© copyright 2007. do not distribute or copy without permission. 1 economics economics is divided...

© Copyright 2007. Do not distribute or copy without permission. 1

Economics

Economics is divided into three major fields

Microeconomics examines behavior of individuals and firms

Macroeconomics examines aggregate behavior of broad sectors of the economy

Econometrics statistical analysis of economic and financial data


Fundamental Principles of Economic Behavior

1. Some choices involve accounting (“explicit”) costs, but all choices involve opportunity costs.

Accounting cost is the giving up of A in order to obtain B.

Opportunity cost is the failure to obtain C because you obtained B.

Economic cost is accounting cost plus opportunity cost.

Example

A firm hires a worker for $70,000 (including benefits). The firm’s weighted average cost of capital is 15%.

The explicit cost of the worker is $70,000 per year. This is what the firm gives up in order to obtain the worker.

The opportunity cost of the worker is ($70,000)(0.15) = $10,500. This is the amount of money the firm could have earned, but failed to earn, had the firm invested the $70,000 elsewhere.

The economic cost of the worker is $70,000 + $10,500 = $80,500.




2. People make decisions at-the-margin.

Example

A firm spends $100 million on building a new factory. The amortized cost of the factory is $10 million annually. The new factory will cost $8 million to operate annually. The factory is expected to bring in an additional $25 million in revenue annually.

After the factory is completed, economic conditions change such that the expected revenue to be generated by the factory drops to $5 million.

Should the firm operate or shut-down the factory (note: shutting down does not recoup the $100 million cost of the factory)?





Example

Some managers will be tempted to operate the factory because of the $100 million invested. This is called the sunk cost fallacy. The sunk cost fallacy arises when one fails to make decisions at-the-margin.

A decision at-the-margin looks only at changes given current conditions. In this case, the given condition is that the factory exists. The choice to operate or not is irrelevant to the $100 million investment.

Operate the factoryAnnual profit = $5 million – $8 million – $10 million = – $13 million

Shutdown the factoryAnnual profit = $0 million – $0 million – $10 million = – $10 million





3. People respond to incentives.

Where people are concerned, we call this utility maximization. Where firms are concerned, we call this profit maximization.

Example

Stockholders can mitigate portfolio risk by diversifying their stock holdings. Therefore, they will want to hold individual stocks that have greater expected returns and greater risks rather than individual stocks that have lesser expected returns and lesser risks.

As a result, stockholders want CEO’s to take risks in pursuit of greater profits.






Problem

If a risk goes bad, the CEO will be fired CEO has incentive not to take risks.

How can stockholders motivate CEO’s to take risks?

“Golden parachute” – guarantee the CEO that, in the event the CEO is fired, CEO will receive a large lump-sum payment from the company.






Other Examples

• Soviet nail manufacturers produced huge, multi-ton nails.

• In Russia, dead light bulbs sold for more than live light bulbs.

• Traffic monitoring devices reduce side-impact, but cause rear-end collisions.






4. Exchange is (usually) not a zero-sum game.

Zero-sum game: A situation in which what one person gains, the other loses.

In an exchange, both parties can end up better off than they were at the outset.

Example

Person A owns a car that he would like to sell. Person A has full knowledge of the condition of the car. Given his need to drive, desire for style/comfort, etc., Person A places a subjective value of $10,000 on the car. This means that Person A would accept nothing less than $10,000 in exchange for the car.







Example

Person B also has full knowledge of the condition of the car. Given her need to drive, etc., Person B places a subjective value of $12,000 on the car. This means that Person B would pay any price up to, but not more than, $12,000 in exchange for the car.







Example

A reservation price is the minimum price the seller is willing to accept or the maximum price the buyer is willing to pay.

Seller’s reservation price = $10,000Buyer’s reservation price = $12,000

If Person B pays $11,000 for the car, Person B gains $1,000 of value ($12,000 car value less $11,000 price), and Person A gains $1,000 of value ($11,000 price less $10,000 car value).







5. The world is non-linear.

Assuming that the world is linear results in erroneous expectations.

ExampleA firm employs 100 workers who, together, produce 100,000 bottles

of beer daily.

Linear assumption: 200 workers will produce 200,000 bottles of beer daily.

Non-linear reality: Factory cannot accommodate 200 workers. Overcrowding puts downward pressure on output 200 workers produce only 140,000 bottles.







5. The world is non-linear.

Linear assumption: Double the workers and the factory size to produce 200,000 bottles of beer daily.

Non-linear reality: Managers are limited in the number of workers they can manage. Without adding an extra layer of management, inefficiencies put downward pressure on output doubled workers and factory space produce only 180,000 bottles.


Terminology

Product A good or service.

Good An object that is desirable.

Durable good A good that is consumed over a long period of time.

Service An action that is desirable.

Attributes Color, taste, smell, size, price, durability, etc. Salient attributes are attributes that are important to the consumer.

Brand A variety of a product identified from other varieties by a commercial name and/or other distinctive attributes.

Consumer One who desires to purchase a product.

End-user A consumer who will not resell a product.

Producer One who offers a product for sale.

Manufacturer One who creates a product.

Retailer One who sells, but does not manufacture, a product.

Factor Labor, materials, capital a producer uses to produce a product.

Capital Buildings, land, machinery used in the production of a product. Also called property, plant, and equipment (PP&E).

Market Interaction of consumers and producers of a given product.


Markets

A market forms when consumers and producers of a product come together.

The behavior of the consumer is summarized by demand.

The behavior of the producer is summarized by supply.

Later, we will examine instances in which markets are influenced by government intervention and foreign competition. For the moment, we will focus on the simple case in which the only players in the market are the producers and consumers.


Demand

The relationship between the number of units of a product a consumer is willing to buy and the price of the product.

Demand

Price per Unit Quantity Demanded

(per unit time) $20 100 $18 120 $16 150

Relationship between price and quantity is demand.

Amount the consumer wants to buy is quantity demanded.

Incorrect: “When the price of the product falls, demand rises.”

Correct: “When the price of the product falls, the quantity demanded rises.”


Demand

The relationship between the number of units of a product a consumer is willing to buy and the price of the product.

Demand


(per unit time) $20 100 $18 120 $16 150

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Quantity Demanded per Unit Time

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Figures from the table can be plotted to form a graph of demand.


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(per unit time) $20 100 $18 120 $16 150

Any event that alters the demand relationship is called a consumer shock.

A positive consumer shock causes consumers to want to purchase more units of the product at all price levels.

A negative consumer shock causes consumers to want to purchase fewer units of the product at all price levels.

Demand

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(per unit time) $20 100 110 $18 120 133 $16 150 166

160

Positive Consumer Shock



(per unit time) $20 100 $18 120 $16 150

A change in the price of a good is not a shock because the price change does not alter the relationship between price and quantity demanded.

When the price falls, consumers want to buy more of the product, but they don’t want to buy more of the product at all price levels.

Demand

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If price had stayed at $20, consumers would not want to buy

more.


Demand

Typical Consumer Shocks

1. Change in consumers’ purchasing power.Increase (decrease) in purchasing power is a positive (negative) shock.

2. Change in price of a substitute product.Increase (decrease) in price of a substitute is a positive (negative) shock. E.g. increase in price of coffee increases demand for tea.

3. Change in price of a complement product.Increase (decrease) in price of a complement is a negative (positive) shock. E.g. increase in price of charcoal decreases demand for lighter fluid.

4. Change in consumer preferences.Increase (decrease) in preferences is a positive (negative) shock.

5. Change in number of consumers.Increase (decrease) in number of consumers is a positive (negative) shock.


Price per Unit Quantity Supplied

(per unit time) $20 140 $18 120 $16 100

Supply

The relationship between the number of units of a product a producer is willing to offer and the price of the product.

Supply

Relationship between price and quantity is supply.

Amount the producer wants to sell is quantity supplied.

Incorrect: “When the price of the product falls, supply falls.”

Correct: “When the price of the product falls, the quantity supplied falls.”


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Quantity Supplied per Unit Time

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Supply

The relationship between the number of units of a product a producer is willing to offer and the price of the product.

Supply

Figures from the table can be plotted to form a graph of demand.


(per unit time) $20 140 $18 120 $16 100


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(per unit time) $20 140 $18 120 $16 100

Supply

Any event that alters the supply relationship is called a producer shock.

A positive producer shock causes producers to want to offer more units of the product at all price levels.

A negative producer shock causes producers to want to offer fewer units of the product at all price levels.


(per unit time) $20 140 160 $18 120 133 $16 100 110

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Positive Producer Shock


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(per unit time) $20 140 $18 120 $16 100

Supply

A change in the price of a good is not a shock because the price change does not alter the relationship between price and quantity supplied.

When the price falls, producers want to offer fewer units of the product, but they don’t want to offer fewer units at all price levels.

If price had stayed at $20, producers would not want to

offer fewer units.


Supply

Typical Producer Shocks

1. Change in producers’ technology.Increase (decrease) in technology is a positive (negative) shock.

2. Change in prices of factors.Increase (decrease) in price of a factor is a negative (positive) shock. E.g. increase in price of steel decreases supply of cars.

3. Change in the number of producers.Increase (decrease) in number of producers is a positive (negative) shock.


Identifying Shocks

First

Identify the market under scrutiny, and the consumers/producers of the market’s product.

Consumer Shocks vs. Producer Shocks

A shock is a consumer shock if it impacts consumers first and producers (if at all) only as a result of the impact on consumers.

A shock is a producer shock if it impacts producers first and consumers (if at all) only as a result of the impact on producers.

Positive Shocks vs. Negative Shocks

A shock is a positive shock if it makes it easier or more attractive for producers/consumers to produce/consume.

A shock is a negative shock if it makes it harder or less attractive for producers/consumers to produce/consume.


Identifying Shocks

Example

Refusing entry visas to Canadian loggers who, previously, cut trees in Maine for use as pulpwood is what sort of shock to the American paper markets?1. Identify the market

Market for American-made paper

2. Identify the producersAmerican paper manufacturers

3. Identify the consumersThose who buy American paper

4. Identify the target of the shock (consumer shock or producer shock)Producer shock

5. Identify the direction of the shock (positive or negative)Negative shock

6. Identify the impact on demand/supplySupply of paper decreases


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Shortage, Surplus, and Equilibrium

Suppose the price of a product is $16.

According to the supply curve, producers will offer 100 units per day.

According to the demand curve, consumers will seek to purchase 150 units per day.

A shortage is a situation in which QD >

QS

Shortage = 50 units per day


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Producers experience a shortage as a reduction in inventories (for goods producers) or limited capacity (for service producers).

Competition by consumers for a limited quantity of product puts upward pressure on price.

As price rises, QS increases and QD

decreases, reducing the shortage.


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Eventually, the price rises to a point such that the shortage is completely eliminated.With the shortage gone, consumers no longer compete for a limited quantity of product, and so the price stops rising.

Equilibrium point

Equilibrium quantity

Equilibrium price


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Suppose the price of a product is $20.

According to the demand curve, consumers will seek to purchase 100 units per day.According to the supply curve, producers will offer 140 units per day.

A surplus is a situation in which QD <

QS

Surplus = 40 units per day


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Producers experience a surplus as an increase in inventories (for goods producers) or excess capacity (for service producers).

Competition by producers for a limited quantity of sales puts downward pressure on price.

As price falls, QD increases and QS

decreases, reducing the surplus.


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Eventually, the price falls to a point such that the surplus is completely eliminated.With the surplus gone, producers no longer compete for a limited quantity of sales, and so the price stops falling.

Equilibrium point

Equilibrium quantity

Equilibrium price



Shortage

QD > QS Competition among consumers causes price to rise

Surplus

QD < QS Competition among producers causes price to fall

Equilibrium

QD = QS No competition and so no price change


In regression analysis, we look at how one variable (or a group of variables) can affect another variable.

We use a technique called “ordinary least squares” or OLS. The OLS technique looks at a sample of two (or more) variables and filters out random noise so as to find the underlying deterministic relationship among the variables.

Example:

A retailer suspects that monthly sales follow unemployment rate announcements with a one-month lag. When the Bureau of Labor Statistics announces that the unemployment rate is up, one month later, sales appear to fall. When the BLS announces that the unemployment rate is down, one month later, sales appear to rise.

The retailer wants to know if this relationship actually exists. If so, the retailer can use BLS announcements to help predict future sales.

In linear regression analysis, we assume that the relationship between the two variables (in this example, sales and unemployment rate) is linear and that any deviation from the linear relationship must be due to noise (i.e. unaccounted randomness in the data).

Regression Analysis


Example:

The chart below shows data (see Data Set #4) on sales and the unemployment rate collected over a 10 month period.

Notice that the relationship (if there is one) between the unemployment rate and sales is subject to some randomness.

Over some months (e.g. May to June), an increase in the previous month’s unemployment rate corresponds to a decrease in the current month’s sales.

But, over other months (e.g. June to July), an increase in the previous month’s unemployment rate corresponds to an increase in the current month’s sales.

Date Montly Sales Unemployment Rate(current month) (current month) (previous month)

January $257,151 4.5%February $219,202 4.7%

March $222,187 4.6%April $267,041 4.4%May $265,577 4.8%June $192,566 4.9%July $197,655 5.0%

August $200,370 4.9%September $203,730 4.7%

October $181,303 4.8%

Regression Analysis


Example:

It is easier to picture the relationship between unemployment and sales if we graph the data. Since we are hypothesizing that changes in the unemployment rate cause changes in sales, we put unemployment on the horizontal axis and sales on the vertical axis.

$160,000

$180,000

$200,000

$220,000

$240,000

$260,000

$280,000

4.3% 4.4% 4.5% 4.6% 4.7% 4.8% 4.9% 5.0% 5.1%

Unemployment Rate (previous month)

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Regression Analysis


y = -11,648,868x + 771,670

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$280,000

4.3% 4.4% 4.5% 4.6% 4.7% 4.8% 4.9% 5.0% 5.1%


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Example:

OLS finds the line that most closely fits the data. Because we have assumed that the relationship is linear, two numbers describe the relationship: (1) the slope, and (2) the vertical intercept.

Vertical intercept = 771,670

Slope = –11,648,868

^

Sales 771,670 11,648,868 (unemp rate)

Regression Analysis


y = -11,648,868x + 771,670

$160,000

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$200,000

$220,000

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$260,000

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4.3% 4.4% 4.5% 4.6% 4.7% 4.8% 4.9% 5.0% 5.1%


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The graph below shows two relationships:1. The regression model is the scattering of dots and represents the actual

data.2. The estimated (or fitted) regression model is the line and represents the

regression model after random noise has been removed.

1Sales (unemp rate )t t tu

^

1ˆSales (unemp rate )ˆt t

Regression model

Estimated regression model

True intercept and slope

Noise (also called “error term”)

Unemp rate of 4.5%…

…is observed with sales of $257,151

After eliminating noise, we estimate that sales should have been 771,670 – (11,648,868)(0.045) = $247,471

^

Estimated noise associated with this observation

ˆSales Sales $257,151 $247,471 $9,680 tu

^

Sales 771,670 11,648,868 (unemp rate)

Estimated intercept, slope, and sales after estimating and removing noise

Regression Analysis


Terminology:

Variables on the right hand side of the regression equation are called exogenous, or explanatory, or independent variables. They usually represent variables that are assumed to influence the left hand side variable.

The variable on the left hand side of the regression equation is called the endogenous, or outcome, or dependent variable. The dependent variable is the variable whose behavior you are interested in analyzing.

The intercept and slopes of the regression model are called parameters. The intercept and slopes of the estimated (or fitted) regression model are called estimated parameters.

The noise term in the regression model is called the error or noise. The estimated error is called the residual, or estimated error.

Y X u ˆu Y Y ˆ ˆˆY X

Regression model Fitted (estimated) model

Explanatory variable

Outcome variable

ParametersParameter estimates

Fitted (estimated) outcome variable Residual (estimated

error)

Error (noise)

Regression Analysis


y = -11,648,868x + 771,670

$160,000

$180,000

$200,000

$220,000

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$260,000

$280,000

4.3% 4.4% 4.5% 4.6% 4.7% 4.8% 4.9% 5.0% 5.1%


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)OLS estimates the regression model parameters by selecting parameter values that minimize the variance of the residuals.

= Residual difference between actual and fitted values of the outcome variable.

Regression Analysis


y = -11,648,868x + 771,670

$160,000

$180,000

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$280,000

4.3% 4.4% 4.5% 4.6% 4.7% 4.8% 4.9% 5.0% 5.1%


Sal

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)OLS estimates the regression model parameters by selecting parameter values that minimize the variance of the residuals.

= Residual difference between actual and fitted values of the outcome variable.

Choosing different parameter values moves the estimated regression line away (on average) from the data points. This results in increased variance in the residuals.

Regression Analysis


To perform regression in Excel: (1) Select TOOLS, then DATA ANALYSIS(2) Select REGRESSION

Regression Analysis


To perform regression in Excel: (3) Enter the range of cells containing outcome (“Y”) and

explanatory (“X”) variables(4) Enter a range of cells for the output

Constant is zeroCheck this box to force the vertical intercept to be zero.

Confidence levelExcel automatically reports 95% confidence intervals. Check this box and enter a level of confidence if you want a different confidence interval.

ResidualsCheck this box if you want Excel to report the residuals.

Standardized residualsCheck this box if you want Excel to report the residuals in terms of standard deviations from the mean.

Regression Analysis


Regression results

Vertical intercept estimate

Slope estimate

Standard deviation of vertical intercept estimate

Standard deviation of slope estimate

Test statistic and p-value for H0: parameter =

0

95% confidence interval around parameter

estimate

Regression Analysis


The properties of a regression parameter estimates:

Population parameter

Standard deviation of varies depending on the regression mode

ˆ is distributed , where = number of parameters in the regression modelN kt k

If we select a different sample of observations from a population and then perform OLS, we will obtain slightly different parameter estimates.

Thus, regression parameter estimates are random variables.

ˆLet be a regression parameter estimate.

Distribution of Regression Parameter Estimates


Regression demoEnter population values here.

Spreadsheet selects a sample from the population and calculates parameter estimates based on the sample.

Press F9 to select a new sample.

Distribution of Regression Parameter Estimates


In multiple regression analysis the OLS technique finds the linear relationship between an outcome variable and a group of explanatory variables.

As in simple regression analysis, OLS filters out random noise so as to find the underlying deterministic relationship. OLS also identifies the individual effects of each of the multiple explanatory variables.

0 1t t tY X u

Simple regression

0 1 1, 2 2, ,...t t t m m t tY X X X u

Multiple regression

Multiple Regression Analysis


Example:

A trucking company wants to be able to predict the round-trip travel time of its trucks. Data Set #6 contains historical information on miles traveled, number of deliveries per trip, and total travel time. Use the information to predict a truck’s round-trip travel time.

Approach #1: Calculate Average Time per Mile

Trucks in the data set required a total of 87 hours to travel a total of 4,000 miles. Dividing hours by miles, we find an average of 0.02 hours per mile journeyed.

Problem:

This approach ignores a possible fixed effect. For example, if travel time is measured starting from the time that out-bound goods begin loading, then there will be some fixed time (the time it takes to load the truck) tacked on to all of the trips. For longer trips this fixed time will be “amortized” over more miles and will have less of an impact on the time/mile ratio than for shorter trips.

This approach also ignores the impact of the number of deliveries.

Miles Traveled Deliveries Travel Time (hours)

500 4 11.3250 3 6.8500 4 10.9500 2 8.5250 2 6.2400 2 8.2375 3 9.4325 4 8450 3 9.6450 2 8.1



Example:


Approach #2: Calculate Average Time per Mile and Average Time per Delivery

Trucks in the data set averaged 87 / 4,000 = 0.02 hours per mile journeyed,and 87 / 29 = 3 hours per delivery.

Problem:

Like the previous approach, this approach ignores a possible fixed effect.

This approach does account for the impact of both miles and deliveries, but the approach ignores the possible interaction between miles and deliveries. For example, trucks that travel more miles likely also make more deliveries. Therefore, when we combine the time/miles and time/delivery measures, we may be double-counting time.



Example:


Approach #3: Regress Time on Miles

The regression model will detect and isolate any fixed effect.

Problem:

The model ignores the impact of the number of deliveries. For example, a 500 mile journey with 4 deliveries will take longer than a 500 mile journey with 1 delivery.


500 4 11.3250 3 6.8500 4 10.9500 2 8.5250 2 6.2400 2 8.2375 3 9.4325 4 8450 3 9.6450 2 8.1

0 1Time (miles )i i iu



Example:


Approach #4: Regress Time on Deliveries

The regression model will detect and isolate any fixed effect and will account for the impact of the number of deliveries.

Problem:

The model ignores the impact of miles traveled. For example, a 500 mile journey with 4 deliveries will take longer than a 200 mile journey with 4 deliveries.


500 4 11.3250 3 6.8500 4 10.9500 2 8.5250 2 6.2400 2 8.2375 3 9.4325 4 8450 3 9.6450 2 8.1

0 1Time (deliveries )i i iu



Example:


Approach #5: Regress Time on Both Miles and Deliveries

The multiple regression model (1) will detect and isolate any fixed effect, (2) will account for the impact of the number of deliveries, (3) will account for the impact of miles, and (4) will eliminate out the overlapping effects of miles and deliveries.


500 4 11.3250 3 6.8500 4 10.9500 2 8.5250 2 6.2400 2 8.2375 3 9.4325 4 8450 3 9.6450 2 8.1

0 1 2Time (miles ) (deliveries )i i i iu



Example:


0 1 2

Regression model:

Time (miles ) (deliveries )i i i iu

SUMMARY OUTPUT

Regression StatisticsMultiple R 0.950678166R Square 0.903788975Adjusted R Square 0.876300111Standard Error 0.573142152Observations 10

ANOVAdf SS MS F Significance F

Regression 2 21.60055651 10.80027826 32.87836743 0.00027624Residual 7 2.299443486 0.328491927Total 9 23.9

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%Intercept 1.131298533 0.951547725 1.188903619 0.273240329 -1.118752683 3.38134975X Variable 1 0.01222692 0.001977699 6.182396959 0.000452961 0.007550408 0.016903431X Variable 2 0.923425367 0.221113461 4.176251251 0.004156622 0.400575489 1.446275244

^

0 1 2

0

1

2

2

Estimated regression model:

ˆ ˆ ˆTime (miles ) (deliveries )

ˆ 1.13 (0.952) [0.2732]

ˆ 0.01 (0.002) [0.0005]

ˆ 0.92 (0.221) [0.0042]

0.90

i i i

R

Standard deviations of parameter estimates and p-values are typically shown in parentheses and brackets, respectively, near the parameter estimates.



Example:


Notes on results:1. Constant is not significantly

different from zero.2. Slope coefficients are

significantly different from zero.

3. Variation in miles and deliveries, together, account for 90% of the variation in time.

^

0 1 2

0

1

2

2

Estimated regression model:

ˆ ˆ ˆTime (miles ) (deliveries )

ˆ 1.13 (0.952) [0.2732]

ˆ 0.01 (0.002) [0.0005]

ˆ 0.92 (0.221) [0.0042]

0.90

i i i

R

The parameter estimates are measures of the marginal impact of the explanatory variables on the outcome variable.

Marginal impact measures the impact of one explanatory variable after the impacts of all the other explanatory variables are filtered out.Marginal impacts of explanatory

variables

0.01 = increase in time given increase of 1 mile traveled.

0.92 = increase in time given increase of 1 delivery.



Types of Analysis

A qualitative analysis attempts to determine the direction of changes in price and quantity.

A quantitative analysis attempts to determine the magnitude of changes in price and quantity.


Qualitative Analysis of Shocks

Example

In March 2005, crude oil rose to a then-record $56 per barrel. Crude oil is the main component of gasoline. Using qualitative analysis, determine the impact of the rise in oil prices on the market for gasoline.

Incorrect approach

The increase in the price of oil will cause an increase in the price of gas. As gas prices rise, it becomes more profitable for retailers to sell gasoline, so the quantity of gas offered for sale will rise. Because people won’t drive less, consumers will not buy less gas, but will cut back on purchases of other things. In summary: The price of gas will rise and the quantity of gas sold will rise.Critique of Analysis

The analysis skips the impact of the price of oil on the demand and supply of gasoline, and instead jumps right to the impact on the price of gas. While the analysis correctly identifies the impact on the price of gas, by skipping the impact on demand and supply, the analysis fails to identify why the price of gas is rising and, as a result, incorrectly concludes that sales of gas will rise.



Correct approach

1. The rise in the price of oil is a negative producer shock.

Q/time

$/unit

D

S

2. Negative producer shock causes supply of gasoline to decrease.

S’

P1

Market for Gasoline

3. Decrease in supply of gasoline causes a shortage of gasoline.

QDQS

shortage

4. Shortage of gasoline causes price of gasoline to rise.

P2

5. Price rises until new equilibrium is attained.

A

B

End result:Market moves from equilibrium A to equilibrium B

Price of gasoline rises and quantity sold of gasoline falls.


Qualitative Analysis of ShocksPublicity surrounding the introduction of the new food pyramid has raised consumer awareness of the health problems associated with eating fast food. Simultaneously, Congress voted to increase the minimum wage effective immediately. Using qualitative analysis, determine the combined impact of these shocks on the market for fast food.1. Identify the market

Market for fast food

2. Identify the producersFast food retailers

3. Identify the consumersPeople who buy fast food

4. Identify the target of the shock (consumer shock or producer shock)Publicity: consumer shockMinimum wage: producer shock

5. Identify the direction of the shock (positive or negative)Publicity: negative shockMinimum wage: negative shock

6. Identify the impact on demand/supplyPublicity: demand decreasesMinimum wage: supply decreases



Perform qualitative analysis (skip intermediate steps – focus on change in equilibrium)

Q/time

$/unit

D

S

P1

Market for Fast Food

Q1

A

3. New equilibrium at B price rises to P2 and quantity sold falls to Q2.

Q2

P2

B

End result:Price of fast food rises and quantity sold of fast food falls.

