The Primary Goals of Any Economy

Every economy has 6 key goals: 1) Full Employment of the Factors of Production, 2) Price Stability, 3) Satisfactory Rate of Economic Growth, 4) Freer Trade, 5)"Correct" Distribution of Income, and 6) Efficient Allocation of the Factors of Production. The first four are macroeconomic goals, while the final two are microeconomic goals.

THE MACROECONOMIC GOALS

FULL EMPLOYMENT of Factors of Production

One economic goal is full employment of the factors of production(land, labor, capital, and technology). Full employment allows for maximum economic output and for economic growth. It does not refer to a zero percent unemployment rate, rather it is roughly equal to the frictional unemployment rate. Frictional unemployment is inevitable, as there are always people switching jobs. This number traditionally lies around 4% for the United States and serves as our target rate of unemployment for full employment of the factors of production. Meanwhile, the natural rate of unemployment is that which maintains price levels (zero inflation) and is usually more than the full employment rate of unemployment. The unemployment rate can be changed through fiscal and monetary policy.

PRICE STABILITY (absence of "excessive" inflation)

Inflation is defined as an increase in average prices in an economy, which means that at any given time, some parts of the economy experience inflation lower than that of the nation, possibly deflation(negative inflation, a general decrease in prices), while other parts experience inflation higher than the national rate. Inflation is measured by price indexes such as the Consumer Price Index (CPI), the Producer Price Index (PPI) and the GDP deflator. Though a zero rate of inflation is possible, the United States shoots for mild inflation rates, which are up to 4%. Moderate inflation lies between 4% and 10%, while high inflation exceeds 10%. The unlikely extreme is hyperinflation, a case where inflation exceeds 100%. "Excessive" or high inflation usually causes political changes in a country, hinders positive net economic growth, and is generally avoided.
A small amount of inflation is acceptable and both beneficial and costly. The costs for mild to moderate inflation include the following: fixed income and low income individuals lose out, lenders(holders of financial assets such as stocks and bonds) hurt from inflation, taxpayers in general lose out, and menu costs(costs to a firm resulting from changing its prices). Costs of high inflation include uncertainty costs(firms become reluctant to purchase capital; this reluctance reduces economic growth) and hyperinflation(unlikely). The benefits of inflation, however, are less obvious. They include the following: holders of real assets gain, borrowers gain, government gains(if taxpayers lose, government gains), labor markets function more smoothly, and lastly, moderate inflation means that those below the average inflation rate aren't experiencing deflation.
It is difficult to determine the actual inflation rate because one of the most widely used measures, the CPI, overstates inflation. The CPI is an overestimate because a substitution bias exists(relative price changes affect consumption but may not affect the price basket), because the increase in purchasing power that results from the introduction of new goods is not reflected in the CPI, and because of unmeasured changes in quality. When a firm changes the quality of a good, not all of the good's price change is a result of a change in the cost of living so the CPI rises faster than it should.

SATISFACTORY RATE OF ECONOMIC GROWTH

To assess whether a country is experiencing a "satisfactory" rate of economic growth, we look to the per capita change in real Gross Domestic Product(GDP). The economy must grow faster than the population for this to be positive. Ideally, per capita economic growth is around 1 or 1.5%. In the United States, economic growth is approximately 3%, while population growth is roughly 1%, making per capita growth 2%. For several developing countries, it is difficult to achieve positive per capita economic growth because their economies cannot keep up with their rapidly multiplying population. For more information, see my post on "Economic Growth."

FREER TRADE WITH OTHER NATIONS

Freer trade means importing and exporting goods and services without barriers such as quotas and tariffs. Fewer barriers means increased trade, which is beneficial to consumers because it increases the goods available to them and/or reduces prices of goods already available to them. The amount of trade a country conducts is measured by comparing total GDP to imports and exports. In the United States, the foreign sector is approximately a quarter of the economy. Meanwhile, our largest trading partner, Canada, has ratios of exports and imports to GDP of around 30%, making foreign trade over half their economy. Because exchange rates are flexible, free trade also implies price and wage equalization. As long as prices and wages differ from one country to the next, free trade will not exist. Freer trade has helped maintain a low inflation rate in the U.S.(There may be a slight tradeoff of higher unemployment in the short run associated with the low inflation-see "Phillips Curve" post for most information).

