13: final review intro econ

13: Final ReviewIntro Econ

C.L. Mattoli

Intro This will be a final review of intro econ. We warn that this is by no means all that might

be tested in the final exam. It is simply meant as a summary of the course,

giving it all in one place with tying threads among the concepts.

Study the book, the lecture notes, the tutorials, and the past final exams as a means of studying for the final exam.

2(C) Red Hill Capital Corp.,

Delaware, USA 2008

Mod 1: intro: Chapters 1,2 & 18

Overview Chapter 1 introduces the idea of

economics as a social science that tries to be scientific by employing the scientific method of research, when it can do that.

We talk about scarcity versus unlimited self-interested wants.

In Chapter 2 we look at production possibilities and its frontier (PPF).


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Overview Because resources, including the labor hours

available in any given period, are scarce, only a certain amount of one thing could be produced in an economy over a given interval of time. That is maximum production capacity.

If the economy wants to produce 2 goods, the scarce resources will have to be divided among production of the 2 goods.

How that decision is arrived at is a function of opportunity cost considerations.


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Overview The only way to expand a PPF is through

investment in new capital. To do that it will have to give up producing

consumer goods to produce more capital goods, which means present sacrifice to get future benefits, another trade-off of opportunities

In Chapter 4, international trade, we also found that an economy can get to a point beyond the PPF by comparative advantage in international trade.


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Chapter 1: intro There is not an unlimited amount of

anything in the world, so resources (factors of production) for making things are scarce.

Economics is the study of choice in the allocation of scarce resources.

The resources are land, labor, and capital (equipment). Entrepreneurs, the people who take the risk and burden of doing business, are a particularly scarce resource.


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Chapter 1: intro It uses the scientific method to try to come

up with simple theories and equations (models) that are based on simple underlying psychology of human beings.

For example, we would expect that people will be willing to buy more of something, if the price is decreased.

That becomes a demand curve of quantity versus price that is downward sloping.


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Chapter 1: intro Models use ceteris paribus, everything else

held constant, many times, so that the affect of one or a few variables at a time can be examined.

Thus, for example, downward-sloping demand assumes that the prices of substitutes does not change.

Problems in theorizing include: causation versus correlation. Things might seem to be related, but it might be only a coincidence.


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Chapter 1: intro Then, there is positive versus normative

economics. Positive deals with facts and verifiable true-false statements. Normative is subjective and talks of what it thinks things should be like.

Thus, GDP will increase, if people work more hours is positive.

Poor people should get more money from the rich is normative


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Chapter 2: PP & OC 3 fundamental questions: what, how, and for

whom to produce. That brings us to our first discussion of

opportunity costs. Scarcity means that choices must be made,

and to choose one path is to sacrifice taking another path.

Opportunity cost is then defined as the best alternative that was sacrificed in choosing to do what we chose.

For example, give up producing one car to make 20 computers, then, your opportunity cost of producing 1 computer is 1/20 cars.


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Chapter 2: PP & OC Economic analysis also involves marginal

thinking. What is important to dynamic analysis of a productive economy is change. Marginal analysis is our first look at change: additions or subtracting, incremental affects, to a current situation.

For example, a farmer figures that he can get $75/acre without fertilizer, and the same land will yield $100/acre with fertilizer. The incremental cost of using fertilizer is $20/acre, so by using it, he will make $100 – $75 – 20 = $5/acre marginal profit by using fertilizer.


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Chapter 2: PP & OC Then, we can finally look at the PPF. The PPF is

the plot of maximum capacity simultaneous production of 2 (or more) goods or services (G&S).

With limited resources, we will have different combinations of producing different numbers of the pair of good, together.

Those maximums are the PPF (see slide below), it is an outer boundary line on the production possibilities set, which are the points inside the outer boundary (not max capacity).


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Chapter 2: PP & OC Points inside the PPF are also possibilities, but

they are not efficient because you could have produced more of both with your capacity and trade-offs.

If we produce 2 goods, we have to allocate some of the fixed resources to both.

For example, we start with 100% of production in good A, then we begin to allocate a larger and larger percentage to good B until we have all of our production in good B.


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Production Possibilities, Graphically•The graph describes the production possibilities for 2 goods or services, with production of each on the separate axes.•The Production possibilities set is contained to the left of the PPF.•Thus, Points A,B,C,D, and F are part of the set, while E is unattainable.•A, C, and F are on the frontier, which represents maximum production, although of different mixes of goods and services.•Point E is beyond the possibilities, given the resources and technology of the economy in the period described in the graph.

A

B

C

D

E

F

Units of Good 1

Un

its

of G

ood

2

A

B

C

D

E

F

Units of Good 1

Un

its

of G

ood

2


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Chapter 2: PP & OC We get our first chance to look at

marginal analysis. That reallocation from only one to 2, in

various proportions, will involve opportunity cost considerations.

To get that PPF plot, we assume fixed, fully utilized resources and unchanged technology.


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Chapter 2: PP & OC As happens in cases of other costs,

marginal opportunity costs change. Thus, PPF is a concave curve because of

the law of increasing opportunity costs.

The more we move from producing one good to producing more of a second and less of the first, the sacrifices become larger and larger.


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Increasing Opportunity cost example Consider the choice between producing

automobiles or university degrees (U.D.). At point A all production is devoted to autos.

Auto production requires a large amount of purpose-built equipment, computers, and some moderately educated labor

University degree production requires some buildings, computers, and highly-educated personnel.


