2022

Reading on Current Economic Issues

BY

DR /WALAA SAAD ELKHALIFA

DEPARTMENT OF ECONOMICS & PUBLIC FINANCE
Contents
Chapter One__________________________________________________________________________________ 5

Economics: The Study of Opportunity Cost _________________________________________________________ 5

Introduction __________________________________________________________________________________ 5

1- Production possibilities frontier _____________________________________________________________ 9

1-1 The Intuition behind Our First Graph ___________________________________________________________ 9

1-2 The Starting Point for a Production Possibilities Frontier __________________________________________ 10

Points between the Extremes of a Production Possibilities Frontier ____________________________________ 11

1-4 Sources of Economic Growth ________________________________________________________________ 16

___________________________________________________________________________________________ 17

1-5 Demonstrating Increasing Opportunity Cost ____________________________________________________ 17

1-6 Demonstrating Constant Opportunity Cost _____________________________________________________ 17

___________________________________________________________________________________________ 18

1-7 Demonstrating Increasing Opportunity Cost ____________________________________________________ 18

Chapter one Questions: _______________________________________________________________________ 20

Chapter Two : EFFICIENCY, MARKETS, AND GOVERNMENTS __________________________________________ 23

• 2.2 The Efficiency Criterion ________________________________________________________________ 23

• 2.3-Marginal Conditions for Efficiency _______________________________________________________ 24

2.4 Market Assumptions: ______________________________________________________________________ 25

2.4.1 Inefficiency in Competitive Markets _________________________________________________________ 25

2.4.2 Loss of Efficiency Due to Monopolistic Power: _________________________________________________ 25

2.4.3 Loss of Efficiency Due to Taxes: _____________________________________________________________ 26

2.4.4 Equity Versus Efficiency: __________________________________________________________________ 26

2.5 Equity Versus Efficiency in Competitive Markets: ________________________________________________ 27

2.6 Introduction to pareto optimality _____________________________________________________________ 28

2.7 Pareto Optimality Conditions: _______________________________________________________________ 29

2.8 Efficiency in Production:____________________________________________________________________ 30

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 2.9 Efficiency Condition in Production ____________________________________________________________ 31

2.10 The production Possibilities curve : __________________________________________________________ 31

2.11 Differences between the Edgeworth box and PPC ______________________________________________ 32

2.12 Pareto Efficiency in Consumption : ___________________________________________________________ 32

2.13 Interpretation of Efficiency Criterion _________________________________________________________ 34

2.14 Efficiency and Economic Institutions _________________________________________________________ 35

2.15 Economics of Negative Production Externalities: _______________________________________________ 36

2.16 Example: The Externality of SUVs ____________________________________________________________ 38

2.17 PRIVATE-SECTOR SOLUTIONS TO NEGATIVE EXTERNALITIES __________________________ 41

Chapter Three: Public Goods ___________________________________________________________________ 43

Introduction _________________________________________________________________________________ 43

3-1 Defining Public Goods and Distinguishing Between Different Kinds of Public Goods ____________________ 43

3-1-1 Non-Rivalry and Non-Excludability __________________________________________________________ 43

3-1.2 Porous Boundaries _______________________________________________________________________ 45

3-2 Different Kinds of Public Goods ______________________________________________________________ 48

3-3 Examples of Public Goods __________________________________________________________________ 48

3-4 Public Goods and Externalities _______________________________________________________________ 51

3-5-2 Negative externalities ____________________________________________________________________ 53

3-5-3-4 Market-based policies (tradable permits) __________________________________________________ 54

3-6 NEGATIVE CONSUMPTION EXTERNALITIES _____________________________________________________ 56

3-8 POSITIVE CONSUMPTION EXTERNALITIES ______________________________________________________ 60

3-9 Common access resources and the threat to sustainability ________________________________________ 62

3-10 The Free Rider Problem ___________________________________________________________________ 63

3-11 Example of the free rider problem ___________________________________________________________ 65

3-12 How to solve the free rider problem _________________________________________________________ 66

3-12-1 Social pressures and personal appeals ______________________________________________________ 66

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• 3-12-2 Privatize public goods ______________________________________________________________ 67

• 3-12-4 Incentivize contributions ____________________________________________________________ 68

3-13 Explaining Collective Action ________________________________________________________________ 68

Review questions: ____________________________________________________________________________ 71

Chapter Four ________________________________________________________________________________ 77

Inflation & Unemployment _____________________________________________________________________ 77

4-1-3 PRICING POWER INFLATION _______________________________________________________________ 79

4-1-4 SECTORIAL INFLATION ____________________________________________________________________ 79

4-1-5 BUILT-IN INFLATION ______________________________________________________________________ 79

CAUSES OF INFLATION ________________________________________________________________________ 79

HIGH PRODUCTION COST ______________________________________________________________________ 80

INTERNATIONAL LENDING AND NATIONAL DEBTS __________________________________________________ 80

FEDERAL TAXES ______________________________________________________________________________ 80

NEGATIVE EFFECTS ___________________________________________________________________________ 81

POSITIVE EFFECTS ____________________________________________________________________________ 82

Natural Rate Hypothesis ______________________________________________________________________ 101

The Short-Run Phillips Curve ___________________________________________________________________ 103

Historical application _________________________________________________________________________ 104

Adaptive Expectations ________________________________________________________________________ 106

__________________________________________________________________________________________ 107

Expectations and the Phillips Curve: _____________________________________________________________ 107

According to adaptive expectations theory, policies designed to lower unemployment will move the economy

from point A through point B, a transition period when unemployment is temporarily lowered at the cost of. _ 107

Rational Expectations ________________________________________________________________________ 108

Stagflation and Aggregate Supply Shocks _________________________________________________________ 110

Shifting the Phillips Curve _____________________________________________________________________ 111

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Chapter Five ________________________________________________________________________________ 121

5-1 Definition of Exchange rate: ________________________________________________________________ 121

5-2 What Is the Purpose of the Forex Market? ____________________________________________________ 123

5-3 Currency Exchange _______________________________________________________________________ 124

5-4 Currency Hedging: ________________________________________________________________________ 124

5-5 Currency Arbitrage: ______________________________________________________________________ 125

5-6 Currency Speculations:____________________________________________________________________ 126

5-8-Spot Rates ______________________________________________________________________________ 130

5-9 Cross Rates: _____________________________________________________________________________ 131

5-10 Forward Rates _________________________________________________________________________ 133

5-10-1 A currency swap _______________________________________________________________________ 134

5-10-2 Currency options ______________________________________________________________________ 135

5-10-2 Currency futures contracts ______________________________________________________________ 135

5-10-3 Exchange traded and standardized terms __________________________________________________ 135

5-10-3-1 Delivery and Settlement: ______________________________________________________________ 135

5-10-3-2 Maturity ___________________________________________________________________________ 136

4
 Chapter One
Economics: The Study of Opportunity Cost

Introduction
Let's begin by discussing scarcity. Resources (land, labor, factory buildings, timber, minerals,

machinery, and the like) are the basis for producing the food, shelter, medical care, and luxury goods

that we want. Some of these are natural resources (land and timber), some are capital goods

resources (factories and machinery) and some are human resources (labor). These resources are

scarce in the sense that there are not enough of them to produce everything we need and desire.

Even when using all resources as efficiently and completely as possible, and using all modern

technology to its fullest extent, there is some limit to the amount we can currently produce. Scarcity

forces us to choose among competing uses for society's resources. What to produce and how to

distribute this output to society's citizens are the most basic economic choices to be made. The

easiest way to think about the problem of societal choice is by looking at a basic economic concept

and graph called the production possibilities curve. (I promise that only two basic graphs will be used

to analyze the issues in this book.) The production possibilities curve shows the maximum amounts

of two different goods that can possibly be produced during any particular time period using society's

scarce resources. Because reality is complex, economists try to simplify it by making assumptions

about the basic elements involved in analyzing an issue.

In examining production possibilities, we must make these simplifying assumptions about our

economy:

1- All available resources will be used fully.

2- All available resources will be used efficiently.

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3- The quantity and quality of available resources are not changing during our period of analysis.

4- Technology is not changing during our period of analysis.

5- We can produce only two goods with our available resources and technology. Let's consider the

implications of these simplifying assumptions. First, all available resources are used fully, so that no

workers are unemployed, no factory buildings sit idle, and so forth. (This does not mean that we fail

to conserve some of our resources for the future. If we think that the habitat of the snowy owl is

important ecologically, we simply do not make that part of the available resources.) Second,

efficiency means that we use our knowledge and technology to produce the maximum amount of

output with these resources. These first two assumptions mean that our economy is doing the best

that it can; it is operating fully and efficiently. Third, the quantity and quality of our resources are not

changing. This means that over the current time period, workers do not begin new training programs

to make them more productive, new natural resources are not discovered, and so on. The next

assumption is similar. Technological change- which might give us a better means of producing more

goods with the same resources- is not occurring. We make these last two assumptions to deal with

the world as it is right now, and not how it might become in the future. And finally, to simplify our

analysis (and because here we graph in only two dimensions), we assume that we can produce only

two goods with our resources. Let's pick bread and roses as the goods. One of our choices is to put

all of our resources and technology into the production of bread. This choice might give us 150 units

of bread. Whether these bread units are loaves, cases, truckloads, or tons is irrelevant here. Let's

suppose they are tons. Two old adages suggest that man (and woman) cannot live by bread alone

and that life is richer if we stop and smell the roses. So, let's allow another choice and take some

resources and some technology out of bread production and use them to produce roses.Now, we

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might end up with 20 units of roses and only 120 tons of

bread. Again, the nature of the units is irrelevant; our rose units might be bouquets, boxes,

truckloads, or tons. Let's suppose they are tons.(Note, however, that we had to give up 30 tons of

bread production in order to produce the 20 tons of roses.) Another alternative might be to give up

even more bread, leaving us with bread production of only 90 tons, in order to produce 40 tons of

roses. (Note that, once again, we had to give up 30 tons of bread production in order to get the

additional 20 tons of roses.) The alternatives could go on and on and might be summarized in a

production possibilities table such as Table 1. Note that each alternative A through F represents one

possible combination of bread and roses that we could produce.

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TABLE 1. Production Possibilities Table

Alternative Bread (tons) Roses (tons)

A 150 0

B 120 20

C 90 40

D 60 60

E 30 80

F 0 100

The information in Table 1. Can be easily displayed in a production possibilities curve, or

graph. Don't let graphs intimidate you. They can be very useful. Every graph has just two axes,
and each axis shows the amounts of one variable. As you move along the axes away from the
origin, the amounts of the variables increase. In Figure 1. The horizontal axis represents tons
of roses, and the vertical axis represents
tons of bread. Each point in the graph represents a row in the table, and the labeling of the points
corresponds to the alternatives in the table. Connecting all points gives us a production possibilities
curve, which shows the alternative combinations of maximum quantities of bread and roses that our
country is capable of producing. (Even though we end up with a straight line, we still call it a
production possibilities curve. The appendix to this chapter considers the more realistic production
possibilities curve that is actually bowed outward.)
A number of important concepts are illustrated by the production possibilities curve. The most basic
concept is that there is some limit to what we can produce. Thus, to produce more of one good, we
must give up production of something else.

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This reality is what economists refer to as opportunity cost. Opportunity cost is the best alternative
that is forgone in order to produce or consume something else. The opportunity cost of producing roses
is not measured in dollars but in the bread that we give up when we produce these roses. And the
opportunity cost of producing bread is the roses we give up when we produce this bread. As economists
are fond of saying, there is no free lunch! There is an
opportunity cost to everything. The second economic concept that is illustrated by production
possibilities is that of unemployment. Realize that our alternative combinations of the two products
represent possible quantities. We have explicitly assumed the full use of our resources, knowledge,
and technology; hence, the phrase production possibilities. In actuality, we rarely if ever produce to
our full potential. In reality, some resources may go unused: factories are idle and workers are laid off.
Nor do we always use resources in the most efficient manner. In these cases, we will not be on the
production possibilities curve, but at some point
below it, such as U (representing unemployment) in Figure 1. At point U, we are producing only 40
tons of roses and 60 tons of bread, though we could produce more of both if we had full employment.
Clearly, we could do much better by putting idle resources to work and moving our way back out to
the production possibilities curve. Finally, it is evident that our country need not be restricted to a
single production possibilities curve forever. Economies may grow, and

1- Production possibilities frontier

A graph that relates the amounts of different goods that can be produced in a fully employed societ
y. Modeling Opportunity Cost Using the Production Possibilities Frontier :

1-1 The Intuition behind Our First Graph

The concept of opportunity cost can be further illustrated by looking at something called a

production possibilities frontier. This graph, Figure 1.1, is the first of more than 100 that you

will see in this book. It is an example of a model, a simplification of the real world that we
an manipulate to explain the real world. This particular one relates the amounts of different goods
that can be produced in a fully employed society.Because chalkboards and book pages have only tw
o dimensions, our explanation is limited. This gives us the first opportunity to introduce something
called a simplifying assumption.

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A simplifying assumption is one that may, on its face, be silly but allows for a clearer explana- tion.
A good one also has the characteristic that the conclusions that spring from it are valid in its more c
omplicated scenario. For our production possibilities frontier we will make several simplifying assu
mptions. We will assume that there are only two goods in the world, that these goods are pizza and
soft drinks, and that these goods will be produced with a fixed number of resources and fixed tech
nology.
For another simplification, suppose that there are five types of people in the world: (1) those

really good at producing pizza but lousy at producing soda; (2) those pretty good at producing pizz
a and not so good at producing soda; (3) those sort of OK at both; (4) those good at pro- ducing sod
a and not so good at producing pizza; and (5) those really good at producing soda but lousy at prod
ucing pizza.

1-2 The Starting Point for a Production Possibilities Frontier

If we imagine that our resource is the time of our workers, it can be consumed directly in the form
of their leisure or it can be combined with other resources to produce goods and services. This reso
urce is also scarce because there is not an infinite number of people to work, those people can do o
nly so much work, they will not work without being paid, and there is only so much soda that can
be produced
even if the people on the planet devote their lives to the production of soda. Of course this point al
so holds if we apply the scarce resource to the production of pizza. There is only so much pizza that
can be produced even if everyone on the planet is producing pizza. This notion of scarcity gives us a
starting point and an ending point for Figure 1.1.

Point S in Figure 1.1 represents the situation where all resources are devoted to the prodution of so
da; point P represents the situation where all resources are devoted to the production of pizza. In b
oth cases all the resources in the world are devoted to the production of a specific good and produ
ction is still limited. It is limited by the ability of people and by the number of people and machines
we have to help those people do their jobs. So that it is clear, remember that the production possib
ilities frontier is giving us a series of choices. We can pick only one of them. We cannot have both S
sodas and P pizzas; thus, it is an either–or situation.

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Points between the Extremes of a Production Possibilities Frontier
We can have some soda and some pizza,
so many points between S and P are possible; we need to determine them. To proceed, assume yo
u want something to eat with your soda, and ask yourself what kind of people you would

remove from soda production to foster pizza production. Clearly, you would remove those who are
not contributing much to the soda pro- duction but would contribute greatly to pizza

production. That is, those with the attributes of people in group 1 above: really good at pizza, lousy
at soda.

Figure 1.2 shows us what happens if we go ahead and move that group. As you see, this increases p
izza production to a respectable level while not costing society much soda. Point X in Figure 1.2 rep
resents that new soda–pizza combination. There everyone except those whom
we will call the “pizza chefs” are still making soda, and the pizza chefs are efficiently crank- ing out
as many pizzas as they can on their own. The thing is, though we gained a great deal of pizza produ
ction, we lost some soda production. That’s why point X, while to the right of point S, is also lower t
han point S.

If we continue this process further, we are not blessed with a similar effect. The reason is that if we
move toward greater pizza production, we do not have those pizza chefs to call on; instead we hav
e our group 2, who are pretty good at pizza and not so good at soda. What that means is that even
though pizza production rises, it does not rise as much as it did before. On top of that, our soda pro
duction falls more than it had before because when we moved the pizza chefs, they were “lousy” at
soda. Now we are moving workers who are simply not so good at soda. Our soda losses are growin
g at an increasing rate. Thus we have point Y in Figure 1.3.

Going further, point M in Figure 1.4 results from moving the workers from group 3 (OK at both) fro
m soda to pizza, point Z results from moving group 4 workers to pizza, and point P results from mov
ing group 5 workers to pizza.

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 Connecting points like this creates Figure 1.5: a production possibilities frontier. This curve represe
nts the most pizza that can be produced for any given amount of soda or, interpreted differently, th
e most soda that can be produced for any given amount of pizza.

Of course, if you can produce on the curve, you can produce less than that as well.
If you do produce at points inside a production possibilities frontier, there are unemployed resourc
es, or
Unemployment for short. Therefore, all points on or inside the production possibilities frontier are
attainable.

Conversely, since the production possibilities frontier represents the maximum amount of one good
that you can produce for a given level of production of another, those points outside the production
possibilities frontier are unattainable. This means that currently available re- sources and technology
are insufficient to produce amounts greater than those illustrated on the frontier. On the graph, eve
rything beyond the frontier is unattainable.
The preceding discussion illustrates something you need to be wary of in this book. Words you think
you know may mean something entirely different to economists. Thus far we have at least three such
words: unemployment, frontier, and good. You think of unemployment as the condition of someone
wanting a job but not having one. Economists do not disagree but expand that defini- tion to resourc
es other than labor. For example, on the interior of the production possibilities fron- tier there is une
mployment, but that unemployment may be of capital. The word frontier is used to describe the bou
ndary of production, not a wooded area with bears to avoid. The word good, to an economist, is a ge
neric term for anything we consume. In the example, soda and pizza are goods. In the soda and pizza
example there were people of different talents at soda and pizza production. The pizza chef had far

different skills from the soda master. If, on the other hand, everyone were identical in their soda an
d pizza production capabilities, then points would fall on the line, as seen in Figure 1.6.

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Increasing and Constant Opportunity Cost

Figures 1.5 and 1.6 have important similarities and differences. In both, the points on the production
possibilities frontier are the most of one good that can
be produced for given amount of the other good. In both, the points on the curve and inside it are att
ainable and those on the outside of it are unattainable. In both, the opportunity cost of moving from o
ne point

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Attributes of the Production Possibilities Frontier:

Increasing and Constant Opportunity Cost

Figures 1.5 and 1.6 have important similarities and differences. In both, the points on the production
possibilities frontier are the most of good that can produced for given amount of the other good. In
both, the points on the curve and inside it are attainable and those on the outside of it are unattainabl
e. In both, the opportunity cost of moving from one point

14
to another is the amount of one good you have to give up to get another. They differ in one important
way, however: whether opportunity cost is increasing or constant.

