Consumption and Investment

A. Consumption and Saving

1. Disposable income is an important determinant of consumption and saving. The consumption function is the schedule relating total consumption to total disposable income. Because each dollar of disposable income is either saved or consumed, the saving function is the other side or mirror image of the consumption function.


2. Recall the major features of consumption and saving functions:


1. The consumption (or saving) function relates the level of consumption (or saving) to the level of disposable income.
2. The marginal propensity to consume (MPC) is the amount of extra consumption generated by an extra dollar of disposable income.
3. The marginal propensity to save (MPS) is the extra saving generated by an extra dollar of disposable income.
4. Graphically, the MPC and the MPS are the slopes of the consumption and saving schedules, respectively.
5. 

Measuring Economic Activity

1. The national income and product accounts contain the major measures of income and product for a country. The gross domestic product (GDP) is the most comprehensive measure of a nation's production of goods and services. It comprises the dollar value of consumption (C), gross private domestic investment (I), government purchases (G), and net exports (X)produced within a nation during a given year. Recall the formula:
   
   GDP = C + I + G + X 
   
   This will sometimes be simplified by combining private domestic investment and net exports into total gross national investment (I^T = I + X):
   
   GDP = C + I^T + G


2. We can match the upper-loop, flow-of-product measurement of GDP with the lower-loop, flow-of-cost measurement, as shown in Figure 20-1. The flow-of-cost approach uses factor earnings and carefully computes value added to eliminate double counting of intermediate products. And after summing up all (before-tax) wage, interest, rent, depreciation, and profit income, it adds to this total all indirect tax costs of business. GDP does not include transfer items such as social security benefits.

Overview of Macroeconomics

A. Key Concepts of Macroeconomics

1. Macroeconomics is the study of the behavior of the entire economy: It analyzes long-run growth as well as the cyclical movements in total output, unemployment and inflation, and international trade and finance. This contrasts with microeconomics, which studies the behavior of individual markets, prices, and outputs.


2. The United States proclaimed its macroeconomic goals in the Employment Act of 1946, which declared that federal policy was "to promote maximum employment, production, and purchasing power." Since then, the nation's priorities among these three goals have shifted. But all market economies still face three central macroeconomic questions: (a) Why do output and employment sometimes fall, and how can unemployment be reduced? (b) What are the sources of price inflation, and how can it be kept under control? (c) How can a nation increase its rate of economic growth?


3. In addition to these perplexing questions is the hard fact that there are inevitable conflicts or tradeoffs among these goals: Rapid growth in future living standards may mean reducing consumption today, and curbing inflation may involve a temporary period of high unemployment.

Capital, Interest and Profits

A. Basic Concepts of Interest and Capital

1. Recall the major concepts:


• Capital: durable produced items used for further production
• Rentals: net annual dollar returns on capital goods
• Rate of return on investment: net annual receipts on capital divided by dollar value of capital (measured as percent per year)
• Interest rate: yield on financial assets, measured as percent per year
• Real interest rate: yield on funds corrected for inflation, also measured as percent per year
• Present value: value today of an asset's stream of future returns
2. Interest rates are the rate of return on financial assets, measured in percent per year. People willingly pay interest because borrowed funds allow them to buy goods and services to satisfy current consumption needs or make profitable investments.

The Labor Market

A. Fundamentals of Wage Determination

1. The demand for labor, as for any factor of production, is determined by labor's marginal product. Therefore, a country's general wage level tends to be higher when its workers are better trained and educated, when it has more and better capital to work with, and when it uses more advanced production techniques.


2. For a given population, the supply of labor depends on three key factors: population size, average number of hours worked, and labor-force participation. For the United States, immigration has been a major source of new workers in recent years, increasing the proportion of relatively unskilled workers.


3. As wages rise, there are two opposite effects on the supply of labor. The substitution effect tempts each worker to work longer because of the higher pay for each hour of work. The income effect operates in the opposite direction because higher wages mean that workers can now afford more leisure time along with other good things of life. At some critical wage, the supply curve may bend backward. The labor supply of very gifted, unique people is quite inelastic: their wages are largely pure economic rent.

