Principles of Microeconomics - College or AP Level

4.1 Demand and Supply at Work in Labor Markets

In the labor market, households are on the supply side, and firms are on the demand side. In the market for financial capital, households and firms can be on either side of the market: they are suppliers of financial capital when they save or make financial investments and demanders of financial capital when they borrow or receive financial investments.

In the demand and supply analysis of labor markets, we can measure the price by the annual salary or hourly wage received. We can measure the quantity of labor in various ways, like several workers or hours worked.

Factors that can shift the demand curve for labor include a change in the quantity demanded of the product that the labor produces, a change in the production process that uses more or less labor, and a change in government policy that affects the quantity of labor that firms wish to hire at a given wage. Demand can also increase or decrease (shift) in response to: workers’ level of education and training, technology, the number of companies, and the availability and price of other inputs.

The main factors that can shift the supply curve for labor are: how desirable a job appears to workers relative to the alternatives, government policy that restricts or encourages the number of workers trained for the job, the number of workers in the economy, and required education.

4.2 Demand and Supply in Financial Markets

In the demand and supply analysis of financial markets, the “price” is the rate of return or the interest rate received. We measure the quantity by the money that flows from those who supply financial capital to those who demand it.

Two factors can shift the supply of financial capital to a particular investment: if people want to alter their existing consumption levels and if the riskiness or return on one investment changes relative to other investments. Factors that can shift the demand for capital include business confidence and consumer confidence in the future—since financial investments received are typically repaid in the future.

4.3 The Market System as an Efficient Mechanism for Information

The market price system provides a highly efficient mechanism for disseminating information about relative scarcities of goods, services, labor, and financial capital. Market participants do not need to know why prices have changed, only that the changes require them to revisit previous decisions about supply and demand. Price controls hide information about the actual scarcity of products and thereby cause the misallocation of resources.

5.1 Price Elasticity of Demand and Price Elasticity of Supply

Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. We compute it as the percentage change in quantity demanded (or supplied) divided by the percentage change in price. We can describe elasticity as elastic (or very responsive), unit elastic, or inelastic (not very responsive). Elastic demand or supply curves indicate that quantity demanded or supplied responds to price changes in a greater than proportional manner. An inelastic demand or supply curve is one where a given percentage change in price will cause a minor percentage change in quantity demanded or supplied. A unitary elasticity means that a given percentage change in price leads to an equal percentage change in quantity demanded or supplied.

5.2 Polar Cases of Elasticity and Constant Elasticity

Infinite or perfect elasticity refers to the extreme case where either the quantity demanded or supplied changes by an infinite amount in response to any price change. Zero elasticity is the extreme case in which a percentage change in price, no matter how large, results in zero change in quantity. Constant unitary elasticity in either a supply or demand curve refers to a situation where a price change of one percent results in a quantity change of one percent.

5.3 Elasticity and Pricing

In the market for goods and services, quantity supplied and quantity demanded are often relatively slow to react to changes in price in the short run but react more substantially in the long run. As a result, demand and supply often (but not always) tend to be inelastic in the short run and relatively elastic in the long run. A tax incidence depends on the relative price elasticity of supply and demand. When supply is more elastic than demand, buyers bear most of the tax burden; when demand is more elastic than supply, producers bear most of the tax cost. Tax revenue is more significant the more inelastic the demand and supply are.

5.4 Elasticity in Areas Other Than Price

Elasticity is a general term that reflects responsiveness. It refers to the change of one variable divided by the percentage change of a related variable that we can apply to many economic connections. For instance, the income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income. The cross-price elasticity of demand is the percentage change in the quantity demanded of a good divided by the percentage change in the price of another good. Elasticity applies in labor and financial capital markets, just as it does in markets for goods and services. The wage elasticity of labor supply is the percentage change in the number of hours supplied divided by the percentage change in the wage. The elasticity of savings concerning interest rates is the percentage change in the quantity of savings divided by the percentage change in interest rates.

6.1 Consumption Choices

Economic analysis of household behavior assumes that people seek the highest level of utility or satisfaction. Individuals are the only judge of their utility. In general, greater consumption of goods brings higher total utility. However, the additional utility people receive from each unit of greater consumption tends to decline in a pattern of diminishing marginal utility.

We can find the utility-maximizing choice on a consumption budget constraint in several ways. You can add the total utility of each choice on the budget line and choose the highest total. You can select a starting point at random and compare the marginal utility gains and losses of moving to neighbor points—and thus eventually seek out the preferred choice. Alternatively, you can compare the ratio of the marginal utility to the price of good 1 with the marginal utility to the price of good two and apply the rule that at the optimal choice, the two ratios should be equal.

