defined in two quite different ways. It can be thought of as changes over time in aggregate or total real output an economy produces or it can be thought of in terms of a change over time in per capita real output. Even seemingly small rates of growth lead to substantial effects on the level of GDP when the growth rates are compounded over a number of years. It is these are compounded over a number of years. It is these small, but persistent, rates of economic grwoth that have allowed the industrialized countries of the world to achieve their present economic positions. Similarly, it is the small, but persistent, growth rates in per capita income that have created the high standard of living enjoyed, on average, by people living within these economies.
Several factors determine the rate of growth in an economy. Historically, the growth of inputs--capital, land, and labor--have been quite important. More recently, economic growth has largely been accounted for by increases in productivity.
is determined by the resources available to an economy. Changes in these resources will change the _________. of an economy. Thus, increases or improvements in natural resources, the capital stock, the labor supply, or in the technologies that combine these inputs in productive ways will increase potential real output.
The effect of labor on potential real output is both straightforward and subtle. Any change in the number of people actually employed will change the amount of people actually employed will change the amount the economy actually produces. However, the number of people actually employed will be determined by the demand for labor, the supply of labor, expectations that demanders and suppliers have about price levels and real wages, and contracts between suppliers and demanders. When households and firms have the same expectations and contracts have fully adjusted to market conditions, the labor market will be in equilibrium. The amount of labor provided to the economy when this amount of labor is employed will determine the potential real output for the economy. Changes in the equlibrium level of employment in the labor market will lead to changes in potential real output. Not all persons will be employed when the labor market is in equilibrium, only those willing to work at the equilibrium real wage. When the labor market is in equilibrium, however, actual output and potential real output coincide.
The important difference between an economy's response in the short run and the long run is that, in the long run, wages and prices are flexible and can respond to changes in market supplies and demands as well as to changes in the overall price level. In the short run, wages are sticky and cannot adjust fully to changes in supply and demand or to changes in the overall price level. The failure of prices and wages to adjust immediately in the short run and wages to adjust immediately in the short run means that adjustments occur in the actual output produced and, hence, in the the actual output produced and, hence, in the employment of labor and other resources. At times, therefore, actual real output will deviate from potential real output. Hence, both changes in output as well as changes in prices are an important part of the macroeconomic adjustment process. The frictional rate of unemployment represents a kind of natural rate to which the economy returns. It appears, however, that the natural unemployment rate increased from 1970 to 1990, and then, perhaps, decreased. Several reasons have been suggested for these changes: First, the composition of the labor force has shifted in the 1970s and 1980s toward younger workers and more women: both groups have traditionally had higher unemployment rates. Second, unemployment compensation has increased over time, thereby reducing the costs of being unemployed somewhat and increasing the rate of frictional unemployment as a consequence. Third, the increase in dual-income households has reduced the costs for one of the income earners to be unemployed. As a consequence, the frictional unemployment rate increased. Its apparent decline in the 1990s is more puzzling. Although fiscal and monetary policy appear to solve the problems of unemployment and inflation quite nicely, they are not simple to implement.
1. Shocks to the economy are not always easy to predict. As a consequence, it takes time to discover that an aggregate demand or aggregate supply shock has occurred.
2. Designing an appropriate policy requires knowledge of both the size of the shock to the economy and the magnitude of the effect on the economy that the policy response will have.
3. Appropriate stabilization policies must affect aggregate demand reasonably quickly and in predictable ways. In this regard, monetary policy, which can be implemented rapidly, affects the economy indirectly and slowly over time. Fiscal policy, which is usually difficult to implement rapidly, affects the economy directly and quickly.
Even if the appropriate responses to an economic shock are understood and are "in principle" possible, they may do little good in practice. The economy may be able to move to full employment more rapidly than a policy can be designed, implemented, and have an effect. Indeed, if the timing of countercyclical monetary and fiscal policy is off, they may actually exacerbate economic cycles.
An individual's production possibilities depend upon individual skill, the tools available to the individual, training and acquired skills, work effort, and the technology that combines ability, skills, tools, and resources. Because these differ for different individuals, individuals will typically have different opportunity costs.
The ability to produce, the possible choices, and their costs can be represented by a production possibilities frontier. A PPF indicates the maximum amount that can be produced of any particular mix of goods and services.
