher inflation can affect the actual rate of inflation.

(Workers demand higher wages; lenders demand higher interest rates; all this feeds higher inflation.)

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Trouble Spots Emphasize that because all prices do not increase by the same amount during periods of inflation, relative prices change. This change in relative prices introduced one of the costly uncertainties of inflation. But changes in relative prices are usually a natural reflection of changes in market forces.

Additional Examples Frictional unemployment — A student has just graduated from college and is in the job market looking for the best position available. A real-estate agent leaves that profession seeking more exciting work in insurance.

Structural unemployment — The introduction of the compact disc player put those who manufactured tape decks out of work. Unemployment in the coal-mining hills of West Virginia is higher than the national average, but those unemployed do not move to where job opportunities are better.

Seasonal unemployment — The ski resorts of Vermont and Colorado are dead during the summer months, and many people who cater to the ski crowd are unemployed. Ice-cream vendors hire more workers in the summer.

Cyclical unemployment — During recessions, the demands for autos and new homes decline; therefore, many auto workers and construction workers are unemployed.

Hyperinflation — Documented hyperinflations include collapses of the continental during the American Revolution, the ruble during the Russian revolution (the ruble was again in trouble during the 1990s), and the peng in Hungary right after World War II. You might discuss how Zimbabwe solved its hyperinflation (the country allowed people to use foreign currencies so the worthless local currency disappeared).

What If? What if all exchange took place through barter? Would inflation be possible? (No.) What if a computer program were developed to quickly match job openings with unemployed workers?

Would this eliminate unemployment? (Frictional unemployment would fall, but the other types of unemployment would be little affected.)

Chapter 21

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CHAPTER 22 PRODUCTIVITY AND GROWTH This chapter introduces productivity and growth as keys to economic prosperity; the production possibilities frontier and per-worker production function are used as a framework. The U.S. growth record, particularly since World War II, is examined, and possible explanations for the 1973-1982 slowdown in productivity growth and subsequent pick up are discussed. Some labor market imperfections that reduce the economy’s potential output are explored along with U.S. public policies aimed at reducing these imperfections. This is one of the easier chapters because the only new tool is the per-worker production function. Much of the material is descriptive. Yet given all the concern accorded productivity growth, this is an important chapter because of the critical role of information technology in this new century.

CHAPTER OUTLINE 22-1 THEORY OF PRODUCTIVITY AND GROWTH 22-1a Growth and the Production Possibilities Frontier 22-1b What Is Productivity?

22-1c Labor Productivity 22-1d Per-Worker Production Function 22-1e Technological Change 22-1f Rules of the Game 22-2 PRODUCTIVITY AND GROWTH IN PRACTICE 22-2a Education and Economic Development 22-2b U.S. Labor Productivity 22-2c Slowdown and Rebound in Productivity Growth 22-2d Output Per Capita 22-2e International Comparisons 22-3 OTHER ISSUES OF TECHNOLOGY AND GROWTH 22-3a Does Technological Change Lead to Unemployment?

22-3b Research and Development 22-3c Industrial Policy CASE STUDY:Income and Happiness 22-4 CONCLUSION

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

labor productivity, the per-worker production function, capital deepening, rules of the game, industrial market countries, developing countries, the record of U.S. labor productivity growth during the last century, possible reasons for the slowdown in U.S. productivity growth from 1973 to 1982 and the subsequent acceleration (the price of oil quadrupled from 1973 to 1974, boosting inflation and contributing to recessions; in the early 1970s, federal measures needed to protect the environment and promote workplace safety may have slowed productivity growth), basic research, applied research, and industrial policy.

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Students should also be able to: 䉴

explain why more concern is expressed when labor productivity growth slows down than when population growth slows down.

䉴

explain why less developed countries don’t simply follow the lead of more developed countries as a path to growth.

䉴

describe what factors contribute to rising labor productivity.

䉴

explain the role of education in boosting productivity growth.

䉴

discuss the significance of the “rules of the game” in establishing a framework for productivity and growth.

DISCUSSION MATERIAL ■

One resource not emphasized in the chapter is the role of the entrepreneur. You might discuss how important entrepreneurial ability is to productivity and growth. Unless entrepreneurs combine the other resources to produce goods and services, the economy stagnates. Entrepreneurs try to increase the productivity of resources because, if they can produce at a lower cost per unit than can their competitors, they stand to earn a profit.

■

The advent of machines has eliminated much physical labor and has increased labor productivity.

When physical labor was important, the strongest people earned the most. Likewise, electronic computers are reducing the amount of mental labor required. Will computers reduce the relative earnings of the smartest people? (Not likely; in fact, computers have increased the relative pay of the well educated, who are in the best position to leverage the power of computers. For example, better software and hardware allows a manager to estimate and reward the marginal product of individual employees.)

■

Research suggests that the quality of labor and capital is much more important for economic growth than the quantity of labor and capital. Discuss with the class why quality is more important. You might compare using ten obsolete computers versus just one that is state-of-the-art.

■

Measures of labor productivity are usually based on GDP, and as such these measures are subject to the same limitations as is GDP. For example, labor productivity measures ignore household production, any negative externalities arising from production, and output from the underground economy. Could a shift of production from recorded economic activity to the underground economy explain part of the slowdown in the official measure of labor productivity growth from 1973 to 1982?

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Trouble Spots As noted earlier, this is a relatively easy chapter. Ironically, because so much detail is provided about the U.S. growth record, students may get lost in the details. Your contributions, therefore, could be to keep their focus on the big picture while using details to support your arguments. Remind students that increases in productivity are the keys to economic prosperity, but most countries have very low levels of productivity when compared to the United States. In other words, remind students of the difference between the level of labor productivity and the growth rate in labor productivity.

Additional Examples Tax cuts and economic incentives — In 1986 marginal tax rates were reduced on federal personal income taxes, to take effect in 1988. The top rate was cut from 50 percent to 28 percent, so you might talk about how this tax cut could affect individual incentives and the economy’s potential output. President Clinton in 1993 increased the top marginal tax rate to about 40 percent. President Bush’s tax cuts reduced the top rate to 35 percent, but the top rate was scheduled to return to 40 percent in 2013. With the exception of France, most advanced economies around the world have been cutting their highest marginal rates.

What If? What if robots were invented to replace virtually all manufacturing workers? What would happen to the levels of prosperity and unemployment? (Total output and prosperity would increase, workers would eventually be absorbed by the service sector, and the unemployment rate would not change much in the long run. The key is that human wants are unlimited.)

What if population growth were zero? Could such an economy still prosper? (Sure. The key to prosperity is output per capita, not total output. Population in what had been West Germany, one of the strongest economies in the world, had been flat since 1973. West Germany was willing to absorb East Germany to gain population. Population in some other developed countries, such as Austria, Great Britain, Italy, and Switzerland, has also been relatively flat.) On the other hand, the poorest countries in the world are also experiencing the fastest population growth.

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CHAPTER 23 AGGREGATE EXPENDITURE AND AGGREGATE DEMAND The first half of this chapter introduces consumption, investment, government purchases, and net exports as the building blocks of aggregate demand. Consumption and saving are linked to disposable income through the marginal propensities to consume and to save.

The emphasis in the first half of the chapter is the positive and relatively stable relationship between consumption and income.

The second half of the chapter combines consumption, investment, government purchases, and net exports to derive, for a given price level, the quantity of aggregate output demanded. This combination represents a single point on the aggregate demand curve. Real GDP on the demand side is achieved when aggregate spending equals income and output. Toward the end of the chapter, the relation between the aggregate expenditure model and the aggregate demand curve is examined.

CHAPTER OUTLINE 23-1 CONSUMPTION 23-1a Consumption and Income 23-1b The Consumption Function 23-1c Marginal Propensities to Consume and to Save 23-1d The MPC Is the Slope of the Consumption Function 23-2 NONINCOME DETERMINANTS OF CONSUMPTIO 23-2a Net Wealth and Consumption 23-2b The Price Level 23-2c The Interest Rate 23-2d Expectations 23-3 OTHER SPENDING COMPONENTS 23-3a Investment Investment Demand Curve Investment and Income CASE STUDY: Investment Varies More than Consumption 23-3b Government Purchases 23-3c Net Exports 23-4 AGGREGATE EXPENDITURE AND INCOME 23-4a The Components of Aggregate Expenditure 23-4b Real GDP Demanded 23-4c What is Spending Exceeds Real GDP? 23-4d What if Real GDP Exceeds Spending?

23-5 THE SIMPLE SPENDING MULTIPLIER 23-5a An Increase in Spending Round One Round Two Round Three and Beyond 23-5b Using the Simple Spending Multiplier

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23-6 THE AGGREGATE DEMAND CURVE 23-6a A Higher Price Level 23-6b A Lower Price Level 23-6c The Multiplier and Shifts in Aggregate Demand 23-7 CONCLUSION

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

the consumption function, the marginal propensity to consume (MPC), the marginal propensity to save (MPS) net wealth, the aggregate expenditure line, income-expenditure model, simple spending multiplier

Students should also be able to: 䉴

distinguish between the effects on consumption of an increase in income versus an increase in net wealth. (Both will increase consumption but for different reasons. An increase in income results in a movement to the right along a given consumption function. An increase in net wealth results in an upward shift of the consumption function, so consumption increases even if income remains unchanged.)

䉴

explain the relation between the income-expenditure model and the aggregate demand model

䉴

derive real GDP demanded and then show how changes in desired spending, in the price level, and in interest rates change real GDP demanded.

DISCUSSION MATERIAL ■

Contrast the consumption function with a market demand curve. A market demand curve shows the amount that people are willing and able to spend on a particular good at alternative prices, given the income level. The consumption function shows the amount that people are willing and able to spend on all final goods and services at alternative income levels, given the price level prevailing in the economy.

■

U.S. consumption was equal to disposable income during the Great Depression but fell far short of disposable income during World War II. During the Great Depression, unemployment was high and incomes were low, so nearly every dollar of available income was spent on consumption. During World War II, price ceilings were placed on many consumer goods. Goods that were especially scarce, such as gasoline, tires, fuel oil, sugar, coffee, and meat, were rationed. Thus, incomes were relatively high, but the selection of goods was limited and popular goods were rationed, so people saved more; this amounted to forced saving.

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Since World War II, U.S. consumption has been relatively stable as a fraction of U.S. disposable income. Discuss why this relation has been relatively stable. (It’s an average of all consumers in the economy—young and old, rich and poor—and averages tend to be more stable than consumption for particular households. Consumption by a particular household varies over that household’s life cycle.)

The income-expenditure framework relies on consumer sovereignty. Consumers get their way in the sense that their consumption plans are satisfied, so firms must do all the adjusting. Discuss the adjustment process when aggregate expenditure exceeds aggregate output and when aggregate expenditure falls short of aggregate output. Note that we ask what the quantity demanded would be at a given price level. Real GDP does all the adjusting, not the price level.

In the income-expenditure framework, the horizontal axis measures real GDP and the vertical axis measures desired spending, or planned aggregate expenditure. Students are tempted to think that an increase in the price level will reduce consumption simply because prices are higher. But, since the horizontal axis is already in real terms, any given level of real income could purchase the same amount of real goods and services, even after the price level increases. The question we ask is what happens to desired consumption at each level of real income if the price level changes. One way price changes affect desired consumption is through consumer holdings of dollar-fixed assets such as savings accounts. The higher the price level, the lower the value of dollar-fixed assets and the less planned spending at each level of real GDP.

Trouble Spots There are no especially difficult sections in this chapter, though you could give the marginal propensities to consume and to save some extra attention.

Because real GDP demanded is introduced here for the first time, students will benefit from a careful presentation of new graphical material. Students must understand the fundamentals, or they will have trouble as more difficult material is introduced in later chapters. Toward the end of the chapter, diagrams distinguish between the effects of a change in aggregate expenditure given the price level and the effects of a change in the price level on aggregate expenditure. Trace through these effects for students.

Additional Examples Relationship between income and consumption — How can you tell whether households in a particular neighborhood are rich or poor? (Just observe the quality of housing in the neighborhood and the make and year of cars in the driveways.) How can sales clerks get some idea of a customer's income? (They can observe what people buy.)

Net wealth and consumption — Pose the following question to the students. “Suppose that you are notified that a distant relative died, leaving you $10 million after taxes. What might you do differently?”

What If? What if business expectations never changed? Would investment remain the same from year to year?

(Business expectations affect the investment demand curve. Even if business expectations remained unchanged, however, the quantity of investment would change if the market interest rate changed, if the population grew, or if the marginal productivity of capital changed.)

What if consumers always spend all their income, regardless of their income level? What would happen to the equilibrium quantity of real GDP demanded? (The consumption function would be a 45-degree line. There would be no household saving to finance investment, so investment would be zero. Since the consumption function overlays the 45-degree line, there would be no unique equilibrium in the private economy.)

Chapter 23

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CHAPTER 24 AGGREGATE SUPPLY In the previous chapter, we took the price level as given and derived the quantity of aggregate output that would be demanded at that particular price level. In this chapter, the price level is not known ahead of time, but resource suppliers and firms have certain expectations about what the price level will be. Based on these expectations, resource suppliers, such as workers, negotiate with firms about resource payments. Thus, the aggregate supply curve is based on an expected price level. If the price level turns out as expected, everyone is content with the deals struck, and the economy produces its potential output. If the price level turns out to be higher than expected, firms find production more profitable, so they expand output, increasing the quantity of aggregate output supplied. If the price level turns out to be lower than expected, firms find production less profitable, so they reduce output, reducing the quantity of aggregate output supplied. Thus the short-run aggregate supply curve is upward sloping. This chapter examines the adjustment process that occurs in the short run and in the long run when the actual price level differs from the expected price level reflected in long-term resource price agreements.

CHAPTER OUTLINE 24-1 AGGREGATE SUPPLY IN THE SHORT RUN 24-1a Labor and Aggregate Supply 24-1b Potential Output and the Natural Rate of Unemployment 24-1c Actual Price Level Is Higher Than Expected 24-1d Why Costs Rise When Output Exceeds Potential 24-1d An Actual Price Level Lower Than Expected 24-1e The Short-Run Aggregate Supply Curve

24-2 FROM THE SHORT RUN TO THE LONG RUN 24-2a Closing an Expansionary Gap 24-2b Closing a Recessionary Gap

24-3 THE LONG-RUN AGGREGATE SUPPLY CURVE 24-3a Tracing Potential Output 24-3b Wage Flexibility and Employment CASE STUDY: U.S. Output Gaps and Wage Flexibility

24-4 SHIFTS OF THE AGGREGATE SUPPLY CURVE 24-4a Aggregate Supply Increases 24-4b Decreases in Aggregate Supply 24-5 CONCLUSION

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CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

the distinction between nominal wages and real wages, the distinction between the expected price level and the actual price level, potential output, natural rate of unemployment, short-run and long-run aggregate supply curves, short-run equilibrium, long-run equilibrium, expansionary gap, recessionary gaps, coordination failure, supply shocks, benefi cial supply shocks, and adverse supply shocks.