Competition among the Few

A. Behavior of Imperfect Competitors

1. Recall the four major market structures: (a) Perfect competition is found when no firm is large enough to affect the market price. (b) Monopolistic competition occurs when a large number of firms produce slightly differentiated products. (c) Oligopoly is an intermediate form of imperfect competition in which an industry is dominated by a few firms. (d) Monopolycomes when a single firm produces the entire output of an industry.


2. Measures of concentration are designed to indicate the degree of market power in an imperfectly competitive industry. Industries which are more concentrated tend to have higher levels of R&D expenditures, but on average their profitability is not higher.


3. High barriers to entry and complete collusion can lead to collusive oligopoly. This market structure produces a price and quantity relation similar to that under monopoly.

Imperfect Competition and Mononply

A. Patterns of Imperfect Competition

1. Most market structures today fall somewhere on a spectrum between perfect competition and pure monopoly. Under imperfect competition, a firm has some control over its price, a fact seen as a downward-sloping demand curve for the firm's output.


2. Important kinds of market structures are (a) monopoly, where a single firm produces all the output in a given industry; (b) oligopoly, where a few sellers of a similar or differentiated product supply the industry; (c) monopolistic competition, where a large number of small firms supply related but somewhat differentiated products; and (d) perfect competition, where a large number of small firms supply an identical product. In the first three cases, firms in the industry face downward-sloping demand curves.


3. Economies of scale, or decreasing average costs, are the major source of imperfect competition. When firms can lower costs by expanding their output, perfect competition is destroyed because a few companies can produce the industry's output most efficiently. When the minimum efficient size of plants is large relative to the national or regional market, cost conditions produce imperfect competition.

Analysis of Perfectly Competitive Markets

A. Supply Behavior of the Competitive Firm

1. A perfectly competitive firm sells a homogeneous product and is too small to affect the market price. Competitive firms are assumed to maximize their profits. To maximize profits, the competitive firm will choose that output level at which price equals the marginal cost of production, that is, P = MC. Diagrammatically, the competitive firm's equilibrium will come where the rising MC supply curve intersects its horizontal demand curve.


2. Variable costs must be taken into consideration in determining a firm's short-run shutdown point. Below the shutdown point, the firm loses more than its fixed costs. It will therefore produce nothing when price falls below the shutdown price.


3. A competitive industry's long-run supply curve, S_L S_L, must take into account the entry of new firms and the exodus of old ones. In the long run, all of a firm's commitments expire. It will stay in business only if price is at least as high as long-run average costs. These costs include out-of-pocket payments to labor, lenders, material suppliers, or landlords and opportunity costs, such as returns on the property assets owned by the firm.

Analysis of Costs

A. Economic Analysis of Costs

1. Total cost (TC) can be broken down into fixed cost (FC) and variable cost (VC). Fixed costs are unaffected by any production decisions, while variable costs are incurred on items like labor or materials which increase as production levels rise.


2. Marginal cost (MC) is the extra total cost resulting from 1 extra unit of output. Average total cost (AC) is the sum of ever-declining average fixed cost (AFC) and average variable cost (AVC). Short-run average cost is generally represented by a U-shaped curve that is always intersected at its minimum point by the rising MC curve.


3. Useful rules to remember are
   
   

Production and Business Organization

A. Theory of Production and Marginal Products

1. The relationship between the quantity of output (such as wheat, steel, or automobiles) and the quantities of inputs (of labor, land, and capital) is called the production function. Total product is the total output produced. Average product equals total output divided by the total quantity of inputs. We can calculate the marginal product of a factor as the extra output added for each additional unit of input while holding all other inputs constant.


2. According to the law of diminishing returns, the marginal product of each input will generally decline as the amount of that input increases, when all other inputs are held constant.


3. The returns to scale reflect the impact on output of a balanced increase in all inputs. A technology in which doubling all inputs leads to an exact doubling of outputs displays constant returns to scale. When doubling inputs leads to less than double (more than double) the quantity of output, the situation is one of decreasing (increasing) returns to scale.

Demand and Consumer Behaviour

1. Market demands or demand curves are explained as stemming from the process of individuals' choosing their most preferred bundle of consumption goods and services.


2. Economists explain consumer demand by the concept of utility, which denotes the relative satisfaction that a consumer obtains from using different commodities. The additional satisfaction obtained from consuming an additional unit of a good is given the name marginal utility, where "marginal" means the extra or incremental utility. The law of diminishing marginal utility states that as the amount of a commodity consumed increases, the marginal utility of the last unit consumed tends to decrease.


