ECONOMIC THEORIES

Economic theories broadly fall under two categories: microeconomics and macroeconomics. In most basic terms, microeconomics deals with the economy at a smaller level or at a smaller scale, such as the market for a particular product (e.g., automobiles) or the behavior of an individual firm in a particular industry (e.g., decisions made by one of the Big Three in the U.S. automobile industry). Macroeconomics, on the other hand, studies the behavior of the overall economy (e.g., the U.S. economy as a whole), although it sometimes also looks at economies of different regions that comprise the overall economy.

MICROECONOMIC THEORIES

Economics in general (and microeconomics in particular) is defined as the social science that deals with the problem of allocating limited resources to satisfy unlimited human wants. Solving this riddle is based on the price mechanism that, in turn, uses forces of supply and demand for different products. Price mechanism refers to an adjustment mechanism in which the price of a product serves as a signal to both buyers and sellers; it is often considered the centerpiece of microeconomic theory. Theories of demand, supply, and the price mechanism are briefly discussed in what follows.

THEORY OF DEMAND, SUPPLY, AND THE PRICE MECHANISM.

The demand for a particular product by an individual consumer is based on three important factors. First, the price of the product determines how much of the product the consumer buys, given that all other factors remain unchanged. In general, the lower the price of the product the more a consumer buys. Second, the consumer's income also determines how much of the product the consumer is able to buy, given that all other factors remain constant. In general, the greater is his or her income, the more commodities a consumer will buy. Third, prices of related products are also important in determining the consumer's demand for the product. The total of all consumer demands yields the market demand for a particular commodity. The market demand curve shows quantities of the commodity demanded at different prices, given that all other factors remain constant; as price increases, the quantity demanded falls.

The amount supplied by an individual firm depends on profit and cost considerations. In general, a producer produces the profit by maximizing output. The total of all individual company supplies yields the market supply for a particular commodity. The market supply curve shows quantities of the commodity supplied at different prices, given that all other factors remain constant; as price increases, the quantity supplied increases.

The interaction between market demand and supply determines the equilibrium or market price (where demand equals supply). Shifts in the demand curve and/or the supply curve lead to changes in the equilibrium price. The market price and the price mechanism play crucial roles in the capitalist system—they send signals to both producers and consumers. The price mechanism is an integral part of the study of market structures that constitute the bulk of microeconomic theory.

Analyses of different market structures have yielded economic theories that dominate the study of microeconomics. Four such theories, associated with four kinds of market organizations, are discussed below: perfect competition, monopolistic competition, oligopoly, and monopoly. Based on the differing outcomes of different market structures, economists consider some market structures more desirable, from the point of view of the society, than others.

PERFECT COMPETITION MARKET STRUCTURE.

Perfect competition is the idealized market structure that provides a foundation for understanding how markets work in a capitalist economy. The nature of competition under the perfectly competitive market form is based on three conditions that need to be satisfied before a market structure is considered perfectly competitive: homogeneity of the product sold in the industry, existence of many buyers and sellers, and perfect mobility of resources or factors of production. The first condition, the homogeneity of product, requires that the product sold by any one seller is identical with the product sold by any other supplier—if products of different sellers are identical, buyers do not care whom they buy from, so long as the price charged is also the same. The second condition, existence of many buyers and sellers, also leads to an important outcome—individual buyers or sellers are so small relative to the entire market that they do not have any power to influence the price of the product under consideration, and they simply decide how much to buy or sell at the given market price. The implication of the third condition, the perfect mobility of resources or factors of production, is that resources move to the most profitable industry.

There is no industry in the world that can be considered perfectly competitive in the strictest sense of the term. Token examples of industries, however, come quite close to having perfectly competitive markets. Some markets for agricultural commodities, while not meeting all three conditions, come reasonably close to being characterized as perfectly competitive markets. The market for wheat, for example, can be considered a reasonable approximation.

The study of the idealized version of perfect competition leads to some important conclusions regarding the solutions of key economic problems, such as the quantity of the relevant product produced, price charged, and the mechanism of adjustment in the industry. The total output produced under perfect competition is larger than, say, under monopoly. This follows from the mechanics of maximizing profit, the guiding force behind a supplier's output decision. In order to maximize profits, a supplier has to look at costs and revenues. The firm will stop production at the level where marginal revenue (the revenue that the sale of an additional unit generates) equals marginal cost (the cost of producing an additional unit of the product under consideration)—this output level maximizes profits (or minimizes loss). In the case of a perfectly competitive firm, the market price for the product is also the marginal revenue, as the firm can sell additional units at the going market price. This is not so for a monopolist. A monopolist must reduce price to increase sales—as a result, a monopolist's price is always higher than the marginal revenue. Thus, even though a monopolist also produces the profit-maximizing output, where marginal revenue equals marginal cost, it does not produce to the point where price equals marginal cost (as does a perfectly competitive firm). Perfect competition is therefore considered desirable from the point of the view of society for at least two reasons—in general, output produced under a perfectly competitive market structure is larger and the price charged is lower than under other market structures.

