CHAPTER 2

Understanding
Economics
and
How it Affects
Business

McGraw-Hill/Irwin Copyright © 2015 by the McGraw-Hill Companies, Inc. All rights reserved.
 What Is Economics?
Economics is the study of how society
chooses to employ resources to produce
goods and services and distribute them
among competing groups and individuals.
 BRANCHES OF ECONOMICS
Macroeconomics: Concentrates on the
operation of a nation’s
economy as a whole.

Microeconomics: Concentrates on the

behavior of people and
organizations in markets
for particular products or
services.
 RESOURCE DEVELOPMENT
Resource Development -- The study of
how to increase resources and create
conditions that will make better use of them.
We accomplish this by:

• New Technology
• New Methods
• New Processes
• Better Resources
 EXAMPLES of RESOURCE
DEVELOPMENT

• Making resources last longer - Recycling

• New energy sources - Hydrogen fuel
• New ways of growing foods - Hydroponics
• New ways of creating goods and services
– Aquaculture
– Nanotechnology

Resource Development is often referred to as the New

Economy.
 Economic Systems
CAPITALISM is an economic system in which all or most of
the factors of production and distribution are privately owned
and operated for profit.

SOCIALISM is an economic system based on the premise

that some, if not most, basic businesses should be owned by
the government so that profits can be distributed among the
people.

COMMUNISM is an economic and political system in which

the state (the government) makes almost all economic
decisions and owns almost all the major factors of
production.

Note: These are nothing but economic philosophies of how

society (country) chooses to employ its resources.
 TWO MAJOR
ECONOMIC SYSTEMS

• Free-Market Economies -- The market largely

determines what goods and services are
produced, who gets them, and how the
economy grows. (Capitalism)

• Command Economies -- The government

largely determines what goods and services are
produced, who gets them, and how the economy
will grow. (Socialism, Communism}

2-7
 MIXED ECONOMIES
• Note: Neither free-market nor command
economies have created sound economic
conditions so countries use a mix of the two
economic systems.

• Mixed Economies -- Some allocation of

resources is made by the market and some by
the government.

• Although the U. S. subscribes to the Capitalism

philosophy, the U.S. does employ some
Socialism and Communism philosophies
making it a mixed economy. 2-8
 Limits of Free-Markets
(Capitalism)
• Inequality of Wealth Causes
National & World Tension

• Greed Compromises Ethics

• Limitations Push Country

towards Socialism, which
Leads to More Government
Regulation
 Trends in World Economies

• Communist governments are disappearing.

• Socialist governments are
cutting back on social
programs, lowering taxes and
moving toward capitalism.
• Capitalist countries are
increasing social programs
and moving more toward
socialism.
 FOUR DEGREES
of COMPETITION or FORMS of CAPITALISM

1. Perfect or Pure
Competition

2. Monopolistic
Competition

3. Oligopoly

4. Monopoly
 EXAMPLES
Perfect (Pure) Competition: Many sellers, similar
products. Example  Agricultural Products
Kansas Nebraska
VS.
Wheat Wheat

Monopolistic Competition: Large number of sellers,

products differ but are close substitutes. Example
 Fast Food
 EXAMPLES
Oligopoly: Few sellers that dominate market.
Example  Soft Drinks

Pure Monopoly: Single seller has all the sales.

Example  Public Utilities
 PRICING
• A seller may want to sell shirts for
$50, but only a few people may
buy them at that price. This
creates a surplus of goods.
• A seller lowers the price to $30,
more people than normal buy the
shirts. This creates a shortage of
goods.
• The seller establishes a price of
$40 based on what consumers
are willing to pay and what the
seller is willing to provide.
 SUPPLY CURVES
• Supply -- The quantities of products businesses are
willing to sell at different prices.
 DEMAND CURVES
• Demand -- The quantities of products consumers are
willing to buy at different prices.
 Supply and Demand

Surplus
High

Market Price
(Equilibrium Point)
Price

S Shortage D
Low Quantity High
 Price Elasticity
When Elastic Demand exists, a slight decrease in
the price of a product results in a relatively large
increase in demand or items sold. On the other hand,
a slight increase in price results in a relatively large
decrease in demand or items sold. In other words,
people are price sensitive. When Inelastic Demand
exist, a slight increase or decrease in price will not
significantly change the demand or items sold.
However, lowering price will increase the quantity
sold but revenues will decrease. In other words,
people are not as price sensitive.
 Price Elasticity
Elastic Demand (E>1): Percentage change in
quantity demanded is greater than
percentage change in price

