The Great Inflation-Unemployment Trade-Off

Table of Content

Inflation and unemployment Gregory Minima, Harvard Economics professor and author of “Principles of Economics” explains that society experiences a short-run trade-off with rising rises and unemployment: As the monetary supply expands and inflation occurs, unemployment rises. However, the Phillips curve indicates that in the long-run, inflation has no bearing on levels Of unemployment. Effects Of price Controls Price controls, like setting food prices in the former Soviet Union or rent control in New York, have negative effects for both buyers and sellers.

Price ceilings create shortages and rationing of goods, and price floors create disincentives to improve on the quality of a good when it cannot be sold at the equilibrium price. Elasticity Elasticity measures price responsiveness of a good or service. If the demand for a product changes significantly when the price changes, it is considered elastic. Examples of elastic goods include makeup and concert tickets. Inelastic goods show little or no change in demand when the price changes. Examples include electricity and gas.

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Firm Behavior The goal off firm is to maximize profit. William Impeacher explains in the book, “Microeconomics: A Contemporary Introduction” that perfectly- competitive firms maximize profit when the marginal cost equals the marginal revenue. When this equilibrium is reached, the firm can stay competitive and profitable. When marginal cost exceeds the marginal revenue, the firm exits the market. Consumer Behavior Consumers wish to maximize their utility within their budget constraint. Simply put, consumers try to “get the most bang for their buck. Consumers make decisions to buy luxury, normal or inferior goods based on their income. Perfect Competition The textbook, “Business Economics” states perfect competition occurs when there are many firms selling identical products. The firm accepts the market price, and is not a price-maker. Monopolies Monopolies occur when firms are able to set the price of a specialized good r service due to limited or no competition. The firm is a price-maker and consumers must accept the price due to no alternatives. Oligopoly Oligopolies are small groups Of firms offering a similar good or service.

Game theory suggests the price of these goods remains at or below a competitive price because each of the firm tries outbidding the other to gain market share. Examples of oligopolies include airlines and cable companies. Negative Externalities Negative externalities are an external consequence of an action. Pollution and waste are good examples of a negative consequence caused by companies ho pay no price for these consequences. The Ten Principles of Economics part 1: The Four Principals of Decision-making Here I will break down the principals into three sections and briefly explain them from my point of view.

The first four basic principles of economics are on how people make decisions on the individual level. Principal 1: People face trade-offs. This means that for everything you do, you make a decision. Each decision you make requires you to choose or “trade-off one thing for another. If you stay up late to finish your homework, you are trading off sleep to do your homework. Bottom line is, everything you do is a decision between one thing or another. Principal 2: The cost of something is what you give up to get it. Is the trade-off you just made worth it? Will you make it to class on time if you stay up late?

Will you pass your class if the assignment is late? Right here, you are comparing the Cost of sleep versus homework. Although this does not have much financial value, it does have opportunity cost. Principal 3: Rational people think at the margin. This essentially means that you need to think things through completely. What would change if you went to sleep now, but woke up early to finish the assignment? The difference would be marginal, or small, but a rational person would think marginally to maximize the benefits of their decision. Principal 4: People respond to incentives.

If your instructor offered five extra points to assignments turned in early, would you be up late doing your homework? Most likely, you would respond to the incentive, and not be in the predicament you are in now. Incentives can mean both reward and punishment, so staying up late to finish your homework is responding to the incentive as well. You are avoiding punishment, or a bad grade for a late assignment. The Ten Principles of Economics Part 2: The Three Principals Concerning People’s Economic Interactions The first four basic principles of economics are on how people make decisions on the individual level.

The following three principals are about how decisions affect interaction between people. Principal 5: Trade can make everyone better off. Imagine living with a roommate. You decide to split up the chores, and take turns grocery shopping. In a sense, you are trading your resources (time, money, etc.. ). By doing so, you are both benefiting from the results. Both of you are carrying an equal workload, which makes this a win-win situation. On a larger scale, think of international trade. The USA purchases coffee and sugar from other countries instead Of producing it here.

