economics student handbook

IFY Economic Studies

Student Handbook

Composed By

Dr Stephen Byrd PhD, MBA, FITOL, FICM

Economic Studies Student Handbook

of 406 Dr Stephen Byrd PhD MBA FICM FITOL

Week Topic 5th

Edition 4th

Edition

1 A: The Economic Problem

Positive and Normative Economics

1

4

1

B: Economic Systems 37 2, 41-43

C: Production Possibility Frontier 1 1

2 F: Determination of Demand 5 4

H: Determination of Supply 6 5

3 J: Price Determination in the Market System 7 6

K: Interrelationship between Markets 8 7

4 G: Price Elasticity of Demand 9 8

I: Price Elasticity of Supply 10 9

5 L: Market Failure 14 16, 17 11, 16, 21

M: The Functions of Price 13 15

6 D: Externalities 15 19-20

E: Cost Benefit Analysis 58 22

7 N: Production in the Short Run 38, 39 (Pp.

271-275),

40, 41

46-48

8 O: Objective of Firms 42 50, 52

9 P: Production in the Long Run & Economies

of Scale

39 (Pp. 275-

279) 49

10 Q: Growth of Firms 55 64

11 Market Structures

R: Perfect Competition

43

44, 53

53

12 S: Monopoly 45, 54 18, 54

13 T: Oligopoly 47, 48 56

14 Revision

15 TERM 1 END OF SEMESTER EXAM

Notes to Students:

All reading should be completed before the Week number listed.

The weeks may change, but you will be informed well in advance



ECONOMICS – the science that deals with the production,

distribution and consumption of goods and services, and with the

theory and management of economies or economic systems

BASIC ECONOMIC PROBLEM: Resources = scarce; wants =

unlimited

FREE GOODS – resources available in unlimited quantities

ECONOMIC GOODS – resources are limited in quantity –

SCARCITY

Production Possibility Frontier (PPF)

(Also called PPCurve, PPBoundary, Transformation Curve)

PPF = the different combinations of goods which can be produced

if all resources are fully and efficiently used.

ECONOMIC RESOURCES – FACTORS OF PRODUCTION

LAND – also includes natural resources on, below, above

and sea

o NON-RENEWABLE RESOURCES – coal, oil, gold, etc

which will never be replaced

o RENEWABLE RESOURCES – forests, soils, water, fish

LABOUR – The working force of an economy (Western

economies – very scarce, due to people and cost)

CAPITAL – all resources used in the production of goods

and services, i.e. machines, materials, offices, factories,

roads, etc.

o WORKING or CIRCULATING CAPITAL – raw

materials, semi-manufactured and finished goods:

circulate throughout an economy until they reach the

final consumer



o FIXED CAPITAL – factories, offices, machinery, roads

and bridges, etc

ENTREPENEURS – Individuals who organize companies to

produce goods and services, take related risks (different

from ord. workers)

GENERAL LABOUR – individuals; small firms. Workers do all

jobs.

Features:

Convenient;

complete;

takes higher levels of knowledge

As technology progresses:

work may become too complicated

require too high a level of education/training

if large equipment required, may be inconvenient and

inefficient

materials or processes may be too far away

SPECIALISATION – Labour tasks are divided

Advantages:

higher level of skills, smaller range;

cost effective to provide special tools;

efficient way to produce more, using more people;

workers can do the work they are best suited to;

Disadvantages:

boring;

feeling alienated from the process, management

Example: Ford Motor Co.

OPPORTUNITY COST – relates to choices and lost opportunities;

the value of the next best choice given up in making a choice



Normative statements

Contains a value statement or opinion

Whether something is desirable (good) or undesirable

(bad)

Positive statements

Indicates a fact

Shows no opinion about whether something is good or

bad



1 An economy can produce both agricultural goods and manufactured goods. It faces the

production possibility curve A* M* shown in the diagram. What would most satisfactorily explain a change production from (A1, M1) to (M1, A2)?

[1]



Microeconomics – Basic

1 An economy can produce both agricultural goods and manufactured goods. It faces

the production possibility curve A* M* shown in the diagram. What would most satisfactorily explain a change production from (A1, M1) to (M1, A2)?

[1]



Economic Systems

ECONOMY: a social organization making

decisions about:

WHAT is to be produced; HOW production is organized and run;

and

FOR WHOM the production takes place

Planned or Controlled

Market Economy

Actors: Government,

Consumers, Workers

Actors: Consumers, Producers, Owners

of Private Property, and, the Government

Motivation: For the common good

Motivation: Individuals maximize personal gain or utility; Producers to

maximize profits; Gov’t maximize social

welfare

All Factors of Prod’n, except the workers are

owned by the State

Most Factors of Prod’n owned by individuals; Gov’t to protect their rights

and interests

All resources allocated by the State –

“Planning Mechanism”

Free Enterprise: All businesses are free to buy / sell at ? Workers can work

where they want. People can open their

own business. Consumers buy as they like and can afford.

Competition: None Competition: People choose to buy

where they like. Businesses are forced to respond.

Mixed Economy Resources allocated both by government

through the planning mechanism; and, by private sector through

market mechanism

Economic Systems

ECONOMY: a social

organization making

decisions about:

WHAT is to be produced;

HOW production is organized and run;

and FOR WHOM the production takes

place



Planned or

Controlled

Market Economy

Actors: Government, Consumers, Workers

Actors: Consumers, Producers, Owners of Private Property, and, the Government

Motivation: For the

common good

Motivation: Individuals maximize

personal gain or utility; Producers to

maximize profits; Gov’t maximize social welfare

All Factors of Prod’n,

except the workers are owned by the State

Most Factors of Prod’n owned by

individuals; Gov’t to protect their rights and interests

All resources allocated

by the State –

“Planning Mechanism”

Free Enterprise: All businesses are free

to buy / sell at ? Workers can work

where they want. People can open their own business. Consumers buy as they

like and can afford.

Competition: None Competition: People choose to buy where they like. Businesses are forced to

respond.


through the planning mechanism; and, by private sector through market mechanism



Companies’ (or individuals’) actions have costs + effects, both

within the companies and outside. SOCIAL COSTS = the total of

all those costs.

PRIVATE COST = the cost to the company.

EXTERNALITY or SPILLOVER EFFECT = the outside effect of

activities

EXTERNAL COST or NEGATIVE EXTERNALITY = bad effect, i.e.

pollution

EXTERNAL BENEFIT or POSITIVE EXTERNALITY = benefit, i.e.

inoculation

Prices and costs generally do not reflect the effects of

EXTERNALITIES.

Government intervention:

Regulation: i.e. Gov’t rules on how much pollution allowed. Easy

to understand; cheap to implement. But: often difficult to

determine how much should be allowed; do not necessarily

discriminate between different costs of reducing the externalities.

Also, the losers are not compensated and the polluters are free to

pollute up to their regulated allowances.

Extending Property Rights: property rights are not fully allocated.

Effects of externalities can be far-reaching, even to different

countries. Gives those who are injured the right to sue. Gov’t does

not have to try to assess the cost of externalities. Also has

problems: externalities that occur in different countries; degree of

proof required to win in court; fairness of awards vs. perceived

costs to different parties; may take a long time to win.

Taxes: Gov’t assesses the cost to society, taxes the externalities.

Shifts the cost to the consumers.



Permits: Gov’t determines how much of an externality should be

allowed in society, divides those effects into units, then issues

permits which than be traded and sold between companies.

Public Goods: Public goods = consumption by one doesn’t

reduce amount available for another (non-rivalry); no one

excluded from the benefit (non-excludability). Eg: Defence;

judiciary and prison system; police service; street lighting

In Free Market economy, unlikely to be provided by the private

sector.

(Private goods = consume by one, not available for another)

Merit Goods: underprovided by the economy / people think there

should be more available to more people: i.e. health care and

insurance

Demerit goods: overprovided by the economy / people think

there is too much: i.e. drugs; cigarettes; alcohol. Produce

negative externalities

Equity: Free market will not lead to equitable distribution of

resources

This leads to allocative inefficiency – Government intervention:

Direct – government do it; Gov’t Subsidy – costs shared with

consumers



Cost Benefit Analysis

Easy to analyze private costs and benefits

May not be so easy to analyze the costs and benefits of

Externalities

Analyze social (ALL) costs and benefits to assist policymakers in

making economic decisions

Problem: may not be easy to place a value on Externalities

The example: 5 million travelers save 30 minutes, for a cost

savings of 2.5 million hours per year. What is the value of that

time? In UK, in PRC?

Also need to look at Costs and Benefits across time



Market Failures and Externalities

Principle of Economics #7: Governments can sometimes improve market outcomes. Markets

do many things well. With competition and no externalities, markets will allocate resources so as to maximize the surplus available. However, if these conditions are not met, markets may fail to achieve the optimal outcome. This is also known as "market failure".

Externalities

In previous analysis, we assumed that all goods consumed or produced have been private, in the sense that one individuals consumption or production of a good does not affect the other.

When our actions impact on those not directly involved, an externality exists. As one

individual's behaviour increases or decreases, another's satisfaction or profit changes as well. It can have a positive or negative effect on a third-party not directly involved with the buyer or seller of the transaction. These costs (or benefits) are not included in the cost curve faced by the decision makers.

Examples of externalities:

A smoker annoys others with second hand smoke.

A gardener delights a neighbour with his beautiful garden.

A pulp mill pollutes the air and water in town.

A perfume wearer gives a friend an allergic reaction.

Negative Externalities

When economic agents not directly involved, negative externalities can exist, such as pollution.

A free market tends to over-produce the good which produces a negative externality, and under produce those with positive externality. If we include costs borne by everyone, then we get social costs, which are the total costs of production no matter who bears them. We say that the total cost is equal to private costs plus external costs.

Negative externalities result in a lower free-market output. In order to make the market

produce the optimal amount, we must impose a tax. This is called "internalizing the externality", and forces those involved to account for external costs. There are also externalities in "consumption", when consumption has costs for persons other than those actually consuming the product. Examples of these are cigarettes and second-hand smoke, and drinking alcohol and car accidents.

Positive Externalities

Not all externalities are negative. Some create benefits to those not directly involved. Such is the case with "technology spillover", where new inventions benefit those beyond the inventors.

Some have argued that governments should subsidize research and development, since it will

have positive externalities to everyone else. Another method is to allow patents to give monopoly rights to new inventions for a period of time, and encourage such activity. Without this method, there could be an under investment in research. Positive externalities in production means that social cost is less than private cost, and more of the good should be produced than will occur in a free market.

There may also be positive externalities in consumption, such as education. In this case, the social value is greater than the private value



ECONOMICS – the science that deals with the production,

distribution and consumption of goods and services, and with the

theory and management of economies or economic systems

FREE GOODS – resources available in unlimited quantities

ECONOMIC GOODS – resources are limited in quantity –

SCARCITY

An ECONOMY is a social organization which makes decisions

about:

WHAT is to be produced;

HOW is the production to be organized and run; and

FOR WHOM is the production to take place

WANTS and NEEDS

BASIC ECONOMIC PROBLEM: Resources = scarce; wants =

unlimited

ECONOMIC RESOURCES – FACTORS OF PRODUCTION

LAND – also includes natural resources on, below, above

and sea

o NON-RENEWABLE RESOURCES – coal, oil, gold, etc

which will never be replaced

o RENEWABLE RESOURCES – forests, soils, water, fish

LABOUR – The working force of an economy (Western

economies – very scarce, due to people and cost)

CAPITAL – all resources used in the production of goods

and services, i.e. machines, materials, offices, factories,

roads, etc.

o WORKING or CIRCULATING CAPITAL – raw

materials, semi-manufactured and finished goods:



circulate throughout an economy until they reach the

final consumer

o FIXED CAPITAL – factories, offices, machinery, roads

and bridges, etc

ENTREPENEURS – Individuals who organize companies to

produce goods and services, take related risks (different

from ord. workers)

General labour – individuals; small businesses. Each person does

all jobs.

Features:

Convenient;

complete;

takes higher levels of knowledge

As technology progresses:

work may become too complicated

require too high a level of education/training

if large equipment required, may be inconvenient and

inefficient

materials or processes may be too far away

SPECIALISATION – Labour tasks are divided

Advantages:

higher level of skills, smaller range;

cost effective to provide special tools;

efficient way to produce more, using more people;

workers can do the work they are best suited to;

Disadvantages:

boring;

feeling alienated from the process, management

Example: Ford Motor Co.



Production Possibility Frontier (PPF)

(Also called PPCurve, PPBoundary, Transformation Curve)

PPF = the different combinations of goods which can be produced

if all resources are fully and efficiently used.