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Increasing Opportunity cost example To move from A to B we move some

buildings, computers and educated personnel from auto production to U.D. production, and sacrifice one grid-unit of autos to produce about 2 1/3 grid-units of U.D.’s.

However, to move from B to C we sacrifice the same amount of autos as in the first step to produce less U.D.’s.

Even less, in steps from C to D and D to E (see next slide).


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20

Autos vs. University Degree production Recall that on the PPF, all factors of production are fully

employed, so that by the time we have gone from A to E all of the capital and laborers have been moved from autos to university degrees.

However, some of those resources, like unskilled labor and robots, were better suited to auto making than U.D. production.

Thus, at first those well-suited to U.D. production were moved. However, more and more resources that were better suited to autos are moved to U.D.’s and we have to sacrifice more auto production for incremental U.D. production.

A

B

C

D

Aut

os

U.D.’s E(C) Red Hill Capital Corp., Delaware, USA 2008

Law of increasing opportunity cost explained In this example, because the factors of

production are not equally suited to autos and U.D.’s, the marginal addition of U.D. production for each equal decrease of auto production decreases.

In another way of looking at it, the slope of the line ΔA/ΔU is negative and becomes more negative as we move down the curve.


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Law of increasing opportunity cost explained We give up producing cars (negative) to

make more U.D.’s (positive), so slope is negative

In fact, in a case where the factors of production were equally suited to production two outputs, the PPF would be a straight line and a straight line has a constant slope (Constant opportunity costs).

(C) Red Hill Capital Corp., Delaware, USA 2008 22

Chapter 2: PP & OC

To move the PPF out (expand it) means investing in capital because newer better capital will allow greater productive capacity.

New technology is particularly helpful in moving PPF’s outward.

Another means is by increasing resources, like finding gold or having an influx of employable population.


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Chapter 2: PP & OC

A means of reaching a point above the PPF is by using comparative advantage in the production of one good to trade for another from another economy, in foreign trade.

Comparative advantage means that one country can produce a good at a relatively lower opportunity cost than other nations.


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Trade and the PPF Assume 2 countries that produce the same 2

goods: agricultural products and electronics. Further assume, for simplicity, that their

resources are equally suited for both industries, so that the PPF’s of each are linear, i.e., straight lines instead of curves.

Econ 1 starts at B, producing 60,000 tons of agricultural goods and 20,000 tons of electronics. Econ 2 starts at D, producing 30,000 tons agricultural goods and 10,000 tons electronics.


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Trade and the PPF We assume that points along the PPF’s also

describe the consumption possibilities of the country in a closed self-sufficient system without trade.

If each specializes, Econ 1 producing only agriculture, and 2 producing only electronics, they can trade the excesses and each can go beyond their PPF’s.

Then, econ 1 will produce 100, 000 tons of agricultural goods and economy 2 will produce 50,000 tons of electronics.


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International Trading PPF’s

Econ 1 Econ 2

Ag.

20,

000

tons

/day

Electronics 10,000 tons/day

B’ with trade

B without trade

C

D’ with tradeD without trade

A

Econ 1 trades 30,000 tons of agricultural goods for 20,000 tons electronics from Econ 2. Economy 1 ends up with 70,000 tons of agricultural goods and 20,000 tons of electronics, more than they

would have had on their own. Similarly, economy 2 ends up with 30,000 ton of agricultural goods and 20,000 tons of electronics, again,

beyond what they could have done on their own Both move beyond their PPF’s to B’ and D’. See figure, below


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Chapter 18: Int’l. Trade We all specialize in something, and the economy

benefits from specialization: we produce more than we would, if we all did everything for ourselves.

We saw that nations can gain from the use of comparative advantage in international trade.

There is also the concept of absolute advantage. Absolute advantage means that a nation can

produce something using fewer resources than any other country.

However, even a nation with absolute advantage in a number of goods can benefit from trading.


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Mod 2: Markets

Chapter 3: market analysis One efficient and effective means of allocation is

by markets. In markets, there is consumer sovereignty: the

consumer decides what to buy, which ultimately should determine what will be produced.

The law of demand says that the quantity of a good that consumers will purchase is an inverse function of price (quantity demanded decreases with increasing price) in a given period of time, ceteris paribus (which means that prices of substitutes, for example, remain unchanged).


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Chapter 3: market analysis It is based on the behavioral fact that

consumers have a marginal utility for things that is decreasing.

From all of the individual demand schedules, intentions to buy, we add up all quantities at each price to get the total demand curve for something.

Quantity demanded changes with changing price, that is a move along a demand curve.


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Chapter 3: market analysis Demand curves can be transformed

(shifted) into new demand curves by non-price factors, like prices of substitutes, change in number of buyers, income, tastes and preferences, and expectations.

The law of supply says that sellers are willing to offer more goods at a higher price, ceteris paribus. It is upward sloping


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Chapter 3: market analysis

Changes in the supply curve come from non-price: number of sellers, technological change, input prices, taxes/subsidies, expectations, and prices of competing goods.

Note: new curves, i.e., new demand or new supply, always come from non-price factors. The curves we draw show quantify as a function of price only.


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Chapter 3: market analysis

Finally, we need to put supply and demand together to find out, through working out surpluses and shortages, an actual equilibrium price and quantity that the price system mechanism has used the forces of the market to ultimately efficiently determine.

Then, society has maximized the benefits of some scarce resources.


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Chapter 4: markets in action Now that supply and demand have met,

we look at what happens when either the supply or demand curve changes.

We get new equilibrium price and quantity, as shown in the next 2 slides.

