Episode 454: The Lollipop War : Planet Money : NPR

This episode of my favorite podcast, Planet Money provides a great overview of the effects of the US government's long-time protectiono f the sugar industry on various stakeholders.

When teaching the effects of protectionism, I urge students to evaluate its effects on both consumers and producers. Often, however, students generalize this analysis, and make broad statements like “consumer will pay higher prices for the good”, without clarifying who, exactly, the consumers of the protected good are. In the case of agricultural commodities, the “consumer” is typically not a private individual who buys the product at a store, rather, it's the producers of process foods that use the commodities as inputs into their products which then are sold to consumers.

This is all to say that there is more than just a loss of “consumer surplus” in the market for a protected agricultural commodity. Rather, the effects can be far more serious, as the producers of hte consumer goods that use the commodity as an input may be forced to shut down their domestic production and move overseas. This is the story told in the podcast, as the maker of the candy dum dums has moved its plants to Mexico to take advantage not of lower wages or less regulation, rather the cheaper sugar that can be acquired there.

Listen to the podcast, and respond to the discussion questions that follow:

Discussion Questions:

1. What method does the US government use to protect domestic sugar producers?
2. What are the main economic arguments for continued protection of the US sugar industry?
3. What are the main arguments for the removal of protection of US sugar producers?

With the Econ exam just two days away, many students out there are wondering what to expect on the new higher level paper 3, the “quantitative methods” paper. I put this post together to share my own understanding of all the calculations students may be asked to do on this section of the exam.

First, let's review the command terms you can expect to encounter on HL paper 3, and look at what is expected of students in questions of each type.

Command terms to expect on paper 3:

• Calculate: “Obtain a numerical answer showing the relevant stages in the working.”
• Construct: “Display information in a diagrammatic or logical form.”
• Derive: “Manipulate a mathematical relationship to give a new equation or relationship.”
• Determine: “Obtain the only possible answer.”
• Draw: “Represent by means of a labelled, accurate diagram or graph, using a pencil. A ruler (straight edge) should be used for straight lines. Diagrams should be drawn to scale. Graphs should have points correctly plotted (if appropriate) and joined in a straight line or smooth curve.
• Identify: “Provide an answer from a number of possibilities.”
• Label: “Add labels to a diagram.”
• Plot: “Mark the position of points on a diagram.”
• Show: “Give the steps in a calculation or derivation.”
• Show that: “Obtain the required result (possibly using information given) without the formality of proof. “Show that” questions do not generally require the use of a calculator.”
• Sketch: “Represent by means of a diagram or graph (labelled as appropriate). The sketch should give a general idea of the required shape or relationship, and should include relevant features.”
• Solve: “Obtain the answer(s) using algebraic and/or numerical and/or graphical methods.”

Calculations you may be required to make:

Section 1 Microeconomics

1.1 Markets

Demand:

1. Explain a demand function (equation) of the form Qd = a – bP.
2. Plot a demand curve from a linear function (eg. Qd = 60 – 5P).
3. Identify the slope of the demand curve as the slope of the demand function Qd = a – bP, that is –b (the coefficient of P).
4. Outline why, if the “a” term changes, there will be a shift of the demand curve.
5. Outline how a change in “b” affects the steepness of the demand curve.

Supply:
1. Explain a supply function (equation) of the form Qs = c + dP.
2. Plot a supply curve from a linear function (eg, Qs = –30 + 20 P).
3. Identify the slope of the supply curve as the slope of the supply function Qs = c + dP, that is d (the coefficient of P).
4. Outline why, if the “c” term changes, there will be a shift of the supply curve.
5. Outline how a change in “d” affects the steepness of the supply curve.

Equilibrium:
1. Calculate the equilibrium price and equilibrium quantity from linear demand and supply functions.

HOW TO: Set the demand and supply equations equal to one another and solve for P. Once you know the equilibrium price, plug it into either equation to find the quantity.

2. Plot demand and supply curves from linear functions, and identify the equilibrium price and equilibrium quantity.

HOW TO:
Find the q-intercept of demand (this is the ‘a’ variable)
Find the p-intercept of both demand and supply (set Q = 0 and solve for P in both equations)
Draw the demand curve by connecting the q-intercept and the p-intercept of demand
Find the equilibrium price
Plot the supply curve by connecting the p-intercept of supply and the equilibrium price.
Draw dotted lines over to the equilibrium price and down to the equilibrium quantity.

3. State the quantity of excess demand or excess supply in the above diagrams.

HOW TO: There will only be an excess demand or supply if the question asks how a price OTHER THAN the equilibrium would affect the market. See the section on price controls below for more.

1.2 Elasticities:
1. Calculate PED using the following equation: PED=% change in Qd% change in P
2. Calculate PED between two designated points on a demand curve using the PED equation above.
3. Calculate XED using the following equation: XED = % change in Qd of good X% change in price of good Y
4. Calculate YED using the following equation: YED=% change in Qd% change in income
5. Calculate PES using the following equation: PES=% change in Qs% change in price

1.3 Government Intervention

Taxes
1. Plot demand and supply curves for a product from linear functions and then illustrate the effects of a specific tax.
2. Calculate the effects of the imposition of a specific tax on the market (on price, quantity, consumer expenditure, producer revenue, government revenue, consumer surplus and producer surplus).

HOW TO: A tax takes money AWAY from the seller of a product. So to caclulate the effect of the tax in a supply equation you must subtract the amount of the tax from the price the seller receives.

For example: assume the supply of pencils is represented by Qs = -10 + 3P, and a $2 per unit tax is places on pencils. The new supply equation is: Qs = -10 + 3(P-2). Simplified, this gives us Qs = -16 + 3P. This is the new supply equation. Graphically, the supply curve has shifted leftwards by 6 units, or “upwards” by $2.

Subsidies
1. Plot demand and supply curves for a product from linear functions and then illustrate and/or calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer expenditure, producer revenue, government expenditure, consumer surplus and producer surplus).

HOW TO: A subsidy is like a “tax in reverse”. It is a payment to the seller ABOVE what consumers pay, so it’s added to the price in the supply equation.