6.2 How Changes in Income and Prices Affect Consumption Choices

The budget constraint framework suggests a range of responses is possible when income or price changes. When income rises, households demand a higher quantity of everyday goods but a lower quantity of inferior goods. When the price of good rises, households typically demand less of that good—but whether they will demand a much lower quantity or only a slightly lower quantity depends on personal preferences. Also, a higher price for one good can lead to more or less demand for the other.

6.3 Behavioral Economics: An Alternative Framework for Consumer Choice

People regularly make decisions that seem less than rational and contradict traditional consumer theory. This is because traditional theory ignores people’s state of mind or feelings, which can influence behavior. For example, people value a dollar lost more than a dollar gained, even though the amounts are the same. Similarly, many people over-withhold their taxes, essentially giving the government a free loan until they file their tax returns so that they are more likely to get money back than have to pay money on their taxes.

7.1 Explicit and Implicit Costs and Accounting and Economic Profit

Privately owned firms are motivated to earn profits. Profit is the difference between revenues and costs. While accounting profit considers only direct costs, economic profit considers both explicit and implicit costs.

7.2 Production in the Short Run

Production is a firm's transforming inputs (e.g., labor, capital, raw materials, etc.) into outputs. It is impossible to vary fixed inputs (e.g., capital) in a short time. Thus, the only way to change output in the short run is to change the variable inputs (e.g., labor). Marginal product is the additional output a firm obtains by employing more labor. At some point, employing additional labor leads to diminishing marginal productivity, meaning the additional output obtained is less than for the previous increment to labor. Mathematically, the marginal product is the slope of the total product curve.

7.3 Costs in the Short Run

Every input (e.g., labor) has an associated factor payment (e.g., wages and salaries). The cost of production for a given quantity of output is the sum of the amount of each input required to produce that quantity of output times the associated factor payment.

In a short-run perspective, we can divide a firm’s total costs into fixed costs, which a firm must incur before producing any output, and variable costs, which the firm incurs in the act of producing. Fixed costs are sunk costs; because they are in the past and the firm cannot alter them, they should play no role in economic decisions about future production or pricing. Variable costs typically show diminishing marginal returns so that the marginal cost of producing higher levels of output rises.

We calculate the marginal cost by taking the change in total cost (or the change in variable cost, which will be the same thing) and dividing it by the change in output for each possible change. Marginal costs are typically rising. A firm can compare the marginal cost to the additional revenue it gains from selling another unit to determine whether its marginal unit adds to profit.

We calculate the average total cost by taking the total cost and dividing it by the total output at each different output level. Average costs are typically U-shaped on a graph. If a firm’s average cost of production is lower than the market price, a firm will be earning profits.

We calculate the average variable cost by taking the variable cost and dividing it by the total output at each output level. Average variable costs are typically U-shaped. If a firm’s average variable cost of production is lower than the market price, then the firm would be earning profits if fixed costs are left out of the picture.

7.4 Production in the Long Run

In the long run, all inputs are variable. Since diminishing marginal productivity is caused by fixed capital, there are no diminishing returns in the long run. Firms can choose the optimal capital stock to produce their desired output level.

7.5 Costs in the Long Run

Production technology refers to a specific combination of labor, physical capital, and technology that makes up a particular production method.

In the long run, firms can choose their production technology, so all costs become variable. In making this choice, firms will try to substitute relatively inexpensive inputs for relatively expensive ones where possible to produce at the lowest possible long-run average cost.

Economies of scale refer to a situation where the output level increases and the average cost decreases. Constant returns to scale refer to a situation where the average cost does not change as output increases. Diseconomies of scale refer to a situation where as output increases, average costs also increase.

The long-run average cost curve shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm chooses its production technology. A downward-sloping LRAC shows economies of scale; a flat LRAC shows constant returns to scale; an upward-sloping LRAC shows diseconomies of scale. If the long-run average cost curve has only one quantity produced that results in the lowest possible average cost, then all firms competing in an industry should be the same size. However, if the LRAC has a flat segment at the bottom so that a firm can produce a range of different quantities at the lowest average cost, the firms competing in the industry will display a range of sizes. The market demand and the long-run average cost curve determine how many firms will exist in a given industry.

Suppose the quantity demanded in the market of a particular product is much greater than that found at the bottom of the long-run average cost curve, where the cost of production is the lowest. In that case, the market will have many firms competing. If the quantity demanded in the market is less than that at the bottom of the LRAC, there will likely be only one firm.

8.1 Perfect Competition and Why It Matters

A perfectly competitive firm is a price taker, meaning it must accept the equilibrium price at which it sells goods. If a perfectly competitive firm attempts to charge even a tiny amount more than the market price, it will be unable to make any sales. In a perfectly competitive market, there are thousands of sellers, easy entry, and identical products. A short-run production period is when firms are producing with some fixed inputs. Long-run equilibrium in a perfectly competitive industry occurs after all firms have entered and exited the industry and seller profits are driven to zero.