Students should also be able to: 䉴

explain why the short-run aggregate supply curve sloped upward.

䉴

draw a graph to show the short-run equilibrium level of price and output when the actual price level exceeds the expected price level and indicate the adjustment that will occur in the long run. Students should be able to do the same when the actual price level is below the expected price level.

䉴

distinguish between the effects of short-run supply shocks and changes in the economy’s potential output.

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explain why the long-run aggregate supply curve is vertical at potential output.

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explain why the economy is in both short-run equilibrium and long-run equilibrium when the actual price level equals the expected price level.

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explain what is natural about the natural rate of unemployment.

DISCUSSION MATERIAL ■

Typically we define equilibrium as a position from which there is no tendency to change. But nearly all points along the short-run aggregate supply curve are short-run equilibrium points only. When the actual price level differs from the expected price level reflected in long-term resource price agreements, market forces will shift the short-run aggregate supply curve. Discuss the forces that cause this shift. (When the actual price level exceeds the expected price level, people supplying resources under long-term contracts are earning less in real terms than they expected, so they will seek higher nominal payments at the first opportunity. When the actual price level is below the expected price level, firms are paying more in real terms for some resources than they expected, so they will seek to reduce nominal payments.)

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Why would workers make long-term wage agreements knowing that if the price level turns out to be higher than expected, their real wage will be less than they bargained for? (Workers and firms evidently prefer the security of long-term wage agreements. Workers themselves face many payments that are fixed for a year or more—car payments, rent, mortgage payments, insurance, property taxes, utilities, and so on. What’s more, the price level could turn out to be lower than expected, so real wages would be higher than those for which the workers bargained.)

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In Chapter 21 students were introduced to demand-pull and cost-push inflation. When aggregate demand exceeds expectations, the result is demand-pull inflation, a higher-than-expected price level, and output exceeding the economy’s potential. But output in excess of the economy’s potential will generate cost-push inflation in the long run as resource owners try to catch up with the higher-than-expected price level.

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Trouble Spots What may be confusing for students is that the aggregate supply curve is based on a particular expected price level, yet the vertical axis measures the actual price level. The point to keep in mind is that many resource owners agree on resource payments before the actual price level is known. Firms, however, get to know the actual price level before they decide how much to produce. Thus, along the aggregate supply curve, resource owners and firms have implicit and explicit contracts based on the expected price level, but the production decision is based on knowledge of the actual price level. It is this asymmetry in who knows what and when that gives the aggregate supply curve its upward-sloping shape. If both resource suppliers and firms based their payment agreements on full knowledge of the actual price level, as they do in the long run, then the short-run aggregate supply curve would be vertical, as it is in the long run.

Additional Examples Implicit and explicit contracts — Students might consider the implicit or explicit contracts that bind them in the short run. Tuition, dormitory fees, and meal charges are typically set annually. When students accept a summer job, the wage is usually determined for the season and may be decided long before the summer even begins. Magazine subscriptions can be purchased for several years at a fixed rate.

What If? What if the future price level were always known with certainty? What would the aggregate supply curve look like? (It would be vertical.)

What if the prices that firms pay for resources changed constantly with market forces? That is, what if no resource payments were contractually fixed but were determined in “spot” markets? What would the aggregate supply curve look like? (It would probably be vertical.)

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CHAPTER 25 FISCAL POLICY This chapter considers the role of government outlays and taxes in determining real GDP demanded. In light of the severe recession of 2007-2009 and fiscal efforts to stimulate the economy, this is an important policy chapter. More generally, the chapter analyzes fiscal policy, including taxes, government purchases, and transfer payments. The chapter combines this description of aggregate demand with the aggregate supply curve developed in the previous chapter. The objective is to show the pros and cons of fiscal policy as a way of closing expansionary and contractionary gaps. The latter part of the chapter describes fi scal policy since World War II.

CHAPTER OUTLINE 25-1 THEORY OF FISCAL POLICY 25-1a Fiscal Policy Tools 25-1b Discretionary Fiscal Policy to Close a Recessionary Gap 25-1c Discretionary Fiscal Policy to Close an Expansionary Gap 25-1d The Multiplier and the Time Horizon 25-2 FISCAL POLICY UP TO STAGFLATION OF THE 1970S 25-2a Prior to the Great Depression 25-2b The Great Depression and World War II 25-2c Automatic Stabilizers 25-2d From the Golden Age to Stagflation 25-3 LIMITS OF FISCAL POLICY©S EFFECTIVENESS 25-3a Fiscal Policy and the Natural Rate of Unemployment 25-3b Lags in Fiscal Policy 25-3c Discretionary Fiscal Policy and Permanent Income 25-4 FISCAL POLICY SINCE 1980 25-4a Fiscal Policy During the 1980s 25-4b 1990 to 2007 : From Deficits to Surpluses Back to Deficits 25-4c Fiscal Policy and the Great Recession The Financial Crisis and Aftermath The Stimulus Package Government Spending and Real GDP CASE STUDY: Cash for Clunkers 25-5 CONCLUSION APPENDIX: DEMAND-SIDE EFFECTS OF GOVERNMENT PURCHASES AND NET TAXES Changes in Government Purchases Changes in Taxes

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CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

automatic stabilizers, classical economists, Employment Act of 1946, political business cycles, discretionary fiscal policy, expansionary fiscal policy, contractionary fiscal policy, Golden Age of fiscal policy, lags in fiscal policy, permanent income, and the American Recovery and Reinvestment Act.

Students should also be able to: 䉴

distinguish between automatic stabilizers and discretionary fiscal policy.

䉴

describe the appropriate fiscal policy to close a recessionary gap or an expansionary gap and draw graphs to illustrate the point.

䉴

discuss the results of the supply-side tax cuts introduced in the early 1980s. (Taxes were cut but government spending was not, so large deficits resulted.)

If students are expected to know the material in the appendix, they should be able to explain why a reduction in net taxes does not have the same effect on equilibrium income as an identical increase in government purchases.

DISCUSSION MATERIAL ■

No sooner do we develop the simple spending multiplier than we start introducing reasons why the actual change in output will likely be smaller than the simple multiplier indicates. Once we introduce aggregate supply, we must incorporate the impact on equilibrium output of changes in the price level.

Price changes reduce the spending multiplier still further.

■

Discuss the factors that make fiscal policy so difficult to execute effectively. (These include lags in implementation, ignorance of the natural rate of unemployment, the inability of temporary tax changes to affect permanent income, and possible feedback effects of fiscal policy on aggregate supply.)

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Discuss why fiscal policy seemed poorly suited for addressing problems of stagflation that arose during the 1970s. (An expansionary fiscal policy would worsen inflation, and a contractionary fiscal policy would worsen unemployment.)

■

What if the Great Depression had not occurred? Would Keynes have posed his alternative to the classical view? (Probably not, but it’s worth discussing.)

■

Discuss the effectiveness of the February 2009 stimulus plan. The chapter offers some estimates of the spending multiplier (estimates range from less than 1.0 to more than 1.0). What was one of the big drawbacks of the stimulus plan? (It increased the federal deficit.)

Trouble Spots The appendix presents the geometry and algebra of fi scal policy. It looks more intimidating than it actually is. If you expect your students to be responsible for this material, you should go over it step-bystep in class.

Note that throughout the book, government outlays equal government purchases plus transfer payments. This chapter talks about government purchases and net taxes. Net taxes equal taxes minus transfer payments.

Additional Examples The next chapter discusses fiscal policy in greater detail, particularly events since 1980. If you don’t plan to cover that chapter it in class, take a look at that chapter for material that might be useful in class discussion.

President Bill Clinton’s first federal budget offered a complicated example of fiscal policy in practice; he proposed stimulating the economy in the short run with an additional $16 billion in spending. But he also proposed reducing the deficit in the long run by cutting spending and raising taxes on high-income households. His spending plan was rejected by Congress but his tax hike was approved.

What If? What if the price level and wages were flexible enough to close a contractionary gap? What might be the role of fiscal policy? (Fiscal policy could still be used to close an expansionary gap without creating inflation.)

What if federal deficits were continually needed to keep the economy producing at its potential? What are the problems of chronic federal deficits? (The biggest problem is a mounting federal debt, which must be serviced by federal outlays. There is more on this in the next chapter.)

What if the aggregate supply curve were horizontal? How would this affect the multiplier? (A horizontal aggregate supply curve implies a constant price level, which is an assumption of the simple multiplier.)

Chapter 25

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CHAPTER 26 FEDERAL BUDGETS AND PUBLIC POLICY The first third of the chapter explains the U.S. federal budget process and the problems associated with budgeting. The middle third focuses on the sources and effects of U.S. federal deficits, especially the ones experienced since the 1980s. And the final third examines the federal debt arising from chronic deficits.

This chapter is a blend of theory and policy and presents a contemporary analysis of fiscal issues.

CHAPTER OUTLINE 26-1 THE FEDERAL BUDGET PROCESS 26-1a The Presidential and Congressional Roles 26-1b Problems with the Federal Budget Process Continuing Resolutions Instead of Budget Decisions Lengthy Budget Process Uncontrollable Budget Items Overly Detailed Budget 26-1c Possible Budget Reforms 26-2 THE FISCAL IMPACT OF THE FEDERAL BUDGET 26-2a Rationale for Defi cits 26-2b Budget Philosophies and Deficits 26-2c Federal Deficits Since the Birth of the Nation 26-2d Why Deficits Persist?

26-2e Deficits, Surpluses, Crowding Out and Crowding In 26-2f The Twin Deficits 26-2g The Short-Lived Budget Surplus Tax Increases Slower Growth in Federal Outlays A Reversal of Fortunes in 2001 Trillion Dollar Deficits 26-2hThe Relative Size of the Public Sector 26-3 THE NATIONAL DEBT IN PERSPECTIVE 26-3a Measuring the National Debt 26-3b International Perspective on Public Debt 26-3c Interest Payments on the National Debt 26-4 HUGE FEDERAL DEBT AND THE ECONOMY 26-4a Are Persistent Defi cits Sustainable?

26-4b The Debt Ceiling and Debt Default 26-4c Who Bears the Burden of the Debt?

We Owe It to Ourselves Foreign Ownership of Debt 26-4d Crowding Out and Capital Formation 26-4e The National Debt and Economic Growth CASE STUDY: Reforming Social Security and Medicare 26-5 CONCLUSION

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CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

the presidential and congressional roles in the budget process, problems with the budget process (lengthy budget process, continuing resolutions, overly detailed budget, uncontrollable budget items), suggested budget reforms (biennial budget, budgeting by major categories, budget philosophies (annually balanced budgets, cyclically balanced budgets, functional finance), source of the large U.S. federal deficits between 1982 and 1996 and since 2002, record of deficits since the birth of the nation, crowding out and capital formation, the burden of the debt, foreign holders of federal debt, measures to reduce the defi cit (line-item veto, balanced budget amendment), the short-lived budget surplus, and the huge deficits following the financial crisis, and the debt ceiling.

Students should also be able to: 䉴

explain why deficit financing became so common at the federal level but not at the state and local levels (nearly all state and local officials are not allowed to approve a budget in deficit).

䉴

explain under what circumstances deficit financing may be justified, regardless of the level of government (for capital expenditures such as roads, airports, and buildings).

䉴

explain the relationship between federal budget deficits and trade deficits.

䉴

explain why the U.S. federal deficit had been such a vexing problem for the Congress and the president.

DISCUSSION MATERIAL ■

One way to bring deficits into perspective is to compare government with the household. Banks lend money to households to finance homes and cars because these items provide a flow of services into the future; households pay for these goods over time. Likewise, government borrowing for purchases of capital goods can be justified because these goods provide a flow of services over time. Therefore, taxpayers can pay for these goods over time. In contrast, banks would be unwilling to lend households money to buy groceries. Similarly, deficit financing for farm subsidies and retirement benefits are harder to justify.

■

Nobel Prize winner James Buchanan argues that politicians have always had a desire to spend more than they tax, but Keynesian fiscal policy provided an economic argument for deficits being good for the country. Discuss with the class why politicians prefer spending to taxing.

■

The burden of the debt is a good topic for discussion because the issue is still open to debate, and there are so many aspects of the problem. We can say that the burden of the debt will be greater the more that debt financing crowds out private investment and the more that debt is financed by foreigners.

■

You might discuss why there was not more public pressure to eliminate the federal budget deficits after the early 1980s. For one thing, during most of the period unemployment and inflation were both relatively low (the economy has been in recession for less than 36 months since 1983—that is, for less than 3 of the last 27 years), so people didn’t observe any immediate cost of the deficits. One cost of the deficit during the 1980s was high real rates of interest, but people did not associate the higher real cost of mortgages with the federal deficit. The high deficits of recent years have not be associated with high interest rates.

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Federal spending increased from 22.5 percent of GNP in 1980 to 24.4 percent in 1986. This increase in spending contributed significantly to the deficits. Federal revenues dropped during the same period from 20.3 percent of GNP to 19.5 percent. Thus, the increase in federal spending contributed more to the increase in federal deficits than did Reagan’s tax cut.

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By 1996 both Clinton and the Republican Congress vowed to eliminate the federal deficit in seven years. Both were stunned to see the deficit temporarily erased by 1998. Discuss the confluence of events that brought the budget into balance, albeit temporarily.

Trouble Spots Because much of the chapter describes the U.S. federal budget process and the deficit, this chapter is relatively easy. There are no major trouble spots.

What If? What if the United States were run by a dictator rather than through democratic elections? Would deficit financing be as common?

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CHAPTER 27 MONEY AND THE FINANCIAL SYSTEM This chapter begins with a barter economy and traces money’s evolution from commodity money to fiat money and electronic money. Money is shown to serve most importantly as a medium of exchange but also as a unit of account and a store of value. Problems of too much and too little money in the economy are discussed. The development of the U.S. financial system is traced from the National Banking Act of 1863. The formation and function of the Federal Reserve System dominates the last half of the chapter.