3. Economists assume that consumers allocate their limited incomes so as to obtain the greatest satisfaction or utility. To maximize utility, a consumer must satisfy the equimarginal principle that the marginal utilities of the last dollar spent on each and every good must be equal.
   

Basic Elements of Supply and Demand

1. The analysis of supply and demand shows how a market mechanism solves the three problems of what, how, and for whom. A market blends together demands and supplies. Demand comes from consumers who are spreading their dollar votes among available goods and services, while businesses supply the goods and services with the goal of maximizing their profits.

A. The Demand Schedule

2. A demand schedule shows the relationship between the quantity demanded and the price of a commodity, other things held constant. Such a demand schedule, depicted graphically by a demand curve, holds constant other things like family incomes, tastes, and the prices of other goods. Almost all commodities obey the law of downward-sloping demand, which holds that quantity demanded falls as a good's price rises. This law is represented by a downward-sloping demand curve.


3. Many influences lie behind the demand schedule for the market as a whole: average family incomes, population, the prices of related goods, tastes, and special influences. When these influences change, the demand curve will shift.

The Modern Mixed Economy

A. The Market Mechanism

1. In an economy like the United States, most economic decisions are made in markets, which are mechanisms through which buyers and sellers meet to trade and to determine prices and quantities for goods and services. Adam Smith proclaimed that the invisible hand of markets would lead to the optimal economic outcome as individuals pursue their own self-interest. And while markets are far from perfect, they have proved remarkably effective at solving the problems of how, what, and for whom.


2. The market mechanism works as follows to determine the what and the how: The dollar votes of people affect prices of goods; these prices serve as guides for the amounts of the different goods to be produced. When people demand more of a good, its price will increase and businesses can profit by expanding production of that good. Under perfect competition, a business must find the cheapest method of production, efficiently using labor, land, and other factors; otherwise, it will incur losses and be eliminated from the market.


3. At the same time that the what and how problems are being resolved by prices, so is the problem of for whom. The distribution of income is determined by the ownership of factors of production (land, labor, and capital) and by factor prices. People possessing fertile land or the ability to hit home runs will earn many dollar votes to buy consumer goods. Those without property or with skills, color, or sex that the market undervalues will receive low incomes.

The Central Concepts of Economics

A. Why Study Economics?

1. What is economics? Economics is the study of how societies choose to use scarce productive resources that have alternative uses, to produce commodities of various kinds, and to distribute them among different groups. We study economics to understand not only the world we live in but also the many potential worlds that reformers are constantly proposing to us.



2. Goods are scarce because people desire much more than the economy can produce. Economic goods are scarce, not free, and society must choose among the limited goods that can be produced with its available resources.



3. Microeconomics is concerned with the behavior of individual entities such as markets, firms, and households. Macroeconomics views the performance of the economy as a whole. Through all economics, beware of the fallacy of composition and the post hoc fallacy, and remember to keep other things constant.

Glossary Financial Accounting Terms

account payable an amount due for payment to a supplier of goods or services, also described as a trade creditor.

account receivable an amount due from a customer, also described as a trade debtor.

accountancy firm A business partnership (or possibly a limited company) in which the partners are qualified accountants. The firm undertakes work for clients in respect of audit, accounts preparation, tax and similar activities.

accountancy profession The collective body of persons qualified in accounting, and working in accounting-related areas. Usually they are members of a professional body, membership of which is attained by passing examinations.

accounting The process of identifying, measuring and communicating financial information about an entity to permit informed judgements and decisions by users of the information.

accounting equation The relationship between assets, liabilities and ownership interest.

accounting period Time period for which financial statements are prepared (e.g. month, quarter, year).

accounting policies Accounting methods which have been judged by business enterprises to be most appropriate to their circumstances and adopted by them for the purpose of preparing their financial statements.

accounting standards Definitive statements of best practice issued by a body having suitable authority.

Accounting Standards Board The authority in the UK which issues definitive statements of best accounting practice.

accruals basis The effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate (see also matching).

accumulated depreciation Total depreciation of a non-current (fixed) asset, deducted from original cost to give net book value.

acid test The ratio of liquid assets to current liabilities.