Perfect competition means that there are many sellers, there is easy entry and exiting of firms, products are identical from one seller to another, and sellers are price takers.

8.2 How Perfectly Competitive Firms Make Output Decisions

As a perfectly competitive firm produces more output, its total revenue steadily increases at a constant rate determined by the market price. Profits will be highest (or losses will be smallest) at the quantity of output where total revenues exceed total costs by the greatest amount (or where total revenues fall short of total costs by the smallest amount). Alternatively, profits will be highest where marginal revenue equals marginal cost, which is the price for a perfectly competitive firm. If the market price faced by a perfectly competitive firm is above average cost at the profit-maximizing quantity of output, then the firm is making profits. If the market price is below average cost at the profit-maximizing quantity of output, then the firm is making losses.

If the market price equals the average cost at the profit-maximizing output level, the firm makes zero profits. We call the point where the marginal cost curve crosses the average cost curve, at the minimum of the average cost curve, the “zero profit point.” If the market price that a perfectly competitive firm faces is below average variable cost at the profit-maximizing quantity of output, then the firm should shut down operations immediately. Suppose the market price that a perfectly competitive firm faces is above average variable cost but below average cost. In that case, the firm should continue producing in the short run but exit in the long run. We call the point where the marginal cost curve crosses the average variable cost curve the shutdown point.

8.3 Entry and Exit Decisions in the Long Run

In the long run, firms will respond to profits through a process of entry, where existing firms expand output and new firms enter the market. Conversely, firms will react to losses in the long run through a process of exit, in which existing firms cease production altogether. Through entry in response to profits and exit in response to losses, the price level in a perfectly competitive market will move toward the zero-profit point, where the marginal cost curve crosses the AC curve at the minimum of the average cost curve.

The long-run supply curve shows the long-run output of firms in three different types of industries: ongoing cost, increasing cost, and decreasing cost.

8.4 Efficiency in Perfectly Competitive Markets

Long-run equilibrium in perfectly competitive markets meets two essential conditions: allocative and productive efficiency. These two conditions have significant implications. First, resources are allocated to their best alternative use. Second, they provide the maximum satisfaction attainable by society.

9.1 How Monopolies Form: Barriers to Entry

Barriers to entry prevent or discourage competitors from entering the market. These barriers include economies of scale that lead to natural monopoly; control of a physical resource; legal restrictions on competition; patent, trademark, and copyright protection; and practices to intimidate the competition like predatory pricing. Intellectual property refers to legally guaranteed ownership of an idea rather than a physical item. The laws that protect intellectual property include patents, copyrights, trademarks, and trade secrets. A natural monopoly arises when economies of scale persist over a large enough output range. If one firm supplies the entire market, no other firm can enter without facing a cost disadvantage.

9.2 How a Profit-Maximizing Monopoly Chooses Output and Price

A monopolist is not a price taker; when it decides what quantity to produce, it also determines the market price. For a monopolist, total revenue is relatively low at low output quantities because it is not selling much. Total revenue is also relatively low at high output quantities because a very high quantity will sell only at a low price. Thus, total revenue for a monopolist will start low, rise, and decline. The marginal revenue for a monopolist from selling additional units will decline. Each additional unit a monopolist sells will push down the overall market price, and as it sells more units, this lower price applies to increasingly more units.

The monopolist will select the profit-maximizing output level where MR = MC and then charge the price for that quantity of output as determined by the market demand curve. If that price is above average cost, the monopolist earns positive profits.

Monopolists are not productively efficient because they do not produce at the minimum of the average cost curve. Monopolists are not allocatively efficient because they do not produce at the quantity where P = MC. As a result, monopolists produce less, at a higher average cost, and charge a higher price than a combination of firms in a perfectly competitive industry. Monopolists also may lack incentives for innovation because they need not fear entry.

10.1 Monopolistic Competition

Monopolistic competition refers to a market where many firms sell differentiated products. Differentiated products can arise from characteristics of the good or service, the location from which the firm sells the product, intangible aspects, and perceptions of the product.

The perceived demand curve for a monopolistically competitive firm is downward-sloping, which shows that it is a price maker and chooses a combination of price and quantity. However, the perceived demand curve for a monopolistic competitor is more elastic than the perceived demand curve for a monopolist because the monopolistic competitor has direct competition, unlike the pure monopolist. A profit-maximizing monopolistic competitor will seek out the quantity where marginal revenue equals marginal cost. The monopolistic competitor will produce that output level and charge the price the firm’s demand curve indicates.