Although the chapter is not especially analytical, many new terms are introduced.

CHAPTER OUTLINE 27-1 THE BIRTH OF MONEY 27-1a Barter and the Double Coincidence of Wants 27-1b Earliest Money and Its Functions Medium of Exchange Unit of Account Store of Value 27-1c Properties of the Ideal Money CASE STUDY: Mackerel Economics in Federal Prisons 27-1d Coins 27-2 MONEY AND BANKING 27-2a Early Banking 27-2b Bank Notes and Fiat Money 27-2c The Value of Money 27-2d When Money Performs Poorly 27-3 FINANCIAL INSTITUTIONS 27-3a Commercial Banks and Thrifts 27-3b Birth of the Fed 27-3c Powers of the Federal Reserve System 27-3d Banking Troubles During the Great Depression Board of Governors Federal Open Market Committee Regulating the Money Supply Deposit Insurance Goals of the Fed 27-3e Banks Lost Deposits When Inflation Increased 27-3f Banking Deregulation 27-3g Banks on the Ropes 27-3h U.S. Banking Developments 27-4 BANKING DURING AND AFTER THE GREAT RECESSION OF 2007-2009 27-4a Subprime Mortgages and Mortgage-Backed Securities 27-4b Incentive Problems and the Financial Crisis of 2008 27-4c The Troubled Asset Relief Program 27-4d The Dodd-Frank Act 27-4e Top Banks in America and the World 27-5 CONCLUSION

82 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

b arter and the double coincidence of wants, functions of money (medium of exchange, unit of account, store of value), commodity money, token money, fiat money, electronic money, fractional reserve banking system, bank notes, legal tender, fi nancial intermediaries, depository institutions, commercial banks, thrift institutions, demand deposits, Federal Reserve System, Federal Reserve notes, open market operations, discount rate, banking deregulation, bank holding companies, the savings and loan crisis, subprime mortgages, mortgage-backed securities, the Troubled Asset Relief Program (TARP), too big to fail, the Dodd-Frank Wall Street Reform and Consumer Protection Act, and the largest banks in the nation and in the world.

Students should also be able to: 䉴

describe the evolution of money (from commodity money to fiat money and electronic money).

䉴

describe the six properties of an ideal money (durable, portable, divisible, of uniform quality, has a low opportunity costs, and is relatively stable in value)

䉴

discuss the problems that arise when there is too much or too little money in the economy.

䉴

explain why the United States has more banks than other countries and why deposits here tend to be more evenly distributed among banks. (Historical restrictions on intrastate and interstate branching promoted the formation of new banks rather than the branching of existing banks.)

䉴

explain how the Federal Reserve System may have worsened the Great Depression. (The Fed failed to supply liquidity to otherwise healthy banks with short-term liquidity problems.)

䉴

discuss the effect of subprime mortgages on the financial crisis of September 2008.

䉴

discuss how U.S. banks rank among the world’s largest banks.

DISCUSSION MATERIAL ■

Discuss what products could today serve as commodity money, keeping in mind the qualities that make for an ideal money (again, these qualities are divisibility, durability, portability, of uniform quality, low opportunity cost, and stable value).

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With a barter economy, products are exchanged directly for products, but with money, products are exchanged for money, which sooner or later is exchanged for other products. Money thus allows transactions to be split in two. Discuss how money gets around the need for a double coincidence of wants.

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The chapter introduces problems that arise when there is too much or too little money in the economy.

First, you might ask, too much or too little money relative to what? (Relative to the number of transactions that must be financed by money.) Next ask what specific problems are associated with too much money and with too little money.

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During the U.S. era of competing moneys prior to the National Banking Act of 1863, each bank could issue its own bank notes. More than 10,000 different kinds of notes circulated, and nearly all were redeemable for gold or silver. But to redeem a note the bearer had to present it to the issuing bank. To discourage redemption, some banks located “out in the sticks”—out where the wildcats lived. Thus, this period of banking became known as the “wildcat era.” Discuss the problems created by the existence of many different kinds of money. (Most well-known notes were counterfeited, and the gold value of notes was not immediately obvious.) *Though not mentioned in the chapter, bank robberies usually interest students. The average robbery yields the criminal about $5,000. But a high tech crime called skimming tries to read ATM cards and passwords with phony card readers attached to the ATM or some combination of card readers and tiny cameras. These heists yields an average of about $50,000 before they are removed.

Trouble Spots Students have been around money so long that they take it for granted. Students have difficulty thinking about its role in the economy. Try to give them a fresh view of money. Since money is nothing more than a sophisticated system of IOUs, you can think of a monetary system as follows. Suppose you give the baker an IOU for a dozen doughnuts. The baker can use your IOU to pay for flour. This piece of paper can circulate as money as long as your debt is outstanding. Likewise, the Federal Reserve Banks issue IOUs in the form of Federal Reserve notes, except that ultimately these notes cannot be redeemed for anything of intrinsic value—just more Federal Reserve notes. Why do people accept these pieces of paper? Because they believe others will accept them (which is a reasonable assumption since by law these pieces of paper must be accepted—that is, money is legal tender.)

Additional Examples Commodity money — Commodities that have been used as money over the years include rice, wheat, olive oil, cocoa, and beaver and seal skins.

Fiat money — To finance the Revolutionary War, the United States issued notes called continentals in such abundance that these notes became worthless; this gave rise to the expression “not worth a continental” to describe something of little value.

What If? What if each U.S. state had its own currency? What problems would this create for interstate commerce?

What if people lost confidence in the official currency—that is, what if people no longer believed others would accept the nation’s currency? How would transactions occur?

What if several kinds of money were in circulation at the same time? Which kind would people tend to hold as a store of wealth and which kind would they try to exchange for goods and services?

Chapter 27

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CHAPTER 28 BANKING AND THE MONEY SUPPLY The previous chapter introduced money and the U.S. fi nancial system. This chapter considers how financial institutions work by examining the kinds of fi nancial institutions in the U.S. economy and the types of deposits they hold. By starting from scratch and slowly developing each side of a bank’s balance sheet, the chapter shows how a bank operates. The heart of the chapter is how banks affect the money supply through the credit creation process and how the Federal Reserve System attempts to control the money supply by regulating excess bank reserves.

CHAPTER OUTLINE 28-1 MONEY AGGREGATES 28-1a Narrow Definition of Money: M1 CASE STUDY: Faking It 28-1b Broader Definition of Money: M2 28-1c Credit Cards and Debit Cards: What’s the Difference?

28-2 HOW BANKS WORK 28-2a Banks Are Financial Intermediaries Coping with Asymmetric Information Reducing Risk Through Diversification 28-2b Starting a Bank 28-2c Reserve Accounts 28-2d Liquidity Versus Profitability 28-3 HOW BANKS CREATE MONEY 28-3a Creating Money Through Excess Reserves Round One Round Two Round Three Round Four and Beyond 28-3b A Summary of Rounds 28-3c Reserve Requirements and Money Expansion 28-3d Limitations on Money Expansion 28-3e Multiple Contraction of the Money Supply 28-4 THE FED’S TOOLS OF MONETARY CONTROL 28-4a Open-Market Operations and the Federal Funds Rate 28-4b The Discount Rate 28-4c Reserve Requirements 28-4d Coping with Financial Crises 28-4e The Fed Is a Money Machine 28-5 CONCLUSION

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CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

the role of banks (interm ediation, expertise w ith loans, and risk m inim ization through diversification), assets, liabilities and net worth, checkable deposits, money and near moneys, M1 and M2, savings deposits, time deposits, liquidity, debit cards, asymmetric information, required reserve ratio, required reserves, excess reserves, federal funds market, federal funds rate, discount rate, open-market operations, and money multiplier.

Students should also be able to: 䉴 explain why a bank’s objectives of liquidity and profitability are at odds and why there is a trade-off between the two. 䉴

explain the difference between credit cards and debit cards.

䉴

explain how an individual bank can create money (by exchanging a borrower’s IOU for checkable deposits) and how the banking system as a whole can create money.

䉴

explain why an individual bank can lend only as much as its excess reserves, yet the banking system as a whole can lend some multiple of excess reserves.

䉴

explain the maximum effects on the money supply if the Fed purchases a $1,000 government bond from a securities dealer, given the initial conditions of no excess reserves in the banking system and a reserve requirement on checkable deposits of 10 percent.

䉴

explain the effects of changes in the following on the size of the money multiplier: the required reserve ratio, banks’ desire to hold excess reserves, customers’ desire to hold cash, banks’ willingness to lend, and customers’ willingness to borrow.

䉴

explain the multiple contraction of money and credit (the process that reduces the money supply).

䉴

explain the possible impact of changes in the discount rate on the money supply.

DISCUSSION MATERIAL ■

Because banks operate on a fractional reserve requirement, their success depends on depositors’ confidence in the safety of deposits. Discuss the ways that banks try to convey confidence (their names, their buildings, their vaults, their date of incorporation, the reputations of their managers, their promotional methods, their status in the community).

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The importance of banks in the economy lies in their ability to turn an IOU into money. Discuss how this happens for an individual bank and for the banking system more generally.

■

Students are often surprised that banks can operate quite comfortably with small margins of excess reserves—often only one or two percent of deposits. While an individual bank loses deposits to other banks when checks clear against its deposits, that same bank also gains deposits when account holders deposit checks written against deposits at other banks. The thousands of transactions that occur in a bank each week tend to even out the gains and the losses of deposits so that the need for excess reserves is relatively modest.

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Automatic teller machines (ATMs) allow access to our money at any time. Discuss why banks would introduce a machine that encourages people to withdraw their deposits. (Since people know they can get at their money at any time, they have more confidence in the safety of their deposits. Since cash is so readily available, people may withdraw less at any one time, which leaves more money on deposit.

The ATM not only allows for withdrawals but for deposits as well. The convenience of ATMs is a way to attract new depositors, and banks that fail to offer them would lose customers to other banks that do. Finally, the ATM saves labor costs, and this may be the most important reason why banks have introduced them.)

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Discuss how the computer has affected banking. (Banks now have more flexibility, which allows depositors using an ATM to switch from one account to another. Banks can constantly sweep their balance sheets, looking for excess reserves that can be put to work. Many depositors bank online from home or on the road.)

■

It’s been said that the Fed is more able to contract the money supply than to expand it. Why can’t the Fed’s ability to create excess reserves ensure that an expansion of the money supply will follow?

(The Fed cannot make banks lend or customers borrow. This was the problem immediately following the financial crisis of September 2008.)

Trouble Spots Students will likely have the hardest time understanding the credit expansion process traced through a number of banks. Present an overview of the process, including the intuition of why the banking system as a whole can expand credit by some multiple of excess reserves in the system. Then review step-by-step the credit expansion process; show the cumulative effect through exhibits.

Additional Examples You can plug different numbers into any of the many numerical examples in this chapter to give each a different twist. For example, you can change the amount of government bonds purchased by the Fed or the required reserve ratio.

What If? What if people had little confidence in depository institutions and withdrew their deposits at the first sign of trouble? How would this affect depository institutions’ ability to make loans for a day or for a year?

(This indeed is the case in many developing countries; as a result, banks have difficulty making any but the shortest-term loans.)

Banking and the Money Supply © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

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CHAPTER 29 MONETARY THEORY AND POLICY The chapter first introduces the effect of money on the economy in the short run, concentrating on the relationship between the money supply and the interest rate. This first section traces federal funds rates since 1996. Next is a discussion of the long-run effect of money. This addresses the more immediate effects of changes in the money supply on the kinds of assets that people choose to hold. According to the long-run perspective, the money supply affects the demand for homes, cars, and other real assets. This chapter is difficult in part because the economics profession is not yet of one mind regarding monetary theory and policy in the short run and the long run.

CHAPTER OUTLINE 29-1 THE DEMAND AND SUPPLY OF MONEY 29-1a The Demand for Money 29-1b Money Demand and Interest Rates 29-1c The Supply of Money and the Equilibrium Interest Rate 29-2 MONEY AND AGGREGATE DEMAND IN THE SHORT RUN 29-2a Interest Rates and Investment 29-2bAdding the Short-Run Aggregate Supply Curve 29-2c Recent History of the Federal Funds Rate CASE STUDY: Greater Fed Transparency As a Policy Tool 29-3 MONEY AND AGGREGATE DEMAND IN THE LONG RUN 29-3a The Equation of Exchange 29-3b The Quantity Theory of Money 29-3c What Determines the Velocity of Money?

29-3d How Stable Is Velocity?

29-4 TARGETS FOR MONETARY POLICY 29-4a Contrasting Policies 29-4b Targets Until 1982 29-4c Targets After 1982 29-4d Other Fed Responses to the Financial Crisis Bailing Out AIG Reducing the Risk of “Too Big to Fail” Quantitative Easing 29-4e What About Inflation?

29-4f International Considerations 29-5 CONCLUSION

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

money versus income, monetary theory and policy in the short run and in the long run, demand for money, money demand and interest rates, equation of exchange, velocity of money, quantity theory of money, monetary targets, the stress test, the shadow banking system, and quantitative easing.

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Students should also be able to: 䉴

graph the supply and demand for money, label the axes, and show the equilibrium interest rate.

䉴

trace through the effects of a money supply increase and discuss the process that leads to a new equilibrium rate of interest.

䉴

use a flowchart to trace the effects of a change in the money supply on aggregate demand.

䉴

use graphs to trace the effects of an increase in the money supply on aggregate demand and explain the logic of each step.

䉴

explain what the addition of an aggregate supply curve to the analysis tells us. (It indicates how changes in aggregate demand divide between price changes and changes in real output.)

䉴

explain why the introduction of money represents yet another reason why the simple spending multiplier may be overstated. (Increases in autonomous spending will increase the demand for money, which raises interest rates and “crowds out” some investment spending.)

䉴

explain the similarities and differences between the short-run and long-run impact of money on the economy.

䉴

write the equation of exchange, explain why it is an identity, and point out what would make it a theory. (It becomes a theory when velocity is assumed to be constant or at least predictable.)

䉴

explain why the Fed cannot, at the same time, target both the money supply and the interest rate.

䉴

explain why did not increase despite the large increase in the money supply.

DISCUSSION MATERIAL ■

Students have a hard time with the idea of the demand for money. To get them involved, take a class poll; have them write on a piece of paper how much money they typically carry around. The poll can be anonymous so as not to make anyone feel uncomfortable. Also ask how many usually carry checkbooks or debit cards. You can collect the results and find the range of usual cash holdings for the class.

Then ask them why they carry money.