OPPORTUNITY COST

Demand: The quantity of goods or services that will be bought over a period of time

at any given price

The Demand Curve – Go over

Price: If all else remains the same, as prices rise, people will demand less, and, if

prices go down, people will demand more

Income: As Incomes rise, the demand curve moves outward

Rising prices may shift demand for other (replacement) goods

Other factors that affect the Demand Curve:

Population changes

Changes in fashions and tastes

Changes in laws (seatbelt laws, smoking laws)

Advertising

Demand of Individuals or entire Markets are shown the same way

Market Demand: add together all Individual Demand Curves

CONSUMER SURPLUS – (above price level) The more that is available, the less

value consumers place on it. (A gain to consumers)

Supply: The quantity of goods or services that will be produced and sold over a

period of time at any given price

Price: If all else remains the same, as prices rise, producers will

supply more, and, if prices go down, producers will supply less

The Supply Curve:

Costs of Production: If production cost rises, producer tries to pass on cost in higher

prices to the consumers. Higher prices cause fewer consumers to buy. Reduced



sales and reduced profits cause less producers to produce. So, a rise in costs will

generally cause the Supply Curve to shift up and to the left.

PRODUCER SURPLUS: (below price level) At any given price level,

some firms receive a higher price than the lowest price they were

willing to supply the market

Price of other goods

Goals of sellers change

Government legislation

Future expectations

Price Determination in the Market

Buyers and sellers come together to buy and sell goods, and the

Market Price is “struck”

EQUILIBRIUM PRICE is where Demand equals Supply – where the

Demand Curve and the Supply Curve meet.

If Market Price is below Equilibrium price, Demand exceeds Supply

– EXCESS DEMAND

If Market Price is above Equilibrium price, Supply exceeds

Demand – EXCESS SUPPLY

Changes in Demand and Supply:

Changes in prices lead to movement along the Demand or Supply

Curves. Changes in any other factors will lead to shifts in the

Demand Curve or Supply Curve. These shifts will create a new

Equilibrium Price

Market Clearing: For many different reasons, Market Price very

often does not equal Equilibrium Price – there could be excess

Demand or excess Supply at any time. And, economists cannot

agree on how much markets will tend to move towards market-

clearing prices.



If FREE MARKET FORCES push prices to equilibrium point, this is

called stable equilibrium.

In some cases, FREE MARKET FORCES may not be strong enough

to push price to equilibrium – unstable equilibrium.

Interrelationships in the Markets

So far, Price affected by Supply and Demand – a Partial model.

Now: how events in 1 market lead to changes in another –

General model.

Goods that are used together

(Examples: Mobile phones and SIM cards; DVD’s and DVD

players)

in supply of “A” in quantity demanded for “A” and

a in price demand for “B”, in price

Complementary goods – JOINT DEMAND

Goods that can replace one another

(Examples: Beef or pork; rice or noodles)

in supply of “C” in price and decrease in quantity

demanded in demand for “D” in price of “B”

Substitute Goods – COMPETITIVE DEMAND

Goods needed to produce other goods

(Examples: Cars need steel; bread and cakes need flour)

in demand for finished good “E” in demand for

needed good “F” in price of “F”

DERIVED DEMAND

Goods demanded for 2 or more different uses

(Examples: Land, for housing or growing vegetables; grain,

for feeding animals or making bio-fuel)



in demand for Good “G” for one use in supply

available for and in price of the good supplied for the

different use

COMPOSITE DEMAND

One good supplied for producing 2 different goods.

(Examples: beef and leather both come from cows)

If demand for 1 good rises, the price will rise. Producers will

increase supply of the source product, leading to a rise in

supply of the other product, and price will lower

JOINT SUPPLY

Price Elasticity of Demand

Elasticity = Effect on quantity demanded by a change in price.

Elastic = Change in Price causes a larger change in Quantity

Inelastic = Change in Price causes a smaller change in Quantity

A wide variety of things can affect Elasticity of Demand, but

according to economists, the two factors that most determine

Elasticity are probably:

1. Substitute Goods – more tend to create higher price

elasticity

Noodles / rice, corn, potatoes, etc; if price of noodles

rises a bit, a larger group of consumers shift to rice, corn,

potatoes, etc. So, price elasticity for noodles is high.

Salt has few substitutes – a rise in the price of salt will

have little effect on total demand. Price elasticity for salt

is low.

2. Time – Several times in recent history, the price of oil has

risen sharply. In those times, price elasticity for oil was low

– there was little people could do to replace it. However,

over time, people could change their driving habits, taking



public transportation, buying more efficient cars, causing

demand to fall in response to the higher prices

In general:

Necessities – lower PED; luxury goods – higher PED

Low-priced goods – lower PED; high-priced goods – higher

PED

Price Elasticity of Demand =

Alternative Calculation (percentage not known)

PED =

P. 55 – Table 8.1 illustration

Perfectly Inelastic: No matter price , Demand remains same –

vertical

Unitary Elasticity: Any in price offset by equal and opposite

in demand

Perfectly Elastic: Any amount demanded at that price or less –

horizontal

IMPORTANT: Elasticity along Straight-line Demand Curves can be

different!

Page 57, Figure 8.2 – Elasticity at any given point “B” along a

Demand Curve calculated as follows:

Point A is Perfectly Elastic

Point C is Perfectly Inelastic

Page 57, Figure 8.3

Percentage change in quantity

Percentage change in price

Price

Quantity

Quantity

Price X

Quantity

Quantity

Price

Price ÷

OR

OR

Quantity

Quantity X Price

Price

PED Value Elasticity

-0- Perfectly Inelastic

0–1 Inelastic

1 Unitary Elasticity

1–∞ Elastic

∞ Perfectly Elastic

Distance from “B” to the Quantity axis

Distance from “B” to the Price axis

A = ∞ = Elastic

B = 1 Unitary Elasticity

C = 0 = Inelastic

Pri

ce

Quantity



Income Elasticity of Demand – How demand changes with change

of consumers’ Income?

Cross Elasticity of Demand – How demand for a good changes

with a change in the price of another good?

Substitute goods – a positive Cross Elasticity of Demand. Increase

in price of one leads to increased demand of the other.

(Noodles/Rice)

Complementary goods – a negative Cross Elasticity of Demand.

Price increase in one leads to decrease in demand for the other.

(Sand/Cement)

A final point: Price Elasticity of Demand and effect on spending /

income

Quantity Purchased X Price = Total Expenditure (like income)

For Inelastic products, a rise in prices results in a rise in total expenditure

For Elastic products, a rise in prices results in a drop in total expenditure

An example:

Qty Qty Price TotalDem Price Dem Price Elast.Expend.

5 10 0.5 50

5 10 4 14 0.50 56 % Δ P ≥ % Δ in Q - Inelastic, TE rises5 10 2 14 1.50 28 % Δ P ≤ % Δ in Q - Elastic, TE drops

Original Values New Values

Price Elasticity of Supply – effect a change in Price has on

quantity supplied.

Elasticity of Supply is affected primarily by two factors:

Substitute Goods – Goods that the producer can produce as alternatives

Time – Over time, producers can shift to producing other goods

PES elasticity is analyzed as follows:

I

Q

Q

I X / OR OR

Q

Q X

I

I

Q

Q

I

I

% in quantity demanded of good X

% in price of another good Y

P of Y

Q of X

Q of X

P of Y X OR

Q of X

Q of X / P of Y

P of Y OR

Percentage change in quantity supplied


Price

Quantity

Quantity

Price X OR

Quantity

Quantity /

Price

Price

OR



PES Value Elasticity Response to Change in Price

-0- Perfectly

Inelastic

No response in Supply

0–1 Inelastic Less than proportionate response

1 Unitary Elasticity % in Q supplied = % in Price

1–∞ Elastic More than proportionate response

∞ Perfectly Elastic Producers will supply any amount

at given price

Planned or Controlled Market Economy

Actors: Government,

Consumers, Workers

Actors: Consumers, Producers, Owners

of Private Property, and, the

Government

Motivation: For the common good

Motivation: Individuals maximize personal gain or utility; Producers to

maximize profits; Gov’t maximize social

welfare

All Factors of Prod’n, except the workers are

owned by the State

Most Factors of Prod’n owned by individuals; Gov’t to protect their rights

and interests

All resources allocated by the State – “Planning

Mechanism”

Free Enterprise: All businesses are free to buy / sell at ? Workers can work

where they want. People can open their

own business. Consumers buy as they like and can afford.

Competition: None Competition: People choose to buy

where they like. Businesses are forced to

respond.


through the planning mechanism; and, by private sector through

market mechanism

Companies’ (or individuals’) actions have costs + effects, both

within the companies and outside. SOCIAL COSTS = the total of

all those costs.

PRIVATE COST = the cost to the company.

EXTERNALITY or SPILLOVER EFFECT = the outside effect of

activities



EXTERNAL COST or NEGATIVE EXTERNALITY = bad effect, i.e.

pollution

EXTERNAL BENEFIT or POSITIVE EXTERNALITY = benefit, i.e.

inoculation

Prices and costs generally do not reflect the effects of

EXTERNALITIES.

Government intervention:

Regulation: i.e. Gov’t rules on how much pollution allowed. Easy

to understand; cheap to implement. But: often difficult to

determine how much should be allowed; do not necessarily

discriminate between different costs of reducing the externalities.

Also, the losers are not compensated and the polluters are free to

pollute up to their regulated allowances.

Extending Property Rights: property rights are not fully allocated.

Effects of externalities can be far-reaching, even to different

countries. Gives those who are injured the right to sue. Gov’t does

not have to try to assess the cost of externalities. Also has

problems: externalities that occur in different countries; degree of

proof required to win in court; fairness of awards vs. perceived

costs to different parties; may take a long time to win.

Taxes: Gov’t assesses the cost to society, taxes the externalities.

Shifts the cost to the consumers.

Permits: Gov’t determines how much of an externality should be

allowed in society, divides those effects into units, then issues

permits which than be traded and sold between companies.

Public Goods: Public goods = consumption by one doesn’t

reduce amount available for another (non-rivalry); no one

excluded from the benefit (non-excludability). Eg: Defence;

judiciary and prison system; police service; street lighting



In Free Market economy, unlikely to be provided by the private

sector.

(Private goods = consume by one, not available for another)

Merit Goods: underprovided by the economy / people think there

should be more available to more people: i.e. health care and

insurance

Demerit goods: overprovided by the economy / people think

there is too much: i.e. drugs; cigarettes; alcohol. Produce

negative externalities

Equity: Free market will not lead to equitable distribution of

resources

This leads to allocative inefficiency – Government intervention:

Direct – government do it; Gov’t Subsidy – costs shared with

consumers

Cost Benefit Analysis

Easy to analyze private costs and benefits

May not be so easy to analyze the costs and benefits of

Externalities

Analyze social (ALL) costs and benefits to assist policymakers in

making economic decisions

Problem: may not be easy to place a value on Externalities

The example: 5 million travelers save 30 minutes, for a cost

savings of 2.5 million hours per year. What is the value of that

time? In UK, in PRC?

Also need to look at Costs and Benefits across time

Economic Efficiency and Market Failure



Rvw: 3 Basic Economic Questions: What it produces (goods and

services); How well it produces them; and, For whom it

produces.

Judge an economy by how well it answers those questions.

Efficiency is only achieved

MARKET EFFICIENCY – if producing on the PPF – Competition can

create

For MARKET EFFICIENCY, there must be…

PRODUCTIVE EFFICIENCY – production achieved at the lowest

cost

Can be achieved if there is…

TECHNICAL EFFICIENCY – the maximum quantity of output

(products) with the minimum of inputs (resources)

ALLOCATIVE / ECONOMIC EFFICIENCY – resources used to

produce goods and services that consumers most wish to buy.

STATIC EFFICIENCY – at 1 point in time / allocating resources

differently. Company produce more if it used less labor and more

capital? Country produce more if it reduced unemployment?

DYNAMIC EFFICENCY – effects over a period of time. If a

company distributed less profit and used the money for capital

investment; if an economy directed its resources more to

investment and less to consumption.

MARKET FAILURE / INEFFICIENCY –

Lack of competition in the market

Externalities – actual prices and profits do not represent true …

Information failure – products bought infrequently

Factor (F.ofP.) immobility – products, worker skills, worker

locations



Inequality: Wages; Wealth and its related earnings; Pension

earnings; Other components of income.

The Role of the Market

Adam Smith; An Enquiry Into the Nature and Causes of the Wealth of Nations;

attacked protectionism, economic restrictions, legal barriers

Free market system where the “invisible hand” of the market would allocate resources to

everyone’s advantage

The Actors:

Consumer – all powerful, free to spend, choose to allocate their

resources to maximize their utility

Firms – servants to the consumers, motivated to maximize their

profits (Revenues – Expenses), if they fail…

Owners of Factors of Production – maximize their rate of return on

capital

The Function of prices in the Market

Rationing (explain classic) – Price does it

Signaling – the price does it

Incentives – the Price (demand) (supply)

Maximizing behavior

Judging the Market

Market Stabilization

Price fluctuations (irregular rises and falls) can also lead to market

failure

Prices may be too high, making it impossible for some to buy it

Prices may be too low, causing producers to stop producing

Large fluctuations – may be difficult to identify the “signal”

Price Controls

Maximum pricing (draw curve, price below equilibrium) lead to

excess supply

Minimum pricing (draw curve, price above equilibrium) lead to

excess demand



Buffer Stock Scheme – large fluctuations in commodities

(agriculture or mining products to be resold) come for different

reasons: seasonal, bumper / failed crops; etc. Commodities tend

more inelastic (near vertical curves), so shifts in D or S can lead

to large changes in prices, little change in quantities

Buffer stock scheme has elements of Maximum and Minimum

pricing and deals with the “Supply Side” (later – 2nd term).

