Brian

THE ECONOMIC ENVIRONMENT OF BUSINESS


Due via OwlSpace, Friday, August 17th, 8a
1. Unemployment

a. Many are concerned that the U.S. went directly from a period of high cyclical unemployment to a period of high structural unemployment. Should an unemployed person care which label an economist applies or is out of work is just out of work?

Cyclical unemployment is caused by recessions. Recessions can have various kinds of causes. Structural unemployment is caused by a mismatch between workers’ skills and the skills employers are seeking, or between workers’ location and the places where employers are hiring. Given that the economist is actually correct in what is behind the unemployment rate, the more serious one for an unemployed person is a recession in that there are just not enough jobs regardless of training. Structural unemployment can be addressed through re-training and relocation since the jobs are actually there. The one of more concern is high cyclical unemployment since there is a quicker solution to high structural unemployment. Still being out of work is being out of work and no paycheck is no paycheck!!!

b. Unemployment near 0% is expected for a healthy economy. True? False? Why?
False:
While on the surface it appears that a 0% unemployment rate would be terrific for the citizens of a country, having a small amount of unemployment is actually desirable. To understand why, we need to look at the three types (or causes) of unemployment: cyclical, frictional, and structural
Most people would argue that since cyclical unemployment is the by-product of a weak economy, it is necessarily a bad thing, though some have argued that recessions are good for the economy. The latter is not a position I hold, so I'm willing to accept that generally speaking, a zero level of cyclical unemployment is likely to be beneficial.
What about frictional unemployment? Let's go back to our friend who quit his job as an economic research to pursue his dreams in the music industry. He quit a job he disliked to attempt a career at the music industry, even though it caused him to be unemployed for a short while. Or consider the case of a person who is tired of living in Flint and decides to make it big in Hollywood and who arrives in Tinseltown without a job. A great deal of frictional unemployment comes from people following their hearts and their dreams. This is certainly a positive type of unemployment, though we would hope for these individuals' sakes that they do not stay unemployed for too long.
Finally, structural unemployment. When the car became commonplace, it cost a lot of buggy manufacturers their jobs. At the same time, most would argue that the automobile, on net, was a positive development. The only we could ever eliminate all structural unemployment is by eliminating all technological advancement.
By breaking down the three types of unemployment into cyclical unemployment, frictional unemployment, and structural unemployment, we see that an unemployment rate of 0% is not a positive thing. A positive rate of unemployment is the price we pay for technological development and for people chasing their dreams.


c. In terms of economic health, what do you think is more telling, the trend in job destruction or the trend in job creation? If you could only see one of these series before making a guess on the economic health of a nation, which would you want to see? Why?
Job creation is measured as the net employment change of establishments that are expanding employment plus the employment at newly opened establishments. Job destruction is measured as the net employment change at establishments that are reducing employment plus the employment loss due to establishment closings. The difference between job creation and job destruction reflects the net change in the number of jobs. I would want to see job destruction since these are job that are definitely over and we have yet to see the benefit of jobs being created. Job destruction in my opinion has an immediate impact on the health of the economy since people will be out of work and unable to consume at prior levels.

d. Does the idea of “efficiency wages” ring true to you? Why or why not?
A higher than market-clearing wage set by employers to, for example: to discourage shirking by raising the cost of being fired, encourage worker loyalty, raise group output norms, improve the applicant pool, raise morale. These ring true to me since people are being paid well in their jobs and no they will not be paid more in alternate jobs and this helps retain them . This is especially true for structural employment where workers are hard to replace or find.
e. HO page 271 shows a graph of both a broad measure of unemployment and the usual measure. Claim: If the gap between the two were constant, policy makers would draw the same conclusions from either series. Yes? No? Maybe? Explain.