If the firms in a monopolistically competitive industry earn economic profits, the industry will attract entry until profits are driven to zero in the long run. Suppose the firms in a monopolistically competitive industry are suffering economic losses. In that case, the industry will experience the exit of firms until economic losses are driven up to zero in the long run.

A monopolistically competitive firm is not productively efficient because it does not produce at the minimum of its average cost curve. A monopolistically competitive firm is not allocatively efficient because it does not produce where P = MC but instead produces where P > MC. Thus, a monopolistically competitive firm will tend to produce a lower quantity at a higher cost and charge a higher price than a perfectly competitive firm.

Monopolistically competitive industries offer consumers benefits in the form of greater variety and incentives for improved products and services. There is some controversy over whether a market-oriented economy generates too much variety.

10.2 Oligopoly

An oligopoly is a situation where a few firms sell most or all goods in a market. Oligopolists earn their highest profits if they can band together as a cartel and act like monopolists by reducing output and raising prices. Since each member of the oligopoly can benefit individually from expanding output, such collusion often breaks down—especially since explicit collusion is illegal.

The prisoner’s dilemma is an example of the application of game theory to the analysis of oligopoly. It shows how, in certain situations, all sides can benefit from cooperative behavior rather than self-interested behavior. However, the parties' challenge is finding ways to encourage cooperative behavior.

11.1 Corporate Mergers

A corporate merger involves two private firms joining together. An acquisition refers to one firm buying another firm. In either case, two formerly independent firms become one firm. Antitrust laws seek to ensure active market competition, sometimes by preventing large firms from forming through mergers and acquisitions, sometimes by regulating business practices that might restrict competition, and sometimes by breaking up large firms into smaller competitors.

A four-firm concentration ratio is one way of measuring the extent of competition in a market. We calculate it by adding the market shares—the percentage of total sales—of the four largest firms in the market. A Herfindahl-Hirschman Index (HHI) is another way of measuring the extent of competition in a market. We calculate it by taking the market shares of all firms in the market, squaring them, and then summing the total.

The forces of globalization and new communications and information technology have increased the competition that many firms face by increasing the amount of competition from other regions and countries.

11.2 Regulating Anticompetitive Behavior

Antitrust firms block authorities from openly conspiring to form a cartel to reduce output and raise prices. Companies sometimes attempt to find other ways around these restrictions. Consequently, many antitrust cases involve restrictive practices that can reduce competition in certain circumstances, like tie-in sales, bundling, and predatory pricing.

11.3 Regulating Natural Monopolies

In the case of a natural monopoly, market competition will not work well. So, the government may wish to regulate prices and output rather than allow an unregulated monopoly to raise prices and reduce output. Common examples of regulation are public utilities, the regulated firms that often provide electricity and water service.

Cost-plus regulation refers to the government regulating a firm which sets the price that a firm can charge over time by looking at the firm’s accounting costs and then adding an average rate of profit. Price cap regulation refers to government regulation of a firm where the government sets a price level several years in advance. In this case, the firm can either earn high profits if it manages to produce at lower costs, sell a higher quantity than expected, or suffer low profits or losses if costs are high or sell less than expected.

11.4 The Great Deregulation Experiment

The U.S. economy experienced a wave of deregulation in the late 1970s and early 1980s when the government eliminated several regulations that had set prices and quantities produced in several industries. Major accounting scandals in the early 2000s and, more recently, the Great Recession have spurred new regulations to prevent similar occurrences. Regulatory capture occurs when regulated industries strongly influence what regulations exist.

12.1 The Economics of Pollution

Economic production can cause environmental damage. This tradeoff arises for all countries, whether high-income or low-income, and whether their economies are market-oriented or command-oriented.

An externality occurs when a buyer and seller exchange impacts a third party not part of the exchange. An externality, sometimes called a spillover, can negatively or positively impact the third party. If those parties imposing a negative externality on others had to account for the broader social cost of their behavior, they would be incentivized to reduce the production of whatever is causing the negative externality. In the case of a positive externality, the third party obtains benefits from the exchange between a buyer and a seller, but they are not paying for these benefits. If this is the case, then markets would tend to produce output because suppliers are unaware of the additional demand from others. If the parties generating benefits to others would somehow receive compensation for these external benefits, they would be incentivized to increase production of whatever is causing the positive externality.

12.2 Command-and-Control Regulation

Command-and-control regulation sets specific limits for pollution emissions and specific pollution-control technologies that firms must use. Although such regulations have helped to protect the environment, they have three shortcomings: they provide no incentive for going beyond the limits they set, they offer limited flexibility on where and how to reduce pollution, and they often have politically motivated loopholes.

12.3 Market-Oriented Environmental Tools

Examples of market-oriented environmental policies, called cap and trade programs, include pollution charges, marketable permits, and better-defined property rights. Market-oriented environmental policies include taxes, markets, and property rights so that those who impose negative externalities must face the social cost.