Gov’t sets “Intervention Price”

If Market Price lower, Gov’t buys, increasing demand, pushing

up price

If Market Price higher, Gov’t sells, increasing supply, pushing

down price

Taxes – Other actions Gov’t can take:

Indirect taxes – paid to sellers, when

goods are bought

o VAT, Ad Valorem – based on

price

o Excise Tax – based on, charged

per unit

o Tend to reduce Supply, push S

curve up and to the left

Subsidies (money given out by the government)

o Reduces overall producer costs, pushing S curve down, to

the right

S2

S1

D

Consumers

pay

Producers

Indirect Taxes



The amount of tax burden shared by

each side depends on Elasticity (See P.

76, Figs 11.4 & 11.5)

S = Perf Elastic / D = Perf Inelastic –

Consumers

S = Perf Inelastic / D = Perf elastic –

Producers

S1

S2

D

Consumers

Producer

Subsidies



Production in the Short Run

Short Run: at least one Factor of Production cannot be changed

Long Run: all Factors of Production can be changed, technology remains unchanged

Long Long Run: technology changes

Production Function: Formula to calculate Production (output) based on the

amounts of Labour and Capital (inputs) used: Q = L + C

Law of Diminishing Returns: (Short run) excess inputs lead to inefficiency

Total Product: quantity of total output based on given inputs over time

Average Product: quantity of output per unit of input

Marginal Product: addition to output by an extra unit of input

Ss review Table 46.1, Figure 46.1 – each curve declines, first MP, AP, TP

Returns to Scale: What happens in long run, as firms increase all inputs?

Increasing RtoS: Greater efficiency – change input leads to greater TP

Constant RtoS: change input lead to equal increase TP

Decreasing RtoS: lower efficiency – change input leads to lower TP

Total Revenue (TR) = Total Quantity (Q) x Average Price

Average Revenue (AR) = Total Revenue (TR) ÷ Total Quantity (Q)

Marginal Revenue = Additional receipts from selling one additional unit

Cost (in Economics) = Opportunity Cost = materials + owners’ time + earnings on

cash + cost of buildings and equipment + goodwill

Fixed Costs: generally costs of capital, do not change in the relevant range

Variable Costs: materials, other costs, that change with changes in output

Total Cost (TC) = Fixed Cost (TFC) + Variable Cost (TVC)

Average Cost (AC) = Total Cost (TC) ÷ units of output (Q)

Marginal Cost (MC) = cost of one additional unit of output (ΔTC÷ΔQ)

Profits = TR – TC

Review AVC, AFC, ATC, MC (p 322)



Summary

MC, AC curves “U” shaped – bottom is where diminishing returns

set in

MC, AC curves mirror images of MP, AP

When MP starts decreasing (efficiency), MC starts rising

MC crosses the AC, AVC curves at their lowest point (p 322),

where costs are neither rising or lowering, so it should equal the

MC

Objectives of Firms

Control – important to know who controls

Small businesses – single/few owners

Large companies

o Shareholders elect Directors

o Directors appoint Officers/Managers

o May be a separation, with different interests

o Workers with Trade unions

o State through legislation and regulations

o Consumers through organizations

Managerial Theories

Assumes a separation (divorce) between Ownership and control

Owners are interested in the company having profit

Managers interested in their own: working conditions; salaries and benefits;

power; etc. and will work for company’s profit too

Behavioral theories – decision-making by different groups that compete for power.

Each group has its own minimum goals, and they go from there.

Neo-Classical economics – Short-run Profit Maximization

Assumed owners or shareholders most important



Firms may not always have profits. Predicts they will continue to operate as

long as they cover their variable costs

Adjust Prices and Output based on the Market

P 331 – continue to produce, even possibly thru Period 4 – then, Period 5,

would not produce.

Short Run Profit Maximization – Where a firm should produce

Maximum level of profit: where TR–TC is greatest

Add: profit a company expects to make included as a cost: Normal Profit

Abnormal / Economic Profit – profit above Normal Profit

Add in TR to show Break Even Points



P 345 shifts in cost and revenue curves

Rises and falls in the curves / changes profit maximizing levels

Firms don’t do this calculation – but if they’re maximizing profits, they should be at

the level where MR = MC / As long as MR from one unit is greater than MC, they

will produce one more.

Neo-Keynesian – Long-run Profit Maximization

COST PLUS PRICING – average total cost, based on full capacity, plus a

profit.

Assumes consumers do not like frequent price changes

Will continue to produce even with losses



Production in the Long Run

Review: Short Run Cost Curves

AFC downwards

ATC starts moving up where diminishing returns set in

Economies & Diseconomies of Scale and average costs

In long run, all FofP are variable (can add factories, etc)

Draw LRAC Curve –

Long run costs fall as output increases – economies of scale

At some point, LRAvgCost stays the same – constant returns to scale

o The optimum level of production

o The center section of curve

o Minimum Efficient Scale (MES) is the beginning of the lowest point

Later, LRAC’s begin to rise – diseconomies of scale

Sources of economies of scale – Larger companies

Technical Economies / Diseconomies: In production process: can’t use

equipment to maximum efficiency (indivisibility). Also, may be more

productively efficient

Specialization: Employ more specialists – greater efficiency (in small firms,

specialists are an indivisibility)

Buy larger quantities (bulk); use more employees efficiently; etc.

Financial economies: More sources of financing, lower costs

Sources of Diseconomies of scale

Mainly due to problems with management

As firms grow, more difficult for management to control company’s activities –

Centralized / Decentralized

Movements along and shifts in the long run average cost curve

LRAC Curve: boundary, represents the C

Attainable

Output



minimum attainable average costs

Increases in production lead to

movements along the LRAC Curve

Downward shifts in the LRAC Curve caused by:

External Economies of Scale: savings from growths in its industry: better

roads; lower training costs (more qualified workers); gov’t programs, etc

New technologies

Upward shifts in the LRAC Curve caused by:

Taxation

External Diseconomies of scale: generally industries expand too quickly

Relationship between the SRAC and LRAC Curves

Short run – AC fall at first (econ of scale); rise (dim rnts)

Long run – all factors are variable; economies and diseconomies of scale

Growth of Firms

Mergers and the Growth of Firms

LL: ProdInLR: to reach level where EconOfScale SetIn

Large firms: Economies of Scale, or, high barriers to entry.

Smaller firms: lower barriers; operate at MES, lower costs (before diseconomies of

scale, productive inefficiency); offer localized service, etc

No direct correlation between size and efficiency

Reasons for growth:

Take advantage of economies of scale

A better ability to impact its market

Risk reduction

Methods of growth:



Internal Growth

External Growth – Merger; Amalgamation; Takeover – all involve the joining

together of 2 companies

Reasons / Motivations for Merger, Amalgamation or Takeover:

Cost and time – cheaper and quicker – after budgeting the cost for internal

growth, a firm may find stock of a company on the open market

Asset Stripping – Buy large company, keep some assets, sell the rest

Rewards to Management – mergers result in a larger company, quickly, and

often, managers use the chance to improve their compensations

Types of Mergers

Horizontal Merger – 2 firms, the same industry, same stages

Vertical Merger – 2 firms, same industry, different stages

o Forward integration – supplier merging with a buyer

o Backward integration – a buyer merging with its supplier

Conglomerate Merger – 2 firms, different industries

Notes about Mergers

Not clear that mergers increase economic efficiency

Productive efficiency may incr if average costs fall (economies of scale)

But, sometimes the economies of scale are losses of jobs

Allocative efficiency may incr if wider range or better quality product

But, mergers tend to reduce competition in the market

Asset stripping controversial

Perfect Competition

Remainder of 1st term on different models of competition in the market, and how

firms might make decisions under those conditions

Assumptions about Perfect Competition:



Large number of sellers in the market, change

in output of one firm will have minimal effect

on market (draw enlarged Supply/Demand)

Low barriers – easy (freedom) for firms to enter and exit the market

Perfect knowledge – buyers, sellers, about prices (if one firm increases prices, its

demand will go to zero), so firms must accept the market price

Price takers – many buyers, sellers; none big enough to influence market

Homogeneous product – no branding, products are identical

(Relatively few industries like this - agriculture)

So, each seller’s Demand Curve is perfectly elastic – horizontal (=AR=MR)

SRAVC and LRAC are the

lowest points where a Firm

would sell.

In short run, Firm will stay in

business as long as it covers

AVC.

So in the short run, MC

(includes

Normal Profit) above SRAVC is the Firm’s Supply curve

Short run equilibrium is where D = MC

Short run profit maximization – Firm produces at H (along D Curve) and G is

abnormal profit

Long Run Equilibrium – in long run neither losses nor abnormal profits:

Losses: leave the industry (fig 53.7), pushing industry’s S Curve in, left,

increasing prices



If abnormal profits (knowledge fully available), other firms follow, push S

Curve out, right, pushing down prices

Competitive pressures force: no losses, no abnormal profits – equilibrium

AC = MC, (from before) D = AR = MC, (intuitively) MR = MC, so,

AC = AR = MR = MC

In the long run, costs will be the same – perfect knowledge

New technologies, special operating methods will be available to all

Even if high-efficient personnel push down costs, they will demand more pay

So in the long run, costs will remain the same

Monopoly

The only producer / supplier in an industry – IS the industry

Barriers: Government; resources; competitive practices; cost – Natural Monopolies

minimum costs EconOfScale: purchasing; marketing; technical; managerial /

specialization; financial. Examples: telephone; rail; water; etc.

Some monopolies may be regional or local monopolies

Monopolies remain if barriers to entry remain high

Can charge higher price (may not maximize profits)

Profit likely to be Abnormal (higher than PerfComp)

Efficiencies:

Natural monopolies productively efficient – lowest possible costs

Allocatively inefficient – high prices / abnormal profits

ProdEff and AllocEff are forms of Static efficiencies

Monopolies provide Dynamic efficiency: abnormal profits put into R & D …

Other firms innovate jump over monopoly (good / economy) – process of creative

destruction



Monopolies can avoid innovation: keep their abnormal profits

Market failure –– the government may intervene:

Taxes – no incentive to reduce costs;

Subsidies – to reduce prices, no way to know right price;

Price controls – can force down costs, no effect;

Nationalize / Privatize; Deregulate; Break Up; Reduce barriers to entry

Downward-sloping Demand Curve (draw) is industry’s, monopolist’s – can only

increase sales by reducing price

Consumer: monopolists must produce products consumers want, and are willing to

pay the monopolist’s price

Average Revenue at different pts on D Curve (D = AR)

Q TR AR MR TR

0 0

1 8 8 8 8

2 12 6 4 12

3 12 4 0 12

4 8 2 8

5 0 0 00

2

4

6

8

10

0 2 4 6

AR

MR

Short run profit maximiser – produce at the level where MR = MC (graph)

Price: Drop a line down from D through MR = MC point

Abnormal profits: rectangle from D Curve down to AC Curve

Area above is “Consumer Surplus”

Monopolist can Price Discriminate: some consumers willing to pay more; split

market; keep it split without spending too much money

1st Degree Discrimination: different price to each consumer

2nd

Degree Discrimination: by volume

3rd

Degree Discrimination: can separate consumers into 2 or more groups

Other:

No Supply Curve



Increase output only where Elasticity is ≥ 1 (above mid-point)

Oligopoly

Characteristics:

Relatively few Suppliers in the industry (could still be many small ones)

Firms are interdependent (actions of one affect others – i.e. sales)

Most markets are Oligopolistic – imperfectly competitive

In addition, according to “Neo-classical” theory:

There are barriers to entry

There are abnormal profits

Characteristics (compared with Perfect Competition):

Non-price competition – means they compete in different areas, not just on price

– marketing strategy looks at all 4 P’s, and Brands

Price rigidity – fewer price changes, even if costs change

AC Curve more “L” shaped than “U” shaped

Collusion – oligopolists acting together

Neo-class theory on Oligopolistic firm’s market D (draw, start with Price):

A price rise by one firm results in lost sales, others will not follow (up)

A price drop = smaller reaction, others follow, so no big Q increase (down)

Review: So, from the market price:

Increases in price results in Price Elastic reactions

Decreases in price results in Price Inelastic reactions

So the Demand Curve is “Kinked”

Draw in MR curve (kinked and broken)

Monopolistic Competition



Imperfect Competition / Monopolistic Competition

Assumptions:

Large number of buyers & sellers

No or Low barriers to entry

Short-run profit maximizers

Different goods

Firms not Price Takers / Downward sloping Demand Curve

Different products / substitute goods / higher elasticity

In the Long Run:

They will produce (quantity/output) where MR = MC;

Price is at Average Revenue (same as Monopolies)

If abnormal profits:

o More firms enter the market – Supply increases

o Price goes down, so MR & AR both decrease, until AC = AR

(tangent)

So, in Monopolistic Competition, MR = MC; AR = AC

Same as Perfect Competition



Typical Exam Questions


Short Run: at least one Factor of Production cannot be changed

Long Run: all Factors of Production can be changed, technology remains unchanged























Profits = TR – TC




Summary


set in





MC

Objectives of Firms



Large companies







Managerial Theories














P 331 – continue to produce, even possibly thru Period 4 – then, Period 5,

would not produce.