Assume pencil producers receive a $2 subsidy per pencil. With an original supply equation of Qs = -10 + 3P, the new supply is: -10 + 3(P+2). Simplified, this gives us Qs = -4+3P. The supply curve has shifted rightward by 6 units, or down by $2.

Price controls:
1. Calculate possible effects from the price ceiling diagram, including the resulting shortage and the change in consumer expenditure (which is equal to the change in firm revenue).
2. Calculate possible effects from the price floor diagram, including the resulting surplus, the change in consumer expenditure, the change in producer revenue, and government expenditure to purchase the surplus.

HOW TO: Simply plug the price floor or ceiling into the demand and supply equations to find the quantities that would be supplied and demanded. If there’s an effective price floor, the Qs should be greater than the Qd, meaning there’s a surplus. If there’s a price ceiling, Qd should be greater than Qs, meaning there’s a shortage.

1.5 Theory of the Firm

Costs
1. Calculate total, average and marginal product from a set of data and/or diagrams.

HOW TO: Total product is the output of workers as the number of workers increases.

Average product is the “output per worker” = TP/# of workers

Marginal product is the “output of the last worker” = Change in total product / change in the number of workers.

2. Calculate total fixed costs, total variable costs, total costs, average fixed costs, average variable costs, average total costs and marginal costs from a set of data and/or diagrams.

HOW TO: TFC is constant as output increases. It is the firm’s total cost when output = 0.

TVC increases as output increase, at first at a decreasing rate (due to increasing returns), and then at an increasing rate (due to diminishing marginal returns).

TC = TVC + TFC. If you know the firm’s fixed costs and its variable costs, TC can easily be calculated.

AFC = TFC / Q of output. AFC falls as output increases as the firm “spreads its overhead”. Graphically, it is the distance between AVC and ATC.

AVC = TVC / Quantity of output. AVC falls at first due to increasing returns and then increases due to diminishing returns. MC and AVC should intersect at the lowest point of AVC

ATC = AFC + AVC, or TC / Quantity of output. ATC lies ABOVE the AVC curve (since it includes the average fixed costs), and will intersect MC at its lowest pont.

MC = the change in TC / the change in output. It is the cost of the last unit produced. MC sloped down when a firm’s workers experience increasing returns and upwards once the firm experiences diminishing marginal returns.

Revenues:
1. Calculate total revenue, average revenue and marginal revenue from a set of data and/or diagrams.

HOW TO: Total revenue (TR) = price X quantity.

Average revenue (AR) is simply the price of the good. The demand curve can be labelled “D=AR=P” to help you remember this.

Marginal revenue (MR) = the change in total revenue divided by the change in quantity. This is the change in total revenue resulting from the last unit sold. For a PC firm, MR is constant and equal to the market price (since the firm is a price taker and can sell additional units for the same price.) But for an imperfectly competitive firm, MR is lower than price beyond the first unit of output, since the firm must lower its price to sell additional units of output. MR fall twice as steeply as the D=AR=P curve in an imperfect competitor diagram.

Profit:
1. Calculate different profit levels from a set of data and/or diagrams.

HOW TO: Economic profit is usually found by the following equation. Profit = (P-ATC)Q. Find the per-unit profit (P-ATC) and multiply it by the quantity of output (Q).

If you are given total revenue (TR) and total cost (TC) data, than economic profit = TR-TC.

If ATC>P or if TC>TR, then the firm’s profit is negative, and it is earning losses.

Perfect Competition:
1. Calculate the short run shutdown price and the breakeven price from a set of data

HOW TO: A firm should shut down if the price in the market is lower than the firm’s minimum average variable cost. At this point, the firm’s total losses are greater than its total fixed costs, so it will LOSE LESS by shutting down!

A firm will break even when the price in the market equals the firm’s minimum ATC, or if the TR = TC (see above). Economic profits = 0.

Monopoly:
1. Calculate from a set of data and/or diagrams the revenue maximizing level of output.

HOW TO: Total revenue is maximized when MR=0. If you have a table you can calculate the change in TR at each level of output, and when this equals zero, the firm would be maximizing its total revenues. Anything beyond this level of output, MR will be negative and the firm’s revenues will begin to fall.

Section 2 Macroeconomics

2.1 GDP
1. Calculate nominal GDP from sets of national income data, using the expenditure approach.

HOW TO: Nominal GDP is the quantity of output in a particular year multiplied by the prices in that year.

2. Calculate GNP/GNI from data

HOW TO: The difference between GDP and GNP is that you must SUBTRACT the value of output produced in a nation by companies based in other nations, but you must ADD the value of output produced in other nations by companies based in the nation you are calculating GNP for.

3. Calculate real GDP, using a price deflator.

HOW TO: Real GDP is the value of a nation’s output in a particular year measured using the prices from a base year. So you must multiply the quantity from the year in question by the prices from the base year (which should be provided).

If you are not given price and quantity data, rather you are given the GDP deflator price index, you can divide the nominal GDP for a particular by the GDP deflator for that year, and multiply by 100 to get the real GDP.

If you know the nominal GDP and the real GDP and are asked to calculate the GDP deflator, you simply divide the nominal by the real and multiply by 100.

If you have two years’ GDP deflators, and are asked to calculate the inflation between those years, you simply find the percentage change in the GDP deflator price indexes between the years given.

2.2 AD/AS
1. Calculate the multiplier using either of the following formulae: k=11-MPC or 1MRl=(MPS+MRT+MPM)
2. Use the multiplier to calculate the effect on GDP of a change in an injection in investment, government spending or exports.

HOW TO: If you know the MPC, you can estimate the effect of any change in spending in the economy on total GDP. For example. Assume the MPC = 0.8 and Net exports increase by $100 million. Calculate the total change in GDP.

k = 1/(1-0.8) = 5.

Now multiply the change in net exports by the multiplier: $100 million X 5 = $500 million
GDP will increase by $500 million as a result of the increase in net exports of $100 million.

2.3 Macroeconomic Objectives
1. Calculate the unemployment rate from a set of data.

HOW TO: The unemployment rate is the proportion of the labor force that is unemployed. This means they are actively seeking work but unable to find it.