12.4 The Benefits and Costs of U.S. Environmental Laws

We can make a strong case, taken as a whole, that the benefits of U.S. environmental regulation have outweighed the costs. As the extent of environmental regulation increases, additional expenditures on environmental protection will probably increase marginal costs and decrease marginal benefits. This pattern suggests market-oriented environmental policies' flexibility and cost savings will become more critical.

12.5 International Environmental Issues

Specific global environmental issues, such as global warming and biodiversity, spill over national borders and require addressing with some form of international agreement.

12.6 The Tradeoff Between Economic Output and Environmental Protection

Depending on their different income levels and political preferences, countries are likely to make different choices about allocative efficiency—that is, the Choice between economic output and environmental protection along the production possibility frontier. However, all countries should prefer to make a choice that shows productive efficiency—that is, the Choice is somewhere on the production possibility frontier rather than inside it. Revisit Choice in a World of Scarcity for more on these terms.

13.1 Investments in Innovation

Competition creates pressure to innovate. However, if one can easily copy new inventions, the original inventor loses the incentive to invest further in research and development. New technology often has positive externalities; that is, there are often spillovers from the invention of new technology that benefit firms other than the innovator. Once the firm accounts for these spillovers, the social benefit of an invention typically exceeds the private benefit to the inventor. If inventors could receive a more significant share of the broader social benefits for their work, they would have a greater incentive to seek out new inventions.

13.2 How Governments Can Encourage Innovation

Public policy about technology must often strike a balance. For example, patents incentivize inventors but should be limited to genuinely new inventions and not extend forever.

Government has various policy tools for increasing the rate of return for new technology and encouraging its development, including direct government funding of R&D, tax incentives for R&D, protection of intellectual property, and forming cooperative relationships between universities and the private sector.

13.3 Public Goods

A public good has two key characteristics: it is nonexcludable and non-rival. Nonexcludable means that it is costly or impossible for one user to exclude others from using the good. Non-rival means that when one person uses the good, it does not prevent others from using it. Markets often have difficulty producing public goods because free riders will attempt to use the public good without paying for it. One can overcome the free rider problem through measures to assure that users of the public good pay for it. Such measures include government actions, social pressures, and specific situations where markets have discovered a way to collect payments.

14.1 The Theory of Labor Markets

A firm demands labor because of the value of the labor’s marginal productivity. For a firm operating in a perfectly competitive output market, this will be the value of the marginal product, which we define as the marginal product of labor multiplied by the firm’s output price. The appropriate concept for a firm that is not perfectly competitive is the marginal revenue product, which we define as the marginal product of labor multiplied by the firm’s marginal revenue. Profit-maximizing firms employ labor until the market wage is equal to the firm’s demand for labor. In a competitive labor market, we determine market wage through the interaction between the market supply and market demand for labor.

14.2 Wages and Employment in an Imperfectly Competitive Labor Market

A monopsony is the sole employer in a labor market. The monopsony can pay any wage it chooses, subject to the market supply of labor. If the monopsony offers too low a wage, they may not find enough workers willing to work for them. Since to obtain more workers, they must offer a higher wage, the marginal cost of additional labor is greater than the wage. To maximize profits, a monopsonist will hire workers until the marginal cost of labor equals their labor demand. This results in a lower level of employment than a competitive labor market would provide, but also a lower equilibrium wage.

14.3 Market Power on the Supply Side of Labor Markets: Unions

A labor union is an organization of workers that negotiates with employers over compensation and work conditions. Union workers in the United States are paid more on average than workers with comparable education and experience. Thus, union workers must be more productive to match this higher pay, or the higher pay will lead employers to hire fewer union workers than they otherwise would. American union membership has been falling for decades. Some possible reasons include shifting jobs to service industries; greater competition from globalization; the passage of worker-friendly legislation; and U.S. laws that favor organizing unions.

14.4 Bilateral Monopoly

A bilateral monopoly is a labor market with a union on the supply side and a monopsony on the demand side. Since both sides have monopoly power, the equilibrium level of employment will be lower than that of a competitive labor market. Still, the equilibrium wage could be higher or lower depending on which side negotiates better. The union favors a higher wage, while the monopsony favors a lower wage, but the outcome is indeterminate in the model.

14.5 Employment Discrimination

Discrimination occurs in a labor market when employers pay workers with the same economic characteristics, such as education, experience, and skill, who are paid differently because of race, gender, religion, age, or disability status. In the United States, female workers, on average, earn less than male workers, and Black workers earn less than White workers. There is controversy over which discrimination differences in factors like education and job experience can explain these earnings gaps. Free markets can allow discrimination to occur, but the threat of a loss of sales or a loss of productive workers can also create incentives for a firm not to discriminate. A range of public policies can reduce earnings gaps between men and women or between White and other racial/ethnic groups: requiring equal pay for equal work and attaining more equal educational outcomes.