2. Demand decreases and supply decreases.

S’

D’

1. Market starts at equilibrium A price is P1 and quantity sold per unit time

is Q1.

Question:What is wrong with this analysis?

Analysis assumes that the producer shock was larger than the consumer shock.



Perform qualitative analysis (skip intermediate steps – focus on change in equilibrium)

Q/time

$/unit

D

S

P1

Market for Fast Food

Q1

A

End result:Price of fast food falls and quantity sold of fast food falls.

We looked at two possibilities (1) consumer shock is greater than producer shock, and (2) producer shock is greater than consumer shock.

In both cases, quantity sold fell, but in case (1) price rose while in case (2) price fell.

1. Market starts at equilibrium A price is P1 and quantity sold per unit time is Q1.2. Demand decreases and supply decreases (but, this time, demand shift is

greater).

S’

D’

Assume now that the consumer shock is larger than the producer shock.

Conclusion: Quantity sold will fall. Impact on price is unknown.

Q2

P2

B

3. New equilibrium at B price falls to P2 and quantity sold falls to Q2.


Quantitative Analysis of Shocks

In a quantitative analysis, we apply regression techniques to data in an attempt to estimate the parameters of the demand and supply functions.

Ordinary Least Squares

One might be tempted to use OLS to estimate the demand (or supply) function. One problem with using OLS is that we don’t know if different observations are due to shifts in demand or supply.

D

S

••••

S’S’’

S’’’

Data on P and Q show demand, but not supply.

D

S

••••

D’ D’’

D’’’

Data on P and Q show supply, but not demand.


Quantitative Analysis of ShocksWe employ a procedure called two-stage least squares in an attempt to account for the fact that we don’t know whether the price and quantity data were generated by changes in supply, demand, or both together.

Two-Stage Least Squares

1. Identify factors that could cause shifts in demand and supply (over the sample period represented in the data set). Example: Consumer Income, Prices of Substitutes/Complements, Prices of Factors, Number of Producers, etc.

2. Run an OLS regression of quantity on all of the factors that could cause shifts in either demand or supply. This is stage #1 of the TSLS procedure.

3. Using the parameter estimates from stage #1, calculate fitted values for quantity.

4. Run an OLS regression of price on the fitted values for quantity and the factors that could cause shifts in demand. The results from this regression comprise the estimated demand function. This is stage #2 (as applied to demand).

5. Run an OLS regression of price on the fitted values for quantity and the factors that could cause shifts in supply. The results from this regression comprise the estimated supply function. This is stage #2 (as applied to supply).


Quantitative Analysis of ShocksExample

Using the following data, estimate the demand and supply functions.

Qt Quantity (units) sold at time t

Pt Price per unit at time t

It Customers’ average incomes at time t

Ft Average prices of factors at time t

St Price of primary substitute at time t

Ct Price of primary complement at time t

1. Factors that could cause a shift in demand or supply: I, F, S, C

1 2 3 4t t t t t tQ I F S C u

2. Regress quantity sold on factors that could shift demand or supply.



1. Factors that could cause a shift in demand or supply: I, F, S, C

1 2 3 4t t t t t tQ I F S C u

2. Regress quantity sold on factors that could shift demand or supply.

3. Using parameter estimates, calculate fitted quantities.

1 2 3 4ˆ ˆ ˆ ˆ ˆˆt t t t tQ I F S C

1 2 3 4

1 2 3 4

ˆ

ˆ ˆ ˆ ˆDemand equation is: ˆ

t t t t t t

t t t t t

P Q I S C u

P Q I S C

4. Regress price on fitted quantity sold and factors that could shift demand. Regress price on fitted quantity sold and factors that could shift supply.

1 2

1 2

ˆ

ˆ ˆSupply equation is: ˆ

t t t t

t t t

P Q F u

P Q F



Data Set #1 contains monthly data relevant to a firm’s 40 retail locations. Using this data, estimate the demand equation faced by the firm as a whole.

1 2 3 4t t t t t tQ MAHI LC CPPU AB u

1. What factors could cause changes in demand or supply?

Household income (MAHI), Labor costs (LC), Competitor price per unit (CPPU), Advertising budget (AB)

2. Regress output on these factors then calculate fitted output.



Data Set #1 contains monthly data relevant to a firm’s 40 retail locations. Using this data, estimate the demand equation faced by the firm as a whole.2. Regress output on these factors then calculate fitted output.




Dependent variable

Independent variable(s)


SUMMARY OUTPUT



Regression 4 1668625705 4.17E+08 6099.189 3.15186E-49Residual 35 2393838.615 68395.39Total 39 1671019544

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%Intercept -474.5638082 602.9004286 -0.787135 0.436501 -1698.518244 749.3906274Median Income 0.169918856 0.005828559 29.15281 3.85E-26 0.158086238 0.181751475Labor Costs -0.067582498 0.003374014 -20.0303 9.34E-21 -0.074432119 -0.060732878Competitor Price 90.76936788 53.69585291 1.690435 0.099833 -18.23914202 199.7778778Advertising Budget 0.462282487 0.003017196 153.2159 4.48E-51 0.456157247 0.468407728



1 2 3 4ˆ ˆ ˆ ˆ ˆˆQ MAHI LC CPPU AB

ˆ 474.56 0.17 0.07

90.77 0.46

Q MAHI LC

CPPU AB




ˆ 474.56 0.17 0.07

90.77 0.46

Q MAHI LC

CPPU AB

9936 850424765 2391413396 1144318889 2234123004 124727317 18385

15999 1305826254 2192519429 1114815518 197428025 114747521 13264

22670 519021715 1948826640 1511713372 2132025071 1219310543 64668940 15521

26480 4865

Fitted Unit Sales

Note: The figures shown in the equation are rounded to two decimal places. The figures on the right are calculated using the non-rounded coefficients.



Data Set #1 contains monthly data relevant to a firm’s 40 retail locations. Using this data, estimate the demand equation faced by the firm as a whole.3. Regress price on fitted quantity and factors that could shift demand.

1 2 3 4ˆ

t t t t t tP Q MAHI CPPU AB u SUMMARY OUTPUT



Regression 4 17550.63891 4387.659727 503.3350432 2.14659E-30Residual 35 305.10113 8.717175143Total 39 17855.74004

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%Intercept 0.487756046 7.013101584 0.069549263 0.944948276 -13.74961448 14.72512657Fitted Quantity Sold -0.001273075 0.000563621 -2.25874303 0.030234817 -0.002417287 -0.000128862Median Income 0.000501297 0.000119796 4.184601716 0.000182421 0.000258099 0.000744496Competitor Price -0.0143109 0.609609764 -0.02347551 0.981404306 -1.251886027 1.223264226Advertising Budget 0.002112162 0.000262718 8.03964832 1.83457E-09 0.001578815 0.002645509

ˆˆ 0.4878 0.0013 0.0005

0.0143 0.0021

t t t

t t

P Q MAHI

CPPU AB



Data Set #1 contains monthly data relevant to a firm’s 40 retail locations. Using this data, estimate the supply equation faced by the firm as a whole.4. Regress price on fitted quantity and factors that could shift supply.

1 2 3ˆ

t t t t tP Q LC AB u SUMMARY OUTPUT




Coefficients Standard Error t Stat P-value Lower 95% Upper 95%Intercept 0.408493319 5.869001067 0.069601848 0.944895759 -11.49437686 12.3113635Fitted Quantity Sold 0.001590068 0.000332424 4.783254098 2.90824E-05 0.000915882 0.002264255Labor Cost 0.000193847 4.55408E-05 4.256551323 0.000141656 0.000101486 0.000286208Advertising Budget 0.000787492 0.000153962 5.114837906 1.05727E-05 0.000475243 0.001099742

ˆˆ 0.4085 0.0016 0.0002

0.0008

t t t

t

P Q LC

AB



The firm is going to open a new retail store and is faced with a choice between two locations. Location A is in a higher income area (median household income = $80,000) while location B is in a lower income area (median household income = $40,000). This means, in part, that the firm would have to pay a higher wage to its workers if it located at A versus B. The firm is willing to spend, for labor costs plus advertising combined, a total of $200,000 per month.

The firm estimates that its monthly labor costs at location A would be $150,000 while its monthly labor costs at location B would be $100,000.

Suppose the firm wants to sell 15,000 units per month. Using your estimate of the demand curve, provide a recommendation as to which location the firm should choose. Assume that the competition price is the average of the prices observed at the firm’s 40 locations.

ˆˆ 0.4878 0.0013 0.0005 0.0143 0.0021t t t t tP Q MAHI CPPU AB

Location A

ˆ 0.4878 0.0013 15,000 0.0005 $80,000 0.0143 $7.58 0.0021 $50,000

$125.88tP



Suppose the firm wants to sell 15,000 units per month. Using your estimate of the demand curve, provide a recommendation as to which location the firm should choose. Assume that the competition price is the average of the prices observed at the firm’s 40 locations.

Location A

ˆ 0.4878 0.0013 15,000 0.0005 $80,000 0.0143 $7.58 0.0021 $50,000

$125.88tP

Location B

ˆ 0.4878 0.0013 15,000 0.0005 $40,000 0.0143 $7.58 0.0021 $100,000

$210.88tP


For the same cost and generating the same unit sales, the firm will be able to charge more for its product at location B.


Elasticities

The information contained in the estimated demand and supply functions can be summarized in elasticities. An elasticity is a number that indicates the sensitivity of an outcome to a factor.

%%

QX

An elasticity is defined as the percentage change in quantity (either demanded or supplied) divided by the percentage change in a factor.

Q Q XX X Q

%%

The elasticity can be rewritten as:

The ratio of the change in Q to a change in X can be derived from the coefficients in the demand and supply equations.


Elasticities

A different elasticity can be constructed corresponding to each factor in the demand and supply equations. Typical elasticities include:

From the demand equation

Price elasticity of demand

Cross-price elasticity of demand

Income elasticity of demand

Advertising elasticity of demand

From the supply equation

Price elasticity of supply

Labor cost elasticity of supply

%%

dQPrice

%%

dQPrice of Other Product

%%

dQIncome

%%

dQAdvertising

%%

sQPrice

%%

sQLabor Cost


Elasticities

Continuing with the demand equation derived from Data Set #1, calculate the price elasticity of demand for Store Location #10.

d dQ Q PP Q

%Price Elasticity of Demand

% Price

t t t t tP Q MAHI CPPU AB

Demand Equation

ˆˆ 0.4878 0.0013 0.0005 0.0143 0.0021

d

PQ

0.0013

Use “appropriate” values for P and Q.

Examples: most current values, average values


Elasticities

Continuing with the demand equation derived from Data Set #1, calculate the price elasticity of demand for Store Location #10.

d

P

Q

For Store Location #10

$78.33

15,931

Price Elasticity of Demand

11 78.33

3.80.0013 15,931

d

d d

d

Q P PP Q QP

Q

“At current price and unit sales levels, every 1% rise (fall) in price results in a 3.8% fall (rise) in unit sales.”

We say, “at current price…” because, as price and quantity change, the elasticity changes.


Elasticities

Continuing with the demand equation derived from Data Set #1, calculate the advertising elasticity of demand for Store Location #10.

d dQ QQ

% AdvertisingAdvertising Elasticity of Demand

% Advertising Advertising

t t t t tP Q MAHI CPPU AB

Demand Equation

ˆˆ 0.4878 0.0013 0.0005 0.0143 0.0021

1. Calculate ΔQd/ΔAdvertising

11

1 0.0021 1 1.6150.0013

d

d

Q PP

AB AB Q

1.615

AdvertisingdQ

Multiply by 1 because we are multiplying

two effects together.


Elasticities


d dQ QQ

% AdvertisingAdvertising Elasticity of Demand

% Advertising Advertising

2. Select “appropriate” values for Q and Advertising.

dQ

For Store Location #10

15,931

Advertising $35,552

3. Calculate advertising elasticity of demand.

d

d

QQ

Advertising Elasticity of Demand

Advertising 35,5521.6154 3.6

Advertising 15,931


Elasticities


4. Interpret the elasticity.

d

d

QQ

Advertising Elasticity of Demand

Advertising 35,5521.6154 3.6

Advertising 15,931

“At current unit sales and advertising levels, every 1% increase

(decrease) in advertising increases (decreases) unit sales by 3.6%.”


Example

Suppose that the labor cost elasticity of supply for a product is –0.1. We say that unit sales of the product are “labor cost inelastic” or “labor cost insensitive.”

This means that a given change in labor cost causes a proportionally smaller change in quantity supplied.

Inelastic vs. Elastic

Elasticity measures that are less than one (in absolute value) are called inelastic or insensitive. Elasticity measures that are greater than one (in absolute value) are called elastic or sensitive.

Suppose that the advertising elasticity of demand for a product is 5. We say that unit sales of the product are “advertising elastic” or “advertising sensitive.”

This means that a given change in advertising causes a proportionally larger change in quantity demanded.



The price elasticity of demand indicates a product is a luxury or a necessity.

If the elasticity is greater than one in absolute value, then unit sales of this product move proportionally more than the change in price the product is a luxury.

%Price Elasticity of Demand

% PricedQ

If the elasticity is less than one in absolute value, then unit sales of this product move proportionally less than the change in price the product is a necessity.

0-

strong necessitystrong luxury weak necessityweak luxury

-1



Using Data Set #1, find the average price price elasticity for your product across the 40 retail locations.

Demand Equation



11

0.0013d

d d d

d

Q P P PP Q Q QP

Q

d

PQ



Using Data Set #1, find the average price price elasticity for your product across the 40 retail locations. Store

LocationUnit Sales

Price per Unit

P / Qd (1 / -0.0013) (P / Qd)

1 10414 $65.23 0.0063 -4.822 24677 $111.16 0.0045 -3.473 13723 $64.25 0.0047 -3.604 18889 $90.05 0.0048 -3.675 22978 $100.32 0.0044 -3.366 7198 $58.16 0.0081 -6.227 15777 $82.91 0.0053 -4.048 25963 $112.89 0.0043 -3.349 19084 $93.65 0.0049 -3.7710 15931 $78.33 0.0049 -3.7811 8278 $56.66 0.0068 -5.2712 7379 $53.42 0.0072 -5.5713 22630 $104.35 0.0046 -3.5514 21377 $101.14 0.0047 -3.6415 26836 $112.05 0.0042 -3.2116 12886 $64.76 0.0050 -3.8717 25199 $111.46 0.0044 -3.4018 10660 $64.39 0.0060 -4.6519 8897 $62.15 0.0070 -5.3720 26351 $108.29 0.0041 -3.1621 8353 $61.07 0.0073 -5.6222 23814 $105.85 0.0044 -3.4223 11627 $69.58 0.0060 -4.6024 22842 $104.43 0.0046 -3.5225 12688 $55.82 0.0044 -3.3826 18522 $82.38 0.0044 -3.4227 12759 $57.25 0.0045 -3.4528 22015 $110.43 0.0050 -3.8629 10812 $59.93 0.0055 -4.2630 19522 $90.95 0.0047 -3.5831 11511 $65.71 0.0057 -4.3932 13611 $63.76 0.0047 -3.6033 4889 $47.62 0.0097 -7.4934 19688 $80.12 0.0041 -3.1335 14937 $78.66 0.0053 -4.0536 21522 $100.87 0.0047 -3.6137 12292 $61.92 0.0050 -3.8738 6706 $56.91 0.0085 -6.5339 15418 $77.18 0.0050 -3.8540 4658 $46.02 0.0099 -7.60

Average price elasticity of demand across the 40 stores = -4.23

Interpretation:

Consumers consider the product a luxury.

Consumers shopping at location #40 regard the product as a strong luxury (relative to other store locations).

Consumers shopping at location #34 regard the product as a weak luxury (relative to other store locations).


Cross-Price Elasticity of Demand

The cross-price elasticity of demand indicates whether two products are complements, substitutes, or unrelated.

If the elasticity is positive, then unit sales of this product move in the same direction as the price of the different product the different product is a substitute for this product.

% of this productCross-Price Elasticity of Demand

% Price of a different productdQ

If the elasticity is negative, then unit sales of this product move in the opposite direction of the price of the different product the different product is a complement for this product.

+-

strong substitutesstrong complements weak substitutesweak complements

0



Using Data Set #1, find the average cross-price price elasticity between your product and your competitor’s product.

Demand Equation


Find /

1 11 0.0143 1 11

0.0013

d

d

d

Q CPPU

Q PPCPPU CPPUQ


11d

d d

Q CPPU CPPUCPPU Q Q


Cross-Price Elasticity of DemandUsing Data Set #1, find the average cross-price price elasticity between your product and your competitor’s product.

Average cross-price elasticity of demand across the 40 stores = -0.003

Interpretation:

Consumers consider our product to be virtually unrelated (competition-wise) to our competitors.

If anything, consumers perceive that the products are slight complements.

Store Location

Unit SalesCompetitor Price per

UnitP competitor / Qd

our product(-11) (P competitor / Qd

our product)1 10414 $7.40 0.0007 -0.00782 24677 $6.96 0.0003 -0.00313 13723 $8.23 0.0006 -0.00664 18889 $8.31 0.0004 -0.00485 22978 $6.23 0.0003 -0.00306 7198 $6.21 0.0009 -0.00957 15777 $6.50 0.0004 -0.00458 25963 $8.82 0.0003 -0.00379 19084 $8.56 0.0004 -0.004910 15931 $7.38 0.0005 -0.005111 8278 $7.95 0.0010 -0.010612 7379 $8.51 0.0012 -0.012713 22630 $7.93 0.0004 -0.003914 21377 $7.65 0.0004 -0.003915 26836 $7.54 0.0003 -0.003116 12886 $7.97 0.0006 -0.006817 25199 $6.35 0.0003 -0.002818 10660 $8.40 0.0008 -0.008719 8897 $8.55 0.0010 -0.010620 26351 $9.12 0.0003 -0.003821 8353 $6.15 0.0007 -0.008122 23814 $8.43 0.0004 -0.003923 11627 $8.40 0.0007 -0.007924 22842 $7.96 0.0003 -0.003825 12688 $7.91 0.0006 -0.006926 18522 $8.52 0.0005 -0.005127 12759 $7.91 0.0006 -0.006828 22015 $7.47 0.0003 -0.003729 10812 $8.39 0.0008 -0.008530 19522 $8.03 0.0004 -0.004531 11511 $6.80 0.0006 -0.006532 13611 $8.66 0.0006 -0.007033 4889 $7.29 0.0015 -0.016434 19688 $7.32 0.0004 -0.004135 14937 $6.09 0.0004 -0.004536 21522 $6.27 0.0003 -0.003237 12292 $7.07 0.0006 -0.006338 6706 $7.06 0.0011 -0.011639 15418 $6.41 0.0004 -0.004640 4658 $6.55 0.0014 -0.0155


Income Elasticity of Demand

The income elasticity of demand indicates whether a product is superior, inferior, or normal.

If the elasticity is greater than one, then unit sales of this product rise faster than income rises the product is superior.

%Income Elasticity of Demand

% IncomedQ

If the elasticity is less than one, then unit sales of this product rise slower than income rises the product is inferior.

If the elasticity equals one, then unit sales of this product rise at the same rate as the product is normal.

+-

strongly superiorstrongly inferior weakly superiorweakly inferior

1

normal



Using Data Set #1, find the average income elasticity of demand for your product.

Demand Equation


dQIncome

ˆSolve Demand Equation for

ˆ ˆ375 769 0.385 11 1.615

t

t t t t t

Q

Q P MAHI CPPU AB


0.385d

d d

Q Income IncomeIncome Q Q



Using Data Set #1, find the average income elasticity of demand for your product.

Average income elasticity of demand across the 40 stores = 2.76Interpretation:

Overall, consumers consider our product to be strongly superior.

However, at 16 of the 40 stores, consumers consider our product to be inferior.

As consumers’ incomes rise, we should shift resources away from those 16 stores toward the remaining stores.

Store Location

Unit SalesMedian Annual

Household IncomeIncome / Qd (0.385) (Income / Qd)

1 10414 $38,622 3.7087 1.42782 24677 $30,728 1.2452 0.47943 13723 $50,925 3.7109 1.42874 18889 $48,711 2.5788 0.99285 22978 $50,117 2.1811 0.83976 7198 $38,209 5.3083 2.04377 15777 $30,679 1.9445 0.74868 25963 $51,498 1.9835 0.76379 19084 $51,605 2.7041 1.0411

10 15931 $39,350 2.4700 0.951011 8278 $46,427 5.6085 2.159312 7379 $52,875 7.1656 2.758813 22630 $44,961 1.9868 0.764914 21377 $33,875 1.5846 0.610115 26836 $52,175 1.9442 0.748516 12886 $54,211 4.2070 1.619717 25199 $43,784 1.7375 0.668918 10660 $46,371 4.3500 1.674819 8897 $47,715 5.3630 2.064820 26351 $44,580 1.6918 0.651321 8353 $37,946 4.5428 1.749022 23814 $49,120 2.0627 0.794123 11627 $50,268 4.3234 1.664524 22842 $46,223 2.0236 0.779125 12688 $54,909 4.3276 1.666126 18522 $52,460 2.8323 1.090427 12759 $48,502 3.8014 1.463528 22015 $30,915 1.4043 0.540629 10812 $50,492 4.6700 1.797930 19522 $31,803 1.6291 0.627231 11511 $39,607 3.4408 1.324732 13611 $40,861 3.0021 1.155833 4889 $31,655 6.4747 2.492834 19688 $52,210 2.6519 1.021035 14937 $48,131 3.2223 1.240636 21522 $31,616 1.4690 0.565637 12292 $32,856 2.6730 1.029138 6706 $33,823 5.0437 1.941839 15418 $52,968 3.4355 1.322740 4658 $32,273 6.9285 2.6675


Elasticities and Sales

Sales (“total revenue”) is calculated as:

Total Revenue = (Price per unit) (Unit sales)

By extension, %Δ Total Revenue = %Δ Price per unit + %Δ Unit sales

Example

Suppose that the price of a product rises by 12% and the unit sales drop by 8%.

Sales (total revenue) of the product change by 12% – 8% = 4%.


Applying Elasticities

US Air’s market researchers estimate that, were US Air to decrease the price of its coach fairs by 10%, then the number of coach tickets sold would increase by 20%.

To increase US Air’s sales, should US Air increase or decrease its coach fairs?

% 0.2

Price Elasticity of Demand 2% Price 0.1

dQ

A 1% increase in price will be accompanied by a 2% decrease in Qd. Similarly, a 1% decrease in price will be accompanied by a 2% increase in Qd.

A 1% increase in price will result in a 1% – 2% = –1% change in sales.

A 1% decrease in price will result in a –1% + 2% = +1% change in sales.



The May Company owns Filenes and Hechts. May is going to open two new stores (one Filenes and one Hechts) in New York and Philadelphia. The populations in each area (adjusted for the difficulty of getting to the stores) are comparable, and unit sales are initially equivalent in the two markets. Research shows that the income elasticity for major selling items at Filenes is approximately 1.1 while the income elasticity for major selling items at Hechts is approximately 0.9. Demographers predict that the average income level in New York will rise by 30% over the next twenty years (the expected life of the store) while the average income level in Philadelphia will rise by 20% over the same period. Assume that price at Filenes and Hechts are roughly equivalent and that unit sales at the two stores are also roughtly equivalent. Based on this information, given that May is going to open one of each store, which should it locate in New York and which in Philadelphia?

%Income Elasticity of Demand for Filenes 1.1

% Income%

Income Elasticity of Demand for Hechts 0.9% Income

d

d

Q

Q

New York

Philadelphia

% Income 0.3

% Income 0.2



New York

Philadelphia

Hechts

%% % Income 0.9 0.3 0.27

% Income

%% % Income 0.9 0.2 0.18

% Income

dd

dd

QQ

QQ

New York

Philadelphia

Filenes

%% % Income 1.1 0.3 0.33

% Income

%% % Income 1.1 0.2 0.22

% Income

dd

dd

QQ

QQ



The May Company owns Filenes and Hechts. May is going to open two new stores (one Filenes and one Hechts) in New York and Philadelphia. The populations in each area (adjusted for the difficulty of getting to the stores) are comparable, and unit sales are initially equivalent in the two markets. Research shows that the income elasticity for major selling items at Filenes is approximately 1.1 while the income elasticity for major selling items at Hechts is approximately 0.9. Demographers predict that the average income level in New York will rise by 30% over the next twenty years (the expected life of the store) while the average income level in Philadelphia will rise by 20% over the same period. Assume that price at Filenes and Hechts are roughly equivalent and that unit sales at the two stores are also roughtly equivalent. Based on this information, given that May is going to open one of each store, which should it locate in New York and which in Philadelphia?New York PhiladelphiaFilenes 0.33 0.22Hechts 0.27 0.18

27% + 22% = 49% change in unit sales

33% + 18% = 51% change in unit sales

Mays should locate the Filenes store in New York and the Hechts store in Philadelphia.



Bayer markets a prescription migraine drug and a heart medication. Because of interactions, patients cannot take both the migraine drug and the heart medication. Market research indicates that the price elasticity for the migraine drug is –0.7, the price elasticity for the heart medication is –0.5, and the cross-elasticity for the heart medication and the migraine drug is 0.1. The unit contributions for the migraine and heart drugs are, respectively, $0.75 and $0.52. Bayer sells 10 million units of each quarterly. Should Bayer alter the price of either product, and if so in what direction(s)?

