Economics: GED Test Prep

Microeconomics

The Marketplace

In predominantly market economies like the United States, prices are determined by the principle of supply and demand. Supply is the amount of goods and services available for purchase. Demand is determined by how many people want to buy those goods and services. Generally, when demand increases, supply increases, because more producers want to get into the market. Similarly, when demand decreases, supply decreases, because producers stop producing the unpopular product and instead start producing something they believe will sell better.

Producers and consumers both act out of self-interest. Businesses attempt to earn a profit—money in excess of the amount it costs to manufacture a product or deliver a service. Thus, they will charge the highest price they believe they can get for their goods or services. Consumers, on the other hand, look for the lowest price they can find. This, along with competition among producers for consumer dollars, is what drives prices down. (When there is no competition, there is no force to drive prices down. Businesses that control a market—called monopolies—may essentially set prices at whatever level they wish.)

When companies make the exact amount of a product or service at a price that customers are willing to buy, they have reached a point of equilibrium. If the price is greater than this point, demand drops and there may be a surplus, which is when there are more goods produced than customers are willing to buy. If the price falls below the point of equilibrium, demand may increase and create a shortage in supply.

For example, Company X is introducing a new cell phone model, the XLZ. (See graph.) The business wants to find out the equilibrium point so that it will not have a surplus or shortage of the product. To cover its costs and make a profit, Company X can supply 10 phones for $1,100.As the price increases, the company can offer more phones for sale. However, few customers are willing to pay high prices for the phones. As the price drops, demand increases.

Exercise 1 (see answers below)

Refer to the graph "Supply and Demand Curves for Cell Phone XLZ" to answer the following questions.

1. At what price does the supply of cell phone model XLZ equal that of demand?
   1. $1,400
   2. $1,300
   3. $1,250
   4. $1,500
   5. $1,550
2. If the market price for cell phone model XLZ increased to $1,600, what would be the likely result?
   1. Stores would quickly run out of product.
   2. Demand would decrease.
   3. The manufacturer would not be able to keep up with demand.
   4. The manufacturer would produce the cell phone model at the same rate.
   5. The manufacturer would go out of business.

Labor

Businesses are not just sellers in the marketplace; they are also buyers. Manufacturers must buy raw goods and machinery to produce their products. Retailers must buy goods at wholesale to sell in their stores. All businesses need to hire workers to make their businesses run. We use the term labor market to describe the competition for workers.

As in other markets, the labor market is driven by supply and demand. Jobs for which there are many more potential employees than there are positions—low-end service jobs in fast-food restaurants, for example—pay poorly and typically offer few or no benefits such as paid vacation, health insurance, and professional development training. Jobs that require highly specialized skills typically have fewer suitable candidates, and thus offer high pay and attractive benefits. In each case, the employer looks to pay the worker enough so that the worker will be satisfied (and thus will stay in the job and do it well) while still running the business profitably.

Workers must bargain with employers for their pay and benefits. In order to strengthen their bargaining position, some workers form labor unions that negotiate contracts for all members in a process called collective bargaining. When the employer and the union cannot come to an agreement, the union may call a strike, which means that the workers stop coming to work. They usually picket the site of their employment, shutting down the business in an effort to force an agreement. In some cases, the employer decides to shut down production in an effort to force the union to come to an agreement; this action is called a lockout.

Macroeconomics

Business Cycles

Capitalist economies experience business cycles, periods of growth followed by a period of low productivity and income, called a recession. A depression occurs when recession lasts for a long period and is severe. During the Great Depression in the 1930s, the United States experienced its worst depression. At that time, large numbers of people suffered unemployment and homelessness.

Economic growth is the goal of capitalism. During a boom period, companies are able to produce more goods and services, and consumers are able to buy more goods and services. Inflation occurs when the amount of money in circulation increases and the amount of consumer goods (supply) decreases. The dollar drops in value and prices increase. Deflation happens when the money supply decreases and the amount of consumer goods increases. Prices are lower, but companies lose profit and lay off employees, which results in higher rates of unemployment.

Role of the Government

The government plays many important roles in the functioning of the economy. Free markets cannot exist without some form of government regulation. For example, if the government did not protect patent and property rights, inventors would not have as much incentive to develop new technologies, nor would investors have much incentive to invest in their development; why would they, if they knew the idea could be easily stolen, thus depriving them of any reward for their efforts and investments? The government must also enforce contracts, without which modern commerce is impossible. And, of course, the government must provide a reliable currency with which trade can be conducted.

The government regulates the markets in other ways as well. To avoid inflation and unemployment, the U.S. Federal Reserve System ("the Fed") takes measures to keep the economy in balance by controlling the supply of money in the country. One way it does this is by setting the reserve ratio. Every bank that is a member of the Fed must keep a reserve—a ratio of its deposits—that is not used to make loans. To fight inflation, the Fed might set a high reserve ratio, so that less money is available in the economy. During recession or high unemployment, the Fed might set a low reserve ratio, so there is more money available within the economy.

The Federal Reserve Board can also affect the nation's economy by altering the discount rate, which is the interest rate that the Fed charges banks to borrow money. To make a profit, banks charge their customers a higher interest rate than the rate they pay to the Fed. When the Fed sets a high discount rate, banks charge more interest on loans, which makes it more difficult for people and businesses to borrow. When the Fed sets a low discount rate, banks charge less, and more people and businesses can afford loans.