If the production possibilities frontier is not a line but is bowed out away from the origin, then oppor
tunity cost is increasing. The reason for this is that as we add more resources to the produc- tion of pi
zza, we are using fewer resources to produce soda. Compounding that problem, at each stage as we t
ake the resources away from soda and put them into pizza, we are moving workers who are worse at
pizza production and better at soda production than those moved in the previous stage. This means th
at the increase in pizza production is diminishing and the loss in soda pro- duction is increasing. An
economist would call this an example of increasing opportunity cost.

If the production possibilities frontier is straight line that is not bowed out away from the origin, the
n opportunity cost is constant. If every worker possesses identical skill, though you still have to give
up some soda to get pizza, this is not compounded by anything. The resources you put into producin
g more pizza are just as good as the resources used to get you to that point, and the resources taken a
way from the soda are similarly just as good as the resources used up to that point. An economist wo
uld call this an example of constant opportunity cost.

15
1-4 Sources of Economic Growth
In terms of productive capacity of a society, economic growth results from either an increase in the a
vailability of resources or an increase in the ability of resources to produce goods and services. In the
first case, a newly discovered source of energy, or a source of energy that had, under previous techn
ology, not been exploitable would constitute a newly available resource. Reaching not that far back i
n our history, having women enter the labor force in large numbers during the 1960s through the 199
0s increased the availability of labor. In the second case, sometimes the resources remain the same b
ut the ability to utilize them to produce goods and services increases. For instance, when computers a
nd lasers are added to saw mills, the same logs, saw blades, and labor can produce more lumber. Tha
t is, technology makes resources more productive. Similarly, education makes labor more productive
and can be a source of generalized growth in capacity.

How that we have looked at our first “simplified” model of the economy, it’s time to get an idea of

the “Big Picture.” Think of Figure 1.8 as your road map to the book. This circular flow model is

designed to put all of the pieces that follow in perspective. It has firms, workers, investors, savers,

buyers, and sellers all interacting in markets and dealing with government.

The Circular Flow Model: A Model That Shows the Interactions of All Economic Actors
The ovals in the diagram represent entities of specific kinds: There are households, firms, and gover
nments. Households provide labor for wages. They use those wages to buy goods and services and p
ay their taxes. They receive services from government. Some save, some bor- row, and many do bot
h. Firms provide wages to households and pay taxes to government while getting labor from their wo
rkers and services from the government.
The rectangles in the diagram represent markets of various kinds: There are factor markets, foreign
exchange markets, and goods and services markets. Factor markets are where workers and firms, a
nd borrowers and savers interact to set wages and interest rates. Foreign exchange markets are whe
re holders of various currencies interact to facilitate international trade. Goods and services market
s are where consumers and producers interact to negotiate exchange of goods like cars, and services l
ike dry cleaning.

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Surrounding the whole thing are “The Rest of the World” and “Natural Resources and the Environm
ent.” The former allows us explicitly think about foreign trade and foreign exchange while the latter
lets us think about the use of natural resources and the implications of economic activity on the envir
onment.

1-5 Demonstrating Increasing Opportunity Cost

For example, in Figure 1.9, if we go from the point on the graph where we are producing no pizza to
the point where we are producing a single unit, a unit whose numbers could be in the billions, our op
portunity cost would be characterized by lost units of soda. On Figure 1.9, the opportunity cost of go
ing from 0 units of pizza to 1 unit of pizza is 1 unit of soda. Moving from 1 unit of pizza to 2 units h
as an opportunity cost that is 3 units of soda. Similarly, moving from 2 to 3 units of pizza has an opp
ortunity cost of 6 units of soda. As is visually obvious, the opportunity cost of going from 0 to 1 is s
maller than going from 2 to 3. This is why we say that the opportunity cost is increasing.

1-6 Demonstrating Constant Opportunity Cost

Similarly, we can use Figure 1.10 to show constant opportunity cost. The opportunity cost of moving
from producing no pizza to 1 unit is 3 units of soda. Moving from 1 unit to 2 units and from 2 to 3 u
nits also has an opportunity cost of 3 units of soda. In this case the opportunity cost of going from 0 t
o 1 is the same as going from 2 to 3. This is why we say that the oppor- tunity cost is constant.

What this all means is simple: Choices have consequences. Sometimes those consequences are great
and sometimes they are small. If studying for five hours moves you from an F to a B on a test, then t
he higher grade has a low opportunity cost in terms of lost television watching. Viewed from the oth
er side, the opportunity cost of another five hours of television watching (instead of studying to get a
good grade) could be substantial. Opportunity cost is everywhere and is a consequence of every deci
sion you make.

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1-7 Demonstrating Increasing Opportunity Cost
For example, in Figure 1.9, if we go from the point on the graph where we are producing no pizza to
the point where we are producing a single unit, a unit whose numbers could be in the billions, our op
portunity cost would be characterized by lost units of soda. On Figure 1.9, the opportunity cost of go
ing from 0 units of pizza to 1 unit of pizza is 1 unit of soda. Moving from 1 unit of pizza to 2 units h
as an opportunity cost that is 3 units of soda. Similarly, moving from 2 to 3 units of pizza has an opp
ortunity cost of 6 units of soda. As is visually obvious, the opportunity cost of going from 0 to 1 is s
maller than going from 2 to 3. This is why we say that the opportunity cost is increasing.

18
1-8 Demonstrating Constant Opportunity Cost

Similarly, we can use Figure 1.10 to show constant opportunity cost. The opportunity cost of moving
from producing no pizza to 1 unit is 3 units of soda. Moving from 1 unit to 2 units and from 2 to 3 u
nits also has an opportunity cost of 3 units of soda. In this case the opportunity cost of going from 0 t
o 1 is the same as going from 2 to 3. This is why we say that the oppor- tunity cost is constant.

What this all means is simple: Choices have consequences. Sometimes those consequences are great
and sometimes they are small. If studying for five hours moves you from an F to a B on a test, then t
he higher grade has a low opportunity cost in terms of lost television watching. Viewed from the oth
er side, the opportunity cost of another five hours of television watching (instead of studying to get a
good grade) could be substantial. Opportunity cost is everywhere and is a consequence of every deci
sion you make.

19
Chapter one Questions:
Choose the correct answer:

1. Scarcity implies that the allocation scheme chosen by society can

a. not make more of any one good.

b. always make more of any good.

c. typically make more of a good but at the expense of making less of another.

d. always make more of all goods simultaneously.

2. A production possibilities frontier is a simple model of

a. scarcity and allocation.

b. prices and output.

c. production and costs.

d. inputs and outputs.

3. The underlying reason that there are unattainable points on a production possibilities f
rontier diagram is that there

a. is government.

b. are always choices that have to be made.

c. is a scarcity of resources within a fixed level of technology.

d. is unemployment of resources.

4. The underlying reason production possibilities frontiers are likely to be bowed out (rath
er than linear) is

a. choices have consequences.

b. there are always opportunity costs.

c. some resources and people can be better used producing one good rather than another.

20
d. there is always some level of unemployment.

5. The optimization assumption suggests that people make

a. irrational decisions.

b. unpredictable decisions.

c. decisions to make themselves as well off as possible.

d. decisions without thinking very hard.

6. Imagine an economist ordering pizza by the slice

When deciding how many slices to order she would pick that number where the enjoym
ent of the equals the enjoyment she could get from using the money on another good.

a. first slice

b. last slice

c. average slice

d. total number of slices

7. Of course, all individual students are better off if they get better grades. If you were to c
onclude that all students would be better off if everyone received an A you would

a. have fallen victim to the fallacy of scarcity.

b. be right.

c. have fallen victim to the fallacy of composition.

d. be mistaking correlation with causation.

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8. If you were to conclude, after carefully examining data and using proper evaluation tec
h- niques, that a tax credit for attending college benefits the poor more than a tax deduc
tion (of equal total cost to the government) would, you would have engaged in analysis t
o reach that conclusion.

a. negative

b. positive

c. normative

d. creative

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Chapter Two : EFFICIENCY, MARKETS, AND
GOVERNMENTS

How Much Government is Enough?

The question of how much government is enough is an important one in any society. It is the
tradeoff between public and private goods.When government gets bigger, it comes at the expense of
less private consumption.

• Total social benefit – any given quantity of an economic good available in a give time
period will provide satisfaction to those who consume it
• Marginal social benefit – the extra benefit by making one more unit of that good
available in a given time period
• Total social cost – the value of all resources necessary to make a given amount of the
good available
• Marginal social cost – minimum sum required to compensate the owners of inputs used
for making an extra unit of the good available

• 2.2 The Efficiency Criterion

• Normative criterion for evaluating effects of resource use on individual well-being
• Satisfied when resources are used in such a way as to make it impossible to increase the
well-being of any one without reducing the well-being of another.
• Often referred to as the criterion of Pareto optimality.

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• 2.3-Marginal Conditions for Efficiency
• Total social benefit – any given quantity of an economic good available in a give time
period will provide satisfaction to those who consume it

• Marginal social benefit – the extra benefit by making one more unit of that good
available in a given time period.

• Total social cost – the value of all resources necessary to make a given amount of the
good available.

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• Marginal social cost – minimum sum required to compensate the owners of inputs used for making

an extra unit of the good available .

2.4 Market Assumptions:

For simplification purposes, we assume we are In a perfectly competitive market , where :

1- All productive resources are privately owned.
2- All transactions take place in markets, in which competing sellers offer a standardized
product to many buyers.
3- Economic power is dispersed in that no single buyer or seller can influence prices.
4- All relevant information is available to buyers and sellers.
5- Resources are mobile and may be freely employed in any enterprise.

2.4.1 Inefficiency in Competitive Markets

• Prices do not always fully reflect marginal social benefits/costs of output

• Means other than markets needed to make social benefits of certain goods available
• Failure of markets to make available certain goods (national defense, environmental
protection) gives rise to demand for government production and regulation.

2.4.2 Loss of Efficiency Due to Monopolistic Power:

• Occurs when a firm influences the price of a product by reducing output to a level at
which the price it sets exceeds marginal cost of production
• Causes failure of markets to result in inefficient levels of output
• Normative economists would prescribe government intervention to increase output in
order to attain efficiency .

25
2.4.3 Loss of Efficiency Due to Taxes:
• Tax causes the amount of a good or service that is traded to be influenced by tax paid per
unit, not only marginal social benefit/cost.
• Therefore, the tax distorts decisions of market participants.
• Taxes influence decisions to work by reducing the net gain from working.

2.4.4 Equity Versus Efficiency:

• Many argue that resource allocation should also be evaluated in terms of equity, or
perceived fairness of the outcome.
• People differ in their ideas about fairness.
• Analysts usually try to determine the effects of government actions on both resource
allocation and the distribution of well-being.

26
 • The utility-possibility curve presents the maximum attainable level of well-being (utility)
for one individual, given the utility level of others in the economy, their tastes, resource
availability, and technology.

2.5 Equity Versus Efficiency in Competitive Markets:

Critics of the market system argue that many participants cannot satisfy basic needs because they

cannot pay for goods and services.

• Critics of the market system argue that the poor should receive transfers financed by taxes on

the more fortunate.

• However, taxes used to alter the distribution of income distort incentives to produce,
preventing achievement of efficiency.
•
• Thus, equity versus efficiency causes conflict for policy makers.

27
2.6 Introduction to pareto optimality

• The Italian economist Vilfredo Pareto (1848-1923) said that if a change in the economic
state makes at least one individual better off without making anyone worse off, then the
change is for the betterment of social welfare, i.e., the change is desirable. In that case, we
say that the initial state was Pareto-non-optimal.
• Obviously, the concept of Pareto optimality avoids interpersonal comparison of utility.
Since most government policies involve changes in the economic state, which benefit
some people and bring discomforts to others, it is obvious that the concept of Pareto
optimality is of limited applicability in the real-world situations.

28
 2.7 Pareto Optimality Conditions:
For the attainment of Pareto-efficient situation in an economy, three marginal conditions must be
satisfied.
These are:
(i) Marginal condition for efficiency in the allocation of factors among firms (efficiency in production);
(ii) Marginal condition for efficiency of distribution of commodities among consumers (efficiency in
consumption); and
(iii) Marginal condition for efficiency in the allocation of factors among commodities (efficiency in
product-mix or composition of output).

2.1.1 Assumptions:

In order to derive these three marginal conditions for the attainment of Pareto optimality, we shall
assume, for the sake of simplicity, that there are only two consumers (A and B), two factors of
production (L and K). and two commodities (F and K), i.e., our model here would be a 2 x 2 x 2 model.
• 2 inputs (capital and labor)
▪ 2 outputs (food and clothing)
▪ 2 consumers (A & B)
L = LF + Lc
K = KF + Kc
Production Functions
F = F(LF,KF)
C = C(LC,KC)
Where,
F = food production
C = clothing production
Li = labor devoted to the production of good i
Ki = capital devoted to the production of good i

29
 2.8 Efficiency in Production:

It occurs when It is not possible to reallocate inputs to alternative uses in such a manner as to increase
the output of any good without reducing the output of some alternative good. We may derive the
marginal condition for Pareto-efficiency in production by using Edge-worth box diagram.

The dimensions of the rectangle represents the total available quantities of inputs L and K that would all
be used to produce the consumer goods F and C Any point in the box represents a particular allocation of
the inputs over the production of the two goods.
At point Z1 in Figure 2A.1, the input combination used results in an annual output F4 of food and C2 of
clothing. The input mix at Z1 is not efficient. Why? Because it is possible to increase the production of
clothing to C3, which represents a higher level of production for clothing, without decreasing the
production of food. This is accomplished by moving along the isoquant F4 until the highest clothing
isoquant is reached.

30
- It easily can be seen that each point within the box corresponds to values for six variables. Referring to
point Z*, it has already been shown that it corresponds to values of LF, KF, LC, and KC. As soon as the
input mix is specified, so are the production levels of the two outputs. Therefore, at point Z*, the use of
LF labor and 0KF capital in the production of food implies an annual output level of F4 of food, where
F4 is the level of production of the good corresponding to the isoquant through Z*. The annual output of
clothing at Z* is C3.

2.9 Efficiency Condition in Production

The slope of the food isoquant is its marginal rate of technical substitution of labor for capital multiplied
by -1 in the production of food

MRTSFLK = MRTSCLK

•
• Now, the marginal condition for Pareto efficiency in production would be obtained if we
maximize the output of good F subject to a given output level of good C. Such maximization would
occur at a point of tangency between the IQs for the two goods.
• The marginal rate of technical substitution of labor for capital diminishes as more labor is
substituted for capital in the production of food. Through any point within the box will be, of course,
an isoquant corresponding to some level of production of food. Isoquants farther away from the
origin 0 represent higher production levels for food.

2.10 The production Possibilities curve :

• The economic information displayed in the efficiency locus may be summarized in an
alternative fashion. To do this, consider what the efficiency locus implies. Given the economy’s
resources (L and K), any point on 00 gives the maximum amount of food that can be produced for
any given level of production of clothing each year and the maximum amount of clothing that can be
produced given any level of production for food each year.
• The curve TT’ gives all the efficient combinations of food and clothing per year that can be
produced in the economy, given the resource constraints and technology.

31
2.11 Differences between the Edgeworth box and PPC
The first difference concerns what goes inside the box. Instead of production functions for food and

clothing, utility functions are plotted.

sides of the production box were taken to be fixed, the sides of the consumption box are variable;

that is, the assumption was a fixed annual amount of labor and capital available to produce food and

clothing.

The side of the Edgeworth box for consumption represents the total amount of food and clothing

available for consumption each year. It is clear that these are variables.

2.12 Pareto Efficiency in Consumption :

• Preferences on Consumption
• UA = U(FA,CA)
• UB = U(FB,CB)
•
• Where
• Ui = the utility of person i
• Fi = food consumed by person i
• Ci = clothing consumed by person i
• Constraints:
• F = FA + FB
• C = CA + CB
• It is obvious from above that the Pareto efficiency point in production must necessarily be a
point of tangency between the IQs for the two goods.
• We have obtained then that all the points on the CCP are Pareto-efficient points in production.
That is, if we are at some point on the CCP, then we are no longer able to effect by a change in the
allocation of the inputs, an increase in the output of one of the goods without reducing the quantity of
the other.

32
• On the other hand, any point like Z in Fig. 2A.1, which does not lie on the CCP and which
does not satisfy the optimality condition is Pareto-non-optimal. At the point Z, we are on IQ4 for good
F and on IQ’2 for good C.

33
 If we join all the points of tangency between the IQs for the two goods, by a curve, we would obtain

what is called the Edge-worth contract curve for production which we would denote by CCP. The

CCP would run from the point O to the point O’.

Efficiency Criterion on Consumption and Production

MRSACF = MRSBCF = MRTCF
2.13 Interpretation of Efficiency Criterion

Suppose we say that the “price of a unit of clothing is $1.” Then clothing is the same as “money.” We
can then say that MRS.A.CF (marginal rate of substitution of the consumer A between two goods f and c
) is A’s willingness to substitute clothing for money, which is their marginal benefit of clothing, MBAC.
The same is true for B. If these are equal to the MRTCF (Marginal rate of technical substitution between
the two commodities C and F), then this represents the capability of turning money into clothing as well.
Thus, it reflects the costs of production. Lastly if there are no other people who gain from either A or B
consuming clothing or food then:
MSB = MBAC = MBBC = MSCC
At least one output combination will satisfy the efficiency condition. The actual number of efficient
output solutions depends on the differences in tastes among households. If A and B have different tastes,
then any change in income distribution would alter relative demands and cause a change in the efficient
output mix (that is, lead the economy to a new efficient point on the production-possibility curve).