THE MICROECONOMIC GOALS

"CORRECT" DISTRIBUTION OF INCOME

There is a whole spectrum of income distributions with two extremes. The first being perfectly equal income distribution in which every individual has an identical income. The opposite extreme is perfectly unequal income distribution in which one person or family has almost all, if not all, the income, while everyone else has no income or just enough to survive. The United States has an income distribution in between the two extremes, as established by governmental and political action. The "correct" distribution is simply a matter of opinion; the opinion of many economists is that people should be paid according to the value of the work they perform or the value of the output of the assets they own. This concept that people be paid in proportion to their work ethic is known as the productivity principle. Exceptions are established for people unable to do the same work as others-these exceptions form the tax and transfer system. Pell grants, housing assistance, unemployment compensation, food stamps, Social Security, Medicare, and Medicaid are all components of the tax and transfer system in the United States.

EFFICIENT ALLOCATION OF FACTORS OF PRODUCTION

Arguably the most important of the six goals, efficient allocation of the factors of production, or of resources, is otherwise referred to as economic efficiency. It is the best use of labor, capital, natural resources, and technology achieved through two conditions. The first condition is maximum output from a given set of factors of production(called technical efficiency); the second condition is the production of the correct mix of goods and services. A free market system is the best way to achieve these conditions: maximum production of the correct mix of goods and services.

Economic Growth

Economic growth is defined as increases in per capita real GDP over time(percent change in real GDP-percent change in population). Recently, annual real GDP growth has been around 3% in the United States, while population growth has remained around 1%, making economic growth approximately 2%. A satisfactory rate of economic growth is one of the six economic goals(along with full employment of factors of production, price stability, freer trade with other nations, "correct" distribution of income, and efficient allocation of resources). According to most economists, a "satisfactory" rate lies somewhere between 1 and 1.5%. This is difficult for many countries to maintain because they have larger population growth rates than we do(some as high as 3-5%).

Economic growth is important for several reasons. Primarily, it improves the overall standard of living for individuals in a country. Additionally, economic growth is one way to reduce poverty in an economy and possibly worldwide if the economy is big enough and therefore influential enough.

Economic growth is maintained by technological change, or Total Factor Productivity. Economist Robert Solow worked on this concept in the 1950s with his neo-classical economic growth model. Output(real GDP) is a function of technological change, stock of capital, and the total population. Therefore, to increase real GDP, a positive change in the stock of capital and population control is necessary. To increase investment spending on capital, savings must be increased. Savings have three sources: households(personal savings), businesses(retained earnings), and the government(budgetary balance). 401ks and IRAs boost savings, thereby increasing investment spending, and leading to positive changes in capital and economic growth. Similarly, investment tax credits encourage business savings and investment.

With the desire to increase capital investment, comes the question: Should governments decide capital projects? The answer is yes, in some cases, they should because they have to. Projects such as roads, bridges, and the educational system must be government capital because individuals won't provide or build those things on their own.

Population control and enhancement can be costly for some countries but aids in economic growth. Population growth must be controlled to a manageable level at which per capita economic growth is feasible. Investing in human capital through higher education breeds more productive workers, increasing the output of the economy. A more educated and specialized economy is able to produce more with the same amount of resources because the quality of their resources has improved.

Technology, as mentioned earlier, can increase economic growth. New and/or improved technology arises from research and development. R&D includes basic research, which is government sponsored via the National Science Foundation and others, and applied research, which is conducted by firms and private businesses. Technological research can be expensive, thus we have 17 year patents that protect intellectual property rights and serve as incentives to invest in research. Unfortunately, some countries do not honor the patents of other countries(historically, China has not honored many of the United States' patents). There exist two types of technological change: embodied, which requires new capital to implement, and disembodied, for which no new capital is necessary.