Maximum level of profit: where TR–TC is greatest






P 345 shifts in cost and revenue curves







profit.







AFC downwards




Draw LRAC Curve –




















LRAC Curve: boundary, represents the C

Attainable

Output









New technologies


Taxation





Growth of Firms







Reasons for growth:



Risk reduction

Methods of growth:



Internal Growth









Types of Mergers






Notes about Mergers

Not clear that mergers increase economic efficiency

Productive efficiency may incr if average costs fall (economies of scale)

But, sometimes the economies of scale are losses of jobs

Allocative efficiency may incr if wider range or better quality product

But, mergers tend to reduce competition in the market

Asset stripping controversial

Perfect Competition

Remainder of 1st term on different models of competition in the market, and how

firms might make decisions under those conditions
















would sell.



AVC.


(includes




abnormal profit



increasing prices







AC = AR = MR = MC





Monopoly



minimum costs EconOfScale: purchasing; marketing; technical; managerial /

specialization; financial. Examples: telephone; rail; water; etc.




Profit likely to be Abnormal (higher than PerfComp)

Efficiencies:

Natural monopolies productively efficient – lowest possible costs


ProdEff and AllocEff are forms of Static efficiencies


Other firms innovate jump over monopoly (good / economy) – process of creative

destruction









Downward-sloping Demand Curve (draw) is industry’s, monopolist’s – can only

increase sales by reducing price



Average Revenue at different pts on D Curve (D = AR)

Q TR AR MR TR

0 0

1 8 8 8 8

2 12 6 4 12

3 12 4 0 12

4 8 2 8

5 0 0 00

2

4

6

8

10

0 2 4 6

AR

MR

Short run profit maximiser – produce at the level where MR = MC (graph)

Price: Drop a line down from D through MR = MC point






2nd


3rd


Other:

No Supply Curve




Oligopoly

Characteristics:





















Monopolistic Competition



Imperfect Competition / Monopolistic Competition

Assumptions:

Large number of buyers & sellers



Different goods

Firms not Price Takers / Downward sloping Demand Curve

Different products / substitute goods / higher elasticity

In the Long Run:

They will produce (quantity/output) where MR = MC;





(tangent)





Purchasing power parity (PPP) is an economic technique used when attempting to

determine the relative values of two currencies. It is useful because often the amount

of goods a currency can purchase within two nations varies drastically, based on

availability of goods, demand for the goods, and a number of other, difficult to

determine factors. PPP solves this problem by taking some international measure and

determining the cost for that measure in each of the two currencies, then comparing

that amount.

An economic theory that estimates the amount of adjustment needed on the exchange rate

between countries in order for the exchange to be equivalent to each currency's purchasing

power.

The relative version of PPP is calculated as:

Where:

"S" represents exchange rate of currency 1 to currency 2

"P1" represents the cost of good "x" in currency 1

"P2" represents the cost of good "x" in currency 2

In other words, the exchange rate adjusts so that an identical good in two different

countries has the same price when expressed in the same currency.

For example, a chocolate bar that sells for C$1.50 in a Canadian city should

cost US$1.00 in a U.S. city when the exchange rate between Canada and the U.S. is 1.50

USD/CDN. (Both chocolate bars cost US$1.00.)

Read more: http://www.answers.com/topic/purchasing-power-parity#ixzz1F7C8mTeu

The Big Mac Index is an informal way of measuring the purchasing power parity (PPP)

between two currencies and provides a test of the extent to which market exchange rates

result in goods costing the same in different countries.

The Human Development Index (HDI)

The first Human Development Report introduced a new way of measuring development by

combining indicators of life expectancy, educational attainment and income into a

composite human development index, the HDI. The breakthrough for the HDI was the

creation of a single statistic which was to serve as a frame of reference for both social and

economic development. The HDI sets a minimum and a maximum for each dimension,

called goalposts, and then shows where each country stands in relation to these goalposts,

expressed as a value between 0 and 1.

http://www.wisegeek.com/what-is-purchasing-power.htm

http://www.answers.com/topic/purchasing-power-parity#ixzz1F7C8mTeu

http://en.wikipedia.org/wiki/Purchasing_power_parity

http://en.wikipedia.org/wiki/Currency

http://en.wikipedia.org/wiki/Exchange_rate

http://hdr.undp.org/en/reports/global/hdr1990/



The education component of the HDI is now measured by mean of years of schooling for

adults aged 25 years and expected years of schooling for children of school going age.

Mean years of schooling is estimated based on duration of schooling at each level of

education (for details see Barro and Lee, 2010). Expected years of schooling estimates are

based on enrolment by age at all levels of education and population of official school age

for each level of education. The indicators are normalized using a minimum value of zero

and maximum values are set to the actual observed maximum values of the indicators from

the countries in the time series, that is, 1980–2010. The education index is the geometric

of two indices.

The life expectancy at birth component of the HDI is calculated using a minimum value of

20 years and maximum value of 83.2 years. These are the observed maximum value of the

indicators from the countries in the time series, 1980–2010. Thus, the longevity

component for a country where life expectancy birth is 55 years would be 0.554.

For the wealth component, the goalpost for minimum income is $163 (PPP) and the

maximum is $108,211 (PPP), both observed minimum observed during the same time

series.

The decent standard of living component is measured by GNI per capita (PPP US$)

instead of GDP per capita (PPP US$) The HDI uses the logarithm of income, to reflect the

diminishing importance of income with increasing GNI. The scores for the three HDI

dimension indices are then aggregated into a composite index using geometric mean.

Refer to the Human Development Report 2010 Technical notes [388 KB] for more

details.

http://hdr.undp.org/en/media/HDR_2010_EN_TechNotes_reprint.pdf



The HDI facilitates instructive comparisons of the experiences within and between

different countries.




at any given price

Law of Demand: If all else remains the same, as prices rise, people will demand less,

and, if prices go down, people will demand more

The Demand Curve – Diagram

Downward sloping – inverse / negative relationship: as price

decreases, quantity demanded increases, and, vise versa

Demand of entire Markets shown the same way


Determinants of Demand (factors that affect Demand)

Price (movement along the demand curve)

Prices of other goods (with, or, instead of)

Incomes


Population size or structure

Advertising

Expectations of consumers

Changes in laws

CONSUMER SURPLUS

The area above price level and to the left of the Demand Curve. The amount that

consumers who were willing to spend more, don’t have to spend. The benefit to

consumers of having markets. (The more quantities are available, the less value

consumers place on it.)

Elasticities

Elasticity = Effect (responsiveness) on factor “Y” by a change in factor “X”

Price Elasticity of Demand (PED) = Effect on quantity demanded by change in price,

or, responsiveness of quantity demanded to price changes

Elastic = Change in Price causes large change in Quantity

Demanded

Inelastic = Change in Price causes small change in Quantity

Demanded

Changes in any

of these will

cause Demand Curve to shift,

either inward

or outward






PED =

Determinants of PED:

3. Availability of substitute goods tends to increase PED

Noodles & rice, etc; if price of noodles rises, consumers

shift to rice, etc. So, price elasticity for noodles is high.

Salt has few substitutes, so a rise in price will have little

effect on total demand. Price elasticity for salt is low.

4. Time tends to increase PED

Oil: when price rises, with nothing to replace it, people

buy more. But over time, people change driving habits,

buy more efficient cars, take public transportation,

causing quantity demanded to fall

5. Necessities tend to have lower PED

6. Low-priced goods tend to have lower PED

7. Luxury goods tend to have higher PED

8. High-priced goods tend to have higher PED

Price

Quantity

Quantity

Price X

Quantity

Quantity

Price

Price ÷

OR

OR

Quantity

Quantity X

Price

Price

PED Value Elasticity Response to Change in Price

-0- Perfect Inelasticity No response in quantity demanded


1 Unitary Elasticity % in Q demanded = % in Price


∞ Perfect Elasticity Consumers demand ∞ Q at that price



IMPORTANT: PED along straight Demand curves can be different!

PED at any given point “B” =



PED is important because it affects total spending (expenditure)

on the product, and therefore total income (revenue) received by

the firm. This helps determine whether a company’s total income

(revenue) will increase or decrease when they raise prices.

Total Expenditure (TE) = Q x P

Inelastic products: rise in price results in increase in Total Revenue

Elastic products: rise in price results in decrease in Total Revenue

Example:

Qty Price Qty Price PED TE5 10 50

5 10 4 14 0.50 56 %ΔP ≥ %ΔQ - Inelastic - TR increases5 10 2 14 1.50 28 %ΔP ≤ %ΔQ - Elastic - TR decrease

Original New



A = ∞ = Elastic


C = 0 = Inelastic

P

rice

Quantity





Law of Supply: If all else remains the same, as prices rise,

producers will supply more, and, if prices go down, producers will

supply less

The Supply Curve – diagram

Upward sloping – positive relationship: as price increases,

quantity supplied increases, and, vise versa

Supply of entire Markets shown the same way

Market Supply: add together all Individual Supply Curves

Determinants of Supply (factors that affect Supply)

Price (movement along the supply curve)

Costs of Production


Technology

Producers’ Goals


Future expectations

PRODUCER SURPLUS

The area below price level and to the left of the Supply Curve. The

low prices that producers who were willing to sell, don’t have to

sell so low. The benefit to producers of having markets (some

firms receive a higher price than the lowest price they were willing

to supply the market)


quantity supplied.

Changes in any

of these will cause Supply

Curve to shift,

either inward or outward



OR








-0- Perfectly

Inelastic





∞ Perfectly Elastic Producers supply ∞ Q at that price

Price

Quantity

Quantity

Price X OR

Quantity

Quantity /

Price

Price








EXCESS DEMAND: Market Price below Equilibrium price, Demand

> Supply

EXCESS SUPPLY: Market Price above Equilibrium price, Demand <

Supply





Equilibrium Price

Market Clearing Price: Equilibrium price. For many different

reasons, Market Price very often does not equal Equilibrium Price

– there could be excess Demand or excess Supply at any time.

Stable equilibrium – where FREE MARKET FORCES push prices

to equilibrium point.

Unstable equilibrium – in some cases, FREE MARKET FORCES

may not be strong enough to push price to equilibrium.

Consumer / Producer Surplus – Review

Interrelationships in the Market

How events in 1 market lead to changes in another

COMPETITIVE DEMAND / Substitute Goods – Goods that replace

each other

Examples: rice and noodles; beef and pork



An increase in price of one good “C” leads to a decrease in

quantity demanded for that good (movement along D).

This leads to an increase in demand for the substitute good

“D” (D shifts out) and an increase in price (movement along

S)

JOINT DEMAND / Complementary Goods – Goods that are used

together

Examples: cement and sand; DVD’s and DVD players

A decrease in price of one good “A” leads to an increase in

quantity demanded for that good (movement along D)

This leads to an increase in demand for the complementary

good “B” (D shifts out) and an increase in price (movement

along S)



Cross Elasticity of Demand (CED) – How demand for good “X”

changes with change in price of another good “Y”

Substitute goods (noodles and rice) have a positive CED. Increase

in price of one (rice) leads to increase in demand of the other

(noodles)

Complementary goods (sand and cement) have a negative CED.

Increases in Price of one (sand) leads to decrease in demand for

the other (cement)


% in price of another good Y P of Y

Q of X

Q of X

P of Y X OR

Q of X

Q of X / P of Y

P of Y OR

CED =



DERIVED DEMAND – Goods needed to produce other goods

Examples: Cars need steel; bread and cakes need flour

An increase in demand for finished good “E” (D shifts out)

results in an increase in demand for good “F” (needed to

produce “E”) (D shifts out) and an increase in price of “F”

(movement along S)

JOINT SUPPLY – One good supplied for producing 2 different

goods

Examples: cows supply us with beef and leather

Increase in demand for finished good “G” (D shifts out)

results in an increase in the price (movement along S).



Producers will increase supply of the resource, leading to an

increase in supply of the other product “H” (S shifts out),

and price will decrease (movement along D)

Income Elasticity of Demand – change in demand with change

of consumers’ Income

Demand for most products increases as incomes rise

Inferior goods: Goods where a rise in income causes a decrease in

demand

I

Q

Q

I X / OR OR

Q

Q X

I

I

Q

Q

I

I



MARKET FAILURE / INEFFICIENCY

If the market does not achieve these efficiencies, there is Market

Failure

Some specific Market Failures:

Lack of competition in the market

When prices and profits do not represent true costs to society

– Externalities

Information failure – products bought infrequently

Factor immobility – products, worker skills, worker locations

Inequality: Wages; Wealth and its related earnings; Pension

earnings; Other components of income.