▪ Social Welfare Functions

▪ W = W(UA,UB)
▪ Where,
▪ W is social welfare
▪ UA is A’s utility
▪ UB is B’s utility

34
 2.14 Efficiency and Economic Institutions
Given the conditions for a market rendering a Pareto Optimal outcome referred to in Chapter 2 then if
costs are:
C = PKK + PLL
then production of a particular amount of a good is efficient if the slope of the production function for
each good is equal to the slope of the iso-cost line.
14-Efficiency and Economic Institutions
Given the conditions for a market rendering a Pareto Optimal outcome referred to in Chapter 2 then if
costs are:
C = PKK + PLL
then production of a particular amount of a good is efficient if the slope of the production function for
each good is equal to the slope of the iso-cost line.
Pure Market Economy and Pareto Efficiency Final

PC
MRS
A
CF
= MRSBCF = MRTCF =
PF

35
2.15 Economics of Negative Production Externalities:

Somewhere in the United States there is a steel plant located next to a river. This plant produces steel

products, but it also produces “sludge,” a by-product useless to the plant owners. To get rid of this

unwanted by-product, the owners build a pipe out the back of the plant and dump the sludge into the

river. The sludge produced is directly proportional to the production of steel; each additional unit of

steel creates one more unit of sludge as well.

• The steel plant is not the only producer using the river, however. Farther downstream is a
traditional fishing area where fishermen catch fish for sale to local restaurants. Since the steel plant
has begun dumping sludge into the river, the fishing has become much less profitable because there
are many fewer fish left alive to catch.
• This scenario is a classic example of what we mean by an externality. The steel plant is exerting
a negative production externality on the fishermen, since its production adversely affects the well-
being of the fishermen but the plant does not compensate the fishermen for their loss.
• One way to see this externality is to graph the market for the steel produced by this plant
(Figure 5-2) and to compare the private benefits and costs of pro- duction to the social benefits and
costs. Private benefits and costs are the benefits and costs borne directly by the actors in the steel
market (the producers and consumers of the steel products). Social benefits and costs are the private
benefits and costs plus the benefits and costs to any actors outside this steel market who are affected
by the steel plant’s production process (the fishermen).
• Recall from Chapter 2 that each point on the market supply curve for a good (steel, in our
example) represents the market’s marginal cost of producing that unit of the good—that is, the private
marginal cost (PMC) of that unit of steel. What determines the welfare consequences of production,
how- ever, is the social marginal cost (SMC), which equals the private marginal cost to the producers
of producing that next unit of a good plus any costs associated with the production of that good that
are imposed on others. This distinction was not made in Chapter 2, because without market failures
SMC = PMC, the social costs of producing steel are equal to the costs to steel producers. Thus, when
we computed social welfare in Chapter 2 we did so with reference to the supply curve.

36
• This approach is not correct in the presence of externalities, however. When there are
externalities, SMC = PMC + MD, where MD is the margin- al damage done to others, such as the
fishermen, from each unit of production (marginal because it is the damage associated with that
particular unit of pro- duction, not total production). Suppose, for example, that each unit of steel
production creates sludge that kills $100 worth of fish. In Figure 5-2, the SMC curve is therefore the
PMC (supply) curve, shifted upward by the marginal
• damage of $100.5 That is, at Q1 units of production (point A), the social marginal cost is the
private marginal cost at that point (which is equal to P1), plus
• $100 (point B). For every level of production, social costs are $100 higher than
• private costs, since each unit of production imposes $100 of costs on the fishermen for which
they are not compensated.
• Recall also from Chapter 2 that each point on the market demand curve for steel represents the
sum of individual willingness’s to pay for that unit of steel, or the private marginal benefit (PMB)
of that unit of steel. Once again, however, the welfare consequences of consumption are defined
relative to the social marginal benefit (SMB), which equals the private marginal benefit to the
consumers minus any costs associated with the consumption of the good that are imposed on others.
In our example, there are no such costs imposed by the consumption of steel, so SMB = PMB in Figure
5-2.
• is at point A in Figure 5-2, with a level of production Q1 and a price of P1.We also showed that
this was the social-efficiency-maximizing level of consumption for the private market. In the presence
of externalities, this relationship no longer holds true. Social efficiency is defined relative to social
marginal benefit and cost curves, not to private marginal benefit and cost curves. Because of the
negative externality of sludge dumping, the social curves (SMB and SMC) intersect at point C, with a
level of consumption Q2. Since the steel plant owner doesn’t account for the fact that each unit of steel
production kills fish downstream, the supply curve understates the costs of producing Q1 to be at point
A, rather than at point B. As a result, too much steel is produced (Q1 > Q2), and the private market
equilibrium no longer maximizes social efficiency.
• When we move away from the social-efficiency-maximizing quantity, we create a
deadweight loss for society because units are produced and consumed for which the cost to society
(summarized by curve SMC) exceeds the social benefits (summarized by curve D = SMB). In our
example, the deadweight loss is equal to the area BCA. The width of the deadweight loss
triangle is determined by the number of units for which social costs exceed social bene- fits (Q1 —

37
Q2). The height of the triangle is the difference between the marginal social cost and the marginal
social benefit, the marginal damage. Negative Consumption Externalities
• It is important to note that externalities do not arise solely from the production side of a market.
Consider the case of cigarette smoke. In a restaurant that allows smoking, your consumption of
cigarettes may have a negative effect on my enjoyment of a restaurant meal. Yet you do not in
any way pay for this negative effect on me.This is an example of a negative consumption
externality, whereby consumption of a good reduces the well-being of others, a loss for which they
are not compensated. When there is a negative consumption externality, SMB = PMB — MD, where
MD is the marginal damage done to others by your consumption of that unit. For example, if MD
is 40¢ a pack, the marginal damage done to others by your smoking is 40¢ for every pack you smoke.
• Figure 5-3 shows supply and demand in the market for cigarettes. The sup- ply and demand
curves represent the PMC and PMB.The private equilibrium is at point A, where supply (PMC) equals
demand (PMB), with cigarette consumption of Q1 and price of P1.The SMC equals the PMC because
there are no externalities associated with the production of cigarettes in this example.
• Note, however, that the SMB is now below the PMB by 40¢ per pack; every
• pack consumed has a social benefit that is 40¢ below its private benefit. That is, at Q1 units of
production (point A), the social marginal benefit is the private marginal benefit at that point (which is
equal to P1), minus 40¢ (point B). For each pack of cigarettes, social benefits are 40¢ lower than
private benefits, since each pack consumed imposes 40¢ of costs on others for which they are not
compensated.
• The social-welfare-maximizing level of consumption, Q2, is identified by point C, the point at
which SMB = SMC. There is overconsumption of cigarettes by Q1 — Q2: the social costs (point A on
the SMC curve) exceed social benefits (on the SMB curve) for all units between Q1 and Q2. As a result,
there is a deadweight loss (area ACB) in the market for cigarettes.

2.16 Example: The Externality of SUVs

• In 1985, the typical driver sat behind the wheel of a car that weighed about 3,200 pounds, and
the largest cars on the road weighed 4,600 pounds. In 2008, the typical driver is in a car that weighted
about 4,117 pounds and the largest cars on the road can weigh 8,500 pounds. The major culprits in
this evolution of car size are sport utility vehicles (SUVs). The term SUV was originally reserved for
large vehicles intended for off-road driving, but it now refers to any large passenger vehicle marketed

38
as an SUV, even if it lacks off-road capabilities. SUVs, with an average weight of 4,742 pounds,
represented only 6.4% of vehicle sales as recently as 1988, but 20 years later, in 2008, they accounted
for over 29.6% of the new vehicles sold each year.
• The consumption of large cars such as SUVs produces three types of negative externalities:

1- Environmental Externalities The contribution of driving to global warming is directly

proportional to the amount of fossil fuel a vehicle requires to travel a mile. The typical compact
or mid-size car gets roughly 25 miles to the gallon but the typical SUV gets only 20 miles per
gallon. This means that SUV drivers use more gas to go to work or run their errands, increasing
fossil fuel emissions. This increased environmental cost is not paid by those who drive SUVs.
2- Wear and Tear on Roads Each year, federal, state, and local governments in the United States
spend $33.1 billion repairing our roadways. Damage to roadways comes from many sources, but
a major culprit is the passenger vehicle, and the damage it does to the roads is proportional to
vehicle weight. When individuals drive SUVs, they increase the cost to government of repairing
the roads. SUV drivers bear some of these costs through gasoline taxes (which fund highway
repair), since the SUV uses more gas, but it is unclear if these extra taxes are enough to compensate
for the extra damage done to roads.
3- Safety Externalities One major appeal of SUVs is that they provide a feeling of security because
they are so much larger than other cars on the road. Off- setting this feeling of security is the added
insecurity imposed on other cars on the road. For a car of average weight, the odds of having a
fatal accident rise by four times if the accident is with a typical SUV and not with a car of the same
size. Thus, SUV drivers impose a negative externality on other drivers because they don’t
compensate those other drivers for the increased risk of a dangerous accident.

•
• When economists think about externalities, they tend to focus on negative externalities, but not
all externalities are bad. There may also be positive production externalities associated with a
market, whereby production benefits parties other than the producer and yet the producer is not
compensated. Imagine the following scenario: There is public land beneath which there might be
valuable oil reserves. The government allows any oil developer to drill in those public lands, as long
as the government gets some royalties on any oil reserves found. Each dollar the oil developer spends
on exploration increases the chances of finding oil reserves. Once found, however, the oil reserves can

39
be tapped by other companies; the initial driller only has the advantage of get- ting there first. Thus,
exploration for oil by one company exerts a positive pro- duction externality on other companies: each
dollar spent on exploration by the first company raises the chance that other companies will have a
chance to make money from new oil found on this land.
• Figure 5-4 shows the market for oil exploration to illustrate the positive externality to
exploration: the social marginal cost of exploration is actually lower than the private marginal cost
because exploration has a positive effect on the future profits of other companies. Assume that the
marginal benefit of each dollar of exploration by one company, in terms of raising the expected profits
of other companies who drill the same land, is a constant amount MB. As a result, the SMC is below
the PMC by the amount MB.Thus, the private
• equilibrium in the exploration market (point A, quantity Q1) leads to under- production relative
to the socially optimal level (point B, quantity Q2) because
• the initial oil company is not compensated for the benefits it confers on other
• oil producers. Note also that there can be positive consumption externalities. Imagine, for
example, that my neighbor is considering improving the landscaping around his house. The improved
landscaping will cost him $1,000, but it is only worth $800 to him. My bedroom faces his house, and
I would like to have nicer landscaping to look at. This better view would be worth $300 to me. That
is, the total social marginal benefit of the improved landscaping is
• $1,100, even though the private marginal benefit to my neighbor is only $800. Since this social
marginal benefit ($1,100) is larger than the social marginal costs ($1,000), it would be socially efficient
for my neighbor to do the land- scaping. My neighbor won’t do the landscaping, however, since his
private costs ($1,000) exceed his private benefits. His landscaping improvements would have a
positive effect on me for which he will not be compensated, thus leading to an underconsumption of
landscaping.
• Negative production externality: SMC curve lies above PMC curve
• Positive production externality: SMC curve lies below PMC curve.
• ▶
Negative consumption externality: SMB curve lies below PMB curve.
• ▶
Positive consumption externality: SMB curve lies above PMB curve.
• Armed with these facts, the key is to assess which category a particular example fits into. This
assessment is done in two steps. First, you must assess whether the externality is associated with

40
producing a good or with consuming a good. Then, you must assess whether the externality is positive
or negative.
• The steel plant example is a negative production externality because the externality is
associated with the production of steel, not its consumption; the sludge doesn’t come from using steel,
but rather from making it. Likewise, our cigarette example is a negative consumption externality
because the externality is associated with the consumption of cigarettes; secondhand smoke doesn’t
come from making cigarettes, it comes from smoking them.

2.17 Private-Sector Solutions to Negative Externalities

• To see how a market might compensate those affected by the externality, let’s look at what
would happen if the fishermen owned the river in the steel plant example. They would march up to
the steel plant and demand an end to the sludge dumping that was hurting their livelihood. They would
have the right to do so because they have property rights over the river; their ownership confers to
them the ability to control the use of the river.
• Suppose for the moment that when this conversation takes place there is no pollution-control
technology to reduce the sludge damage; the only way to reduce sludge is to reduce production. So
ending sludge dumping would mean shutting down the steel plant. In this case, the steel plant owner
might propose a compromise: she would pay the fishermen $100 for each unit of steel produced, so
that they were fully compensated for the damage to their fishing grounds. As long as the steel plant
can make a profit with this extra
• $100 payment per unit, then this is a better deal for the plant than shutting down, and the
fishermen are fully compensated for the damage done to them. This type of resolution is called
internalizing the externality. Because the fishermen now have property rights to the river, they have
used the market to obtain compensation from the steel plant for its pollution. The fishermen have
implicitly created a market for pollution by pricing the bad behavior of the steel plant. From the steel
plant’s perspective, the damage to the fish becomes just another input cost, since it has to be paid in
order to
• produce.
• This point is illustrated in Figure 5-5. Initially, the steel market is in equilibrium at point A,
with quantity Q1 and price P1, where PMB = PMC1. The socially optimal level of steel production is
at point B, with quantity Q2 and price P2, where SMB = SMC = PMC1 + MD. Because the marginal

41
cost of producing each unit of steel has increased by $100 (the payment to the fisher- men), the private
marginal cost curve shifts upward from PMC1 to PMC2, which equals SMC,That is, social marginal
costs are private marginal costs plus
• $100, so by adding $100 to the private marginal costs, we raise the PMC to equal the SMC.
There is no longer overproduction because the social marginal costs and benefits of each unit of
production are equalized. This example

Negative production externality When a firm’s production reduces the well-being of others who
are not compensated by the firm.

42
Chapter Three: Public Goods
Introduction
The government plays a significant role in providing goods such as national defence, infrastructure,

education, security, and fire and environmental protection almost everywhere. These goods are often

referred to as “public goods”. Public goods are of philosophical interest because their provision is, to

varying degrees, essential to the smooth functioning of society—economically, politically, and

culturally—and because of their close connection to problems concerning the regulation of

externalities and the free-rider problem. Without infrastructure and their protection goods cannot be

exchanged, votes cannot be cast, and it would be harder to enjoy the fruits of cultural production.

There is widespread agreement among political philosophers that some level of education is required

for democracy to be effective. Due to their connection to externalities and the free-rider problem, the

provision of public goods raises profound economic and ethical issues.

3-1 Defining Public Goods and Distinguishing Between Different

Kinds of Public Goods
3-1-1 Non-Rivalry and Non-Excludability
• Even though Nobel laureate Paul Samuelson is usually credited with having introduced the

theory of public goods to modern economics (e.g., in Sandmo 1989), the origins of the idea go

back to John Stuart Mill, Ugo Mazzola (an Italian writer on public finance), and the Swedish

economist Knut Wicksell (Blaug 1985: 218–9 and 596–7]). Samuelson defined what he called

a “collective consumption good” as:

• [a good] which all enjoy in common in the sense that each individual’s consumption of such a

good leads to no subtractions from any other individual’s consumption of that good In the

contemporary debate, this feature or characteristic of goods is usually referred to as “non-

rivalry”.
43
 A good is rivalrous if and only if an individual’s consumption of it diminishes others’ ability

to consume it. Bob’s consumption of a grain of rice makes it impossible for Sally to consume

the same grain of rice. By contrast, Sally’s enjoyment of Bruckner’s Symphony No. 9 in no

way diminishes Bob’s ability to do the same. Rice is thus rivalrous while music is not.. A few

years after Samuelson, Richard Musgrave introduced an alternative criterion, that of (non-)

excludability (Musgrave 1959). As the name suggests, a good is excludable if and only if it is

possible to prevent individuals from consuming it, to “draw a fence around it” as it were. Land

is thus a good that is considered excludable, while streetlight is not excludable: if Bob pays for

a streetlight to be installed, he cannot stop his neighbour Sally from benefitting from it.

• In contemporary economics, goods are usually defined as public goods if and only if they

are both non-rivalrous and non-excludable (e.g., Varian 1992: 414). Rivalrous and excludable

goods are called private goods. National defence is a paradigmatic example of a public good.

Not only does Sally’s consumption of national defence not reduce Bob’s consumption; she

could not prevent him from consumption if she tried. Food, clothes and flats are paradigmatic

examples of private goods.

• There are also goods that are rivalrous and non-excludable and goods that are non-rival and

excludable. The former are sometimes called “common pool resources” (e.g., V. Ostrom & E.

Ostrom 1977, E. Ostrom et al. 1994; E. Ostrom 2003). An example is fish stocks. The latter

are sometimes called “club goods” (e.g., Mankiw 2012: 219; see also Buchanan 1965).

Examples include watching a movie in a cinema and the services provided by social and

religious associations.

• Table 1 provides an overview of the different types of goods that have been distinguished so

far.

44
Characteristic Rivalrous Non-rivalrous

Excludable Private goods (homesteads, Club goods (Sports clubs, movie theatres)

bathroom cleaner)

Non- Common resource goods Public goods: local (fire protection), national (national

excludable (fish stocks) defence), global (climate mitigation measures), partial

(parades)

Table 1: Different kinds of economic goods

3-1.2 Porous Boundaries

• The boundaries between these different types of goods are neither sharp nor fixed. For

example, whether or not Bob’s enjoyment of a movie in a theatre is affected by Sally’s

watching the movie in the same theatre at the same time depends on Bob’s values or tastes as

well as details of the context. Sally might sit in front of Bob and partially block his view. Or

she might be one of those people who sits right next to you even though fifty other seats are

available. Or Bob might be bothered by anyone sitting in the same theatre at the same time, or

enjoy watching the movie together with others. Thus, even supposing that Sally doesn’t alter

Bob’s viewing of the movie as such, her presence can have a positive or negative effect on

Bob’s enjoyment of it. Thus, whether or not a good is rivalrous in consumption depends on

many contextual details and not just the nature of the good alone.

• The same good can be excludable at one time, but non-excludable at another, or excludable in

one society, but non-excludable in another. For example, radio broadcasts used to be a public

good because it was not (easily) possible to prevent individuals from tuning in, but this is no

45
 longer the case in the digital age. But technology is only part of the story. A particular plot of

land—a prime example of a private good—can be protected by building a fence around it. But

there is no fence that cannot be overcome. In reality, a fence is more like a signal indicating

that the owner prefers to keep others out, or it makes it more costly for them to do so. What

matters for the characterisation of land as a private good is that the landowner has the right to

stop potential trespassers and that this right will be enforced by the legal system. Of course,

which sets of rights are attached to property depends on the norms prevailing in a society.

Property rights are never absolute (property in a chain saw gives me the right to use it to cut

my own trees but not to cut my neighbour’s trees, much less to use it to hurt anyone), and

always the result of past negotiations.

• To give a silly example, not everyone enjoys the sight of (particularly, white) socks in sandals.