This benefits the supplying company by stimulating their economy, but also benefits the US. We can use the land for higher revenue agricultural purposes, and save on the other expenditures necessary to grow those crops. Everybody wins with trade. Principal 6: Markets are usually a good way to organize economic activity. The market or market economy is a free flowing system of supply and demand. Individuals and businesses buy and sell products that affect the prices of the products. This is good for the economic activity because it allows for better choices.

You know that gasoline prices rise in the summer because more people drive more in better weather. Although you know the government will tax this gasoline, consumers are generally in control of the market via supply and demand. Principal 7: Governments can sometimes improve the market outcomes. This principal states that unlike the previous principal, government policy is able to influence a positive market outcome rather than the consumer. Although the government does not always have the ability to influence the market, sometimes it does. Even when this occurs, it does not mean that the government will actually act upon it.

How can government policy improve market outcomes? A good example is the green movement. Consumers that purchase “green” automobiles are given a hefty tax rebate. This increases demand for green vehicles, and stimulating all businesses associated with them. The Ten Principles of Economics Part 3: How the Economy Works as a Whole The last three, which will briefly go over here, are on how the economy works on a whole. Principal 8: A country’s standard of living depends on its ability to produce goods and services. Persons, who have a higher income, have a higher standard of living.

The reason these people have a higher income is directly related to their productivity level. Productivity is going to dictate the standard of living for any household or economy. If a country’s only goods are limited, it will show. If you look at some of the poorer countries you know they have a lack of plumbing and name brand coffee houses. If their economy had more goods and services to trade, the standard of living would consequentially increase as well. Principal 9: Prices Rise when the Government prints too much money. The more money that is printed in recirculation, the less the money is worth. You can think of this as supply and demand.

When the worth of the dollar drops, businesses have to spend more to purchase products overseas because of the exchange rates. This causes the cost of their products to rise. This principal is about Inflation, and what happens to the economy when all costs go up. Principal 10: Society faces a short-run trade-off between inflation and unemployment This is something that happens frequently. During inflation, businesses lose out on profit because the dollar is worth less and more must be spent for the same product. These businesses will fire employees or go out of business, and all of this leads to unemployment.

When inflation comes, inevitably so will higher unemployment rates. This is considered a trade off because with one, there is the other, and it is easy to see this especially in today’s economy. Part 1 (PRINCIPLES 1 -4) PRINCIPLE : PEOPLE FACE TRADEOFFS The first lesson about making decisions is summarized in the adage: “There is no such thing as a free lunch. ” To get one thing that we like, we usually have to give up another thing that we like. Making decisions requires trading off one goal against another. Consider a student who must decide how to allocate her most valuable resource-? her time.

She can spend all of her time studying economics; she can spend all of her time studying psychology; or she can divide her time between the two fields. For every hour she studies one subject, she gives up an hour she could have used studying the other. And for every hour she spends studying, she gives up an hour that she could have spent napping, bike riding, watching TV, or working at her part-time job for some extra spending money. Or consider parents deciding how to spend their family income. They can buy DOD, clothing, or a family vacation. Or they can save some of the family income for retirement or the children’s college education.

When they choose to spend an extra dollar on one of these goods, they have one less dollar to spend on some other good. When people are grouped into societies, they face different kinds of tradeoffs. The classic tradeoff is between “guns and butter. ” The more we spend on national defense to protect our shores from foreign aggressors (guns), the less we can spend on consumer goods to raise our standard of living at home (butter). Also important in modern society is he tradeoff between a clean environment and a high level of income. Laws that require firms to reduce pollution raise the cost of producing goods and services.

Because of the higher costs, these firms end up earning smaller profits, paying lower wages, charging higher prices, or some combination of these three. Thus, while pollution regulations give us the benefit of a cleaner environment and the improved health that comes with it, they have the cost of reducing the incomes of the firms’ owners, workers, and customers. Another tradeoff society faces is between efficiency and equity. Efficiency means that society is getting the most it can from its scarce resources. Equity means that the benefits of those resources are distributed fairly among society’s members.