% MigrainePrice Elasticity of Demand for Migraine 0.7

% Price

% HeartPrice Elasticity of Demand for Heart 0.5

% Price

% Heart % MigraineCross-price Elasticity of Demand

% Price Migraine % P

d

d

d d

Q

Q

Q Q0.1

rice Heart



Migraine Migraine Migraine

Heart Heart Heart

% Sales % %

% Sales % %

P Q

P Q

Suppose Bayer increases the price of the migraine drug by 15%

Migraine

Heart

% Sales 0.15 0.105 0.045 4.5%

% Sales 0 0.015 0.015 1.5%

Migraine

Heart

Total

Contribution 4.5% 10 million $0.75 $337,500


Contribution $337,500 $78,000 $415,500

MigraineMigraine Migraine

Migraine

HeartHeart Migraine

Migraine

%% % 0.7 0.15 0.105

%

%% % 0.1 0.15 0.015

%

QQ P

P

QQ P

P



Suppose Bayer increases the price of the heart medication by 15%

Migraine

Heart

% Sales 0 0.015 0.015 1.5%

% Sales 0.15 0.075 0.075 7.5%

Migraine

Heart

Total



Contribution $112,500 $39,000 $151,500

Migraine Migraine Migraine

Heart Heart Heart

% Sales % %

% Sales % %

P Q

P Q

MigraineMigraine Heart

Heart

HeartHeart Heart

Heart

%% % 0.1 0.15 0.015

%

%% % 0.5 0.15 0.075

%

QQ P

P

QQ P

P



Compare the 15% increase in the price of the migraine drug to the 15% increase in the price of the heart drug.

Migraine

Heart

Total

Increase Price of Heart Drug by 15%



Contribution $112,500 $39,000 $151,500

Migraine

Heart

Total

Increase Price of Migraine Drug by 15%



Contribution $337,500 $78,000 $415,500

Firm obtains greater profit from increasing the price of the migraine drug.


Analysis of the Firm

The firm’s goal is to maximize shareholder value. Specifically, the firm seeks to maximize the present discounted value of future cash flows. In economics, we call this “profit maximization.”

Business Terminology Economics Terminology

Sales Total Revenue

COGS, SG&A, R&D Variable Costs

D&A Fixed Costs

Contribution Producer Surplus

Net Income Accounting Profit

“Normal Profit” Zero Economic Profit

“Excess Profit” Economic Profit



Long-run vs. Short-run Costs

Long-run (or “fixed”) costs are costs that remain even if the firm produces no output. These costs include things like rent on office space, depreciation on buildings and equipment, and casualty insurance.

Fixed costs can be eliminated, but only by selling off the firm’s assets and discharging its debt. Because this cannot be done quickly, we call these fixed costs “long-run” costs.

Short-run (or “variable”) costs are costs that are change as the firm’s level of output changes. These costs include things like materials used in production, electricity, fuel, and labor.

Variable costs can be eliminated virtually immediately by ceasing operations.

Note that both variable and fixed costs include both explicit and opportunity costs.



Average and Marginal Cost Measures

Total Cost Variable Cost Fixed Cost

Total CostAverage Total Cost

Units Output

Variable CostAverage Variable Cost

Units Output

Fixed CostAverage Fixed Cost

Units Output

Total CostMarginal Cost

Units Output

Average cost measures are useful for analyzing costs that the firm has incurred up to the present.

Marginal cost measures are useful analyzing costs that the firm will incur in the future.



Economies and diseconomies of scale arise from the non-linear relationship between inputs and output.

Production Stage IAs inputs rise, output rises proportionally more. Example: Double inputs and output more than doubles.

Cause: Adding inputs presents opportunities for specialization.

Production Stage IIAs inputs rise, output rises proportionally less. Example: Double inputs and output less than doubles.

Cause: Adding inputs creates physical and/or managerial congestion.



Stages of production give rise to economies and diseconomies of scale

Economies of scale: Average cost as decreases as output increases.

Diseconomies of scale: Average cost increases as output increases.

Units Output Total Cost Average Total Cost

10,000 $1.0 million $1.0 million / 10,000 = $100

15,000 $1.4 million $1.4 million / 15,000 = $93

20,000 $1.9 million $1.9 million / 20,000 = $95

Economiesof scaleDiseconomiesof scale



$

Units output

ATC

AVC

MC

AFC

Specialization

Congestion

Increasing Returns to Variable Factors

Economies of Scale Diseconomies of Scale

Decreasing Returns to Variable Factors



$

Units output

ATC

AVC

MC

AFC

Specialization Over this range, the firm continues to experience economies of scale despite the fact that congestion has set in the congestion is not yet severe enough to have overcome the cumulative positive effect of specialization

Economies of Scale



Your firm can produce 10,000 units of product at a total cost of $1 million, or 11,000 units of product at a total cost of $1.2 million. Your firm can sell, at a fixed price of $120 per unit, as much product as it can produce.

Should your firm produce 10,000 units or 11,000 units?

Average cost analysis

Average cost @ 10,000 units = $1 million / 10,000= $100 per unitAverage cost @ 11,000 units = $1.2 million / 11,000 = $109 per unit

At a price of $120 per unit, price exceeds per-unit cost. Produce the extra 1,000 units.

Marginal cost analysis

Marginal cost of additional 1,000 units = Δ Total Cost / Δ Units Output= ($1.2 m. – $1 m.) / (11,000 – 10,000)= $200 per unit

At a price of $120 per unit, price is less than marginal cost. Do not produce the extra 1,000 units.



Output rule for profit maximization

Produce the output level at which MR = MC.

Suppose MR > MC

If the firm increases its output level, what it gains in sales (MR) exceeds what it loses in increased costs (MC).

As the firm increases its output level, MC rises thereby resulting in MR = MC.

Suppose MR < MC

If the firm decreases its output level, what it loses in sales (MR) is less than what it saves in decreased costs (MC).

As the firm decreases its output level, MC falls thereby resulting in MR = MC.



Consider a simple case wherein the firm can sell as many units as it wants at a fixed price.

Example

The market price is $100 per unit.

If the firm sells 50 units, its TR = ($100)(50) = $5,000

If the firm sells 51 units, its TR = ($100)(51) = $5,100

MR = ΔTR / ΔQ = ($5,100 – $5,000) / (51 – 50) = $100

When MR = Price, we say that the firm is a price taker.

When would MR not be the same as price?

If, in altering the quantity of output produced, the firm caused a change in the market price. We say that the firm is a price setter.



$

Units output

ATCAVC

MC

AFC

P = $10

A Price Taking Firm Firm’s output level has no impact on market price MR = Price

Q = 150

When P=$10, MR = MC at an output of 150 units firm will produce 150 units

P = $15

Q = 200

When P=$15, MR = MC at an output of 200 units firm will produce 200 units



$

Units output

ATCAVC

MC

AFC

Shutdown price

Breakeven price



Three Pricing Scenarios

Price is above breakeven price: Price > ATC

Firm is making an economic profit

Price is below breakeven price but above shutdown price: ATC > Price > AVC

Firm is incurring a loss and should continue producing in the short run. In the long run, the firm must either shutdown or reorganize.

Price is below shutdown price: AVC > Price

Firm is incurring a loss and should shutdown in the short run.



Example

A firm’s profit maximizing output level is 1,000 units per day. The firm’s fixed costs are $50,000 per day. At 1,000 units per day, the firm’s variable costs are $80,000 per day.

What are the firm’s AVC and ATC?

$80,000 per dayAVC $80 per unit

1,000 units per day

$50,000 per dayAFC $50 per unit

1,000 units per day

ATC AVC AFC $80 per unit $50 per unit $130 per unit



Example


The market price of the firm’s product is $100 per unit. How much profit would the firm make (a) if it continued to produce and (b) if it shutdown?

Continue to produce

VC $80 per unit per day 1,000 units per day $80,000 per day

FC $50,000 per day

TC VC FC $80,000 per day $50,000 per day $130,000 per day

TR Price per unit Units per day $100 1,000 $100,00

0 per day

Profit TR TC $100,000 per day $130,000 per day $30,000 per day



Example


The market price of the firm’s product is $100 per unit. How much profit would the firm make (a) if it continued to produce and (b) if it shutdown?

Shutdown

VC $80 per unit per day 0 units per day $0 per day

FC $50,000 per day

TC VC FC $0 per day $50,000 per day $50,000 per day

TR Price per unit Units per day $100 0 $0 per day

Profit TR TC $0 per day $50

,000 per day $50,000 per day

Firm is better off producing at a loss than shutting down.


Quantitative Analysis of a Firm

We have already seen how to estimate a demand function.

If the unit sales data we use to estimate demand are unit sales for a single firm, then the demand function we obtain is the firm demand function.

If the unit sales data we use to estimate demand are unit sales for the industry, then the demand function we obtain is the industry demand function.

To estimate the firm’s total cost function, we employ data on the firm’s unit sales, the firm’s accounting costs, and the firm’s opportunity costs.


Data Set #2 contains monthly unit sales and cost figures for a firm.

1. For each month, calculate the firm’s total accounting cost, opportunity cost, total (economic) cost, and ATC.

Total accounting cost COGS SG&A D&A

0.08Opportunity cost Total accounting cost

12

Total (economic) cost Total accounting cost Opportunity cost

Total cost

ATCUnits output



Data Set #2 contains monthly unit sales and cost figures for a firm.

2. Using the unit sales data, the total (economic) cost data, and knowledge of the expected shape of the total cost function, estimate the ATC function.

We expect ATC to be parabolic ATC should be a function of both Q and Q 2. Because AFC = FC / Q, we also expect ATC to be a function of 1/Q.

Use OLS to estimate the ATC function.


21 2 3

1ATC Q Q u

Q

ATC Q Q^2 1 / Q$0.2710 169,344 28,677,390,336 5.90514E-06$0.2742 242,431 58,772,789,761 4.12489E-06$0.3152 110,871 12,292,378,641 9.01949E-06$0.2593 211,975 44,933,400,625 4.71754E-06$0.3514 91,596 8,389,827,216 1.09175E-05$0.2668 171,039 29,254,339,521 5.84662E-06$0.3268 246,864 60,941,834,496 4.05081E-06$0.2867 247,696 61,353,308,416 4.03721E-06$0.2662 171,600 29,446,560,000 5.82751E-06$0.2988 128,896 16,614,178,816 7.75819E-06$0.2622 224,079 50,211,398,241 4.46271E-06$0.3040 249,964 62,482,001,296 4.00058E-06$0.2657 180,304 32,509,532,416 5.54619E-06


2. Using the unit sales data, the total (economic) cost data, and knowledge of the expected shape of the total cost function, estimate the ATC function.


ATC = 0.9709 – (0.000006) Q + (0.00000000001) Q2 – 17505 / Q

SUMMARY OUTPUT




Coefficients Standard Error t Stat P-value Lower 95% Upper 95%Intercept 0.970926175 0.300855057 3.227222387 0.002333554 0.364972994 1.576879356X Variable 1 -6.00076E-06 1.86697E-06 -3.214177278 0.002421263 -9.76103E-06 -2.2405E-06X Variable 2 1.43492E-11 3.66995E-12 3.909921027 0.000308356 6.95755E-12 2.17409E-11X Variable 3 -17505.55997 15232.04504 -1.149258679 0.256521162 -48184.47307 13173.35312


3. Find the firm’s efficient output level.


Minimize the ATC function with respect to Q.

ATC is minimum when Q = 192,665.

4. Find the firm’s breakeven price.

Breakeven price is the minimum attainable ATC.

ATC = 0.9709 – (0.000006) Q + (0.00000000001) Q2 – 17505 / Q

ATC = 0.9709 – (0.000006)(192,665)+ (0.00000000001)(192,665)

– 17505 / 192,665

= $0.26


5. Looking at the data, at what output level was the firm’s ATC minimum?


ATC was minimum ($0.2593) at 211,975 output.

6. Explain why this figure differs from the figure we calculated in step #3.

Step #3 gave us the best estimate of the efficient output level. Step #5 gave the output level that, possibly by random chance, produced the historically lowest ATC.


SUMMARY OUTPUT




Coefficients Standard Error t Stat P-value Lower 95% Upper 95%Intercept 0.222387617 0.02876938 7.73001074 7.41553E-10 0.164477859 0.280297375X Variable 1 -1.41482E-06 3.53371E-07 -4.003778415 0.000225205 -2.12612E-06 -7.03521E-07X Variable 2 5.5078E-12 9.90754E-13 5.559200359 1.31852E-06 3.51352E-12 7.50209E-12

Using Data Set #2, find the firm’s shutdown price.


The shutdown price is the minimum attainable AVC.

AVC = α + β1 Q + β2 Q 2

ATC Q Q^2$0.1476 169,344 28,677,390,336$0.1904 242,431 58,772,789,761$0.1345 110,871 12,292,378,641$0.1639 211,975 44,933,400,625$0.1314 91,596 8,389,827,216$0.1480 171,039 29,254,339,521$0.2452 246,864 60,941,834,496$0.2025 247,696 61,353,308,416$0.1482 171,600 29,446,560,000$0.1379 128,896 16,614,178,816$0.1713 224,079 50,211,398,241$0.2224 249,964 62,482,001,296$0.1509 180,304 32,509,532,416


Using Data Set #2, find the firm’s shutdown price.


Minimum AVC is $0.13 (at Q = 128,438) this is the shutdown price.

AVC = 0.2239 – (0.0000014) Q + (0.00000000006) Q2


Industry Structures

Industry structure refers to the market power that individual firms in an industry have.

MonopolyOligopolyMonopolistic Competition

Perfect/PureCompetition

Individual firms have greater influence over the market price

Individual firms have less influence over the market

price


Industry StructuresPerfect/Pure Competition1. Many firms2. Individual firm’s output is small relative to the market3. Firms produce a homogeneous product4. Free entry/exit to/from the industry5. All market participants have full information (perfect competition)

Monopolistic Competition1. Many firms2. Individual firm’s output is small relative to the market3. Firms produce a heterogeneous product4. Free entry/exit to/from the industry

Oligopoly1. Few, but more than one, firms2. Individual firm’s output is large relative to the market3. May or may not be free entry/exit to/from the industry

Monopoly1. (Usually) one firm2. Individual firm’s output is virtually the entirety of the market3. May or may not be free entry/exit to/from the industry


Perfect/Pure Competition

$

Q

S

D

Equilibrium price is determined by the market

$

Q

ATC

AVC

MC

AFC

Cost curves depict a single firm in the industry

All firms in the industry charge the market price (firms are “price takers”) MR = Price


4. Area is economic loss


$

Q

ATC

AVC

MC

AFC

A Single Firm in the Industry

2. Profit max output is here

1. Equilibrium price is here

MR

3. Firm’s ATC is here


Firm is incurring an economic loss

The accounting profit the firm is making is less than the accounting profit earned by firms in other industries that are exposed to comparable risk.


$

Q

ATC

AVC

MC

AFC


MR The economic loss provides incentive (1) for firms to exit to similar industries (e.g. due to low margins in the PC market, Hewlett-Packard will likely sell off its PC division and focus on its printer division), and (2) for firms to shut down entirely (e.g. due to on-going losses, Eastern Airlines shut down in 1991).



$

Q

D

$

Q

ATC

AVC

MC

AFC


SS’1. Departure of firms from the

industry is a negative producer shock Supply decreases

2. Decrease in supply causes market price to rise

4. When economic profit reaches zero, there is no longer incentive for firms to leave the industry and so price stabilizes.

3. As market price rises, profit maximiz-ing output level and economic profit increase



$

Q

S

D

$

Q

ATC

AVC

MC

AFC

Equilibrium price is determined by the market

All firms in the industry charge the market price (firms are “price takers”) MR = Price

MR


4. Area is economic profit


$

Q

ATC

AVC

MC

AFC


2. Profit max output is here

1. Equilibrium price is here

MR

3. Firm’s ATC is here


Firm is incurring an economic profit

The accounting profit the firm is making is more than the accounting profit earned by firms in other industries that are exposed to comparable risk.


$

Q

ATC

AVC

MC

AFC


MR

The economic profit provides incentive (1) for firms in similar industries to enter this industry (e.g. in the 1980’s Hewlett-Packard, which made mainframe computers, entered the PC industry), and (2) for entrepreneurs to create new firms in this industry (e.g. in the 1990’s Dell computer was launched as a PC manufacturer/retailer).



$

Q

$

Q

ATC

AVC

MC

AFC


S’

1. Entrance of firms to the industry is a positive producer shock Supply increases

4. When economic profit reaches zero, there is no longer incentive for firms to enter the industry and so price stabilizes.

S

D

3. As market price falls, profit maximiz-ing output level and economic profit decrease

2. Increase in supply causes market price to rise



$

Q

ATC

AVC

MC

AFC

Efficient output is the output level at which ATC is minimum.

A firm that produces at the minimum attainable ATC is called “efficient.”

Efficient firms utilize the minimum possible resources to produce their product.

From an economy-wide perspective, efficient firms are good because they waste little or no resources.



Conclusions

1. In the short-run, firms in perfect/pure competition may make an economic profit or incur an economic loss.

2. In the long-run, firms in perfect/pure competition will make zero economic profit.

3. Firms in perfect/pure competition are efficient in the long-run.


Monopoly

In a monopoly industry there is (usually) one firm. The firm represents (virtually) the entirety of market supply.

There are instances in which an industry may contain a single very large firm and some (perhaps many) very small firms (e.g. long distance service prior to AT&T’s breakup). In such an industry, the large firm behaves as if it were the only firm and the small firms behave as if they were in perfect competition.


MonopolyA firm that can influence the market price does so by altering output. When the firm increases output, a surplus results and the market price falls. When the firm decreases output, a shortage results and the market price rises.

When a firm can alter the market price by altering output, MR is no longer equal to price.Example

• A large firm produce 100 units per day.• The resulting market price is $10 per unit.• TR = ($10 per unit)(100 units per day) = $1,000 per day

If the firm increases its output to 110 units per day, a surplus results. The market price falls to $9.95 per unit.

TR = ($9.95 per unit)(110 units per day) = $1,094.50 per day

MR = ΔTR/ΔQ = ($1,094.50 – $1,000) / (110 – 100) = $9.45.

MR is less than price because the increase in output lowers the price for all units.


Monopoly

$

Q

A Monopoly Firm

D

MR

When the firm produces 100 units…

…the resulting price is $10…

…but the MR is $9.45.


4. Economic profit is profit-per-unit multiplied by units sold.

Monopoly

$

Q

ATC

MC

A Monopoly Firm

D

MR

1. Firm produces where MR = MC

2. Resulting price is determined by D

3. Cost per unit is determined by ATC


Monopoly

$

Q

ATC

MC

A Monopoly Firm

D

MR

Profit maximizing output level

Efficient output level

Notice that the firm’s efficient output level is different from its profit maximizing output level.


Monopoly

$

Q

ATC

MC

Produce at Profit Max Output

D

MR

If the firm were to produce at the efficient output level, gains in cost savings due to lower per-unit costs would be more than offset by losses in revenue due to decreased price.

$

ATC

MC

Produce at Efficient Output

D

MR


Monopoly

Suppose a monopoly firm faces the following demand and average total cost functions

2

6,354 4.5

100ATC 3,021 4.9 0.002

P Q

Q QQ

1. Find the firm’s profit maximizing output level. Hint: Use Excel’s SOLVER to maximize profit with respect to output.

Q = 815 maximizes profit

Q

2 100ATC 3,021 4.9 0.002Q Q

Q6,354 4.5P Q

TC ATC Q TR P Q

Profit TR TC



2. Find the market price that results when the firm produces at its profit maximizing output level

P = 6,354 – (4.5)(815) – 100/Q = $2,686.68

3. Find the firm’s ATC when it produces at the profit maximizing output level.ATC = 3,021 – 4.9Q + 0.002Q 2 – 100/Q = $356.14

4. Find the firm’s economic profit when it produces at the profit maximizing output level.

Profit = TR – TC = (P)(Q) – (ATC)(Q) = ($2,686.68)(815) – ($356.14)(815)

= $1.9 million

Monopoly

2

6,354 4.5

100ATC 3,021 4.9 0.002

P Q

Q QQ



5. Find the efficient output level. Hint: Use SOLVER to minimize ATC with respect to output.

Q = 1,225

6. Find the firm’s ATC when it produces at the efficient output level.

ATC = 3,021 – 4.9Q + 0.002Q 2 – 100/Q = $19.83

7. Find the market price that would result if the firm produced at the efficient output level.

P = 6,354 – (4.5)(1,225) = $841.43

Monopoly

2

6,354 4.5

100ATC 3,021 4.9 0.002

P Q

Q QQ



8. Find the firm’s economic profit when it produces at the efficient output level.Profit = TR – TC = (P)(Q) – (ATC)(Q) = ($841.43)(1,225) – ($19.83)(1,225)

= $1.0 million

Monopoly

2

6,354 4.5

100ATC 3,021 4.9 0.002

P Q

Q QQ


Monopoly

$

Q

ATC

MC

D

MR

815

$356.14

$2,686.68

1,225

$1.9 million

$19.83


Monopoly

Conclusions

1. The monopoly firm makes an economic profit.

2. The monopoly firm is inefficient.


Oligopoly

In an oligopoly industry, there are several firms. Each of the firms is large enough (relative to the market) to cause an impact on the market price via altering output.

An oligopoly exists in one of three states

1. Competitive oligopoly Firms do not coordinate their production levels.

2. Cartel oligopoly Firms coordinate their production levels effectively acting as a single firm.

3. Chiseling oligopoly One or more firms renege on a cartel agreement while other firms adhere to the cartel agreement.


Oligopoly

Suppose an oligopoly industry is comprised of two firms (a two-firm oligopoly is sometimes called a duopoly). The firms face the following demand and average total cost functions:

Notice that the two firms face the same market price, P, and that the market price is determined by the combined output of the two firms.

1 2

21 1 1

22 2 2

6,354 4.5

ATC 3,021 4.9 0.002

ATC 3,021 4.9 0.002

P Q Q

Q Q

Q Q


Oligopoly

1 2

21 1 1

22 2 2

6,354 4.5

ATC 3,021 4.9 0.002

ATC 3,021 4.9 0.002

P Q Q

Q Q

Q Q

1. Assume that the industry is a competitive oligopoly. Find the profit maximizing output levels, ATC, and profits for the two firms.

Follow an iterative procedure in which you set the output level for one firm, then find the profit maximizing output for the other firm.

Example: Set both the output of each firm to 400 units.

Q P ATC TR TC ProfitFirm #1 400 $2,754 $1,381 $1,101,600 $552,400 $549,200Firm #2 400 $2,754 $1,381 $1,101,600 $552,400 $549,200


Oligopoly


Example: Given that Firm #2 is producing 400 units, adjust Firm #1’s output so as to maximize the profit for Firm #1.

Q P ATC TR TC ProfitFirm #1 577 $1,960 $861 $1,129,787 $496,274 $633,513Firm #2 400 $1,960 $1,381 $783,875 $552,400 $231,475

1 2

21 1 1

22 2 2

6,354 4.5

ATC 3,021 4.9 0.002

ATC 3,021 4.9 0.002

P Q Q

Q Q

Q Q


Oligopoly


Example: Now, given Firm #1’s profit maximizing output, adjust Firm #2’s output so as to maximize the profit for Firm #2.


1 2

21 1 1

22 2 2

6,354 4.5

ATC 3,021 4.9 0.002

ATC 3,021 4.9 0.002

P Q Q

Q Q

Q Q


Oligopoly


Example: Given Firm #2’s profit maximizing, adjust Firm #1’s output so as to maximize the Firm #1’s profit.


1 2

21 1 1

22 2 2

6,354 4.5

ATC 3,021 4.9 0.002

ATC 3,021 4.9 0.002

P Q Q

Q Q

Q Q


Oligopoly


Continue iteratively until the two profit maximizing output levels converge.

Q P ATC TR TC ProfitFirm #1 498 $1,870 $1,076 $931,613 $536,159 $395,454Firm #2 498 $1,870 $1,076 $931,613 $536,159 $395,454

1 2

21 1 1

22 2 2

6,354 4.5

ATC 3,021 4.9 0.002

ATC 3,021 4.9 0.002

P Q Q

Q Q

Q Q


Oligopoly

2. Assume that the industry is a cartel oligopoly. Find the profit maximizing output levels, ATC, and profits for the two firms.

Maximize the combined profits of the two firms with respect to the two firm’s output levels.

1 2

21 1 1

22 2 2

6,354 4.5

ATC 3,021 4.9 0.002

ATC 3,021 4.9 0.002

P Q Q

Q Q

Q Q



Oligopoly

3. Assume that Firm #1 adheres to the cartel profit maximizing output level, but that Firm #2 chisels. Find the profit maximizing output levels, ATC, and profits for the two firms.

Set Firm #1’s output at the cartel profit max level and maximize Firm #2’s profit with respect to Firm #2’s output.

1 2

21 1 1

22 2 2

6,354 4.5

ATC 3,021 4.9 0.002

ATC 3,021 4.9 0.002

P Q Q

Q Q

Q Q

Q P ATC TR TC ProfitFirm #1 328 $2,057 $1,630 $674,298 $534,223 $140,075Firm #2 627 $2,057 $735 $1,289,846 $460,750 $829,096


Oligopoly

Compare the results from the three cartel scenarios

Q P ATC TR TC ProfitFirm #1 328 $2,057 $1,630 $674,298 $534,223 $140,075Firm #2 627 $2,057 $735 $1,289,846 $460,750 $829,096


Q P ATC TR TC ProfitFirm #1 498 $1,870 $1,076 $931,613 $536,159 $395,454Firm #2 498 $1,870 $1,076 $931,613 $536,159 $395,454

Competitive Oligopoly

Cartel Oligopoly

Chiseling Oligopoly


Oligopoly

Cartel Instability and the Cyclicality of Oligopoly Structure

1. Starting from a competitive oligopoly, firms have incentive to form a cartel thereby increasing their profits at the expense of consumers.

2. Once a cartel is formed, individual firms have incentive to chisel on the cartel agreement thus garnering even more profit, though at the expense of the other oligopolists and to the benefit of consumers.

3. Firms remaining in the cartel now have even more incentive to chisel. As the cartel agreement falls apart, firms are now acting independently return to competitive oligopoly.