You may be given a table showing the number of people in different groups, like college students, retirees, people looking for jobs, people who have given up looking for jobs, part time workers, full time workers, etc… You will have to calculate the unemployment rate from this information.

NOTE: People who are working part time but want to work full time ARE EMPLOYED. People who have given up looking for jobs are DISCOURAGED WORKERS and are no longer considered unemployed, rather, they have dropped out of the labor force. Discouraged workers are not accounted for in unemployment data.

2. Construct a weighted price index, using a set of data provided.

HOW TO: Refer to pages 303 – 305 in the textbook (Pearson Baccalaureate Economics)  for a worked solution to this type of problem. It’s not difficult math, you just have to know how to do it.

3. Calculate the inflation rate from a set of data.

HOW TO: The inflation rate = (CPI year 2 – CPI year 1)/CPI year 1. It is the rate of change in the CPI between two years. You do NOT always simply take the CPI and calculate the rate of change since it was 100. This would tell you how much inflation there was since the base year, but inflation is usually measured between two years.

4. Calculate the rate of economic growth from a set of data.

HOW TO: The rate of economic growth is the percentage change in the real GDP between two periods. = (GDP year 2 – GDP year 1)/GDP year 1

5. Calculate the marginal rate of tax and the average rate of tax from a set of data.

HOW TO: Refer to pages 361 – 362 in the text. The important thing here is to take your time and do the math very carefully.

The difference between the marginal rate and the average rates is as follows:

Assume the marginal tax rates for Country S are:

Income:

0-20,000 - 5%

20,001 – 50,000 - 15%

50,001 – 100,000 - 25%

100,001 – above - 35%

Assume an individual earns $75,000. Calculate:

• The amount of tax he will pay:
• He will pay 5% on the first 20,000. 20,000 x 0.05 = $1,000
• He will pay 15% on the NEXT 30,000 (up to $50,000). 30,000 x 0.15 = $4,500
• He will pay 25% on the NEXT $25,000 (the income he earns between $50,000 and $75,000). 25,000 x 0.25 = $6,250.
• Total tax paid = 1,000+4,500+6,250 = $11,750
• His average tax rate: This is his total tax liability divided by his income = $11,750 / $75,000 = 0.1567 x 100 = 15.67%.

You may also be given data on a INDIRECT taxes, which are taxes on consumption (such as a VAT). You may be told that the same individual consumes $45,000 of his income, of which 8% was paid in consumption taxes. Calculate the percentage of his income paid in indirect taxes:

$45,000 x 0.08 = $3,600 paid in indirect taxes.

$3,600 / $75,000 = 0.048 x 100 = 4.8% of his income paid in indirect taxes.

Section 3 International Economics

3.1 Free trade:
1. Calculate opportunity costs from a set of data in order to identify comparative advantage.

HOW TO: You may be given a production possibilities table OR a production possibilities curve for two countries. With either of these, you can calculate the opportunity costs of the countries for the two goods shown and determine comparative advantage.

For example: Assume Country S and Country I can produce the following amounts of wine and cheese on a single hectare of land

• Country S: 4 barrels of wine and 5 tons of cheese
• Country I: 8 barrels of wine and 8 tons of cheese

If the two countries were to specialize and trade, who should produce what?

• In country S: 4w = 5c so 1w = 1.25c.
• 5c = 4w, so 1c = 0.8w
• In country I: 8w = 8c, so 1w=1c

In Country S, 1 ton of cheese costs only 0.8 ton of wine, while 1 barrel of wine costs 1.25 cheeses. In Country I cheese “costs” more (1 ton of wine), while wine “costs” less (only 1 ton of cheese).

So Country S should specialize in cheese, because it is cheaper, and Country I in wine. The two countries can then trade and enjoy the foreign produced good at a lower opportunity cost than they could have achieved domestically.

3.2 Protectionism:
1. Calculate from diagrams the effects of imposing a tariff on imported goods on different stakeholders, including domestic producers, foreign producers, consumers and the government.

HOW TO: If you are comfortable with the tariff diagram and can identify the different areas identified above, then you simply find the AREA of those shapes on the graph to determine the costs, benefits, and revenues necessary.

2. Calculate from diagrams the effects of setting a quota on foreign producers on different stakeholders, including domestic producers, foreign producers, consumers and the government.

HOW TO: Same as for tariffs. Once you are familiar with the graph, simply find the areas representing the impact on each of the stakeholders.

3. Calculate from diagrams the effects of giving a subsidy to domestic producers on different stakeholders, including domestic producers, foreign producers, consumers and the government.

HOW TO: Calculate the areas on a graph! EASY!

3.3. Exchange Rates:
1. Calculate the value of one currency in terms of another currency.

HOW TO: If you know the price of one currency in terms of another, you can quickly find the price of the other.

For example. If 1 euro = 1.2 CHF, then 1 CHF = 1/1.2 euro, or 0.83 Euro. The price of one currency is the inverse of the price of the other.

2. Calculate the exchange rate for linear demand and supply functions.

HOW TO: If you can calculate equilibrium price and quantity for a good using linear equations, then finding the equilibrium exchange rate is easy. Given the equations for two currencies, simply set them equal to each other and find the equilibrium.

Example: Assume the demand for Euros in Switzerland is represented by the equation Qd = 10 -2P, where P is the exchange rate of the Euro in CHF.

Supply of Euros in Switzerland is represented by the equation Qs = -3 + 4P where P is the exchange rate of the Euro in CHF.

3. Calculate the equilibrium exchange rate of the Euro in Switzerland.

Set the demand and supply equal to one another: 8 – 4P = -4 + 6P, and solve for P.

12 = 10P.
P = 12/10 = 1.2 CHF / Euro

4. Plot demand and supply curves for a currency from linear functions and identify the equilibrium exchange rate.

HOW TO: This is the same as plotting linear demand and supply equations for any good.

• Find the q-intercept of demand (this is the ‘a’ variable)
• Find the p-intercept of both demand and supply (set Q = 0 and solve for P in both equations)
• Draw the demand curve by connecting the q-intercept and the p-intercept
• Find the equilibrium price (or exchange rate in this case).
• Plot the supply curve by connecting the p-intercept of supply and the equilibrium exchange rate.
• Draw dotted lines over to the equilibrium exchange rate and down to the equilibrium quantity.