In other words, efficiency refers to the size of the economic pie, and equity refers to how the pie is divided. Often, when government policies are being designed, these two goals conflict. Consider, for instance, policies aimed at achieving a more equal distribution of economic well-being. Some of these policies, such as the welfare system or unemployment insurance, try to help those members Of society who are most in need. Others, such as the individual income tax, ask the financially successful to contribute more than others to support the government.

Although these policies have the benefit of achieving greater equity, they have a cost in terms of reduced efficiency. When the government redistributes income from the rich to the poor, it reduces the reward for working hard; as a result, people work less and produce fewer goods and services. In other words, when the government tries to cut the economic pie into more equal slices, the pie gets smaller. Recognizing that people face tradeoffs does not by itself tell us what decisions they will or should make. A student should not abandon the study of psychology just because doing so would increase the time available for the study of economics.

Society should not stop protecting the environment just because environmental regulations reduce our material standard of living. The poor should not be ignored just because helping them distorts work incentives. Nonetheless, acknowledging life’s tradeoffs is important because people are likely to make good decisions only if they understand the options that they have available. PRINCIPLE THE COST OF SOMETHING IS WHAT YOU GIVE up TO GET Because people face tradeoffs, making decisions requires comparing the costs and benefits of alternative courses of action.

In many cases, however, the cost of some action is not as obvious as it might first appear. Consider, for example, the decision whether to go to college. The benefit is intellectual enrichment and a lifetime of better job opportunities. But what is the cost? To answer this question, you might be tempted to add up the money you spend on tuition, books, room, and board. Yet this total does not truly represent what you give up to spend a year in college. The first problem with this answer is that it includes some things that are not really costs of going to college. Even if you quit school, you would need a place to sleep and food to eat.

Room and board are costs of going to college only to the extent that they are more expensive at college than elsewhere. Indeed, the cost of room and board at your school might be less than the rent and food expenses that you would pay living on your own. In this case, the savings on room and board are a benefit of going to college. The second problem with this calculation of costs is that it ignores the largest cost of going to college-?your time. When oh spend a year listening to lectures, reading textbooks, and writing papers, you cannot spend that time working at a job.

For most students, the wages given up to attend school are the largest single cost of their education. The opportunity cost of an item is what you give up to get that item. When making any decision, such as whether to attend college, decision makers should be aware of the opportunity costs that accompany each possible action. In fact, they usually are. College-age athletes who can earn millions if they drop out Of school and play professional sports are well aware that their opportunity cost of college is very high. It is not surprising that they often decide that the benefit is not worth the cost.

PRINCIPLE #3: RATIONAL PEOPLE THINK AT THE MARGIN Decisions in life are rarely black and white but usually involve shades of gray. When it’s time for dinner, the decision you face is not between fasting or eating like a pig but whether to take that extra spoonful of mashed potatoes. When exams roll around, your decision IS not between blowing them off or studying 24 hours a day, but whether to spend an extra hour reviewing your notes instead of watching W. Economists use the term marginal changes to scribe small incremental adjustments to an existing plan of action.

Keep in mind that “margin” means “edge,” so marginal changes are adjustments around the edges of what you are doing. In many situations, people make the best decisions by thinking at the margin. Suppose, for instance, that you asked a friend for advice about how many years to stay in school. If he were to compare for you the lifestyle of a person with a Ph. D. To that of a grade school dropout, you might complain that this comparison is not helpful for your decision. You have some education already and most likely are deciding whether to spend an extra year or two in school.

To make this decision, you need to know the additional benefits that an extra year in school would offer (higher wages throughout life and the sheer joy of learning) and the additional costs that you would incur (tuition and the forgone wages while you’re in school). By comparing these marginal benefits and marginal costs, you can evaluate whether the extra year is worthwhile. As another example, consider an airline deciding how much to charge passengers who fly standby. Suppose that flying a 200-seat plane across the country costs the airline $100,000. In this case, the average cost of each seat is $100,000/200, which is $500.