Teams are often more productive than individuals working alone. However, team production creates opportunities for individual workers to shirk. Shirking can be reduced, and the substantial gains from team production realized, if some people monitor the work effort of others. Since these monitors have, in turn, incentives to shirk ,firms are organized where there is a hierarchy of monitors. Thus, the typical pyramidal organization of a firm evolved to reduce or minimize the shirking problem. Likewise, the rich array of compensation schemes (e.g., wages, salaries, commissions, tips, bonuses, stock options, etc.) evolved as ways to eliminate or reduce the costs of shirking and monitoring. If the quantity demanded is greater than the quantity supplied at a particular price, there is excess demand. If the quantity demanded is less than the quantity supplied at a particular price, however, there is excess supply. If the market price increaes when there is excess demand, and decreases when there is excess supply, a market coordinates the differing interests of demanders and suppliers. Specifically, the price moves to equate the quantity that suppliers willingly provide to the market with the quantity that demanders want to purchase. When the price is such that there is neither excess demand nor excess supply, the amount that demanders wish to purchase will be equal to the amount that suppliers wish to sell: the market is in equilibrium at that price.
Changes in the desires of either suppliers or demanders will lead to predictable changes in price:
1. An increase in demand, if nothing else happens, will lead to an increase in the market price.
2. An increase in supply if nothing else happens will lead to a decrease in the market price.
3. A decrease in demand, if nothing else happens, will lead to a decrease in the market price.
4. A decrease in supply, if nothing else happens, will lead to an increase in the market price.
An appreciation of an economy's currency in foreign exchange markets will make its exports appear more costly to foreigners and, generally, its exports will fall. Also, as just noted, an appreciation also makes imports from abroad appear less costly to domestic citizens, and, as a consequence, imports will increase. The combined effects of an appreciation, then, is that net exports will fall. If a country has balanced trade--that is, net exports are zero--then it will find itself with a trade deficit (net exports will be less than zero). If a country has a trade surplus--that is, its net exports are positive--the effect of the appreciation will be to reduce the size of the surplus.
A depreciation of an economy's currency in foreign exchange markets will have the opposite effect: net exports will increase. In this case, an economy with balanced trade will find that now has a trade surplus; one with a trade deficit will find that the deficit falls or is eliminated.
It follows that if a country's currency appreciates when it is running a trade surplus, the appreciation will tend to eliminate the surplus and if depreciation occurs when there is a trade deficit, the depreciation will tend to eliminate the deficit. For this reason, net exports can be persistently different from zero (e.g., negative) only if individuals in one economy choose to hold the currency or assets of another economy.
When too little is produced because of a monopoly, the government can provide an incentive for the monopolist to increase its output, thereby moving the market toward the efficient level of output, by regulating the monopolist's prices.
Setting the maximum price that a monopoly can charge below what it would set on its own will force the monopolist to increase its output, as long as the marginal cost curve is below the demand curve. The maximum price is set below the point at which the marginal cost curve is equal to the demand curve, a monopolist will decrease its output and the quantity demanded will increase, thus creating a shortage. The efficient outcome can be obtained if the regulated price is set equal to marginal cost, as long as marginal cost is greater than or equal to average total cost.
For a natural monopoly, setting price equal to marginal cost will lead to losses because, in this case, marginal cost is less than average total cost. In this case, a regulatory agency has no choice but to set price at or above average total cost. If the regulated price is set equal to average total cost, a regulated natural monopoly will break even, but will not operate at the efficient scale.
Setting the regulated price equal to either marginal cost or average total cost is, in general, a difficult matter because a regulated firm's costs are not easy to observe.
Externlaities arise because property rights are not clearly defined. If transaction costs are low, strategic bargaining problems avoidable, and private valulations accurate, then once property rights are clearly defined resources will move to the highest-valued use, thus eliminating externalities, regardless of to whom the property rights are assigned. Or, conversely, even when property rights are clearly defined, if transaction costs are high, strategic bargaining problems serious, or private valuations inaccurate, resources might not move to the highest-valued use. In this case, externalities might not be eliminated without more, direct public policy responses. When information is imperfect, either inherently or because searching is too costly, decisions will bem ade in partial ignorance. This creates uncertainty or risk. The degree to which individuals prefer less risk will be reflected by a demand for insurance against the risk. A supply of insurance is possible if some people are tolerant of risks and become speculators who are willing to assume risks for some payment. A supply of insurance is also possible if risks can be pooled so that firms can take advantage of the law of large numbers. However, certain kinds of risks, notably those that are not independent, and certain kinds of behavior, notably moral-hazard or adverse-selection, make it more difficult to supply insurance. In some cases, these difficulties can be overcome by selecting risk pools carefully, by offering contracts with deductibles, by requiring coinsurance, or by all-or-nothing insurnace pools.