ECON 202 - MACROECONOMIC PRINCIPLES

Instructor: Dr. Juergen Jung

Towson University

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Disclaimer

These lecture notes are customized for the Macroeconomics Principles 202course at Towson University. They are not guaranteed to be error-free.Comments and corrections are greatly appreciated. They are derived fromthe Powerpoint c© slides from online resources provided by PearsonAddison-Wesley. The URL is: http://www.pearsonhighered.com/osullivan/

These lecture notes are meant as complement to the textbook and not asubstitute. They are created for pedagogical purposes to provide a link tothe textbook. These notes can be distributed with prior permission.

This version was compiled on: August 31, 2016.

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Chapter 2-4: MicroeconomicReview

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Topics - Micro Review

What is EconomicsApply the Principle of

Opportunity CostMarginal PrincipleVoluntary ExchangeDiminishing ReturnsReal-Nominal Principle

Specialization and TradeDemand and SupplyMarket Equilibrium

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Factors of Production

The resources used for production are called factors of production:

Natural resources

Labor

Physical capital

Human capital

Entrepreneurship

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Production Possibility Frontier

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PPF

A curve that shows the possible combinations of products that aneconomy can produceProductive resources are fully employed and efficiently used

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PPF

When the economy is at point e, resources are not fully employedand/or they are not used efficiently

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PPF

A Point to the right of the green curve is desirable because it yieldsmore of both goodsBut it is not attainable given the amount of resources available

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PPF

To increase the amount of farm goods by 40 tons, we must sacrifice350 tons of factory goods: move from b → c

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PPF

The PPF curve is bowed out because resources are not perfectlyadaptable to the production of the two goods →As we increase theproduction of one good, we sacrifice progressively more of the other

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Increasing Opportunity Cost

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Expansion of PPF

An increase in the quantity of resources or technological innovation inan economy shifts the production possibilities curve outward

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Basic Principles

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Opportunity Cost Principle

The opportunity cost of something is what you sacrifice to get it

You calculate the opportunity cost of something by picking the bestalternative to it

The principle of opportunity cost also explains why the productionpossibilities frontier is negatively sloped

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Marginal Principle

A small change in one variable is called a marginal change: ∆y (deltay) or y ′

Marginal Benefit (MB): is the extra benefit resulting from small (oneunit) increase in an activity

Marginal Cost (MC): is the extra cost resulting from a small (one unit)increase in an activity

The Principle → Increase/decrease the level of an activity until

MB = MC

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Marginal Principle

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Principle of Diminishing Returns

Example:1 copy machine and 1 worker produce 1000 pages

1 copy machine and 2 workers produce how many pages?

1 copy machine and 100 workers produce how many pages?

As we increase the number of workers and hold the number of copymachines constant output per additional worker decreases

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Principle of Voluntary Exchange

A voluntary exchange between two people makes both people better off

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Percentage Change

Percentage change =(

absolute changeinitial value

)×100

%∆ = (new−old)old × 100

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Real vs. Nominal

Nominal valueThe face value of an amount of money

Real valueThe value of an amount of money in terms of what it can buy

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Example of Real vs Nominal

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Markets

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Markets

A market is an arrangement that allows buyers and sellers to exchangethings → trading what they have for what they want

Markets determine the price of goods and services purely by bringingtogether people who act in their self interest

The invisible hand (Adam Smith, 1776, The Wealth of Nations)“It is not from the benevolence of the butcher, the brewer, or the bakerthat we expect our dinner, but from their regard to their own interest.We address ourselves, not to their humanity but to their self-love, andnever talk to them of our own necessities but of their advantages. [Manis] led by an invisible hand to promote an end which was not part of hisintention . . . . By pursuing his own interest he frequently promotes thatof the society more effectually than when he really intends to promote it.”