Inelastic Demand (E<1):

Price (P)

Percentage change in
quantity demanded is less
than percentage change
in price

Quantity
(Q)
 Elasticity Example
Elastic Demand
Price Demand Revenue
$7.00 50 $350.00
$9.00 20 $180.00

Inelastic Demand
Price Demand Revenue
$7.00 50 $350.00
$9.00 47 $423.00
SOME DETERMINANTS OF ELASTICITY
Price elasticity can vary with products and services.
A product could have elastic demand in one part of
the country and inelastic demand in another part of
the country. Also price elasticity for a product or
service is influenced by several factors.

Availability of Substitutes: If a product or service

has close substitutes, demand would be elastic.
However if a product or service has few substitutes,
demand would be inelastic. For example, a new
shirt or blouse has many possible substitutes, but
gasoline has almost no substitutes.
SOME DETERMINANTS OF ELASTICITY
Viewed As A Necessity or Luxury: If a person
views a product or service as a necessity, demand
would be inelastic. If a person views a product or
service as a luxury, demand would be elastic. For
example, Person A and Person B enjoy eating
steak. Person A sees steak as a necessity and
Person B sees steak as a luxury. The price of steak
increases. Person A will keep
buying steak because they see
it as a necessity. Person B will
stop buying steak because they
see it as a luxury and will start
buying something else.
SOME DETERMINANTS OF ELASTICITY
A Person’s Income or Budget: The amount of money
a person allocates in their budget for a product or service
will influence demand. If a person has a tight budget for the
product/service, demand would be elastic. If a person has a
flexible budget for a product/service, demand would be
inelastic. Person A has a tight budget for groceries and buys
three cans of peas for $1. The price increases to three cans
of peas for $1.25. Because of the
tight budget, Person A stops buying
peas and searches for something else
that is three cans for $1. Person B
has a flexible budget for groceries.
The price increase in peas stays
within Person B’s range and they
buy the three can of peas.
 BUSINESS CYCLE
• Business Cycles -- Periodic rises and falls that occur in
economies over time.
• Four Phases of a Business Cycle:
1. Prosperity --- Consumer spending is brisk, economic
boom
2. Recovery – Consumer is cautious, reluctant. The
economy stabilizes and starts to grow.
3. Recession – Two or more consecutive quarters of
decline in the GDP. Consumer buys basic, functional
products.
4. Depression – A severe recession, lowest spending.
 BUSINESS CYCLE
Although the business cycle consist of four stages, the
U.S. economy goes through three stages (Prosperity,
Recession, Recovery) on the average every 7 years.
The World business cycle goes through the same three
stages on the average every 48 to 60 years. For
example if the World is in prosperity, more economies
(countries) are doing good than bad. If the World is in a
recession, more
economies
(countries) are
doing bad than
good.
Key Economic Indicators
• Gross Domestic Product (GDP)

• Unemployment Rate

• Price Indexes
• Consumer Price Index (CPI)
• Producer Price Index (PPI)
 GROSS DOMESTIC PRODUCT
Gross Domestic Product (GDP) -- Total
value of final goods and services produced
in a country in a given
year. As long as a
company is within a
country’s border, their
numbers go into the
country’s GDP
(even if they are
foreign-owned).
 UNEMPLOYMENT

• Unemployment Rate -- The percentage of

civilians at least 16-years-old who are unemployed
and tried to find a job within the prior four weeks.

• Four Types of
Unemployment
1. Frictional
2. Structural
3. Cyclical
4. Seasonal
 TYPES OF UNEMPLOYMENT
1. Frictional --- Caused by workers seeking new jobs or
new entrants into the labor force.

2. Structural --- Caused by a mismatch between skills or

location of job seekers and the requirements of location
of available job.