In our society, the sight of socks in sandals is something individuals have to endure because it

is considered to be within the rights of the owners of white socks that they can wear them in

public, in sandals or in other types of shoes. It is easy, however, to imagine societies that define

the rights of sock-owners differently and value the tastes of those who are bothered by the

blight of socks in sandals more highly. Indeed, even in modern liberal societies social norms

regulate what is decent to wear in public. Since a good’s degree of excludability depends in

part on property rights, and what property rights entail may differ between societies and, within

societies, may change over time, a good’s excludability may differ between societies and

change over time.

• Another, related aspect is that the cost of enforcing property rights differs between cases, partly

for technological, partly for legal and political reasons. That automobiles are private goods

depends on the relatively cheap availability of suitable locks and also on the fact that the

46
 government enforces property rights in automobiles. If the price of locks were higher, or the

government made it illegal to secure one’s car using a lock, or the government stopped

prosecuting theft, automobiles would be “non-excludable” (Demsetz 1964).

• A corollary of the non-excludability characteristic is that there are limitations to consumers’

consumption decisions regarding the public good, if it is produced. Individuals might have

different preferences for the level of security provided by national defence, but once national

defence is in place, they will consume the level that has been produced, not more or less of it.

One cannot “opt out” of the consumption of a public good. Similarly, while everyone might

like clean air, individuals will differ in their degree of tolerance of pollution. But once “clean

air” has been produced, consumers must consume it independently of their preferences.

• It has been suggested that the “public” nature of a public good may be an effect of its provision

by the public rather than its cause (Cowen 1992: 6 credits unpublished work from 1987 by

Boudewijn Bouckaert). If a good is provided by government, private actors have no reason to

develop technologies that allow the exclusion of non-paying individuals. Accordingly, public

investment in the good thereby makes a good that could be private a public good. Even if this

idea is mistaken, it illustrates the fact that the boundary between private and public goods is

not fixed because what is technologically possible depends in part on investment in research

and development.

• The physical characteristics of a good, then, together with the context of its consumption,

values, tastes, legal, moral and social norms as well as technological possibilities determine

the proper categorization of a good as a private, common pool, club, or public good.

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3-2 Different Kinds of Public Goods
• Distinctions can also be drawn among public goods. Most public goods do not affect all

inhabitants of a large community equally. Fire protection services in Lower Manhattan are not

consumed by those living in the Bronx, much less by Californians. Public parks benefit those

who live in the neighborhood, playgrounds only those who live in the neighborhood and have

children of a certain age (and indeed they might constitute a public bad for others). Charles

Tiebout has developed a theory of local government, after which the term “local public good”

was coined (Tiebout 1956, Stiglitz 1982). Other public goods may benefit all of humanity,

such as climate change mitigation. We can therefore distinguish local, national,

and global public goods (on the latter, see Kaul et al. 2003).

• A partial public good is one from whose consumption some individuals can be excluded but

not others. Mancur Olson gives the example of a parade that is a public good for those living

in tall buildings overlooking the parade route but a private good to those who need to buy a

ticket for a seat in the stands along the way (Olson 1971: 14). A full public good, by contrast,

is one from whose consumption all individuals can be excluded.

3-3 Examples of Public Goods

• The following are examples of goods that are typically regarded as public goods:

• Security. National defence has already been mentioned as an example. More generally, the

ability to live safely and peacefully in a neighbourhood, city, region, or country (for instance,

through police and armed forces) is considered a public good because it is difficult to exclude

any inhabitant of the protected area from benefitting from the protection and one inhabitant’s

enjoyment of protection does not generally diminish other inhabitants’ equal enjoyment.

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• Education and science. The public goods character of education and science is somewhat more

subtle. It is easily possible to exclude individuals from being schooled, and so “having an MIT

engineering degree” is a private good. However, the more educated the general population is,

the more individuals benefit from this general education—independently of how much they

invest (or the public invests) in their own education—in a manner that is non-excludable and

non-rivalrous. A better educated population makes it easier for businesses to thrive, and

everybody profits from a thriving economy, not only those who are well-educated. It is difficult

to exclude individuals from a thriving economy and a given individual’s benefit is not

diminished by anybody else’s benefit. Scientific ideas are also considered to be public goods

(Boldrin & Levine 2008). Once an idea (such as a scientific theory) has been created it is

difficult to exclude individuals from benefitting (unless the idea is protected by a patent, see

below), and individuals’ benefit is non-rivalrous. It is important to distinguish between the idea

and its physical manifestation. The idea of a steam engine is a public good, whereas particular

steam engines are both excludable and rivalrous.

• Infrastructure. Though infrastructure is often referred to as a public good (e.g., OECD 2016),

whether the classification is correct depends on the details of the specific kind of infrastructure

and technology. Paradigmatic examples of infrastructure are often not public goods. Roads and

motorways are excludable, as the existence of toll roads attests. If the toll for a private road is

sufficiently low, it can be rivalrous as well due to congestion. The same can be said about the

internet. A traditional lighthouse is more likely to have public-goods character, though

depending on the physical nature of the signal it sends, it may well be excludable (Varian 1992:

415). The reason many commentators classify infrastructure as a public good is that it tends to

49
 lead to positive externalities. The (close) relationship between public goods and externalities

is explained below.

• Environment. Clean air is a paradigmatic good, at least outside. Without massive infringements

of an individual's rights it is virtually impossible to exclude him or her from benefitting from

clean air. And outside of narrowly enclosed spaces, clean air is non-rival. Similarly with the

absence of littering. If I decide not to litter, I cannot easily prevent you from enjoying the clean

space, and your enjoyment of it does not reduce anyone else’s.

• Public health. Individuals benefit from a healthy population in a variety of ways. For example,

the fewer individuals are infected with a contagious disease, the less likely it is that any given

(currently healthy) infects him- or herself. These benefits obtain in a non-excludable and non-

rivalrous manner. A healthier population is also more likely to be productive, making public

health analogous to education.

An Alternative Definition

• Angela Kallhoff has offered an alternative, albeit similar, definition of a public good (Kallhoff

2011: Ch. 2). According to her, a public good is one that satisfies the “basic availability

condition” and the “open access condition”. Basic availability is her analogue of non-rivalry.

A good satisfies this condition whenever each person benefitting from it has access to the same

amount and the same types of benefits. To state the condition in these terms makes explicit

that there may exist a level of consumption at which sameness of amount and types of benefit

are no longer guaranteed. A single ship’s enjoying the benefits of a lighthouse does not affect

another ship’s doing the same but once the sea is congested this may no longer be the case. A

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 lighthouse is a public good because there exists a level at which each person has access to the

same amount and the same types of benefits. Open access is Kallhoff’s analogue of non-

excludability. It states that

• entrance barriers that regulate access to a good are not combined with criteria which define a

list of potential beneficiaries and exclude others. (Kallhoff 2011: 43)

• Clubs produce services for a specific group of beneficiaries, the club members. In order to

profit from a lighthouse, an individual needs a boat and a desire to travel to the coast where

the lighthouse is located but there is no pre-specified collective that constitutes the intended

beneficiaries of this good.

3-4 Public Goods and Externalities

• Externalities are effects of economic transactions on individuals that are not party to the

transaction. The paradigm example is pollution: a company produces some good the

production process for which is “dirty” in that it affects individuals independently of whether

or not they are customers of the company. If such effects are undesired, as in the case of

pollution, they are called negative externalities; if they are desired, positive externalities. A

paradigmatic example of a positive externality is the pollination created by a honey producer’s

bees. Individuals benefit from pollination whether or not they buy honey.

• Public goods create positive externalities. Suppose a group of individuals get together and pay

some company to produce (analog) radio broadcasts. Individuals who are not party to the

transaction can now benefit from the good. Similarly, if a group of citizens get together to

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 clean up a public park, individuals will benefit whether or not they were part of the group of

citizen cleaners.

• The existence of a public good implies the existence of (positive) externalities, but the reverse

is not true. The beekeeper’s bees may pollinate the trees in the neighbouring orchard, thereby

increasing its production, but that does not mean that it is impossible to exclude others from

this or other benefits or that these benefits are non-rivalrous.

• 3-5 FAILURE TO ACHIEVE ALLOCATIVE EFFICIENCY

• Allocative efficiency is achieved when marginal benefit equals marginal cost (MB = MC)

• Unrealistic in real life. • Market failure suggests that markets need appropriate government

support to reach potential.

• Market failure - failure of the market to allocate resources efficiency.

• An externality occurs when producer/consumer actions have positive/negative side

effects on other people not involved in the actions.

• If the effect benefits the third party, there is a positive externality.

• If it harms the third party, there is a negative externality.

3-5-1 MARGINAL BENEFITS AND COSTS

• The demand curve also represents a marginal benefit curve. Since the benefit received is

to the owner of the good, it represents the marginal private benefits.

• The supply curve represents the marginal private costs.

• If there are no externalities, the MPB and MPC curves determine the equilibrium price

and quantity, where there is allocative efficiency.

• If there is an externality, there will be benefits and costs for the third party, causing the full

52
 society cost/benefit to differ from the private ones.

• The intersection of MPC and MPB is no longer the social optimum

• The intersection of the marginal social cost and marginal social benefit will result in

allocative efficiency.

3-5-2 Negative externalities

NEGATIVE PRODUCTION EXTERNALITIES

• Negative production externalities are external costs created by producers. • Too much is being

allocated to the production of the good. Qm is greater than the Qopt. At the point of production

(Qm), MSC > MSB. • There is welfare loss (loss in social benefits; yellow shaded area >• Equal to

difference between MSC and MSB and overproduced output.

3-5-3 CORRECTIONS

3-5-3-1 Government regulations

• Gov’t uses authority to make regulations to reduce/prevent the externalities.

• Lowers quantity produced, so the MPC curve shifts up towards MSC.

3-5-3-2 Market-based policies (tax)

• Gov’t can impose tax per unit of output produced or per unit of pollutants emitted.

• Shifts supply curve from S = MPC to MSC (or MPC + tax).

• Best to shift it so it overlaps with the MSC curve.

•3-5-3-3 Taxes on output/taxes on pollutants

• A tax on output works by correcting overallocation of resources and reducing overall

output.

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• A tax on pollutants works by making incentives for firms to use less polluting

resources.

• A carbon tax is a tax per unit of carbon emissions: the more carbon emitted, the

higher the tax.

3-5-3-4 Market-based policies (tradable permits)

• Governments can also issue tradable permits (cap and trade schemes) to firms that

permit them to produce a certain amount of pollutants.

• If they need more, they can trade with other firms.

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• The supply curve for these permits is perfectly inelastic because there is a fixed

number of permits.

• Encourages firms to use less polluting resources so they don’t need to use permits.

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3-6 NEGATIVE CONSUMPTION EXTERNALITIES

• Negative consumption externalities are

external costs made by consumers. • There is overallocation of the good, as Qm > Q opt and MPB >

MSB at Qm.

• The welfare loss is the shaded area.

• Demerit goods are goods that are overprovided and undesirable, like cigarettes.

CORRECTIONS

• Government regulation

• Regulations to limit activities will shift D=MPB curve.

• Advertising

• Can persuade consumers to use less of a good, which decreases demand.

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EVALUATION

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Market-based policies

• Imposition of excise tax will decrease the supply and shift supply curve upwards.

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3-7 Positive externalities

POSITIVE PRODUCTION EXTERNALITIES

• PPEs are external benefits made by producers. If a firm succeeds in making a new technology that

spreads through economy, the society benefits from this new technology.• The market is

underallocating resources. Qm < Q opt and MSB > MSC and Qm. • An example of PPE: When a

new medicine benefits the user and those around it because of the increased quality of life.• The

shaded area is the welfare loss. They are the benefits that are lost because not enough of a good is

being produced.

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CORRECTIONS

• Government provision

• The government can engage in R&D and pay for training. This is paid for by gov’t funds. It results

in the shifting of the MPC curve towards the MSC curve.

• Subsidies

• The gov’t can provide a subsidy and shift the S = MPC curve towards the MSC curve.

This is similar to government provisions.

3-8 POSITIVE CONSUMPTION EXTERNALITIES

• PCEs have benefits made by consumers. Consumption of education results in benefits not only for

the consumer but society. • The market underallocates resources. Qm < Q opt and MSB > MPB at

Qm. • The shaded area is the welfare loss, and represents the lost benefits because of the

externality.

• Merit goods are goods that are desirable for consumers but are underprovided. The reasons are:

• the goods are positive externalities

• there are low levels of income and poverty

• consumers are ignorant of the benefits

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CORRECTIONS

• Legislation

• Legislations promote greater consumption, which shifts the MPB curve closer to the

MSB curve. Many countries have legislation that makes education mandatory.

• Advertising

• Promotes greater consumption. Same effect as legislation.

• Direct gov’t provision

• The gov’t is involved in provision of goods and services, like education and health

care. This has the effect of increasing supply and shifts the supply curve downwards.

• Subsidies

• This has the same effect as the government provisions by shifting supply downward.

Gov’t needs to perform cost-benefit analysis to see the benefits of a certain public good. If benefits <

costs, good shouldn’t be provided. • Costs are easy to estimate, but the benefits are hard. Some

people exaggerate values.

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3-9 Common access resources and the threat to sustainability

COMMON ACCESS RESOURCES AND MARKET FAILURE

• Common access resources are resources that are not owned by anyone and have no price.

Examples: clean air, fish, rivers, ozone layer, etc. They are rivalrous but nonexcludable.

• Overused by consumers and producers because of non-excludability

• Common access resources used without payment can cause serious environmental

problems.

SUSTAINABILITY

• Sustainability - ability of something to be maintained or preserved over time

• Conflicts between environmental and economic goals

• Focusing on economic goals could cause destruction.

• Focusing on environmental goals could result in unsatisfiable needs/wants.

• Sustainable development - development that meets needs of the present without

compromising ability of future generations to meet their own needs.

• Sustainable resource use - using resources at a rate so that they don’t get depleted

POLLUTION

• Pollution of affluence - pollution caused because of high consumption that rely on the

use of fossil fuels and open access resources

• Negative externality of production.

• Pollution of sustainability - environmental destruction caused by overexploitation by

poor people because of the lack of modern technology.

• For example, they drain the nutrients of soil, making it less productive.

• Sustainability is threatened by the increased economic activities.

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GOVERNMENT RESPONSES

• Legislation

• The gov’t limits threats to sustainability by having licenses, permits, restrictions, etc.

• They are easy to put in effect and oversee, and are effective. They don’t offer

incentives, however.

3-10 The Free Rider Problem

• free rider is someone who wants others to pay for a public good but plans to use the good

themselves; if many people act as free riders, the public good may never be provided.

• Markets often have a difficult time producing public goods because free riders attempt to use

the public good without paying for it.

• The free rider problem can be overcome through measures that ensure the users of a public

good pay for it. Such measures include government actions, social pressures, and collecting

payments—in specific situations where markets have discovered a way to do so.

• The free rider problem is an economic concept of market failure that occurs when people enjoy

a shared resource without having to contribute to it.

• Private companies usually can't profit from providing public goods, so they're usually supplied

by the government and paid for with tax dollars.

• Solutions to the free rider problems vary depending on how you expect consumers to behave.

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 In many contexts, all of the individual members of a group can benefit from the efforts of each

member and all can benefit substantially from collective action. For example, if each of us

pollutes less by paying a bit extra for our cars, we all benefit from the reduction of harmful

gases in the air we breathe and even in the reduced harm to the ozone layer that protects us

against exposure to carcinogenic ultraviolet radiation (although those with fair skin benefit far

more from the latter than do those with dark skin). If all of us or some subgroup of us prefer

the state of affairs in which we each pay this bit over the state of affairs in which we do not,

then the provision of cleaner air is a collective good for us. (If it costs more than it is worth to

us, then its provision is not a collective good for us.)

• Unfortunately, my polluting less does not matter enough for anyone—especially me—to

notice. Therefore, I may not contribute my share toward not fouling the atmosphere. I may be

a free rider (or free rider) on the beneficial actions of others. A free rider, most broadly

speaking, is someone who receives a benefit without contributing towards the cost of its

production. The free rider problem is that the efficient production of important collective

goods by free agents is jeopardized by the incentive each agent has not to pay for it: if the

supply of the good is inadequate, one’s own action of paying will not make it adequate; if the

supply is adequate, one can receive it without paying. This is a compelling application of

the logic of collective action, an application of such grave import that we pass laws to regulate

the behavior of individuals to force them to pollute less.

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 • In economics, goods are defined by two characteristics: excludability and rivalry. Excludability

means that once the good is provided, you can exclude people from using it even if they didn't

pay to use it. Rivalry means that one person's consumption of a good means that another person

cannot consume that good, or their own use is detracted.

• The free rider problem is a market failure that occurs when a good is non-rivalrous and non-

excludable, also known as a public good. Once a public good is established, "benefits are all

privatized, cost is all socialized," In other words, people can consume the good without having

to pay their fair share in its upkeep

• Because of the free rider problem, the costs of maintaining a public good heavily outweigh any

profits that they might make, which discourages private companies from producing them

through the free market. It usually falls upon the government to provide these goods, such as

national defense or transportation infrastructure.

• These public goods can avoid the free rider problem because technically you are paying the

government to provide these services — through taxes. However, in small-scale scenarios

where a community is trying to provide a public good, it can be difficult to overcome free

riders.

3-11 Example of the free rider problem

• As an example of a free rider problem, let's say the neighborhood association is taking

donations to refurbish the neighborhood sidewalk. If they raise enough money, they can redo

the entire neighborhood's sidewalks. This means that even if you don't donate, you'll still be

able to enjoy the benefits of this neighborhood project.

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 • Unfortunately, if everyone comes to this realization, there's very little incentive for any

individual person to donate. Assuming that everyone in your neighborhood acts solely in their

self-interest, chances are, your neighborhood will be stuck with the old, cracked neighborhood

until someone fixes it. Therein lies the free rider problem.

3-12 How to solve the free rider problem

• Private companies find it difficult to produce public goods. If a good or service is

nonexcludable—like national defense—it is impossible or very costly to exclude people from

using the good or service. So how can a firm charge people for it?

• When individuals make decisions about buying a public good, a free-rider problem can arise—

people have an incentive to let others pay for the public good and then to “free ride” on the

purchases of others.

• The best way to pay for public goods is to find a way of ensuring that everyone will make a

contribution, thus preventing free riders. For example, if people come together through the

political process and agree to pay taxes and make group decisions about the quantity of public

goods, they can defeat the free rider problem by requiring—through the law—that everyone

contribute.