14.6 Immigration

The current level of U.S. immigration is at a historically high level if we measure it in absolute numbers but not if we measure it as a share of the population. The overall gains to the U.S. economy from immigration are real but relatively small. However, immigration also causes effects like slightly lower wages for low-skill workers and budget problems for certain state and local governments.

15.1 Drawing the Poverty Line

Supply and demand influence wages in labor markets influence wages. This can lead to meager incomes for some people and high incomes for others. Poverty and income inequality are not the same thing. Poverty applies to the condition of people who cannot afford the necessities of life. Income inequality refers to the disparity between those with higher and lower incomes. The poverty rate is what percentage of the population lives below the poverty line, which determines the amount of income it takes to purchase the necessities of life. Choosing a poverty line will always be somewhat controversial.

15.2 The Poverty Trap

A poverty trap occurs when government-support payments decline as the recipients earn more income. As a result, the recipients do not receive much more income when they work because the loss of government support largely or entirely offsets any income that one earns by working. Phasing out government benefits more slowly, as well as imposing requirements for work as a condition of receiving benefits and a time limit on benefits, can reduce the harshness of the poverty trap.

15.3 The Safety Net

We call the group of government programs that address poverty the safety net. In the United States, prominent safety net programs include Temporary Assistance to Needy Families (TANF), the Supplemental Nutrition Assistance Program (SNAP), the earned income tax credit (EITC), Medicaid, and the Special Supplemental Food Program for Women, Infants, and Children (WIC).

15.4 Income Inequality: Measurement and Causes

Measuring inequality involves making comparisons across the entire distribution of income. One way of doing this is to divide the population into groups, like quintiles, and then calculate what share of income each group receives. An alternative approach is to draw Lorenz curves, which compare the cumulative income received to a perfectly equal income distribution. Income inequality in the United States increased substantially from the late 1970s and early 1980s into the 2000s. The two most common explanations that economists cite are changes in household structures that have led to more two-earner couples and single-parent families and the effect of new information and communications technology on wages.

15.5 Government Policies to Reduce Income Inequality

Policies affecting economic inequality include redistribution between rich and poor, making it easier for people to climb the ladder of opportunity, and estate taxes, which are taxes on inheritances. Pushing too aggressively for economic equality can run the risk of decreasing economic incentives. However, a moderate push for economic equality can increase economic output through methods like improved education and by building a base of political support for market forces.

16.1 The Problem of Imperfect Information and Asymmetric Information

Many make economic transactions with imperfect information, where either the buyer, the seller, or both are less than 100% certain about the qualities of what they buy or sell. When information about the quality of products is highly imperfect, it may be difficult for a market to exist.

A "lemon" is a product that turns out, after the purchase, to have low quality. When the seller has more accurate information about the product's quality than the buyer, the buyer will be hesitant to buy out of fear of purchasing a "lemon."

Markets have many ways to deal with imperfect information. In goods markets, buyers facing imperfect information about products may depend upon money-back guarantees, warranties, service contracts, and reputation. Employers facing imperfect information about potential employees may turn to resumes, recommendations, occupational licenses for specific jobs, and employment for trial periods in labor markets. In capital markets, lenders facing imperfect information about borrowers may require detailed loan applications and credit checks, cosigners, and collateral.

16.2 Insurance and Imperfect Information

Insurance is a way of sharing risk. People in a group pay premiums for insurance against an unpleasant event, and those in the group who experience the unpleasant event then receive compensation. The fundamental law of insurance is that what the average person pays over time cannot be less than what the average person gets. In an actuarially fair insurance policy, the premiums a person pays to the insurance company are the same as the average benefits for a person in that risk group. Moral hazard arises in insurance markets because those insured against risk will have less reason to take steps to avoid the costs of that risk.

Many insurance policies have deductibles, copayments, or coinsurance. A deductible is the maximum amount the policyholder must pay out-of-pocket before the insurance company pays the rest of the bill. A co-payment is a flat fee that an insurance policyholder must pay before receiving services. Coinsurance requires the policyholder to pay a certain percentage of costs. Deductibles, copayments, and coinsurance reduce moral hazard by requiring the insured party to bear some costs before collecting insurance benefits.

In a fee-for-service health financing system, medical care providers receive reimbursement according to the cost of services they provide. An alternative method of organizing health care is through health maintenance organizations (HMOs), where medical care providers receive reimbursement according to the number of patients they handle, and it is up to the providers to allocate resources between patients who receive more or fewer health care services. Adverse selection arises in insurance markets when insurance buyers know more about the risks they face than the insurance company. As a result, the insurance company runs the risk that low-risk parties will avoid its insurance because it is too costly, while high-risk parties will embrace it because it looks like a good deal to them.