Oligopoly

Conclusions

1. In a competitive oligopoly, firms make an economic profit and are inefficient.

2. In a cartel oligopoly, firms make greater economic profit and are more inefficient than in a competitive oligopoly.

3. In a chiseling oligopoly, the chiseling firms make greater economic profit and are less inefficient than in a cartel oligopoly, while the non-chiseling firms make less economic profit and are as inefficient as in a cartel oligopoly.


Monopolistic Competition

In a monopolistically competitive industry, there are many firms. Individual firms are too small to impact the market price for the brand category, but, via product differentiation, can influence the market prices of their individual brands.

To the extent that the consumer focuses on the brand category, the individual firm acts like a firm in perfect competition. To the extent that the consumer focuses on the individual brand, the individual firm acts like a monopoly (i.e. the individual firm is the only producer of a given brand).

Whereas oligopoly and monopoly firms rely more on their abilities to impact market price via changes in their output levels, monopolistically competitive firms rely more on their abilities to impact the prices of their individual brands via shifts in the firm demand curves due to product differentiation and marketing.



Monopolistic Competition and the Consumer Information Problem

Consumer information problem Consumers must acquire enough information to make an informed purchase decision, but information gathering is costly (both explicitly and cognitively).

Monopoly Industry Lack of competing brands makes information gathering negligible.

Oligopoly Industry Few competing brands makes information gathering low cost.

Perfect Competition Intense competition causes competing brands to be identical making information gathering negligible.

Monopolistic Competition Many different brands makes information gathering very costly.



External Uncertainty Partial Information Measurement Error Obsolete Information

True Brand Universe

Estimated Brand Universes

Estimated Utilities

Perceived Product-Market Characteristics Cluster Sizes Cluster Variances Cluster Frontiers Brand Variances Granularity

Internal Uncertainty Absolute Error Utility Relative Error Utility

Consideration

Brand information mitigates external uncertainty

Consumption experience mitigates internal uncertainty

Choice-Given-Consideration

True Utilities

The iterative choice process and consumer information

Perceived Brand Universe Characteristics


MGD

Samuel Adams

Budweiser

Coors

Heineken

Guinness

Genesee

Fosters

Aff

ord

abili

ty


Taste

Affordability cluster

Taste cluster

Cluster frontier combines the best attributes of the observed brands within the cluster

A Consumer’s Perceived Brand Universe


MGD

Samuel Adams

Budweiser

Coors

Heineken

Guinness

Genesee

Fosters

Aff

ord

abili

ty


Taste

Characteristics of the Perceived Brand Universe

Cluster size: How many brands are in a cluster

Cluster variance: How “spread out” are brands within a cluster

Cluster frontier: How far away are brands from the frontier

Brand variance: How uncertain is the consumer about a brand’s true attributes

Granularity: How distinct are the clusters from each other



Compensatory vs. Non-Compensatory Decision-Making

Compensatory Decision-Making: Levels of one attribute are traded-off for levels of another attribute. Example: A car buyer chooses a less powerful engine in exchange for greater fuel efficiency.

Non-Compensatory Decision-Making: Levels of an attribute must surpass some minimal boundary independent of other attribute levels. Example: A home buyer requires a minimum of three bedrooms regardless of location, number of bathrooms, garage, etc.

Pros and Cons:

Compensatory decision-making• Cognitively costly• Unlikely to erroneously reject brands

Non-compensatory decision-making• Cognitively inexpensive• Likely to erroneously reject brands


MGD

Samuel Adams

Budweiser

Coors

Heineken

Guinness

Genesee

Fosters

Aff

ord

abili

ty


Taste

A Consumer’s Perceived Brand Universe

Consideration Phase: Consumer selects a single cluster of brands via non-compensatory decision-makingChoice Phase: Consumer selects a single brand from within the consideration cluster via compensatory decision-making



Behavioral Propositions

1. An increase in cluster size increases the consumer’s probability of consideration for the cluster.

2. An increase in cluster variance decreases the consumer’s probability of consideration for the cluster.

3. An increase in the distance of a brand to its cluster frontier decreases the probability of choice-given-consideration for the brand.

4. An increase in brand variance decreases the effect of a brand’s distance-to-frontier on the probability of choice-given-consideration.

5. An increase in granularity increases the effect of cluster size on the probability of consideration, and decreases the effect of cluster variance on the probability of consideration.

Pr Choice Pr Consideration Pr Choice | Consideration


MGD

Red Dog

Miller introduces a new brand, Red Dog. Miller positions Red Dog to be close, but strictly inferior to its flagship brand MGD.

Samuel Adams

Budweiser

Coors

Heineken

Guinness

Genesee

Fosters

Aff

ord

abili

ty


Taste

Case Study: Miller’s Red Dog Brand

Red Dog’s introduction did not move the cluster frontier no impact on Pr(Choice|Consideration)

Red Dog’s introduction increased the size of the cluster.

Because Red Dog was positioned close to MGD, there was minimal impact on the cluster variance.

Net result: Red Dog’s introduction increased Pr(Consideration) for the clusterConclusion: Pr(Choice) for MGD (and, in fact, all brands within the cluster) increased

MGD gained market share at the expense of “imports.”


Ben & Jerry

Breyers

Haagen-Dazs

Carnival

Weight Watchers

EdysC

alo

ries

(revers

e

scale

)


Taste

Case Study: Ben & Jerry’s Ice Cream

Ad campaign reduces the perceived distance between Ben & Jerry’s and the cluster frontier.

Result: Campaign increased Pr(Choice-given-Consideration) for Ben & Jerry’s.

Conclusion: Pr(Choice) for Ben & Jerry’s increased

Ben & Jerry’s gained market share at the expense of other premium ice-creams.

Ben & Jerry’s launches an ad campaign around the phrase, “High calories are the price of great taste.”

Campaign causes consumers to believe that the previously-perceived frontier is unattainable. Consumers perceive a new frontier that reflects the tradeoff of taste with calories.



The firm’s goal is to increase the Pr(Choice) for its brand. Whether the firm should focus on increasing Pr(Consideration) or increasing Pr(Choice|Consideration) depends on the probabilities.

Pr Choice Pr Consideration Pr Choice | Consideration

Example

Pr(Choice) = 1.0 and Pr(Choice|Consideration) = 0.1 Pr(Choice) = 0.1

Marketing effort aimed at increasing Pr(Consideration) is wasted. Firm should focus on increasing Pr(Choice|Consideration).

Example

Pr(Choice) = 0.1 and Pr(Choice|Consideration) = 1.0 Pr(Choice) = 0.1

Marketing effort aimed at increasing Pr(Choice|Consideration) is wasted. Firm should focus on increasing Pr(Consideration).



$

Q

ATC

MC

A Monopolistically Competitive Firm in the Long Run

D

MR

1. Profit maximizing output level

4. Zero economic profit

3. Cost per unit

2. Resulting price

5. Efficient output level



$

Q

ATC

MC

A Monopolistically Competitive Firm in the Short Run

D

MR

Firm increases Pr(Choice) for its brand via increase in Pr(Consideration) and/or increase in Pr(Choice | Consideration)

Demand (and MR) increases

D’

MR’


4. Economic profit


$

Q

ATC

MC


D’

MR’


2. Resulting price


3. Cost per unit



$

Q

ATC

MC

A Monopolistically Competitive Firm Returning to the Long Run State

In the long run, either (a) competitors duplicate the firm’s brand innovation (e.g. cruise control), or (b) consumers realize that the supposed innovation has no real value (e.g. “ice” beers). Either way, demand (and MR) for the firm’s brand declines.

D’

MR’ D’’

MR’’



$

Q

ATC

MC


D

MR

A competing firm causes an increase in Pr(Choice) for its brand. If that increase comes at the expense of this brand’s market share, then this firm’s demand decreases.

D’MR’


4. Economic loss


$

Q

ATC

MC


D’MR’



2. Resulting price

3. Cost per unit



$

Q

ATC

MC


D’MR’

D’’

MR’’

In the long run, either (a) this firm duplicates the competitor’s brand innovation, or (b) consumers realize that the competitor’s supposed innovation has no real value. Either way, demand (and MR) for this firm’s brand increases.



Conclusions

1. Firms can make an economic profit or incur an economic loss in the short-run.

2. Firms make zero economic profit in the long run.

3. Firms are usually inefficient in both the short and long runs.

Monopolistic Competition or Perfect Competition?

If the summed expected present values of the economic profits due to marketing exceed the sum of the present values of the costs of marketing campaigns plus the summed expected present values of the economic losses due to competitors’ marketing campaigns, then a given industry will be monopolistically competitive rather than perfectly competitive.

Firms will continue to advertise in an attempt to garner short-run “bursts” of economic profit (e.g. Budweiser advertises during every Super Bowl).


Long Run vs. Short Run ATC


Thus far, the ATC curve we have seen has been constructed holding long run costs fixed. In the long run, all costs (including “fixed” costs) become variable.

We can now distinguish between short run ATC and long run ATC. The short run ATC (i.e. the ATC curve we have so far been using) assumes that long run costs are fixed. The long run ATC allows for long run costs to be variable.



$

Q

SRATC’s – each corresponds to a different level of fixed costs

LRATC



$

Q

1. Suppose the firm’s fixed costs are $100,000 per week. This is the firm’s SRATC function.

2. With fixed costs of $100,000 per week, the firm’s efficient output level is 20,000 units per week.

3. If, in the long run, the firm acquires more PP&E, its fixed costs will increase to $150,000 per week and the firm’s SRATC will move here.

4. With the additional PP&E, the firm’s efficient output level is 25,000 units per week.

LRATC



$

Q

In the long run, the firm acquires still more PP&E and so the firm’s SRATC again shifts.

With the additional PP&E, this is the firm’s new efficient output level.

This is the lowest ATC that can be attained in the long run. If the firm were to produce any more or any less output, or have any more or any less PP&E, the firm’s cost per unit would rise above this point.

We call this the long run efficient output level. To achieve long run efficiency, the firm would have to produce this much output and have the long run efficient quantity of PP&E.

LRATC


Determinants of Industry Structure

Whether an industry will develop more to the extreme of monopoly or more to the extreme of perfect competition depends on two factors:

1. Firms’ LRATC functions, and

2. Market demand.

The LRATC function is determined by technology and the prices of factors. Market demand is determined by consumers.

The implication is that the factors that determine the degree of competition within an industry are independent of the skills of the managers involved. If market forces are such that a particular industry will evolve toward perfect competition, then it will be impossible for any single firm to successfully establish itself as a monopoly within that industry.



$

Q

LRATC

1. Suppose all firms in the industry have LRATC’s that look like this.

6. In equilibrium, there must be 1,000 firms.500,000 / 500 = 1,000 firms

D

2. Suppose market demand is positioned here.

3. Without incurring a loss, the lowest price a firm could possibly charge is $10.

$10

4. To charge a price of $10 and not incur a loss, the firm must produce 500 units of output per day using the long run efficient quantity of fixed factors.

500

5. If all the firms in the industry charge $10, the quantity market demanded will be 500,000 units per day.

500,000



$

Q

LRATC

1. Suppose all firms in the industry have LRATC’s that look like this.

6. In equilibrium, there can be only 1 firm.

D

2. Suppose market demand is positioned here.

3. Without incurring a loss, the lowest price a firm could possibly charge is $10.

$10

4. To charge a price of $10 and not incur a loss, the firm must produce 10,000 units of output per day using the long run efficient quantity of fixed factors.

10,000

5. If all the firms in the industry charge $10, the market quantity demanded will be 10,000 units per day.


Government Intervention

Government intervention takes the following typical forms:

Price controls

By law, certain products cannot be sold below a price floor (e.g. workers are prohibited from selling their labor for less than the minimum wage) or above a price ceiling (e.g. state laws prohibit credit card companies from charging more than (in some states) 40% interest, rent control limits the rent landlords can charge in NYC).

Quotas

By law, producers may not sell more than a certain quantity of product per time period. Quotas are most often imposed on imports and infrequently imposed on domestically produced products.

Technical Regulations

By law, producers must produce products to a certain standard or via a certain method. Example: Cars sold in the U.S. must adhere to EPA regulations. Employers must adhere to OSHA safety regulations in the workplace.



Taxes

Types of taxes:

• Income tax (tax on wages and salaries, and interest and dividend income)• Sales tax (tax on the value of products sold – e.g. 6% of the sale)• Excise tax (tax on the quantity of products sold – e.g. 35 cents per gallon of gas)• Capital gains tax (tax on the difference between the sale and purchase prices)• Property tax (periodic tax on owned assets)• Tariff (tax on imports)

Classifications of taxes:

• Flat (called “poll” in the media; tax is same dollar amount for all)• Proportional (called “flat” in the media; tax is same percentage of income for all)• Progressive (tax is a greater percentage of income for higher income people)• Regressive (tax is a lesser percentage of income for higher income people)


Who Pays Federal Personal Income Taxes?

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%Proportion of Taxpayers (by AGI)

Pro

po

rtio

n o

f T

ax R

even

ues

Federal Taxes 2004 Perfect Equity


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Proportion of Taxpayers (by AGI)

Pro

po

rtio

n o

f T

ax R

even

ues

Federal Taxes 2004 Perfect Equity Social Security Taxes Medicare Taxes

Who Pays Wage Taxes?


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%Proportion of Taxpayers (by AGI)

Pro

po

rtio

n o

f T

ax R

even

ues

Perfect Equity Federal Income Taxes Social Security Taxes

Medicare Taxes Capital Gains Taxes

Who Pays Wage and Capital Gains Taxes?


What is the Expected Return on Social Security Taxes?Age Wage Prob(Alive) SS Tax SS Benefit Expected SS Tax/Benefit Age Wage Prob(Alive) SS Tax SS Benefit Expected SS Tax/Benefit21 $57,000 100.0% $7,068 ($7,068) 56 $284,452 89.2% $35,272 ($31,460)22 $59,679 99.9% $7,400 ($7,390) 57 $297,821 88.4% $36,930 ($32,638)23 $62,484 99.7% $7,748 ($7,727) 58 $311,819 87.5% $38,666 ($33,831)24 $65,421 99.6% $8,112 ($8,079) 59 $326,474 86.5% $40,483 ($35,033)25 $68,495 99.4% $8,493 ($8,447) 60 $341,818 85.5% $42,385 ($36,243)26 $71,715 99.3% $8,893 ($8,831) 61 $357,884 84.4% $44,378 ($37,456)27 $75,085 99.2% $9,311 ($9,233) 62 $374,704 83.2% $46,463 ($38,669)28 $78,614 99.0% $9,748 ($9,652) 63 $392,316 82.0% $48,647 ($39,878)29 $82,309 98.8% $10,206 ($10,089) 64 $410,754 80.7% $50,934 ($41,079)30 $86,178 98.7% $10,686 ($10,544) 65 $430,060 79.3% $53,327 ($42,268)31 $90,228 98.5% $11,188 ($11,019) 66 $450,273 77.8% $55,834 ($43,444)32 $94,469 98.3% $11,714 ($11,514) 67 $471,435 76.3% $58,458 ($44,604)33 $98,909 98.1% $12,265 ($12,030) 68 74.7% $119,580 $89,37534 $103,558 97.9% $12,841 ($12,569) 69 73.1% $125,200 $91,56335 $108,425 97.7% $13,445 ($13,130) 70 71.5% $131,085 $93,70236 $113,521 97.4% $14,077 ($13,715) 71 69.8% $137,246 $95,78637 $118,856 97.2% $14,738 ($14,325) 72 68.1% $143,696 $97,80938 $124,442 97.0% $15,431 ($14,961) 73 66.3% $150,450 $99,76739 $130,291 96.7% $16,156 ($15,623) 74 64.5% $157,521 $101,65240 $136,415 96.4% $16,915 ($16,313) 75 62.7% $164,925 $103,45941 $142,826 96.2% $17,710 ($17,031) 76 60.9% $172,676 $105,22442 $149,539 95.9% $18,543 ($17,778) 77 59.2% $180,792 $106,94343 $156,568 95.6% $19,414 ($18,555) 78 57.4% $189,289 $108,61344 $163,926 95.3% $20,327 ($19,363) 79 55.6% $198,186 $110,23145 $171,631 94.9% $21,282 ($20,203) 80 53.9% $207,500 $111,79446 $179,697 94.6% $22,282 ($21,075) 81 49.9% $217,253 $108,50047 $188,143 94.2% $23,330 ($21,979) 82 44.2% $227,464 $100,56848 $196,986 93.8% $24,426 ($22,915) 83 37.3% $238,154 $88,82849 $206,244 93.4% $25,574 ($23,882) 84 29.9% $249,348 $74,58250 $215,938 92.9% $26,776 ($24,881) 85 22.7% $261,067 $59,36651 $226,087 92.4% $28,035 ($25,909) 86 18.2% $273,337 $49,72552 $236,713 91.9% $29,352 ($26,967) 87 13.6% $286,184 $39,04653 $247,838 91.3% $30,732 ($28,052) 88 9.1% $299,635 $27,25454 $259,487 90.6% $32,176 ($29,164) 89 4.5% $313,718 $14,26855 $271,683 89.9% $33,689 ($30,301) 90 2.0% $328,462 $6,569

Assumptions: Age 21 income is average for Economics majors. Wages grow by inflation (3.5%) plus average growth in real wages for college graduates (1.2%). Burden is based on both halves of SS tax. Benefit at retirement is estimated by SSA and is assumed to grow by 4.7% annually. Mortality figures are for white males.


What is the Expected Return on Social Security Taxes?

($60,000)

($40,000)

($20,000)

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

21 24 27 30 33 36 39 42 45 48 51 54 57 60 63 66 69 72 75 78 81 84 87 90

Internal rate of return = 2.2%

SS benefits average $82,000 annually for 23 years.


($500,000)

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

21 24 27 30 33 36 39 42 45 48 51 54 57 60 63 66 69 72 75 78 81 84 87 90

What is the Return on Social Security Taxes?

Investing both halves of the SS taxes at 12% expected return yields $18.5 million at retirement.

This sum can generate a stream of $2.4 million annual payments for the following 23 years.



Modeling Government Interventions

Shocks are modeled according to which group, consumers or producers, are impacted first by the shock. For example, an increase in income impacts consumers first and producers second (through the change in consumer behavior).

A single government intervention that impacts consumers and producers simultaneously is not modeled as a shock at all, but as the presence of a “third party” to the market. For example, a price ceiling impacts both consumers and producers at the same time as producers are not allowed to ask prices above the ceiling and consumers are not allowed to offer prices above the ceiling. However, technical regulations impact producers first because the regulations apply to the production process.

Interventions modeled as shocks: Technical regulationsInterventions not modeled as shocks: Price controls, quotas, taxes


Price Controls

$

Q

D

S

Market for Labor

Employers demand labor

Workers supply labor

Labor employed in free market equilibrium

Free market equilibrium wage rate

Government imposed price floor

Labor employed with price floor


Price Controls

$

Q

D

S

Market for Labor

Employers demand labor

Workers supply labor

Qd Qs

Unemployment = surplus of labor

Unemployment is not “people out of work.” It is “people who want work being out of work.”

Prior to the minimum wage, there was no unemployment (everyone who wanted a job at the prevailing wage had one).

The minimum wage causes unemployment by simultaneously enticing more people to offer their labor and fewer firms to desire labor.


Price Controls

Money to pay for increased wages comes from one (or more) of three sources:

• Unemployed workers whose former earnings are now used to pay higher wages to those who are still employed

Workers who add less value per hour than the minimum wage are laid off. The workers who are retained are those who would have (via competition among employers) ended up earning above minimum wage anyway. Either the work they performed is eliminated (e.g. full-service gas stations, fast food drink dispensers), or they are replaced by machines (e.g. telephone operators, toll collectors, elevator operators), or the work load is placed on remaining higher productive employees (e.g. formerly hourly jobs becoming “salaried”).

• Consumers who now pay higher prices for the employers’ products

Higher prices for products that utilize minimum wage workers cause consumers to buy less, further reducing employment for these workers.

• Investors who now earn less return on firm’s stocks and bonds

Lower rate of return causes investors to invest in other firms, reducing the number of start-ups that employ low-skilled workers.


Price Controls

• The more price-elastic (i.e. the more of a luxury) are low-skilled workers, the more of the increased wage will come from layoffs.

• The more price-inelastic (i.e. the more of a necessity) is a product, the more of the increased wage will come from consumers paying higher prices for the firm’s product.

• The more interest-rate-inelastic (i.e. the less risky) are a firm’s stocks and bonds, the more of the increased wage will come from investors receiving less return on their investments in the firm.

From which of these three sources, money required to pay the increased wage comes depends on elasticities:


Price Controls

$

Q

D

S

Market for Apartments in NYC

Qs Qd

Housing shortage

Price ceiling on rent causes more people to want to rent than there are apartments available. This results in a chronic housing shortage.

The lowered rental price also reduces incentive for investors to build more housing units.

© Copyright 2007. Do not distribute or copy without permission.

Prices Ration GoodsAll things are scarce. Scarce resources will be rationed. The question is, by what mechanism? Who will be excluded?

Cap on interest rates?Rationed by risk. Higher risk borrowers excluded.

Cap on tuition?Rationed by talent. Less talented students

excluded.

Minimum wage?Rationed by skill. Less skilled workers excluded.

Minimum Wage


Minimum WageWhen we force an employer to pay a worker more than the job is worth, the job disappears.

40 years ago: Telephone operators30 years ago: Gas station attendants10 years ago: Fast food serversLast year: Pizza deliverers

What happens to workers whose jobs are eliminated? Those whose labor is worth more than minimum wage? Those whose labor is worth less than minimum wage?

Minimum Wage


Source: Statistical Abstract of the United States, and Bureau of Labor Statistics

College Education (1984-2004)

y = 0.003x + 0.02

R2 = 0.0002p = 0.95

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

0.3 0.32 0.34 0.36 0.38 0.4 0.42 0.44

Min Wage as Fraction of Avg Hourly Wage

Un

emp

loym

ent

Rat

e



HS Education (1984-2004)

y = 0.23x - 0.03

R2 = 0.18p = 0.05

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

0.3 0.32 0.34 0.36 0.38 0.4 0.42 0.44


Un

emp

loym

ent

Rat

e



Less than HS Education (1984-2004)

y = 0.46x - 0.07

R2 = 0.26p = 0.02

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

0.3 0.32 0.34 0.36 0.38 0.4 0.42 0.44


Un

emp

loym

ent

Rat

e


What percentage of workers earn minimum wage?

Minimum Wage


0%

1%

2%

3%

4%

5%

6%

7%

8%

16 - 19 20 - 24 25 +

Worker Age

% of Hourly Workers Earning Minimum Wage or Less

Source: Bureau of Labor Statistics, 2008



0%

1%

2%

3%

4%

5%

6%

7%

8%

Part time Full time

Worker Status



0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

Service Occupations

Sales and Office Occupations

Production, Transportation

Management, Professional Occupations

Construction, Maintenance,

Natural Resources Occupations

Industry




Source: Bureau of Labor Statistics

Unemployment for Teenagers Relative to Adults (1964-2004)

1.5

1.7

1.9

2.1

2.3

2.5

2.7

2.9

3.1

3.3

0.3 0.32 0.34 0.36 0.38 0.4 0.42 0.44 0.46 0.48Minimum Wage as Percentage of Average Hourly Earnings

Un

emp

loym

ent

Po

pu

lati

on

Rat

io f

or

16-1

9 Y

ear

Old

s as

Per

cen

tag

e o

f 20

-64

Yea

r O

lds

Minimum Wage as Percentage of Average Hourly Wage

Unem

plo

ym

ent

Popu

lati

on

Rati

o f

or

16-1

9

Year

Old

s as

a P

erc

enta

ge o

f R

ati

o f

or

20

-64

Year

Old

s


Source: Bureau of Labor Statistics

Minority vs. Non-Minority Household Income (1970-2001)

y = -0.33x + 0.73

R2 = 0.15

55%

57%

59%

61%

63%

65%

67%

69%

32% 34% 36% 38% 40% 42% 44% 46% 48%

Minimum Wage as Fraction of Average Hourly Earnings

Rat

io o

f M

edia

n H

ou

seh

old

In

com

es

(Bla

ck/W

hit

e)


How to Pay for a Minimum Wage

There are three ways in which a firm can find additional money to pay workers.

1. Layoff some workers and shift their wages to the remaining workers.

2. Keep all the workers and pay for the additional wages out of profits.3. Keep all the workers and pay for the additional wages by raising prices.

Minimum Wage


Source: Bureau of Labor Statistics, California Department of Finance

Comparison of Minimum Wage to CA Inflation (1970-2004)

y = 0.44x - 0.14

R2 = 0.28p = 0.001

0%

2%

4%

6%

8%

10%

12%

14%

16%

35% 37% 39% 41% 43% 45% 47% 49% 51% 53%

Real CA Min Wage as % of Real US Avg Hourly Wage

CA

In

flat

ion


But, we have to do something about the distribution of income.

The rich are getting richer while the poor get poorer!

Minimum Wage


Source: Statistical Abstract of the United States, U.S. Bureau of the Census, 2009, Table 668.

% of Households in Each Income Bracket (2006$)




From 1980 to 1990, the number of households with purchasing power of at least $75,000 grew while the number with purchasing power less than $75,000 declined.




From 1990 to 2006, the number of households with purchasing power of at least $75,000 grew while the number with purchasing power less than $75,000 declined.



1980 The top 20% of households earned 44% of all income.

2003 The top 20% of households earned 50% of all income.

Minimum Wage


In which world would each person rather live?

(prices are the same in the two worlds)

Household Income in World #1 Household Income in World #2Person 1 $32,000 $40,000Person 2 $33,500 $41,875Person 3 $35,000 $43,750Person 4 $36,500 $45,625Person 5 $38,000 $47,500Person 6 $39,500 $49,375Person 7 $41,000 $51,250Person 8 $42,500 $53,125Person 9 $44,000 $77,000

Person 10 $45,500 $79,625

In world #1, Person 10 earns 10% of all income.In world #2, Person 10 earns 15% of all income.