3. Cyclical --- Caused by a downturn in the business cycle.

4. Seasonal --- Demand for labor varies over the year (farm
workers, construction, lifeguards).
 UNEMPLOYMENT FIGURES CAN BE
MISLEADING
 Does not include discouraged and
underemployed workers.
 About 2% of people are considered part of the
workforce but unemployable such as the
mentally retarded and the physically
handicapped. So if unemployment is 6.5%,
subtract 2% (6.5% - 2.0% = 4.5%) and that
reflects truly who is looking for a job.
 President Ronald Regan’s new method of
calculating unemployment that includes the
military.
President Ronald Regan’s New Method
The U.S. was in a deep recession and one of
President Regan’s campaign promises was to
lower unemployment. After two years in office,
unemployment was still double digits. During his
annual State of the Union address, he told the
country that the military would be
included in the employment figures
to truly reflect the unemployment
rate in the country. But think about
it. Is there unemployment in the
military?
President Ronald Regan’s New Method
(Continued)
Let’s say a workforce has 100,000 people and
10,000 people are looking for a job, which is a
10% unemployment rate. Now let’s add 100,000
military people to the workforce making the
workforce now 200,000; but there is no
unemployment in the military so 10,000 people
are still looking for a job. 10,000 / 200,000 is
now a 5% unemployment rate. President Regan
kept his promise, unemployment rate was now
single digits, and everybody was happy.
 INFLATION
The general rise in the prices of goods and services over
time. A major constraint on consumer spending, which can
occur during any stage of the business cycle, is inflation,
which is the devaluation of a person’s money in terms of
what it can buy. The impact of inflation would be less
restrictive if income kept pace with rising prices, but often it
does not. The next slide shows what a person would need
to make in 10 years if Inflation was 5% a year for 10 years
to have the same purchasing power they had 10 years
earlier. For example if you made $25,000 today with 5%
annual inflation, in 10 years you would need to be making
$40,722 to have the same purchasing power you had 10
years earlier. Also there are two types of inflation:
Demand-Pull inflation and Cost-Push inflation.
HOW INFLATION AFFECTS PURCHASING POWER

Annual inflation rate of

5% for 10 years

Source: USA Today Research

 TWO TYPES OF INFLATION
Demand – Pull Inflation
(Commonly measured by CPI or Consumer
Price Index)
Refers to a condition in which buyers want to buy more
goods and services than are available at the time. The
demand for goods and services is related to the amount of
money in the economy. If the supply of money increases
faster than production increases, the result is
inflation. This is called “TOO MUCH
MOMEY CHASING TOO FEW GOODS.”
 TWO TYPES OF INFLATION
Cost – Push Inflation
(Commonly measured by PPI or Producer
Price Index)

Refers to the fact that business people raise prices when

the costs of various factors of production go up. For
example, increases in the cost of labor, machinery, raw
materials, fuels, and credit push up prices.
 INFLATION EXAMPLE
Everybody decides to eat one BigMac a day at McDonald’s.
McDonald’s does not have enough resource (beef for
burgers) to meet demand and you don’t grow a cow over
night. To curb demand, McDonald raises the price of their
BigMac. By the consumer demanding a product too fast,
they have caused Demand – Pull inflation. Now let’s say
the rancher that raises cattle for burgers has to pay more for
the corn that is fed to the cattle. The rancher charges
McDonald’s more for the beef, in turn McDonald charges
consumers more for the BigMac, thus causing Cost – Push
inflation.
 FISCAL POLICY
FISCAL POLICY refers to the federal
government’s efforts to keep the economy
stable. This is done by:

1. Increasing or decreasing taxes

2. Government spending (borrowing)

 DOWNSIDE OF FISCAL POLICY
2015 Interest on National Debt = 220 Billion

2024 Projected Interest on National Debt =

$799 Billion
Social Security/Medicare facts:

 Disability fund part of social security will run dry

around 2016 – 2018
 Medicare for elderly will run dry in 2024
 Social Security will run dry in 2038
Sources: TreasuryDirect , Associated Press, & Congressional Budget Office
 DOWNSIDE OF FISCAL POLICY
 If $1 bills were stacked, the National Debt
would stretch over 1,000,000 miles. The
moon is only 238,857 miles away.
 If we had one billion dollars that we could
put back into the economy instead of using
it to pay the interest on the national debt,
what could one billion dollars buy? The
next slide shows what we could do with
one billion dollars.
 WHAT $1 BILLION CAN BUY
An Egg McMuffin and large coffee for the
President & his 2,000 Secret Service
agents every morning for 489 years.

Average annual grocery bill for 250,000 families

of 4.

One year’s food for 5 million cats & dogs.