• Interestingly, solutions vary based on how you expect consumers to behave or, in other words,

if you think people are selfish or altruistic.

3-12-1 Social pressures and personal appeals

• In some cases, social pressures and personal appeals can be used—instead of the force of law—

to reduce the number of free riders and to collect resources for the public good.For example,

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 neighbors sometimes form an association to carry out beautification projects or to patrol their

area after dark to discourage crime. In low-income countries, where social pressure strongly

encourages all farmers to participate, farmers in a region may come together to work on a large

irrigation project that will benefit all. Many fundraising efforts, including raising money for

local charities and for the endowments of colleges and universities, also can be viewed as an

attempt to use social pressure to discourage free riding and to generate an outcome that will

produce a public benefit.

• 3-12-2 Privatize public goods: In an economic view where people are inherently self-

interested, you can't count on consumers contributing to a public good. If you believe this,

Kushwaha says, "you can never have a completely free public good that is sustainable in the

future forever. It eventually will fail.

• One solution would be to privatize the public good and make it excludable or get rid of it

entirely. For example, certain gated parks are only accessible to residents in the surrounding

area. In our sidewalk situation, a homeowners association might just scrap the project and

implement requirements for homeowners to maintain the section of the sidewalk in front of

their house.

• 3-12-3 Appeal to altruism: In most economic models, we assume that consumers are rational,

which means that they will make choices based on what's most beneficial to them. Though this

assumption makes economic theory easier on larger scales, this isn't necessarily true in

practice. People are not always rational in the way that economics assumes they are, which

offers a way to combat the free rider problem.

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 • Instead of taking away the choice of whether or not to contribute to a public good, this approach

encourages people to contribute because it's the right thing to do. In our sidewalk example, this

might mean contributing to the sidewalk fund for no reason other than that you feel obligated

to as a member of the community.

• 3-12-4 Incentivize contributions: Offering an incentive to contribute to a public good

lies somewhere between this spectrum of human behavior. An incentive gives potential free

riders a reason to contribute even if they could enjoy a public good without it.

• These incentives don't necessarily need to have monetary value. Instead, they can be symbolic.

3-13 Explaining Collective Action

The facts that there is a lot of collective action even in many large-number contexts in which the

individuals do not have rich relationships with each other and that, therefore, many people are not free

riding in relevant contexts suggest at least three possibilities. First, there are ways to affect the

incentives of group members to make it their interest to contribute. Second, motivations other than

self-interest may be in play. Third, the actors in the seemingly successful collective actions fail to

understand their own interests. Each of these possibilities is important and interesting, and the latter

two are philosophically interesting. Each is also supported by extensive empirical evidence.

In the first category are the by-product theory proposed by Olson and the possibility that political

entrepreneurs, at least partially acting in their own interest, can engineer provisions. In the by-product

theory, I might contribute to my group’s effort because the group ties my contribution to provision of

some private good that I want, such as participation in the Sierra Club’s outdoor activities or, in the

early days of unions, low-cost group-insurance benefits not available in the market. Such private goods

can commonly be provided in the market, so that their usefulness may eventually be undercut. Indeed,

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firms that provide insurance benefits to their employees thereby undercut one of the appeals of union

membership. The general decline of American unions in recent decades is partially the result of their

success in resolving problems for workers in ways that do not require continuing union effort.

When collective goods can be supplied by government or some other agency, political entrepreneurs

might organize the provision. For example, Senator Howard Metzenbaum worked to get legislation

on behalf of the poor and of unions, although he was certainly not poor and was not himself a working

member of a union. Yet he benefited from his efforts in support of these groups if they voted to keep

him in office. Because there is government, collective action of many kinds is far more likely than we

might expect from the dismal logic of collective action.

Turn now to the assumption of self-interest. In generalizing from the motive of self-interest to the

explanation and even justification of actions and institutions, Hobbes wished to reduce political theory

to an analog of geometry or physics, so that it would be a deductive science. All of the statements of

the logic of collective action above are grounded in an assumption of the self-interested incentives of

the actors. When the number of members of a group that would benefit from collective action is small

enough, we might expect cooperation that results from extensive interaction, mutual monitoring, and

even commitments to each other that trump or block narrowly self-interested actions. But when the

group is very large, free riding is often clearly in the interest of most and perhaps all members.

Against the assumption of purely self-interested behavior, we know that there are many active, more

or less well funded groups that seek collective results that serve interests other than those of their own

members. For a trivial example, none of the hundreds of people who have been members of the

American League to Abolish Capital Punishment is likely to have had a personal stake in whether

there is a death penalty (Schattschneider 1960, 26). In our time, thousands of people are evidently

willing to die for their causes (and not simply to risk dying—we already do that when we merely drive

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to a restaurant for dinner). Perhaps some of these people act from a belief that they will receive an

eternal reward for their actions, so that their actions are consistent with their interests.

Finally turn to the possible role of misunderstanding in leading people to act for collective provisions.

Despite the fact that people regularly grasp the incentive to free ride on the efforts of others in many

contexts, it is also true that the logic of collective action is hard to grasp in the abstract. The cursory

history above suggests just how hard it was to come to a general understanding of the problem.

Today, there are thousands of social scientists and philosophers who do understand it and maybe far

more who still do not. But in the general population, few people grasp it. Those who teach these issues

regularly discover that some students insist that the logic is wrong, that it is, for example, in the interest

of workers to pay dues voluntarily to unions or that it is in one’s interest to vote. If the latter is true,

then about half of voting-age Americans evidently act against their own interests every quadrennial

election year.

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Review questions:
Choose The correct answer:

Q1 : An allocation ins Pareto-efficient in no reallocation of resources would make some people

without making others

A) worse off, worse off

B) better off, better off

C) better off, worse off

D) equal, unequal

Q2 The effect of a tax to offset a negative externality will be to

A) quantity

B) reduce, reduce

C) increase, increase

D) increase, reduce

E) reduce, increase

Q3: Taxes creat a wedge between the sales price and purchase price that prevents the price system

equating and _

F) marginal costs, marginal benefits

G) demand, supply

H) marginal cost, marginal revenue

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 I) marginal cost, average cost

Q.4: A competitive equilibrium is Pareto-efficient

A) True

B) False

Q.5: We cannot say whether one allocation of resources is better than another allocation because

A) some people cant count

B) some people may not be permanent residents

C) not all economic activity is legal

D) we cant make value judgeements to compare different people’s welfare

Q.6: A competitive equilibrium is Pareto-efficient because

A) producers are price takers

B) consumers and producers face the same prices

C) marginal costs and benefits are equal

D) prices equal marginal cost and benefit

E) all of the above

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Q.7: The allocation of resources is not efficient if _

A) the marginal cost of production does not equal society’s marginal benefit

B) the distribution is inequitable

C) economic growth is low

D) unemployment is high

Q.8: If my neighbor burns garden waste causing my house to fill with smoke this is an example of

A) a production externality

B) a second-best solution

C) transaction costs

D) a consumption externality

Q.9: Externalities arise because there is a divergence between _ and

A) private costs, private benefits

B) private costs, social costs or benefits

C) social costs, social benefit

D) insiders, outsiders

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Q.10: Market failure may arise because of

A) imperfect competition

B) taxation

C) externalities

D) missing markets

E) all of the above

Q.11: Markets sometimes fail to exist because of

J) externalities

K) the free-rider problem

L) poor transport

M) a and b

N) a and c

Q.12: A good example of a public good is _

O) public transport

P) the national health service

Q) national defence

R) rail transport

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Q.13: If the consumption of a good by one person does not reduce the quantity available by others

and nobody can be easily excluded from consumption, we are referring to a

S) private good

T) merit good

U) public good

V) abundant good.

Q.14: Satellite television subscription and television detection devices are ways in which

broadcasting companies address the _ problem.

W) externality

X) market imperfection

Y) deadweight burden

Z) free-rider

Q.15: Taxes to offset externalities are distortionary

AA) True

BB) False

Q.16: Except for taxes to offset , taxes are

CC) imperfect competition, popular

DD) externalities, distortionary

EE) inequality, a first best option

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FF) poor health, unnecessary

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Chapter Four
Inflation & Unemployment
Introduction
Inflation refers to a rise in prices that causes the purchasing power of a nation to fall. Inflation is

abnormal economic development as long as the annual percentage remains low; once the percentage

rises over a pre-determined level, it is considered an inflation crisis. The term "inflation" once referred

to increases in the money supply (monetary inflation); however, economic debates about the

relationship between money supply and price levels have led to its primary use today in describing

price inflation. Inflation can also be described as a decline in the real value of money.

A loss of purchasing power in the medium of exchange which is also the monetary unit of account.

When the general price level rises, each unit of currency buys fewer goods and services. A

chief measure of general price-level inflation is the general inflation rate, which is the percentage

change in general price index, normally the Consumer Price Index, over time. Inflation can cause

adverse effects on the economy. For example, uncertainty about future inflation may discourage

investment and saving. High inflation may lead to shortages of goods if consumers begin hoarding out

of concern that prices will increase in the future. Economists generally agree that high rates of inflation

and hyperinflation are caused by an excessive growth of the money supply. Views on which factors

determine low to moderate rates of inflation are more varied. Low or moderate inflation may be

attributed to fluctuations in real demand for goods and services, or changes in available supplies such

as during scarcities, as well as to growth in the money supply.

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However, the consensus view is that a long sustained period of inflation is caused by money supply

growing faster than the rate of economic growth. Today, most economists favor a low steady rate of

inflation. Low (as opposed to zero or negative) inflation may reduce the severity of economic

recessions by enabling the labor market to adjust more quickly in a downturn, and reducing the risk

that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the

rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary

authorities are the central banks that control the Size of the money supply through the setting of interest

rates, through open market operations, and through the setting of banking reserve requirement set to

adjust more quickly in a downturn, and reducing the risk that a liquidity trap prevents monetary policy

from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given

to monetary authorities. Generally, these monetary authorities are the central banks that control the

size of the money supply through the setting of interest rates, through open market operations, and

through the setting of banking reserve requirements

4-1 TYPES OF INFLATION

There are many types of inflation.

4-1-1 DEMAND-PULL
The most important inflation is called demand-pull or excess demand inflation. It occurs when the

total demand for goods and services in an economy exceeds the available supply, so the prices for

them rise in a market economy

4-1-2 COST-PUSH INFLATION

Another type of inflation is called cost-push inflation. The name suggests the cause--costs

of production rise, for one reason or another, and force up the prices of finished goods and services.

Often a rise in wages in excess of any gains in labor productivity is what raises unit costs of production

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and thus raises prices. This is less common than demand-pull, but can occur independently as well as

in conjunction with it.

4-1-3 PRICING POWER INFLATION

A third type of inflation could be called pricing power inflation, but is more frequently called

administered price inflation. It occurs whenever businesses in general decide to boost their prices to

increase their profit margins. This does not occur normally in recessions but when the economy is

booming and sales are strong.

4-1-4 SECTORIAL INFLATION

The fourth type is called sectorial inflation. The term applies whenever any of the other three factors

hits a basic industry causing inflation there, and since the industry hit is a major supplier of many other

industries, as for example steel is, or oil is, that raises costs of the industries using say steel or oil, and

forces up prices there also, so inflation becomes more widespread throughout the economy, although

it originated in just one basic sector.

4-1-5 BUILT-IN INFLATION

induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers

trying to keep their wages up (gross wages have to increase above the CPI rate to net to CPI after-tax)

with prices and then employers passing higher costs on to consumers as higher prices as part of a

"vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover

inflation.

CAUSES OF INFLATION
There are many causes for inflation, depending on a number of factors.

EXCESS MONEY PRINTING

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Inflation can happen when governments print an excess of money to deal with a crisis. As a result,

prices end up rising at an extremely high speed to keep up with the currency surplus. In which prices

are forced upwards because of a high demand.

HIGH PRODUCTION COST

Another common cause of inflation is a rise in production costs, which leads to an increase in the price

of the final product. For example, if raw materials increase in price, this leads to the cost of production

increasing which in turn leads to the company increasing prices to maintain steady profits. Rising labor

costs can also lead to inflation. As workers demand wage increases, companies usually chose to pass

on those costs to their customers.

INTERNATIONAL LENDING AND NATIONAL DEBTS

Inflation can also be caused by international lending and national debts. As nations borrow money,

they have to deal with interests, which in the end cause prices to rise as a way of keeping up with their

debts. A deep drop of the exchange rate can also result in inflation, as governments will heat deal with

differences in the import/export level.

FEDERAL TAXES
Finally, inflation can be caused by federal taxes put on consumer products such as cigarettes or fuel.

As the taxes rise, suppliers often pass on the burden to the consumer; the catch, however, is that once

prices have increased, they rarely go back, even if the taxes are later reduced. For example arise in the

rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard

rate of Value Added Tax or an extension to the range of products to which VAT is applied. These

taxes are levied on producers (suppliers) who, depending on the price elasticity of demand and supply

for their products, can opt to pass on the burden of the tax onto consumers. For example, if the

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government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in

cost-push inflation.

EFFECTS OF INFLATION
Most effects of inflation are negative, and can hurt individuals and companies alike, below is a list

of negative and

“positive” effects of inflation

NEGATIVE EFFECTS
Hoarding (people will try to get rid of cash before it is devalued, by hoarding food and other

commodities creating shortages of the hoarded objects).

Distortion of relative prices (usually the prices of goods go higher, especially the prices

of commodities).

Increased risk - Higher uncertainties (uncertainties in business always exist, but with inflation risks

are very high, because of the instability of prices).

Income diffusion effect (which is basically an operation of income redistribution).

Existing creditors will be hurt (because the value of the money they will receive from their borrowers

later will be lower than the money they gave before).

Fixed income recipients will be hurt (because while inflation increases, their income doesn’t Increase,

and therefore their income will have less value over time).

Increased consumption ratio at the early stages of inflation (people will be consuming more because

money is more abundant and its value is not lowered yet).

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Lowers national saving (when there is a high inflation, saving money would mean watching your cash

decrease in value day after day, so people tend to spend the cash on something else).

Illusions of making profits (companies will think they were making profits while in reality they’re

losing money if they don’t take into consideration the inflation rate when calculating

Profits).

Causes an increase in tax bracket (people will be taxed a higher percentage of their income increases

following an inflation increase).

Causes mal-investment (in inflation times, the data given about an investment is often deceptive and

unreliable, therefore causing losses in investments)

Causes business cycles (many companies will have to go out of business because of the losses they

incurred from inflation and its effects).

Currency debasement (which lowers the value of a currency, and sometimes cause a new currency to

be born)

Rising prices of imports (if the currency is debased, then it’s purchasing power in the International

market is lower).

POSITIVE EFFECTS
It can benefit the inflators (those responsible for the inflation)

It can benefit early and first recipients of the inflated money (because the negative effects of inflation

are not there yet).

It can benefit the cartels (it benefits big cartels, destroys small sellers, and can cause price control set

by the cartels for their own benefits).

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It might relatively benefit borrowers who will have to pay the same amount of money they borrowed

(+ fixed interests), but the inflation could be higher than the interests; therefore they will be paying

less money back. (example, you borrowed $1000 in 2005 with a 5% fixed

Interest rate and you paid it back in full in 2007, let’s suppose the inflation rate for 2005,

2006 and 2007 has been 15%, you were charged %5 of interests, but in reality, you were earning %10

of interests, because 15% (inflation rate)

– 5% (interests) = %10 profit, which means you have paid only 70% of the real value in the 3 years.

Note: Banks are aware of this problem, and when inflation rises, their interest rates might rise as well.

So don't take out loans based on this information.

Many economists favor a low steady rate of inflation, low (as opposed to zero or negative)inflation

may reduce the severity of economic recessions by enabling the labor market to adjust more quickly

in a downturn, and reducing the risk that a liquidity trap prevents monetary policy from stabilizing the

economy.

The task of keeping the rate of inflation low and stable is usually given to monetary authorities.

Generally, these monetary authorities are the central banks that control the size of the money supply

through the setting of interest rates, through open market operations, and through the setting of banking

reserve requirements.

Tobin effect argues that: a moderate level of inflation can increase investment in an economy leading

to faster growth or at least higher steady state level of income. This is due to the fact that inflation

lowers the return on monetary assets relative to real assets, such as physical capital. To avoid inflation,

investors would switch from holding their assets as money (or a similar, susceptible to inflation, form)

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to investing in real capital projects. The first three effects are only positive to a few elite, and therefore

might not be considered positive by the general public.

The most commonly cited measure of inflation in the United States is the Consumer Price Index (CPI).

Government statisticians at the U.S. Bureau of Labor Statistics calculate the CPI based on the prices

in a fixed basket of goods and services that represents the purchases of the average family of four. In

recent years, the statisticians have paid considerable attention to a subtle problem: that the change in

the total cost of buying a fixed basket of goods and services over time is conceptually not quite the

same as the change in the cost of living, because the cost of living represents how much it costs for a

person to feel that his or her consumption provides an equal level of satisfaction or utility.

1. To understand the distinction, imagine that over the past 10 years, the cost of purchasing a

fixed basket of goods increased by 25% and your salary also increased by 25%. Has your

personal standard of living held constant? If you do not necessarily purchase an identical fixed

basket of goods every year, then an inflation calculation based on the cost of a fixed basket of

goods may be a misleading measure of how your cost of living has changed. Two problems

arise here: substitution bias and quality/new goods bias.

2. When the price of a good rises, consumers tend to purchase less of it and to seek out substitutes

instead. Conversely, as the price of a good falls, people will tend to purchase more of it. This

pattern implies that goods with generally rising prices should tend over time to become less

important in the overall basket of goods used to calculate inflation, while goods with falling

prices should tend to become more important. Consider, as an example, a rise in the price of

peaches by $100 per pound. If consumers were utterly inflexible in their demand for peaches,

this would lead to a big rise in the price of food for consumers. Alternatively, imagine that

people are utterly indifferent to whether they have peaches or other types of fruit. Now, if

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 peach prices rise, people completely switch to other fruit choices and the average price of food

does not change at all. A fixed and unchanging basket of goods assumes that consumers are

locked into buying exactly the same goods, regardless of price changes—not a very likely

assumption. Thus, substitution bias—the rise in the price of a fixed basket of goods over

time—tends to overstate the rise in a consumer’s true cost of living, because it does not take

into account that the person can substitute away from goods whose relative prices have risen.