One might be tempted to conclude that the airline should never sell a ticket for less than $500. In fact, however, the airline can raise its profits by thinking at the margin. Imagine that a plane is about to take off with ten empty seats, and a standby passenger is waiting at the gate willing to pay $300 for a seat. Should the airline sell it to him? Of course it should. If the plane has empty seats, the cost of adding one more passenger is minuscule. Although the average cost of flying a passenger is 5500, the marginal cost is rely the cost of the bag of peanuts and can of soda that the extra passenger will consume.

When the price of an apple rises, for instance, people decide to eat more pears and fewer apples, because the cost of buying an apple is higher. At the same time, apple orchards decide to hire more workers and harvest more apples, because the benefit of selling an apple is also higher. As we will see, the effect of price on the behavior of buyers and sellers in a market-?in this case, the market for apples-?is crucial for understanding how the economy works. Public policymakers should never forget about incentives, for many policies change the costs or benefits that people face and, therefore, alter behavior.

A tax on gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars. It also encourages people to take public transportation rather than drive and to live closer to where they work. If the tax were large enough, people would start driving electric cars. When policymakers fail to consider how their policies affect incentives, they can end up with results that they did not intend. For example, consider public policy regarding auto safety. Today all cars have seat belts, but that was not true 40 years ago. In the late sass, Ralph Nadir’s book Unsafe at Any Speed enervated much public concern over auto safety.

Congress responded with laws requiring car companies to make various safety features, including seat belts, standard equipment on all new cars. How does a seat belt law affect auto safety? The direct effect is obvious. With seat belts in all cars, more people wear seat belts, and the probability of surviving a major auto accident rises. In this sense, seat belts save lives. But that’s not the end of the story. To fully understand the effects of this law, we must recognize that people change their behavior in response to the incentives they face. The relevant behavior ere is the speed and care with which drivers operate their cars.

Driving slowly and carefully is costly because it uses the driver’s time and energy. When deciding how safely to drive, rational people compare the marginal benefit from safer driving to the marginal cost. They drive more slowly and carefully when the benefit of increased safety is high. This explains why people drive more slowly and carefully when roads are icy than when roads are clear. Now consider how a seat belt law alters the cost-benefit calculation of a rational driver. Seat belts make accidents less costly for a driver because hey reduce the probability of injury or death.

Thus, a seat belt law reduces the benefits to slow and careful driving. People respond to seat belts as they would to an improvement in road conditions-?by faster and less careful driving. The end result of a seat belt law, therefore, is a larger number of accidents. How does the law affect the number of deaths from driving? Drivers who wear their seat belts are more likely to survive any given accident, but they are also more likely to find themselves in an accident. The net effect is ambiguous. Moreover, the reduction in safe driving has an diverse impact on pedestrians (and on drivers who do not wear their seat belts).

They are put in jeopardy by the law because they are more likely to find themselves in an accident but are not protected by a seat belt. Thus, a seat belt law tends to increase the number of pedestrian deaths. At first, this discussion of incentives and seat belts might seem like idle speculation. Yet, in a 1975 study, economist Sam Appellant showed that the auto-safety laws have, in fact, had many of these effects. According to Appellant’s evidence, these laws produce both fewer deaths per accident and more accidents. The et result is little change in the number of driver deaths and an increase in the number of pedestrian deaths.

Appellant’s analysis of auto safety is an example of the general principle that people respond to incentives. Many incentives that economists study are more straightforward than those of the auto-safety laws. No one is surprised that people drive smaller cars in Europe, where gasoline taxes are high, than in the United States, where gasoline taxes are low. Yet, as the seat belt example shows, policies can have effects that are not obvious in advance. When analyzing any policy, we must consider not only the direct effects but also the indirect effects that work through incentives.

Trade between the United States and Japan is not like a sports contest, where one side wins and the other side loses. In fact, the opposite is true: Trade between two countries can make each country better off. To see why, consider how trade affects your family. When a member of your family looks for a job, he or she competes against members of other families who are looking for jobs. Families also compete against one another when they go shopping, because each family wants to buy the best goods at the lowest prices. So, in a sense, each family in the economy is competing with all other families.