17.1 How Businesses Raise Financial Capital

Companies can raise early-stage financial capital in several ways: from their owners' or managers' personal savings or credit cards and private investors like angel investors and venture capital firms.

A bond is a financial contract through which a borrower agrees to repay the borrowed amount. A bond specifies an amount that one will borrow, the amounts that one will repay over time based on the interest rate when the bond is issued, and the time until repayment. Corporate bonds are issued by firms; cities issue municipal bonds; state bonds by U.S. states; and Treasury bonds by the federal government through the U.S. Department of the Treasury.

Stock represents firm ownership. A company's stock is divided into shares. A firm receives financial capital when it sells stock to the public. We call a company's first stock sale to the public the initial public offering (IPO). However, a firm receives no funds when one shareholder sells stock to another investor. One receives the rate of return on stock in two forms: dividends and capital gains.

A private company is usually owned by the people who run it daily, although hired managers can run it. We call a private company owned and run by an individual a sole proprietorship, while a firm owned and run by a group is a partnership. When a firm decides to sell stock that financial investors can buy and sell, it is owned by its shareholders, who elect a board of directors to hire top day-to-day management. We call this a public company. Corporate governance is the name economists give to the institutions that are supposed to watch over top executives, though it does not always work.

17.2 How Households Supply Financial Capital

We can categorize all investments according to three key characteristics: average expected return, degree of risk, and liquidity. To obtain a higher rate of return, an investor must typically accept either more risk or less liquidity. Banks are an example of a financial intermediary that operates to coordinate supply and demand in the financial capital market. Banks offer a range of accounts, including checking accounts, savings accounts, and certificates of deposit. Under the Federal Deposit Insurance Corporation (FDIC), banks purchase insurance against the risk of a bank failure.

A typical bond promises the financial investor a series of payments over time, based on the interest rate when the financial institution issues the bond and when the borrower repays it. Bonds that offer a high rate of return but also a relatively high chance of defaulting on the payments are called high-yield or junk bonds. The bond yield is the rate of return a bond promises to pay at the time of purchase. Even when bonds make payments based on a fixed interest rate, they are somewhat risky because if interest rates rise for the economy, an investor who owns bonds issued at lower interest rates is now locked into the low rate and suffers a loss.

Changes in the stock price depend on changes in expectations about future profits. Investing in any individual firm is somewhat risky, so investors are wise to practice diversification, which means investing in a range of companies. A mutual fund purchases an array of stocks and bonds. An investor in the mutual fund then receives a return depending on the fund's overall performance. A mutual fund that seeks to imitate the overall behavior of the stock market is called an index fund.

We can also regard housing and other tangible assets as forms of financial investment that pay a rate of return in capital gains. Housing can also offer a nonfinancial return—specifically, you can live in it.

17.3 How to Accumulate Personal Wealth

It is tough, even for financial professionals, to predict changes in future expectations and thus to choose the stocks whose prices will rise. Most Americans can accumulate considerable financial wealth if they follow two rules: complete additional education and training after graduating high school and start saving money early in life.

18.1 Voter Participation and Costs of Elections

The theory of rational ignorance says voters will recognize that their single vote is doubtful to influence the outcome of an election. Consequently, they will choose to remain uninformed about issues and not vote. This theory helps explain why voter turnout is so low in the United States.

18.2 Special Interest Politics

Particular interest politics arises when a relatively small group, called a particular interest group, each of whose members has a significant interest in a political outcome, devotes considerable time and energy to lobbying for the group’s preferred choice. Meanwhile, the majority, each of whose members has only a slight interest in this issue, pays no attention.

We define pork--barrel spending as legislation whose benefits are concentrated on a single district while the costs are spread widely over the country. Logrolling is when two or more legislators agree to vote for each other’s legislation, which can encourage pork-barrel spending in many districts.

18.3 Flaws in the Democratic System of Government

The majority votes can run into difficulties when more than two choices exist. A voting cycle occurs when, in a situation with at least three choices, choice A is preferred by a majority vote to choice B, a majority vote prefers choice B to choice C, and choice C is preferred by a majority vote to choice A. In such a situation, it is impossible to identify what the majority prefers. Another difficulty arises when the vote is so divided that no choice receives a majority.

A practical approach to microeconomic policy will need to take a realistic view of the specific strengths and weaknesses of markets and government, rather than making the easy but wrong assumption that either the market or government is always beneficial or harmful.