5. Using exchange rates, calculate the price of a good in different currencies.

HOW TO: If you know the price of a good in one currency and you know the exchange rate between that currency and another, you can always find the price of the good in the other currency.

For example: A hotel room in London costs 250 British Pounds per night. The British Pound exchange rate in Switzerland is 1.5 CHF / pound. How much does the London hotel room cost in CHF?

Convert the room’s price to CHF. So, 250 x 1.5 = 375 CHF per night.

6. Calculate the changes in the value of a currency from a set of data.

HOW TO: Consider the following. A London hotel room that costs 250 pounds per night used to cost 375 CHF. Following a change in the exchange rate, the same room now costs 400 CHF. Calculate the new exchange rate of British Pounds in Switzerland.

The old exchange rate was: 375 / 250 = 1.5 CHF / GBP. The new exchange rate, therefore, is 400 / 250 = 1.6 CHF / GBP

3.4 Balance of Payments:
1. Calculate elements of the balance of payments from a set of data.

HOW TO: You must know the components of a nation’s current and financial accounts, and be able to determine from a set of payments data which type falls into which category, and whether it counts as a credit or a debit.

For practice, complete the HL exercise on page 491 (with answers in the back of the book).

With just a few weeks remaining before the AP and IB Economics exams take place, you may be looking for some good resources for exam review. In the last months,  I have released two newly updated revision guides for students studying in these courses.

The Microeconomics Revision Guide for the Introductory Economics Student:

• This resources includes chapters on all the topics from both Advanced Placement and IB Economics, including the new quantitative components of the IB Higher Level syllabus. Also included are the two AP-only topics, Resource Markets and Theory of Consumer Behavior
• Every chapter includes a link to the corresponding section from my economic video lectures site, The Economics Classroom.
• At the end of a book is a glossary including definitions to over 150 Microeconomics terms
• The book is also available in the European and British Amazon stores: Amazon.de and Amazon.co.uk

The Macroeconomics and International Economics Revision Guide for the Introductory Economics Student: 

• Includes chapters covering every topic from the AP Macroeconomics course, as well as sections 2 and 3 from the IB Economics syllabus. 
• Like the Micro Revision Guide, the Macro guide includes links at the top of every page to the corresponding section of The Economics Classroom, so the student can easily find video lessons to accompany their review process.
• The Macro and International Glossary at the end of this book includes over 200 key terms.
• The book is also available in the European and British Amazon stores: Amazon.de and Amazon.co.uk

The books are a great resources for students in classes in which the teacher already uses the Welker’s Wikinomics PowerPoint lecture notes, as the revision guides follow the PowerPoints very closely.

Enjoy! And good luck on your exams next month!

Over the next three weeks I will be covering issues in Development Economics with my year 2 IB students. I have often used TED Talks to inspire our class discussions, and this year I decided to compile a “best of TED” playlist to guide us through the IB topics in development.

Day 1 – The Nature of Economic Growth and Development and Measuring Development:

• Hans Rosling: Debunking third-world myths with the best stats you’ve ever seen – YouTube

Days 2 and 3 – The role of foreign aid

• David Damberger: What happens when an NGO admits failure | Video on TED.com - International aid groups make the same mistakes over and over again. David Damberger uses his own engineering failure in India to call for the development sector to publicly admit, analyze, and learn from their missteps. Reading Room | Admitting Failure
• Jacqueline Novogratz: A third way to think about aid | Video on TED.com - The debate over foreign aid often pits those who mistrust “charity” against those who mistrust reliance on the markets. Jacqueline Novogratz proposes a middle way she calls patient capital, with promising examples of entrepreneurial innovation driving social change.
• Esther Duflo: Social experiments to fight poverty | Video on TED.com - Alleviating poverty is more guesswork than science, and lack of data on aid's impact raises questions about how to provide it. But Clark Medal-winner Esther Duflo says it's possible to know which development efforts help and which hurt — by testing solutions with randomized trials.

Days 4 and 5 – The Role of Domestic Factors:

• Hans Rosling: Religions and babies | Video on TED.com - Hans Rosling had a question: Do some religions have a higher birth rate than others — and how does this affect global population growth? Speaking at the TEDxSummit in Doha, Qatar, he graphs data over time and across religions. With his trademark humor and sharp insight, Hans reaches a surprising conclusion on world fertility rates.
• Hans Rosling: The magic washing machine | Video on TED.com - What was the greatest invention of the industrial revolution? Hans Rosling makes the case for the washing machine. With newly designed graphics from Gapminder, Rosling shows us the magic that pops up when economic growth and electricity turn a boring wash day into an intellectual day of reading.
• Ernest Madu on world-class health care | Video on TED.com - Dr. Ernest Madu runs the Heart Institute of the Caribbean in Kingston, Jamaica, where he proves that — with careful design, smart technical choices, and a true desire to serve — it's possible to offer world-class healthcare in the developing world.
• Andrew Mwenda takes a new look at Africa | Video on TED.com - In this provocative talk, journalist Andrew Mwenda asks us to reframe the “African question” — to look beyond the media's stories of poverty, civil war and helplessness and see the opportunities for creating wealth and happiness throughout the continent.

Micro-finance

• Jacqueline Novogratz on escaping poverty | Video on TED.com - Jacqueline Novogratz tells a moving story of an encounter in a Nairobi slum with Jane, a former prostitute, whose dreams of escaping poverty, of becoming a doctor and of getting married were fulfilled in an unexpected way.
• Jessica Jackley: Poverty, money — and love | Video on TED.com - What do you think of people in poverty? Maybe what Jessica Jackley once did: “they” need “our” help, in the form of a few coins in a jar. The co-founder of Kiva.org talks about how her attitude changed — and how her work with microloans has brought new power to people who live on a few dollars a day.