Despite this imputation, your family would not be better off isolating itself from all other families. If it did, your family would need to grow its own food, make its own clothes, and build its own home. Clearly, your family gains much from its ability to trade with others. Trade allows each person to specialize in the activities he or she does best, whether it is farming, sewing, or home building. By trading with others, people can buy a greater variety of goods and services at lower cost. Countries as well as families benefit from the ability to trade with one another.

Trade allows countries to specialize in what they do best ND to enjoy a greater variety of goods and services. The Japanese, as well as the French and the Egyptians and the Brazilian, are as much our partners in the world economy as they are our competitors. PRINCIPLE MARKETS ARE USUALLY A GOOD WAY TO ORGANIZE ECONOMIC ACTIVITY The collapse of communism in the Soviet Union and Eastern Europe may be the most important change in the world during the past half century. Communist countries worked on the premise that central planners in the government were in the best position to guide economic activity.

These planners decided what good sand services were produced, owe much was produced, and who produced and consumed these goods and services. The theory behind central planning was that only the government could organize economic activity in a way that promoted economic well-being for the country as a whole. Today, most countries that once had centrally planned economies have abandoned this system and are trying to develop market economies. In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households.

Arms decide whom to hire and what to make. Households decide which firms to work for and what to buy with their incomes. These firms and households interact in the marketplace, where prices and self-interest guide their decisions. At first glance, the success Of market economies is puzzling. After all, in a market economy, no one is looking out for the economic well-being of society as whole. Free markets contain many buyers and sellers of numerous goods and services, and all of them are interested primarily in their own well-being.

Yet, despite decentralized decision making and self- interested decision makers, market economies have proven remarkably successful in organizing economic activity in a way that promotes overall economic well-being. In his 1 776 book An Inquiry into the Nature and Causes of the Wealth of Nations, economist Adam Smith made the most famous observation in all of economics: Households and firms interacting in markets act as if they are guided by an “invisible hand” that leads them to desirable market outcomes. One Of our goals in this book is to understand how this invisible hand works its magic.

As you study economics, you will learn that prices are the instrument with which the invisible hand directs economic activity. Prices reflect both the value of a good to society and the cost to society of making the good. Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social benefits and costs of their actions. As a result, prices guide these individual decision makers to reach outcomes that, in many cases, maximize the welfare of society as a whole.

There is an important corollary to the skill of the invisible hand in guiding economic activity: When the government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the millions of households and firms hat make up the economy. This corollary explains why taxes adversely affect the allocation Of resources: Taxes distort prices and thus the decisions Of households and firms. It also explains the even greater harm caused by policies that directly control prices, such as rent control.

And it explains the failure of communism. In communist countries, prices were not determined in the marketplace but were dictated by central planners. These planners lacked the information that gets reflected in prices when prices are free to respond to market forces. Central planners failed because they tried to run he economy with one hand tied behind their backs-?the invisible hand of the marketplace. PRINCIPLE GOVERNMENTS CAN SOMETIMES IMPROVE MARKET OUTCOMES Although markets are usually a good way to organize economic activity, this rule has some important exceptions.

There are two broad reasons for a government to intervene in the economy: to promote efficiency and to promote equity. That is, most policies aim either to enlarge the economic pie or to change how the pie is divided. The invisible hand usually leads markets to allocate resources efficiently. Nonetheless, for various reasons, the invisible hand sometimes does not work. Economists use the term market failure to refer to a situation in which the market on its own fails to allocate resources efficiently. One possible cause Of market failure is an externalities.

An externalities is the impact of one person’s actions on the well- being of a bystander. The classic example of an external cost is pollution. If a chemical factory does not bear the entire cost of the smoke it emits, it will likely emit too much. Here, the government can raise economic well-being through environmental regulation. The classic example of an external benefit is the creation of knowledge. When a scientist makes an important discovery, e produces a valuable resource that other people can use.

In this case, the government can raise economic well-being by subsidizing basic research, as in fact it does. Another possible cause of market failure is market power. Market power refers to the ability of a single person (or small group of people) to unduly influence market prices. For example, suppose that everyone in town needs water but there is only one well. The owner of the well has market power-?in this case a monopoly-?over the sale of water. The well owner is not subject to the rigorous competition with which the invisible and normally keeps self-interest in check.

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