So what role does the government play in promoting economic growth? Governments act to influence capital, population, and technology. To increase capital investment, they need to increase levels of savings or maintain already high levels. The US government offers IRAs, 401ks, Roth IRAs, and others to encourage personal saving. The government also ensures transparency in financial markets (as much as possible) through the SEC (Securities Exchange Commission) and the CFTC (Commodity Future Trading Commission), among others. The more uncertain people are about the financial markets, the less likely they are to invest in them. Governments also try to keep budget deficits low, to avoid a worse budgetary balance, and to help the economy grow without being held back by such a large debt. To influence population, governments provide human capital investment (education and training). Finally, the government sponsors research for technology and gives tax credits to businesses for conducting technological research.

There are some additional factors which promote economic growth. The first is free markets, which drive economic efficiency, allowing for maximum output in the economy. Freer trade, advocated most famously by Adam Smith, allows for optimal economic growth because it also implies economic efficiency. Protection of private property (such as through patents), "Free Press," and minimal graft and corruption(especially in governments) are all vital factors for economic growth in a country.

The Phillips Curve

Though some had noted the relationship between inflation and unemployment before him, New Zealand economist, AW Phillips was the first to describe it via the graphic representation of the Phillips curve in 1958. He published his findings after studying British data for eight years while teaching at the London School of Economics(1951-1958).

      The Phillips curve reflects the tradeoff which exists between inflation and unemployment. In this sense, the Phillips curve is also a reflection of an economy’s Aggregate Supply curve, as movement along the AS curve produces opposite changes in inflation and unemployment, two key measures of economic performance. It can be expressed mathematically through the following equation:

π = [(Eπ) – β (cyclical unemployment rate) + (V)]

      

      Where π denotes inflation; Eπ refers to expected inflation (or inflation from the previous time period); and β shows the sensitivity of inflation to unemployment. Finally, V stands for adverse (-) or favorable (+) shocks to inflation.

      The Phillips curve is just too simple to be able to accurately predict the economy over the long term. Thus, unfortunately, theories based on the Phillips curve fail to be effective in analyzing possible governmental policy actions to influence the economy and business cycles. The Phillips curve gives a general relationship between inflation and unemployment, while being more a representation of the economy in the short run, and less a reliable predictor of the long term. A historical example of this comes from the 1970s and early 1980s, when inflation was much higher than the Phillips curve would have predicted given the level of unemployment.   

      

      The Phillips Curve is shown graphically in Figure 1 below.          

  

Figure 1: The Phillips Curve demonstrates the indirect relationship between inflation(pi) and unemployment.

A Phillips Curve analysis wouldn't be complete without also discussing Okun's Law(which, of course, is more of a theory). Okun's Law denotes the relationship between unemployment and a country's production. The higher the unemployment, the larger the GDP gap(the amount by which actual GDP falls short of potential GDP).                                                                

Issues in Fiscal Policy and Monetary Policy

Business cycles are inevitable and have adverse impacts such as recessions and bubbles. This is why we have stabilization policies. Stabilization policies include fiscal policies(change in government spending, change in transfer payments) and monetary policies(change in the money supply) designed to lessen the adverse impacts of business cycles. John Maynard Keynes was the first to argue for such policies, back in 1933, insisting that the government needed to take action to counteract business cycles. Meanwhile, Milton Friedman, an avid proponent of small government, argued the opposing side: active fiscal and monetary policies should not be used to control the economy, rather policy rules needed to be implemented. And so, the question remains today: Should we utilize fiscal policy and/or monetary policy as a means of controlling our economy?

Before policies are considered, we must know when turning points in the economy occur. For this, we look to leading indicators, variables or economic data that tend to change before the whole economy changes. More often than not, leading indicators are used to predict the future behavior of the economy. Examples of leading economic indicators include the Consumer Confidence Index, the Consumer Price Index(CPI), and the Producer Price Index(PPI).