Days 6 and 7 – The Role of International Trade:

• Paul Collier on the “bottom billion” | Video on TED.com - Around the world right now, one billion people are trapped in poor or failing countries. How can we help them? Economist Paul Collier lays out a bold, compassionate plan for closing the gap between rich and poor.
• Ngozi Okonjo-Iweala on aid versus trade | Video on TED.com - Ngozi Okonjo-Iweala, the former finance minister of Nigeria, sums up four days of intense discussion on aid versus trade on the closing day of TEDGlobal 2007, and shares a personal story explaining her own commitment to this cause.

Day 8 – The role of Foreign Direct Investment (FDI)

• Euvin Naidoo on investing in Africa | Video on TED.com - South African investment banker Euvin Naidoo explains why investing in Africa can make great business sense.
• Jacqueline Novogratz invests in Africa’s own solutions | Video on TED.com - Jacqueline Novogratz applauds the world's heightened interest in Africa and poverty, but argues persuasively for a new approach.

Days 9 and 10 – Conclusions and Data Response Question practice

Competitively Priced Electricity Costs More, Studies Show – New York Times

The problem with monopolies, as our AP students have learned, is that a monopolistic firm, left to its own accord, will most likely choose to produce at an output level that is much lower and provide their product at a price that is much higher than would result from a purely competitive industry. A monopolist will produce where its price is greater than its marginal cost, indicating an under-allocation of resources towards the product. By restricting output and raising its price, the monopolist is assured maximum profits, but at the cost to society of less overall consumer surplus or welfare.

Unfortunately, in some industries, because of the wide range of output over which economies of scale are experienced, it sometimes makes the most sense for only one firm to participate. Such markets are called “natural monopolies” and some examples are cable television, utilities, natural gas, and other industries that have large economies of scale. (click graph to see full-sized)

Government regulators face a dilemma in dealing with natural monopolistic industries such as the electricity industry. A electricity company with a monopoly in a particular market will base its price and output decision on the profit maximization rule that all unregulated firms will; they'll produce at the level where their marginal revenue is equal to their marginal cost. The problem is, for a monopolist its marginal revenue is less than the price it has to charge, which means that at the profit maximizing level of output (where MR=MC), marginal cost will be less than price: evidence of allocative inefficiency (i.e. not enough electricity will be produced and the price will be too high for some consumers to afford).

Here arises the need for government regulation. A government concerned with getting the right amount of electricity to the right number of people (allocative efficiency) may choose to set a price ceiling for electricity at the level where the price equals the firm's marginal cost. This, however, will likely be below the firm's average total cost (remember, ATC declines over a WIDE RANGE of output), a scenario which would result in losses for the firm, and may lead it to shut down altogether. So what most governments have done in the past is set a price ceiling where the price is equal to the firm's average total cost, meaning the firm will “break even”, earning only a “normal profit”; essentially just enough to keep the firm in business; this is known as the “fair-return price”.

Below AP Economics teacher Jacob Clifford illustrates and explains this regulatory dilemma. Watch the video and see how he shows the effect of the two price control options on the firm's output and the price in the market.

The article above examines the differences in the price of electricity in states which regulate their electricity prices and states that have adopted “market” or unregulated pricing, in which firms are free to produce at the MR=MC level:

“The difference in prices charged to industrial companies in market states compared with those in regulated ones nearly tripled from 1999 to last July, according to the analysis of Energy Department data by Marilyn Showalter, who runs Power in the Public Interest, a group that favors traditional rate regulation.

The price spread grew from 1.09 cents per kilowatt-hour to 3.09 cents, her analysis showed. It also showed that in 2006 alone industrial customers paid $7.2 billion more for electricity in market states than if they had paid the average prices in regulated states.”

The idea of deregulation of electricity markets was that removing price ceilings would lead to greater economic profits for the firms, which would subsequently attract new firms into the market. More competitive markets should then drive prices down towards the socially-optimal price, benefiting consumers and producers by forcing them to be more productively efficient in order to compete (remember “Economic Darwinism”?). It appears, however, that higher prices have not, as hoped, led to lower prices:

“Since 1999, prices for industrial customers in deregulated states have risen from 18 percent above the national average to 37 percent above,” said Mrs. Showalter, an energy lawyer and former Washington State utility regulator.

In regulated states, prices fell from 7 percent below the national average to 12 percent below, she calculated…

In market states, electricity customers of all kinds, from homeowners to electricity-hungry aluminum plants, pay $48 billion more each year for power than they would have paid in states with the traditional system of government boards setting electric rates…”

That $48 billion represents higher costs of production for other firms that require large inputs of energy in their own production, higher electricity bills for cash-strapped households, and greater profits and shareholder dividends for the powerful firms that provide the power. On the bright side, higher prices for electricity should lead to more careful and conservative use of power, reducing Americans' impact on global warming (since the vast majority of the country's power is generated using fossil fuels).

Here arises another question? Should we be opposed to higher profits for powerful electricity firms if their profits result in much needed energy conservation and a reduction in greenhouse gas emissions? An environmental economist might argue that if customers are to pay higher prices for their energy, it might as well be in the form of a carbon tax, which rather than increasing profits for a monopolistic firm would generate revenue for the government. In theory tax revenue could be used to subsidize or otherwise promote the development and use of “green energies”.

Whether customers paying higher prices for traditionally under-priced electricity is a good or bad thing depends on your views of conservation. But whether higher profits for a powerful electricity company are more desirable than increased tax revenue for the government are beneficial for society or not seems clear. If we're paying higher prices, the resulting revenue is more likely to be put towards socially desirable uses if it's in the government's hands rather than in the pockets of shareholders of fossil fuel burning electricity monopolies.

Discussion Questions:

1. Why do governments regulate the prices in industries such as natural gas and electricity?
2. Why would a state government think that de-regulation of the electricity industry might eventually result in lower prices in the long-run?
3. Why, in reality, did the price of electricity in unregulated electricity markets ultimately increase so much that consumers in the market states paid billions of dollars more than in regulated states?
4. What industries besides that for electricity share characteristics that might qualify them as “natural monopolies”? Which of the industries you identified should be regulated by government, and WHY?

Facts: 65% of all the beer bought in the United States is produced by one of two companies: Anheuser Busch / InBev or Miller. 7% is produced by a company called Grupo Modelo. 72% of all the beer bought comes from these three companies. Much of the remaining market is shared by thousands of “micro-breweries” of varying sizes.