Other government actions impact the economy. Government regulations increase the cost of producing goods and thus increase prices. While people argue about the need for specific regulations, most agree that some regulations are worthwhile even though they drive prices up. For example, government regulations ensure that the food and drugs we use are safe (through the Food and Drug Administration), protect the environment (through the Environmental Protection Agency), protect workers from unsafe work conditions (through the Occupational Safety and Health Administration), and protect consumers from false advertising (through the Federal Trade Commission).

Finally, there is the impact of government taxation on the economy. The rate at which individuals and businesses are taxed, for example, has a direct influence on how much money is available for investment and consumer spending. The effect of taxes on the economy is a complex one. The government spends the money it collects in taxes, which helps drive certain sectors of the economy (military contractors, for example). Also, when the government does not collect enough taxes to pay for federal spending, it must borrow money, either by selling bonds or by borrowing the money from foreign governments. When that debt grows too high, it can have a negative impact on the economy.

Measuring Economic Growth

Economists use different data to study the health of the economy. They look at stock market trading, the cost of living, unemployment rates, and the gross domestic product (GDP). The GDP measures the total value of goods and services produced within the United States over the course of a year. The gross national product (GNP) takes into account both the GDP and foreign investments. If the GNP decreases for two consecutive quarters during a year, the economy is considered to be in recession.

The Consumer Price Index (CPI) measures changes in the cost of living. To calculate the CPI, the U.S. Bureau of Labor Statistics tracks changes in prices in common goods and services—food, clothing, rent, fuel, and others—each year. The graph shows the CPI in all U.S. cities between 1990 and 2007. To make comparisons between years, the graph uses the years 1982–1984 as a base period (1982–1984 = $100). For instance, if the average urban consumer spent $100 on living expenses in 1982–1984, he or she spent more than $150 on the same expenses in 1995.

Exercise 2

Using the graph and passage about the Consumer Price Index, answer the following questions.

1. How much would an urban consumer expect to pay in 2001 for an item that cost $50 in 1982–1984?
   1. $88
   2. $100
   3. $176
   4. $43
   5. $131
2. What conclusion can you make based on the graph?
   1. The CPI tracks price changes for common household expenses.
   2. The cost of living has decreased in recent years.
   3. The rate of increase in the cost of living slowed between 1999 and 2000.
   4. If the cost of living continues to rise, people will move out of the cities.
   5. The cost of living for city residents steadily increased between 1990 and 2001.

Foreign Trade

Foreign trade—trade that crosses national borders—involves both microeconomic and macroeconomic issues. In terms of microeconomics, the law of supply and demand once again holds sway. Countries typically are not self-sufficient; in fact, even if they could provide all the goods and services they need, it would not necessarily be in their interests to do so, because doing so may require them to spend resources that could be spent more productively elsewhere. For example, it is possible that the United States could grow enough coconuts to meet domestic consumption. However, it is probably more efficient for the United States simply to buy coconuts from a country where they can be produced cheaply; that allows the United States to spend the resources it might use to grow coconuts in a more profitable way (in software development, for example). This is a process known as specialization, and it's a good thing. Economists believe that it is more advantageous for an economy to do some things very well than to do all things poorly.

When one country buys goods from another county, it imports those goods. When it sells goods to another country, it exports those goods. The ratio of exports to imports is called the balance of trade. When a country imports more than it exports, it has a trade deficit. When it exports more than it imports, it has a trade surplus.

Macroeconomic issues in foreign trade include government policies. Governments may enact tariffs, which are taxes on imported goods. Some such tariffs are enacted to counter unfair trade policies by foreign nations. Others are enacted simply to protect domestic producers; these tariffs are often described as protectionist. Foreign trade is also influenced by the value of each trading nation's currency, or money. The more valuable one currency is relative to another, the more goods it can buy. A strong currency is good for importers but bad for exporters, because it makes goods more expensive overseas. Thus, a strong dollar means that imported electronics are relatively cheap, but it also means that American automobiles are more expensive overseas, making them more difficult to sell outside the United States.

Exercise 3

Use the following table and the text of the preceding section on foreign trade to answer question 1.

1. What happened to the value of one Chinese Yuan between February and June 2007?
   1. It increased by approximately $0.25.
   2. It increased by approximately $0.0025.
   3. Its value in U.S. dollars did not change.
   4. It decreased by approximately $0.0025.
   5. It decreased by approximately $0.25.
2. Based only on the data in the graph, which MOST likely occurred between February and June 2007?
   1. Chinese exports to the United States decreased.
   2. The United States enacted protectionist tariffs against China.
   3. China had a trade deficit with the United States.
   4. The United States increased exports to Japan.
   5. Chinese exports to the United States increased.

Answers

Exercise 1

1. a.   The point where the lines connect is at $1,400. That is the point of equilibrium.
2. b.   As the price increases, the demand decreases.

Exercise 2

1. a.   The graph's baseline is an item that cost $100 in the time period 1982–1984. The graph shows that an item that cost $100 in the base period cost about $176 in 2001. Thus, something that cost $50—half of $100—in the base period would cost about $88 (half of $176) in 2001.
2. e.   Choice a is not a conclusion based on the graph. Choices b and c are not true, and choice d is speculation not supported by the information of the graph. Only choice e is a valid conclusion.

Exercise 3

1. b.   The table shows that the value of the Yuan increased against the dollar; therefore, choice a or b must be correct. The Yuan increased in value from just under $0.13 to just over $0.13. The increase was less than one penny, so b must be the correct answer.
2. a.   The value of the Yuan increased against the dollar. According to the passage, that would make Chinese goods more expensive to United States consumers. Therefore, it is most likely that Chinese exports to the United States would decrease as a result of the change shown in the graph.