MONOPOLISTIC COMPETITION MARKET STRUCTURE.

Many industries have market structures that are monopolistic competition or oligopoly. The apparel retail industry, which features stores and differentiated products, provides an example of monopolistic competition. As in the case of perfect competition, monopolistic competition is characterized by the existence of many sellers. Usually, if an industry has 50 or more firms (producing products that are close substitutes for each other), it is said to have a large number of firms. The sellers under monopolistic competition differentiate product—unlike under perfect competition, products are not considered identical. This characteristic is often called the product differentiation. In addition, relative ease of entry into the industry is considered another important requirement of a monopolistically competitive market structure.

As in the case of perfect competition, a firm under monopolistic competition determines the quantity of the product produced on the basis of the profit maximization principle—it stops production when marginal revenue equals marginal cost of production. One very important difference between perfect competition and monopolistic competition, however, is that a firm under monopolistic competition has some control over the price it charges, since it differentiates its products from those of others. As a result, the price associated with the product (at the equilibrium or profit-maximizing output) is higher than the marginal cost (which equals marginal revenue). Thus, the production under monopolistic competition does not take place to the point where price equals marginal cost of production. The net result of the profit-maximizing decisions of monopolistically competitive firms is that the price charged is higher than under perfect competition and the quantity produced is simultaneously lower. Thus, both on the basis of price charged and output produced, monopolistic competition is less socially desirable than perfect competition.

OLIGOPOLY MARKET STRUCTURE.

Oligopoly is a fairly common market organization. In the United States, both the steel and automobile industries (with about three large firms each) provide good examples of oligopolistic market structures.

The most important characteristic of an oligopolistic market structure is the interdependence of firms in the industry. The interdependence, actual or perceived, arises from the small number of firms in the industry. Unlike under monopolistic competition, if an oligopolistic firm changes its price or output, it has perceptible effects on the sales and profits of its competitors in the industry. Thus, an oligopolist always considers the reactions of its rivals in formulating its pricing or output decisions.

There are huge, though not insurmountable, barriers to entry into an oligopolistic market. These barriers can exist because of large financial requirements, availability of raw materials, access to the relevant technology, or simply existence of patent rights with the firms currently in the industry. Several industries in the United States provide good examples of oligopolistic market structures with obvious barriers to entry; for example, the U.S. automobile industry has financial barriers to entry.

An oligopolistic industry is also typically characterized by economies of scale. Economies of scale in production imply that as the level of production rises the cost per unit of product falls from the use of any plant (generally, up to a point). Thus, economies of scale are an obvious advantage to a large producer.

There is no single theoretical framework that provides answers to output and pricing decisions under an oligopolistic market structure. Analyses exist only for special sets of circumstances. One of these circumstances refers to an oligopoly in which there are asymmetric reactions from rivals when a particular firm formulates policies—if a certain oligopolistic firm cuts price, it is met with price reductions by competing firms; if it raises the price of its product, however, rivals do not match the price increase. For this reason, prices may remain stable in an oligopolistic industry for a prolonged period.

Due to theoretical difficulties, it is hard to make concrete statements regarding price charged and quantity produced under oligopoly. Nevertheless, from the point of view of the society, an oligopolistic market structure provides a fair degree of competition in the market place if the oligopolists in the market do not collude. Collusion occurs if firms in the industry agree to set price and/or quantity. In the United States, there are laws that make collusion illegal.

MONOPOLY MARKET STRUCTURE.

Monopoly can be considered the polar opposite of perfect competition. It is a market form in which there is only one seller. While, at first glance, a monopolistic form may appear to be rare, several industries in the United State have monopolies. Local electricity companies are examples of monopolists.

There are many factors that give rise to a monopoly. Patents can lead to a monopoly situation, as can ownership of critical raw materials (to produce a good) by a single firm. A monopoly can also be legally created by a government agency when it sells a market franchise to sell a particular product or to provide a particular service. Often a monopoly so established is also regulated by an appropriate government agency. Provision of local telephone services in the United States provides an example of such a monopoly. Finally, a monopoly may arise due to the declining cost of production for a particular product. In such a case the average cost of production keeps on falling and reaches a minimum at an output level that is sufficient to satisfy the entire market. In such an industry, rival firms will be eliminated until only the strongest firm (now the monopolist) is left in the market. Such an industry is popularly dubbed natural monopoly. A good example of a natural monopoly is the electric power industry, which reaps the benefits of economies of scale and yields decreasing average cost. Government agencies usually regulate natural monopolies.