The broadest measure, U-6, is useful to keep an eye on. It adds up those traditionally labeled as unemployed, plus persons "marginally attached" to the labor force, plus all the people working part time when they'd rather have a fuller schedule. Then it divides that big total by the civilian labor force (adding in the "marginally attached" people to this side of the equation as well). The broad measure of joblessness will always be higher than the official rate, but the two tend to move in tandem. And when an economic expansions gains steam, people will come out of the marginally attached camp and back into the official labor force. Even if they don't find jobs right away, just the fact they are looking again is a good sign. The conclusions for the usual measure can only be made about the traditional unemployed and the broadest U-6 measures the “marginally attached”, part-time and traditional to the labor force. They move together so they can conclude that the economy is moving forward or slowing down in either case



f. In 2007, Segolene Royal, in an unsuccessful bid for president of France, proposed that workers who lost their jobs would receive unemployment payments equal to 90% of the previous wages during their first year of unemployment. If this proposal were enacted, what would likely be the effect on the unemployment rate in France? Why?

Unemployment would increase since why work when you can make almost the same being unemployed? Companies would let people go easily and they would leave with no real concerns for their welfare since without working they will still have almost full salary. There is just not motivation on either the employer or employees side to retain or let go..work or not work. The government would also go into a great deal of debt.




Let’s say, to keep these unemployment payments from adding to government debt, it was required that the payment be made by the business that fired the worker. What would the likely impact of this policy be on unemployment in the short- and long-terms? Explain.
In the short-term, companies would fight to keep their employees on board because the cost would be so high to let them go. In the short-term unemployment should not significantly go up. In the long-term, however, companies could not make employee changes needed and would begin facing not being able to afford keep employees or afford to pay their unemployment so companies would begin shutting down, out sourcing, relocating, etc thus having unemployment skyrocket !

{Based on HO Ch. 9 question 3.4 which is based on Alessandra Galloni and David Gautheir-Villars, “France’s Royal Introduces Platform Ahead of Election,” WSJ, February 12, 2007.}
2. Inflation
a. How is it that inflation redistributes income? Please provide a numerical example.

Unanticipated inflation, inflation that is not expected, will redistribute income. Redistribution of income occurs because some wages and salaries increase more rapidly than the price level while other wages and salaries increase more slowly than the price level. The problem with inflation is one of redistribution: inflation makes some people worse off, but it makes others better off. The end result is that income and wealth are redistributed from some resource owners to others. Suppose, for example, that the overall inflation rate is 10 percent. However, health care prices rise by 20 percent while food prices do not change. Labor and other resource owners in the health care industry end up with 20 percent more income that they can spend on production that is only 10 percent more expensive. Their real income, wealth, and living standards increase. In contrast, labor and other resources in the food industry are forced to pay 10 percent higher prices, but they have the same amount of income. Their real income and wealth decreases.
b. If an economy is experiencing deflation, will the nominal interest rate be higher or lower than the real interest rate? What is the equation that relates nominal rates, real rates, and inflation?

If inflation is positive, which it generally is, then the real interest rate is lower than the nominal interest rate. If we have deflation and the inflation rate is negative, then the real interest rate will be larger.
The relationship between the nominal interest rate, inflation, and the real interest rate is described by the Fisher Equation:
Real Interest Rate = Nominal Interest Rate - Inflation









c. The following appeared in a newspaper article: “Inflation in the Lehigh Valley during the first quarter of [the year] was less than half the national rate … So, unlike much of the nation, the fear here is deflation—when prices sink so low the CPI drops below zero.” Do you agree with the reporter’s definition of deflation? Was Lehigh Valley experiencing deflation? Briefly explain.
Deflation occurs when prices are declining over time. This is the opposite of inflation; when the inflation rate (by some measure) is negative, the economy is in a deflationary period. Deflation occurs when the inflation rate falls below 0%. The reports definition of deflation is true when inflation falls below zero. Lehigh valley was not experiencing deflation but instead they are experiencing disinflation which is when the inflation rate is shrinking but not below zero.

d. Does the idea of “menu costs” of inflation ring true to you? Why or why not?