Minimum Wage


Quotas

$

Q

D

S

U.S. Market for Foreign Cars

Foreign car demand (by American consumers)

Foreign car supply (from foreign producers)

Free market equilibrium quantity

Free market equilibrium price

At the quota limit, consumers are willing to pay this price for foreign cars.

Government imposed quota on unit sales

At the price consumers are willing to pay, foreign producers want to offer this many cars, but can’t because of the quota.


Technical Regulations

$

Q

D

S

Market for Gasoline The federal government requires all gasoline sold in major urban areas to contain a certain quantity of ethanol.

Ethanol is more expensive to produce than gasoline (ironically, the production of 1 gallon of ethanol requires the burning of 1.2 gallons of gasoline).

Free market equilibrium quantity

Free market equilibrium price

S’

This regulation increases the cost of production for gasoline, shifting supply to the left.

The market price of gasoline rises and the quantity sold falls.


Taxes

All taxes can be treated as sales taxes

A wage tax is a tax on the sales of labor.

A property tax is a tax that is paid every year on the past sale of a physical asset.

Interest and dividend taxes are property taxes on financial assets.

A capital gains tax is a sales tax on a re-sold asset.

The one from whom a tax is collected is not the same as the one who pays the tax

While the law states from whom a tax is collected, the government is powerless to determine who pays the tax. Who pays the tax is determined by market forces and is found by comparing the price of the taxed item before and after imposition of the tax.

The split in the tax between the consumer and producer is called the tax burden.


Taxes

When the government imposes a tax, two prices result:

1. The price the consumer pays (the price of the product plus the tax)

2. The price the producer receives (the price the consumer pays less the tax)

For an excise tax, the relationship between the two prices is:

Pc = Pp + Tax per unit

For a sales tax, the relationship between the two prices is:

Pc = Pp (1 + Tax Rate)


Taxes

$

Gallons/day

D

S

Market for Gasoline

$1.50

380 m.

1. Prior to the tax, the equilibrium price is $1.50 per gallon, and the equilibrium quantity is 380 million gallons per day.

The steep demand curve reflects the fact that consumers regard gasoline as a necessity.

2. The government imposes a $0.50 per gallon tax.

This distance is $1.50

This distance is $0.50

$0.50 separation between Pc

and Pp

3. The resulting consumer price is $1.90 and the resulting producer price is $1.40

$1.90

$1.40

4. The market is in equilibrium

because both Qs and Qd are 370

m.

370 m.


Producers pay $0.10 of the $0.50 tax, for a total tax payment of($0.10)(370 m.) = $37 million per day

Consumers pay $0.40 of the $0.50 tax, for a total tax payment of($0.40)(370 m.) = $148 million per day

Taxes

$

Gallons/day

D

S

Market for Gasoline

$1.50

$1.90

$1.40

370 m.


Taxes

$

Cars/year

D

S

Market for Luxury Cars

$40,000

100,00

0

1. Prior to the tax, the equilibrium price is $40,000 per car, and the equilibrium quantity is 100,000 cars per year.

The flat demand curve reflects the fact that consumers regard these cars as luxuries

2. The government imposes a $5,000 per car tax.

This distance is $40,000

This distance is $5,000

$5,000 separation between Pc and

Pp

3. The resulting consumer price is $40,500 and the resulting producer price is $35,500 $40,50

0

$35,500

4. The market is in equilibrium

because both Qs and Qd are

70,000.

70,000


Consumers pay $500 of the $5,000 tax, for a total tax payment of($500)(70,000) = $35 million per year

Producers pay $4,500 of the $5,000 tax, for a total tax payment of($4,500)(70,000) = $315 million per year

Taxes

$

Cars/year

Market for Luxury Cars

D

S

$40,50

0

$35,500

$40,000

70,000


Taxes

Conclusion:

From whom the tax is collected is irrelevant. What is important is who pays the tax. The law can only specify from whom the tax is collected. Market forces determine who pays the tax.

Example:

Social Security wage tax. The law specifies that the employer “pays” half of the tax (7.5%) and that the worker “pays” the other half (7.5%). In fact, the law is stating from whom the tax is collected. Who really bears the burden of the tax depends on the elasticities of labor demand and labor supply.

Data indicate that the supply of labor tends to be inelastic (i.e. as wages fall a given percentage, a proportionally smaller percentage of people drop out of the workforce), and that the demand for labor tends to be more elastic the less skilled is the labor (i.e. the less skilled the labor is, the more the firm regards the labor as a luxury).


Taxes

$

Worker-hours/year

Market for Lower Skilled Labor

D

S $

Worker-hours/year

Market for Higher Skilled Labor

D

S

Portion of Social Security wage tax paid by the employerPortion of Social Security wage tax paid by the employee


Quantitative Analysis of a Price Control

You have analyzed industry data for the market for gasoline and estimated the following demand and supply functions (where Q is millions of gallons per day).

ˆˆDemand: 1187.08 3.12 dP Q

ˆˆSupply: 302.52 0.80 sP Q

1. Find the estimated free market price and equilibrium quantity of gasoline.

P = $1.48 per gallon, Q = 380 million gallons

2. The government is debating imposing a $1.25 per gallon price ceiling on gasoline. Estimate the impact of the price ceiling on the market.

1187.08 1.25ˆ ˆ1.25 1187.08 3.12 380.073.12d dQ Q

302.52 1.25ˆ ˆ1.25 302.52 0.80 379.710.80s sQ Q

Shortage of 360,000 gallons per day.


Quantitative Analysis of a Tax

3. An alternate proposal calls for the imposition of a $0.40 per gallon tax on gasoline. Estimate the impact of the tax on the market and also estimate the burden of the tax on consumers and on producers.

Two conditions for equilibrium

Tax per gallond s

c p

Q Q

P P

1187.08ˆ ˆ1187.08 3.12 3.12

302.52ˆ ˆ302.52 0.80 0.80

cc d d

pp s s

PP Q Q

PP Q Q

302.521187.08ˆ ˆ 7.25 3.93.12 0.80

Tax per gallon 7.25 3.9 0.40

$1.40, $1.80, 379.90

pcd s c p

c p p p

p c

PPQ Q P P

P P P P

P P Q

Consumers pay $1.80 – $1.48 = $0.32 of the tax.

Producers pay $1.48 – $1.40 = $0.08 of the tax.


Quantitative Analysis of a Subsidy

You have analyzed industry data for the market for higher education and estimated the following demand and supply functions (where Q is full-time equivalent students per semester in millions, and P is tuition, fees, room and board).

ˆˆDemand: 32796.8 1781 dP Q

ˆˆSupply: 2595.2 984 sP Q

1. Find the estimated free market price and equilibrium quantity.

P = $10,000 per semester, Q = 12.8 million FTE students

2. To ease the burden of tuition, the government is debating providing grants to all full-time students equal to 10% of their semester tuition. State the two conditions required for equilibrium.


1 Tax Rate 0.9d s

c p c p

Q Q

P P P P


Quantitative Analysis of a Subsidy

3. Estimate the impact of the subsidy on the market and also estimate the share of the subsidy for consumers and for producers.

32796.8ˆ ˆ32796.8 1781 1781

2595.2ˆ ˆ2595.2 984 984

cc d d

pp s s

PP Q Q

PP Q Q

2595.232796.8ˆ ˆ 15525 0.551781 984

0.9 0.9 15525 0.55

$9,332, $10,369, 13.175

pcd s p c

c p c c

c p

PPQ Q P P

P P P P

P P Q

Students receive $10,000 – $9,332 = $668 of the subsidy.

Colleges absorb $10,369 – $10,000 = $369 of the subsidy.


1 Tax Rate 0.9d s

c p c p

Q Q

P P P P


Macroeconomics

Macroeconomic analysis looks at economic phenomena that impact broad sectors of the economy.

Microeconomics focuses on individual firms, consumers, and industries, and analyzes the markets for particular products.

Macroeconomics treats all consumers as a single group, all producers as a single group, and analyzes production in general.


In the following slides, you will be asked a series of questions.

Answer honestly – only your opinion matters.

You will not be asked to share your results.

Answer by writing the number corresponding to your answer.


Military service should be voluntary – no draft.

Yes = 2Maybe = 1 No = 0


Government should not control radio, TV, the press,or the Internet.

Yes = 2Maybe = 1No = 0


Repeal regulations on sex by consenting adults.



Drug laws do more harm than good. Repeal them.



Let peaceful people cross borders freely.



Businesses and farms should operate without government subsidies.



People are better off with free trade than with tariffs.



Minimum wage laws cause unemployment. Repeal them.



End taxes. Pay for services with user fees.



All foreign aid should be privately funded.



What are “Liberalism” and “Conservatism”?

Team up with the person next to you. Between the two of you, come up with a definition for “liberalism” and a definition for “conservatism.”

Each definition should be no more than one or two sentences.


Formal Definitions: “Liberalism” and “Conservatism”

Webster’s Collegiate Dictionary

Liberalism is “a political philosophy based on belief in…the essential goodness of the human race, and on the autonomy of the individual, and (stands) for the protection of political and civil liberties.”

Conservatism is “a political philosophy based on tradition and social stability, stressing established institutions, and preferring gradual development to abrupt change.”


Representative Ted Weiss (D, NY)“Liberals believe (that) government has an obligation to provide equal educational and job opportunities for all. To those whose survival requires economic assistance, government should extend a helping hand. Individual liberties and human rights must be safeguarded from and by government.”

Contradictions

Webster’s Collegiate DictionaryLiberalism is “a political philosophy based on belief in…the essential goodness of the human race, and on the autonomy of the individual, and (stands) for the protection of political and civil liberties.”


Webster’s Collegiate DictionaryConservatism is “a political philosophy based tradition and social stability, stressing established institutions, and preferring gradual development to abrupt change.”

Contradictions

Senator John Tower (R, TX)“Conservatives have more faith in people than in government institutions, and would keep government out of issues that can be handled in the private sector.”


Drug War

What Issues are “Liberal” versus “Conservative”?

“Conservative”

“Liberal”

Universal Health Care

Minimum WageReduced TaxesGay MarriageMandatory Prayer in Public School

Prohibit Prayer in Public SchoolFree Trade


What Issues are “Liberal” versus “Conservative”?

“Conservative”

“Liberal”


Minimum Wage

Reduced Taxes

Gay Marriage

Mandatory Prayer in Public School

Drug War

Prohibit Prayer in Public School

Free Trade

Rather than thinking in terms of “liberal” and “conservative”, think in terms of “more individual

freedom” vs. “less individual freedom”.


Two spheres in which humans exercise freedoms:Social sphere where they choose how to behave

Economic sphere where they enter into contracts with others

The two spheres are not necessarily independent.

Choice to marry a goat = social choiceChoice to buy foreign goods = economic choice

Choice to do drugs = social choiceChoice to buy drugs = economic choice

Less Individual Freedom vs. More Individual Freedom

Less Freedom More Freedom


Minimum Wage

Reduced Taxes

Gay Marriage


Drug War


Free Trade


Better terms are:

Control vs. FreedomCentralized Decision Making vs. Decentralized

Decision MakingPower from Above vs. Power from BelowSlavery vs. Liberty

The terms “liberal” and “conservative” are ambiguous.


Less Social Freedom

More Social Freedom

More Economic Freedom

Less Economic Freedom

Less Individual Freedom vs. More Individual Freedom


Minimum Wage

Reduced Taxes

Gay Marriage


Drug War


Free Trade


Who is “Liberal” and Who is “Conservative”?

“Conservative”

“Liberal”


Who is “Liberal” and Who is “Conservative”?

Socially “Conservative”

Economically “Conservative”

Economically “Liberal”

Socially “Liberal”


Socially “Conservative”

Socially “Liberal”

Economically “Conservative”

Economically “Liberal”

Economic Freedom

Personal Freedom


Economic Freedom

Personal Freedom

“Democrat”

“Republican” Classical Liberal

Authoritarian

Centrist5

0

10

50 10


What kind of society do we want to live in?

Take a few minutes to list what you want from a well-functioning social order.

Keep the list abstract.

“Prosperity” not “adequate per-capita income”


What is more important?

Copy the list and identify the four items of highest priority (in your opinion).

Write a #1 next to the highest priority item, #2 next to the second highest priority item, etc.


Does the importance change?

You have identified the four most important goals/features of a society.

Will these goals/features always be the most important?

Consider: Crime vs. Car PollutionIndicate the four most important goals/features of a society when

considering each of these two problems.

Indicate the four least important goals/features of a society when considering each of these two problems.


Consensus

Divide into groups.Discuss your rankings and come to a consensus.

Note main areas of agreement and disagreement.


Market Systems

Market systems are categorized according to the degree of separation between the ones who make decisions and the ones who must endure the consequences of the decisions.

Capitalism Communism

Market socialism

Planned socialism

Free markets

Less separation between decisions and consequences

Command markets

Greater separation between decisions and consequences


Market Systems

Capitalism

No government intervention. No transactions are illegal. Not anarchy – government is necessary to protect property rights. Individuals are motivated to maximize profit. Called “capitalism” because individuals, not government, own the means of production (i.e. capital – buildings, land, machinery).

Market Socialism

Significant government intervention. Some transactions are illegal. Output levels and prices are determined by market forces of demand and supply. Individuals are motivated to maximize profit. Government owns means of production, but people own all other property. Government seizes profits for use for “good of society.”

Planned Socialism

Significant government intervention. Many transactions are illegal. Output levels and prices are set by the government. Individuals are motivated to hit production targets. Government owns means of production and virtually all other property. Government directs production and spending for “good of society.”


Market Systems

Communism

Total government intervention. Transactions do not exist. Money does not exist. Government owns everything. No personal property. People work for “free” and receive what they need for “free” from the government.

What we call “communism” in the common usage of the word is really economic planned socialism mixed with political totalitarianism. Communism in the economic sense is more akin to the common usage of the word “commune.”


Political Systems

Political systems can also be categorized according to the degree of separation between the ones who make decisions and the ones who must endure the consequences of the decisions.

Anarchy Dictatorship

Democracy Republic

Political Freedom

Less separation between decisions and consequences

Political Oppression

Greater separation between decisions and consequences


Political Systems

The choice of political system hinges on whether one believes that

1. Government derives its power from the people, or

2. People are granted power by the government.

For example, one can argue tax policy from one of two starting points. Either:

1. Income belongs to the people and the government confiscates part of that income (in the form of taxes) to be used for the public good, or

2. Income belongs to the government and the government allows people to keep part of that income (in the form of tax relief) to be used for their own purposes.For example, one can argue patents from one of two starting points. Either:

1. Intellectual property belongs to the inventor and the government protects the inventor’s IP through the use of patents, or

2. Intellectual property belongs to the government and the government allows the inventor to earn a profit off of the IP through the use of patents.


Political Systems

When making social decisions, power derives from…

the Individual the Government

When making economic decisions, power derives

from…

the IndividualLibertarianism

(“Classical Liberalism”)

“Conservatism”

the Government “Liberalism” Populism

Political Classifications According to the Origin and Application of the Power of Decision Making


Political Systems

A vote in the political arena is the equivalent of a purchase in the economic arena.

Political vote

1 person = 1 vote

Vote does not reflect the intensity of the voter’s desire

There is no opportunity cost to the vote vote is not a “real” measure

There is one winner up to 50% of the voters are left with a decision they did not want

Economic vote

1 person = multiple votes (depending on person’s abilities)

Vote reflects the intensity of the voter’s desire

There is an opportunity cost to the vote vote is a “real” measure

There are multiple winners potentially every voter is left with a decision he wants


Market Systems

Free market system Command market system

Singapore (1.6)

Index of Economic Freedom (2005 Scores)

1.0

5.0

United States (1.9)Japan (2.5)Canada (1.9)

Germany (2.0)

United Kingdom (1.8)

France (2.6)Sweden (1.9)

Spain (2.3)Italy (2.3)

Saudi Arabia (3.0)

Poland (2.5)

Mexico (2.9)

Russia (3.6)India (3.5)

North Korea (5.0)

China (3.5)

Hong Kong (1.4)

Iran (4.2)


Market Systems


Market Systems

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

$40,000

$45,000

1 2 3 4 5

Index of Economic Freedom (1=Free, 5=Repressed)

Per

-Cap

ita

Inco

me

(US

$, P

PP

Eq

uiv

alen

t)

U.S.

Luxembourg


Market Systems

Income vs. Equity

Historically, individuals have tended to “rate” economic systems according to their subjective assessments of both income and equity.

Formally, income is measured as “income per capita,” or “GDP per capita,” and equity is measured via the Gini coefficient.

Gini coefficient

Scale is 0 to 100.

0 indicates perfect equality All people earn same income.

100 indicates perfect inequality One person earns all the income, everyone else earns nothing.

Gini coefficient ignores income level and looks only at income distribution.


$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

$40,000

$45,000

10.0 20.0 30.0 40.0 50.0 60.0 70.0

Gini Coefficient (0=Equitable, 1=Inequitable)

Per

-Cap

ita

Inco

me

(US

$, P

PP

Eq

uiv

alen

t)

Market Systems

Finland

Brazil

South Africa

Cyprus

U.S.

Luxembourg


Production Possibilities Frontier

Because an economy has limited resources (land, energy, labor, technology, raw materials), the amount of output the economy can produce is limited.

Further, because of economies and diseconomies of scale, the tradeoffs between production of different types of products is limited.

We represent these limits on production by the production possibilities frontier. The PPF shows all combinations of products an economy is capable of producing.

The PPF does not represent desires only possibilities.



Durables

Non-d

ura

ble

s

Consider an economy that produces two types of goods: durables and non-durables

Economy has enough resources to produce any combination of products along the PPF line.

Combinations of products within the PPF represent unemployment.

Combinations of products outside the PPF are unattainable.



Durables

Non-d

ura

ble

s

PPF is non-linear due to specialization and congestion.

1. Suppose the economy is producing this combination of durables and non-durables.

3. The economy was producing so many durables that there was a lot of congestion in the durables industry moving resources out of durables production caused a relatively small decline in durables output.

2. If the economy reduces production of durables, the freed-up resources can be employed in the production of non-durables.

4. The economy was producing so few non-durables that there were many opportunities for specialization in the non-durables industry moving resources into non-durables production caused a relatively large increase in non-durables output.



Durables

Non-d

ura

ble

s

Technological and resource changes move the PPF.

Over time, improvements in technology and the discovery/creation of new resources causes the PPF to shift out.

The economy can now produce combinations of products that were previously unattainable.

Levels of productivity that used to represent full employment now represent unemployment.


Measures of Productivity: GDP and GNP

The two major measures of productivity are GDP and GNP.

Gross Domestic Product (GDP)

The value of all final goods and services produced by firms within a country in a given year.

Gross National Product (GNP)

The value of all final goods and services produced by a country’s firms in a given year.

Domestic Foreign

Domestic Domestic GDPDomestic GDP Foreign GNP

ForeignDomestic GNP Foreign GDP

Foreign GDP

Res

iden

ce o

f F

irm

Nationality of Firm



$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$80,000

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GDP Growth Rate (2003 to 2004)

0%

50%

100%

150%

200%

250%

300%

350%

400%

Zim

babw

e

Angola

Burm

a

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Bela

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Afg

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Ghana

Turk

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Iran

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Venezuela

Chad

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epublic



RGDP Growth Rate (2003 to 2004)

0%

5%

10%

15%

20%

25%

30%

Afg

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tan

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menis

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Equato

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Arg

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India

San M

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Russia



2008 FiguresGDP (trillions, US$,

PPP)Per-Capita GDP Growth RGDP Inflation

Public Debt Share of GDP

Unemployment

World $69.60 $10,400 3.1% 1% to 20% 30.0%

United States $14.26 $46,900 1.1% 3.8% 61% 7.2%

China $7.97 $6,000 9.0% 5.9% 16% 4.0%

Japan $4.33 $34,000 -0.7% 1.4% 173% 4.0%

Germany $3.67 $35,400 1.0% 2.7% 64% 7.8%

United Kingdom $2.26 $36,500 0.7% 3.6% 52% 5.6%

France $2.13 $33,200 0.3% 2.8% 68% 7.4%

Canada $1.30 $39,100 0.4% 2.4% 64% 6.2%

Mexico $1.56 $14,200 1.3% 5.1% 19% 4.0%



Final Goods and Services

By measuring the value of final goods and services, we automatically include the values of the intermediate goods and services.

Economic Costs of Processes

Extract Iron Ore Smelt Steel Stamp Parts Assemble Refrigerator

$175 $225 $125 $200

Sale Prices

Iron Ore Smelted Steel Stamped parts Refrigerator

$175 $175 + $225 $175 + $225 + $125 $175 + $225 + $125 + $200

The price of the refrigerator includes the values of all the intermediate goods that went into the production of the refrigerator.


Circular Flow of Income and Spending

Households

Firms

Labor

Wages and Salaries

Products

Payments for Products

Risky return

Lending

Risky return

Savings

Financial Institution

s

Savings

Safe return

Labor market

Goods market

Financial markets

Foreign Markets

Financial intermediation

Financial disintermediation


Circular Flow of Income and Spending

The circular flow model implies that there are two methods for accounting for all economic activity within a country.

1. Add up all the spending on final goods and services (the expenditures approach).

2. Add up all the income earned (the income approach).


Expenditure Approach to GDP

GDP = C + I + G + X – M

C = Personal Consumption Expenditures

= Consumption of Durable Goods

+ Consumption of Non-durable Goods

+ Consumption of Services

I = Gross Private Domestic Investment

= Non-Residential Fixed Investment

+ Residential Fixed Investment

+ Changes in Private Inventories



GDP = C + I + G + X – M

G = Government Consumption and Investment

= Federal Government Spending on Defense

+ Federal Government Spending on Non-defense

+ State and Local Government Spending

X = Exports

= Exports of Goods

+ Exports of Services

M= Imports

= Imports of Goods

+ Imports of Services



Expenditures Components of GDP (2004)

-$4.0

-$2.0

$0.0

$2.0

$4.0

$6.0

$8.0

$10.0

C I G X M

Tril

lio

ns



Expenditures Components of GDP (2004)

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

$6.0

C (

dura

bles

)

C (

non-

dura

bles

)

C (

serv

ices

)

I (n

on-r

esid

entia

l)

I (r

esid

entia

l)

I (Δ

inve

ntor

ies)

G (

defe

nse)

G (

non-

defe

nse)

G (

stat

e &

loca

l)

X (

good

s)

X (

serv

ices

)

M (

good

s)

M (

serv

ices

)

Tril

lio

ns



Expenditure Components of GDP (2004)

C (durables)

C (non-durables)

C (services)

I (non-residential)

I (residential)

I (Δ inventories)

G (defense)

G (non-defense)

G (state & local)

NX (goods) (negative)

NX (services)


Economic Activity vs. Transactional Activity

The intent of GDP is to measure economic activity. Economic activity is not the same as transactional activity.

Transactional activity includes all activity in which dollars change hands.

Economic activity includes only those activities in which production takes place.

Economists are concerned with economic activity because it is the production of new goods and services, not the transfer of existing goods and services that benefits people.

Note: You might argue that “moving a car from a seller’s home in Maine to the buyer’s home in Florida” represents economic value. It is the physical moving that has value, not the transfer of ownership.


Transactions Excluded from GDP

Things not included in GDP

1. Spending in the current year on products produced in prior years.

Example:

Buy a new book on Amazon that was printed this year. This transaction counts as GDP (Consumption) because the book was produced in the current year.

Buy a new book on Amazon that was printed last year. This transaction does not count as GDP because the book was counted last year when it was produced (as Changes in Inventory)

Buy a used book on Amazon that was printed last year. This transaction does not count as GDP because the book was counted last year (as Consumption) when the original owner purchased it.

With the intent of measuring production, not transactions, certain transactions are excluded from GDP calculations.




2. Spending on “used” products that are re-sold.

Example:

Buy a new book on Amazon that was printed this year. This transaction counts as GDP (Consumption) because the book was produced in the current year.

Buy a used book on Amazon that was printed this year. This transaction does not count as GDP because the book was counted earlier in the year (as Consumption) when the original owner purchased it.




3. Spending on intermediate products.

Example:

Buy new tires from a car dealer that were produced this year. The value of the tires counts as GDP (Consumption) because the tires were produced in the current year.

Car dealer buys new tires that were produced this year, puts them on a car and offers the car for sale. The value of the tires on the car does not count as GDP because the value will be counted, as part of the value of the car, when the car is sold.




4. Spending on financial assets.

Example:

Buy a share of stock. The stock is neither a good nor a service, but a financial asset; the purchase of the stock is the transformation of a safe, liquid asset that yields no return (cash) into a risky, less liquid asset that yields an expected return (stock).




5. Full value of government services.

Example:

Government provides interstate road system. The cost of building and maintaining the system is included in GDP, but, because drivers are not charged to use the roads, the value of the road system (which is likely more than the cost) is not included in GDP.

If the road system were private and drivers paid a market-determined price to use the roads, then the full value of the roads would be included in GDP.

Note: If drivers were charged to use the road system, they would have less money to spend on other things, so much of the “increase” in GDP due to proper accounting of roads would be offset due to decreased consumption of other goods and services.


Invisible Transactions That Should Be Included in GDP

Things not included in GDP that should be included

1. “Under-the-table” spending on labor.

Example:

Hire a babysitter. This transaction should count as GDP (Consumption) because babysitting is a service. But, because the babysitter does not declare the money as income and because the parents do not claim the money as a child-care tax deduction, the government has no way of knowing the transaction occurred.

Some transactions represent economic activity and should be included in GDP but are not because the transactions are “invisible.”




2. Spending on illegal goods and services.

Example:

Buy illegal drugs. This transaction should count as GDP (Consumption) because the drugs were produced in the current year. But, because neither the dealer nor the buyer want the government to know the transaction occurred, the transaction is not counted as part of GDP.




3. Home labor.

Example:

Mow your lawn. There is no transaction associated with this activity because you do not pay yourself to mow your lawn. However, the mowing of the lawn is the production of a service. That service should be included in GDP but isn’t because there is no transaction and hence no record of a transaction.