Generally speaking, price and output decisions of a monopolist are similar to a monopolistically competitive firm, with the major distinction that there are a large number of firms under monopolistic competition and only one firm under monopoly. Nevertheless, at any output level, the price charged by a monopolist is higher than the marginal revenue. As a result, a monopolist does not produce to the point where price equals marginal cost (a condition met under a perfectly competitive market structure).

An industry characterized by a monopolistic market structure produces less output and charges higher prices than under perfect competition (and presumably under monopolistic competition). Thus, on the basis of price charged and quantity produced a monopoly is less socially desirable. One must recognize, however, that a natural monopoly is generally considered desirable if the monopolist's price behavior can be regulated.

SUMMARY OF MARKET STRUCTURES.

The real world is rarely characterized by perfect competition, and in certain circumstances, the society has to tolerate a monopoly (e.g., a natural monopoly or a monopoly due to patent rights). Nevertheless, the idea of competition is very deeply ingrained in the society. So long as there is a reasonable degree of competition (as in the case of monopolistic competition or oligopoly), the society feels reasonably secure with respect to the working of its markets.

MACROECONOMICS

Macroeconomics is a social science that studies an economy at the aggregate (or nationwide) level. Macroeconomic theories study an overall economy and prescribe policy recommendations based on the study of the behavior of key macroeconomic variables. While numerous additional measures or variables are used to understanding the behavior of an economy, the following four variables are considered to be the most important in gauging the state or health of an economy: aggregate output or income, the unemployment rate, the inflation rate, and the interest rate.

OUTPUTANCOME.

An economy's overall economic activity is summarized by a measure of aggregate output. As the production or output of goods and services generates income, any aggregate output measure is closely associated with an aggregate income measure. The United States now uses an aggregate output indicator known as the gross domestic product or GDP. The GDP is a measure of all currently produced goods and services valued at market prices. Other related measures of output can be derived from the GDP measure.

UNEMPLOYMENT RATE.

The level of employment is the next crucial macroeconomic variable. The employment level is often quoted in terms of the unemployment rate. The unemployment rate itself is defined as the fraction of the labor force not working but actively seeking employment. Labor force, in turn, is defined as consisting of those working and those not working but seeking work. Thus, the unemployment rate leaves out people who are not working but also not seeking work—termed by economists as voluntarily unemployed. For purposes of government macroeconomic policies, only those who are involuntarily unemployed are of primary concern.

For various reasons, it is not possible to reduce the unemployment rate to zero even in the best of circumstances. Realistically, economists expect the labor force to always include an unemployed fraction—usually estimated at six percent for the U.S. labor market. The six percent unemployment rate is often referred to as the benchmark unemployment rate. In effect, if the unemployment level is at the six percent level, the economy is considered to be at full employment.

INFLATION RATE.

Inflation is considered to be a macroeconomic variable of key concern. The inflation rate is defined as the rate of change in the price level. Most economies face positive rates of inflation year after year. The price level, in turn, is measured by a price index which measures the level of prices of goods and services at any point of time. The number of items included in a price index vary depending on the objective of the index. Usually three kinds of price indexes are periodically reported by government sources: the consumer price index or (CPI), which measures the average retail prices paid by consumers for goods and services typically bought by them; the producer price index or (PPI), which measures the wholesale prices of items that are typically used by producers; and the implicit GDP price deflator, which measures the prices of all goods and services included in the GDP. The inflation rate index most commonly reported in the popular media is the consumer price index.

INTEREST RATE.

The concept of the interest rate used by economists is the same as the one commonly used. The interest rate is invariably quoted in nominal terms—i.e., the rate is not adjusted for inflation. Thus, the commonly followed interest rate is actually the nominal interest rate. Nevertheless there are hundreds of nominal interest rates.

Fortunately, while the hundreds of interest rates that one encounters may appear baffling, they are closely linked to each other. Two characteristics that account for the linkage are the risk worthiness of the borrower and the maturity date of the loan involved. So, for example, the interest rate on a six-month U.S. Treasury bill is related to that on a 30-year Treasury bond, just as bonds and loans of different maturities command different rates. Furthermore, a 30-year General Motors bond will carry a higher interest rate than a 30-year U.S. Treasury bond, since a General Motors bond is riskier than a U.S. Treasury bond.