19.1 Absolute and Comparative Advantage

A country has an absolute advantage in those products in which it has a productivity edge over other countries; it takes fewer resources to produce a product. A country has a comparative advantage when it can produce a good at a lower cost than other goods. Countries that specialize based on comparative advantage gain from trade.

19.2 What Happens When a Country Has an Absolute Advantage in All Goods

Even when a country has high productivity levels in all goods, it can still benefit from trade. Gains from trade come about as a result of comparative advantage. By specializing in a good that gives up the least to produce, a country can produce more and offer that additional output for sale. If other countries specialize in their comparative advantage as well as trade, the highly productive country can benefit from a lower opportunity cost of production in other countries.

19.3 Intra-industry Trade between Similar Economies

A large share of global trade happens between high-income economies that are pretty similar in having well-educated workers and advanced technology. These countries practice intra-industry trade, importing and exporting the same products simultaneously, like cars, machinery, and computers. In the case of intra-industry trade between economies with similar income levels, the gains from trade come from specialized learning in particular tasks and economies of scale. Splitting up the value chain means several stages of producing a good occur in different countries around the world.

19.4 The Benefits of Reducing Barriers to International Trade

Tariffs are placed on imported goods to protect sensitive industries, for humanitarian reasons, and for protection against dumping. Traditionally, tariffs were used as a political tool to protect specific vested economic, social, and cultural interests. The WTO has been and continues to be, a way for nations to meet and negotiate to reduce trade barriers. The gains of international trade are huge, especially for smaller countries, but are beneficial to all.

20.1 Protectionism: An Indirect Subsidy from Consumers to Producers

Three tools for restricting trade flow are tariffs, import quotas, and nontariff barriers. When a country places limitations on imports from abroad, regardless of whether it uses tariffs, quotas, or nontariff barriers, it is said to be practicing protectionism. Protectionism will raise the price of the protected good in the domestic market, which causes domestic consumers to pay more, but domestic producers to earn more.

20.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions

As international trade increases, it contributes to a shift in jobs away from industries where that economy does not have a comparative advantage and toward industries where it does have a comparative advantage. The degree to which trade affects labor markets has much to do with the structure of the labor market in that country and the adjustment process in other industries. Global trade should raise the average level of wages by increasing productivity. However, this average wage increase may include gains to workers in specific jobs and industries and losses to others.

In thinking about labor practices in low-income countries, it is helpful to draw a line between what is unpleasant to think about and what is morally objectionable. For example, low wages and long working hours in poor countries are unpleasant to think about, but for people in low-income parts of the world, it may be the best option. Practices like child labor and forced labor are morally objectionable, and many countries refuse to import products made using these practices.

20.3 Arguments in Support of Restricting Imports

Several arguments support restricting imports. These arguments are based on industry and competition, environmental concerns, and safety and security issues.

The infant industry argument for protectionism is that small domestic industries need to be temporarily nurtured and protected from foreign competition for a time so that they can grow into strong competitors. In some cases, notably in East Asia, this approach has worked. Often, however, the infant industries never grow up. On the other hand, arguments against dumping (setting prices below the cost of production to drive competitors out of the market) often seem to be a convenient excuse for imposing protectionism.

Low-income countries typically have lower environmental standards than high-income countries because they worry more about immediate basics such as food, education, and healthcare. However, except for a few extreme cases, shutting off trade seems unlikely to be an effective method of pursuing a cleaner environment.

Finally, there are arguments involving safety and security. Under the rules of the World Trade Organization, countries are allowed to set whatever standards for product safety they wish. Still, the standards must be the same for domestic and imported products, and there must be a scientific basis for the standard. The national interest argument for protectionism holds that it is unwise to import certain essential products because if the nation becomes dependent on critical imported supplies, it could be vulnerable to a cutoff. However, it is often wiser to stockpile resources and use foreign supplies when available rather than preemptively restricting them so as not to become dependent on them.

20.4 How Governments Enact Trade Policy: Globally, Regionally, and Nationally

Governments determine trade policy at many levels: administrative agencies within government, laws passed by the legislature, regional negotiations between a small group of nations (sometimes just two), and global negotiations through the World Trade Organization. During the second half of the twentieth century, trade barriers generally declined substantially in the United States and the global economies. Countries sign international trade agreements to commit themselves to free trade to protect themselves against their particular interests. When an industry lobbies for protection from foreign producers, politicians can point out that their hands are tied because of the trade treaty.

20.5 The Tradeoffs of Trade Policy

International trade certainly has income distribution effects. This is hardly surprising. All domestic or international competitive market forces are disruptive. They cause companies and industries to rise and fall. Government has a role to play in cushioning workers against market disruptions. However, just as it would be unwise in the long term to clamp down on new technology and other causes of disruption in domestic markets, it would be unwise to clamp down on foreign trade. In both cases, the disruption brings with it economic benefits.