When Market Failure occurs, governments step in to correct the

failure


Price fluctuations (irregular rises and falls) can also lead to market

failure

Prices may be too high, making it impossible for some to buy it

Prices may be too low, causing producers to stop producing

Large fluctuations – may be difficult to identify the “signal”

Price Controls

Maximum pricing (price below equilibrium) lead to excess supply

Minimum pricing (price above equilibrium) lead to excess demand

Buffer Stock Scheme – large fluctuations in commodities

(agriculture or mining products to be resold) come for different

reasons: seasonal, bumper / failed crops; etc. Commodities tend

more inelastic (near vertical curves), so shifts in D or S can lead

to large changes in prices, little change in quantities

Buffer stock scheme:



Gov’t sets “Intervention Price”

If Market Price lower, Gov’t buys, increases demand, pushes up

price

If Market Price higher, Gov’t sells, increases supply, pushes

down price

Taxes – Other actions Gov’t can take:

Indirect taxes – paid to sellers, when

goods are bought

o VAT, Ad Valorem – based on

price

o Excise Tax – based on, charged

per unit

o Tend to reduce Supply, push S

curve to the left

Subsidies (money given out by the government)

Reduces overall producer costs, pushing S curve to the right

The amount of tax burden shared by

each side depends on Elasticity (See P.

76, Figs 11.4 & 11.5)

S = Perf Elastic / D = Perf Inelastic –

Consumers

S = Perf Inelastic / D = Perf elastic –

Producers

S2

S1

D

Consumers

pay

Producers

S1

S2

D

Consumers

Producer

Indirect Taxes

Subsidies



The Market

Review: Demand and Supply, Interrelationships between markets,

and, Elasticities – together called The Market Mechanism


Adam Smith: Advocated: Free market system where the “invisible hand” of the

market would allocate resources to everyone’s advantage

Opposed: protectionism, economic restrictions, legal barriers

The Actors:

Consumer – all powerful, free to spend, choose to allocate their

resources to maximize their utility

Firms – servants to the consumers, motivated to maximize their

profits (Revenues – Expenses), if they fail…

Owners of Factors of Production – maximize their rate of return on

capital

The Function of prices in the Market

Rationing (explain classic) – Price does it

Signaling – the price does it

Incentives – the Price (demand) (supply)

Maximizing behavior

Judging the Market

Review: 3 Questions: What to produce; How to produce; and,

For whom to produce – all deal with the Basic Economic Problem,

and an economy is judged by how well it answers those

questions.

Efficiency is only achieved

MARKET EFFICIENCY – if producing on the PPF – Competition can

create



For MARKET EFFICIENCY, there must be…

PRODUCTIVE EFFICIENCY – production achieved at the lowest

cost


TECHNICAL EFFICIENCY – the maximum quantity of output

(products) with the minimum of inputs (resources)

ALLOCATIVE / ECONOMIC EFFICIENCY – resources used to

produce goods and services that consumers most wish to buy.

STATIC EFFICIENCY – at 1 point in time / allocating resources

differently. Company produce more if it used less labor and more

capital? Would a country produce more if it reduced

unemployment?

DYNAMIC EFFICENCY – effects over a period of time. If a

company distributed less profit and used the money for capital

investment; if an economy directed its resources more to

investment and less to consumption.



Short Run: at least one FofP cannot be changed

Long Run: all FofP can be changed, technology remains unchanged























Profits = TR – TC




Summary


set in





MC

(a) (b) (c) (d) (e) (f) (g)

Output

Total

Revenue Total Cost Profit

Marginal

Revenue

Marginal

Cost

Additional

Profits(b) - (c) (e) - (f)

1 £25 £35 -£10 £25 £35 -£10

2 £50 £61 -£11 £25 £26 -£1 26

3 £75 £81 -£6 £25 £20 £5 20

4 £100 £96 £4 £25 £15 £10 15

5 £125 £110 £15 £25 £14 £11 14

6 £150 £125 £25 £25 £15 £10 15

7 £175 £148 £27 £25 £23 £2 23

8 £200 £180 £20 £25 £32 -£7 32

9 £225 £220 £5 £25 £40 -£15 40

Short Run Profit Maximization

At an output of 7 unit, Profit is at the maximum, so the Firm will produce at 7 units - to maximize profits.

Notice that at an output of 7 units, Marginal Cost is rising, but not yet equal to Marginal Revenue, and

beyond 7 units, Marginal Cost exceeds Marginal Revenue.

So, Profit Maximizing Level of Output can be determined using MR and MC curves, where MR = MC,

and at any output beyond that point, MC exceeds MR.

Increases in Costs or Revenues

With these graphs, it is easy to see the effect of changes in Costs or Revenues

If Costs increase, Total Cost and Marginal Cost Curves both shift upwards, Firm produces less.

If Prices increase, Total Revenue and Marginal Revenue Curves shift upwards, Firm produces more.

Total Revenue and Total Cost

0

50

100

150

200

250

0 5 10

Total Revenue

Total Cost

Marginal Revenue and Marginal Cost

0

10

20

30

40

50

0 5 10

Marginal Revenue

Marginal Cost





Large companies







Managerial Theories













Maximum level of profit: where TR–TC is greatest (Review FC, VC, TC Graph)












profit.





Tutorial

Tutorial P.332 Question 2 Units

Output

Fixed

Cost

Variable

Cost

Total

Cost

Total

Revenue Produce

Shut

Down

(a) 10 10 10 20 30 10 -10 Produce

(b) 15 10 15 25 25 0 -10 Produce

(c) 20 10 20 30 22 -8 -10 Produce

(d) 25 10 25 35 20 -15 -10 Shut Down

P 344, Q1

Output TR TC Profit MR MC

1 10 8 2 -- --

2 20 14 6 10 6

3 30 20 10 10 6

4 40 30 10 10 10

5 50 50 0 10 20

6 60 80 -20 10 30

0

20

40

60

80

100

0 2 4 6 8

TR

TC

0

5

10

15

20

25

30

35

0 2 4 6 8

MR --

MC --



Units

Output

Fixed

Cost

Variable

Cost

Total

Cost

Total

Revenue Produce

Shut

Down

(a)

(b)

(c)

(d)

Units

Output

Fixed

Cost

Variable

Cost

Total

Cost

Total

Revenue Produce

Shut

Down

(a) 10 10 10 20 30 10 -10 Produce

(b) 15 10 15 25 25 0 -10 Produce

(c) 20 10 20 30 22 -8 -10 Produce

(d) 25 10 25 35 20 -15 -10 Shut Down




AFC downwards




Draw LRAC Curve –






















LRAC Curve: boundary, represents the







New technologies


Taxation





Tutorial:

U 49, P 325, Q 1

C

Attainable

Output









Reasons for growth:



Risk reduction

Methods of growth:

Internal Growth









Types of Mergers








Notes about Mergers

Not clear that mergers increase economic efficiency. Productive efficiency may

increase if average costs fall (economies of scale). But, sometimes the economies

of scale are losses of jobs. Allocative efficiency may increase if wider range or

better quality product. But, mergers tend to reduce competition in the market. Asset

stripping controversial.

Tutorial

P. 419, Q 3

(a) Horizontal

(b) Vertical, forward integration

(c) Vertical, backward integration

(d) Conglomerate



Market Structures

Remainder of 1st term on different models of market structures, and how firms

might make decisions under those conditions

Influences on firms’ size and behaviour:

Pricing

Supply

Barriers to Entry

Efficiency

Competition

Determinants of Market Structure

Barriers to entry / Freedom to enter and exit

Nature of the product – homogenous (identical),

differentiated?

Control over supply/output

Control over price

Direct relationship with different levels of competition
















would sell.



AVC.


(includes




abnormal profit



increasing prices







AC = AR = MR = MC







Review:

Perfect Competition: Best prices for consumers (allocatively

efficient); productively inefficient (not lowest costs); only Normal

profits (no abnormal); no innovation (not enough profit, and, no

incentive)

Monopoly



can minimize costs through Economies Of Scale: purchasing; marketing; technical;

managerial / specialization; financial. Examples: telephone; rail; water; etc.




Profit likely to be Abnormal (higher than Perfect competition)

Efficiencies:

Natural monopolies may be productively efficient – lowest possible costs

(Other non-natural monopolies may not be productively efficient)


Productive and Allocative Efficiencies are forms of Static efficiencies


Other firms may innovate, jumping over monopoly (good for the economy) –

process of creative destruction









The market / industry downward-sloping Demand Curve is the monopolist’s also.

Monopolist can only increase sales by reducing price



Demand Curve is the Average Revenue curve (D = AR)

MR Curve has a steeper slope than the AR Curve

Profit maximizing level – where MR = MC

Profit maximizing quantity: vertical line from D through MR = MC point

Price: horizontal line from D to y axis






2nd


3rd


Other:

No Supply Curve


Tutorial:

P 355, Q 1

P 356, Q 2



Q TR AR MR

0 0

1 10 10.0 10

2 17 8.5 7

3 21 7.0 4

4 22 5.5 1

5 20 4.0 -2-5

0

5

10

15

0 2 4 6

AR

MR



Static Efficiency Static efficiency occurs at a point in time and focuses on how much output can be produced now from a given stock of resources, and whether producers are charging a price to consumers that fairly reflects the cost of the factors used to produce a good or a service.

Dynamic Efficiency Dynamic efficiency occurs over time. It focuses on changes in the degree of consumer choice available in markets together with the quality of goods and services available. For example – the opening up of the market for parcel deliveries has had an impact on price and output levels (these are changes in static efficiency). However we have noticed the entry of new suppliers into the market, an increase in the level of capital investment and improvements in the quality and reliability of services in local, regional, national and international parcel deliveries – this represents an improvement in dynamic efficiency. Dynamic efficiency also refers to the rate of technological advancement in a particular market or industry – this is linked to the investment made by suppliers in new capital and research and development.



Oligopoly

Characteristics:























Week

Begin

5th

Edition Pages

Topic

16 U: Introduction to Macro Economics 19 – 20 129-142

17

18 V. Economic Growth 27 185-194

19 W: Aggregate Demand & Aggregate Supply 24 – 26 161-184

20 X: Consumption, Savings & Investment 21 – 22 143-157

21 Y: Taxation 77,

12

523-530

78-83

22 Z: Government Expenditure 78,

33

531-538

231-237

AA: Redistribution of Income & Wealth 65 455-463

23 AB: Money & Monetary Policy 35,

82

246-252

567-572

24 AC: Inflation 31 217-223

25 AD: Unemployment 30,

79

209-216

539-549 26

27

AE: International Trade

36 253-257

28 AF: The Balance of Payments 32 224-230

29 Review

30 FINAL EXAMS

Notes to Students:

All reading should be completed before the Week number listed.