THE MACROECONOMIC THEORIES AND
ASSOCIATED POLICY
RECOMMENDATIONS

The branch of social science called macroeconomics essentially examines the factors that lead to changes in the main characteristics of the economy—output, employment, inflation, and interest rates. A set of principles that describes how the key macroeconomic variables are determined is called a macroeconomic theory. Typically, every macroeconomic theory comes up with a set of policy recommendations that the proponents of the theory hope the government will follow. Since the 1930s, four macroeconomic theories have been proposed: Keynesian economics, monetarism, the new classical economics, and supply-side economics. All these theories are based, in varying degrees, on the classical economics that preceded the advent of Keynesian economics in the 1930s.

CLASSICAL ECONOMICS.

The macroeconomic theory that dominated capitalist economies prior to the advent of Keynesian economics in 1936 has been widely known as the classical macroeconomics. The classical economists believed in free markets and that the economy would always achieve full employment through forces of demand and supply. So, if there were more people seeking work than the number of jobs available, wages would fall until all those seeking work are employed. Thus, the full employment of workers was guaranteed by market forces. The level of full employment resulted in a fixed aggregate output/income. The price level (and thus the inflation rate) was determined by the supply of money in the economy. Since, the output level was fixed, a 10 percent increase in money supply would lead to a 10 percent increase in the price level—too many dollars chasing too few goods. The real interest rate (the nominal interest rate minus the inflation rate) was also determined by forces of demand and supply in the market: the demand and supply for lendable funds. The nominal interest rate was then simply the sum of the real interest rate and the prevailing inflation rate. The classical economists thus had an unwavering faith in a self-adjusting market mechanism. For the market mechanism to work, however, the market structure had to be that of perfect competition, and wages and prices had to be fully flexible.

The classical economists did not see any role for the government. As market forces led to a full employment equilibrium in the economy, there was no need for government intervention. Monetary policy (increasing or decreasing the money supply) would only affect prices—it did not affect the important factors of output and employment. Fiscal policy (using government spending or taxes), on the other hand, was perceived to be harmful. For example, if the government borrowed to finance its spending, it would simply reduce the funds available for private consumption and investment expenditures—a phenomenon popularly termed as crowding out. Similarly, if the government raised taxes to pay for increased spending, it would reduce private consumption in order to fund public consumption. Instead, if it financed the spending by an increase in the money supply, it would have the same effects as an expansionary monetary policy. Thus, the classical economists recommended use of neither monetary nor fiscal policy by the government. This hands-off policy recommendation is known as the laissez-faire policy.

KEYNESIAN ECONOMICS.

Keynesian economics was born during the Great Depression of the 1930s. The classical economists had argued that the self-adjusting market mechanism would restore full employment in the economy, should the economy deviate from the full employment path for some reason. The experience of the Great Depression, however, showed that the market forces did not work as well as the classical economists had believed. The unemployment rate in the United States rose to above 25 percent of the labor force. Hard-working people were out in the street looking for nonexisting jobs. Wages fell substantially, but the lower wages did not reestablish full employment.

The English economist John Maynard Keynes (1883-1946) argued that the self-adjusting market forces would take a long time to restore full employment. He predicted that an economy can be stuck at a high level of unemployment for a prolonged period, leading to untold miseries. Keynes explained that the classical economics suffered from major flaws. Wages and prices are not as flexible as classical economists assumed, in fact, nominal wages tend toward the downward direction. Keynes further argued that classical economists had ignored a key factor that determined the level of output and employment in the economy—the aggregate demand for goods and services in the economy from all sources (consumers, businesses, government, and foreigners). Producers produce (and provide employment in the process) to meet the demand for their goods and services. If the level of aggregate demand is low, the economy would not create enough jobs and unemployment can result. In other words, the free working of the macroeconomy does not guarantee full employment—deficient aggregate demand can cause unemployment. Thus, if the aggregate private demand (i.e., the aggregate demand excluding government spending) falls short of the demand level needed to generate full employment, the government should step in to take up the slack.

The central issue underlying Keynesian thought was that those who have incomes demand goods and services and, in turn, help to create jobs. The government should thus find a way to increase aggregate demand. One direct way of doing so is to increase government spending. For example, increased spending on a government project will generate jobs and incomes for the persons employed on the project. This, in turn, would provide demand for goods and services from private producers and generate additional employment in the private sector. The early Keynesian economists thus recommended that the government should use fiscal policy (which includes decisions regarding both government spending and taxes) to make up for the shortfall in private aggregate demand and to create jobs in the private sector. Keynesian economists went so far as to recommend that it may be worthwhile for the government to employ people to dig holes and to fill them up.