We can look at what happens when governments try to fix prices.

We also look at how markets can fail and lead to not good outcomes.


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Effects of demand shifts on equilibrium Diagrams and causal chains

D1 D2 D2 D1P P

Q Q

S S

Increase indemand

Increase inEquilibrium price

Increase inQuantitysupplied

Decrease indemand

Decrease inQuantitysupplied

Decrease inEquilibrium price

When Haircut demand rises When SUV demand falls


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Supply Changes Causal chain and graphs. Note there is a mistake in the arrow for price in the graph in the book on page 92 for

decrease in supply

S2S1 S1S2

P P

Q Q

D D

Increase insupply

Decrease inEquilibrium price

Increase inQuantity demanded

Decrease insupply

Increase inEquilibrium price

Decrease inquantitydemand


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Chapter 4: markets in action Given those basic facts, what will happen if

the government tries to fix the price of something, either above or below, floor (lowest allowed sale price) or ceiling (highest allowed price), this natural equilibrium price.

A common example of a ceiling is on rents. The government might be concerned that its citizens be able to afford rent, so they put caps (ceilings) on rental prices.


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Chapter 4: markets in action That will lead to a shortage, that will

lead to bad behavior, like black market renting and subletting, bribes, and, ultimately, inefficiency and market failure.

Minimum wages is a common floor, leading to surplus, to market failure, to unemployment.


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Chapter 4: markets in action Markets can also have failures, even

without the interference of the government in natural markets affairs.

First, a market might lack competition. Maybe only one company ever found that a particular good was profitable, and it grew into a huge percentage of the market. What if there is market that no on cares about, supply-wise? Any sort of lack of competition is a failure.


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Chapter 4: markets in action Governments get involved in trying to

solve these other failures. For lack of competition, governments

might act to make the few people in the industry act as though they are in a competitive market.

For example, that is done with electric and water utility companies that have to be necessarily large and cannot easily exist in great multiplicity.


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Chapter 4: markets in action It would be difficult to offer citizens of a town

an option to buy water from 100 companies, because there would have to be 100 main water lines running through the whole town.

Externalities are external affects by or on markets. They can be good or bad.

Pollution is an example of bad. A steel producer pollutes the atmosphere. People get sick, everything, including the water, gets dirty, and there is a large cost to society.


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Chapter 4: markets in action By taxing bad or regulating that the

producer must buy and install pollution control, the cost will rise, the offer price will rise, and the market price and quantity will be a new equilibrium, with higher price and lower quantity, as the supply curve is shifted against a fixed demand curve.

A positive externality is something that benefits people who do not buy the product.


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Chapter 4: markets in action Inoculation of children against bad

diseases benefits the people whose children go to school with them. Since most are inoculated, the others are fairly well protected against being with someone with the disease.

Those who benefit are free-riders. Free rides give the government another

reason to get involved in the economy.


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Chapter 4: markets in action Public works is a function performed by a

government wherein without intervention, the things would likely not get done.

These are things, like interstate highways, national defense, or community parks.

If you asked people to contribute to such things as they saw fit, most would probably try to get away with paying nothing and still getting the benefit of everyone else's payment.


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Chapter 4: markets in action It is another general behavior of human

beings. A debatable failure is the income

inequality issue. Some argue that markets are inefficient in

that people’s incomes vary so widely; others would argue that that is just the market making efficient use an pricing of what it has got.


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Chapter 5: Elasticity So, since we have talked about how supply

and demand relate quantities to prices, and that both curves can change, it would be nice to know how things might change.

Percentage change of one thing with unit percentage change of another variable is called elasticity.

Price elasticity of demand tells how demand will change with price changes. That will be interesting information for producers.


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Chapter 5: Elasticity

It is always a negative number (downward sloping curve), so we usually just drop the minus sign.

A downward sloping demand curve will show ranges of the different types of elasticity, with elastic towards higher prices and with inelastic range towards the bottom of price.

Income elasticity of demand looks at how demand varies with a person’s income.


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There is a division: inferior goods have negative elasticity, while normal good have a positive elasticity.

Inferior goods, formerly called necessities, have e negative change versus income. As income rises, people buy better food, and buy a car instead of taking a bus.

Normal goods, formerly called luxuries, have an increase when people earn more money.


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Chapter 5: Elasticity Price elastic of demand has to do with

substitutes and budgets versus wants and needs.

If something is elastic, that means that changes in price will lead to bigger changes in quantity demanded.

Inelastic means that there is no choice, we have to have the good or we don’t care much about the price.


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Chapter 5: Elasticity Cross-elasticity of demand looks at

change in quantity demanded of one good versus change in price of another good.

Then, we have a division: substitutes and complements. It can be positive or negative, depending.

For a substitute, the increase of the price of a competitor will give you more business, so cross elasticity for substitutes is positive.


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Chapter 5: Elasticity If a complement, like French fries with a

hamburger, an increase in the price of one will cause the quantity demanded of the other to drop, so it is negative.

Price elasticity affects the shares that supplier and consumer will pay of an excise tax slapped onto the price of a good.

If demand is perfectly inelastic, the consumer will bear the whole cost. If it is perfectly elastic, the supplier will pay all of the tax.


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In between, an upward-sloping supply curve will shift upward by the tax. Price will move up the old downward sloping demand curve to a new price. However, the change in the market equilibrium price will not be as large as the tax added, and consumer and producer will share the tax burden.

That phenomenon is called tax incidence.


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Elasticity and Taxation When demand is other than

perfectly elastic (vertical) it will have a downward slope.