3. The other major problem in using a fixed basket of goods as the basis for calculating inflation

is how to deal with the arrival of improved versions of older goods or altogether new goods.

Consider the problem that arises if a cereal is improved by adding 12 essential vitamins and

minerals—and also if a box of the cereal costs 5% more. It would clearly be misleading to

count the entire resulting higher price as inflation, because the new price reflects a higher

quality (or at least different) product. Ideally, one would like to know how much of the higher

price is due to the quality change, and how much of it is just a higher price. The Bureau of

Labor Statistics, which is responsible for computing the Consumer Price Index, must deal with

these difficulties in adjusting for quality changes.

4. We can think of a new product as an extreme improvement in quality—from something that

did not exist to something that does. However, the basket of goods that was fixed in the past

obviously does not include new goods created since then. The basket of goods and services in

the Consumer Price Index (CPI) is revised and updated over time, and so new products are

gradually included. However, the process takes some time. For example, room air conditioners

were widely sold in the early 1950s, but were not introduced into the basket of goods behind

the Consumer Price Index until 1964. The VCR and personal computer were available in the

late 1970s and widely sold by the early 1980s, but did not enter the CPI basket of goods until

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 1987. By 1996, there were more than 40 million cellular phone subscribers in the United

States—but cell phones were not yet part of the CPI basket of goods. The parade of inventions

has continued, with the CPI inevitably lagging a few years behind.

5. The arrival of new goods creates problems with respect to the accuracy of measuring inflation.

The reason people buy new goods, presumably, is that the new goods offer better value for

money than existing goods. Thus, if the price index leaves out new goods, it overlooks one of

the ways in which the cost of living is improving. In addition, the price of a new good is often

higher when it is first introduced and then declines over time. If the new good is not included

in the CPI for some years, until its price is already lower, the CPI may miss counting this price

decline altogether. Taking these arguments together, the quality/new goods bias means that the

rise in the price of a fixed basket of goods over time tends to overstate the rise in a consumer’s

true cost of living, because it does not account for how improvements in the quality of existing

goods or the invention of new goods improves the standard of living. The following Clear It

Up feature is a must-read on how statisticians comprise and calculate the CPI.

6. When the U.S. Bureau of Labor Statistics (BLS) calculates the Consumer Price Index, the first

task is to decide on a basket of goods that is representative of the purchases of the average

household. We do this by using the Consumer Expenditure Survey, a national survey of about

7,000 households, which provides detailed information on spending habits. Statisticians divide

consumer expenditures into eight major groups (seen below), which in turn they divide into

more than 200 individual item categories. The BLS currently uses 1982–1984 as the base

period.

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7. For each of the 200 individual expenditure items, the BLS chooses several hundred very

specific examples of that item and looks at the prices of those examples. In figuring out the

“breakfast cereal” item under the overall category of “foods and beverages,” the BLS picks

several hundred examples of breakfast cereal. One example might be the price of a 24-oz. box

of a particular brand of cereal sold at a particular store. The BLS statistically selects specific

products and sizes and stores to reflect what people buy and where they shop. The basket of

goods in the Consumer Price Index thus consists of about 80,000 products; that is, several

hundred specific products in over 200 broad-item categories. Statisticians rotate about one-

quarter of these 80,000 specific products of the sample each year, and replace them with a

different set of products.

8. The next step is to collect data on prices. Data collectors visit or call about 23,000 stores in 87

urban areas all over the United States every month to collect prices on these 80,000 specific

products. The BLS also conducts a survey of 50,000 landlords or tenants to collect information

about rents.

9. Statisticians then calculate the Consumer Price Index by taking the 80,000 prices of individual

products and combining them, using weights (see Figure 22.2) determined by the quantities of

these products that people buy and allowing for factors like substitution between goods and

quality improvements, into price indices for the 200 or so overall items. Then, the statisticians

combine the price indices for the 200 items into an overall Consumer Price Index. According

the Consumer Price Index website, there are eight categories that data collectors use:

10. The Eight Major Categories in the Consumer Price Index

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11. Food and beverages (breakfast cereal, milk, coffee, chicken, wine, full-service meals, and

snacks)

12. Housing (renter’s cost of housing, homeowner’s cost of housing, fuel oil, bedroom furniture)

13. Apparel (men’s shirts and sweaters, women’s dresses, jewelry)

14. Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance)

15. Medical care (prescription drugs and medical supplies, physicians’ services, eyeglasses and

eye care, hospital services)

16. Recreation (televisions, cable television, pets and pet products, sports equipment, admissions)

17. Education and communication (college tuition, postage, telephone services, computer software

and accessories)

18. Other goods and services (tobacco and smoking products, haircuts and other personal services,

funeral expenses)

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Figure 22.2 The Weighting of CPI Components Of the eight categories used to generate the Consumer

Price Index, housing is the highest at 42.7%. The next highest category, food and beverage at 15.3%,

is less than half the size of housing. Other goods and services, and apparel, are the lowest at 3.4% and

3.3%, respectively. (Source: www.bls.gov/cpi)

The CPI and Core Inflation Index

19. Imagine if you were driving a company truck across the country- you probably would care

about things like the prices of available roadside food and motel rooms as well as the truck’s

operating condition. However, the manager of the firm might have different priorities. He

would care mostly about the truck’s on-time performance and much less so about the food you

were eating and the places you were staying. In other words, the company manager would be

paying attention to the firm's production, while ignoring transitory elements that impacted you,

but did not affect the company’s bottom line.

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20. In a sense, a similar situation occurs with regard to measures of inflation. As we’ve learned,

CPI measures prices as they affect everyday household spending. Economists typically

calculate a core inflation index by taking the CPI and excluding volatile economic variables.

In this way, economists have a better sense of the underlying trends in prices that affect the

cost of living.

21. Examples of excluded variables include energy and food prices, which can jump around from

month to month because of the weather. According to an article by Kent Bernhard, during

Hurricane Katrina in 2005, a key supply point for the nation’s gasoline was nearly knocked

out. Gas prices quickly shot up across the nation, in some places by up to 40 cents a gallon in

one day. This was not the cause of an economic policy but rather a short-lived event until the

pumps were restored in the region. In this case, the CPI that month would register the change

as a cost of living event to households, but the core inflation index would remain unchanged.

As a result, the Federal Reserve’s decisions on interest rates would not be influenced.

Similarly, droughts can cause world-wide spikes in food prices that, if temporary, do not affect

the nation’s economic capability.

22. As former Chairman of the Federal Reserve Ben Bernanke noted in 1999 about the core

inflation index, “It provide(s) a better guide to monetary policy than the other indices, since it

measures the more persistent underlying inflation rather than transitory influences on the price

level.” Bernanke also noted that it helps communicate that the Federal Reserve does not need

to respond to every inflationary shock since some price changes are transitory and not part of

a structural change in the economy.

23. In sum, both the CPI and the core inflation index are important, but serve different audiences.

The CPI helps households understand their overall cost of living from month to month, while

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 the core inflation index is a preferred gauge from which to make important government policy

changes.

Practical Solutions for the Substitution and the Quality/New Goods Biases

24. By the early 2000s, the Bureau of Labor Statistics was using alternative mathematical methods

for calculating the Consumer Price Index, more complicated than just adding up the cost of a

fixed basket of goods, to allow for some substitution between goods. It was also updating the

basket of goods behind the CPI more frequently, so that it could include new and improved

goods more rapidly. For certain products, the BLS was carrying out studies to try to measure

the quality improvement. For example, with computers, an economic study can try to adjust

for changes in speed, memory, screen size, and other product characteristics, and then calculate

the change in price after accounting for these product changes. However, these adjustments are

inevitably imperfect, and exactly how to make these adjustments is often a source of

controversy among professional economists.

25. By the early 2000s, the substitution bias and quality/new goods bias had been somewhat

reduced, so that since then the rise in the CPI probably overstates the true rise in inflation by

only about 0.5% per year. Over one or a few years, this is not much. Over a period of a decade

or two, even half of a percent per year compounds to a more significant amount. In addition,

the CPI tracks prices from physical locations, and not at online sites like Amazon, where prices

can be lower.

26. When measuring inflation (and other economic statistics, too), a tradeoff arises between

simplicity and interpretation. If we calculate the inflation rate with a basket of goods that is

fixed and unchanging, then the calculation of an inflation rate is straightforward, but the

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 problems of substitution bias and quality/new goods bias will arise. However, when the basket

of goods is allowed to shift and evolve to reflect substitution toward lower relative prices,

quality improvements, and new goods, the technical details of calculating the inflation rate

grow more complex.

Additional Price Indices: PPI, GDP Deflator, and More

27. The basket of goods behind the Consumer Price Index represents an average hypothetical U.S.

household's consumption, which is to say that it does not exactly capture anyone’s personal

experience. When the task is to calculate an average level of inflation, this approach works

fine. What if, however, you are concerned about inflation experienced by a certain group, like

the elderly, or the poor, or single-parent families with children, or Hispanic-Americans? In

specific situations, a price index based on the buying power of the average consumer may not

feel quite right.

28. This problem has a straightforward solution. If the Consumer Price Index does not serve the

desired purpose, then invent another index, based on a basket of goods appropriate for the

group of interest. The Bureau of Labor Statistics publishes a number of experimental price

indices: some for particular groups like the elderly or the poor, some for different geographic

areas, and some for certain broad categories of goods like food or housing.

29. The BLS also calculates several price indices that are not based on baskets of consumer goods.

For example, the Producer Price Index (PPI) is based on prices paid for supplies and inputs by

producers of goods and services. We can break it down into price indices for different

industries, commodities, and stages of processing (like finished goods, intermediate goods, or

crude materials for further processing). There is an International Price Index based on the

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 prices of merchandise that is exported or imported. An Employment Cost Index measures

wage inflation in the labor market. The GDP deflator, which the Bureau of Economic Analysis

measures, is a price index that includes all the GDP components (that is, consumption plus

investment plus government plus exports minus imports). Unlike the CPI, its baskets are not

fixed but re-calculate what that year’s GDP would have been worth using the base-year’s

prices. MIT's Billion Prices Project is a more recent alternative attempt to measure prices:

economists collect data online from retailers and then put them into an index that they compare

to the CPI (Source: http://bpp.mit.edu/usa/).

30. What’s the best measure of inflation? If one is concerned with the most accurate measure of

inflation, one should use the GDP deflator as it picks up the prices of goods and services

produced. However, it is not a good measure of the cost of living as it includes prices of many

products not purchased by households (for example, aircraft, fire engines, factory buildings,

office complexes, and bulldozers). If one wants the most accurate measure of inflation as it

impacts households, one should use the CPI, as it only picks up prices of products purchased

by households. That is why economists sometimes refer to the CPI as the cost-of-living index.

As the Bureau of Labor Statistics states on its website: “The ‘best’ measure of inflation for a

given application depends on the intended use of the data.”

• The relationship between inflation rates and unemployment rates is inverse. Graphically, this

means the short-run Phillips curve is L-shaped.

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 • A.W. Phillips published his observations about the inverse correlation between wage changes

and unemployment in Great Britain in 1958. This relationship was found to hold true for other

industrial countries, as well.

• From 1861 until the late 1960’s, the Phillips curve predicted rates of inflation and rates of

unemployment. However, from the 1970’s and 1980’s onward, rates of inflation and

unemployment differed from the Phillips curve’s prediction. The relationship between the two

variables became unstable.

• Phillips curve: A graph that shows the inverse relationship between the rate of unemployment

and the rate of inflation in an economy.

• stagflation: Inflation accompanied by stagnant growth, unemployment, or recession.

The Phillips curve relates the rate of inflation with the rate of unemployment. The Phillips curve argues that

unemployment and inflation are inversely related: as levels of unemployment decrease, inflation increases.

The relationship, however, is not linear. Graphically, the short-run Phillips curve traces an L-shape when

the unemployment rate is on the x-axis and the inflation rate is on the y-axis.

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Theoretical Phillips Curve: The Phillips curve shows the inverse trade-off between inflation and

unemployment. As one increases, the other must decrease. In this image, an economy can either experience

3% unemployment at the cost of 6% of inflation, or increase unemployment to 5% to bring down the

inflation levels to 2%.

History

The early idea for the Phillips curve was proposed in 1958 by economist A.W. Phillips. In his original paper,

Phillips tracked wage changes and unemployment changes in Great Britain from 1861 to 1957, and found

that there was a stable, inverse relationship between wages and unemployment. This correlation between

wage changes and unemployment seemed to hold for Great Britain and for other industrial countries. In

1960, economists Paul Samuelson and Robert Solow expanded this work to reflect the relationship between

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inflation and unemployment. Because wages are the largest components of prices, inflation (rather than

wage changes) could be inversely linked to unemployment.

The theory of the Phillips curve seemed stable and predictable. Data from the 1960’s modeled the trade-off

between unemployment and inflation fairly well. The Phillips curve offered potential economic policy

outcomes: fiscal and monetary policy could be used to achieve full employment at the cost of higher price

levels, or to lower inflation at the cost of lowered employment. However, when governments attempted to

use the Phillips curve to control unemployment and inflation, the relationship fell apart. Data from the

1970’s and onward did not follow the trend of the classic Phillips curve. For many years, both the rate of

inflation and the rate of unemployment were higher than the Phillips curve would have predicted, a

phenomenon known as “stagflation. ” Ultimately, the Phillips curve was proved to be unstable, and

therefore, not usable for policy purposes.

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 US

Phillips Curve (2000 – 2013): The data points in this graph span every month from January 2000 until

April 2013. They do not form the classic L-shape the short-run Phillips curve would predict. Although it

was shown to be stable from the 1860’s until the 1960’s, the Phillips curve relationship became unstable –

and unusable for policy-making – in the 1970’s.

The Relationship Between the Phillips Curve and AD-AD

Changes in aggregate demand cause movements along the Phillips curve, all other variables held constant.

• Aggregate demand and the Phillips curve share similar components. The rate of unemployment

and rate of inflation found in the Phillips curve correspond to the real GDP and price level of

aggregate demand.

• Changes in aggregate demand translate as movements along the Phillips curve.

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 • If there is an increase in aggregate demand, such as what is experienced during demand-pull

inflation, there will be an upward movement along the Phillips curve. As aggregate demand

increases, real GDP and price level increase, which lowers the unemployment rate and

increases inflation.

Key Terms

• Phillips curve: A graph that shows the inverse relationship between the rate of unemployment

and the rate of inflation in an economy.

• aggregate demand: The the total demand for final goods and services in the economy at a

given time and price level.

The Phillips Curve Related to Aggregate Demand

The Phillips curve shows the inverse trade-off between rates of inflation and rates of unemployment. If

unemployment is high, inflation will be low; if unemployment is low, inflation will be high.

The Phillips curve and aggregate demand share similar components. The Phillips curve is the relationship

between inflation, which affects the price level aspect of aggregate demand, and unemployment, which is

dependent on the real output portion of aggregate demand. Consequently, it is not far-fetched to say that the

Phillips curve and aggregate demand are actually closely related.

To see the connection more clearly, consider the example illustrated by. Let’s assume that aggregate supply,

AS, is stationary, and that aggregate demand starts with the curve, AD1. There is an initial equilibrium price

level and real GDP output at point A. Now, imagine there are increases in aggregate demand, causing the

curve to shift right to curves AD2 through AD4. As aggregate demand increases, unemployment decreases

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as more workers are hired, real GDP output increases, and the price level increases; this situation describes

a demand-pull inflation scenario.

Phillips Curve and Aggregate Demand: As aggregate demand increases from AD1 to AD4, the price level

and real GDP increases. This translates to corresponding movements along the Phillips curve as inflation

increases and unemployment decreases.

As more workers are hired, unemployment decreases. Moreover, the price level increases, leading to

increases in inflation. These two factors are captured as equivalent movements along the Phillips curve from

points A to D. At the initial equilibrium point A in the aggregate demand and supply graph, there is a

corresponding inflation rate and unemployment rate represented by point A in the Phillips curve graph. For

every new equilibrium point (points B, C, and D) in the aggregate graph, there is a corresponding point in

the Phillips curve. This illustrates an important point: changes in aggregate demand cause movements along

the Phillips curve.

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The Long-Run Phillips Curve

The long-run Phillips curve is a vertical line at the natural rate of unemployment, so inflation and

unemployment are unrelated in the long run.

LEARNING OBJECTIVES

Examine the NAIRU and its relationship to the long term Phillips curve

• The natural rate of unemployment is the hypothetical level of unemployment the economy

would experience if aggregate production were in the long-run state.

• The natural rate hypothesis, or the non-accelerating inflation rate of unemployment (NAIRU)

theory, predicts that inflation is stable only when unemployment is equal to the natural rate of

unemployment. If unemployment is below (above) its natural rate, inflation will accelerate

(decelerate).

• Expansionary efforts to decrease unemployment below the natural rate of unemployment will

result in inflation. This changes the inflation expectations of workers, who will adjust their

nominal wages to meet these expectations in the future. This leads to shifts in the short-run

Phillips curve.

• The natural rate hypothesis was used to give reasons for stagflation, a phenomenon that the

classic Phillips curve could not explain.

• Natural Rate of Unemployment: The hypothetical unemployment rate consistent with

aggregate production being at the long-run level.

• non-accelerating inflation rate of unemployment: (NAIRU); theory that describes how the

short-run Phillips curve shifts in the long run as expectations change.

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The Phillips curve shows the trade-off between inflation and unemployment, but how accurate is this

relationship in the long run? According to economists, there can be no trade-off between inflation and

unemployment in the long run. Decreases in unemployment can lead to increases in inflation, but only in

the short run. In the long run, inflation and unemployment are unrelated. Graphically, this means the Phillips

curve is vertical at the natural rate of unemployment, or the hypothetical unemployment rate if aggregate

production is in the long-run level. Attempts to change unemployment rates only serve to move the economy

up and down this vertical line.

Natural Rate Hypothesis

The natural rate of unemployment theory, also known as the non-accelerating inflation rate of

unemployment (NAIRU) theory, was developed by economists Milton Friedman and Edmund Phelps.

According to NAIRU theory, expansionary economic policies will create only temporary decreases in

unemployment as the economy will adjust to the natural rate. Moreover, when unemployment is below the

natural rate, inflation will accelerate. When unemployment is above the natural rate, inflation will

decelerate. When the unemployment rate is equal to the natural rate, inflation is stable, or non-accelerating.