■

The quantity theory of money depends on the stability, or at least the predictability, of the velocity of money. Discuss the role of velocity in the quantity theory. Then assess the stability of velocity in recent decades. Distinguish between the velocity of M1 and the velocity of M2.

■

Beginning with the supply and demand for money, show the effect of an increase in the demand for money and discuss why monetary authorities can attempt to hold the interest rate constant or can attempt to hold the money supply constant but can’t do both. This sort of presentation is well suited for the chalkboard because you can show a variety of possibilities.

■

The effect of money on economic activity depends on how much money people choose to hold. Discuss some of the factors that affect people’s desire to hold cash balances (the interest rate, expected inflation, conventions of commerce, frequency of paychecks, accessibility to ATMs, acceptance of check cards by retailers the price level, and the level of economic activity).

■

Discuss why the velocity of money slowed following the financial crisis of 2008.

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89

■

In February 2006, Ben Bernanke succeeded Alan Greenspan as chairman of the Federal Reserve.

Discuss similarities and differences in their approaches.

Trouble Spots One difficult portion of the chapter is the discussion of monetary theory in the short run. Given the money supply, an increase in spending will increase the demand for money, which will raise the interest rate. With the interest rate higher, people hold less money as an asset, so the velocity of money increases. Thus, in the short run, velocity adjusts so that the existing money supply can accommodate alternative levels of aggregate demand. This story becomes less logical as the interest rate offered on money, through bank deposits and the like, gets closer to the interest rates offered on other assets.

Additional Examples Equation of exchange — Suppose the economy during the year produces 5 billion Big Macs at $2 each, 5 billion orders of fries at $1 each, and 5 billion chocolate shakes at $1.25 each. So the nominal value of output, P x Y, is $21.25 billion, which also equals the income received by resource suppliers. If the money supply is $2.5 billion, what is the velocity of money? V = (P x Y)/M = $21.25/$2.5 = 8.5

What If? What if the advent of sophisticated computers allows for all transactions to be recorded in a way that eliminates the use of physical money? Under such a sophisticated system of record-keeping would there be a role for monetary theory and policy?

What if more countries adopt the U.S. dollar as their medium of exchange, as some Latin American countries have done already? What affect would this have on U.S. monetary policy?

What if the economy was beset by hyperinflation? What would happen to velocity? What would cash balances look like and why?

Chapter 29

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CHAPTER 30 MACRO POLICY DEBATE: ACTIVE OR PASSIVE? This chapter reduces the policy issues of macroeconomics to a single question: Is the economy inherently stable and self-correcting, or is it unstable and unable to right itself when thrown off course? The active approach views the private sector, particularly investment, as unstable, so government intervention is required to return the economy to its potential output. The passive approach views the private sector as inherently stable and able to correct itself through price and wage flexibility when output departs from the economy’s potential. This chapter examines both monetary and fiscal policy, though most examples relate to monetary policy.

CHAPTER OUTLINE 30-1 ACTIVE POLICY VERSUS PASSIVE POLICY 30-1a Closing a Recessionary Gap 30-1b Closing an Expansionary Gap 30-1c Problems with Active Policy 30-1d The Problem of Lags 30-1e A Review of Policy Perspectives 30-2 THE ROLE OF EXPECTATIONS 30-2a Discretionary Policy and Expectations 30-2b Anticipating Policy 30-2c Policy Credibility CASE STUDY: Central Bank Independence and Price Stability 30-3 POLICY RULES VERSUS DISCRETION 30-3a Limitations on Discretion 30-3b Rules and Rational Expectations 30-4 THE PHILLIPS CURVE 30-4a The Phillips Framework 30-4b The Short-Run Phillips Curve 30-4c The Long-Run Phillips Curve 30-4d The Natural Rate Hypothesis 30-4e Evidence of the Phillips Curve 30-5 CONCLUSION

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

active versus passive policy, self-correcting mechanisms, problems with lags (recognition lag, decision-making lag, implementation lag, effectiveness lag), rational expectations, rules versus discretion, time-inconsistency problem, cold turkey, short-run and long-run Phillips curves, and the natural rate hypothesis.

91 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

Students should also be able to: 䉴

explain the differences in those advocating an active policy and those advocating a passive policy view the economy.

䉴

describe the kinds of lags associated with fiscal and monetary policy and explain why the existence of lags creates problems with executing active policy.

䉴

explain why passive policy advocates believe that economic fluctuations may worsen as a result of discretionary policy (that is, why discretionary policy may take hold only after the economy has corrected itself).

䉴

explain why those advocating passive policy believe discretionary policy has no effect on output and employment in the long run.

䉴

explain why anticipated discretionary policy has less effect than unanticipated policy.

䉴

discuss why monetary authorities may want to pursue an inflationary monetary policy even though slower growth in the money supply is the optimal long-run policy.

䉴

distinguish between the reasons both monetarists and rational expectationists support policy rules.

(Monetarists support rules because the economy is too complicated and the various lags too varied to allow for a reliable discretionary policy. Rational expectationists support rules because they believe that the public can correctly anticipate discretionary policy so the anticipated policy is largely ineffective.)

䉴

explain the rationale behind the Phillips curve and the early support for this tool.

䉴

explain what undermined belief in the validity of the Phillips curve during the 1970s (supply shocks and stagflation).

䉴

distinguish between the short-run and the long-run Phillips curves.

䉴

explain how movements along and shifts of the short-run Phillips curve are related to the short-run aggregate supply curve.

䉴

explain what the long-run Phillips curve implies about the trade-off between unemployment and inflation. (No trade-off exists in the long run.)

DISCUSSION MATERIAL ■

Students have more difficulty comprehending macroeconomic principles, particularly those as abstract as discussed in this chapter, so they benefit from the use of metaphor and the analogy of viewing the economy as a machine (such as the story about heating and cooling at the shopping mall). Trying to operate the economy could be compared to the operation of any big, complicated piece of machinery, such as a supertanker on the high seas.

■

Discretionary policy requires that policy makers know much about the economy now and in the next year or two. Ask students what policy makers need to know and why. Also discuss the problems that lags create for activist policy.

92

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■

Discuss why advocates of passive policy prefer policy rules to policy discretion. What can possibly go wrong with discretion?

■

At one time the Phillips curve was thought to offer the menu of policy choices for public officials, who could choose a combination of high inflation with low unemployment or low inflation with high unemployment. Now we realize that, although we may sometimes face such a trade-off in the short run, we do not face that trade-off in the long run. Discuss how the absence of a long-run trade-off between unemployment and inflation affects policy choices.

Trouble Spots This chapter ignores dated arguments about monetary versus fiscal policy and instead focuses on the broader question of active versus passive policy, though even this distinction exaggerates the policy alternatives.

You will help your students if you focus on the reasons for those who prefer active policy and those who prefer passive policy to believe as they do. Try to be balanced in discussing the pros and cons of each. For example, just as there are costs associated with activism, there are also costs of passive policy. Discuss the effectiveness of efforts to stimulate the economy during the recession of 2007–2009. Which appeared to be more effective—monetary policy or fiscal policy?

Additional Examples You could trace the effects of anticipated versus unanticipated fiscal policy, just as the chapter has focused more on monetary policy. For example, if firms and workers expect fiscal policy to stimulate aggregate demand, they will build the higher expected prices into their wage agreements; fiscal policy will thus have little real effect on the level of output and employment in the long run. Only when workers and firms are caught off guard will an expansionary fiscal policy push output beyond the economy’s potential level.

What If? What if monetary policy were run by Congress instead of by the Fed? How might it be different?

What if fiscal policy were run by an independent fiscal entity (called the “Fisc”)? How might fiscal policy be different? For example, would the government continue to experience large federal deficits?

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93

CHAPTER 31 INTERNATIONAL TRADE The fi rst half of the chapter considers comparative advantage and the gains from international trade. The second half examines trade restrictions, the net welfare loss they impose on the economy, and the reasons why restrictions persist. A theme of the chapter is that the beneficiaries of restrictions know they are winners, and they are well organized; but those who bear the cost of restrictions— mainly domestic consumers—fail to recognize their losses, so they voice not a peep. This is another case of rational ignorance by the majority of consumers. The asymmetric information about of gains and losses explains the resilience of some trade restrictions, even though the economy as a whole would benefi t from their elimination. Because the gains and losses from trade restrictions rely on an analysis of consumer and producer surplus, the chapter includes a short summary of these tools.

CHAPTER OUTLINE 31-1 THE GAINS FROM TRADE 31-1a A Profile of Exports and Imports U.S. Exports U.S. Imports Trading Partners 31-1b Production Possibilities without Trade 31-1c Consumption Possibilities Based on Comparative Advantage 31-1d Reasons for International Specialization Differences in Resource Endowments Economies of Scale Differences in Tastes More Variety 31-2 TRADE RESTRICTIONS AND WELFARE LOSS 31-2a Consumer Surplus and Producer Surplus from Market Exchange 31-2b Tariffs 31-2c Import Quotas 31-2d Quotas in Practice 31-2e Tariffs and Quotas Compared 31-2f Other Trade Restrictions 31-2g Freer Trade by Multilateral Agreement 31-2h The World Trade Organization CASE STUDY: Doha Round and Round 31-2 iCommon Markets 31-3 ARGUMENTS FOR TRADE RESTRICTIONS 31-3a National Defense Argument 31-3b Infant Industry Argument 31-3c Antidumping Argument 31-3d Jobs and Income Argument 31-3e Declining Industries Argument 31-3f Problems with Protection 31-4 CONCLUSION

94 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

terms of trade, consumption possibility frontier, autarky, world price, tariffs, import quotas, General Agreement on Tariffs and Trade (GAAT), World Trade Organization (WTO), dumping, Uruguay Round, Doha Round, voluntary export restraints, export subsidies, domestic content requirements, arguments for trade restrictions (national defense, infant industry, antidumping, job protection, and shoring up a declining industry), and the winners and losers from trade restrictions.

Students should also be able to: 䉴

explain why people in different countries can gain from specialization and exchange. (Gains from trade arise from differences across countries in resource endowments, economies of scale, and tastes.)

䉴

explain why special interest groups are more likely to push for an import quota than for a tariff. (Two special interest groups support quotas: domestic producers who compete with the imports and those with the right to buy the product at the lower world price and sell it at the higher domestic price. Only one special interest group supports tariffs: domestic producers who compete with the imports.)

䉴

explain why trade restrictions persist even though they impose a net welfare loss on the economy.

(Gains tend to be concentrated among a few, who recognize the benefits; losses tend to be widely distributed among the many, who for the most part are unaware they are losers.)

䉴

explain why restrictions on textile imports would also require restrictions on the importation of finished clothing.

DISCUSSION MATERIAL ■

International trade seems more relevant if you can tie it directly to students’ consumption patterns. Ask your students to examine what they are wearing the next time they get dressed, to find out where their clothes were made. Discuss other goods made abroad that students consume.

■

One of the great ironies of international trade is that the United States, one of the most developed economies in the world, is also a major exporter of agricultural products. Exports of corn, wheat, and soybeans combine to exceed the exports of any other major product. Discuss how the United States can have a comparative advantage in both high technology products and agricultural products.

■

The international trade of goods is technologically much easier than the international trade of services.

After all, we can’t import haircuts from China. The difficulty of trading services explains in part why jobs at General Motors—not jobs at McDonald’s—have been lost to imports. Yet the international trade of services is still possible. When Americans vacation overseas, they consume services produced by foreigners. Tourism is important in some countries, such as those in the Caribbean. Some U.S. insurance companies fly their claim forms and other paperwork overseas by overnight courier, where data are entered and the results transmitted electronically back to the United States. Many U.S. software firms have outsourced code-writing to places like India. Phone call and email queries about U.S. products are frequently answered by workers in places such as the Philippines and India. What’s more, higher education is a major U.S. export because of all the foreign students enrolled here.

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■

The losses resulting from trade restrictions exceed the gains. Yet restrictions persist because the winners know who they are and tend to be organized, but the losers do not even know they are losers. This asymmetry in the gains and losses can help explain why restrictions that harm consumers can persist.

Because consumers purchase many goods and services, they care less about import restrictions on any one product; they choose to remain rationally ignorant about trade barriers. Households tend to be more concerned about their role as resource suppliers because there they specialize. Households enthusiastically support any trade restriction that might save their jobs, even if the measure results in higher consumer prices.

■

Why have some trade restrictions persisted for decades?

Trouble Spots Exhibits 7 and 8, which examine tariffs and quotas, are bound to cause students the most problems.

Review these exhibits step-by-step on the board or with PowerPoint and identify each relevant area of redistribution or welfare loss.

Additional Examples U.S. imports — Swiss chocolate, Japanese cameras, Italian marble, Egyptian cotton, Argentinean beef, Chinese toys, German pharmaceuticals, Turkish apricots, Philippine papaya, and Ceylon tea.

U.S. exports — Autos and auto parts, power-generating machinery, scientific instruments, plastics, telecommunication equipment, pharmaceuticals, software, and movies.

What If? What if a “truth in trade” law were passed that required price labels to indicate the actual price along with what the good would sell for in the absence of trade restrictions? For example, the actual price of a fivepound bag of sugar might be $2, but on the world market that same bag could be purchased for $1. Aside from creating a demand for thousands of economists to figure out the free trade prices, what do you suppose would be the effect of a “truth in trade” measure on international trade policy?

What if all trade restrictions were abolished overnight? What sort of adjustments would occur in the short run and in the long run? Who would be the winners and who would be the losers?

Chapter 31

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CHAPTER 32 INTERNATIONAL FINANCE This chapter examines foreign exchange markets , beginning with an explanation of the balance of payments. The chapter works through flexible and fixed exchange rates. After the mechanics of foreign exchange markets have been discussed, the history of the international financial system over the last century is reviewed. The chapter closes with a discussion of the current exchange regime, the managed float. There is much packed into this chapter; it’s not the sort of material you can jam into a lecture at the end of the term.