While there are literally thousands of beer makers in the US, technically speaking, the market is oligopolistic, since such a large share of the market (72%) is dominated by just three firms. To be classified as an oligopoly, a market must be dominated by a few large firm selling a differentiated (and sometimes a homogeneous) product. Firms are interdependent on one another and they tend to compete for consumers using “non-price competition”, which may include improving the quality of their product and offering customers a wider variety to choose from, and especially through advertising. A final characteristic of oligopoly is that high barriers to entry exist.

In the case of the beer market,  there are minimal economies of scale, since anyone with a $200 home brewing kit can technically “enter the market”. But other barriers to entering the national market for beer are significant, which explains why the market is dominated by three huge firms. Notably, brand recognition poses a barrier to entry to the thousands of small brewers in America. The brands owned by the big three firms are well-established and liked among consumers, making it difficult for smaller brewers to gain share in the market.

In the Planet Money podcast below, we hear the story two of these “big three” beer makers. Anheuser Busch / InBev is attempting to merge with Grupo Modelo, a transaction that would reduce the “big three” to the “big two”, which would give the new single firm a truly dominant position in the market, and increase the two-firm concentration ratio from 65% to 72%. The podcast explains how competition in the market for beer benefits consumers, and how a decrease in competition will harm consumers. Below, I will provide a graphical analysis of the situation.

As the podcast explains, the competition between the big three beer producers has several benefits for consumers, not least of which is the huge variety of beers available across the three firms, each trying to capture a larger share of the market by offering consumers beers that appeal to their diverse tastes. In addition, however, the nature of competition in oligopolistic markets tends to result in stable prices over time. Here’s why:

Imagine Anheuser Busch / InBev, which wishes to raise its price from P1 to P2 in the graph below. If AB/InBev raises its prices, while Modelo and Miller keep theirs unchanged, the demand for AB/InBev’s beer is likely to be highly elastic, meaning that even a small price increase will cause the quantity demanded to fall dramatically (from Q1 to Q2). Due to the high elasticity of demand above P1, such a price hike will lead to lower revenues for AB/InBev. Conclusion? A price hike is a bad idea.

So what if AB/InBev decides to lower its prices? The graph below shows that at any price below P1, demand will most likely be highly inelastic, because a price cut will most likely be matched by Modelo and Miller, who would have to cut their prices to avoid losing a significant number of consumers to AB/InBev. If all three firms lower their prices, then each firm will see hardly any increase at all in their total sales. A price decrease by AB/InBev will set off a “price war” and the firm will see its revenues fall.

What we end up with is what is known as a “kinked” demand curve for AB/InBev’s beers.

The firm has almost no incentive to raise or lower its prices, since a change in either direction will cause revenues to decline. Therefore, beer consumers enjoy stable prices, and the firms choose to compete through product differentiation, innovation and, of course, advertising!

So how would a merger between two of the big three beer makers change the situation in the market? What if just TWO firms controlled 72% of the market instead of three? The fear is that AB/InBev, once it owns Modelo, will be less interdependent on the actions of Miller. In other words, it will care less whether Miller ignores its price increases or matches its price decreases. Since there will be fewer substitutes for the gigantic firm’s dozens (or hundreds?!) of beer brands, demand for them overall will be more inelastic. This would give AB/InBev more price making power, and essentially make the market look more like a monopoly.

When a firm has monopoly power, as we can see, a large increase in price (from P1 to P2) leads to a relatively smaller decrease in sales (from Qt to Q2). If AB/InBev and Modelo were to merge the firm would be able to get away with raising the price of all of its beer brands, as consumers are less likely to switch to the competition, since a big chunk of the competition would be owned by the firm itself!

The amount of competition that exists in a market has major bearings on the consumers, as this podcast demonstrates and our graphs illustrate. With just three big firms making 72% of the beer in the US, it may not seem like that big a deal if two of them merge. But even the loss of one firm in a highly concentrated market like beer could lead to higher prices for dozens of the top selling beers in the country; hence the US government’s hesitance to give AB/InBev a green light in its plan to acquire Grupo Modelo!

Discussion Questions:

1. How can a market with thousands of individual sellers be considered oligopolistic?
2. Why is “brand recognition” considered a barrier to entry into the beer market?
3. Explain why prices in oligopolistic markets tend not to increase or decrease very often.
4. Why is “non-price competition” so important for beer makers in the US? What are some forms of non-price competition that they practice?
5. What is meant by the statement that “monopoly price is higher and output is lower than what is socially optimal.” Would this apply to the beer market if the AB/InBev and Modelo merger were to proceed?

Introduction: In order to understand the goals of economic development, it is useful to examine the characteristics of more economically developed countries and compare them to those of less economically developed countries. Before beginning the assignment below, watch the following TED Talk by Swedish Professor of world health Hans Rosling:

Resources: Use the following websites to find the required data for the assignment below.

• Statistics – Human Development Reports (UNDP)
• CIA – The World Factbook
• Hans Rosling’s GapMinder

Part 1 – Development Data:

Using the two websites above, locate the following for TWO COUNTRIES, one from the list of countries with “high human development” and one from the list of countries with “low human development”. Use the tables below to fill in the data for the two countries you have chosen.

Social Indicators (find and record figures for both the countries you chose below)

• HDI ranking and value
• Age structure
• Population growth rate
• School life expectancy
• Life expectancy at birth
• Total fertility rate
• Education expenditures

Economic Indicators:

• GDP per capita
• GDP – composition by sector
• Unemployment rate
• Public debt
• Stock of direct foreign investment – at home:
• Labor force – by occupation

Part 2 – Dependency Ratio:

A nation’s dependency ratio tells us something about the ability of members of a nation’s workforce to provide necessities to him or herself and his or her dependents. Typically, less economically developed nations will have a higher dependency ratio than more economically developed countries. The lower a nation’s dependency ratio, the greater capacity for its workers to accumulate savings, which leads to investment, accumulation of capital, greater productivity, higher incomes and more economic development.

Calculation the dependency ratio: To calculate a nation’s dependency ratio, you must find demographic information on its population. You may need to do additional research beyond the two websites above to find this data.