Yes it does… When prices are constant over long periods of time, firms benefit in that they don't need to worry about changing the prices for their output. When prices change over time, on the other hand, firms would ideally like to change their prices in order to keep pace with the general trends in prices, since this would be the profit-maximizing strategy. Unfortunately, changing prices is generally not costless, since changing prices requires printing new menus, relabeling items, and so on. These costs are referred to as menu costs, and firms have to decide whether to operate at a price that is not profit-maximizing or incur the menu costs involved in changing prices. Either way, firms bear a very real cost of inflation.


e. Is anticipated inflation or unanticipated inflation more harmful to an economy? Why?
Unanticipated is the most harmful as it redistributes wealth and cannot be controlled. See below:
In anticipated inflation is when people/businesses can make accurate predictions of inflation, they can take steps to protect themselves from its effects.
Unanticipated is when inflation is volatile from year to year, it becomes difficult for individuals and
businesses to correctly predict the rate of inflation in the near future. This produces uncontrolled redistribution of wealth as explained in question 2 a.
3. Economic Growth

a. Briefly, what is the connection between “rule of law” and entrepreneurship?
The rule of law is essential to entrepreneurship. It goes without saying that a breakdown in rule of law prohibits economic growth and disincentivizes entrepreneurs. Countries must be stable and have laws enforced and in order to be conducive to businesses. Oil prices go up just at the mention of instability in certain nations.

b. Let’s say that Europe is set to grow at a long-term average rate of 1.5% and the United States at 2.5%. Is this one-percentage point difference a big deal? Briefly explain.

It is important in the sense of the labor force. In that the US will grow in it need for labor while Europe will decline as its labor force ages. US and Europe account for 40% of the world’s economy so even a one percent difference is huge!!!





c. What is the curse embodied in the standard production function? How does technological advance allow an economy to avoid this curse?

The production function relates the output of a firm to the amount of inputs, typically capital and labor. This curse is it does not measure economic behavior. Advances in all the monitoring now of economic behavior is a way to avoid this curse when using this function.
It is important to keep in mind that the production function describes technology, not economic behavior. A firm may maximize its profits given its production function, but generally takes the production function as a given element of that problem. (In specialized long-run models, the firm may choose its capital investments to choose among production technologies.)

d. In what important way does knowledge capital differ from physical capital?

Knowledge capital is an intangible asset that comprises the information and skills of a company's employees, their experience with business processes, group work and on-the-job learning. Knowledge capital is not like the physical factors of production - land, labor and capital - in that it is based on skills that employees share with each other in order to improve efficiencies, rather than on physical items. Having employees with skills and access to knowledge capital puts a company at a comparative advantage to its competitors.



e. According to Joseph Schumpeter there is no good destruction. Fostering economic growth requires protection of the old rather than creating the new. Yes? No? Why?
Absolutely no! He calls it creative destruction that is necessary for economic growth. Although Schumpeter devoted a mere six-page chapter to “The Process of Creative Destruction,” in which he described CAPITALISM as “the perennial gale of creative destruction,” it has become the centerpiece for modern thinking on how economies evolve.

f. Like a fundamental law in physics, it has to be that poor countries catch-up to rich countries. True? False? What’s the story?

False. The fact that a country is poor does not guarantee that catch-up growth will be achieved. This comes from convergence theory which assumes that there is a natural catch-up effect is possible. Abromwitz emphasized the need for 'Social Capabilities' to benefit from catch-up growth. These include an ability to absorb new technology, attract capital and participate in global markets. According to Abramovitz, these prerequisites must be in place in an economy before catch-up growth can occur, and explain why there is still divergence in the world today.


g. Wheelan wishes for “Goldilocks Regulation.” What is he talking about?

Goldilocks regulation: not too much, not too little, but just the right amount. Wheelan is wishing for regulation of business to strike this balance that Goldilocks was famous for quoting about porridge. Just the right amount!






Some think that regulation is the answer to corruption. Others insist that regulation engenders corruption. What is the basic argument underlying the latter conclusion?