An Example

To get a better sense of the long-run Phillips curve, consider the example shown in. Assume the economy

starts at point A and has an initial rate of unemployment and inflation rate. If the government decides to

pursue expansionary economic policies, inflation will increase as aggregate demand shifts to the right. This

is shown as a movement along the short-run Phillips curve, to point B, which is an unstable equilibrium. As

aggregate demand increases, more workers will be hired by firms in order to produce more output to meet

rising demand, and unemployment will decrease. However, due to the higher inflation, workers’

expectations of future inflation changes, which shifts the short-run Phillips curve to the right, from unstable

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equilibrium point B to the stable equilibrium point C. At point C, the rate of unemployment has increased

back to its natural rate, but inflation remains higher than its initial level.

NAIRU and Phillips Curve: Although the economy starts with an initially low level of inflation at point

A, attempts to decrease the unemployment rate are futile and only increase inflation to point C. The

unemployment rate cannot fall below the natural rate of unemployment, or NAIRU, without increasing

inflation in the long run.

The reason the short-run Phillips curve shifts is due to the changes in inflation expectations. Workers, who

are assumed to be completely rational and informed, will recognize their nominal wages have not kept pace

with inflation increases (the movement from A to B), so their real wages have been decreased. As such, in

the future, they will renegotiate their nominal wages to reflect the higher expected inflation rate, in order to

keep their real wages the same. As nominal wages increase, production costs for the supplier increase, which

diminishes profits. As profits decline, suppliers will decrease output and employ fewer workers (the

movement from B to C). Consequently, an attempt to decrease unemployment at the cost of higher inflation

in the short run led to higher inflation and no change in unemployment in the long run.

The NAIRU theory was used to explain the stagflation phenomenon of the 1970’s, when the classic Phillips

curve could not. According to the theory, the simultaneously high rates of unemployment and inflation could

be explained because workers changed their inflation expectations, shifting the short-run Phillips curve, and

increasing the prevailing rate of inflation in the economy. At the same time, unemployment rates were not

affected, leading to high inflation and high unemployment.

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 The Short-Run Phillips Curve
The short-run Phillips curve depicts the inverse trade-off between inflation and unemployment.

• The long-run Phillips curve is a vertical line at the natural rate of unemployment, but the short-

run Phillips curve is roughly L-shaped.

• The inverse relationship shown by the short-run Phillips curve only exists in the short-run;

there is no trade-off between inflation and unemployment in the long run.

• Economic events of the 1970’s disproved the idea of a permanently stable trade-off between

unemployment and inflation.

• Phillips curve: A graph that shows the inverse relationship between the rate of unemployment

and the rate of inflation in an economy.

The Phillips curve depicts the relationship between inflation and unemployment rates. The long-run Phillips

curve is a vertical line that illustrates that there is no permanent trade-off between inflation and

unemployment in the long run. However, the short-run Phillips curve is roughly L-shaped to reflect the

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initial inverse relationship between the two variables. As unemployment rates increase, inflation decreases;

as unemployment rates decrease, inflation increases.

Short-Run Phillips Curve: The short-run Phillips curve shows that in the short-term there is a tradeoff

between inflation and unemployment. Contrast it with the long-run Phillips curve (in red), which shows that

over the long term, unemployment rate stays more or less steady regardless of inflation rate.

Consider the example shown in. When the unemployment rate is 2%, the corresponding inflation rate is

10%. As unemployment decreases to 1%, the inflation rate increases to 15%. On the other hand, when

unemployment increases to 6%, the inflation rate drops to 2%.

Historical application
During the 1960’s, the Phillips curve rose to prominence because it seemed to accurately depict real-world

macroeconomics. However, the stagflation of the 1970’s shattered any illusions that the Phillips curve was

a stable and predictable policy tool. Nowadays, modern economists reject the idea of a stable Phillips curve,

but they agree that there is a trade-off between inflation and unemployment in the short-run. Given a

stationary aggregate supply curve, increases in aggregate demand create increases in real output. As output

increases, unemployment decreases. With more people employed in the workforce, spending within the

economy increases, and demand-pull inflation occurs, raising price levels.

Therefore, the short-run Phillips curve illustrates a real, inverse correlation between inflation and

unemployment, but this relationship can only exist in the short run. The idea of a stable trade-off between

inflation and unemployment in the long run has been disproved by economic history.

Relationship Between Expectations and Inflation

There are two theories of expectations (adaptive or rational) that predict how people will react to inflation.

Key Points

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 • Nominal quantities are simply stated values. Real quantities are nominal ones that have been

adjusted for inflation.

• Adaptive expectations theory says that people use past information as the best predictor of

future events. If inflation was higher than normal in the past, people will expect it to be higher

than anticipated in the future.

• Rational expectations theory says that people use all available information, past and current,

to predict future events. If inflation was higher than normal in the past, people will take that

into consideration, along with current economic indicators, to anticipate its future performance.

• According to adaptive expectations, attempts to reduce unemployment will result in temporary

adjustments along the short-run Phillips curve, but will revert to the natural rate of

unemployment. According to rational expectations, attempts to reduce unemployment will

only result in higher inflation.

• adaptive expectations theory: A hypothesized process by which people form their

expectations about what will happen in the future based on what has happened in the past.

• rational expectations theory: A hypothesized process by which people form their

expectations about what will happen in the future based on all relevant information.

The short-run Phillips curve is said to shift because of workers’ future inflation expectations. Yet, how are

those expectations formed? There are two theories that explain how individuals predict future events.

Real versus Nominal Quantities

To fully appreciate theories of expectations, it is helpful to review the difference between real and nominal

concepts. Anything that is nominal is a stated aspect. In contrast, anything that is real has been adjusted for

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inflation. To make the distinction clearer, consider this example. Suppose you are opening a savings account

at a bank that promises a 5% interest rate. This is the nominal, or stated, interest rate. However, suppose

inflation is at 3%. The real interest rate would only be 2% (the nominal 5% minus 3% to adjust for inflation).

The difference between real and nominal extends beyond interest rates. In an earlier atom, the difference

between real GDP and nominal GDP was discussed. The distinction also applies to wages, income, and

exchange rates, among other values.

Adaptive Expectations
The theory of adaptive expectations states that individuals will form future expectations based on past

events. For example, if inflation was lower than expected in the past, individuals will change their

expectations and anticipate future inflation to be lower than expected. To connect this to the Phillips curve,

consider. Assume the economy starts at point A at the natural rate of unemployment with an initial inflation

rate of 2%, which has been constant for the past few years. Accordingly, because of the adaptive

expectations theory, workers will expect the 2% inflation rate to continue, so they will incorporate this

expected increase into future labor bargaining agreements. This way, their nominal wages will keep up with

inflation, and their real wages will stay the same.

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Expectations and the Phillips Curve:
According to adaptive expectations theory, policies designed to lower unemployment
will move the economy from point A through point B, a transition period when
unemployment is temporarily lowered at the cost of higher inflation. However,
eventually, the economy will move back to the natural rate of unemployment at point C,
which produces a net effect of only increasing the inflation rate. According to rational
expectations theory, policies designed to lower unemployment will move the economy
directly from point A to point C. The transition at point B does not exist as workers are
able to anticipate increased inflation and adjust their wage demands accordingly. Now
assume that the government wants to lower the unemployment rate. To do so, it engages
in expansionary economic activities and increases aggregate demand. As aggregate
demand increases, inflation increases. Because of the higher inflation, the real wages
workers receive have decreased. For example, assume each worker receives $100, plus
the 2% inflation adjustment. Each worker will make $102 in nominal wages, but $100
in real wages. Now, if the inflation level has risen to 6%. Workers will make $102 in

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 nominal wages, but this is only $96.23 in real wages.
Although the workers’ real purchasing power declines, employers are now able to hire labor for a cheaper

real cost. Consequently, employers hire more workers to produce more output, lowering the unemployment

rate and increasing real GDP. On, the economy moves from point A to point B.

However, workers eventually realize that inflation has grown faster than expected, their nominal wages have

not kept pace, and their real wages have been diminished. They demand a 4% increase in wages to increase

their real purchasing power to previous levels, which raises labor costs for employers. As labor costs

increase, profits decrease, and some workers are let go, increasing the unemployment rate. Graphically, the

economy moves from point B to point C.

This example highlights how the theory of adaptive expectations predicts that there are no long-run trade-

offs between unemployment and inflation. In the short run, it is possible to lower unemployment at the cost

of higher inflation, but, eventually, worker expectations will catch up, and the economy will correct itself

to the natural rate of unemployment with higher inflation.

Rational Expectations
The theory of rational expectations states that individuals will form future expectations based on all available

information, with the result that future predictions will be very close to the market equilibrium. For example,

assume that inflation was lower than expected in the past. Individuals will take this past information and

current information, such as the current inflation rate and current economic policies, to predict future

inflation rates.

As an example of how this applies to the Phillips curve, consider again. Assume the economy starts at point

A, with an initial inflation rate of 2% and the natural rate of unemployment. However, under rational

expectations theory, workers are intelligent and fully aware of past and present economic variables and

change their expectations accordingly. They will be able to anticipate increases in aggregate demand and

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the accompanying increases in inflation. As such, they will raise their nominal wage demands to match the

forecasted inflation, and they will not have an adjustment period when their real wages are lower than their

nominal wages. Graphically, they will move seamlessly from point A to point C, without transitioning to

point B.

In essence, rational expectations theory predicts that attempts to change the unemployment rate will be

automatically undermined by rational workers. They can act rationally to protect their interests, which

cancels out the intended economic policy effects. Efforts to lower unemployment only raise inflation.

Shifting the Phillips Curve with a Supply Shock

Aggregate supply shocks, such as increases in the costs of resources, can cause the Phillips curve to shift.

LEARNING OBJECTIVES

Give examples of aggregate supply shock that shift the Phillips curve

KEY TAKEAWAYS

Key Points

• In the 1970’s soaring oil prices increased resource costs for suppliers, which decreased

aggregate supply. The resulting cost-push inflation situation led to high unemployment and

high inflation ( stagflation ), which shifted the Phillips curve upwards and to the right.

• Stagflation is a situation where economic growth is slow (reducing employment levels) but

inflation is high.

• The Phillips curve was thought to represent a fixed and stable trade-off between unemployment

and inflation, but the supply shocks of the 1970’s caused the Phillips curve to shift. This ruined

its reputation as a predictable relationship.

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Key Terms

• stagflation: Inflation accompanied by stagnant growth, unemployment, or recession.

• supply shock: An event that suddenly changes the price of a commodity or service. It may be

caused by a sudden increase or decrease in the supply of a particular good.

The Phillips curve shows the relationship between inflation and unemployment. In the short-run, inflation

and unemployment are inversely related; as one quantity increases, the other decreases. In the long-run,

there is no trade-off. In the 1960’s, economists believed that the short-run Phillips curve was stable. By the

1970’s, economic events dashed the idea of a predictable Phillips curve. What could have happened in the

1970’s to ruin an entire theory? Stagflation caused by a aggregate supply shock.

Stagflation and Aggregate Supply Shocks

Stagflation is a combination of the words “stagnant” and “inflation,” which are the characteristics of an

economy experiencing stagflation: stagnating economic growth and high unemployment with

simultaneously high inflation. The stagflation of the 1970’s was caused by a series of aggregate supply

shocks. In this case, huge increases in oil prices by the Organization of Petroleum Exporting Countries

(OPEC) created a severe negative supply shock. The increased oil prices represented greatly increased

resource prices for other goods, which decreased aggregate supply and shifted the curve to the left. As

aggregate supply decreased, real GDP output decreased, which increased unemployment, and price level

increased; in other words, the shift in aggregate supply created cost-push inflation.

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 Aggregate Supply Shock: In this example of a negative supply shock, aggregate supply decreases

and shifts to the left. The resulting decrease in output and increase in inflation can cause the situation

known as stagflation.

Shifting the Phillips Curve

The aggregate supply shocks caused by the rising price of oil created simultaneously high unemployment

and high inflation. At the time, the dominant school of economic thought believed inflation and

unemployment to be mutually exclusive; it was not possible to have high levels of both within an economy.

Consequently, the Phillips curve could not model this situation. For high levels of unemployment, there

were now corresponding levels of inflation that were higher than the Phillips curve predicted; the Phillips

curve had shifted upwards and to the right. Thus, the Phillips curve no longer represented a predictable

trade-off between unemployment and inflation.

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Disinflation

Disinflation is a decline in the rate of inflation, and can be caused by declines in the money supply or

recessions in the business cycle.

Key Points

• Disinflation is not the same as deflation, when inflation drops below zero.

• During periods of disinflation, the general price level is still increasing, but it is occurring

slower than before.

• The short-run and long-run Phillips curve may be used to illustrate disinflation.

Key Terms

• disinflation: A decrease in the inflation rate.

• inflation: An increase in the general level of prices or in the cost of living.

• deflation: A decrease in the general price level, that is, in the nominal cost of goods and

services.

Inflation is the persistent rise in the general price level of goods and services. Disinflation is a decline in the

rate of inflation; it is a slowdown in the rise in price level. As an example, assume inflation in an economy

grows from 2% to 6% in Year 1, for a growth rate of four percentage points. In Year 2, inflation grows from

6% to 8%, which is a growth rate of only two percentage points. The economy is experiencing disinflation

because inflation did not increase as quickly in Year 2 as it did in Year 1, but the general price level is still

rising. Disinflation is not to be confused with deflation, which is a decrease in the general price level.

Causes

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Disinflation can be caused by decreases in the supply of money available in an economy. It can also be

caused by contractions in the business cycle, otherwise known as recessions. The Phillips curve can illustrate

this last point more closely. Consider an economy initially at point A on the long-run Phillips curve in.

Suppose that during a recession, the rate that aggregate demand increases relative to increases in aggregate

supply declines. This reduces price levels, which diminishes supplier profits. As profits decline, employers

lay off employees, and unemployment rises, which moves the economy from point A to point B on the

graph. Eventually, though, firms and workers adjust their inflation expectations, and firms experience profits

once again. As profits increase, employment also increases, returning the unemployment rate to the natural

rate as the economy moves from point B to point C. The expected rate of inflation has also decreased due

to different inflation expectations, resulting in a shift of the short-run Phillips curve.

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Disinflation: Disinflation can be illustrated as movements along the short-run and long-run Phillips curves.

Inflation vs. Deflation vs. Disinflation

To illustrate the differences between inflation, deflation, and disinflation, consider the following example.

Assume the following annual price levels as compared to the prices in year 1:

• Year 1: 100% of Year 1 prices

• Year 2: 104% of Year 1 prices

• Year 3: 106% of Year 1 prices

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 • Year 4: 107% of Year 1 prices

• Year 5: 105% of Year 1 prices

As the economy moves through Year 1 to Year 4, there is a continued growth in the price level. This is an

example of inflation; the price level is continually rising. However, between Year 2 and Year 4, the rise in

price levels slows down. Between Year 2 and Year 3, the price level only increases by two percentage

points, which is lower than the four percentage point increase between Years 1 and 2. The trend continues

between Years 3 and 4, where there is only a one percentage point increase. This is an example of

disinflation; the overall price level is rising, but it is doing so at a slower rate.

Between Years 4 and 5, the price level does not increase, but decreases by two percentage points. This is an

example of deflation; the price rise of previous years has reversed itself.

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Review Questions:
Question 1

Demand pull inflation may be caused by:

a) An increase in costs

b) A reduction in interest rate

c) A reduction in government spending

d) An outward shift in aggregate supply

Question 2

Inflation:

a) Reduces the cost of living

b) Reduces the standard of living

c) Reduces the price of products

d) Reduces the purchasing power of a pound

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Question 3

An increase in injections into the economy may lead to:

a) An outward shift of aggregate demand and demand pull inflation

b) An outward shift of aggregate demand and cost push inflation

c) An outward shift of aggregate supply and demand pull inflation

d) An outward shift of aggregate supply and cost push inflation

Question 4

An increase in aggregate demand is more likely to lead to demand pull inflation if:

a) Aggregate supply is perfectly elastic

b) Aggregate supply is perfectly inelastic

c) Aggregate supply is unit elastic

d) Aggregate supply is relatively elastic

Question 5

An increase in costs will:

a) Shift aggregate demand

b) Shift aggregate supply

c) Reduce the natural rate of unemployment

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 d) Increase the productivity of employees

Question 6

The effects of inflation on the price competitiveness of a country's products may be offset by:

a) An appreciation of the currency

b) A revaluation of the currency

c) A depreciation of the currency

d) Lower inflation abroad

Question 7

Menu costs in relation to inflation refer to:

a) Costs of finding better rates of return

b) Costs of altering price lists

c) Costs of money increasing its value

d) Costs of revaluing the currency

Question 8

In the short run unemployment may fall below the natural rate of unemployment if:

a) Nominal wages have risen less than inflation

b) Nominal wages have risen at the same rate as inflation

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 c) Nominal wages have risen more than inflation

d) Nominal wages have risen less than unemployment

Question 9

According to the Phillips curve unemployment will return to the natural rate when:

a) Nominal wages are equal to expected wages

b) Real wages are back at equilibrium level

c) Nominal wages are growing faster than inflation

d) Inflation is higher than the growth of nominal wages

Question 10

The Phillips curve shows the relationship between inflation and what?

a) The balance of trade

b) The rate of growth in an economy

c) The rate of price increases

d) Unemployment

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Chapter Five: Exchange Rates

Learning Objective

After studying This Chapter, the student will be able to:

1- Define the Exchange rate

2- Determine the functions and importance of the exchange rates markets

3- Quote a currency

4- Distinguish between spot rates, cross rates, and forward rates

5- Explain the exchange rates theories

6- Determine the advantages and criticism of the exchange theories.

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Chapter Five
5-1 Definition of Exchange rate:
To comprehend the worldwide financial environment, capital markets, and their influence on global

company, we must first grasp the operation of currencies and foreign exchange rates.

Concisely, currency is any type of money that is widely circulated in a country. What is the definition

of a foreign exchange? Foreign exchange, in essence, is money denominated in the currency of another

nation or, with the euro, a set of countries. To put it simply, an exchange rate is the rate at which the

market converts one currency into another.

Any firm that operates on a worldwide scale must deal with foreign currencies. It must pay suppliers

in other nations in a currency other than its own.