4. Barter.

Example:

Trade lawn mowing for babysitting. There is no transaction associated with this activity because you agree to trade services with your neighbor. However, the mowing of the lawn and the babysitting are the productions of services. Those services should be included in GDP but aren’t because there is no transaction and hence no record of a transaction.


Income Approach to GDPInterest income less

interest expenseEmployee

compensation

Corporate profits

Rental incom

e

Proprietors income

Personal IncomeIndirect taxes (sales, excise, business

property taxes) and transfers less subsidies

National Income

Depreciation(“capital consumption”)

Gross National Product

Net National Product

Statistical discrepancy

Income to foreigners in the US less income to Americans

abroad

Gross Domestic Product


Income Approach to GDP

Income Components of GDP (2004)

Employee Compensation

Corporate Profits

Rental Income

Proprietors Income

Net Interest Income

Indirect Taxes

Statistical Discrepancy

Capital Consumption

Net Income from Abroad


National vs. Domestic Measures

National Income Net Domestic Income at Factor Cost

Net National Product

Net Domestic Product

Gross National Product

Gross Domestic Product

+ Income to foreigners in the US

– Income to Americans abroad


Nominal vs. Real Measures

A dollar measure is relevant only to the extent that the person reading the measure understands the implied value of the dollar.

Example

In 2006, one gallon of gasoline cost (on average) $2.59, while in 1967, one gallon of gasoline cost $0.26.

These two figures imply that the cost of gasoline has risen 896% over 40 years.

However, in 2006, per-capita disposable income (income after taxes) was $31,240, while in 1967, per-capita disposable income was $2,895.

These two figures imply per-capita disposable income rose 979% over 40 years.

Comparing gasoline to income, we see that the price of gasoline has risen less than per-capita income.

Conclusion: Relative to our incomes, gasoline is cheaper now than it was 40 years ago.


Stripping away what economists call, “money illusion,” we see that what ultimately matters to people is how hard they have to work to obtain goods.

The following slides show the number of minutes the average American had to work to afford various goods from the 1920’s to the present.

Note that there are many goods that cannot be represented because the goods did not exist in the past. For example, in 1950 it would have taken an infinite amount of time to earn enough money to buy a DVD player because DVD players did not exist.

Source: Working for Sears Goods, Donald Boudreaux(cafehayek.typepad.com/hayek/2006/01/working_for_sea.html)

Purchasing Power


0

10

20

30

40

50

60

70

80

1920 - 1930 1950 1980 1997

Min

utes

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ork

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ffor

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Milk (1 gallon)

Purchasing Power


0

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10

15

20

25

30

35

1920 - 1930 1950 1980 1997

Min

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Gas (1 gallon)

Purchasing Power


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400

500

600

700

800

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1920 - 1930 1950 1980 1997

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Electricity (1 kWh)

Purchasing Power


0

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300

400

500

600

700

800

900

1920 - 1930 1950 1980 1997

Min

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ork

to A

ffor

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Air Travel (100 miles)

Purchasing Power


0

100

200

300

400

500

600

700

1920 - 1930 1950 1980 1997

Min

utes

of W

ork

to A

ffor

d

Levis Jeans (1 pair)

Purchasing Power


The following slides show prices taken from the Sears catalogues for 1975 and 2006. The goods are selected so as to have the same (or very similar) qualities across the two years.

Source: Working for Sears Goods, Donald Boudreaux(cafehayek.typepad.com/hayek/2006/01/working_for_sea.html)

Purchasing Power


0500

100015002000250030003500400045005000

1975 2006

Min

utes

of W

ork

to A

ffor

d

Freezer

Purchasing Power


0

200

400

600

800

1000

1200

1400

1975 2006

Min

utes

of W

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to A

ffor

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Garage Door Opener

Purchasing Power


0

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200

300

400

500

600

1975 2006

Min

utes

of W

ork

to A

ffor

d

Car Tire

Purchasing Power


0

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200

300

400

500

600

700

800

900

1975 2006

Min

utes

of W

ork

to A

ffor

d

Lawn Mower

Purchasing Power


0

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1000

1500

2000

2500

3000

3500

1975 2006

Min

utes

of W

ork

to A

ffor

d

Table Saw

Purchasing Power


0

200

400

600

800

1000

1200

1400

1975 2006

Min

utes

of W

ork

to A

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d

Garbage Disposal

Purchasing Power


0

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40

60

80

100

120

140

160

1975 2006

Min

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ork

to A

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d

Interior Latex Paint (1 gallon)

Purchasing Power


Nominal vs. Real Measures

A nominal dollar measure (or “current dollar measure”) is the actual dollar measure that was taken at a point in time – e.g. the average price of gas in 1967 was $0.26 per gallon in 1967 dollars.

A real dollar measure (or “constant dollar measure”) is the dollar measure taken at a point in time and then adjusted for the overall rate of inflation that has occurred since that point in time – e.g. the average price of gas in 1967 was $2.80 in 2006 dollars.

To compare dollar measures from two different points in time, we first must convert the dollar measures to the same base year. The conversion is achieved using price indices.


Price Indices

Major types of price indices

CPI (consumer price index) Measures prices of things consumers typically buy

PPI (producer price index) Measures prices of things producers typically buy

IPD (implicit price deflator) Measures prices of all things produced in the economy

Some variations on the price indices

CPI-U CPI for all urban consumers

CPI-W CPI for urban wage earners and clerical workers

C-CPI Chain weighted CPI


Price Indices

Using Economy.com’s database, find the following consumer price indices for 1974 and 2004.

CPI-U (all items) 1974: 49.32 2004: 188.89

CPI-U (energy) 1974: 38.04 2004: 151.33

CPI-U (medical care) 1974: 42.37 2004: 310.14

CPI-U (transportation) 1974: 45.76 2004: 163.06

On average, the prices of all items purchased by urban consumers in 2004 was 188.89% of the prices in the base year.

On average, the prices of all items purchased by urban consumers in 1974 was 49.32% of the prices in the base year.


Price Indices

Calculation of a (Simple) Price Index

1. Establish a representative basket of goods and services for the base year.

2. Find the average prices of the goods/services during the base year, and the average prices of the goods/services during the current year.

3. Calculate the total cost of the base-year basket using the base year’s prices and the current year’s prices.

4. The (simple) price index is the ratio of the current year’s total cost to the base year’s total cost (multiplied by 100).


Price Indices

The average prices of these goods over three years were:

2000 2001 2002Beer $20 $21 $20Car $28,000 $30,000 $31,000House $100,000 $98,000 $102,000

Example

Let 2000 be the base year. In 2000, the average consumer purchased the following quantities of goods/services.

2000Beer 30 unitsCar 0.1 unitsHouse 0.02 units


Price Indices

Example

Multiplying the quantities of goods in the basket by the prices in each year gives the cost of the base year’s basket in each year.

2000 $5,400 = (30 units)($20) + (0.1 units)($28,000) + (0.02 units)($100,000)



2000 2001 2002Basket 2000 $5,400 $5,590 $5,740

Prices


Price Indices

Example

The price index for a year is the total cost of the basket in that year divided by the total cost of the basket in the base year multiplied by 100.

2001

2000

Basket Cost $5,590100 100 103.5

Basket Cost $5,400

2002

2000

Basket Cost $5,740100 100 106.3

Basket Cost $5,400

Basket CostPrice Index for Year using Year as the Base Year 100

Basket CostX

Y

X Y

2000 2001 2002Basket 2000 $5,400 $5,590 $5,740

Prices


Chain Weighted Price Indices

Calculation of a Chain-Weighted Price Index

1. Establish a representative basket of goods and services for the base year, and a representative basket of goods and services for the current year.

2. Find the average prices of the goods/services during the base year, and the average prices of the goods/services during the current year.

3. Calculate the total cost of the base-year basket and the current-year basket using the base year’s prices.

4. The first simple price index is the ratio of the current year’s total cost to the base year’s total cost.

5. Calculate the total cost of the base-year basket and the current-year basket using the current year’s prices.

6. The second simple price index is the ratio of the current year’s total cost to the base year’s total cost.

7. The chain-weighted price index is the geometric mean of the two simple price indices (multiplied by 100).



Chain weighted price indices are an attempt to correct the inflation biases

Over three years, the average consumer purchased the following quantities of goods/services.

2000 2001 2002Beer 30 units 28 units 33 unitsCar 0.10 units 0.09 units 0.08 unitsHouse 0.02 units 0.03 units 0.01 units

The average prices of these goods over three years were:

2000 2001 2002Beer $20 $21 $20Car $28,000 $30,000 $31,000House $100,000 $98,000 $102,000


2000 2001

2000 $5,400 $5,590

2001 $6,080 $6,228

Prices

Ba

sk

et

2000 2002

2000 $5,400 $5,740

2002 $3,900 $4,160

Prices

Ba

sk

et

2002 Index Calculations2001 Index Calculations


Let 2000 be the base year

$6,0801.126

$5,400

$6,2281.114

$5,590

2001C-CPI 1.126 1.114 100 112.0

$3,9000.722

$5,400

$4,1600.725

$5,740

2002C-CPI 0.936 0.934 100 72.3


Inflation

Price indices are expressed in terms of a base year. The index for the base year is defined as 100. Indices for other years give prices relative to the base year.

Example

Suppose 2002 is the base year and the CPI for 2003 is 102.5. This means that, on average, prices in 2003 were 102.5 / 100 = 102.5% times the prices in 2002.

Inflation is calculated as the growth rate in a price index

Total inflation from year to year ln Price Index ln Price Index

ln Price Index ln Price IndexEffective annual inflation from year to year

Y X

Y X

X Y

X YY X


Inflation

Using the price indices, calculate the following effective annual inflation rates from 1974 to 2004.

ln 188.89 ln 49.324.5%

2004 1974

CPI-U (all items)

CPI-U (energy)

CPI-U (medical care)

CPI-U (transportation)

ln 151.33 ln 38.044.6%

2004 1974

ln 310.14 ln 42.376.6%

2004 1974

ln 163.06 ln 45.764.2%

2004 1974


Inflation

There does not appear to be much difference between a 4.2% inflation rate (for transportation) and a 4.5% inflation rate (for all items). However, compounded over 30 years, the 0.3% difference can become significant.

ln 188.89 ln 49.32 134% CPI-U (all items)

CPI-U (transportation) ln 163.06 ln 45.76 127%

Using the price indices, calculate the following total inflation rates for all items and for transportation alone.

Total inflation for all items is 7% more than for transportation alone.


Inflation

On which price index the inflation measure is based alters the definition of inflation.

Example

Inflation calculated from the CPI-U is called “consumer inflation.”

Inflation calculated from the PPI is called “producer inflation.”

Inflation calculated from the IPD is called “(overall) inflation.”


Inflation

Biases in inflation measures

1. New Goods Bias

Newly invented goods are more expensive, but usually more desirable.

Example: If people stop buying $50 VHS players and start buying $100 DVD players, we will see an increase in inflation measures. However, the extra happiness people get from DVD players exceeds the additional cost of the players (vs. VHS players) – otherwise people would buy the VHS players instead.

Conclusion: Inflation measure can mask the fact that people are happier buying the more expensive product.


Inflation


2. Quality Change Bias

Inflation measures imperfectly account for quality changes.

Example: As computers become more powerful, even though their retail prices do not change, for the purpose of price index calculations computers are recorded as being less expensive. The purpose of this is to account for the fact that, one computer today is the equivalent of several computers from five years ago.

Conclusion: Depending on how statisticians interpret quality changes, the official inflation measures can erroneously account for changes in product quality.


Inflation

September 1977

4 MHz

Disk storage extra

Monitor extra

RAM extra

$1,000 (assembled)


Inflation

October 1981

32K RAM

1 180K Disk drive

Monitor extra

$1,275


Inflation

October 1984

64K RAM

Monochrome monitor

2 360K Disk drives

$1,300


Inflation

March 1986

10 MB HD

Monochrome monitor

256K RAM

360K Disk Drive

Mouse

$1,700


Inflation

July 1996

75 MHz

510 MB hard drive

Color monitor

8 MB RAM

16 bit audio

$2,900


Inflation

August 2006

2.8 GHz

250 GB hard drive

19” Flat panel monitor

1 GB RAM

$990


Inflation


3. Commodity and Outlet Substitution

As prices change, consumers’ buying habits change.

Example: As the price of shoes rises, people will alter what they buy (fewer shoes and more of other things) and where they buy (buy shoes at discount retailers rather than high-end retailers).

Conclusion: As people change what they buy, the official basket will no longer reflect people’s true purchase decisions. As people change where they buy, official price measures will no longer reflect the prices people are actually paying.


Inflation

Consequences of erroneously measuring inflation

Wage increases, Social Security benefits, and variable interest rates are tied to official inflation measures.

Many economists believe that the simple CPI-U overstates annual inflation by as much as 1%.

Because Social Security retirement benefits are indexed to inflation, these benefits will increase faster than intended.


Inflation

Example

In 1970, the law intended (1) that a retiree receive $4,000 annually in Social Security retirement benefits, and (2) that the retirement benefits be increased each year to adjust for inflation.

Suppose the actual annual inflation rate is 2.9%.

By 2004, retirees should receive $10,573 annually. This sum will buy the same quantity of goods and services that $4,000 bought in 1970.

Suppose that the official inflation rate is 3.9%.

By 2004, retirees are actually receiving $14,689 annually. The overstating of inflation has caused retirement benefits to grow in real terms.

Current debate about indexing Social Security benefits to the chain-weighted CPI is an attempt to correct this real growth.


Effects of Unanticipated Inflation

Anticipated inflation is not a problem because people will incorporate their (correct) expectations about inflation into their decisions.

Unanticipated inflation creates a problem because, had people known what inflation was going to be, they would have made different decisions.

Losers: LendersWhen lenders receive back the monies they loaned, the monies have less purchasing power than the lenders anticipated.

Winners: BorrowersThe dollars that borrowers pay back to lenders have less value (i.e. purchasing power) than the borrowers had anticipated.

Losers: Workers and those on fixed incomesUntil workers’ contracts expire, they cannot negotiate higher wages to compensate for the unexpectedly higher inflation. Similarly, people on fixed incomes have less purchasing power than they anticipated.

Winners: EmployersUntil workers’ contracts expire, the cost of wages to employers is less (in real terms) than the employers anticipated.


Nominal vs. Real Return

Example

A lender is willing to loan $100,000 for one year in exchange for an annual interest rate of 6%. The 6% rate is called the nominal interest rate and represents the dollar return on the loan Each year, the lender receives ($100,000)(0.06) = $6,000 in interest.

The 6% loan compensates the lender for three costs:

1. Credit risk risk of loan default (e.g. 1%)2. Opportunity risk risk of not investing money in a better opportunity (e.g. 3%)3. Inflation risk risk of purchasing power of loaned money eroding (e.g. 2%)

Nominal return is the dollar return on an investment.Real return is the purchasing power return on an investment.

As with GDP and RGDP, what matters to the investor is the real return, not the nominal return.



As long as inflation remains at 2%, the lender is exactly compensated for the risks from lending the lender makes “zero economic return.”

At the end of one year, the lender will receive $106,000. Meanwhile, inflation will have reduced the purchasing power of the $106,000 to $106,000 / 1.02 = $103,922. Thus, the lender’s expected nominal return on the loan is $6,000 while the expected real return on the loan is $3,922.

Suppose that, the day after the loan is made, inflation increases to 3%. The lender still receives $106,000 at the end of the year. But, the purchasing power of the $106,000 is only $106,000 / 1.03 = $102,913. Thus, the lender’s nominal return is $106,000, but the real return is $2,913 – or $1,009 less than the lender had expected.



The real rate of return is given by the formula:

11

1

real interest rate

nominal interest rate

inflation rate

Rr

r

R

Example

At 6% nominal interest and a 2% inflation rate, the real rate of return is:

1 0.061 0.039 3.9%

1 0.02

An increase in inflation to 3% reduces the real rate of return to:

1 0.061 0.029 2.9%

1 0.03


Nominal vs. Real GDP

Nominal GDP measures productivity in terms of the dollar value generated.

Real GDP measures productivity in terms of the purchasing power generated.

Productivity in 2001

Cars produced1,000,000

Average price per unit$28,000

Contribution to GDP$28.0 billion

Productivity in 2002

Cars produced1,030,000

Average price per unit$30,000

Contribution to GDP$30.9 billion

From 2001 to 2002

Contribution to GDP rose 9.9%

But, production of cars only increased 3.0%

Discrepancy of 6.9% is due to the price of cars rising. We say that GDP rose

9.9%, but RGDP rose 3.0%.


Nominal vs. Real GDP

We can use price indices to convert GDP to RGDP.

The price index used to convert is called (generically) the GDP deflator. We can use either the IPD (to obtain RGDP) or the chain-weighted IPD (to get chain-weighted RGDP).

GDP for year XReal GDP for year X in terms of year Y prices GDP deflator for year Y

GDP deflator for year X

2001: GDP = $10.0 trillion, IPD = 109.82002: GDP = $10.4 trillion, IPD = 111.3

What is the growth rate in nominal and real GDP from 2001 to 2002?

Growth rate of nominal GDP = ln(10.4) – ln(10.0) = 3.9%

Real GDP for 2002 in 2001 prices = ($10.4 trillion / 111.3) (109.8) = $10.26 trillion

Growth rate of real GDP = ln(10.26) – ln(10.0) = 2.6%


4000

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Business Cycles

GDP (trillions)

RGDP (1991.1 trillions)


Business Cycles

Business cycles are the natural fluctuations in economic output around “full employment output.”

Full employment RGDP is the maximum sustainable output level.

For short periods, the economy can operate above full employment GDP. This is achieved by, for example, significant numbers of workers working more than 40-hour weeks, factories being run around the clock, etc.

In the long-run, the economy cannot sustain such overproduction because workers and machinery “burnout” – workers move to less stressful jobs, machines breakdown due to lack of maintenance due, in turn, to a lack of down-time.


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Business Cycles

2001.1: Dot-com crash

2003.1: Iraq War begins

1996.1: End of Clinton’s first term

2001.3: 9/11 and Enron

1992.1: Start of Clinton’s first term

2005.4: Hurricane Katrina

2008.2: Housing Crash


0

2

4

6

8

10

12

1419

47Q

119

48Q

119

49Q

119

50Q

119

51Q

119

52Q

119

53Q

119

54Q

119

55Q

119

56Q

119

57Q

119

58Q

119

59Q

119

60Q

119

61Q

119

62Q

119

63Q

119

64Q

119

65Q

119

66Q

119

67Q

119

68Q

119

69Q

119

70Q

119

71Q

119

72Q

119

73Q

119

74Q

119

75Q

119

76Q

119

77Q

119

78Q

119

79Q

119

80Q

119

81Q

119

82Q

119

83Q

119

84Q

119

85Q

119

86Q

119

87Q

119

88Q

119

89Q

119

90Q

119

91Q

119

92Q

119

93Q

119

94Q

119

95Q

119

96Q

119

97Q

119

98Q

119

99Q

120

00Q

120

01Q

120

02Q

120

03Q

120

04Q

120

05Q

120

06Q

120

07Q

120

08Q

120

09Q

1

Trill

ions

357

Business Cycles


Employment

Population

Institutionalized Non-institutionalized

MilitaryCivilians

Non-participating Labor Force

EmployedUnemployed

Labor Force

Participation RateCivilians

UnemployedUnemployment Rate

Labor Force


Employment

0

2

4

6

8

10

12

1948

1949

1950

1951

1952

1953

1954

1955

1956

1957

1958

1959

1960

1961

1962

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Perc

ent o

f Civ

ilian

Lab

or F

orce

Unemployment Rate


Employment

Unemployment Rates by Educational Attainment

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%19

70

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

MBA BS/BA Total


Employment

Official unemployment figures understate true unemployment

1. Excludes people who have been unemployed for a long time.People who have been unemployed for 12 months or longer are no longer counted as part of the labor force and are classified as non-employed.

2. Does not account for overqualified workers.People who are overqualified for their positions are not being used to their full capacity. While, in reality, these people are underemployed, they are counted as fully employed.

Example: Someone who qualifies for a $100,000 job but currently holds a $40,000 job should be counted as only 40% employed, but is actually counted as fully employed.

3. Does not account for part-time work.People who work work full-time and people who only work part-time are both considered “employed” to the same extent. In reality, those who are employed part-time are underemployed.

Example: Someone who works 20 hours per week should be counted as 50% employed, but is actually counted as fully employed.


Employment

Components of Unemployment

1. Cyclical unemployment unemployment because job was temporarily eliminated due to business cycle downturn.

2. Structural unemployment unemployment because job was permanently eliminated due to market changes.

3. Frictional unemployment unemployment due to a job change.

Natural unemployment = Structural unemployment plus Frictional unemployment

Natural unemployment remains in the long-run as “background” unemployment.


Employment

Relationship between RGDP and Unemployment

Because RGDP measures the production of goods and services, and because labor is required for all production, business cycles and unemployment tend to move in opposite directions.

Frictional unemployment is estimated to be 1% to 2%.

This is the lowest attainable unemployment rate.

Occurs when structural and cyclical unemployment rates are both zero.


3

4

5

6

7

8

9

10

5000 6000 7000 8000 9000 10000 11000 12000 13000 14000 15000

Perc

ent U

nem

ploy

ed

RGDP (billions 2005$)

Relationship between RGDP and Unemployment (1991.1 to 2009.2)

364

Employment

2003.2

2001.1: Dot-com crash

2007.3


Employment

Structural Unemployment and Economic Development

While structural unemployment is the most painful (jobs disappear permanently), it is often necessary for even greater future employment.

Example

Foreign competition in the steel industry causes a permanent loss of manufacturing jobs in the U.S. But, resources shift from manufacturing to other sectors resulting in unforeseen employment gains.

Example

When the automobile replaced the horse, there was tremendous structural unemployment among horse breeders, stables, tack, buggy, wagon manufacturers, and blacksmiths.

What no one at the time could have foreseen was the massive creation of jobs in automobile manufacturing, service, sales, tire manufacturing, gasoline production, distribution, retailing, automotive sound systems production, car detailing, etc.


Employment

Economic, social, and political factors contribute to cross-country differences in unemployment

Economic factors

Less infrastructure (e.g. roads, electricity, water) in Central America results in higher unemployment because it is too costly for many modern firms to locate there.

Social factors

As a matter of tradition, Japanese employers do not fire or layoff workers. This results is higher unemployment as less productive employees cannot be replaced with more productive employees. The tradition extends to banks continuing to provide credit to firms that are insolvent. As with the workers, this results in an inability of the economy to replace unprofitable firms with profitable firms.

Political factors

German law makes it extremely difficult to fire workers. As a result, firms are reluctant to hire workers and so the unemployment rate in Germany is consistently above 10%.


Employment

Unemployment Rates (2004)

0%

5%

10%

15%

20%

25%U

nite

dK

ingd

om

Uni

ted

Sta

tes

Can

ada

Chi

le

Ital

y

Eur

opea

nU

nion

Fra

nce

Spa

in

Ger

man

y

Bra

zil

Mex

ico

Ven

ezue

la

Chi

na


Aggregate Demand and Aggregate Supply

As with microeconomic analysis, we can summarize the behaviors of producers and consumers with demand and supply.

The behavior of all consumers as a whole is summarized by aggregate demand.

The behavior of all producers as a whole is summarized by aggregate supply.

The equilibrium formed by aggregate demand and aggregate supply is called the macroequilibrium.


Aggregate DemandPri

ce

Ind

ex

RGDP

AD

Typical Aggregate Demand Shocks

1. Change in consumers’ spending that is independent of price changes.

2. Change in investment spending that is independent of price changes.

3. Change in government spending that is independent of price changes.

4. Change in net export spending that is independent of (domestic) price changes.

AD’

Increase in AD

AD’’

Decrease in AD


Aggregate DemandPri

ce

Ind

ex

RGDP

AD

Aggregate demand is the relationship between the average price level and aggregate expenditures.

Aggregate expenditures is the amount of purchasing power the economy spends at a given price level.

Average price level

Aggregate Expenditure

s

AD in macro is analogous to D in micro.

AE in macro is analogous to Qd in

micro.


Aggregate SupplyPri

ce

Ind

ex

RGDP

Short-Run Aggregate Supply Shock

1. Change in resource prices.

Long-Run Aggregate Supply Shock

1. Change in quantity of resources.

2. Change in technology.

SRAS

Full employment RGDP

LRAS


Aggregate SupplyPri

ce

Ind

ex

RGDP

Decrease in SRAS

Pri

ce

Ind

ex

RGDP

Increase in SRAS

A change in resource prices without a change in the quantity of resources impacts SRAS, but does not impact LRAS because the maximum attainable production level (i.e. full employment RGDP) has not changed.

SRAS’

SRAS

SRAS

SRAS’


Aggregate SupplyPri

ce

Ind

ex

Increase in full employment RGDP

A change in the quantity of resources impacts LRAS because the maximum attainable production level (i.e. full employment RGDP) has changed.

Pri

ce

Ind

ex

LRAS

LRAS’

Decrease in full employment RGDP

LRAS’

LRAS


Aggegate SupplyPri

ce

Ind

ex

An increase in LRAS and an increase in the PPF are the same thing. The PPF shows how the increase in production can be broken down into two types of goods. The LRAS shows production of all goods combined into a single measure.

Durables

Non-

dura

ble

s

Increase in PPF

LRAS

LRAS’


Aggegate SupplyPri

ce

Ind

ex

An increase in SRAS is caused by a reduction in the prices of factors. This will cause the economy to shift production toward products that intensively use factors. Because the quantity of factors has not changed, the PPF does not change.

Factor non-intensive products

Fact

or

inte

nsi

ve

pro

duct

s

Movement along the PPF

SRAS

SRAS’


Aggregate SupplyPri

ce

Ind

ex

RGDP

SR aggregate supply is the relationship between the average price level and aggregate output in the short run.