Because of the downward slope, the burden will shift from totally on the buyer to a split between buyer and seller.

Thus, of T = Tax, the added cost, the part that is shifted to the buyer is the difference between what he paid before and what he is paying now, which change in price is less than the added cost = T

54

BuyerSeller

Change in market price = ΔP

T – ΔP

TotalTax = T

(C) Red Hill Capital Corp., Delaware, USA 2008

Elasticity and Taxation In the diagram, we also

show what happens when supply is more inelastic (blue lines). Then, the part of the tax shifted to the buyer is less, the more inelastic the supply for the same tax.

55

BuyerSeller

Change in market price = ΔP

T – ΔP

TotalTax = T

(C) Red Hill Capital Corp., Delaware, USA 2008

Mod 3: Business, Company & Industry Analysis

Chapter 6: Production costs. People are in business to make profits,

which depend on revenues and costs. They are self-interested.

Economics adds a cost to normal accounting profits: implicit, opportunity costs, to arrive at economic profit.

Opportunity costs arise again. We have the opportunity costs associated with doing a business or taking our time and money and doing something else.


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Chapter 6: Production costs. To look at production and costs, we divide

time into a long-run, over which everything can be changed in the production operation, including scope, and the short-run, over which at least one input to the production process is fixed and cannot be changed.

The production function is the relationship between the maximum output that can be achieved with various quantities of inputs.


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Chapter 6: Production costs.

Then, another marginal concept, marginal product, which is the change in output with a change in unit input of labor (variable input).

Marginal product curves will slope upward, peak out, and turn downward because of the law of diminishing returns.


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Chapter 6: Production costs. Returns diminish as more variable inputs are

added to a fixed input, the extra output at each addition will be less and less.

The first employ gets you in business. The second employee shares tasks with the first in such as way as to more than double output of just one. The third helps, but it gets to a point where the added efficiency is gone, and they just start to get into each other ways.

It is a short-run law.


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Chapter 6: Production costs. Total (short-run) costs can be divided into fixed

costs, which are paid no matter how many units produced, build a minimum cost into the business, and variable costs that vary with units. TC=TFC+TVC.

Average costs are costs per unit. ATC=AFC+AVC. They are more interesting.

Then, we can talk about marginal costs (MC) as the additional cost incurred by producing one more marginal unit of production. They are the most interesting of all, and they tell how to run the business.


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Chapter 6: Production costs. First marginal cost and marginal product

are inversely related. The marginal-average rule says that

when the marginal is below the average, the average will fall with the marginal change. When it is above, the average will become larger.

The M-A rule results in MC cuts the AVC and ATC curves at their minimums. We include the picture in the next slide.


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AC & MC Data Average and marginal

costs are shown for MAT ATM’s.

MAT ATM's

Q MC AFC AVC AC

1 50 100.00 50.00 150.00

2 34 50.00 42.00 92.00

3 24 33.33 36.00 69.33

4 19 25.00 31.75 56.75

5 23 20.00 30.00 50.00

6 30 16.67 30.00 46.67

7 38 14.29 31.14 45.43

8 48 12.50 33.25 45.75

9 59 11.11 36.11 47.22

10 75 10.00 40.00 50.00

11 95 9.09 45.00 54.09

12 117 8.33 51.00 59.33

Average and Marginal Costs vs. Output

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

0 2 4 6 8 10 12 14

Quantity

Uni

t Cos

t($)

AVC

AFC

ATC

MC


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Chapter 6: Production costs In the long-run, the LR ATC curve is built up of all of

the possible SR ATC curves. (See next slide). The general form will be U-shaped.

The U-shaped curve has 3 distinct regions. The downward sloping part is economies of scale,

which comes from a increasing efficiency of larger scale of production.

The flat middle region is constant returns to scale. The upward sloping region is diseconomies of scale

where bigger becomes not better but more cumbersome to manage. (see second next slide).


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Long run average cost curves We might imagine a more comprehensive case of more

possibilities in the long run, as shown in the graph below.


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Long run Possibilities In the long run there can be economies of scale, constant returns to

scale, and even diseconomies of scale as size becomes too bulky and unmanageable.

0

5

10

15

20

25

30

35

0 20 40 60 80 100 120

Economies of scale

Constant returns to scale

Diseconomies of scale

Cost

Output 66(C) Red Hill Capital Corp.,

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Chapter 7: Perfect competition We want competitive markets because we can have confidence in price and quality. We don’t want producers to take advantage of us and make excessive profits.

Perfect competition is an ideal, not reality, but we can learn from looking at this idealism.

There are a number of market structures that depend on how many suppliers, uniformity of product, and ease of entry/exit.


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Chapter 7: Perfect competition Markets can vary from one supplier, a monopolist, who decides what profit he will make.

In an oligopolistic market, there are few suppliers, and they could collude to set the price.

In monopolistic competition, people, like restaurants and exclusive boutiques try to distinguish themselves from their competitors so as to be like a mini-monopoly.


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Chapter 7: Perfect competition Finally, perfect competition is characterized by

many indistinguishable firms with indistinguishable products and ease of entry/exit.

As a result, firms are price takers because they have no control over the price set by the interaction of total demand with total supply. Each, effectively, faces a horizontal demand curve, completely elastic, because people can just go next door and buy the same exact product. (See next slide for summary)


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Comparative Market StructuresStructure # of sellers Product Entry Examples

Perfect Competition

Large Homogeneous Very easy Small crops, commodities markets

Monopolistic competition

Large Differentiable Easy Restaurants, motels, clothing or other types of boutiques

Oligopoly Few Usually differentiable; can be homo

Difficult Airlines, Automobile manufacturing, oil production

Monopoly One Unique Extremely difficult

Public utilities


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Chapter 7: Perfect competition The perfect competitive firm will have max

profits when MR (marginal revenue) equals MC.