If you have ever gone outside of your own country, you have probably encountered the currency

market—for instance, while trying to figure out how much your hotel bill would be or if an item would

be cheaper in one nation than another. When you arrive at a foreign airport, you will almost certainly

notice boards displaying the current foreign exchange rates for major currencies. There are two

numbers in these rates: the bid and the offer. A bank or financial services firm's bid (or buy) is the

price at which they are willing to purchase a certain currency. The ask (also known as the offer or sale)

is the price at which a bank or financial services business will sell a currency. In most cases, the bid

or the purchase is the price at which a bank or financial services business will purchase a particular

currency.

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The ask (also known as the offer or sale) is the price at which a bank or financial services business

will sell a currency. Typically, the bid or purchase is always less expensive than the sell; the difference

allows banks to profit from the transaction. Consider the following scenario: you are on vacation in

Thailand, and the exchange rate board says the Bangkok Bank is prepared to convert currencies at the

following rates (see the following figure). As indicated in the diagram, GBP stands for the British

pound, JPY for the Japanese yen, and HKD for the Hong Kong dollar. Since There are numerous

nations that use the dollar as part or all of their name; nevertheless, this chapter uses the terms "US

dollar" or "US$" or "USD" to refer to American money.

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This chart shows that when you arrive in Thailand, you may exchange one US dollar for 31.67 Thai

baht. When you leave Thailand and determine that you do not need to carry all of your baht back to

the US, you convert your baht to US dollars. We must therefore use additional baht—32.32 according

to the prior figure—to purchase one US dollar. The difference between these two figures, 0.65 baht,

is the profit made by the bank for each US dollar purchased and sold. The bank charges a fee since it

provided a service in the form of currency conversion. As you move around the airport, you'll see

more boards representing other banks, each with a distinct purchase and sell rate. While the change

may be negligible, about 0.1 baht, it adds up if you are a worldwide firm that conducts big foreign

exchange transactions. As a result, before exchanging currencies, multinational corporations are

inclined to look around for the best rates.

5-2 What Is the Purpose of the Forex Market?

The foreign exchange market (or FX market) is a system for buying and selling currencies. Pricing, or

the rate at which a currency is purchased or sold, is a critical component of this system. In this section,

we will look more carefully at how exchange rates are determined, but first, let's examine why the FX

market exists. Foreign currency markets are used primarily by international enterprises for four

purposes:

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5-3 Currency Exchange
Companies, investors, and governments all want to be able to convert currencies. The major reason

for a firm desiring or having to convert currencies is to pay or receive money for the purchase of goods

or services.

Assume you own a company in the United States that imports wines from all around the globe. French

winemakers must be paid in euros, Australian wine suppliers in Australian dollars, and Chilean

vineyards in pesos. Obviously, you will not be able to physically access these funds. Instead, you'll

tell your bank to pay each of these vendors in their native currency. Your bank will convert the

currencies for you and debit your account for the equivalent in US dollars depending on the current

exchange rate.

5-4 Currency Hedging:

The danger of rates growing or dropping in bigger amounts or directions than expected is one of the

most difficult issues in foreign exchange. Currency hedging is a strategy for reducing the risk of losing

money due to exchange rate fluctuations. Hedging is a strategy used by businesses to protect

themselves in the event that there is a time lag between when they bill and when they are paid by a

client. In contrast, a firm may owe money to an overseas vendor and wish to hedge against currency

fluctuations that would raise the payment amount.

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A Japanese retail store, for example, imports or purchases Italian shoes. The Japanese company has

90 days to compensate the Italian company. To be safe, the Japanese company contracts with its bank

to exchange the money in ninety days at the agreed-upon exchange rate. This way, the Japanese

company knows exactly how much it will have to pay and is protected from a sudden yen devaluation.

If the yen depreciates, it will take more yen to buy the same amount of euros, making the trade more

expensive. The firm secures the rate through hedging.

5-5 Currency Arbitrage:

Arbitrage is the practice of buying and selling a currency at the same time for a profit. Trading systems

can now detect minor price discrepancies and conduct transactions in seconds, thanks to technological

advancements. Previously, arbitrage was carried out by a trader based in a single place, such as New

York, who used the Bloomberg terminal to monitor currency markets. When a trader notices that the

value of a euro is lower in Hong Kong than in New York, he can purchase euros in Hong Kong and

sell them for a profit in New York. Nowadays, sophisticated computer systems handle virtually all of

these transactions. Within seconds, the programs scan several exchanges, detect possible

discrepancies, and execute trades.

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5-6 Currency Speculations:
Speculation is defined as the act of purchasing and selling a currency in the hopes of profiting from a

change in its value. Such changes might occur in an instant or over decades.

Nonfinancial firms' high-risk, speculative investments are less prevalent these days than the current

headlines would suggest. While firms can participate in all four of the applications described in this

section, many have found that arbitrage and speculation are too risky and out of harmony with their

fundamental goals over time. In other words, these businesses have concluded that a loss from high-

risk or speculative investments would be unpleasant and unacceptable for them.

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5-7 How Do You Calculate Exchange Rates?
How to Make a Currency Quote

There are various methods for quoting currencies, but we will keep things simple for now. When we

quote currencies, we are showing how much of one currency is required to purchase another. The base

currency and the quoted currency are both required for this quote. The quoted currency is the one that

will be used to purchase another currency. The quoted currency is usually the numerator in an

exchange rate quote. The denominator includes the base currency, which is the currency that will be

purchased with another currency.

For example, if we want to know how many Hong Kong dollars it takes to buy one US dollar, we may

write HKD 8 / USD 1. (In this case, 8 represents the overall exchange rate average.) The cited currency

in this example is the Hong Kong dollar, which is mentioned in the numerator. The denominator

includes the US dollar, which is the foundation currency. "Eight Hong Kong dollars are necessary to

acquire one US dollar," we read this remark as. If you get lost when looking at exchange rates, keep

in mind the currency you wish to purchase or sell. Using the example in this paragraph, if you wish to

sell one US dollar, you can buy eight Hong Kong dollars.

There are two types of currency quotes: direct and indirect.

In addition, there are two techniques for noting the base and quoted currency: American words and

European terms. Based on each reference point, these two techniques, often known as direct and

indirect quotations, are diametrically opposed. Let's take a closer look at what this entails.

The American words, often known as US terms, are defined from the perspective of a person living in

the United States. Foreign exchange rates are represented in terms of how many US dollars may be

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exchanged for one unit of another currency in this technique (the non-US currency is the base

currency). In American terminology, a dollar-pound quote is USD/GP (US$/£) = 1.56.

"1.56 US dollars are required to purchase 1 pound sterling," it says. This is also known as a direct

quotation, and it shows the price of one unit of foreign currency in domestic currency. To put it another

way, a company that wants to acquire a foreign currency needs to know how many US dollars it needs

to sell in order to buy one unit of the foreign currency. The local currency is a changeable quantity in

a direct quote, whereas the foreign currency is fixed at one unit.

The European terms, on the other hand, are the alternative method of quoting rates. Foreign exchange

rates are represented in terms of how many currency units may be exchanged for one US dollar in this

method (the US dollar is the base currency). In European terms, the pound-dollar exchange rate is

£0.64/US$1 (£/US$1). In Europe, this is a direct quote, while in the United States, it is an indirect

quote. In an indirect quotation, the price of the home currency is expressed in terms of the foreign

currency. The foreign currency is a changeable quantity in an indirect quote, while the local currency

is fixed at one unit.

A direct and indirect quote are simply the opposites of one another. If you have one, you can quickly

compute the other using the following formula:

1 / indirect quote / direct quote / indirect quote / direct quote / indirect quote / direct quote

Let us use our dollar-pound scenario as an example. US$1.56 = 1/£0.64 is the direct quotation (the

indirect quote).

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This can be interpreted as:

1.56 is the result of 1 divided by 0.64.

The straight currency quotation is written as US$/£ = 1.56 in this example.

It is critical to maintain track of which currency is in the numerator and which is in the denominator

when completing the computations, otherwise you will wind up saying the statement backward. The

rate at which you buy a currency is referred to as a direct quotation. To buy a British pound in this

example, you will need US$1.56.

Tip: Over the course of their careers, many international business professionals gain expertise and can

adjust themselves if there is a currency mismatch. To use the preceding example, a seasoned global

professional is aware that the British pound has traditionally had a higher worth than the US dollar.

This means that buying a pound in US dollars costs more than buying a pound in British pounds. When

we say, "greater in value," we are referring to the British pound's ability to buy more US dollars. Using

this logic, we may infer that it takes 1.56 US dollars to buy one British pound.

As international businesspeople, we know it can't be less than 0.64 US dollars to buy a British pound.

This would indicate that the monetary worth was higher. While the value of major currencies has

fluctuated substantially in relation to one another, this has tended to occur across extended periods of

time. As a result, using logic to keep track of difficult exchange rates is a smart approach to apply this

self-test. It is excellent for big currencies that don't move a lot in relation to others.

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As international businesspeople, we know it can't be less than 0.64 US dollars to buy a British pound.

This would indicate that the monetary worth was higher. While the value of major currencies has

fluctuated substantially in relation to one another, this has tended to occur across extended periods of

time. As a result, using logic to keep track of difficult exchange rates is a smart approach to apply this

self-test. It's excellent for big currencies that don't move a lot in relation to others.

Nowadays, you can readily get up-to-date quotes on all currencies over the Internet, albeit the Wall

Street Journal, the Financial Times, or any website of a reputable financial institution remain the most

credible sources.

5-8-Spot Rates
Spot rates—exchange rates that demand prompt settlement with delivery of the exchanged currency—

are covered in this chapter. The phrase "immediate" generally refers to a currency transaction that

takes place "on the spot," thus the name "spot rate." The spot exchange rate is the rate at which a buyer

and seller of a currency interact at a certain point in time. When we purchase and sell foreign money

at a bank or through American Express, we are offered the current exchange rate. For currency traders,

however, the spot might vary by fractions of a percent during the trading day.

Consider the following scenario: you work for a garment firm in the United States and wish to purchase

shirts from Malaysia or Indonesia. The shirts are identical; the only difference is the price. (For the

time being, disregard shipping and any taxes.) Assume you're paying with the spot rate and making a

one-time payment. There is no risk of the currency's value rising or falling. (Forward rates will be

discussed in the next section.)

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The Malaysian ringgit, abbreviated MYR, is the country's currency. The estimate from the supplier in

Kuala Lumpur is emailed to you; each shirt costs MYR 35. Let's take a spot rate of MYR 3.13 / USD

as an example.

The rupiah, abbreviated as Rp, is the Indonesian currency. The supplier in Jakarta sends you an e-mail

with a quote for Rp 70,000 for each shirt. Use a Rp 8,960 / USD 1 spot exchange rate.

It's natural to think that the Indonesian company is more expensive but take a closer look. To make a

comparison, you may convert the price of one shirt into US dollars:

MYR 35 / MYR 3.13 = USD 11.18 for Malaysia

Rp 70,000 / Rp 8,960 = USD 7.81 in Indonesia

On the basis of the present currency rate, Indonesia is the cheapest supplier for our shirts.

5-9 Cross Rates:

The cross rate is another phrase that pertains to the spot market. This is the rate of exchange between

two currencies that are neither the official currency of the nation in which the quotation is given. For

example, if an American bank quoted an exchange rate between the euro and the yen on US land, the

rate would be a cross rate.

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EUR/GBP, EUR/CHF, and EUR/JPY are the most frequent cross-currency pairs. These currency

combinations broaden trading opportunities in the foreign exchange market, although they are less

regularly traded than currency pairs that contain the US dollar, which are referred to as "majors" due

to their high liquidity. EUR/USD, GBP/USD, and USD/JPY are the majors EUR/USD, GBP/USD,

USD/JPY, USD/CAD (Canadian dollar), USD/CHF (Swiss franc), and USD/AUD are the most often

traded currencies (Australian dollar). Despite changes in the international monetary system and the

growth of capital markets, the currency market is essentially a market for dollars and nondollar.

Central banks throughout the world still use the dollar as their reserve currency. The following

table "Currency Cross Rates" shows various currency exchange rates between major currencies. The

EUR/GBP cross-currency pair, for example, has a rate of 1.1956. This translates to "one British pound

costs 1.1956 euros." The EUR/JPY rate, which is now at 0.00901, is another example. A seasoned

trader, on the other hand, will have a better understanding of the market.

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 Currency cross rates

Currency United Hong Chinese

Canadian Japanese Swiss
codes / Kingdom Euro Kong US Dollar Yuan
Dollar Yen Franc
names Pound Dollar Renminbi
GBP 1 0.6177 0.8374 0.08145 0.007544 0.6455 0.633 0.09512
CAD 1.597 1 1.3358 0.1299 0.012032 1.0296 1.0095 0.1517
EUR 1.1956 0.7499 1 0.09748 0.00901 0.771 0.7563 0.1136
HKD 12.2896 7.7092 10.2622 1 0.09267 7.9294 7.7749 1.1682
JPY 132.754 83.2905 111.088 10.8083 1 85.65 84.001 12.6213
CHF 1.5512 0.9732 1.2981 0.1263 0.011696 1 0.9815 0.1475
USD 1.5807 0.9915 1.3232 0.1287 0.011919 1.0199 1 0.1503
CNY 10.5218 6.6002 8.8075 0.8565 0.07934 6.7887 6.6565 1

Note: The official name for the Chinese currency is renminbi and the main unit of the currency is the yuan.

Source: “Currency Cross Rates: Results,” Oanda, accessed May 25,

2011, http://www.oanda.com/currency/cross-
rate/result?quotes=GBP&quotes=CAD&quotes=EUR&quotes=HKD&quotes=JPY&quotes=
CHF&quotes=USD&quotes=CNY&go=Get+my+Table+++.

5-10 Forward Rates:

The forward exchange rate is the rate at which a buyer and a seller agree to exchange

currencies at a future date. Forward rates are a representation of the market's estimate

of a currency's future spot rate. The currency market for transactions at forward rates is

known as the forward market. Foreign exchange is usually priced against the US dollar

in forward markets. This means that prices are determined by the number of US dollars

required to purchase one unit of the other currency. Because demand in the international

financial markets determines which currencies are exchanged in the forward market,

not all currencies are traded there. In the forward market, the majors are often

exchanged.

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For example, if a US business wanted to buy mobile phones from China and pay for

them in ninety days, it might use the forward market to engage into a forward contract

and lock in a future pricing. This would allow the US company to hedge against the

dollar's devaluation, which would need more dollars to acquire one Chinese yuan. A

forward contract is a contract that calls for the exchange of a predetermined quantity of

a currency at a predetermined rate on a predetermined date.

Most forward contracts have set expiration periods of 30, 90, or 180 days. Most

financial institutions sell custom forward contracts. Forward contracts, currency swaps,

options, and futures are all examples of derivatives.

Derivatives are financial products whose fundamental value is derived from (derived

from) other financial instruments or commodities—in this example, another currency—

in the widest sense.

Futures, Options, and Swaps

Three more currency products utilized in the forward market are swaps, options, and

futures.

5-10-1 A currency swap is when you purchase and sell a currency at the same time for

two separate dates. An American computer company, for example, purchases (imports)

components from China.

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Today, the company must pay its supplier in renminbi. At the same time, the American

company expects to get RMB for its netbooks sold in China in ninety days. Two

transactions are entered into by the American company.

5-10-2 Currency options:

are the right, but not the duty, to exchange a specified quantity of currency at a specific

agreed-upon rate at a specific future date. Because a currency option is a right rather

than a necessity, the parties do not have to swap the currencies if they want to do so.

5-10-2 Currency futures contracts:

are contracts that require the exchange of a specific amount of currency at a specific

future date and at a specific exchange rate. Futures contracts are similar to but not

identical to forward contracts.

5-10-3 Exchange traded and standardized terms:

On exchanges, futures contracts are actively traded, and the terms are standardized. As

a result, futures contracts contain clearinghouses that guarantee transactions,

significantly lowering the risk of either side defaulting. Forward contracts are non-

standardized private contracts between two parties. As a result, the parties are more

likely to breach a contract.

5-10-3-1 Delivery and Settlement:

A forward contract's settlement occurs at the conclusion of the contract. Futures

contracts are marked-to-market on a daily basis, which means daily adjustments are

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settled day by day until the contract expires. A futures contract's settlement might also

take place over a period of time. On the other hand, forward contracts only have one

settlement date at the end of the term.

5-10-3-2 Maturity
Speculators commonly use futures contracts to speculate on the direction in which a

currency's price will change; as a result, futures contracts are routinely closed out before

maturity, and delivery seldom occurs. Forward contracts, on the other hand, are

typically utilized by corporations, institutions, or hedgers that wish to reduce the

volatility of a currency's price in the future while still ensuring that the currency is

delivered.

These tools are frequently used by businesses to manage their currency risk. When a

company operates in a country where currency convertibility is limited or controlled, it

faces a number of challenges.

Some governments have restrictions on how much earnings (money) a firm may take

out of the country. As a result, many businesses turn to countertrade, in which they

exchange goods and services for other goods and services with little or no money

involved.

The problem for businesses is to function in an inefficient global system. Market

variables such as inflation, interest rates, and market psychology influence currency

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markets, but government policy and intervention have a greater impact. Many

businesses relocate their manufacturing and activities to foreign regions to protect

themselves against currency fluctuations and trade obstacles. It's critical for businesses

to keep a close eye on things.

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Review Question:
1- When the $/£ exchange rate rises the pound _, and when $/£ rate
falls the pound

E) depreciates, appreciates

F) revalues, devalues

G) appreciates, depreciates

H) becomes more expensive, becomes cheaper

2- When a government follows a fixed exchange rate regime it allows

the exchange rate to be determined by market forces
F) True

G) False

3- In a fixed exchange rate regime, the central bank will intervene by

pounds to the exchange rate
C) selling, increase

D) buying, reduce

E) selling, reduce

F) buying, increase

G) a and b

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H) c and d

4- A current account deficit means that a country may

E) reduce its stock of foreign assets

F) increase its stock of foreign assets

G) increase its savings

H) increase its foreign currency reserves

5- Under floating exchange rates, a current account deficit must be

exactly matched by a capital account surplus
E) True

F) False

6- Starting from a position of internal and external balance, a reduction

in aggregate demand will cause a current account
E) deficit

F) surplus

G) revaluation

H) devaluation

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 7- A rise in the real exchange rate will the competitiveness of the
domestic economy
E) increase

F) reduce

G) do nothing to

H) disturb.

8- Under floating exchange rates, expectation of higher interest rates are likely to

cause an _________ of the exchange

A) depreciation

B) appreciation

C) fall

D) devaluation

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