Tuition, room and board for freshman classes at

Brown, Cornell, Harvard, Pennsylvania &
Yale with $50M leftover for books.
 MONETARY POLICY
MONETARY POLICY is the management of
the monetary supply and interest rates the
Federal Reserve Bank (the Fed). This is
done by
.1. Increasing or decreasing money supply

2. Raising or lowering interest rates. When the

economy is booming, the Fed tends to
increase interest rates. When the economy is
in a recession, the Fed tends to decrease the
interest rates.
 Federal Reserve Monetary Policy
Contractionary Expansionary
(Fed tightens money supply) (Fed loosens money supply)

Results: Results:

Interest rates Interest rates

Economic growth Economic growth
Unemployment Unemployment
Consumer Spending Consumer Spending
Inflation Inflation
 DOWNSIDE OF MONETARY POLICY
Getting Financial Institutions to Cooperate

When the Fed lowers the interest rate for financial

institutions, usually the financial institutions pass
on the savings by charging a lower interest rate to
consumers so consumers start spending more.
However during our last deep recession, the Fed
was charging financial institutions 0% to ½%
interest rate. Did anybody see the interest rate on
their credit cards go down? No. Financial
institutions did not pass on the savings,
kept the margin themselves, and made
back money they lost during the recession.
 SELF CHECK

Answer the following questions

1. Which is the study of how to
employ resources to produce
goods and services and distribute
them among competing groups
and individuals?

A. Economics
B. Capitalism
C. Marketing
D. Socialism
E. Communism
2. ________ might be a topic emphasized in
a microeconomics class.

A. How a nation’s GDP is computed

B. The reason's why the unemployment
rate for the economy is rising or falling
C. How market conditions determine the
price of a specific product
D. How the government can use fiscal and
monetary policies to stabilize the
economy
E. How a nation’s GO is computed
3. One of the concerns associated with
capitalism is that

A. it is not very successful at creating

wealth.
B. some businesspeople may let greed
guide their behavior.
C. the amount of economic freedom
enjoyed by consumers is very limited.
D. producers are unlikely to supply the
goods and services that consumers
value the most.
E. It creates “Brain Drain.”
4. The market price of apples is currently
rising. In a free-market economy, what
is the most likely explanation of this
price change?

A. The government has decided to set a

higher price so that the firms in the
market make an adequate profit.
B. There is a shortage in the market for
apples.
C. The supply of money has decreased.
D. The equilibrium price is lower than the
market price.
E. There is a surplus in the market for
apples.
5. Which of these represent a major trend in the
world today?

A. Free-market economies are moving more

toward socialism and socialist economies are
moving more toward capitalism.
B. Productivity in the service sector is rapidly
increasing much more than productivity in
manufacturing.
C. Governments in socialist economies are
increasing their use of social programs and
relying on higher tax rates to finance these
programs.
D. Governments in countries with capitalist
economies are paying less attention to
environmental concerns and issues involving
social equality.
6. __________, GDP, and price indices
are the three of the major
indicators of the economic
condition of the U. S.

A. Debt to equity ratio (DER)

B. Gross resource utilization index
(GRUI)
C. Unemployment rate
D. Index of capital formation
E. Gross Output index
7. A collapse in the national banking
system of Moronia has resulted in
a condition where prices are
actually declining. This condition
is known as

A. disinflation.
B. deflation.
C. stagflation.
D. overproduction.
E. core inflation.
8. Ruby recently quit her job because she and
her boss didn’t get along and she saw little
chance for advancement. The economy
appears healthy and lots of firms are hiring
people with her qualifications. Which of the
following statements about Ruby’s current
situation is most accurate? Ruby is

A. not considered unemployed because she

voluntarily quit her job.
B. an example of cyclical unemployment.
C. an example of frictional unemployment.
D. most likely to find employment quickly if she
seeks training in a different field.
E. an example of structural unemployment.
9. Which of these is the most accurate
statements about the Federal Reserve
System (the Fed)?

A. The Fed is an agency of the U.S. Treasury

Department that has the responsibility of
collecting tax receipts for the IRS.
B. The Fed manages the U.S. money supply and
interest rates.
C. The Fed is the primary government agency
involved in carrying out our nation's fiscal
policies.
D. The Fed is the agency of the government
that ensures the U.S. maintains enough gold
reserves to pay any foreign debts that result
from international trade.
10. Senator Alice Mack is alarmed at the state
of the economy. Unemployment is high and
GDP is low. Senator Mack has called for
Congress to take decisive action to increase
its expenditures and cut taxes in order to
stimulate the economy. The actions called
for by Senator Mack are examples of the
government's use of

A. monetary policy.
B. fiscal policy.
C. incomes policy.
D. social investment policy.
E. strategic policy.
 SELF CHECK ANSWERS
1. A
2. C
3. B
4. B
5. A
6. C
7. B
8. C
9. B
10. B