CHAPTER OUTLINE 32-1 BALANCE OF PAYMENTS 32-1a International Economic Transactions 32-1b Merchandise Trade Balance 32-1c Balance on Goods and Services 32-1d Net Investment Income 32-1e Unilateral Transfers and Current Account Balance 32-1f The Financial Account 32-1g Deficits and Surpluses 32-2 FOREIGN EXCHANGE RATES AND MARKETS 32-2a Foreign Exchange 32-2b The Demand for Foreign Exchange 32-2c The Supply of Foreign Exchange 32-2d Determining the Exchange Rate 32-2e Arbitrageurs and Speculators 32-2f Purchasing Power Parity CASE STUDY: The Big Mac Index 32-2g Flexible Exchange Rates 32-2h Fixed Exchange Rates 32-3 DEVELOPMENT OF THE INTERNATIONAL MONETARY SYSTEM 32-3a The Bretton Woods Agreement 32-3b The Demise of the Bretton Woods System 32-3c The Current System: Managed Float 32-4 CONCLUSION

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: balance of payments, merchandise trade balance, balance on goods and services, net investment income from abroad, unilateral transfers, balance on current account, fi nancial account, trade defi cit, trade surplus, exchange rate, foreign exchange, arbitrage, depreciation of the dollar, appreciation of the dollar, speculators, purchasing power parity (PPP), demand for foreign exchange, supply of foreign exchange, flexible exchange rates, fixed exchange rates, currency devaluation, currency revaluation, gold standard, Bretton Woods system, International Monetary Fund, and managed float system.

97 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

Students should also be able to: 䉴

discuss components of the balance of payments accounts.

䉴

describe activities that could result in a current account deficit (an increase in imports, a decrease in exports, a decrease in net investment income from abroad, and an increase in unilateral transfers to foreigners).

䉴

describe activities that could lead to a financial account deficit (an increase in U.S. purchases of foreign assets or a decrease in foreign purchases of U.S. assets).

䉴

explain what caused the demise of the Bretton Woods system. (Because of U.S. infl ation, the U.S. dollar became overvalued, but other nations would not revalue their currencies.)

䉴

draw a diagram showing the market for foreign exchange and explain what factors are held constant along the demand and supply curves.

䉴

suggest a change that will increase the demand for foreign exchange and show the effects of this shift of demand on the equilibrium exchange rate.

䉴

describe the current international financial system (managed float by major economies with developing countries, such as China, fixing their exchange rate relative to the U.S. dollar).

䉴

use dollars and euros to describe an appreciation of the dollar and a depreciation of the dollar.

DISCUSSION MATERIAL ■

Ask students to look up the current exchange rate between the U.S. dollar and the euro. You should convey to your students how dynamic foreign exchange rates are over time.

■

When a country relies on a single major export, its balance of trade depends on the market for that product. For example, Middle East countries had consistent surpluses in their trade until the price of oil fell during the 1990s. Their trade balance then shifted to a deficit, but has recovered with the rise of oil prices.

Chapter 32

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Trouble Spots Students always have trouble with the supply and demand for foreign exchange. Particularly confusing is the fact that the foreign demand for U.S. dollars translates into the supply of foreign exchange. Review a diagram depicting the market for foreign exchange, using the supply and demand for, say, yen. (The euro is used in the chapter, so it’s better to use another currency.) Explain why the quantity of yen demanded in foreign exchange markets increases as the number of U.S. dollars per yen declines. Also, the quantity of yen supplied to foreign exchange markets increases as the number of U.S. dollars per yen increases. Draw the supply and demand for yen to derive the exchange rate.

Additional Examples Arbitrage—Any product sold in various locations will be subject to arbitrage. The “law of one price” says that the price of a well-defined internationally traded product will converge, with price differences reflecting transactions costs. Arbitrageurs ensure that the price of a share of stock will be identical across the various stock exchanges on which the share is traded. If the same good can be purchased for different prices in different parts of the world, buying and selling will eventually erase price differences. If the price of used cars differs substantially in different parts of the country, wholesalers will buy them in a lower-priced region and ship them to the higher-priced region. Such car shipments, in fact, are quite common.

What If? What if there were no organization such as the International Monetary Fund overseeing international finance and trade? Would international trade be possible? (Yes.) How would things change? (The transaction costs of trade would increase, resulting in less trade.)

What if speculators believed the U.S. dollar was going to depreciate against all major currencies? How would this expectation affect the exchange rate? (In the short run, this expectation would be a self-fulfilling prophecy; but if the underlying economic conditions did not support a lower price of the dollar, speculators would be proven wrong in the long run. Speculators, however, typically earn their profits in the short run, so they shoot first and ask questions later, so to speak.)

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CHAPTER 33 ECONOMIC DEVELOPMENT The chapter fi rst discusses theories of economic development, but the balance of the chapter is largely empirical, contrasting developing economies with advanced industrial economies in a variety of ways.

Charts contrast national economies based on (1) population and output, (2) per capita income, (3) infant mortality rates, (4) fertility rates, (5) phone lines per capita, and (6) Internet usage. A representative sample of countries is ranked and compared to the world average. A case study looks at why a billion people are trapped in poor countries that are going nowhere.

CHAPTER OUTLINE 33-1 WORLDS APART 33-1a Developing and Industrial Economies 33-1b Health and Nutrition Malnutrition Infant Mortality 33-1c High Birth Rates 33-1d Women in Developing Countries 33-2 PRODUCTIVITY: KEY TO DEVELOPMENT 33-2a Low Labor Productivity 33-2b Technology and Education 33-2c Inefficient Use of Labor 33-2d Natural Resources 33-2e Financial Institutions 33-2f Capital Infrastructure 33-2g Entrepreneurship 33-2h Rules of the Game CASE STUDY: The Poorest Billion 33-2i Income Distribution within Countries 33-3 INTERNATIONAL TRADE AND DEVELOPMENT 33-3a Trade Problems for Developing Countries 33-3b Migration and the Brain Drain 33-3c Import Substitution versus Export Promotion 33-3d Trade Liberalization and Special Interests 33-4 FOREIGN AID AND ECONOMIC DEVELOPMENT 33-4a Foreign Aid 33-4b Does Foreign Aid Promote Economic Development?

33-4c Doe Economies Converge 33-5 CONCLUSION

100 © 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publically accessible website, in whole or in part.

CHAPTER OBJECTIVES AND QUIZ MATERIAL Students should be able to explain the following: 䉴

the distinctions between developing countries and industrial market countries; the distinctions between low-, middle-, and high-income economies; social capital; the distinctions between the trade policy of export promotion versus the trade policy and import substitution; foreign aid; privatization versus nationalization, and convergence.

Students should also be able to: 䉴

compare the share of world population and world output coming from the high-, middle-, and lowincome economies. (See Exhibit 1).

䉴

describe health differences between rich and poor countries.

䉴

explain why birth rates are so much higher in poor countries. (Children in poor countries are viewed as a source of labor and as economic security in the parent’s old age, because such countries typically have no government-provided social security).

䉴

explain how education contributes to economic development. (Those with more education make better use of an economy’s resources and are more receptive to the technological change that spurs growth.)

䉴

explain in what sense foreign aid is a mixed blessing for developing countries.

䉴

explain why productivity is the key to a higher standard of living.

䉴

explain why those in poor countries have difficulty saving money.

DISCUSSION MATERIAL ■

Discuss the mixed results as formerly socialist economies moved toward market economies. Why have some formerly socialist countries faced such growing pains? (Some countries lacked the customs and laws needed to nurture private property and market forces.)

■

The case study, “The Poorest Billion,” describes three traps that keep poor countries poor. Have students describe each trap, then have the class discuss what, if anything, can be done about each of them.

■

Discuss why in-kind international aid programs, such as those that provide low-cost or free food and used clothing may not be in the best interests of the receiving country.

■

Venezuela is an oil-rich country currently becoming more socialistic. Discuss how oil wealth allows a government head, such as Hugo Chavez, to offer a broader menu of social services.

■

A complex policy question is the effect of the “brain drain” on economic development. Discuss how each country benefits when the brightest professionals migrate from poor countries to rich countries.

How is each country harmed and which is harmed more.

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101

Trouble Spots Because this chapter is more descriptive than theoretical, students should have little difficulty with the concepts. But you should make sure that students don’t get lost in the details. Focus on what’s important.

Additional Examples Given the emphasis in the chapter on practical differences between rich and poor economies, there is no special need for extra examples here.

What If? What if opponents of economic globalization get their way and international transactions is scaled way back, even to the point of cutting tourism to poorer countries because of concern about its environmental impact. Which type of economies would be hurt most?

The U.S. poverty level still affords a standard of living much higher that enjoyed by the average person on the planet. What if U.S. voters would rather provide welfare benefits to the poorest people on earth, regardless of where they happened to live? How would this affect economic development in America and abroad?

Chapter 33

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APPENDIX A CLASSROOM PRESENTATION GENERAL INFORMATION This appendix begins with general advice about teaching for those who serve as graduate as sistants, or section leaders. Asking and answering questions is taken up in the second part, and the final section considers administrative responsibilities. To some extent, this appendix follows the chronological sequence of the term.

Before your first class meets, those of you who serve as graduate assistants should have a thorough grasp of your responsibilities in the course. Ideally, the professor has carefully thought through the course and has communicated what is expected of you. The professor and section leaders should have discussed the course outline, student reading assignments, the preparation of quizzes and exams, the use of homework exercises, factors used to determine final grades, and the like. Everyone’s duties in the course, including the students’, should be clear. Don’t be afraid to ask what is expected of you. If graduate assistants are not scheduled to meet regularly with the professor to update assignments and discuss problems that arise, suggest such meetings. Understand your role before the first class. If you don’t, ask questions until you do. After all, you will suffer the consequences of any misunderstanding.

The professor in the course should have prepared a syllabus telling students all they need to know about the course, such as required textbooks and reading material, course outline, exam schedule, and the relative weights of various course components in the final grade. Students must understand the role their weekly sections play in the course, attendance policy, and what part of the final grade, if any, stems from the weekly sections.

One advantage of the discussion section compared to the large lecture is the informality of the smaller physical size of the room used for a discussion section. Check your classroom before you meet with your section.

Is the room much larger than is necessary? If so, students will spread out, and some will seek the back row.

If the room does not work for you, try to find one more suitable to the class size. If you must use a classroom that is too large, ask students to sit toward the front rather than spread throughout a cavernous room.

Check other features of the room ahead of time. Turn on the lights. Do they work? Is there a table or podium for your notes? Is their equipment to support PowerPoint slides, Internet connections, or other technology you plan on using? By investigating the room before the first day of class, you can head off any possible complications. You might need to ask the technical support staff to correct any deficiencies. Make sure the room will not be locked when you need it. Take nothing for granted.

Class Begins When you begin class, make sure that the room is well lighted and well ventilated, that the chalkboard or display area is clear, and that students can hear you. All of this may seem obvious, but new instructors sometimes forget the fundamentals. Success in the classroom is often a study of the obvious. Remember, you are responsible for everything related to your class. Most students are passive and will not even remind you to turn on the lights, pull up the shades, or close the door. Students will typically do nothing to call attention to themselves, especially during the first class.

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Introduce yourself by pronouncing your name as clearly as possible. On the board or overhead, write your name, the hours and location of your office, an office number where you can be reached, an e-mail address, and a Web address if you have one (you may choose to give students your cell number, but do so only if you are willing to take such calls). Even if attendance is not required, you should read the class rolls to become acquainted with the students who do show up. Use mental tricks to associate the names with the faces. (I read the rolls each class until I have a good idea who’s who. This usually takes a few weeks.)

Display a Class Outline At the beginning of each class, try to give students an idea of how the day’s material will fit into the broader framework of the course and what specifically you hope to accomplish during the period. Put a brief outline on the left-hand side of the board, on an overhead, or on some other display or handout. For example, your outline might begin with “Questions?” indicating that students first get to ask questions about previous lectures or about covered material that was unclear. Next might be a “Review,” during which you go over some trouble spots in the material for that week. (This manual lists possible trouble spots by chapter.)

Third on your outline might be “Class Discussion.” Under that heading, you could list topics you want to discuss that day, such as “Outsourcing” or “The Fed’s Monetary Policy.” (This manual lists a variety of possible discussion topics for each chapter, and Appendix B talks about how to lead a discussion.) Finally, you can present any “New Topics” that you need to cover. Some of you are expected to cover material from the textbook that could not be covered during the large lectures. If you plan to give the students a quiz, the class will be more relaxed if you do that first.

This is a full agenda as described. The emphasis you put on each topic will depend on how much discretion you have in running your section, how much material you must cover, and how much time you have. As you complete each part of the agenda, you can check it off your outline. One advantage of providing the class agenda is that it imposes a unity and continuity to your class.

Do Not Leave Class Discussion Until the End Since discussions are usually flexible and open-ended, you might be tempted to leave class discussion until the end of the period. Then, when the period is over, you could simply bring the discussion to a close. But DO NOT LEAVE DISCUSSION TO THE END. If you do, many students will realize that if they keep quiet, the discussion will die. Then you will have no choice but to end the class early or struggle through a monologue rather than a real discussion. As you know, most students like getting out of class early. (Education is one of the few products where consumers demand less than they pay for.) By putting the discussion in the middle of the agenda, you always have additional material even if the discussion goes nowhere. More generally, you should prepare more than enough material to get through the class. Teaching becomes all the more difficult when you try to stretch 30 minutes of material to cover a 50-minute class. Again, students will sense you are struggling, and they will not help (nothing personal).

The best way to put students to sleep is to try to tell them all you know. Don’t try to pack too much into each class. Think of the material presented during class as furniture in a room. When furniture is crowded together, as in an antique shop or a used furniture store, people have difficulty gaining perspective about any particular item (which, incidentally, is why upscale furniture stores arrange their products in well appointed combinations). Likewise, you should not crowd your presentation then expect students to develop an understanding of individual points or a perspective on how these individual points relate. Narrowing your focus will also help students understand the material better. What you want to avoid is the routine transmittal of predigested information.

Appendix A

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The Key Ingredient: Enthusiasm!

Perhaps the most important quality you need is a desire to be an effective teacher. Enthusiasm is your best ally—an enthusiasm for the material, for the students, and for your ability to get things across. Enthusiasm is the oil that lubricates the machinery of teaching and learning. An average speaker fired with enthusiasm can be more persuasive and more arresting than a skilled orator without it. Your presentation should be bold, aggressive, and animated. You must demonstrate a belief in what you are saying. Pepper your presentation with evidence from common experience to reinforce the point in question.

To be a clear and forceful speaker, avoid crutch words and expressions such as “ahhhh,” “you know,” “now,” “like,” “I mean,” and “okay.” Like, I mean, you know, you, ah, sound like a moron, when you, ah, talk like this, you know. Almost any phrase repeated often enough becomes irritating, you know. Don’t, like, contaminate your speech with feebleminded expressions. Speak clearly and with vigor.