We saw that MC cut the ATC at its minimum, so that is the minimum of unit cost.

Marginal revenue is equal to the extra revenue from one more unit of output MR = ΔTR/ΔQ.

In a perfectly competitive industry, the MR will always equal market price per unit, and the TR will be on a straight line with constant slope = MR.


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Marginal Revenue = Marginal cost Max profits will occur at MC = MR, Profit = TR –

TC. ΔProfit/ΔQ = ΔTR/ΔQ – ΔTC/ΔQ = MR – MC.

That equation tells us that profit will increase (ΔProfit/ΔQ > 0) if MR > MC.

Profit will stop increasing (ΔProfit/ΔQ = 0) when MR=MC

And profit will begin to decrease (ΔProfit/ΔQ < 0) after that point when MC > MR.

Then, we have the MR=MC Rule which says that maximum profits or minimum loss will occur at the point where MR=MC.


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Competition and Policy In chapter 4, we saw that lack of competition

can lead to market failures that result in inefficient outcomes.

On the other hand, perfectly competitive markets will lead to maximum efficiency.

In that regard, governments around the world have devoted much regulation and legislation to promote efficiency by encouraging competition and to discourage anti-competitive behavior through legal and financial penalties.


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Chapter 7: Perfect competition The SR supply curve of a firm will

ultimately be its marginal cost curve, and the industry supply will be the sum of them.

A firm will be able to stay in business when revenues are at least equal to costs, or zero economic profit or above.

If profits are above ZEP, other firms will enter; if they fall below, firms will leave, and prices will be bid up to normal (ZEP).


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Chapter 7: Perfect competition In the long run all suppliers will have

either exited or moved to the minimum on the LR ATC curve, and there will be an intersection of all curves. (See slide below.)

The LR supply curve will depend on the type of industry, decreasing cost as industry grows, flat costs or increasing costs: down, horizontal, upward sloping.


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A Typical Firm in Long-run Equilibrium P = MR = SRMC = SRATC = LRAC. In LR equilibrium, firms will operate at the

minimum of LRAC.

SRMCSRATC

LRAC

MR

Entry/ExitOf Firms

Zero LREconomic Profits

Long-RunEquilibrium

Causal Chain


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Mod 4: The macro economy

Chapter 11: Measuring the economy National income accounting measures

aggregate numbers of economies. One popular measure of aggregate economic

activity is GDP, which is all the new production made inside a country for final users.

There are many other accounts. It uses the concept of value added so as not

to count intermediate goods that go into some other final good, like CPU’s that are put into computers.


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4-Sector ModelProduct Markets

Factor Markets

Supply

Supp

ly

Businesses

$ Dem

and $

Demand

HH

G&S

Dem

and

Factor Payments

Factors:

Government

Financial markets

ForeignEconomies

$ paidimports

$ paid exports

Fixed &

inven

tory

investmen

t

Consumption

expend

Surplus Deficit

Net taxes

SavingsBorrow to invest


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Chapter 11: Measuring the economy One common way to measure GDP is the

expenditure approach. It adds up C, I, and G spending on all products, then, adds X to other countries and subtracts out M because some of the spending was on imports. GDP = C+I+G+(X – M).

Shortcomings of GDP it misses non-market and illegal transactions, quality, distribution, neglect of leisure time, and economic bads.

GDP must be adjusted for price changes, GDP-deflator, to get output, real GDP: nominal GDP = Price index x real GDP.


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Chapter 12: Cycles and growth. There is the long-term trend of growth of an

economy and the shorter-term cycle around the trend: the business cycle.

The 4 phases of the cycle are peak, recession, trough, expansion.

We look at indicators of activity: leading, lagging and coincident, to find out where we are in a cycle.

Changes in total spending, AD, determine business cycles. Also supply shocks can do it.


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Chapter 12: Cycles and growth. Then the GDP gap is the difference between

actual and full-employment real GDP. The aggregate production function is the

output per worker versus quantity of production factors per worker.

Factor accumulation and technological change determine LT growth.

Savings is used to pay for investment. There is a perfect savings rate that leads to the perfect amount of capital, called the golden rule.


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Golden rule in a nut shell

The PPF (capacity to produce) can expand only through producing more capital goods.

S is used to buy I; S comes out of DI and means less C.

Capital goods wear out and need to be replaced, so some capital spending is for replacement.


Golden rule in a nut shell

There will be a maximal capital/person to make a maximal productive capacity.

We need enough S to get to the level of capital accumulation per worker and maintain it through all the wearing out.

That maximal amount of capital that needs replacement each year as it wears out is the golden rule amount of capital leading to the golden rule savings rate.


Chapter 12: Cycles and growth. The Solow model of growth says we need

more factors of production per person to grow.

It assumes that technological change comes from outside the system.

The exogenous growth model adds technology growth as a result of development of a knowledge base within the framework of the economy.


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Chapter 12: Cycles and growth. Suggestions for macroeconomic policy

include trying to dampen cycles. The reason is that unemployment increases in downturns, and inflation tends to increase in upturns.

Pursue policies that allow an economy to achieve its highest potential LT growth. That will also entail microeconomic policy measures.