The more a government is in control of regulating a business the more vulnerable the business becomes to corruption. The officials or government regulating can be bribed or in some other way influenced by interested parties to give their companies break or even pass legislation in favor of the company or the industry. If there is no regulation there is no one to bribe and no corruption. In the US we call these interested parties lobbyists!

h. When it works, government “industrial policy” that funnels critical capital to just the right ventures and facilitates market coordination—in contrast to generally messy market competition—is quite compelling. What primary unappealing aspect of industrial policy leads many economists to prefer the messiness of market competition?
The primary unappealing aspect of industrial policy is that it rarely if ever funnels capital to just the right ventures in order to facilitate market coordination so serious problems occur like food shortages and fuel shortages and less serious like lack of choice and no price competition. The USSR constantly experienced these problems when it existed as an example of how badly the government can function in this role. Market competitions moves swiftly to meet needs and drive prices down and help guarantee no long-term shortages.

4. AS/AD Analysis

a. What major variables cause the Aggregate Demand curve to shift in or out?

The major variables that cause shift by increasing or decreasing are: Disposable Income C(y-t), the interest rate I(r), Government spending (G), and Net exports or NX(e).

There are many actions that will cause the aggregate demand curve to shift. When the aggregate demand curve shifts to the left, the total quantity of goods and services demanded at any given price level falls. This can be thought of as the economy contracting. We know that aggregate demand is comprised of C(Y - T) + I(r) + G + NX(e) = Y. Thus, a decrease in any one of these terms will lead to a shift in the aggregate demand curve to the left.



b. Why is the Long-Run Aggregate Supply Curve a vertical line; i.e., why is long-run aggregate supply not affected by the price level?

A graphical representation of the long-run relation between real production and the price level, holding all ceteris paribus aggregate supply determinants constant. The long-run aggregate supply curve, abbreviated LRAS, is one of two curves that graphically capture the supply-side of the aggregate market. The other is the short-run aggregate supply curve. The demand-side of the aggregate market is occupied by the aggregate demand curve. The vertical long-run aggregate supply curve captures the independent relation between real production and the price level that exists in the long run.

This is why it is a vertical line. The long-run aggregate supply curve reflects the lack of a cause-and-effect relation between real production and the price level. As the price level rises, real production remains constant at the full-employment level. As the price level falls, real production remains constant at the full-employment level. Due to flexible prices, the same level of real production is generated at every price level.



Long-Run Aggregate Supply Curve












c. There has been much talk since 2009 that the United States has an “output gap.” Based on the AS/AD model, what do you think this “output gap” refers to?
The output gap is defined as an economic measure of the difference between the actual output of an economy and the output it could achieve when it is most efficient, or at full capacity. There are two types of output gaps: positive and negative. A positive output gap occurs when actual output is more than the full-capacity output. Negative output gap occurs when actual output is less than full-capacity output.
The output gap in the AS/AD model refers to the difference between production and price.

d. Why can an unexpected increase in oil prices lead to a supply shock, shifting the Short-Run Aggregate Supply curve ____________________?


Up and to the right of the curve as seen when price suddenly increases!

Along the Curve










The positive slope of the short-run aggregate supply curve captures the direct relation between the price level and real production. A higher price level is related to an increase in real production and a lower price level is related to a decrease in real production. Moreover, changes in the price level are the direct cause of changes in real production, which is reflected by a movement along the short-run aggregate supply.





A graphical representation of the short-run relation between real production and the price level, holding all ceteris paribus aggregate supply determinants constant. The short-run aggregate supply, or SRAS, curve is one of two curves that graphical capture the supply-side of the aggregate market. The other is the long-run aggregate supply curve (LRAS). The demand-side of the aggregate market is occupied by the aggregate demand curve. The positive slope of the SRAS curve captures the direct relation between real production and the price level that exists in the short run.

e. What does the dynamic AS/AD model capture that the basic AS/AD model does not?
The Dynamic model captures inflation:
• The basic AD-AS model focuses on how the general level of prices influences the choices of business decision makers.
• If the price level in the product market changes, this indicates that this price has changed relative to other markets.
• This structure implicitly assumes that the actual and expected rates of inflation are initially zero.
• When inflation is present this model can be recast in a dynamic setting.