Strengths of the Lecture Approach The outline you provided students has you answering questions, reviewing trouble spots, leading a class discussion, and presenting new material. When you review trouble spots and introduce new material, you will be, in effect, lecturing. Consider the advantages of the lecture approach. What can lectures do that the textbook can’t, and how does the lecture approach compare to the primary alternative—class discussion?

Lectures are efficient ways of conveying large amounts of material. Lectures are good at laying out facts, relationships, theories, and other material that must be presented in a logical sequence. Lectures can be more selective than the textbook and can focus on topics of special interest to you or your students. Lectures are also live theater; they can convey your enthusiasm for the material. You can weave into the material current events and local color from the particular circumstances of your college or university.

The very process of going through an economic problem can also show students how an economist thinks about it. The lecture approach affords you maximum control of the class agenda; you can present material in any order you choose, and you can encourage or discourage questions. Some students prefer lectures to, say, class discussion because lectures do not require student participation.

Weaknesses of the Lecture Approach Because lectures are one-way communication, they offer little or no feedback about student learning. The typical student’s attention span is said to stretch less than a half hour, so a 50-minute lecture loses many students along the way. In fact, there is no guarantee that students are thinking much even during the fi rst half hour. Students can put their pens on automatic pilot to take notes while their brains head elsewhere; worse yet, some students can just sit there, oblivious to your best efforts (and, of course, some students dont even show up).

Lectures are not well suited for all topics, particularly issues involving value judgments or critical thinking. Finally, the effectiveness of lectures also depends on the effectiveness of the speaker. Some teachers, despite years of practice, are simply not very good at it.

Students in a once-a-week discussion section are probably already getting at least two lectures a week from the lead professor in the course, so your objective should be to put a little variety in the course. Another period of straight lecture in your section may appear to be the easiest alternative for you, for the students, and for the professor, but those of you in charge of your own discussion sections should consider alternatives. As we shall see next, variety will prove to be one of your major allies.

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Variety Spices Up Your Presentation Your presentation is made more interesting through variety—variety in the types of material presented and in the way material is presented. Your presentations could include facts, statistics, graphs, anecdotes, parables, examples, questions, opinions, discussions, and other approaches.

If your objective is to present material, have a good idea of what you are going to say, but don’t read from notes. You can and should refer to notes during your presentations, but reading verbatim is verboten. When you read from notes, some students dutifully take notes without thinking much. Thus, your notes can become the notes of the student without first passing through the mind of either of you.

Another problem with reading from notes is that to do so you must stand in one place—at the podium.

Your presentation will be more dynamic if you are free to move around. So move around, but don’t pace— walking back and forth like a caged tiger can have the same numbing effect on students as your standing in one place.

Don’t present material in a monotone. Vary both the pitch of your voice and, on occasion, your volume.

Since you will likely be in a small classroom, you need not speak loudly to be heard. The best voice is your natural speaking voice with all the modulation and variance you normally express. For some strange reason, certain teachers turn on a “stage voice” when they step in front of a class; this stage voice is often louder, more monotonous, and more irritating than their normal voice.

In your sections, you should aim for give-and-take. After all, the main reason that large lectures are broken down into smaller sections is to provide students with a greater opportunity for interaction with you and with one another. Incorporate student questions into your presentations. An informed conversation is preferable to one-way communication because more critical thinking is likely to occur.

Finally, to introduce variety into your presentations, use visual aids—the board, overheads, handouts, newspapers clippings, Web sites, videotapes, films, slides, and computer simulations. All of these can be helpful as long as their contributions support the topic at hand. Remember, you need to put some zip into your presentation to keep the attention of students raised on a diet of YouTube and video games.

Board Use If you use a chalkboard or a white board, think of it as a large piece of writing paper. If you scribble all over the paper in no apparent order, anyone trying to make the connection between ideas will have difficulty following your reasoning. But if you use the board in an ordered way to present material in a logical sequence, students can see where you have been and where you are going. Make sure students can read what you have written. As a check, at the end of class, sit in the last row and see how well you can read your presentation.

Proper etiquette dictates that instructors erase the board at the end of class, but if the board has not been erased when you start class, erase it completely. Put the day’s agenda on the far left-hand side as noted earlier. Mentally divide the rest of the board into two or three columns and use these imaginary columns as your writing tablet. When the board is filled, go back and erase the first column and start anew. The column you just finished should remain because you may want to refer to it. A surprising number of students cannot keep up with the ideas as they are presented, so they are always trailing the flow of thought. When you present material in an orderly and sequential way, students can take better notes because they can get the logic of the presentation from the board. If you are using PowerPoint slides, you can post them on your Web site, allowing students to download them before or after class.

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Some instructors make poor use of the board because they have given little thought to its use. Using the board is physically and mentally harder than just lecturing, but students get more from the combination of media than from a lecture alone. Some instructors erase a little patch of board at a time—just enough to squeeze in another topic. When class is over, the board is a crazy-quilt of ideas. Someone just coming into the room would make little sense of it.

Students will usually write in their notes whatever you write on the board. Write on the board those central points you want the students to record. First, present the point verbally; second, write the point on the board and say each word as you write it; finally, step back and read what you have written. This procedure helps students take good notes. Since you don’t have time to write down everything you say during the period, write only the central points on the board.

Your notes should contain the material you would like to convey on the board. Try not to misspell words on the board. Check your spelling before class so that you don’t embarrass yourself. If you are unsure of a word as you write on the board, ask students how to spell it.

The board is an especially effective medium for presenting graphical material because students are able to see how the graph was constructed. Moreover, you can follow a logical sequence by showing how graphs shift in response to some change in economic conditions like price or income. You can also do this with the software available with the Tenth Edition. When presenting material involving graphs, don’t be too anxious to get to the graph. Before resorting to the graph, take time to provide the intuition of the economic story you are about to present. Many instructors use graphs the way the drunk uses the lamppost—more for support than for illumination.

Body Language Your nonverbal action conveys as much as what you say. Try to direct your nonverbal action in positive ways. Students are able to sense how organized you are. Send the message that you are in control of things.

Get to class on time. Be prepared, organized, and alert.

Your posture conveys your sense of purpose. You indicate to students that you view your responsibilities as important when you maintain an alert and an erect posture. Schlepping around the front of the room, sitting on the desk, and leaning against the wall may seem cool and you can do this now and then, but these actions do not inspire confidence. Move about the classroom with a certainty and a sense of purpose. Avoid distracting moves.

Gestures are a clear form of body language. They reveal mental activity and convey your interest and enthusiasm for the topic. Gestures can also be an effective way to reinforce a point, such as with the sweep of an arm. Your gestures should appear comfortable and spontaneous, not planned and artificial. So plan to gesture but don’t plan your gestures.

Some instructors choose informal dress and a hang-loose demeanor as a way of conveying to students, “Hey, I’m just like you.” Often implicit in such a message is that the instructor will be easy on students.

But this approach may backfire when the first quiz or exam proves more demanding than students expected.

Some students may feel betrayed. Instructors should choose a style that is in keeping with their objectives in the course. Try dressing a little more neatly on days when you teach.

In your presentation, maintain eye contact with the students. Nothing is more distracting than an instructor who looks at the floor, the ceiling, out the window—everywhere but at the students. Students will perceive your inability to establish or to maintain eye contact as shyness, aloofness, or even a mind that is elsewhere.

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Learn how to “read” your class through the unconscious body language that students transmit. Some students feign interest when they are bored, but the ruse is easily unmasked (and most students make no attempt to conceal their boredom). Teaching is all the more difficult when facing a class of zombies. If this is your problem, you must mix up your delivery, get students more involved, dance on the desk—do something different—because your approach is not working. Do not confuse comatose behavior with shyness. Some students are simply quiet and shy, but they nonetheless may be following your presentation with interest.

Sometimes you will have trouble reading student feedback. For example, suppose a student remarks after class that “You certainly covered a lot of material today.” You might view this as a compliment on your competence as a teacher. Upon further reflection, however, you might realize that the student was saying that you jammed too much material into the period.

How To Handle Mistakes Errors of fact in your presentation are easily corrected: simply acknowledge the mistake and move on.

Nobody said you were perfect. But errors of poor judgment in your dealings with students in class are more serious and can cause more harm. A careless remark that belittles or offends a particular student or a group of students calls for an immediate apology.

How About Humor?

Humor can often be an effective addition to your presentation. If you have a sense of humor, don’t be afraid to use it. The use of humor does not mean trying to go for big laughs, but it does mean seeing the humor in simple things and putting a humorous twist on the material. The use of humor also does not mean telling jokes, like a stand-up comic. The best kind of humor grows naturally out of the situation and is spontaneous in a flexible and comfortable way. Stay away from sexual humor and ethnic humor. Also, never make fun of students to get laughs. Poke fun at yourself if you like. A forced attempt at humor is worse than none at all. If you have no sense of humor, or if humor doesn’t seem to work for you in class, then forget it.

ASKING AND ANSWERING QUESTIONS Don’t expect your students to be note-taking machines. After all, if class notes were the only purpose of attendance, we could save everyone a lot of time by sending students home and simply posting the lecture notes.

Questions That Monitor Student Learning Just because you are speaking does not mean students are listening or learning. Most students avoid the work of thinking if they can. One way to ensure that students are really with the program is to pause frequently in your presentation to ask questions. Frequent questions not only keep students alert, but they also provide you with valuable feedback on your delivery. You may think the presentation is quite clear, but if nobody in class can explain what you just said, perhaps you should reevaluate your approach.

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Ask questions that will let you know what students are learning. Students often process information at a different rate than teachers offer it. It is tempting, but probably wrong, to assume that students are learning while you are teaching. Some students may even provide the body language that they are learning, with assenting nods and the like. But evidence that you have overestimated their learning ability comes from the poor response rate to many of the most basic questions.

Questions that are particularly unhelpful are “Does everyone understand?”, “Is that clear?”, and “Do you have any questions?” The typical response is silence, which you incorrectly take to mean that the lesson has been understood. A question requiring a detailed response will show you quite directly if your message is getting across. For example, you can ask “Why is the aggregate demand curve downward sloping?” or “Why don’t firms in perfect competition earn economic profit in the long run?” Ask specific questions that flow from your presentation. This manual suggests many such questions.

Don’t be too eager to answer your own questions (unless you have posed a question rhetorically). When you ask questions, you must be patient. Silence is unsettling to students, but it gets their attention, and it reminds them that they have not really been paying attention. Note that there is a difference between the silence that follows a question to the entire class versus the silence that follows a question directed to a particular student. The former kind of silence is a healthy reminder to all students that they are not paying attention; the latter kind of silence can seem mean-spirited because you seem to be singling out a particular student for unwarranted scrutiny.

Responding to Questions You should welcome questions at any time. Students often ask vague and squishy questions. A student might say “You lost me” or “I don’t know what’s going on.” That sort of comment is better than no response at all, but not much better. Reviewing all you have said is impractical and would wastes many students’ time. Encourage students to develop the mental discipline to ask a more specific question. At what point did the student get lost? What is their current understanding of the particular point under discussion? Let students know that you welcome all questions but that you especially appreciate the question that specifically identifies their problem. Regardless of how poorly phrased the question is, welcome the interruption and fashion the question into something that will aid your presentation—make a silk purse out of a sow’s ear, so to speak.

Getting useful questions, especially at the outset of class, requires planning. Ask each student to develop one or two questions from the readings or lectures for their next discussion section with you.

COURSE ADMINISTRATION You are likely expected to hold office hours at a regular time each week. Customs vary, but two to four hours a week are usually sufficient. Announce your office hours during your first class. As I noted at the outset, let students know your office location, office telephone number, e-mail address, and the location of your departmental mailbox (in case they want write you a note or drop off an assignment).

Make clear that students are welcome at office hours, but don’t be surprised if business is slow. You will likely have a peak-load problem because students come in mostly around exam time—before the exam for extra help and after the exam to question your grading. Don’t bunch your office hours all at one time, such as Friday from 1:00 to 4:00. Spread your hours over two or three days so that they are more likely to jibe with different students’ schedules.

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As a T.A. you will probably be expected to keep track of students’ grades during the term. This is an important duty, and it is one you must take seriously. During the first few weeks, many students drop the course and others add it, so you might want to wait until enrollments stabilize before you enter a final list of names in your grade book. Even then, changes still occur. Use the registrar’s enrollment list as a temporary record for grades and attendance during the first few weeks of the term. Make sure you have some system to record who turns in exams, quizzes, or other assignments. Ideally, you should check students’ names off a list as soon as assignments are turned in. Be extremely careful with students’ work; don’t lose anything. Also make sure you record the grades before returning papers to students. All this may sound obvious, but screw ups with grades cause the biggest headaches.

Graduate assistants at many universities serve as intermediaries between student and professor. Graduate assistants are usually younger and more accessible than the professor. This role as a go-between often involves divided loyalties, such as when you must defend the answers on an exam prepared by the professor.

Students are often looking for someone who sympathizes with their problems, not another authority figure who represents an obstacle in the course. If you are a graduate assistant, be sensitive to the fine line you must sometimes walk between representing the professor’s course objectives to the students and representing student concerns to the professor. Don’t be too quick to side with students; some students seem to make reasonable arguments about the correct answer to a test question until you later realize that the instructor was correct after all.

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APPENDIX B LEADING A DISCUSSION Those of you who meet with students once a week in smaller sections can spend class time answering questions, reviewing the more difficult material assigned during the week, administering quizzes, and covering new material. But many of you are expected to spend at least some of the class period conducting a discussion about the assigned material. In fact, the class you meet once a week is at some institutions called a “discussion section.” This appendix offers guidance in leading a discussion.

PROS AND CONS OF CLASS DISCUSSIONS Initially you may think that carrying on a discussion is easier than lecturing. You imagine a lively debate among students, where your role is limited to posing the issue and interceding now and then to offer fresh insights to guide an errant discussion back on track. But running a discussion requires more skill and certainly more patience than lecturing. You can’t simply ask the class “So what did you think?” and expect to touch off an enthusiastic, rewarding discussion. Lively discussion emerges when student interest coincides with the material. Before getting into the dynamics of a discussion, let’s consider some advantages and disadvantages of class discussion.

Advantages of Class Discussion As mentioned in the Introduction, lecturing represents an efficient means of transmitting large amounts of information; but lectures, particularly lecturing to large classes, provide few opportunities for student participation and student feedback. The straight lecture approach is one-way communication. Class discussion, however, provides immediate feedback about student learning and comprehension. Questions, comments, explanations, and the like offer two-way communication. Based on students response, you can gauge the extent of understanding. If you are not getting through to students, you can make the appropriate midcourse correction.