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Chapter 13: Inflation & unemployment So, lets look more closely at inflation and

unemployment, two big concerns of people and their governments.

There are a number of inflation measures, like CPI.

Since aggregate inflation measures use an average consumer basket of G&S they will be imperfect for all cases. There is no accounting for quality. Unchanged weightings ignore demand changes with price changes of substitutes.


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Chapter 13: Inflation & unemployment Inflation shrinks purchasing power of income

but it can increase wealth in investment assets, like real estate, stocks, and art, which tend to increase at paces faster than inflation, so those without much wealth suffer the most.

Interest rates are, in fact, composed of a real rate plus inflation (plus other factors that depend on risk, and length of maturity of the investment).

The largest factor in investment, I, is interest rate, and the inflation part, when it is high and volatile discourages business and HH investment.

Inflation can be demand pull or cost push.


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Cost-push & Demand-pull Inflation


PriceLevel

Real GDP

AD1

AS

AD2

Q1 Q2

P1

P2

Cost-push Demand Pull

The important thing to talk about when talking about graphs like these is that a curve moves and there is a new intersection, equilibrium.

Chapter 13: Inflation & unemployment Unemployment is not a simple definition,

either. There are seasonal variations, like farm

workers or people who work at winter resorts.

Frictional unemployment has to do with imperfect information leading to temporary job-personnel mismatching. People either must or want to change their jobs.


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Chapter 13: Inflation & unemployment Structural unemployment has to do with

evolution of the economic system and society: things change, and there is no longer need for certain jobs, like horse-carriage drivers. We need newer things like a person who can do maintenance on robots.

Cyclical unemployment is the variation over recession and expansions. When the economy is good, more businesses hire; when it is bad, they fire.


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Chapter 13: Inflation & unemployment Then, full employment is defined,

practically, as employment with seasonal, frictional and structural but without cyclical unemployment, as the putative zero unemployment rate.

Full employment is also known as the natural rate of unemployment or non-accelerating inflation rate of unemployment (NAIRU), and it will change over time.

Things that can change the full employment unemployment rate are changing composition of the workforce, the interaction of tax and welfare systems, and hysteresis.


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Chapter 13: Inflation & unemployment Hysteresis just means that the full

employment unemployment rate changes with changes in employment.

When the economy comes out of recession, for example, the insiders bid up wages to the point that the company cannot afford as many new people as it could at the end of the last peak.

On the other hand, when people sit around unemployed their skills dull, and it might be hard to get a job when things pick up.


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Mod 5:Macroeconomic Analysis

Chapter 14: simple macro model Classical macroeconomic thinking was

dominated by Say’s Law, which said that supply creates its own demand: production creates just enough income to purchase it all.

It is based on the assumption that all prices, including wages, are flexible, so that if it didn’t work out, prices would drop, the aggregate market would clear, and everyone would remain employed.

Keynes put emphasis on the demand side and said that aggregate expenditures = C+I+G+(X – M) might not be enough for full employment.


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Chapter 14: simple macro model C and I are the major parts. C is more

stable because people tend to maintain their lifestyles.

C depends on DI, personal income after tax, which is split into C+S. C and S are determined by MPC and MPS.

Non-income factors that affect C are expectations, wealth, the price level and interest rates.


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Chapter 14: simple macro model The 2 main factors affecting I are expectations

of future returns and interest rates. Other factors include technological change, capacity utilization, and taxes.

G are autonomous expenditures, not varying in a systematic way, depending on political decisions.

G is a crucial in the Keynes policy prescription, in that the government can use its expenditures to kick start the economy and ride on the multiplier effect for its expenditures.


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Chapter 14: simple macro model X an M are affected by external economic

conditions and internal, respectively, and both are also affected by exchange rates and terms of trade.

At any given time, firms will be offering a quantity of their products, based on their expectations of demand, at certain prices that they feel will be accepted and that will earn them a reasonable profit. This is AS.

The willingness to purchase G&S is AD.


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Chapter 14: simple macro model If AD is not big enough to take AS, then,

firms will experience unintended inventory accumulation, and AS will be adjusted for the next period.

Keynes believed that, at least when an economy is operating below full employment, that changes in the equilibrium will be change in employment, not a drop in prices and remaining unemployment.


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Chapter 14: simple macro model Keynes believed that prices are sticky,

especially labor. It is easier to lay off workers than to ask them all to take a pay cut.

The Keynes cure for that state is for government to increase spending to start the economy out of recession.

The spending increase in G is enhanced by a multiplier effect: the initial earnings get re-spent, and re-spent, and re-spent… and add to demand, so a little government spending can go a long way to increasing overall AD.


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The Keynes Cross The AD line crosses the 45o-angle line, Y = RGDP =

Output: AD=output. The multiplier effect makes output increase by more

than the initial addition to spending.

45o

AD

Agg

rega

te D

eman

d

Real GDP

AD

∆Output

ΔAD


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Chapter 14: simple macro model The downward sloping of AD, real GDP

versus price level, is for different reasons than a market’s demand curve.

The real balances (wealth) effect, interest rate effect and net exports effect affect C, I and X – M, respectively, and cause AD to slope down.

Non-price level determinants of any of the components will shift AD.


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Chapter 14: simple macro model AS can shift from resource costs,

technology, tax/subsidies, and regulations, which change production costs.

In the mid-range, cost push inflation is shift left of AS, while demand pull inflation comes from right shift of AD.

We can then look at interactions of changes in AD and AS. The business cycle is shifts of AD and AS over time.

AS meets AD in the next slide.