Calculate the dependency ratios for:

• Country with high HDI
• Country with low HDI

Part 3 – Lorenz Curve and Gini coefficient:

The Lorenz curve is a graphical representation of the income distribution of a country. It plots the percentage of a nation’s total income (GDP) against its total population. The “line of absolute equality” is the 45 degree line, indicating a nation where each quintile (20% of the population) earns exactly the same income as each other quintile. No country is absolutely equal, therefore the line of equality is only used for comparison.

The Gini coefficient is the ratio of the area below the line of equality and above a country’s Lorenz curve and the total area of the triangle below the line of equality. A country with perfect income equality would have a Gini coefficient of 0. A country in which the top 1% had controlled all of a nation’s income would have a Gini coefficient of nearly 1.
Example: Australia’s income is distributed across its population in the following way:

• 1st 20% – 5.9%
• 2nd 20% – 12%
• 3rd 20% – 17.2%
• 4th 20% – 23.6%
• 5th 20% – 41.3%
• Gini coefficient = 0.352

Illustrating your countries’ Lorenz Curves: This is another activity that may require research beyond the websites provided above. Try to find data on the share of national income earned by various levels of society. If you cannot find data for the 20% ranges, use the percentage ranges you can find. Draw a Lorenz curve for the two countries you researched.

Part 4 – Conclusions:

Evaluate your findings from the two countries you researched.

1. What conclusions can you draw about the correlation between GDP, HDI, income equality, social and economic indicators between developed and developing countries?
2. Does a high HDI correlate with relative income equality? What about low HDI?
3. Is a high GDP indicative of high levels of human development?
4. What other conclusions can you draw about economic development, national income, and equality?
5. To what extent did your country with low HD exhibit the following characteristics?
• Low standards of living?
• Low incomes?
• Inequality?
• Poor health?
• Inadequate education?
• Low levels of productivity?
• High rates of population growth and dependency burdens?
• High levels of unemployment?
• Dependence on agricultural production and primary product exports?
• Imperfect markets?
• Dependency on foreign developed countries for trade, access to technology, foreign investment and aid?

Over the last year, I have been working on two new resources for IB, AP, A level and Econ 101 students. The Microeconomics and Macroeconomics Revision Guides for the Introductory Economics student represent the ultimate resource for exam preparation and subject mastery.

The Macro Revision Guide is in its final stage of development and should be for sale by the middle of March. The Micro Revision Guide is now available now on Amazon in the US, the UK and the EU:

 Order here: Amazon.com   Amazon.co.uk  Amazon.de

Description: The Microeconomics Revision Guide for Introductory Economics students provides a comprehensive overview of the major units covered in an introductory Micro course. The book follows the Advanced Placement and International Baccalaureate syllabuses, and includes over 200 detailed diagrams, clear explanations of concepts, definitions, examples, and a glossary with over 150 key Microeconomic terms.

The revision guide is linked to several online resources which can be accessed for free by students reviewing for exams. Each chapter of the book is accompanied by a section on the website, www.EconClassroom.com, at which students can view video lectures published by the author covering nearly every topic from the course. The website also provides interactive flashcards for reviewing key terms and downloadable practice activities on most units.

For more information on the Microeconomics Revision Guide for the Introductory Economics Student, have a look at the author's website, www.welkerswikinomics.com. There you can also find links to other resources, including teacher lecture notes, a blog, and an Economics news page.

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Tags: AP Economics, AP Economics exam, AP study guides, IB Economics exam, IB study guides, new IB Economics syllabus, study guide

Ben Bernanke Lectures Congress on Austerity Economics : The New Yorker

In just two days, the United States will enact a massive contractionary fiscal policy known as the “sequester”, which includes over $1 trillion in federal spending cuts rolled out over the next ten yeas. The imminent sequester (which is defined as “to isolate, or hide away”) is the result of the failure of Democrats and Republicans to agree upon an acceptable combination of spending cuts and tax increases to put the US government on a more sustainable budgetary path (meaning lower national debt in the future). The sequester was never intended to occur, rather it was put in place to force the two parties to come up with a budget compromise that would cause less harm to the economy than the cuts that the sequester will impose.

The $1.2 trillion cut in spending will have several negative effects on the US economy, including 

…up to 2,100 fewer food inspections, 373,000 mentally ill adults and children going without treatment, 70,000 kids being kicked out of preschool, 2,700 schools losing federal funding, about 30,000 teacher layoffs, a reduction in federal law enforcement capacity equivalent to the loss of 1,000 federal agents, 1,000 fewer criminal prosecutions, and the list goes on and on. The chairman of the Joint Chiefs of Staff, Gen. Martin Dempsey, recently said before the Senate Armed Services Committee that sequestration will “make it much harder for us to preserve readiness after more than a decade of fighting in Iraq and Afghanistan.”

The effects on national output and employment in the US economy, which is still recovering from the Great Recession of 2009, will likely be devastating. According to the Federal Reserve Bank Chairman Ben Bernanke,

“Given the still-moderate underlying pace of economic growth, this additional near-term burden on the recovery is significant… Moreover, besides having adverse effects on jobs and incomes, a slower recovery would lead to less actual deficit reduction in the short run.”

Bernanke, a Republican himself, recognizes that any cut in government spending (known as a contractionary fiscal policy) will harm the US economy's growth potential both in the short-run and the long-run. Bernanke believes that the primary goal of the government right now (and the Central Bank, which he is the head of) should be to promote increased employment to bring the nation's unemployment rate down (back to its natural rate).

So what is the argument FOR a contractionary fiscal policy? Why would the Democrats and Republicans let this sequestration take place even when America's leading economic voice is calling for it to be avoided? If you ask many of the Republicans in Washington, D.C., America's biggest macroeconomic problem is not slow growth or high unemployment, it's the large national debt. The debt (which is the sum of all of the country's past budget deficits), has grown to nearly 80% of the nation's GDP. This means that the nation owes the holders of that debt nearly as much as its total income in a year. If an individual had a debt level this high, that individual would probably have to cut back on his own spending (cut up those credit cards!), to begin paying back that debt; obviously, high personal debt ultimately leads to a decrease in the standard of living of the indebted person as it eventually has to be paid back.