Discussions encourage students to examine and refine ideas in ways not possible with lectures. Discussions are therefore appropriate for higher-level learning objectives, such as applications, analysis, synthesis, and evaluation. For example, the lecture is more appropriate for describing various poverty programs, but the effects of poverty on the family and on the community might be better treated through an informed discussion.

Discussions are also an effective way to generate student interest and to get their blood flowing. In a sense, discussions can be more emotional than lectures and therefore draw students into the topic in a way that lectures cannot. Discussions are better suited for normative issues than positive issues. More generally, discussions include students as active collaborators in the learning process and thereby can ideally serve as a powerful motivator. Students are more inclined to prepare for a class where their participation is expected and valued. Learning can become more fun during a stimulating discussion.

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Limitations of Class Discussions Suppose that you have raised an issue, reminded students of a few facts to set the table, and asked for comments. Nothing happens. The deafening silence seems like a class conspiracy. Perhaps the biggest obstacle to a productive discussion is students’ unwillingness or inability to participate. Many students view discussions as a waste of time or, worse yet, as a source of awkwardness and humiliation. Class discussions teach some students to improvise opinions on the spot and to substitute fast talk for real thought.

One dominant student with an opinion on everything, coupled with a roomful of shy or indifferent students, does not result in a productive discussion. The discussion often breaks down into a test of nerves between you and the dominant student. Another common problem is that the sounds of silence usually drive instructors back to the safety of lectures.

Discussions are time consuming — Discussions can drag on and are time consuming. Because the pace is slower than lectures, not much seems to be happening, so discussions can appear to be a waste of time. If the objective is to cover much material, such as the history of money or the assumptions underlying perfect competition, lectures are more appropriate than discussions.

Discussions require careful preparation — Lively discussions actually require more preparation than lectures, both by you and, especially, by students. You must develop an issue worth discussing. Students need to have enough acquaintance with the topic to make intelligent contributions. They should be told ahead of time what the topic will be and what they should read to prepare for it.

Discussions involve loss of control — During lectures, the instructor is the center of attention and has full control of the agenda. Some of that attention and control is lost during discussions. Student questions and comments can take the topic in a variety of directions and even off the topic.

Why Discussion?

If discussion is so difficult and at times so awkward, why bother? Consider the benefits of class discussion.

First, weekly discussions force students to keep up with the reading and to reflect on its contents. Second, participation helps students develop basic social and academic skills by weighing the evidence, evaluating the arguments, formulating an opinion, and defending it. Discussion can also foster the excitement of small-group collaboration in the learning process. The common goal of any discussion is to understand the material better, retain it longer, and be able to transfer that learning to other applications.

CONDUCTING A DISCUSSION As noted earlier, the biggest problem with discussions is getting students to participate. Some students are shy, they failed to read the background material, or they have little confidence in their own views, so discussions are a threat to them (during lectures, students need not reveal how little they know). Another problem is peer pressure. Athletic skill is valued in college, but academic excellence is often viewed with mixed favor, so students are reluctant to appear to be showing off. Some cultures even frown on personal achievement in this way.

Also, the sad truth is that some students will participate in class discussion only if they feel that part of their grade depends on it. The student figures, “Why devote a scarce resource—time—to preparing for discussions, unless that participation affects the course grade?” Students will get more involved if class participation becomes a component of the final grade. Also you might point out to students that experience gained through discussion, like other experience with public speaking, improves skills that are valued by employers. Another way to ensure student interest is to make sure that some of your quiz questions flow from material covered during class discussions.

Appendix B

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Preparing for a Good Discussion The hardest part of carrying on a good discussion is getting started. Begin with a controversy, a story, an observation, a startling statistic, a personal experience—something to grab students’ attentions. Draw on your own experience, particularly if you believe your experience is a common one. Once you have their attention, how do you hold it? Keep in mind what you want them to learn, but tilt the focus toward what interests them. Adapt the discussion to your audience. Keep the analysis at a level they can handle.

Be prepared — As noted earlier, a good discussion often requires more preparation than does a good lecture. You must be prepared for the possible directions that discussions can take, so you must know the topic quite well. One way to prepare is to list possible issues and questions. For example, the discussion of OPEC could include data relating the world oil price, the relative unity of OPEC over time, and reasons why cartels sometimes break down.

Draw on common experience — The secret to student involvement is to choose topics with which students have had some experience. One way is to rely on assigned readings or on material discussed in the lectures. But some students will not have read the material or attended the lectures (though such students are also less likely to attend your class). Thus, the discussion will be more stilted if student knowledge is limited to what they read (or, worse yet, what they have failed to read). The discussion will appear more relevant if it ties into student experience, such as their last trip to the supermarket or their observations watching TV ads.

Define the topic — Open the discussion by defining the problem. Make sure there is some agreement about what the question or problem is. The topic for discussion should be well defined, so students can focus. For example, the discussion of “cartels” is less clear than a discussion of “why cartels are unstable.” Define the topic in a concrete manner. Give students a reading assignment beforehand so they can prepare for the discussion. For example, you might say, “We will be discussing the president’s fiscal policy next class. Please read the relevant material on fiscal policy in the text and look for relevant stories in the media.”

Serve as a Facilitator Your role as a discussion leader is that of facilitator. First, you should listen to what students have to say. If you don’t understand what they are saying, others likely have the same problem, so you need to draw students out a bit. You might request examples or ask the student to rephrase the point. Use the board to keep track of the discussion. Summarize concisely the major points made and the arguments associated with each. You might even be able to diagram the key relationships. Keep the class on track when matters stray.

Some students will inevitably have more to say than others. The trick is to make the “talkers” feel appreciated without calling on them too frequently. When you pose a question, wait to see if someone other than the primary talkers can answer it. Urge the passive students to get involved, but don’t call unnecessary attention to their lack of participation.

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If all else fails, one way to get students involved is to have a randomly shuffled deck of index cards with each student’s name on a card. Then call on the students as each name appears in the deck. If students realize that participation is inevitable, they may be more inclined to come to class prepared. (One problem with this system is that unprepared students may simply stay away, especially if there is no penalty for doing so.)

If students state an opinion, ask them to support it. Sometimes students feel the objective is simply to have an opinion, but for the critical thinking level expected in college, the opinion itself is less important than the reasons behind it. Push the student a bit, but don’t push so hard as to embarrass the student.

If conflicts erupt in class, don’t try to paper them over. Clarify differences and examine the source of these differences. See if the conflicts are over facts (positive differences) or over opinions (normative differences). This distinction itself offers a lesson.

Note that if everyone agrees on something, then there will be little discussion. Though consensus is not the objective of the discussion, ask if the group has reached a consensus. Sometimes the group appears to have reached one because the two people doing all the talking agree. But since others in the class have abstained, you might have to press for their input. Make sure others who have so far not made a contribution have their say before you prematurely state a common consensus.

Summarize the discussion and state the main conclusions. If differences remain, delineate these differences. Be patient with discussions. They take time to develop. Don’t talk too much.

WAYS TO GENERATE AND SUSTAIN CLASS DISCUSSION Generate an expectation of participation. If the class is small enough, this could be as simple as arranging the chairs in a circle to help students become acquainted with one another. Also encourage students to address not you but the rest of the class. For example, do not always look directly at the student speaking but look at other students. If Susan is responding to something Tom said, look at Tom. Once Susan sees you looking at Tom, she will look at Tom as well, and this opens up the discussion to more than a two-way conversation between you and the class. Also, by looking at other students, you can see how they are reacting to the speaker. You can use gestures and cues to get students to talk to the whole group.

Next we consider three ways of generating and sustaining discussion: (1) asking questions, (2) brainstorming, and (3) role playing.

Ask Questions When students ask questions, they usually are seeking particular information. But teachers and discussion leaders ask questions for a variety of reasons—to see if students are following the material, to raise certain issues, to change the pace of the class, to draw out an otherwise quiet student, or simply to get the class talking.

To get a discussion rolling, ask a question that is open-ended, not one that can be answered “yes” or “no” or one that can be answered with a fact. A question such as “When was the Federal Trade Commission established?” goes nowhere. Ask questions that students can get their teeth into, such as “How effective was U.S. monetary policy during the recession of 2007–2009?” Or lead with a provocative question that has no obvious answer, such as “Is government regulation of business in the public interest or more in the special interest of producers?” Normative questions are especially good. For example, “Should the government guarantee each citizen a job?”

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If students fail to respond to your first question, rephrase it and throw in a bit more material of relevance to the student. Allow students time to consider the question. Provide encouraging feedback for student contributions, but don’t overdo it lest some students feel slighted if you fail to remark on their contributions.

Pick up on the nonverbal cues, particularly from students who seldom have much to say. Draw them in if they seem ready to contribute. Don’t feel obliged to fill in any silences. Pauses in the discussion often allow students to gather their thoughts. At times your proper role is to shut up.

Brainstorming Once the problem is well defined, have students suggest possible solutions. For example, suppose the problem is the slow economic progress in many developing countries. One technique is to brainstorm; have students throw out possible solutions as fast as you can write them on the board. At this stage you should be nonjudgmental. Try to generate as many ideas as possible. Often one idea leads to another, so a suggestion may turn out to be key because it leads to something else.

Once the list is assembled, ask students to comment on the relative advantages and disadvantages of each.

At this time you can begin the evaluative process. Compare the strengths and weaknesses of each suggestion, narrow the list of solutions, and finally settle on some preferred alternatives. Most problems will have more than one possible solution.

Role Playing Role playing is a way of involving otherwise passive students in the discussion. Assign two or three students the role of economic actors and have them discuss a particular policy question. Students can take on the roles of certain key policy makers. For example, suppose the U.S. president is facing re-election and is meeting with the budget director. The president would like a more stimulative fiscal policy, but the budget director is concerned about increasing the federal budget deficit. Have two students take on these roles and discuss the issues. As another scenario, have students assume the roles of farmers, members of Congress, and consumers who are discussing the farm subsidy program.

So that students have time to prepare for possible roles, tell them ahead of time about the policies to be discussed during the next class. Role playing can be effective in drawing out normally shy students who say little during regular discussion. Sometimes you can make it clear to students that you will be staying out of the discussion. But be careful because poorly planned or poorly monitored role playing can get out of hand.

CONCLUDING REMARKS Students are usually armed more with feelings and sentiments than with facts or theories. Be somewhat sensitive to these feelings and sentiments. Don’t threaten students. Students must often be gently drawn into the discussion. If you ask a particular student a question, give that student a chance to respond, but move along to others if a response does not appear to be forthcoming. Don’t focus on a single student for too long. As noted earlier, the silence that follows a question posed to the entire class is different from the silence that follows the question addressed to a particular student. The first sort of silence can be healthy; the second can seem mean-spirited.

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APPENDIX C QUIZZES AND EXAMS Most of you must prepare and administer quizzes and hourly examinations. The hourly exams often include multiple-choice questions. Quizzes typically ask for short answers to perhaps four or five questions; these require a total of 10 to 20 minutes to complete. These short-answer quizzes can be thought of as mini-essay exams. In this appendix we consider some guidelines for preparing, administering, and grading quizzes.

We also discuss (1) the pros and cons of different types of questions, (2) quiz preparation and administration, and (3) grading, student complaints, and cheating. We begin with a discussion of the different types of exam questions.

TYPES OF QUESTIONS In this section we discuss some pros and cons of each type of question, but we do not offer specific questions for your use. Note that each chapter in this manual offers a section entitled “Chapter Objectives and Q uiz M aterial,” w hich includes short-answ er questions plus m any term s that can be used for identifications. Multiple-choice, true/false, fill-in-the-blank, and short-answer questions are available in the Test Bank . There also questions at the end of each chapter; these end-of-chapter questions are answered in the Instructor’s Manual.

Essay Questions Short-answer tests can be viewed as mini-essay questions because they usually require the student to draw a diagram and/or to string together a few sentences. Essay questions, even short-answer questions, allow you to probe more deeply into a particular topic than you could with other types of questions. Essay questions permit students to shape the answer and to emphasize material as they choose.

One problem with any sort of essay exam, even short-answer ones, is that they often confront the grader with a number of factors—such as poor handwriting, incorrect spelling, and bad grammar—that may have little bearing on the student’s knowledge of economics. As such, the essay exam tends to favor students better able to express themselves. The grading of essay questions also has a subjective component—how the answer looks, what’s your mood, what you think of the student, and so on. Different instructors would assign the same answer different grades, and indeed the same instructor might assign the same answer different grades at different times.

If long answers are expected, fewer topics can be covered with essay questions than with, say, short-answer, fill-in-the-blank, multiple-choice, or true/false questions. Since essay questions test the student in greater depth, the trade-off is between examining less material in greater depth versus more material in less depth.

Multiple Choice Questions The advantage of multiple-choice questions is that they can be scored quickly and objectively. Overall, the multiple-choice test can examine a broad range of material in a relatively short time. A disadvantage of multiple-choice questions is that they are often far more time consuming to prepare than an essay test, though test banks supplied by publishers can ease the burden. Students must also spend more time reading

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a multiple-choice exam. The student’s chances of lucky guesses are reduced if five alternative answers are used instead of four. But an increase in the number of alternatives also increases the time that students must spend reading each question.

To ensure the highest quality multiple-choice test, you should never provide more than one acceptable answer. That answer should appear to be the best choice to students. The positions of the correct alternative should be randomly assigned. (Students often look for a pattern for correct alternatives, such as A, B, A, B.) Also construct the exam so that point totals are easy to calculate. For example, have questions worth 2 points each or 3 points each—not 2.3 points each or 3.4 points each. As a rule of thumb in timing the exam, provide students with a little more than one minute per question, not including the time taken to hand out the exam (for example, give students at least 50 minutes to answer 40 multiple choice questions, assuming the questions do not require complex calculations).

Fill-in-the-Blank Questions The fill-in-the-blank, or completion, question requires students to provide the missing words or short phrase. These questions are easier to construct than multiple-choice questions and are easier to score objectively than essay questions. Students need less time to read fill-in-the-blank questions than to read multiple-choice questions. Fill-in-the-blank questions are better suited to short quizzes than are multiplechoice questions because they can be read more quickly; so more material can be probed in the short time allowed.

Make sure you provide enough information so that well prepared students can come up with the correct answer. You must avoid ambiguity in constructing such questions. Often it’s better to have the blanks come toward the end of the sentence rather than at the beginning. Take care not to have more than two blanks per question.