The next step, then, is choosing whether or not to implement policy and if yes, which type of policy. However, one of the largest concerns with fiscal and monetary policy is the associated lag time. The policies may turn out to be pro-cyclical, rather than counter-cyclical, due to the lag effect, making them not only ineffective, but also harmful to the economy. The lag effect can be divided between inside lags and an outside lag. The inside lags include the following: 1) Recognition Lag, which refers to the difference in time between changes in Gross Domestic Product(GDP) and observation of those changes, and 2) Implementation Lag, which is the time difference between recognition of changes in GDP and enactment of counter-cyclical policy. Finally, the outside lag is the Impact Lag and denotes the difference in time between policy enactment and the resulting impact on the economy. As you can see Figure 1 below, total lag time can be up to four years or 2.5 years for fiscal policy and monetary policy, respectively.

Source	Fiscal Policy	Monetary Policy
Inside Lag: Recognition Lag	3-6 months	3-6 months
Implementation Lag	12-24 months	3-6 months
Outside Lag: Impact Lag	6-18 months	12-18 months
TOTAL	21-48 months	18-30 months

Figure 1: Expected Lag Time for Fiscal and Monetary Policy

While policies can take years to help the economy, economic downturns typically do not outlast 12-18 months. Therefore, the policies might not be helpful at all because they fail to be effective within the desired time period. This begs the question: Can the economy be helped at all? Should we even try to change the economy?

There are, fortunately, ways to avoid fiscal and monetary policy and still act to dampen the economy. Automatic stabilizers are government programs or laws (such as tax laws) that act to counter business cycles(counter not eliminate) without discretionary monetary or fiscal policy actions. The following are automatic stabilizers: 1) Progressive Income Tax, 2) Unemployment Compensation, 3) Transfer Payments(food stamps, housing assistance, etc.), and 4) Earned Income Tax Credit(EITC).

Profit Maximization and Cost Minimization

This week, Microeconomics focused on Profit Maximization and Cost Minimization. Profit maximization implies cost minimization; however, cost minimization doesn't necessarily mean profit maximization. Profit maximization is a combination of both revenue maximization and cost minimization because profits(denoted by pi) are equal to the difference between revenues and costs.

π = P*Y-w₁x₁-w₂x₂

Y=output
P=price of output
w₁=cost of input 1

w₂= cost of input 2

x₁=input 1

x₂=input 2

In the short run economy, one of the two hypothetical inputs has to be fixed. In order to solve the profit maximization problem in the short run, therefore, requires marginal benefit to equal marginal cost, with respect to the variable input. 

P*MP₁=w₁

(x₂=fixed)

A profit maximizing choice can only be found with decreasing returns to scale(DRTS); with increasing returns to scale(IRTS) or constant returns to scale(CRTS), no profit maximizing choice can be calculated. 

 Increasing returns to scale: Double the inputs results in more than double the output.
(With Cobb-Douglas production functions, the sum of the exponents is greater than 1)

Constant returns to scale: Doubling inputs results in double the output.
(With Cobb-Douglas production functions, the sum of the exponents is 1)

Decreasing returns to scale: A doubling of inputs results in less than double the output.
(With Cobb-Douglas production functions, the sum of the exponents is less than 1)

Increasing Returns to Scale

Constant Returns to Scale

Decreasing Returns to Scale

Long run profit maximization problems are solved by setting the Technical Rate of Substitution, the TRS, equal to the ratio of the input costs. The TRS is the slope of an isoquant, which is the function that includes all the combination of the inputs that can produce a given level of output. The TRS is equal to the marginal product of input 1 divided by the marginal product of input 2.

The amounts of each input which result in maximum profits are referred to as factor demands; they depend upon the price of output and both input costs.

X₁^*(w₁,w₂,P)

X₂^*(w₁,w₂,P)

Cost minimization problems are solved by finding the intersection of the isocost and isoquant lines. An isocost line includes all combinations of inputs which cost the same amount(a given amount). The amounts of each input which minimize costs are known as conditional factor demands and depend upon a given fixed level of output and both input costs.

X₁^*(w₁,w₂,Y)

X₂^*(w₁,w₂,Y)

Cost minimization problems(unlike those of profit maximization) can always be solved, regardless of the returns to scale. Short run cost minimization problems are easier to solve because one of the inputs has to be fixed. Cost functions are used to solve this type of problem, therefore it is helpful to be able to distinguish returns to scale based on average cost graphs. The average cost curve in the long run looks something like this.

a=IRTS  b=CRTS  c=DRTS