The weeks may change, but you will be informed well in advance



National Economic Performance is a measure of: How the country

is doing

How do we judge? Four basic areas (over and over again):

Economic Growth –

o the rate of change in output – GDP

o RECESSION and DEPRESSION (Output shrinks over a

long period of time)

Unemployment –

o A waste of a resource (scarce)

o Economic Growth and Unemployment linked

Inflation –

o The ongoing rising of price levels

o Prices of what you want to buy go up

o The value of what you’ve saved (what you can use it

for) falls

o Inflation above about 3% starts becoming a problem

o Economic Growth (GDP) and Inflation have a

relationship

The Current Balance – Exports vs Imports – Surplus / Deficit

o Exports: Bring money into country; give up use of

products

o Imports: Send money out of country; get products

o Too much exporting leads to trade surpluses

o Too much importing leads to trade deficits

Government objectives

Economic growth – high

Unemployment – low

Inflation – low



Current Balance – broadly balanced

Trade-offs

Measuring National Income

The Circular flow of Income – The Two Sector (or Closed) Model

A simple diagram to show Nat’l Income 1. Land, Labour and Capital * 2. Rent, wages, interest and profits

National Income = “Y” 3. Goods and services

National Output = “O” 4. Expenditure on goods and services

National Expenditure = “E”

* = Households own the wealth of the nation

All three, “Y” “O” and “E” are equal – National Income Equilibrium

The Circular flow of Income – The Five Sector (or Open) Model

The Multiplier Effect – Injections cause larger effect

Note about Savings – the Paradox of Thrift

Paradox (n) – something that is contrary to common

opinion

Thrift (n) – managing and saving money

Households

Firms

1 2

3 4



Common opinion says that saving money makes us better

off…

The Paradox of Thrift is that if everyone saved more,

everyone would be worse off, because the leakage would

cause the economy to shrink

GDP is value of all goods and services produced, at market price, includes:

Indirect taxes – not really a part of output, so value is inflated

Value of imports and exports

(GDP more difficult to calculate than above circular model)

Gross Value Added (GVA) at basic cost = GDP – indirect taxes + subsidies

(Indirect taxes – subsidies = basic price adjustment)

Gross National Income (GNP) at market price = GDP + income on overseas

investments – income of foreign investments in the UK

GDP is most often used to measure National Income

Calculations exclude Transfer Payments Gov’t payouts, student loans, second

hand sales, etc (no goods or services produced)

Reasons to produce National income statistics:

Help economists to understand economies

To judge economic welfare

To forecast changes and plan for them

To compare: over time; and, between countries



Possible errors in calculation:

Too many statistics, too many changes

Some activity may be hidden: avoid tax; illegal; informal

Self produced goods and services

The Public Sector (Government) – nothing bought or sold

Problems with comparing National Income over time:

Prices change (Inflation) – must consider real, not nominal prices

Accuracy is always going to be a problem

Presentation – if calculation method changes, need to adjust

Population changes – use “per capita” for comparison

Changes in quality will throw of price comparisons

Consumption vs Investment – Investments will affect standard of living now

and in the future. Drawing on investments will increase consumption

Externalities – not measured

Does not take into consideration income distribution

Comparing – difficult because of the differences in economies

Purchasing Power Parities (PPP) – a typical basket of goods



Economic Growth is the change in potential output of the

economy shown by a shift to the right of the production possibility

frontier (PPF). Difficult to measure the productive capacity of an

economy. Usually measured by the change in real national income

– GDP

The Business Cycle

Economies rarely operate at full efficiency

o Peak, boom

o Downturn

o Recession, trough, slump, depression

o Recovery, expansion

Ups and downs in economic performance create the shape of

Actual GDP

During peaks, economy operates closest to full efficiency, closest

to PPF

During other times, it is moving toward or away from full

efficiency

Recovery is not economic growth

From Actual GDP, get the “Trend”

“The Output Gap”

Difference between Actual and Trend GDP

Recovery is different from Economic Growth

What causes Economic Growth?

Increases, or, more efficient use of Inputs

Land – includes all resources (economists say increased use of

natural resources help developing economies more than

developed economies)



Labour – increases in labour force:

Demographics – younger workforce (many countries’ workforce

aging)

Participation – e.g. women

Immigration – may affect output, might not effect economic

welfare (more to share)

Capital – must increase to sustain economic growth – investment

targeted in growth industries

Technological progress – increases economic growth

Decreases average cost of production

Creates new products, which consumers then buy

Efficiency – the way resources are used to produce goods and services

Markets promote efficiency

Arguments for Economic growth

Improved standard of living

Crime reduction

Improved working environment

Improved environment

Reduction / elimination of absolute poverty

Arguments against Economic growth

Problems with national income statistics

Negative externalities

Growth unsustainable

Using up of natural resources

Increased inequality

Economic Growth – Comparing between countries



There are problems with comparing. Often, the amount of goods

that can be purchased in different countries is very different,

because of the following:

• Standard of living

• Exchange rates of currencies

• Cultural differences

Examples:

• Levels of education and development

• Types of housing and relative costs

• Differences in type of food consumed

• Different life styles

• Governments’ control over currencies and exchange rates

Purchasing Power Parity is a method of comparing, based on:

• Availability of goods

• Demand for goods

• Differences exchange rates

Calculation:

Where:

S = exchange rate of currency 1 to currency 2

P1 = cost of good “x” in currency 1


Example:

• A chocolate bar in Canada costs C$1.50

• If exchange rate between Canada and the US is 1.50

USD/CND

• The chocolate bar should cost $1.00 in the US

But the example is a bit simple:

• There are differences between what people use in one

country compared with another country

(Parity: treating something as equal)



• So, PPP is based on a “typical” basket of goods purchased by

a “typical” household during a “typical” month,

• In different countries

The Big Mac© Index

• Compares the price of a McDonald’s Big Mac© in different

countries

• An informal way of measuring purchasing power parity

• Also a way of measuring how much exchange rates affect a

product

Human Development Index – A way to measure a country’s

development

Combines the following aspects:

• Life expectancy

• Education levels

• Income

Based on a minimum and maximum for each aspect



Nominal vs. Real

Certain economics statistics comparison problems because of

inflation

Nominal: “in name only” means, as is

Real: means, as adjusted for inflation

Example:

• Nominal GDP: 8%

• Inflation Rate: 3%

• Real GDP: 5%



Aggregate Demand

Demand for all goods and services produced in the economy

Aggregate Demand Curve: relationship between Price Levels

and Real Expenditure (adjusted for inflation). Output adjusted

based on Retail Price Index. The higher the price levels, the less

that can be purchased.

Reminder: Nat’l Income (Y) = Nat’l Output (O) = Nat’l

Expenditure (E)

E = C + I + G + X - M

National Expenditure (E) = Consumption (C) + Investment (I) + Government Spending (G) + Exports minus Imports (X – M)

Analysis: anything that causes a change in any of these different components will cause a change in National Expenditure

Consumption: Influenced by interest. Prices rise, consumers

need more money to buy, borrow. Money supply limited, drive

price (interest) up. In the end, consumers demand less.

Investment: rise in prices leads to rise in interest rates.

Marginal efficiency of capital theory: Investment affected by

chg in IR

Government spending affected by political decisions

Exports and imports:

o Higher domestic prices = lower X, higher M, AD shifts

in

o Lower domestic prices = higher X, lower M, AD shifts

out

Movement along the AD Curve

AD falls as prices rise, 1) because increases in IR reduce C and I, and 2) because

higher prices reduce X’s and increase M’s

Shifts in AD Curve

Come from anything other than changes in price levels



Consumption: increases in C, caused by: lower unemployment

rate; lower interest rates; rise in stock markets (wealth); new

technologies; lower savings; lower income taxes; all lead to

shift in AD Curve

Investment: Increased confidence by businesses in the

economy; lower interest rates; increased company profits; fall

in taxes on company profits; all lead to increases in I, shift in

AD Curve

Increase in Government spending will shift AD Curve out

Imports and Exports: Fall in exchange rate – X’s more

competitive, M’s less – X’s rise, M’s fall – push AD Curve out

The Multiplier Effect

Remember the Circular flow of money. Every time money is

injected into the economy (i.e. spent on investments, increase in

gov’t spending), it pays for goods and services (materials and

labour), and so it returns to the households in terms of salaries

and profits. Then, it can be turned back to circulate through the

economy again. And each time it is re-spent, it adds to the

economy. This is The Multiplier.

Leakage – every time when money is in the households, some

may be taken out of circulation: savings; taxes and imports

Shape of the Aggregate Demand Curve:

Keynesians – weak link between prices and AD (more steep)

Price levels have little effect on interest rates

IR changes have little effect on consumption and investment

The main determinant of investment is past profits

Classical economists – strong link between prices and AD (more

flat)



Changes in prices have strong effect on interest rates

Changes in IR strong effect on consumption and investment

Shape of AD Curve

Keynesians: Weak link between prices and aggregate demand

• Price levels – little effect on IR

• IR changes – little effect on C and I

• Main determinant of I is prior profits

The Aggregate Demand Curve is more steep

Classicals: Strong link between prices and aggregate demand

• Price levels – strong effect on IR

• IR changes – Strong effect on C and I

The Aggregate Demand Curve is more flat



Shape of Long Run Aggregate Supply (LRAS) Curve

Vertical – limits to capacity and other Factors (LRAS is the PPF)

LRAS shifts over time, as quantity and quality of Factors change

Technology, training and education, etc

LRAS Curve shift represents change in PPF

Effect of excess Labour and changes to wage (salary) rates

Classical Economists – Excess labour causes a drop in wage

rate, labour market slowly clears (Adaptive Expectations); New

Classicals – Labour market clears quickly (Rational

Expectations). Either way, labour market functions perfectly:

unemployed tend to get jobs, and the labour market moves back

to relative equilibrium

Therefore, the LRAS Curve is vertical

Keynesian Economists – wage rates tend not to fall: highly

skilled workers want to keep their high wages; labour unions fight

wage cuts; minimum wage laws; unemployment benefits; mobility

of workforce. So the unemployed remain out of work until some

other force increases demand for labour. Moderate Keynesians

– employers may temporarily push down wage rates, then wage

rates will recover. So, according to Keynesians – The market will

not clear (“sticky downwards”).

At full employment, LRAS Curve is vertical.

If mass unemployment, increased output not likely to lead to

increases in price levels, so at low levels of output, LRAS Curve

horizontal.

Finally, LRAS slowly curves up to connect.



Long Run Equilibrium Output

Main issue is difference in view of the labour market, and the effect on long

run equilibrium output

Classical Economists

• rises in unemployment lead to quick wage cuts

• pushes output back to full employment levels

Keynesian Economists

• unemployed do not reduce wage expectations

• remain out of work much longer


Increase in Aggregate Demand

Economy moves to disequilibrium

Temporary over-employment &

over-output

SRAS shifts left due to increased

costs

New equilibrium, higher prices

Increase in Aggregate Supply



Creates increased output

Causes price levels to drop


Increase in Aggregate Demand

• All periods of dis-equilibrium depend on the situation in the economy,

• specifically unemployment, and

• the effect of unemployment on demand for goods and services (AD)

If at full employment,

Shift causes rise in prices only, no

output change

If in mass unemployment

Shift increases output with no

effect on prices



If some unemployment

Shift causes rising prices and

increased output

Increase in Long Run Aggregate Supply

If at full employment

Shift causes large increase in

output, and big drop in prices

If at mass unemployment

Shift will have no effect at all on

the economy



If some unemployment

Shift causes output to increase,

and small drop in prices

Increases in both Aggregate Demand and Aggregate Supply

Increased Investment causes AD

to shift outward,

Also shifts AS out

Causes increased output with little

effect on prices



Consumption = spend on consumer goods/services;

Consumer goods include both Durable and Non-durable goods

Marginal Propensity to Consume = measure of the change in

consumption

For entire economy, MPC likely positive, less than 1 (will always

save).

Average Propensity to Consume = average amount spent on

consumption

In developed countries, generally less than 1 (will always save)

Consumption Function = relationship between consumption and

the determinants of consumption: Disposable Income, wealth,

inflation, interest rate, expectations, age. Main determinant is

Disposable Income.

If Disposable Income rises, econ theory suggests consumption will

rise.

Wealth of household – 2 parts: Physical wealth; monetary wealth

If household wealth rises, consumption will likely increase: Wealth

Effect

Wealth changes (short term) – 2 ways: house prices; stock

values

Inflation (rising of general price levels) has 2 effects on

consumption:

A. Speed up purchases because prices will be higher (uses up

savings)

B. Save more – inflation tends to reduce value of current

wealth/savings

Change in Consumption

Change in Income

C

Y = MPC =

APC = Consumption

Income =

C

Y



Overall, inflation tends to reduce consumption. The negative effect of “B” is

greater than the positive effect of “A”.

Interest Rate and Credit (ability to borrow)

If interest rate rises: home mortgage payments rise; and,

purchase of durable goods (by credit) reduce – a fall in

consumption

Besides effect of IR on credit, government can restrict borrowing

levels.

Consumer Expectations: If Consumers Expect: Effect on consumption:

Increased prices Spend sooner – increase consumption

Increased real income Spend more – increase consumption “Booming” economy leads to increased consumption

“Harsher” economy leads to decreased consumption

Age: Young, old tend to consume more of income, middle-aged save



Saving: what is not spent – put in bank, invested, added to cash

Savings: a flow concept; the accumulation of prior saving

Note: APC + APS = 1

Increase in savings reduces consumption, increases investment

Savings Function: Determinants = Disposable Income, wealth,

inflation, interest rate, expectations, age (similar to consumption)

Higher earners have lower MPC’s

Economic Theories on consumption and savings

Keynes observed there is a primary relationship between current

income and current consumption; most important: 1) short-term

income; 2) availability of credit. Consumption function relatively

stable; changes in wealth & IR have little effect.

Based on these, Keynes believed: Increased wealth leads to

stagnant economy. Redistributing income from rich to poor would

increase total consumption. This has been proven wrong.

APS in the West is typically very low – income has little effect on

savings

Life Cycle Hypothesis: Current consumption based on likely

income over lifetime, not current income, e.g. manual worker vs.

professional.

Permanent Income Hypothesis (Milton Friedman): studied average

income over lifetime, called Permanent income. Influences: Rise

in wealth will increase C over life; Rise in IR lowers value of

investments and wealth resulting in a fall in C over life, and, Rise

in IR makes future income less valuable, lowers Permanent

Income.

APS = Saving

Income =

S

Y S

Y MPS =

Change in Saving

Change in Income =



Lifetime APC is 1 – in other words, we spend everything!