Aggregate output is the amount of real output the economy generates at a given price level.

Average price level

Aggregate output = RGDP

AS in macro is analogous to S in micro.

RGDP in macro is analogous to Qs in

micro.

SRAS


Short Run MacroequilibriumPri

ce

Ind

ex

RGDP

Short-Run Equilibrium

Equilibrium Point A is a short-run macroequilibrium because (a) at Point A, aggregate expenditures equal aggregate output, and (b) at Point A, aggregate output does not equal full employment output.SRA

S

AD

112

$8 t.

A

LRAS

Full employment RGDP


Long Run MacroequilibriumPri

ce

Ind

ex

RGDP

Long-Run Equilibrium

Equilibrium Point A is a long-run macroequilibrium because (a) at Point A, aggregate expenditures equal aggregate output, and (b) at Point A, aggregate output equals full employment output.

124

$8.2 t.

AD

A

LRAS SRA

S


Short Run to Long Run TransitionPri

ce

Ind

ex

RGDP

1. At Point A, equilibrium output is less than full employment output. This means that there is unemployment.

AD

112

$8 t.

A

4. Point B is a long-run equilibrium because (a) aggregate expenditures equal aggregate output, and (b) aggregate output equals full employment output.

SRAS

LRAS

2. In the long run, competition among the unemployed leads to a reduction in the prices of factors. This results in an increase in SRAS.

SRAS’3. The increase in SRAS causes a

reduction in the average price level and an increase in output. The economy moves to Point B.

110

$8.2 t.

B


Macroeconomic ShocksPri

ce

Ind

ex

RGDP

1. The economy starts at long-run equilibrium Point A.

124

$8.2 t.

AD

A

2. A decrease in consumer confidence causes consumption to fall. This is a negative shock to AD AD decreases.

AD’

3. The economy moves to equilibrium Point B. SR impact of shock: Prices fall, RGDP falls.

B118

$8.1 t.

4. Because there is unemployment at Point B, the equilibrium is only a short-run equilibrium.

6. The economy moves to equilibrium Point C. LR impact of shock: Prices fall, RGDP unchanged.

C116

LRAS

SRAS

5. In the long run, unemployment puts downward pressure on the prices of factors causing SRAS to increase.

SRAS’


Macroeconomic ShocksPri

ce

Ind

ex

RGDP

1. The economy starts at long-run equilibrium Point A.

115

$8.2 t.

AD

A

3. The economy moves to equilibrium Point B. SR impact of shock: Prices rise, RGDP rises.

B118

$8.3 t.

4. Because there is over employment at Point B, the equilibrium is only a short-run equilibrium.

6. The economy moves to equilibrium Point C. LR impact of shock: Prices rise, RGDP unchanged.

C120

LRAS

SRAS

2. The government increases its spending. This is a positive shock to AD AD increases.

AD’

5. In the long run, over employment puts upward pressure on the prices of factors causing SRAS to decrease.

SRAS’


Macroeconomic Shocks: Creation of the InternetPri

ce

Ind

ex

RGDP

1. In 1997, real GDP was $8.7 trillion and the IPD was 109.0 (Point A).

$8.7 t.

109A

LRAS

AD

SRAS

2. The creation and growth of the Internet represents a new resource. LRAS increases over the period 1997 through 2002.

LRAS’

3. Increase in quantity of resources causes a reduction in the prices of resources. SRAS increases.

SRAS’

$10.1 t.

B

4. Economy moves to Point B. Prices are lower and RGDP is higher.



ce

Ind

ex

RGDP

$8.7 t.

109

$10.1 t.

A

LRAS

AD

What really happened

From 1997 to 2002, AD was increasing also, so the economy moved from Point A to Point C.

SRAS

AD’

C

As a result, by 2002, the IPD had risen to 116 instead of falling.

116

LRAS’



ce

Ind

ex

RGDP

$8.7 t.

109A

LRAS

AD

SRAS

However, if the Internet had not been created, the same increase in AD would have increased the prices of resources and pushed the IPD higher than 116 to Point D.

AD’

SRAS’

D


Macroeconomic Shocks: War Disrupts Oil MarketsPri

ce

Ind

ex

RGDP

1. In 2002, real GDP was $10.1 trillion and the IPD was 116 (Point A).

$10.1 t.

116A

LRAS

AD

SRAS

2. The Iraq War causes a disruption in oil markets resulting in an increase in the price of oil. The market does not react as if the quantity of oil available has declined because the market believes the disruption to be temporary.

3. Increase in the price of oil causes the SRAS to decrease.SRAS

’

B

4. Economy moves to Point B (for the short run). RGDP declines and prices rise.



ce

Ind

ex

RGDP

5. In the long run, oil production will return to normal and oil prices will fall.

$10.1 t.

116A

LRAS

AD

SRAS

7. In the long run, RGDP returns to full employment and prices return to their original level.SRAS

’

B

6. This will result in an increase in the SRAS to its original level. The economy will return to Point A.



ce

Ind

ex

RGDP


At the same time that oil markets were disrupted, the Federal government increased spending to pay for the war and Homeland Security.

$10.1 t.

116A

LRAS

AD

SRAS

1. Increase in the price of oil causes the SRAS to decrease.SRAS

’2. Almost simultaneously, AD

increases due to the increase in government spending.

AD’

C

3. Economy moves to Point C. Prices rise, but RGDP remains at full employment.


Macroeconomic Shocks: Housing Bubble BurstsPri

ce

Ind

ex

RGDP

1. In 2008, real GDP was $13 trillion and the IPD was 108 (Point A).

$13 t.

108A

LRAS

AD

SRAS

B

2. When the housing bubble burst, AD fell because people perceived themselves to be less wealthy (decline in consumption), and banks cut back on lending (decline in investment). This would have moved the economy to point B.

AD’

3. Over time, unemployment would have caused prices to fall and the economy would have moved to point C.

SRAS’

C


Macroeconomic Shocks: Housing Bubble BurstsPri

ce

Ind

ex

RGDP


$13 t.

108A

LRAS

AD

SRAS

B

2. When the housing bubble burst, AD fell because people perceived themselves to be less wealthy (decline in consumption), and banks cut back on lending (decline in investment). This would have moved the economy to point B.

AD’

3. The government passed legislation to dramatically increase spending in an attempt to increase AD.

SRAS’

C

4. Unemployment causes prices to drop and the economy begins to heal itself. Then, as increased government spending kicks in, we will find the economy being pushed above full employment RGDP (point C).


Deflationary and Inflationary GapsPri

ce

Ind

ex

RGDP

When the short run equilibrium output is less than full employment output, we say that there exists a deflationary gap. In the long run, SRAS will increase causing the economy to achieve full employment along with a fall in the average price level.

When the short run equilibrium output is greater than full employment output, we say that there exists an inflationary gap. In the long run, SRAS will decrease causing the economy to achieve full employment along with an increase in the average price level.

LRAS

AD

SRAS

Pri

ce

Ind

ex

RGDP

LRAS

AD

SRAS

Deflationary gap

Inflationary gap


Expenditure Multiplier

From the expenditures approach to calculating GDP, we have:

Y C I G X M

Let consumption be comprised of two components: autonomous and induced consumption.

0 dC C bY

Autonomous consumption

Induced consumption

Autonomous consumption An amount of money that (on average) consumers will spend regardless of their incomes.

Induced consumption An amount of money that (on average) consumers will spend as a function of their disposable incomes.



Disposable income is income net of income taxes.

1dY Y t T R

t = marginal tax rate (e.g. 20% of income)

T = flat tax (e.g. $5,000)

R = government transfers (e.g. $2,000)

where b is the marginal propensity to consume (MPC).

Induced consumption is:

1dbY b Y t T R

MPC is the amount of money out of every $1 of disposable income that consumers will spend on consumption.



Example

Suppose C0 = $12,000, Y = $50,000, t = 0.2, T = $1,000, R = $0, and b =

0.8.

Disposable Income: 1 $50,000 1 0.2 $1,000 $39,000dY Y t T R

0Consumption: $12,000 0.8 $39,000 $43,200dC C bY

Savings: $39,000 $43,200 $4,200dS Y C

In this example, households breakeven at (on average) an income level of $76,250.

Disposable Income: 1 $76,250 1 0.2 $1,000 $60,000dY Y t T R

0Consumption: $12,000 0.8 $60,000 $60,000dC C bY

Savings: $60,000 $60,000 $0dS Y C



Similarly, let imports be comprised of autonomous and induced components.

0 dM M mY

Autonomous imports

Induced imports

Note that savings (S ) is Y – C, not Y – C – M, because consumption includes purchases of both domestic products and imports. Because imports should not be counted toward the domestic country’s GDP, we subtract M from Y in the GDP equation.



Autonomous ExpendituresI InvestmentG Government spending

C0 Autonomous consumption

M0 Autonomous importsX Exports

Induced Expenditures

bYd Induced consumption

mYd Induced imports

Parametersb Marginal propensity to consumem Marginal propensity to importt Marginal tax rateT Flat taxR Transfers

Note that exports (X ) do not include an induced component. While it is the case that spending on exports is a function of income, the spending is a function of foreign consumers’ incomes. As such exports are autonomous with respect to domestic income.



0

0

(1 )

d

d

d

Y C I G X M

C C bY

M M mY

Y Y t T R

We now have a set of equations that describe spending.

We can solve these equations for Y to obtain GDP as a function of autonomous spending:

0 0

1

1 (1 )Y C I G X M b m T R

b m t



Retrieve nominal quarterly data on consumption and disposable personal income from Economy.com’s database (1959.1 to 2005.1). Via OLS, find estimates for autonomous consumption and the marginal propensity to consume and construct the estimated consumption equation.

1. State the model we are attempting to estimate.

2. Run the regression.

67.56 0.93 dC Y

0 dC C bY

3. State the estimated regression model.

CoefficientsIntercept -67.55519062Disposable Income 0.931256974



Retrieve nominal quarterly data on imports and disposable personal income from Economy.com’s database (1959.1 to 2005.1). Via OLS, find estimates for autonomous imports and the marginal propensity to import and construct the estimated imports equation.


104.98 0.19 dM Y

0 dM M mY



CoefficientsIntercept -104.9787082Disposable Income 0.192439729



Retrieve nominal quarterly data on GDP and disposable personal income from Economy.com’s database (1959.1 to 2005.1). Via OLS, find estimates for flat taxes less transfers and the marginal tax rate and construct the estimated disposable income equation.


0.75 56.33dY Y

1dY Y t T R



1 0.75 0.25t t 56.33 56.33T R T R

CoefficientsIntercept -56.33440016GDP 0.74648681



Retrieve nominal quarterly data on the remaining autonomous expenditures for 2005.1.

Remaining Autonomous Expenditures

I InvestmentG Government spendingX Exports

$2,130.7 billion$2,316.5 billion$1,262.4 billion



Combine these figures into a single equation that expresses GDP as a function of autonomous spending.

Autonomous Expenditures ParametersI $2,130.7 b. b 0.93G $2,316.5 b. m 0.19

C0 –$67.56 b. t 0.25

M0 –$104.98 b. T – R $56.33 b.X $1,262.4 b.

0 0

1

1 (1 )Y C I G X M b m T R

b m t

167.56 2130.7 2316.5 1262.4 104.98 0.93 0.19 56.33

1 0.93 0.19 (1 0.25)Y

2.25 5683.93 $12,773 billionY Estimate of GDP as of 2005.1



We can use the multipliers to estimate the impact of a change in autonomous spending on GDP.

0 0For , , , , or

1

1 (1 )

For

1 (1 )

A C I G X M

Y Ab m t

A T R

b mY A

b m t

We call the fraction the expenditures multiplier and

the flat tax and transfer multiplier

1

1 (1 )b m t

1 (1 )

b m

b m t


Fiscal Policy

Example

Suppose the expenditures multiplier is 2.21. What is the impact on GDP of the government increasing spending by $200 billion?

0 0For , , , , or

2.21

200 2.21 200 $442 billion

A C I G X M

Y A

A Y

Suppose the flat tax and transfers multiplier is expenditures multiplier is –2.52. What is the impact on GDP of the government reducing transfer payments by $200 billion?

For

2.52

200 200

200 2.52 200 $504 billion

A T R

Y A

R A T R

A Y


Fiscal Policy

Republicans have proposed cutting marginal tax rates from 25% to 23% and leaving government spending unchanged. Democrats have proposed increasing marginal tax rates from 25% to 32% and increasing government spending by $1 trillion.

Using current expenditure values and the previously derived parameter estimates, estimate the impact of each plan on GDP.

Current Republican Plan Democrat Plan

I 2130.7 2130.7 2130.7G 2316.5 2316.5 3316.5C0 -67.6 -67.6 -67.6M0 -105.0 -105.0 -105.0X 1262.4 1262.4 1262.4

b 0.93 0.93 0.93m 0.19 0.19 0.19t 0.25 0.23 0.32T-R 56.3 56.3 56.3

multiplier 2.25 2.32 2.01autonomous expenditures 5683.9 5683.9 6683.9

Predicted GDP 12773 13212 13454


Fiscal Policy

Government surplus Tax Revenues Government Spending

T R tY G

Estimate the impact on the total government surplus of the two plans.

Current Republican Plan Democrat Plan

I 2130.7 2130.7 2130.7G 2316.5 2316.5 3316.5C0 -67.6 -67.6 -67.6M0 -105.0 -105.0 -105.0X 1262.4 1262.4 1262.4

b 0.93 0.93 0.93m 0.19 0.19 0.19t 0.25 0.23 0.32T-R 56.3 56.3 56.3

multiplier 2.25 2.32 2.01autonomous expenditures 5683.9 5683.9 6683.9

Predicted GDP 12773 13212 13454

Tax Revenue 3249.5 3095.2 4361.6Spending 2316.5 2316.5 3316.5

Surplus (Deficit) -933.0 -778.7 -1045.1


Fiscal PolicyPri

ce

Ind

ex

RGDP

1. The economy starts at short run equilibrium Point A. The autonomous expenditures multiplier is 2.5. There is a $200 billion deflationary gap.

$7.6 t.

A

LRAS

AD

SRAS

2. In an attempt to close the deflationary gap, the government increases spending by $80 billion. This will increase GDP by (2.5)($80 billion) = $200 billion.

3. The increase in government spending is a shock to AD. AD increases by $200 billion.

AD’

$200 b. shift

$7.8 t.

100.0

5. If prices had remained constant, RGDP would have increased by $200 billion to $7.8 t. Instead, prices rise by 1.3%.

101.3

6. GDP increased by (2.5)($80 b.) = $200 billion to $7.8 trillion.

RGDP only increased by $100 billion to $7.7 trillion.

$7.7 t. = ($7.8 t.)(100.0)/(101.3)

$7.7 t.

B 4. Economy moves to Point B.


Economic Policy

Any organized attempt to influence the economy is called economic policy.

There are three major types of economic policy:

1. Fiscal policy Any attempt by the Federal government to influence either inflation or RGDP. Government enacts fiscal policy via alterations in government spending and taxation.

2. Monetary policy Any attempt by the Central Bank to influence either inflation or RGDP. Central Bank enacts monetary policy via alterations in the money supply.

3. Trade policy Any attempt by either the Federal government or the Central Bank to influence trade. Trade policy is enacted via alterations in tariffs, the exchange rate, and the money supply.

In the United States, the fiscal policy is almost always aimed at influencing RGDP, monetary policy is usually (though not always) aimed at influencing inflation. Trade policy is almost always conducted by the Federal government.


Economic Policy

Government Spending (including transfers) as Fraction of GDP

15%

16%

17%

18%

19%

20%

21%19

83Q

119

84Q

219

85Q

319

86Q

419

88Q

119

89Q

219

90Q

319

91Q

419

93Q

119

94Q

219

95Q

319

96Q

419

98Q

119

99Q

220

00Q

320

01Q

420

03Q

120

04Q

220

05Q

320

06Q

420

08Q

120

09Q

2


0%

5%

10%

15%

20%

25%19

54

1957

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

409

Economic Policy

Federal Government Revenue (all sources) as Fraction of GDP


$0

$500

$1,000

$1,500

$2,000

$2,500

$3,00019

54

1957

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

410

Economic Policy

Federal Government Revenue (all sources, billions 2008$)


Policy LagsPolicy lags are time intervals that pass between the need for economic policy and the realization of the effects of economic policy.

Major types of policy lags:

1. Recognition lag The time interval between when economic policy is needed and the realization that economic policy is needed. Often, several months will pass between a turning point in the business cycle and the realization that a turning point has been reached.

2. Decision lag The time interval between the realization that economic policy is needed and the determination of the details of what policy to enact.

The Federal Reserve’s decision lag tends to be extremely short because (a) the Board of Governors is small (7 people), (b) the BOG is comprised entirely of professional economists, bankers, and accountants, and (c) the BOG is insulated from political pressures. The Federal government’s decision lag tends to be extremely long for the opposite reasons.

3. Implementation lag The time interval between the decision as to what policy to employ and the full impact of the policy on the economy. Implementation lags can be moderately to extremely long.


Policy LagsBecause the economy is self-correcting (i.e. the economy naturally returns to full employment on its own), and because policy lags cannot be avoided, most economic policy is destabilizing.Example

The economy starts into recession in January. It takes until March before people become aware that the economy is in recession. The Federal government debates enacting tax cuts to help bolster the economy. It takes until June for the Congress and President to agree on a course of action. Tax cuts are enacted in June, but the full impact of the tax cuts doesn’t filter through the economy until October. However, by October, the economy had naturally turned around on its own.

Result: The expansionary policy reinforces the expansion that is naturally taking place resulting in the economy overshooting full employment and so generating inflation.


Attributes of Money

Any object that fulfills the following three criteria is considered money.

1. Medium of exchange

Object is readily accepted in exchange for goods and services.

2. Store of value

Object maintains its value over time.

3. Standard of value

Values of other objects are measured relative to this object.

Notice that it is not necessary for the object to have an inherent value (i.e. value beyond being a medium of exchange).

Objects used for money that have inherent value are called commodity money (e.g. gold coins).

Objects used for money that have no inherent value are called fiat money (e.g. paper bills).


Benefits of Money

An economy based on money (rather than barter) achieves greater productivity.

1. Money eliminates double incidence of wants.

Without money, every exchange must involve two transactions Suppose the a person seeks to buy product A and has product B to offer in exchange. For exchange to occur, the person must find someone who (1) seeks to buy product B, and (2) has product A to offer in exchange. In every exchange, each party is both a buyer and a seller.

With money, every exchange involves one transaction only A person seeks to buy product A. The person must find someone who offers product A. In the exchange, one person is a buyer only and the other person is a seller only.

2. Money makes intertemporal substitution of consumption possible.

Without money, people must consume products as they are produced because most products will degrade over time.

With money, people can forego current consumption for future consumption via saving, and can forego future consumption for current consumption via borrowing.

3. Money makes investment possible.

Because money allows for intertemporal substitution of purchasing power, people can borrow from their future selves to invest (in human or physical capital) so as to create greater future income.


Benefits of MoneyExample

A person requires $90,000 to pay for a college education. Without the education, the person earns $30,000 annually. With the education, the person earns $60,000 annually. The person incurs $15,000 in annual living expenses regardless of his education.Option #1: Save to pay for college

Ages 18 – 27 Earn $30,000 per year and save $15,000 per year

Ages 28 – 31 Attend college at a total cost of $150,000

Ages 32 – 65 Earn $60,000 per year

Lifetime earnings = $2,340,000

Option #2: Borrow $150,000 to pay for college and living expenses

Ages 18 – 21 Attend college at a total cost of $150,000

Ages 22 – 31 Earn $60,000 per year and pay back $15,000 per year

Ages 32 – 65 Earn $60,000 per year

Lifetime earnings = $2,640,000

Borrowing to invest in education increased lifetime earnings by $300,000


Federal Reserve

The entity responsible for maintaining a country’s money supply is the central bank. In the U.S., the central bank is called the Federal Reserve (or the “Fed”).

The Fed prints money, establishes rules under which banks operate, and aids in the check clearing process.

The Fed is comprised of 12 District Banks. Monetary policy decisions are made by the Board of Governors – a panel of seven people appointed to 14-year terms.


Liquidity Classifications

Financial assets are classified according to liquidity.

Liquidity is the ability to turn an asset into cash quickly and without incurring a loss.

M0 Notes + coins

MB M0 + bank deposits at the Federal Reserve

M1 Notes + coins + checkable deposits + travelers checks + other deposits against which checks can be written without penalty.

M2 M1 + savings deposits + retail money market mutual fund deposits + small certificates of deposit (CD’s) (small = under $100,000)

M3 M2 + institutional money market fund deposits + large certificates of deposit (large = over $100,000) + repurchase agreements (short term loan collateralized, typically, by an M2 asset) + Eurodollars (dollar denominated deposits in foreign branches of U.S. banks).

M4 M3 + U.S. government savings bonds + short-term treasury securities + commercial paper + bankers acceptance.

Financial assets = M4 + other publicly traded financial assets + privately traded financial assets

More

liqu

idLe

ss liqu

id


Liquidity Classifications

Assets

Financial Assets

L

M3M2

M1MS

Monetary Base

M4

MBM0


Economic Policy

Total Reserves Divided by RGDP

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420

Economic Policy

Total Reserves Divided by RGDP


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20019

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421

Economic Policy

M2 Divided by Total Reserves


Financial Intermediaries

Transfer of money across time is facilitated by financial markets.

Financial disintermediation ultimate lender lends directly to ultimate borrower (e.g. an individual buys a corporate bond).

Pro: Individual gains a higher rate of return.

Con: Individual is exposed to default risk.

Financial intermediation ultimate lender lends indirectly to ultimate borrower via a financial intermediary (e.g. an individual puts money in a bank; the bank buys a corporate bond).

Pro: Individual is not exposed to default risk.

Con: Individual earns a lower rate of return.


Financial Intermediaries

Major types of financial intermediaries

Commercial banks

Savings and Loans

Credit Unions

Money market mutual funds

Insurance companies

Finance companies


Banking Crisis of 2008

MORTGAGE A

Payment$800

Life 30 yrs

Risk 5%

MORTGAGE B

Payment$1,000

Life 30 yrs

Risk 1%

MORTGAGE C

Payment$1,200

Life 30 yrs

Risk 4%

MORTGAGE D

Payment$1,500

Life 30 yrs

Risk 10%

MORTGAGE E

Payment$300

Life 30 yrs

Risk 15%

MORTGAGE F

Payment$1,200

Life 30 yrs

Risk 20%

MBS #1

Payment$3,000

Life 30 yrs

Risk 3.3%

MBS #2

Payment$3,000

Life 30 yrs

Risk 14.5%


Fractional Reserves

When an individual deposits cash into a bank, the bank creates a deposit account in the person’s name that contains the value of the cash deposited. The deposit account is a liability to the bank. The corresponding asset is the cash the bank received.

Joe Smith’s Deposit Account $100Cash $100

When a bank loans money to an individual, the bank creates a deposit account in the person’s name that contains the value of the loan. The deposit account is a liability to the bank. The corresponding asset is the loan.

Susan Jones’ Deposit Account $100Loan to Susan Jones $100


Fractional Reserves

When a bank loans money, the bank does not give the borrower cash, but creates a deposit account against which the borrower can write checks. As a result, it is possible for a bank to give loans without having cash to “backup” the loans.

Example

Suppose Smith deposits $100 in the bank, and then the bank gives a loan to Jones for $300. The bank’s accounts would look like the following.

Joe Smith’s Deposit Account $100

Susan Jones’ Deposit Account $300

Cash $100

Loan to Susan Jones $300

Notice that, together, Smith and Jones can write checks for a total of $400 despite the fact that the bank only has $100 cash.

We call this fractional reserves because the bank is required to only maintain a fraction of its deposits in the form of cash.


Fractional Reserve Accounting

Deposits (D)The total value held by the bank’s customers in accounts at the bank. Deposits include checking deposits, savings deposits, loan deposits, certificates of deposit, etc.

Total Reserves (TR)The value of cash on hand plus the value of the bank’s deposits at the Federal Reserve.

Reserve Requirement Ratio (rrr)The percentage of deposits held by the bank’s customers for which the bank is required to hold reserves. The reserve requirement ratio is set by the Fed.

Required Reserves (RR)The minimum amount of reserves the bank is required to have.RR = (D)(rrr)

Excess Reserves (ER)An additional amount of reserves the bank has beyond what is required by law.ER = TR – RR



Example

Using the bank’s accounts below and assuming the reserve requirement ratio is 4%, calculate the bank’s TR, RR, and ER.

Customer Deposit Accounts$25,100,000

Cash $100,000

Deposits at the Fed $1,300,000

Loans $23,000,000

Treasury Bills $700,000

Customer Deposits = D = $25,100,000

TR = Vault cash + Deposits at the Fed = $100,000 + $1,300,000 = $1,400,000

RR = (D)(rrr) = ($25,100,000)(0.04) = $1,004,000

ER = TR – RR = $1,400,000 – $1,004,000 = $396,000Assuming that this is the only bank in the economy and the only person holding cash is Smith (who keeps $10,000 under his mattress), what is the money supply?$25,110,000



Example

Continuing with the previous question, suppose Smith deposits his $10,000 cash in the bank. What is the impact on the bank’s accounts?


Smith Deposit Account $10,000

Cash $110,000


Loans $23,000,000


Calculate the bank’s TR, RR, and ER, and the money supply.



RR = (D)(rrr) = ($25,110,000)(0.04) = $1,004,400

ER = TR – RR = $1,410,000 – $1,004,400 = $405,600

MS = $25,110,000



Example

Continuing with the previous question, suppose the bank gives Jones a home loan for $275,000. Prior to Jones spending the money on the home, what is the impact on the bank’s accounts?



Jones Deposit Account $275,000

Cash $110,000


Loans $23,275,000





RR = (D)(rrr) = ($25,385,000)(0.04) = $1,015,400

ER = TR – RR = $1,410,000 – $1,015,400 = $394,600

MS = $25,385,000



Example

Continuing with the previous question, what is the impact on the bank’s accounts when ABC Construction deposits Jones’ check for $275,000 for building her house?