But a nation's debt is a little different than that of an individual. If the US government cuts back on spending to reduce the debt, the result is rising unemployment, lower incomes, reduced confidence among households and firms, a reduction in economic growth, and possibly, a recession. The goal of reducing the debt could ultimately reduce the national output and income, which could ironically make the debt an even bigger deal than it already is. Let me explain why.

Imagine two countries, Country A and Country G. Country A has a national debt of $12,000 billion dollars. Country G has a national debt of $355 billion dollars. Obviously, Country A's debt is around 35 times the size of Country G's. So if I asked you, which of these countries is facing a “debt crisis”, you'd probably say Country A, right? Well, you'd be wrong. Country A is America, and Country G is Greece. So why does Greece's national debt of $355 billion, which represents 182% of Greece's GDP of $195 billion, constitute a “crisis”, while America's debt of $1,200 billion, or just around 80% of its GDP, is simply a cause of concern among one of the country's political parties? The answer is, it's not how large a nation's debt is in dollar terms that matters, rather how large the debt is relative to the country's GDP. A millionaire could handle a $100,000 debt just fine, while for an individual earning minimum wage, a debt of $100,000 would present a crushing burden that is unlikely ever to be overcome without that individual declaring himself bankrupt.

If the sequestration takes place, America's GDP may fall, as Bernanke has warned. But its debt will continue to grow (albeit less slowly than it would without the sequester). If the GDP falls while the debt grows, the country's debt burden actually increases, despite the desired outcome of the sequester, a reduction in debt. In other words, the sequestration will make America more like Greece (the guy on minimum wage) and less like America (the millionaire!).

Rather than working towards debt reduction, as the mainstream of the Republican party advocates, Ben Bernanke would prefer the federal government focus on policies that reduce unemployment. Unemployment, defined as “the state of actively seeking a job, but being unable to find one”, has several negative effects on individuals and the economy as a whole. Here's Bernanke explaining to the US Congress the consequences of unemployment:

High unemployment has substantial costs, including not only the hardship faced by the unemployed and their families, but also the harm done to the vitality and productive potential of our economy as a whole. Lengthy periods of unemployment and underemployment can erode workers’ skills and attachment to the labor force or prevent young people from gaining skills and experience in the first place—developments that could significantly reduce their productivity and earnings in the longer term. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending, thereby leading to larger deficits and higher levels of debt.

Many economists believe that America's huge national debt (in dollar terms) is really not all that bad when compared to its even huger GDP. A nation's debt really only becomes a problem when that nation, like an individual burdened with a high level of personal debt, is forced to reduce its spending and begin paying that debt off. A nation can maintain a high level of debt as long as it can continue to borrow more money to pay off its past debt. And in the current global economy, no nation can borrow money more easily than the United States of America.

The cost of borrowing money is the interest rate that must be paid on loans made to an individual or government. At present, the US government can borrow money at very low interest rates (it pays between 1% and 3% on most of the government bonds it issues). This fact indicates that America's debt, while it is a primary concern of the Republican party, is not a major concern among those to whom the US government owes money, nor to those who may lend it money in the near future.

The tradeoff America faces as it enters this period of sequestration, government spending cuts, and the resulting reduction in aggregate demand, income, output and employment, is one between future debt and future prosperity. The sequester may reduce the level of debt in the future, but it will also increase the debt burden (as Bernanke explained). In exchange for a smaller dollar value of its debt, America may have to accept  increased unemployment and a slower recovery from the Great Recession, which together will make the US less competitive, reduce standards of living, and make it more difficult for future generations to enjoy the quality of life experienced by their parents and grandparents.

Discussion Questions:

1. What is the Unemployment Rate in the United States today? What is thought to be the US's “natural rate of unemployment” How is unemployment measured (simply state the formula)?
2. Based on America's current unemployment rate, where would you expect the US to be on its business cycle? Draw a business cycle model and indicate where the US is most likely to be.
3. Based on America's current unemployment rate, where do you think current US equilibrium output is compared to full employment output? Draw an AD/AS model and indicate the likely equilibrium the US is currently experiencing.
4. If you were in charge of fiscal policy, identify two possible policy recommendations that the US should consider given its current level of unemployment. Explain how each would impact the level of unemployment in the economy.
5. Assume the marginal propensity to consume in the United States is 0.6, and the government decides to cut military and domestic spending by $85 billion. Calculate the effect this will have on America's GDP.
6. On the business cycle and AD/AS diagram you drew above, show the effect of the $85 billion spending cut.
7. Explain how the spending cut will will impact the level of unemployment in the economy.
8. Discuss with your table the wisdom of the $85 billion spending cut described above.

Terms of trade has always been one of the trickier topics to teach in IB Economics. Stated simply, a nation's terms of trade is a numerical representation of the country's export prices relative to its import prices. With this in mind, the intuitive interpretation is that a “strong” terms of trade is desirable, while a “weak” terms of trade is undesirable. However, it's not always so cut and dry.

In looking around for some data on terms of trade, I came upon the World Bank’s database of “Net barter terms of trade index”, which measures “the percentage ratio of the export unit value indexes to the import unit value indexes, measured relative to the base year 2000″. So, basically, the numbers tell use how much higher or lower each nation's export prices are relative to their import prices today as compared to 2000.

Follow the link above and study the data for various countries. Create some graphs and plot a few countries against one another. See if you can come up with some hypotheses regarding what may account for changes in different country's terms of trade since 2000. For example, study the table below and answer the questions that follow.

Questions:

1. Describe the changes in the four nations' terms of trade since 2003.
2. Why do all nations start close to 100?
3. How might China's trade balance have been affected by the changes in its terms of trade since 2000?
4. How might Venezuela's trade balance have been affected by the changes in its terms of trade since 2000?
5. What are some possible causes for the improvements in Venezuela's and Saudi Arabia's terms of trade? 
6. What was the likely cause of the dip in both Venezuela's and Saudi Arabia's terms of trade in 2008-2009?
7. Under what circumstances will an improvement in a nation's terms of trade lead to an improvement in its trade balance? When does a deterioration in terms of trade improve the trade balance?