Investment: (different from savings)

Investment is the purchase of machines and equipment (capital)

used to create goods and services (by business) – to create profit

/ return

Gross Investment – the cost of all investments

Investments wears down as used – Depreciation or capital

consumption

Net Investment – the value of investments after deducting

Depreciation

The rate of return on investment: Marginal Efficiency of Capital

(MEC)

Investment level depends on IR and MEC – more/more, less/less

MEC % Planned Investment

20 4

15 8

10 12

5 16

Planned Investment

Schedule (Demand)0

5

10

15

20

0 5 10 15 20 25

IR

Investment

MEC Theory: Planned investment rises when IR falls, because ….

No matter whether Investment from Retained Profits / Borrowed

Factors that shift the Investment Demand Schedule: Cost of

capital; Technology; Expectations; Gov’t policy

Year Output # Machines Invest Ch Output Ch Invest

Table 32.3, P 216 1 10 10 0

2 10 10 0 0%

3 12 12 2 20%

4 15 15 3 25% 50%

5 15 15 0 0%

6 14 14 0 0%



The Accelerator Theory – planned Investment changes with levels

of income or profits, not with interest rate. And, change in

Investment is greater than change in income

The Accelerator Theory: It = a (Yt – Yt-1)

It = investment in any year “t”; a = “Capital Output Ratio”; Yt –

Yt-1 = change in real income during year “t”, so if capital of $20 is

needed to produce $4 in income, Capital Output ratio is 5

Accelerator model has limitations – simplistic:

Excess capacity, whether due to slow economic times, or for

other reasons may make Capital Output ratio higher

New technologies can change output levels

Expectations can affect planned investment

Still, evidence suggests investment linked to past changes in

income.

Most investment comes from retained profits; companies don’t

necessarily consider interest. So, investment may depend more

on levels of retained profits, and, new capital technologies.



Fiscal Policy: Taxation and Government Expenditure

Taxation

The Canons (general rules) of taxation

Cost of collection should be low

Amount to pay and when should be relatively clear

The method of payment and the timing should be convenient

Should be levied according to the ability to pay

Regarding economic efficiency, economists argue that a “good”

tax should:

Minimize losses in economic efficiency, or even increase econ

efficiency

Fit together (compatible) with other foreign tax systems

Automatically adjust to changes in price levels

Governments collect taxes:

To pay for government expenditures

To connect costs to externalities

To manage the economy / macroeconomics

To redistribute income

Taxation Methods

Direct Taxes – “levied” directly on individuals or organizations

Indirect Taxes – placed on goods or services

Behaviour of Taxes

Progressive: AT increases as Income increases

Regressive: AT decreases as Income increases

Proportional: AT remains the same as Income increases

Types of Taxes



Income Tax: Personal earnings; marginal

tax rates. Progressive. Pay As You Earn

(PAYE) system. To Consolidated Fund,

pays Gov’t expenditures

National Insurance: Separate Fund, pays

pensions, Jobseekers Allowance and a part of

National Health Service. Mildly progressive up

to 645, Regressive above

Corporation Tax: On company’s profits.

Credits reduce tax. Progressive.

Capital Gains Tax: On gains on sale of Assets (excl. most goods &

services, personal residence). Added to Personal earnings, taxed

like Income Tax.

Inheritance Tax: On value of assets left at death. 1st 275,000

passes tax free, thereafter taxed at 40%. Progressive.

Excise Duties: Taxes levied on fuel, alcohol, tobacco and betting. Based on volume

(quantity) sold. Regressive.

Value Added Tax (VAT): A tax on expenditure. Different rates.

Essentials like food, water, children’s clothing, books, newspapers,

publications, public transport are all tax exempt. Domestic fuel

(gas, electric, heating oil and coal) taxed at 5%. All other goods

at 17.5%.

£0 £4,895 Pers Allow.

£4,896 £6,985 10%

£6,986 £37,295 22%

£37,296 40%

£0 £83 0%

£84 £645 11%

£646 1%

£0 £10,000 0%

£10,000 £1.5 mil 19%

£1.5 mil 30%



Council Tax: On domestic properties (residences) by local

authorities. Properties are assessed (valued), then divided into

“bands” A thru H. A is lowest rate, H is highest. Local authority

then sets rates, but differences between rates fixed, highest = 3

times lowest. Regressive.

Business Rates: Local authority tax on business property.

See textbook for more complete analysis of all taxes

Taxation, Inefficiency and Inequality

VAT and excise duties decrease supply

Income tax leads to fall in labour

Corporation tax discourages entrepreneurs

In some cases, taxes may offset the cost of externalities (sin

taxes)

But, in general, taxes tend to distort markets

Taxes lead to economic inefficiency because w/tax, marginal cost

≠ price (so many cases of econ inefficiency make it difficult to

judge taxes)



Goods and Services Provided by the State

Produced by: Paid for by: Examples:

1 Public Sector Public Sector Public Libraries, Hospitals

2 Private Sector Public Sector Doctors, School buildings, etc.

3 Public Sector Private Sector Postal service

Government Spending – factors that suggest the best/optimal

level:

Public, Merit goods: defense, law & order, police, education

More efficient: health care (economies of scale, drive down

costs)

Equity: health care, elderly (high costs, low funds); education –

help poor

Taxation level: Too high will be a disincentive, pushing

businesses out

In the case where State spending too much, various steps to

downsize:

Privatization – Transfers mainly from 3 above

Outsourcing – buying from private sector, i.e. construction,

schooling

Create Internal Market within the public sector

Create partnerships between public and private sectors

Stop funding certain things – transfers from 2 above

Choosing between Public Sector and Private Sector

Productive efficiency – economies of scale

However, as we’ve learned, may also suffer from diseconomies

of scale

State services tend to lack competition, choice, which can also

lead to inefficiency



Prices of services in the public sector are supported by tax

revenue. Private sector pricing may make too expensive

Government Borrowing / Deficit Spending: pressure to spend

more and tax less. But high deficits can not be sustained in the

long run

Fiscal Policy and the Economy:

A decrease in Taxation or an increase in Government Spending:

Will shift Aggregate Demand out

May shift Aggregate Supply out if spent on Investments

Increase Economic Growth

Decrease Unemployment

May cause Inflation

May cause Exports to reduce, Imports to increase (a net

leakage)

Trends in public spending in the UK

1900-1960’s – increased: defence, rebuilding

1960-1975 – increased: the welfare state

1975-1990 – decreased: Conservative gov’t

1990-1999 – recession in 1990-1992; newly elected gov’t

realized public spending couldn’t be frozen forever; overall,

decreased slightly



Redistribution of Income & Wealth

In a Market Economy, Distribution of income and wealth not likely

to be efficient or equitable

Absolute poverty; relative poverty

LORENZ CURVE Handout

Law of Diminishing Marginal Utility – the additional satisfaction

from consuming any good decreases the more the good is

consumed.

Suggests: redistributing from rich to poor would increase

combined utility by all. (£1 means more to poor than rich)

Methods of Redistribution:

Taxation (Progressive / Proportional / Regressive): the more

progressive, the more redistributive, and links tax with ability to

pay

Government Spending: social security; national insurance; (to

target needs) housing grants; distribute clothing; etc.

Legislation: minimum wages; equal pay legislation; sick pay,

pensions, medical insurance; retraining

Costs of Redistribution: government intervention benefits some

people, but not everyone. Taxpayers lose use of funds paid to

government.

Classical economists: redistribution has a heavy cost: Taxes =

disincentive; unemployment benefits & equal employment laws =

higher wages = less employed; high taxes = flight of capital; etc.

Free market economists: big loss of economic growth because of

taxation and redistribution

Supply side economists: the gap between poor and rich should be

increased



Poor would be better off if economy could grow in hands of

wealthy, and that economic benefits would “trickle down” to them.



Measuring Income Distribution

It is possible to measure how equally or unequally a price system rations by looking at the

distribution of income. The table below shows that during 1978, 20% of households in the

United States (groups of people living together, usually families, or single people if they

live alone) had total money incomes of less than $6,391. These people received only 4.3%

of the total income that households earned. Twenty percent of households earned between

$6,391 and $11,955, and these households earned 10.3% of the total income earned. The

rest of the table can be interpreted in the same way.

Percent Distribution of Aggregate Household Income in 1978, by Fifths of Households

Households Percent of Income

Lowest Fifth

(under $6391) 4.3

Second Fifth

($6392 - $11955) 10.3

Third Fifth

($11956 - $18122) 16.9

Fourth Fifth

($18122 - $26334) 24.7

Top Fifth

($26335 and over) 43.9

Source: U.S. Bureau of Census, Current Population Reports, P-60, No. 121,

"Money Income in 1978 of Households in the United States," Washington, D.C.:

U.S. Government Printing Office, 1980. Data taken from cover. (Data are before

taxes.)

The information in the table can be made into a Lorenz curve such as that shown below.

The further the Lorenz curve lies below the line of equality, the more unequal is the

distribution of income.

http://ingrimayne.com/econ/AllocatingRationing/RationIncomDist.html



All economic statistics have problems, and the Lorenz curve and the numbers from which

it is constructed are no exceptions. Problems come from two sources: do the numbers

actually measure what they are supposed to measure, and are the numbers accurate?

Income distribution is intended to tell us about the rich and the poor, or about how much

discrimination exists in a system of price rationing. In a system of price rationing,

however, differences in the ability to use income wisely also determine how much

discrimination there is. If those who receive the most income, for example, also tend to be

the most capable at using that income, then the picture that the Lorenz curve shows will

understate the actual amount of inequality.

If rationing is not done solely by price, but by other methods as well, then looking at

income data may be meaningless. In the United States, most rationing is done with price,

but not all. For example, the purpose of public housing and food stamps is to prevent

rationing by price. Both of these items are ignored in the data in the table. Also, one

should be cautious when comparing income distributions among countries because their

rationing systems can be very different. For example, comparisons of income distribution

between the United States and the Soviet Union were not meaningful--although

economists sometimes made them--because the Soviet Union not only relied heavily on

queuing, but those with special status, such as party members, had access to stores denied

to the ordinary citizen.

Households differ in size and average age, but these differences are not reflected in the

table above. Neither is the fact that the amount of time over which income is earned

affects the shape of the Lorenz curve. Larger households tend to earn more than smaller

households. People in their thirties tend to earn more than people in their twenties.

Households with four or five members, with more than one person working, and whose

working members are between 35 and 55 tend to earn more than other households. In a

paper published in the American Economic Review in September of 1975, Morton Paglin

concluded that ignoring the influence of age on earnings overstates inequality by 50%.

There is also variability from year to year in how much households earn. Some people

appear poor because they had an unusually bad year, and others will seem rich because

they had an unusually good year. The shorter the period over which income is measured,



the more unequal the distribution appears. Thus, if income were measured over a decade,

the distribution would be more equal than any of the yearly distributions.

The other source of problems is in making the initial measurements. The data shown in the

table were obtained from questionnaires given a sample of 56,000 households. Not all of

these households gave correct answers. The publication containing these data had a

lengthy discussion of measurement problems, but when other people use these data in a

book or an article or an argument, that lengthy discussion often gets left out (as it does

here).1

Despite the measuring problems, it is clear that a system of price rationing will distribute

goods less equally than will alternative systems such as those using queuing or coupons.

Many people consider this inequality a major shortcoming of a market economy, and most

critics of market systems emphasize this characteristic. Defenders of market systems, on

the other hand, tend to downplay rationing issues, and instead focus on the ability of a

market economy to coordinate information and incentives. These are tasks that markets

seem to perform very well in comparison to the ways other systems do them.

http://ingrimayne.com/econ/AllocatingRationing/PriceAsIncentive.html



Money

Characteristics of Money

A medium of exchange

A unit of account

A store of value

A standard for deferred payment

Forms of Money

Cash

Money in current accounts (in bank, can be withdrawn as cash)

Near monies – money in “deposit” accounts

Non-money financial assets (all assets that can be converted

into money, i.e. houses, cars, shares)

Monetary Policy

Interest rate (IR): price of money lenders / savers expect to pay /

receive

Nominal Interest Rate – the rate offered by banks

Real Interest Rate – the Nominal Interest Rate adjusted for

inflation

In the UK, the Central Bank sets interest rates

Bank Base rate – basic rate upon which all other interest rates are

based

Changing IR can to some extent control: the amount of credit and

borrowing from banks and financial institutions; and therefore the

amount of money circulating in the economy

Monetary Policy objectives in macroeconomics:

Monetary Policy is the primary method used to control Inflation

Inflation comes together with economic growth

Check your book for definitions of these



Raising the Interest will only moderate inflation – rarely reduce

it

Raising Interest Rate causes a drop in Aggregate Demand, as

follows:

Less purchases of Consumer durable goods

Housing market – drop in purchases of homes

Wealth effects – drop in value of assets / wealth lower

spending

Government Bonds – drop in Bond prices

Savings – increase in savings

Investment – drop in investment in projects

Unemployment – Rising IR tends to lead to drop in output,

which would tend to lead to rise in unemployment

Exchange Rate / Balance of payments: increase in local

currency’s value an increase in exchange rate increase in

price of local goods less exports, more imports; less exports

= lower AD

Therefore, a decrease in Economic Growth

Increase in IR called “Tightening” / Dropping IR is called

“Loosening”

Classical Economics (LRAS is vertical): a rise in IR / drop in AD

causes a drop in prices, no effect on output

Keynesian – if close to full employment, a rise in IR lowers prices,

but also creates a small effect on output and unemployment; if

closer to mass unemployment, a rise in IR has a smaller effect on

prices, mainly lowers output and increases unemployment

Operations of Monetary Policy

IR affects the money supply – they’re linked (market diagram for

money)



Besides changing IR, government can take steps to directly affect

money supply:

Open Market Operations – sell, buy government debt (bonds)

Reserve Asset Rates – the % banks must hold (explain, include

the Credit Multiplier)

Other Rules and regulations that can influence other variables,

such as home sales and purchases

Money Supply and the Budget Deficit

If Government borrows from the public (sells bonds) to

finance the Public Sector Net Cash Requirement (PSNCR), this

is just borrowing from the public to spend, so no effect on

money supply, just IR

Print more money / sell gov’t debt to banking sector. Gov’t

spending goes into the public, in effect increasing the money

supply

Limitations of Monetary Policy

Money supply not always clearly measurable

Reliable, timely data not easy to produce

The links between IR, money supply not clear

Effects often take time to work through the economy

Unexpected events



Inflation: rise in general price levels over a long period of time

Deflation: lowering in general prices, or, slow down in economic

output

Measured by the “Retail Price Index” – a basket of goods,

weighted average, subject to inaccuracy ...