The Roosevelt administration followed the Keynesian recommendations, although reluctantly, and embarked on a variety of government programs aimed at boosting incomes and aggregate demand. As a result, the economy started improving. The really powerful push to the depressed U.S. economy, however, came when World War II broke out. The war generated such an enormous demand for U.S. military and civilian goods that factories in the United States operated multiple shifts. No serious unemployment was seen in the U.S. economy for a long time to come.

Modern Keynesians (also, known as neo-Keynesians) recommend monetary policy, in addition to fiscal policy, to manage the level of aggregate demand. Monetary policy affects aggregate demand in the Keynesian system by affecting private investment and consumption demand. An increase in the money supply, for example, leads to a decrease in the interest rate. This lowers the cost of borrowing and thus increases private investment and consumption, boosting the aggregate demand in the economy.

An increase in aggregate demand under the Keynesian system, however, not only generates higher employment but also leads to higher inflation. This causes a policy dilemma—how to strike a balance between employment and inflation. According to laws that were enacted following the Great Depression, policymakers are expected to use monetary and fiscal policies to achieve high employment consistent with price stability.

MONETARISM.

Monetarism was an attempt by conservative economists to reestablish the wisdom of the classical laissez-faire recommendation. By 1950, Keynesian economics was well established. The birth of monetarism took place in the 1960s. The original proponent of monetarism was Milton Friedman (1912—), now a Nobel Laureate. The monetarists argued that while it is not possible to have full employment of the labor force all the time, it is better to leave the economy to market forces. Friedman contended that the government's use of active monetary and fiscal policies to stabilize the economy around full employment leads to greater instability in the economy. He argued that while the economy would not achieve a state of bliss in the absence of the government intervention, it would be far more tranquil.

Friedman modified some aspects of the classical theory to provide the rationale for his noninterventionist policy recommendation. In essence, monetarism contends that the use of fiscal policy is largely ineffective in altering output and employment. Moreover, it only leads to crowding out. On the other hand, while monetary policy is effective, monetary authorities do not have sufficient knowledge to conduct a successful monetary policy—manipulating the money supply to stabilize the economy only leads to greater instability. Hence, monetarism advocates that neither monetary nor fiscal policy should be used in an attempt to stabilize the economy, and that the money supply should be allowed to grow at a constant rate. The monetarist policy recommendations are similar to those of the classical economists, even though the reasoning is somewhat different.

THE NEW CLASSICAL ECONOMICS.

The 1970s saw a further push to revive the classical orthodoxy. The new classical economists (also known as proponents of rational expectations) provided a theoretical framework and empirical evidence to support the view that neither fiscal nor monetary policy can be effective in altering the output and employment levels in a systematic manner. The proponents of the new classical economics argued that if economic agents (consumers, businesses, and others) used rational expectations (i.e., all available information) regarding government policies, they would frustrate any anticipated policy action by the government by altering their own behavior. Thus, there was no point in conducting monetary and fiscal policies, since market forces are not amenable to such manipulations.

SUPPLY-SIDE ECONOMICS.

While supply-side economics became popular during the Reagan era, it had been a part of the U.S. macroeconomic policies for some time. Supply-side theory was also rooted in classical economics, even though it accepted some Keynesian policies of demand management. Basically, supply-siders emphasized enhancing economic growth by augmenting the supply of factors of production such as labor and capital. This would be accomplished done through increased incentives mainly in the form of reduced taxes and regulations. Ronald Reagan, for example, used a major tax cut as a part of his fiscal policy. The supply-siders, in general, want a greater role for the market forces and a reduced role for the government.

RECENT DEVELOPMENTS IN
MACROECONOMIC THEORY

Followers of New Classical Economics have further built on the rational expectations concept and have developed "real business cycle models." Assuming that output is always at its natural level, they attempt to explain movements of the natural level of output. New Keynesian Economics, on the other hand, is the result of the effort by the followers of neo-Keynesian economics, who further refined Keynesian Economics by explaining imperfections in different markets. New Growth Theory is the third component of recent developments in macroeconomics. It further refines growth theory, the intellectual basis of supply-side economics.

THE DOMINANT MACROECONOMIC THEORY.

While the existence of numerous macroeconomic theories is somewhat confusing, there is usually a dominant theory that the government follows. In the late-1990s one can safely argue that the United States and many other capitalist countries largely follow Keynesian policy recommendations.