Jones Deposit Account $0

ABC Const. Deposit Account$275,000

Cash $110,000


Loans $23,275,000





RR = (D)(rrr) = ($25,385,000)(0.04) = $1,015,400

ER = TR – RR = $1,410,000 – $1,015,400 = $394,600

MS = $25,385,000


Money Creation

Notice that, when Smith deposited the $10,000 cash in the bank, the money supply did not change.

All that happened was that the components of the money supply shifted $10,000 cash in Smith’s hands became Smith’s $10,000 checking deposits. Remember: The cash is the bank’s hands does not count toward the money supply.

Notice that, when Jones obtained the loan for the house, the money supply increased.

When the bank gave Jones a loan, the bank created a loan deposit account for Jones. This deposit account counts toward the money supply just like a checking account because Jones can write checks on the account to pay for her house.

Yes, Jones owes the bank $275,000, but this does not change the fact that Jones now can spend up to $275,000 on a house the increased ability to spend is the cause of the increase in the money supply.


Money Creation

Banks create money when they create loans. Because the bank is required to maintain some minimum quantity of reserves, there is a limit to how much money a bank can create.

Smith Deposit Account $100Cash $100

Start with an economy that has a single bank with $100 in the vault. There is no other cash and the reserve requirement ratio is 10%.

The bank’s reserve calculations and the money supply are

Customer Deposits = D = $100

TR = Vault cash + Deposits at the Fed = $100

RR = (D)(rrr) = ($100)(0.10) = $10

ER = TR – RR = $100 – $10 = $90

MS = $100


Money Creation

Smith Deposit Account $100


Cash $100

Loan to Jones $100

Suppose the bank makes a loan for $100 to Jones. The bank’s accounts are




RR = (D)(rrr) = ($200)(0.10) = $20

ER = TR – RR = $100 – $20 = $80

MS = $200


Money Creation



Cash $100

Loan to Jones $100

Loan to Smith $100

Suppose the bank makes a loan for $100 to Smith. The bank’s accounts are




RR = (D)(rrr) = ($300)(0.10) = $30

ER = TR – RR = $100 – $20 = $70

MS = $300


Money Creation



Other Deposit Accounts $700

Cash $100

Loan to Jones $100

Loan to Smith $100

Loans to Others $700

The bank can continue making loans until its excess reserves fall to zero. When this happens, the bank looks like this


Customer Deposits = D = $1,000


RR = (D)(rrr) = ($1,000)(0.10) = $100

ER = TR – RR = $100 – $100 = $0

MS = $1,000


Money Creation

Notice that the maximum size of the money supply is a function of two things:

1. Cash2. Bank deposits at the Fed

Together, we call these two things the monetary base (or “high powered money”).

The money supply reaches its maximum possible size when:

1. People hold no cash (i.e. all of the economy’s cash is deposited in banks).

2. Banks maintain zero excess reserves.

Monetary BaseMaximum size of the money supply

rrr

Money multiplier = 1 / rrr


Check Clearing Process

Suppose Jones’ account is at Bank A while Smith’s account is at Bank B. The two banks’ accounts are as follows:


Bank B Deposit Account $800


Cash $100

Deposits at Bank B $500

Deposits at Fed $1,000

Bank A



Other Deposit Accounts $1,450

Cash $750

Deposits at Bank A $800

Deposits at Fed $700

Bank B



Smith writes Jones a check for $175 drawn on his account at Bank B. Jones deposits the check in her account at Bank A.

Jones Deposit Account $100+$175=$275

Bank B Deposit Account$800–$175=$625


Cash $100

Deposits at Bank B $500


Bank A

Because the check is drawn on Bank B, Bank A transfers $175 from Bank B’s account to Jones’ account.

Smith Deposit Account$300–$175=$125



Cash $750

Deposits at Bank A$800–$175=$625


Bank B

Bank B registers that its deposits at Bank A have declined by $175 and reduces Smith’s account by the same amount.

Neither bank’s equity changed because the transaction did not involve the banks’ money.



If two banks do not maintain mutual deposits, then the Fed aids the check clearing process.

Suppose the two banks begin as follows:



Cash $100


Bank A



Cash $750


Bank B

Smith writes Jones a check for $175 drawn on his account at Bank B. Jones deposits the check in her account at Bank A.



Jones Deposit Account $100+$175=$275


Cash $100

Deposits at Fed $700+$175=$875

Bank A

Smith Deposit Account$300–$175=$125


Cash $750

Deposits at Fed $1,000–$175=$825

Bank B

Cash outstanding $850

Bank A Deposits $700+$175=$875

Bank B Deposits $1,000–$175=$825


Fed


Monetary Policy

The Fed has three tools it uses to conduct monetary policy.

1. Reserve requirement ratio2. Discount rate3. Open market operations

Reserve requirement ratio

By decreasing (increasing) the reserve requirement ratio, banks are better (less) able to create money.

In practice, the Fed alters the reserve requirement ratio infrequently. Frequent changes will cause banks to hold a lot of excess reserves (to guard against increases in the rrr). As a result, changes in the rrr will end up having little impact.Discount rate

In practice, the Fed discourages banks from borrowing except when most necessary (e.g. during the Christmas season when there are significant cash withdrawals, reducing bank reserves). Over borrowing is an indication of a bank extended more loans than (on average) it has reserves to back.


Monetary Policy

The Fed has three tools it uses to conduct monetary policy.

1. Reserve requirement ratio2. Discount rate3. Open market operations

Open market operations

The most widely used tool of the Fed is open market operations. With OMO, the Fed buys or sells securities (usually government bonds) on the open market. When the Fed purchases bonds from banks, it increases the banks’ deposits at the Fed, thereby increasing the banks’ reserves. When the Fed sells bonds to banks, it decreases the banks’ deposits at the Fed, thereby decreasing bank reserves.


Monetary Policy

By altering the money supply, the Fed can influence two economic measures: inflation and interest rates.

Quantity Theory of Money: How money supply changes affect prices

The quantity theory of money holds that the money supply is related to prices by the following formula.

Mv PYM = money supply

v = velocity of money (number of times a dollar changes hands over a year)

P = IPD

Y = full-employment RGDPIf velocity is constant (which it tends to be, at least over the short run), and the economy is at full employment, an increase in the money supply causes inflation only.


Money Demand

Money demand is not the demand for “money” – it is the demand for holding one’s wealth in the form of money rather than in an illiquid form.

Cost to holding wealth in form of money money yields a low (sometimes negative, often zero) return.

Components of money demand

1. Transactions demand desire to hold wealth in liquid form for purpose of conducting transactions.

2. Speculative demand desire to hold wealth in liquid form for purpose of taking advantage of investment opportunities.

3. Precautionary demand desire to hold wealth in liquid form for purpose of protecting against unforeseen events.


Money Demand

M/P

R

M/P “real money” (i.e. purchasing power)

R nominal interest rate

MD

Holding wealth in the form of money makes it easier to conduct transactions, but yields a low return.

MD is downward sloping because, as interest rates rise, the opportunity cost of holding wealth in the form of money rises.


Money Supply

M/P

R MS

Because the money supply is determined by the Fed, it is constant with respect to interest rates.

MD

Equilibrium interest rate


Money Supply

M/P

R MS

By increasing the money supply (via one of the three policy tools), the Fed causes interest rates to decline.

MD

MS’

5.0%

4.9%


Money Supply

M/P

R MS

In practice, the Fed uses the Federal Funds Rate (the interest rates that banks charge each other for loans) as a target for monetary policy. The Fed will select a level for the Federal Funds Rate (e.g. 4.9%) and then continually adjust the money supply so as to maintain the Federal Funds Rate at the target level.

This is why the media refer to the Fed “lowering the interest rate” when, in fact, the interest rate is determined by market forces. Technically, the Fed increases the money supply.

MD

MS’

5.0%

4.9%


Monetary and Fiscal Policies

When the interest rate falls, it becomes less expensive to borrow. As a result, investment rises. As investment rises, AD rises. As AD rises, RGDP and prices rise.Expansionary Monetary Policy

MS R I AD RGDP

P

Contractionary Monetary Policy

MS R I AD RGDP

P

Expansionary Fiscal Policy

G AD RGDP

P

T C AD RGDP

P

Contractionary Fiscal Policy

G AD RGDP

P

T C AD RGDP

P


Monetary Policy

M/P

R MS

MD

5.0%

Pri

ce

Ind

ex

RGDP

LRAS

AD

SRAS

4.9%

MS R

MS’

MS

AD’

I AD

AD RGDP

R I


Monetary Policy

M/P

R MS

MD

5.0%

Pri

ce

Ind

ex

RGDP

LRAS

AD

SRAS

MS’

MS

Notice that expansionary policy (either fiscal or monetary) has the desired effect only if the economy is operating below full employment.

A

Economy starts at Point A. Increase in MS causes interest rates to fall, investment to rise, and AD to rise. Economy moves to Point B. Economy is now in over employment. Increases in resource prices decrease SRAS. Economy moves to Point C.

4.9%

MS R

AD’B

R I AD CSRAS’

Over employment

causes SRAS


Absolute vs. Relative Advantage

A nation is said to have an absolute advantage in the production of a product if it can produce that product at a lower cost than another nation.

US JapanCost to produce 1 car (US$, PPP) $10,000 $12,000Cost to produce 1 computer (US$, PPP) $2,000 $4,000

In this example, we say that the US has an absolute advantage in the production of both cars and computers.

One might argue that these two countries will not trade because the US can produce both products more cheaply than Japan.

This argument is erroneous because it focuses on the dollar (or “nominal”) cost of production rather than the opportunity cost (or “real cost”) of production.




Example

In the US, to produce one additional car requires moving $10,000 worth of resources out of the production of computers and into the production of cars. Because each computer requires $2,000 worth of resources, the cost of producing one additional car is a loss of 5 computers.

In Japan, to produce one additional car requires moving $12,000 worth of resources out of the production of computers and into the production of cars. Because each computer requires $4,000 worth of resources, the cost of producing one additional car is a loss of 3 computers.

We say that Japan has a relative advantage in the production of cars because the opportunity cost of producing a car in Japan is less than the opportunity cost of producing a car in the US.




Example

Similarly, in the US, to produce one additional computer requires moving $2,000 worth of resources out of the production of cars and into the production of computers. Because each car requires $10,000 worth of resources, the cost of producing one additional computer is a loss of 0.20 cars.

In Japan, to produce one additional computer requires moving $4,000 worth of resources out of the production of cars and into the production of computers. Because each car requires $12,000 worth of resources, the cost of producing one additional computer is a loss of 0.33 cars.

We say that the US has a relative advantage in the production of computers because the opportunity cost of producing a computer in the US is less than the opportunity cost of producing a computer in Japan.



Example

Suppose that Mexican and American labor is equally productive. The chart below shows productivity figures for the two countries’ workers.

Intuition would suggest that Mexico will produce both sneakers and shirts and that the US will produce nothing. This argument is incorrect because it is based on absolute, not relative advantage.

US MexicoPairs of sneakers 1 worker can produce per hour 10 20Shirts 1 worker can produce per hour 20 10

Suppose also that Mexican labor is cheaper than American labor. The chart below shows wages in the two countries.

Labor Cost per Hour (US$, PPP)US $9.00Mexico $2.00



Combining these two charts, we find the cost to produce shirts and sneakers in each country.

In Mexico, the opportunity cost of producing 1 more shirt is 2 pairs of sneakers. In the US, the opportunity cost of producing 1 more shirt is ½ of a pair of sneakers.

Mexico has a relative advantage in the production of sneakers and the US has a relative advantage in the production of shirts.

US MexicoPairs of sneakers 1 worker can produce per hour 10 20Shirts 1 worker can produce per hour 20 10

Labor Cost per Hour (US$, PPP)US $9.00Mexico $2.00

US MexicoCost to produce 1 pair of sneakers (US$, PPP) $0.90 $0.10Cost to produce 1 shirt (US$, PPP) $0.45 $0.20



Relative advantage suggests that Mexico will produce only sneakers and the US will produce only shirts – despite the fact that Mexican labor is significantly cheaper than US labor.


Mexico produces only sneakers but wants more shirts. There are two alternatives:

1. Mexico diverts resources out of the production of sneakers and into the production of shirts. Result: Mexico gains 1 shirt at a loss of 2 sneakers.

2. Mexico trades sneakers to the US in exchange for shirts. Result: Mexico gains 1 shirt at a loss of 1 sneaker.

It is better for Mexico to trade its shirts to the US for sneakers rather than to produce sneakers itself.

Suppose Mexico and the US can exchange shirts for sneakers at a rate of 1-for-1.




The US produces only shirts but wants more sneakers. There are two alternatives:

1. The US diverts resources out of the production of shirts and into the production of sneakers. Result: US gains 1 sneaker at a loss of 2 shirts.

2. The US trades shirts to Mexico in exchange for sneakers. Result: US gains 1 sneaker at a loss of 1 shirt.

It is better for the US to trade its sneakers to Mexico for shirts rather than to produce shirts itself.

Suppose Mexico and the US can exchange shirts for sneakers at a rate of 1-for-1.



Conclusion:

Trade does not occur because of the cost of domestic labor vs. foreign labor.

Trade does not occur because of the productivity of domestic labor vs. foreign labor.

Trade occurs because of the cost and productivity of domestic labor employed in the production of one good vs. the cost and productivity of domestic labor employed in the production of another good.

Example

Because the US has a relative advantage in the production of agricultural products and a relative disadvantage in the production of automobiles, you support American car manufacturers when you buy American cars. But, you support American farmers when you buy foreign cars.


Trade

Trade is the combination of specialization and exchange. Countries specialize in the production of those products in which they have competitive advantages, and then exchange some of those products for products in which they do not have competitive advantages.

In practice, countries do not perfectly specialize because of the production phenomena of specialization and congestion. The more a country focuses on the production of one product, the more congestion occurs in the firms producing that product and the more opportunities for specialization arise in firms producing other products. This results in countries partially specializing.

Warning: Unfortunately, the word “specialization” occurs here with two different meanings. In reference to a country, “specialization” means “to focus resources on the production of a specific product.” In reference to a firm, “specialization” means “an increase in factors employed by the firm causes a proportionally greater increase in units produced.”


Trade

Misconceptions about trade

1. Trade exploits foreign workers.

Reality: US firms that employ foreign labor overseas do pay foreigners less than what American workers earn, but more than the foreigners would have earned from native firms.

Example: In 2000, Nike paid its Indonesian workers $720 per year. This is far less than the average US worker earns ($32,000 per year), but far more than the average Indonesian worker earns ($240 per year).

Example: Mexican firms that produce exportable products pay their workers 10% to 70% more than Mexican firms that do not produce exportable products.


Trade

Misconceptions about trade

2. Trade eliminates US jobs.

Reality: US jobs that compete with foreign-made imports are reduced. However, US jobs that provide foreign-purchased exports are gained. Also, US jobs that use foreign-made imports are gained.

Example: Inflow of cheaper foreign steel hurts US steelworkers, but helps US automobile and US tire workers. Countries that gain income from selling steel to the US are better able to afford American exports. This helps US farmers.

3. Trade leads to a reduction in competition and a consolidation of power in the hands of a few large multi-national firms.

Reality: Trade increases the number of consumers and producers and so increases competition. Increased competition decentralizes economic power.

Example: There are currently 40,000 multi-national firms. This number is far too large to allow for collusion. Also, the number of multi-national firms is growing faster than the world economy. This means that, on average, the economic power of individual multi-national firms is declining.


Trade

Using Economy.com’s database, download quarterly data on exports, imports, and GDP (in current dollars), and the unemployment rate over the period 1980.1 through the present.

Calculate “relative trade” as (Exports + Imports) / GDP.

Create a graph of unemployment compared to relative trade.

0

2

4

6

8

10

12

0.15 0.17 0.19 0.21 0.23 0.25 0.27 0.29

Relative Trade

Un

emp

loym

ent

Rat

e (%

)


Exchange RatesThink of a currency as a product. The exchange rate is the price of that product. The demand for a currency is determined by foreigners who want to buy products and investments denominated in that currency.

£

E

D

The demand for pounds is determined by foreigners who want to purchase pounds either (1) as an investment, (2) for the purpose of purchasing British products, or (3) for the purpose of purchasing British investments.

The exchange rate (E = $/£) is the price (in US dollars) of a pound.

When E rises, it becomes more expensive for Americans to buy pounds, so the quantity of pounds demanded (by Americans) falls.

When E falls, it becomes cheaper for Americans to buy pounds, so the quantity of pounds demanded (by Americans) rises.


Exchange Rates

The supply of pounds is determined by British who want to sell pounds (for foreign currency) either (1) as an investment, (2) for the purpose of purchasing foreign products, or (3) for the purpose of purchasing foreign financial instruments.

£

ES

The exchange rate (E = $/£) is the price (in US dollars) of a pound.

When E rises, it becomes more profitable for the British to sell pounds (to the Americans), so the quantity of pounds supplied (by the British) rises.

When E falls, it becomes less profitable for the British to sell pounds (to the Americans), so the quantity of pounds supplied (by the British) falls.


Exchange Rates

The equilibrium exchange rate is the price of pounds that causes quantity demanded of pounds to equal quantity supplied of pounds.

£

ES

D

Equilibrium exchange rate ($/ £)

Equilibrium quantity of pounds bought/sold

daily


Exchange Rates

A change in the exchange rate implies a change in the relative values of the two currencies.

Exchange rates are typically expressed as Domestic/Foreign. However, because the definition of “domestic” and “foreign” changes depending on one’s perspective, you should always verify which currency is in the numerator and which is in the denominator.

Suppose the exchange rate starts at $2.00/£. This is the same as £0.50/$.

An increase in the exchange rate to $2.10/£ implies that the pound has become more valuable relative to the dollar.

Because $2.10/£ is the same as £0.48/$, the dollar has become less valuable relative to the pound.

If the exchange rate is expressed as Domestic/Foreign, then an increase in the exchange rate means that the domestic currency has become less valuable and a decrease in the exchange rate means that the domestic currency has become more valuable.


Exchange Rates

Notice that, like in any market, the exchange rate (i.e. the price) changes when there is a change in either the demand or supply of pounds.

£

ES

D

$1.82

1. The exchange rate starts at $1.82 per pound.

2. An increase in real interest rates in the US causes US financial instruments to be more attractive to British investors. This is a positive shock to the supply of pounds.

3. Supply of pounds increases causing a decline in the exchange rate.

S’

$1.75

A decline in the exchange rate means that dollars have become more valuable.


Exchange Rates

Notice that, like in any market, the exchange rate (i.e. the price) changes when there is a change in either the demand or supply of pounds.

£

ES

D

$1.82

1. The exchange rate starts at $1.82 per pound.

2. Americans demand more British goods. This is a positive shock to the demand for pounds.

An increase in the exchange rate means that dollars have become less valuable.

3. Demand for pounds increases causing an increase in the exchange rate.

$1.87

D’


Exchange Rate Regimes

An exchange rate regime is a method for determining the exchange rate.

Exchange rates are usually determined by one of three methods.

1. Floating rate Exchange rate is determined by forces of demand and supply. This is also called the “free market rate.”

2. Fixed rate Exchange rate is set by a government. Example: The exchange rate of the Bahamian dollar with the US dollar is fixed by the Bahamian government at 1.

3. Dirty float A government will allow the exchange rate to be determined by market forces provided that the rate stays within some bounds set by the government. If the rate moves outside those bounds, the government will intervene to hold the rate at the bound until such time as market forces act to move the rate back within the bounds. This is also called a “managed float.” Example: The Hong Kong monetary authority will not allow the exchange rate to fall below $HK7.8/$US



A fixed rate or dirty float regime is like a price ceiling and price floor together.

The major difference is that, whereas price controls can be enforced by law, a government cannot legally enforce fixed rates because many (if not most) of the exchange rate transactions involving its currency occur outside the country’s borders.To maintain a fixed rate or dirty float, a government must intervene in the market place by buying up its currency to lower the exchange rate and selling its currency to raise the exchange rate.

Example

The Russian government wants to hold the exchange rate at $0.04/RUB. Because of a decline in the demand for rubles, the exchange rate starts to fall. To counteract the decline in the exchange rate, the Russian government begins buying rubles on the market. The Russian government’s purchases constitute an increase in demand. The government continues to purchase until the market rate rises back to $0.04/RUB.



Question

What does the Russian government use to buy up rubles on the open market? The government must use its stock of foreign currencies (e.g. dollars, pounds, etc.) that it has acquired over time.

Problem

The Russian government can’t print foreign currency. Once it runs out of foreign currency, it is no longer able to buy up rubles and so can no longer support a falling exchange rate.

This happened in August 1998 when Russia was forced to devalue the ruble because Russia had run out of foreign currency with which to buy up rubles.

Result: In the course of 24 hours, the ruble fell by an amount that it otherwise would have fallen over the course of a year or more.



Ruble-Dollar Exchange Rate (1/1/98 - 12/31/98)

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

0.18

$/R

UB



Ruble-Dollar Exchange Rate (1/1/98 - 12/31/98)

0

5

10

15

20

25

RU

B/$



Dollar-Euro Exchange Rate (1/1/01 - 6/9/05)

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

$/E

CU

2001 2002 2003 2004



Terminology

In a floating exchange rate regime, when a currency becomes more valuable, it is said to appreciate. When a currency becomes less valuable it is said to depreciate.

In a fixed exchange rate regime, when a currency is made more valuable, it is said to be revalued. When a currency is made less valuable, it is said to be devalued.


Impact of Exchange Rate FluctuationsExample

Suppose exchange rate is floating and is currently RUB 4 / $.

Russia exports caviar at a price of RUB 2 each. The US exports Coke at a price of $0.50 each.

Russian Importer

Russian Bank

US Exporter

2 Cokes

$1

RUB 4 $1

Russian Exporter

2 caviar

RUB 4

US Importer

US Bank

$1 RUB 4

Flows of currency

Russia: +RUB 4–$1

US: –RUB 4 +$1

Russian Bank

US Bank

RUB 4 $1

Flows after banks exchange surplus currency

Russia: +RUB 0–$0

US: –RUB 0 +$0


Impact of Exchange Rate Fluctuations

Now, suppose Russia fixes the exchange rate at RUB 2 / $.

Russia exports caviar at a price of RUB 2 each. The US exports Coke at a price of $0.50 each.

Russian Importer

Russian Bank

US Exporter

4 Cokes

$2

RUB 4 $2

Russian Exporter

1 caviar

RUB 2

US Importer

US Bank

$1 RUB 2

Flows of currency

Russia: +RUB 2–$2

US: –RUB 2 +$2

Russian Bank

US Bank

RUB 2 $1

Flows after banks exchange surplus currency

Russia: +RUB 0–$1

US: –RUB 0 +$1



Impact of fixing the exchange rate at an artificially low level.

Some People are Better Off

1. The Russian importer buys more Coke at the same price.

2. The US exporter sells more Coke at the same price.

Some People are Worse Off

1. The Russian exporter sells less caviar at the same price.

2. The US importer buys less caviar at the same price.

Russia is Bleeding US Dollars

When the Russian bank attempts to buy back the dollars that left the country, it finds that it does not have enough rubles to buy back all of the dollars. The government bought the remainder in an effort to maintain the artificially low exchange rate.



The alteration in the exchange rate impacts not only exporters and importers, but also Russian investors investing in US securities and US investors investing in Russian securities.

Suppose the exchange rate is $0.50/RUB.

US Investor

US Bank

Russian Firm

Bond @ FV RUB 30

RUB 20

$10 RUB 20

Russian Firm

RUB 30 Bond

US Investor

US Bank

RUB 30 $15

Time

The US investor made a 50% return on the investment, but incurred (in addition to default risk) exchange rate risk.



Suppose the exchange rate is $0.50/RUB initially. But, after the US investor purchases the bond, Russia devalues its currency to $0.25/RUB.

US Investor

US Bank

Russian Firm

Bond @ FV RUB 30

RUB 20

$10 RUB 20

Russian Firm

RUB 30 Bond

US Investor

US Bank

RUB 30 $7.50

Time

The US investor incurred a 25% loss on the investment due to the alteration in the exchange rate.



Impact of depreciation or devaluing of a currency.

Some People are Better Off

1. Russian investors who had invested in US firms prior to the exchange rate change receive back currency (dollars) that is worth more than the currency they invested.

2. US firms that had borrowed from Russian investors prior to the exchange rate change pay back currency (rubles) that is worth less than the currency they borrowed.

Some People are Worse Off

1. US investors who had invested in Russian firms prior to the exchange rate change receive back currency (rubles) that is worth less than the currency they invested.

2. Russian firms who had borrowed from US investors prior to the exchange rate change pay back currency (dollars) that is worth more than the currency they borrowed.


Hedging Exchange Rate Risk

Exchange rate risk can be hedged via currency options and futures.

A futures contract is a bilateral agreement to buy/sell a quantity of foreign currency at a specified future date and at a specified price.

An options contract is a unilateral agreement in which the holder of the option has the right (but not the obligation) to buy or sell a quantity of foreign currency at any time up to a specified future date and at a specified price (the “strike price”).A call option gives the contract holder the right to buy the currency. A put option gives the contract holder the right to sell the currency.

The holder of the contract pays the issuer of the contract a contract premium which the issuer keeps regardless of whether or not the holder executes the contract.


Hedging Exchange Rate Risk

Suppose the exchange rate is $0.50/RUB initially. But, after the US investor purchases the bond, Russia devalues its currency to $0.25/RUB.

US Investor

US Bank

Russian Firm

Bond @ FV RUB 30

RUB 20

$10 RUB 20

Russian Firm

RUB 30 Bond

US Investor

Time

The US investor makes the expected 50% return less the premium paid for the futures contract.

Futures Market

premium

Contract to sell RUB 30 for $15

Futures Market

RUB 30

$15

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