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Changes in AD-AS Equilibrium

Fullemployment


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Chapter 15: monetary of financial system Money has changed from things like beaver

pelts, seashells and precious metals (commodity money) to paper fiat money over the last several thousand years.

To be money, a thing must have the following features: store of value, medium of exchange, and unit of account.

It must have liquidity and be accepted by everyone for any transaction

Other desirable features are scarcity, portability, and divisibility.


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Chapter 15: monetary of financial system Demand for money is formed from:

transactions, precautionary and speculative motives.

Demand is inversely related to interest rates.

When interest rates go up, people will want less money: those who have extra will invest it in bonds, for example, and some who need to borrow will not because rates are too high. And conversely.


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Chapter 15: monetary of financial system Money supply definitions are numerous

and have some variation depending on where you get the definitions.

The RBA makes money, and banks and the RBA, together, create more.

The money base is currency in circulation plus bank deposits at the RBA.

M1 is currency in the hands of the non-bank public plus checking account deposits at banks.


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Chapter 15: monetary of financial system M3 adds all other bank deposits of the

non-bank public plus M1. Broad money is M3 plus the public’s

deposits at NBFI’s less currency and bank deposits of NBFI’s.

The equilibrium interest rate is where MD meets MS, and MS is fairly well fixed, but can be changed by the RBA and banks.


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MS meets MD & causal chains

Shortage

Surplus

Excess Money Demand

ExcessMoney Supply

People buy bonds

PeopleSell

Bonds

Bond priceFalls

Rates rise

Bond pricesUp

Rates fall

MD MS


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Chapter 15: monetary of financial system Thus, the government can affect supply,

which affects interest rates. Interest rates affect the quantity of money

demanded. I is affected. Thus, AD is already affected.

When new equilibrium comes between changed AD and stationary AS, prices and/or employment might be affected.

We show causal chains and graphs in the next few slides.


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The Causal Chain

Change inMoneyPolicy

Change inMoney Supply

Change inInterestRates

Change inInvestment

Change inAggregate

Demand

Change inPrice, GDP,Employment


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Graphical ChainsMS Investment vs. Rates

Real GDP vs. Price level


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The Australian financial system. At the base is the RBA, which is in charge

of system stability, monetary policy, and the payments system (ESA’s). It also acts as banker for the government.

Banks are plugged into the RBA. They have capital and liquidity requirements, but they can create money through fractional reserve banking, which was invented by goldsmiths, along with the first paper money several hundred years ago in Italy.


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The Australian financial system. They are used by the RBA to change MS

through open-market operations. They are also financial intermediaries for other intermediaries: NBFI’s.

There are also a few other types of financial companies, like money market funds and registered financial corporations.

Those are financial institutions.


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The Australian financial system. Then, there are financial markets where

ST MM instruments are traded, inter-bank or wholesale, stocks (corporate equity certificates), bills (short-term debt certificates), and bonds (LT debt certificates) are brought to initial market and traded (secondary market).

The foreign exchange markets deal with the supply and demand for AUD versus other countries’ currencies.


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The Australian financial system. Financial and foreign exchange markets

are all about allocating savings to investment and laying off risk. Financial futures allow for further risk reduction.

The final layer of risk reduction and speculation mechanisms in the system are options, which are the right but not the obligation to buy or sell something at a given price by a specific future date. They allow protection with the ability to profit if things go the other way.


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Mod 6: Macroeconomic Policy

Chapter 16: monetary policy Monetary policy, managing the

money supply, will try to have a stable currency which comes with low inflation, stable economic growth, and low unemployment.

In Australia, the RBA has a stated goal of keeping inflation in the 2-3% range, expecting the rest to follow.


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Chapter 16: monetary policy It achieves that goal by setting

targets for the overnight, inter-bank cash rate that it wants the markets to obey, or it will assist through open market operations to change MS to get its target.

It has been found, through international experiment, that it is easier to set or target rates than to manage MS.


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Open market operations

RBA

Banks

Public

RBA sells Securities; banks

Buy; bank deposits at RBA decline

Banks have more moneyThey increase loans

Interest rates decline

Banks have less moneyThey decrease loansRaise interest rates

RBA buysSecurities; banksSell; deposits at

RBA increase


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Chapter 16: monetary policy The Keynes view of policy is an

active role. The assumption of monetarists is

that money velocity is predictable when it has been changing, in reality, due to financial deregulation and innovation over the past 30 years.

Money velocity is how many times the same dollar bill gets used in transactions in a year.


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Chapter 16: monetary policy Monetarists argue that it is better to stick

with target growth of the money supply and not get involved with micro-management because time lags might lead to the wrong thing at the wrong time, timing-wise.

The differences between what Keynesians and monetarists believe about policy transmission is shown in the next slide.


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The Causal Chain: monetarist vs. Keynes

Change inMoneyPolicy

Change inMoney Supply

Change inInterestRates

Change inInvestment

Change inAggregate

Demand

Change inPrice, GDP,Employment

Monetarist Chain Short circuit

Extended, Keynes Route


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AD-AD response example Suppose that the RBA tightens credit. Then, AD will shift left, as shown, below.

Real GDP vs. Price level

AD1

AD2


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RBA in FX Because the AUD is free floating, the RBA

no longer has need to be too involved in the FX markets.

It will however engage in smoothing operations, when the markets are excessively volatile or testing, if it thinks that there is too much speculative pressure on the AUD.

Operations in the FX markets can also have an affect on MS.


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Chapter 17: Fiscal policy Governments are needed by society, at least

for the creation of public goods and services (public works).