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Specialization and Comparative Advantage

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Comparative Advantage vs Absolute Advantage withWeekly Output

Comparative AdvantageThe ability of one person or nation to produce a good at a loweropportunity cost than another person or nation

Absolute advantageThe ability of one person or nation to produce a product at a lowerresource cost than another person or nation

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Gains from Voluntary Trade

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Efficiency Idea of Market Economies

Competitive markets are (Pareto-)efficient

Positive economics answers the questions:What is orWhat will be?

Normative economics answers the question:What ought to be?

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Specialization

In his 1776 book, An Inquiry into the Nature and Causes of the Wealthof Nations, Adam Smith noted that specialization actually increasedproductivity through the division of labor

1 Repetition

2 Continuity

3 Innovation

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Market Failure

Market failure happens when a market doesn’t generate the mostefficient outcome

There are several sources of market failure and possible responses bygovernment.

ExternalitiesPublic goodsImperfect informationImperfect competition

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Demand - Supply

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Consumer Demand

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Individual and Aggregate Demand

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Demand Shifters

What affects consumer demand?1 Price of the product2 Consumer income3 Price of substitute goods4 Price of complementary goods5 Consumer tastes and advertising6 Consumer expectations about future prices

Item 2 to 6 are held constant in the demand scheduleHolding 2-6 constant the demand curve is downward slopingThat is, as prices increase, demand goes down

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Prices Changes

Income effect

Substitution effect

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Supply Curve

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Aggregate Supply

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Supply

Sellers decisions are influenced by1 Price of the product2 Cost of the inputs used in production (e.g. wages, cost of electricity,

etc.)3 State of production technology4 Number of producers in the market5 Producer expectation about future prices6 Taxes or subsidies from the government

2-6 are supply shifters

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Market Equilibrium

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Market Equilibrium

When the quantity of the product supplied equals the quantity of theproduct demanded, this is called a market equilibrium

Excess demand causes prices to rise

Excess supply causes prices to drop

In equilibrium there is no pressure to change the price

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Market Equilibrium

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Price Increase

As prices increase two things will happen,Fewer goods are demanded as the market moves upward on the demandcurveMore goods are supplied as the market moves up the supply curve

Hence the gap between quantity demanded and supplied narrows

Price continuous to rise until excess demand is eliminated

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Excess Supply

Excess supply causes prices to dropProducers are willing to sell more than consumers are willing to buyTo sell the extra goods firms lower pricesThe market moves downward along the demand curve as prices dropThe market moves downward on the supply curve

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Market Effects of Demand Changes

What shifts the demand curve to the right?1 Income increase (given it is a normal good)2 Increase in price of a substitute good3 Decrease in price of a complementary good4 Increase in population5 Shift in consumer tastes6 Favorable advertising7 Expectations of higher future prices

The effect is an excess demand → prices go up

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Change in Price vs Change in Demand

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Change in Price vs Change in Demand

A change in price causes a change in quantity demanded, a movementalong a single demand curve

For example, a decrease in price causes a move from point a to point b,increasing the quantity demanded

A change in demand caused by changes in a variable other than theprice of the good shifts the entire demand curve

For example, an increase in demand shifts the demand curve from D1 toD2

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Types of Goods

Normal GoodA good for which an increase in income increases demand

Inferior GoodA good for which an increase in income decreases demand. Goods with amore expensive alternative

SubstitutesTwo goods for which an increase in the price of one good increases thedemand for the other good

ComplementsTwo goods for which a decrease in the price of one good increases thedemand for the other good

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Market Effects of Supply Changes

Supply increases , shifts to the right, if1 Decrease in inputs costs2 Advance in technology3 Increase in the number of producers4 Expectations of lower future prices Subsidy.

As supply shifts to the right, excess supply → prices drop.

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Demand and Supply Shifts

When both, demand and supply increase, then the quantity ‘traded’increases

The new price depends on the magnitude of supply change vs. demandchange

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Demand and Supply Shifts

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The Short-Run

Is the time period over which one or more variable are fixed (wages,factors of production etc.)

In the long run most variables are flexible

In the long run, more photo copy machines would be acquired and wewould not see diminishing returns to labor

Since firms can duplicate or replicate production facilities

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