Matching Questions Matching questions consist of two lists; students are required to match an item on one list with the appropriate item on the other list. The directions should be clear about the criteria for matching the lists. This type of test can be constructed relatively quickly and can also be easily scored in an objective manner. But economics is not easily given over to long lists, so you may have difficulty developing matching questions. There are not many parallel situations in economics. Matching exams seldom test for an in-depth understanding of concepts; instead, they are usually limited to identifying general relationships or matters of fact.

True/False Questions True/false questions evaluate the student’s ability to identify correct statements. These questions are easy to construct, easy to grade, and require little time for students to read, so more questions can be asked in a given period. The problem with true/false questions is that students have a fifty-fifty chance of a correct answer just by guessing. Students like questions with such good odds. As a way of offsetting this advantage, you can subtract more for wrong answers. For example, you present 20 true false questions worth five points each. But wrong answers are penalized 10 points each. Given that a students could average 50 points on the exam just by guessing, doubling the cost of wrong answers in not really unfair.

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In my view, the true/false approach is the least desirable way of measuring student ability. If you are inclined to use true/false questions, make sure the statement is clearly either true or false. You might ask students to support their answer—so they must say why the answer is true or why it is false (this reduces guessing). Avoid long, involved statements that are more tests of a student’s ability to decipher the sentence than knowledge of economics. Limit statements to a single idea. Try not to use negative statements. Again, have a random pattern of true and false statements. Don’t have all true or all false, and don’t create a pattern of responses.

Now that we have discussed the types of questions from which to choose, let’s examine test preparation and administration.

TEST PREPARATION AND ADMINISTRATION To discriminate among students of different abilities, present questions that offer a range of difficulty. Some should be easy, some moderately difficult, and some more difficult. If all the questions are easy or all are difficult, your quiz will not sort students out very well. One way to promote attendance is to test students on material covered primarily during your class. But limiting questions only to material covered in class is adopting the standards of high school.

You should not only vary the degree of difficulty, you should vary the type of information requested. Include, for example, a mix of questions requiring analytical skills, an ability to depict graphs and to explain those graphs, and an ability to explain the logic of the major theoretical points introduced in the material.

Questions should be worded with care so that the student’s knowledge, not the wording of the test, determines performance. Before reproducing the quiz, you might ask someone whose judgment you trust to read it and point out ambiguities and other possible sources of confusion. As carpenters say, “Measure twice, cut once.” Your test directions should be clear. Indicate the relative weight of each question and tell students how much time they have. Never underestimate your ability to mess up when putting together a test. As the carpenter says, measure twice, cut once.

Provide enough time so that a typical student can complete the test with time to spare. You should be consistent across students in the way exams are administered. For example, you can’t say that exams will be collected at a certain time and then decide, after most students have written furiously to turn in exams on time, that those students still writing can have five more minutes. If you are going to provide additional time on an exam, announce the fact so that all students can benefit from the additional time. No matter how much time you allot, some students will not finish, but you should not hold up the entire class for a student who is waiting for an inspiration.

GRADING As you know, so-called objective exams are easier to grade than essay exams. In grading long essay questions, point out the major errors of fact or reasoning and note the good responses. Often an overall comment at the end of the exam provides the student with useful guidance. Your comments on student performance should never be sarcastic or personal. Professional courtesy dictates that you take the student’s work seriously, even if sometimes the student appears less than serious. Keep in mind that an examination is a way of evaluating what the student has learned, not a way to terrorize a student.

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Clarity and consistency are a must in evaluating students’ work. Students should understand why they had points deducted. All students should also be evaluated uniformly. Students compare exams and will soon uncover any discrepancies in your grading. You should be prepared to explain exactly why points were deducted. When I grade essay exams, I try to cover or otherwise ignore the student’s name so as not to be influenced by my impression of that students. For example, with “blue books,” I fold over the cover right away, so that I can’t see the student’s name.

Dealing with Complaints When students do ask you to explain the results, don’t get defensive. Students have a right and, indeed, an obligation to understand their source of error. During class you should review the correct answers, but do not be drawn into a debate regarding how a particular student’s exam was graded. Avoid classroom confrontations between you and disgruntled students. Ask such students to see you after class or during office hours.

When dealing one-on-one with students who have questions about the grading, be receptive and courteous.

Listen to their point of view. Presumably you have a fair and rational grading system, so you should be able to explain why the student lost points on particular questions. This system must be applied impartially to all students. You cannot give the complaining student special consideration.

Often students seek higher grades, claiming that they may be placed on academic probation, flunk out, not get accepted to a certain program, or whatever. These and other reasons unrelated to the exam at hand should be irrelevant in your evaluation. You should never change an exam grade for any reason other than a mistaken evaluation or a computing error. Remember, to be fair in your grading, you must be fair to all students in the course, especially those who do not question their grades. If the squeaky wheel gets the grease, you are acting unfairly to those students who never approach you. Moreover, if you show favorable treatment to students who challenge grades, the number of students challenging grades will increase during the term. At the same time, if you find that a particular question was misleading, unfair, or turned out to have more than one correct answer, don’t be afraid to adjust the score of all students affected.

Nothing bothers students more than a belief that the exam was unfair. Special problems arise if you are a graduate assistant and you must defend an exam you had no role in preparing. For example, suppose that deep down you may agree with the student that a certain question on the exam (which was put together by the professor) seemed unfair or misleading. You should be diplomatic. Without indicating how you really feel, say that you will raise the student’s concerns with the professor. Then do just that. But don’t be too quick to criticize the exam, since you could be making the same error as the student.

If you are a graduate assistant, one way to eliminate having to second guess the professor on an exam is to ask to have a hand in its preparation or at least see the exam before it is reproduced so you can flag questions that you feel may create difficulties for you later. Since you are often the one who must explain the correct answers to the class, you should have some input in its preparation. One problem is that exams are often prepared at the last minute, so there is little time for review. But if student complaints are an ongoing problem with exams prepared by the professor, don’t feel you must insulate the professor from these complaints. Pass the complaints along or suggest that students raise their concerns directly with the professor.

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Cheating Academic pressure may prompt some students to cheat. You should become familiar with how your institutions deals with cheating. Armed with knowledge of the college’s policies, you should remind students how cheating will be handled and then follow through if you are confronted with a clear case of cheating. But prevention is the best medicine. Conduct exams in a way that makes cheating unlikely. If there are enough seats in the classroom, see that students are well spaced out, with an empty chair between each student. You could also prepare more than one version of the same quiz and alternate versions so that no student has the same quiz as the student seated to the right and left.

You must also supervise the quiz closely; exercise constant vigilance to prevent cheating. Walk around to make sure “cheat sheets” or electronic assistance of any kind are not used. Don’t leave the room, read, or be otherwise distracted while the quiz is underway. This is not your day off. Give students reasonable time to complete the quiz; however, students with extra time on their hands may be more tempted to cheat. Don’t give them more time than is necessary. As I said, no matter how much time you allot, some students will use it all and want more.

Here is one way to administer exams in large lecture halls where the seats are numbered. Numbers corresponding to each seat number are placed in a paper bag that circulates through the lecture hall during the class prior to the exam. Students draw a random number from the bag, and this number tells them their seat assignment for the exam. (Students who are absent that day draw a number the day of the exam.)

On the day of the exam, students sit in the seat number they randomly selected. The advantage of having seats randomly assigned in this way is that students are not able to sit with their friends. You might also remind students that those sitting to their right and left may be flunking the course. Also make up two or three versions of the same test and stack these in piles so that the exams alternate when they are distributed across a row of seats. The combination of different exams and different seat assignments reduces the avenues of cheating and forces students to focus more on their own work. This system requires a bit more administrative preparation, but the safeguards may be worth the extra trouble. Once students get used to the procedure, they seem to like it. I have been doing this for more than two decades.

Take-Home Assignments For student assignments done outside the classroom, such as homework assignments, problem sets, or even take-home exams, make sure you clearly define the bounds of student interactions. If no student collaboration is allowed, then say so. You should also follow a consistent policy with regard to late or incomplete assignments or make-ups. Whatever policy you follow, make sure that policy is clear early in the term and apply it consistently. Remember that students attach a high value to fairness, and you should too. The importance of perceived fairness cannot be underestimated.

Another kind of cheating you may confront if you assign papers is plagiarism, which is the presentation of someone else’s work as one’s own. Students may copy another student’s work or may copy from some other source; term papers are widely distributed over the Internet. Typically the student has closely paraphrased some source but fails to cite the work. Often students feel that a citation is required only if direct quotes are involved. If you assign a paper, explain proper citation practices to your students and warn them to exercise care. Your school likely has a policy for handling plagiarism. Inform students of this policy when you assign the paper. In this area, an ounce of prevention is worth a pound of cure.

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APPENDIX D SPECIAL CHALLENGES FACING THE FOREIGN GRADUATE ASSISTANT Although post 9/11 immigration restrictions slowed the fl ow of foreign graduate students, this group still represents a significant chunk of most graduate programs. Consequently, foreign graduate assistants must become acquainted with both a different culture and with new teaching responsibilities. This appendix addresses some special challenges that confront the foreign graduate assistant, and it should be read in addition to the other appendices, not instead of them.

LANGUAGE-RELATED ISSUES As a teacher, your primary responsibility is oral communication with students. Perhaps the most difficult problem some of you will confront is learning to communicate in English. Your facility with English will be developed primarily outside of class in social situations. After all, you are in class only a few hours a week, but you have opportunities to speak English with others for many more hours a week.

The temptation is to retreat to the security of your native language with your friends or family, but you should develop the discipline to avoid this trap. Seek out situations where you must converse in English.

Only if you use English on a daily basis will you come to master it. Vocabulary, pronunciation, and grammar require all the attention you can give them through social interaction, tutors, language classes, audio tapes, CDs, TV, or simply listening to the radio. Get a copy of The Foreign Teaching Assistant’s Manual, which was cited in the Introduction. In short, you must take advantage of whatever opportunities arise.

You were selected as a graduate assistant because of your knowledge of economics. The better you are prepared for class in terms of economics, the less of a problem the language will be. Lack of preparation of the topic will only compound your language difficulty. At the same time, your knowledge of English may, in later life, prove more of an asset than your knowledge of economics, so don’t slight the language side of your education.

If your accent is unmistakable, you should acknowledge to the class at the outset that English is not your native language and ask students for their patience. You might remind them that your strength is in economics, not the English language, and that economics is the area where you can help them the most. Have a sense of humor about your language limitations, particularly when you make mistakes. If you appear relaxed about the problem, so will your students. Ask for their tolerance if you need to have them repeat their questions. Also urge them to ask you to repeat whatever they do not understand. You might even develop a form of body language to indicate when communication has broken down. For example, palms facing up, arm bent, and a shoulder shrug often conveys bewilderment.

Make extensive use of the board and other visual aids to ensure that students record your points correctly.

(See the section on chalkboard use in Appendix A.) Also prepare handouts for material that is especially complicated. Board use and prepared handouts can reduce the pressure of oral presentations. You may need all the help you can get. Speak slowly and distinctly. Often those who speak English as a second language talk more quickly than they should. They fail to realize that to the student’s ear the accent makes the words run together. If you are unsure whether or not you are understood, ask students to summarize the point you are making. You should do this anyway.

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A major job at the principles level is to capture and retain student interest. The material in this manual is aimed at promoting interest in various topics. The key is to mix up the pace and the format of the class so that you are not lecturing for the entire period. A varied style is the best approach.

U.S. HIGHER EDUCATION IN PERSPECTIVE In many other countries, students entering college are better prepared than they are in the United States.

Many of the courses offered here to freshman and sophomores are in fact offered in secondary schools abroad. But at U.S. colleges, some students leave after the first year or two, and the level of difficulty picks up in the third and fourth years.

In most foreign countries, the teacher is a revered professional and is in many ways unapproachable. In the United States, students and teachers tend to be more equal, and graduate assistants are closer still to students. So you may not command the respect that teachers in your home country do. Teacher-student interaction is less formal here than abroad. Graduate assistants are expected to be available to help with student questions and problems.

Although teachers in the United States do not hold the exalted status they do in some countries, you should think of yourself as a professional. Carefully maintain the distance necessary to be objective in dealing with students. You must walk a fine line between the informality of serving as a graduate assistant and the formal requirements of the job such as preparing, administering, and grading quizzes.

Your manner of dress in U.S. classrooms is likely to be less formal than in your home country. Still, you should look neat and, on the days you teach, be somewhat better dressed than the typical student. Since U.S. students are less awed by the authority of the teacher, don’t take it personally if a student challenges your quiz answers or questions your approach. You should not be threatened by disagreement. But avoid debating students in class. Make it clear you will gladly discuss the particular problem with the student after class or during office hours.

Because there may be cultural gaps between you and your students, develop a clear understanding of the professor’s and students’ expectations. Don’t expect people to volunteer advice. If you are uncertain about your role, ask whoever is in charge of graduate assistants.

GRADES AND GRADING An area of great concern to students, and one that will require your serious attention, relates to grades and grading. You should be prepared for the inevitable complaints about exam questions. Otherwise mildmannered students will argue about exams because they believe the stakes are so high. They often see their academic future on the line. Above all, students expect to be treated fairly. They become quite upset if they sense that grading seems arbitrary.

Although most of your communication is verbal, you may also be responsible for preparing and grading section quizzes. If so, read the appendix that deals with the topic and make use of the quiz material provided for each chapter. The one point to add here is that before you reproduce your quiz, show it to the professor or to another graduate student whose judgment you trust. You want your questions to be as clear and as unambiguous as possible, and you may need help. Don’t be too proud to ask. A poorly worded question can create big problems for you in grading and in having to defend your grading system. An ounce of prevention is worth a pound of cure.

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Many U.S. students view the final grade as the most important consequence of the course. Mistakes in correcting exams or in transcribing grades will cause you serious problems, so you should be very careful in dealing with grade-related matters. Make sure the course requirements and the relative weights of each part of the course are clear to you and that you communicate this to your students. Nobody likes to be surprised halfway through the term.

CONCLUDING REMARKS On the whole, your foreign heritage should be viewed as an advantage in the classroom because you have a different perspective to offer students. In dealing with economic institutions and practices, you can compare your country with the United States. If you aren’t sure, ask students how things are done in the United States. Students will be interested in your country’s economic system.

Your biggest virtues will be tolerance, patience, openness to students, and an ability to laugh at your own limitations and shortcomings. If students view you as warm and open, they will be more willing to overlook problems that arise. So build up some good will. Most students will welcome the opportunity to be taught by a foreign graduate assistant.

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