So, to pay for those expenditures, it needs revenues.

That is basically the beginning of fiscal policy. Then, there is discretionary fiscal policy is

supposed to be used to influence the economy.

Governments can use taxes, subsidies, or spending to affect economic activity.


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Chapter 17: Fiscal policy If a government uses G to affect the

economy, there will be a multiplier effect of, theoretically, AD = G/MPS. If it uses taxes, the affect will be AD = MPCDI/MPS.

To get the whole multiplier amount in actual change in equilibrium AS meets AD, we must be in the flat range of AS.

If we are in neo-classical, it will be part increased RGDP and prices; if in the classical, increased AD will just get increased prices.


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Chapter 17: Fiscal policy Since governments often spend more than

they take in in revenues, they can run budget deficits, which has brought many people around the world to make governments act more fiscally responsible and balance their budget.

Still, even a balanced budget can affect the economy, but when we combine changes from taxes and spending, from above, we get a balanced budget multiplier of 1.


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Chapter 17: Fiscal policy Since taxes and spending, like

unemployment and welfare benefits will automatically experience some changes in the business cycle, some counteractive fiscal policy to moderate the business cycle is built in.

Beyond that, some governments build in more, in automatic stabilizer policy to specifically to counteract some of the affects of ups and downs of the cycle.

An alternative approach to the demand-side policy from above, there is supply-side theory.


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Chapter 17: Fiscal policy Supply-siders do things to foster growth of

supply by cutting regulations, contributing to R&D for technological development, helping to reducing costs of resources, decreasing taxes on income and investment, and other subsidies.

Then, more quantity will be supplied at every price, AS moves right, and the intersection with demand will be at higher real GDP and lower prices.

Other things governments can do are use GST to tax consumption rather than income, which encourages workers and savers.


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Chapter 17: Fiscal policy It can create job networks to fight

unemployment. Domestic debt held by domestics is just

money out of one pocket into another. Government spending should focus on

accumulating public capital, that way the debt is balanced against assets of the people.


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Lecture

End of lecture part. Read the summary at home; it will

help. The description of the final exam is at

the back of the slides along with review scheduling.


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In sum

Summary Economics is based on psychology, logic

and a little math. Scare resources must be allocated. There

are financial and opportunity costs. The PPF shows the possibilities for

allocation to the supply side. People want, so producers produce to

satisfy them and make a profit to satisfy themselves. Consumers have sovereignty, and they have decreasing marginal utility for things.


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Summary We look at psychology for the underlying

behavioral motivations of people in economic circumstances as buyers or sellers.

We use logic to set up causal chains, so that we can imagine the chain of events that relate one thing that happens in an economy to ultimate logical outcomes. Thus, we develop logical relationships among variables.


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Summary We use math to characterize those logical

relationships as best we can. Indeed, we rely mostly on graphical analysis as the mathematical framework. Actual equations are so complicated as too be next to impossible, in many cases, anyway.

For example, imagine trying to find the demand schedule for hotdogs in New York City. We would have to survey several million people or some representative sample of people, ask them how many hotdogs they would buy at various prices, and in the end, would we really know the demand?


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Summary We looked at supply and demand in markets

as means of allocating the resources in. Elasticity measures how demand and supply

change with various variables, which is a good thing to know for producers.

Diminishing returns leads to marginal product that peaks, leads to MC curves that cut ATC at the minimum and become supply curves.

Then, MC=MR is where supply meets demand.


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Summary We apply these concepts to the aggregate

economy, using different psychology, and analyzed AD, AS, MD, and MS. An we also look at the ancillary affects: inflation and unemployment, which are important variables to society.

We looked at how markets can fail and how governments try to get involved in them. They can use tax, subsidy, public goods, and regulation to do things and to change things in individual or more general markets.


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Summary We finished by looking at how else the

government becomes involved in the more general economy.

It makes and controls the money, which is used as the means to effect transactions in an economy, so it has monetary policy that can affect money supply, interest rates, and the general economy.

Fiscal policy can be used to have government expenditures and taxes that promote effective use of economic resources to make good growth with low inflation and unemployment, and accumulate public capital.


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Marginal summaryMarginals

Marginal utility

Marginal cost = marginal benefit

Marginal product (MP)

Marginal cost (MC)

Marginal revenue (MR)

Marginal propensity to consume/save

Decreasing marginal utility

Market exactly clears

Decreasing marginal product

Inversely related to MP

Demand curve for perfect competition

% extra DI spent and saved

Law of Demand

Equilibrium of S&D

Law of Diminishing returns

Above AVC it is the supply curve

MC = MR for max profits

Used in multiplier for G and tax cuts


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Examination The final examination will consist of one, two hour

paper requiring answers that draw from the study material, text and assessments. It will contain three sections; multiple choice questions, short answer questions and extended response type questions, with the following breakdown of marks.

Structure of the final examinationQuestion type Number of questions Weighting

Compulsory multiple choice

20 25%

Compulsory short answers 3 15%

Extended response questions

2 (of a possible 4) 30%


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Examination Please note: the format of the examination will be

similar to that of past years. However, compared to previous examinations, there will be fewer questions and the time allowed has been reduced to two hours.

Sample questions will be provided on the course home page on USQStudyDesk.

Past examination Copies of past examination papers and suggested

answers can be found on the course home page via USQConnect study desk.


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13: final review intro econ

Documents

mattolic red hill capital

capital goods

capital equipment

new capital

allocation of scarce

overviewbecause resources

production possibilities

consumer goods