Problems during inflationary periods:

Consumers unclear what’s a fair price “Shoe Leather costs”

Less cash (more in savings) (IR higher, opportunity cost),

difficult to plan

“Menu Costs” prices constantly changing (e.g. restaurants)

“Redistributional Costs” income & wealth, may result in transfer

from borrowers to lenders; savers lose if Inflation > Nominal IR

Creates Unemployment and lowers Growth – increases costs of

production, reduces investment – which decreases the

likeliness of long-term growth

Anticipated/Unanticipated: Mostly unanticipated, difficult for cons.

to plan

Causes of Inflation:

Imported – Increases in prices of imported goods

Demand-Pull – Too much spending in relation to output shifts AD.

Use AD/LRAS curves to show

Cost-Push – Changes in costs (supply side): any cost (wages,

salaries; imports; profits; taxes) rises, pushes up SRAS, prices

rise; Workers react by demanding higher salary, prices go up

again; go right into spiraling effect

Both these are “Keynesian” theories



“Monetarists”: inflation is Demand-Pull; sustained inflation caused

by increases in money supply (don’t believe in Cost-Push)

Increase in Money Supply rise in AD, directly and indirectly (Multiplier)

The Fisher formulation of the quantity theory of money

M V = P T

M = Money Supply; V = Velocity, P = Prices; T = number of transactions

Increase in M immediate fall in V, then additional money begins to be spent

gradual increase in Y (income), V increases back to standard – gradual rise leads to

Demand-Pull inflation (rise in prices, P) – P rising Real Income come back down

(adj for Inflation) V & Y return to equilibrium, P remains at higher level Monetary

Transmission Mechanism (see textbook)

Increase in MS increase in AD rise in SRAS – Shift back to LRAS.

(New) Consider where costs rise (shift SRAS up) If Price levels increase when

economy is below full employment – Stagflation. Workers may demand higher

wages, but if MS is fixed, may not come – workers stay out of work for some time,

then economy will begin to return to full employment

Counter-Inflation policy:

Monetary Policy: Raise IR = less spent on durable, investment; reduce wealth –

lower stocks value, homes (mortgage); rise exchange rate; increase saving

This only happens if economic growth slows or reduces (not

popular!)

Fiscal Policy: Government spending: If Demand-Pull, government

reduce spending, AD.

If Cost-Push, government can: reduce (or not increase) indirect

taxes; reduce (or not increase) prices in government controlled

sectors (rail, post, etc.); reduce corporate taxes –– argued these

steps only change money supply

Exchange Rate Policy: controlling exchange rate directly or

through changes in Interest Rate can affect Cost-Push Inflation

Prices and Incomes Policies: To directly control / freeze prices &

wages – argued this can work for some time (short)

Inflation / Deflation

Retail Price Index / Consumer Price Index – be familiar with how

it’s calculated, and, the possibilities of inaccuracy

Be familiar with the effects of inflation, and, anticipated and

unanticipated



Labour market (diagram) & Equilibrium – As more enter the

market the marginal revenue product of labour declines

(downward slope)

Unemployment when labour market is in disequilibrium:

Cyclical / Demand-Deficient (Keynesian) – demand falls Negative

output gap

Classical / Real Wage – wages above equilibrium and factors keep

them from going back down (“sticky downward”). Market fails to

clear because: u/e benefits too high; minimum wages; unions.

Unemployment when labour market is in equilibrium:

Frictional – workers lose jobs, spend a short time looking for

work.

Structural – economy doesn’t provide enough jobs for the labour

supply within a labour market: regional; sectoral; technological

Seasonal – based on seasonal work

Cyclical U/E is Involuntary – no choice – boom time, no cyclical

u/e

All other u/e is Voluntary – workers refuse opportunities for jobs.

The economy is at “full employment” when there is no involuntary

u/e

The natural rate of u/e is the

percentage of voluntarily

unemployed EF = Unemployment

(natural level

of unemployment)

So, Natural rate of u/e =

EF / OE

Classicals: Short run u/e

temporary, wages will fall,

SRAS2

Prices /

Inflation

Real

Wage Workers

Rate

S (Labour

Force)

D (Firms)

0 E F Employment



labour market will move

back to equilibrium; Long

run – unemployment will be

Voluntary.

Inflation & Unemployment using AS/AD:

AD shifts out, causing rise in

prices

Costs will also rise, incl wages

Shift SRAS up

New Equilibrium

higher prices

0 Real Nat’l Income



The Phillips Curve:

Relationship between unemployment and inflation

Money Illusion: Workers not knowing about inflation believe

prices are stable – won’t include inflation in their pay increase

requests

Term: “Money Wage Rate” =

actual wages, not adjusted for

inflation

Unemployment: those not

working

Starting at 0, if gov’t increases

AD, move up P Curve, lower

u/e, but, with

inflation. If workers don’t know there is inflation, moves back to

A.

If they know, they will demand more pay, stay unemployed, push

P Curve out. LRPC is vertical. Increase in AD will push PC out.

Natural rate of u/e = NAIRU (Non-Accelerating Inflation Rate of

Unemployment) – u/e rate sustained with or without change in

inflation

Employment tends back to natural rate of u/e

The Phillips Curve is why there is a “curve” in the Keynesian

LRAS Curve

Keynesians: believe that in high u/e times, it takes a long time for

the labour market to “clear”, so they don’t believe in natural rate

of u/e

0 A Unemployment

Δ MWR

(Inflation)



Neo Classicals: argue that people can see inflation coming, and

immediately adapt (Theory of Rational Expectations) – SR Phillips

Curve doesn’t exist.

Policy steps Government can take to deal with Unemployment

For Cyclical u/e, use demand policies (increase AD), but watch for

inflation

Classical economists (vertical LRAS) say economy will always

return to full employment, so demand policies not necessary and

may be damaging

For other types of unemployment (voluntary), use supply side

policies:

Classical (real wage) u/e: Keynesians say cut unemployment

benefits; pay companies to hire unemployed; give other benefits

to low-wage workers. Classicals agree, and also add reducing

Union power, reducing minimum wages

Frictional (short term) – u/e services; reduce u/e benefits

Structural: If Regional: Keynesians say government should use

financial incentives for businesses to relocate; Classicals say leave

it to free market forces (cheap land, labour costs);

If Industrial: Keynesians say retrain workers; Classicals say lower

benefits & redundancies; (some of these measures will also help

frictional u/e)

Another solution – reduce natural rate of u/e: increase growth

rate of whole economy (assuming this will increase number of

jobs): Keynesians suggest increasing investment in physical and

human capital. Classicals suggest reducing tax rates; privatizing;

increasing competition; deregulating.



Terms of Trade: the ratio of export prices to import prices, or,

costs, or …

Example:

½ resources allocated each Freezers Dishwashers

Germany 1,000 500

Italy 800 200

Total Output 1,800 700

Germany produces more of both than Italy.

But Italy is closer to Germany in producing Freezers than

Dishwashers.

Opportunity costs of producing Freezers:

Germany 1 / 2 Dishwasher

Italy 1 / 4 Dishwasher

Therefore, Italy should specialize in producing Freezers

Output after Specialization Freezers Dishwashers

Germany 400 800

Italy 1,600 0

Total Output 2,000 800

Source: www.tutor2u.com



International Markets

Availability, Price and Product Differentiation lead to International

Trade

Economic Theories on Int’l Trade:

A. Smith Absolute Advantage – based on lower production cost

(labour).

David Ricardo Relative / Comparative Advantage (early 1800’s)

even if one country produces products more cheaply; countries

may be better off to specialize and trade (overall economic

efficiency) – countries will benefit from trade when comparative

cost of production are different

Example of the value of trade:

Tom has an absolute advantage on both products

Evaluate their opportunity costs:

Both can benefit from specializing and trading

Tom should catch fish, and Hank should catch crabs

Assumptions of Theory of Comparative Advantage

Production Possibility Produces &

Consumes Fish Crabs

Tom Fish 40 -0- 28 Crabs -0- 30 9

Hank Fish 10 -0- 6

Crabs -0- 20 8

Tom Hank

1 Fish 3/4 crab 2 crabs 1 Crab 4/3 fish 1/2 fish

Produces &

Consumes

Trade &

Consume Specializing Trading

Tom Fish 28 40 fish -10 fish 30

Crabs 9 0 crabs +10 crabs 10

Hank Fish 6 0 fish +10 fish 10 Crabs 8 20 crabs -10 crabs 10



No transport costs (even with, may still make sense)

No Economies of Scale (EofS enhance this theory)

Two economies, 2 goods

Traded goods are homogeneous

Factors of production perfectly mobile

No tariffs or other barriers

Perfect knowledge

Non-Price theory of trade

For non-homogeneous goods, other things help determine trading

practices, such as: design, reliability, availability, image, etc.

Trade Policy

Benefits of Free Trade

Efficiencies through theory of Comparative Advantage

Economies of scale

Greater choices on what to buy

Seems to enhance competition

Globalisation – Integration of world economies

Benefits Disadvantages

Reduce prices / more affordable Put many local workers out of work

Give poorer countries

development

Destroying the environment

Reasons to justify protection

“Infant Industries” – give time to grow domestically (size,

market, econ of scale, learning curve, etc) then open to

foreign. But gov’t must be able to correctly pick the industries

that will grow well

Protect / preserve jobs – ends up giving consumers less

choices; foreign countries can retaliate, leading to further loss

of choice for consumers



Dumping – some countries selling goods for export at below

their cost

Unfair competition (labour) – a comparative advantage (for

consumers)

Terms of Trade – if a country demands too much of an

imported product, gov’t could impose a tariff. Economy would

lose because consumers would pay higher price. In addition,

exporting country would also lose, as tariff would still restrict

trade.

Others: Defence, protect populations, protect from something

unsafe, etc

Protectionism: acts by

countries (gov’t or private)

to protect industry that

restrict trade

Methods of protectionism:

Tariff: Tax (Duty) imported

good

Effects of tariff:

Increase Price, increase

amount sold by local

producers

Quota: limit on the quantity

that can be imported.

Reduced imports raise

prices, increasing domestic

SDomestic

SWorld+Tariff

SWorld

D

World P

SDomestic

SWorld

D



supply (shaded area is

windfall)

Other Protection: Voluntary

Export

Agreements – enforced by importers; non-competitive purchasing

by governments; safety standards; etc.

In all cases, economists would argue in favour of other methods



Balance of Payments Acct – record financial dealings between

countries

Current Account – exchange of goods and services

Capital Account – flows of monetary assets re savings,

investments, etc

Balance of Payments will always be in balance. Since cash is not

exchanged, shifts in Current Accounts are financed by loans to or

from the Capital Accounts

Current Account divided into 2 groups:

Visibles: trade in goods: Exports are positive, Imports are

negative. Difference between visible exports and visible imports

= Balance of Trade

Invisibles: Trade in services, investment income, etc.

Current account is combination of these two

Small, short term Current Account Deficits or Surpluses not a

problem

Large Current Account Deficits over the long term

Country or its people spend too much on foreign-produced

goods

If too much, too long, doubts repayment, foreign lenders stop

loaning

Less goods available – imports stop, domestic goods exported

If economy strong, foreign institutions won’t stop, country can

benefit

Large Current Account Surpluses over the long term

Can be seen as sign of economic strength … but they can:

Reduce what’s available for consumption within the country

Can cause problems between trading nations



Exchange Rate Policy – ways to affect the Exchange Rate

Fixed Exchange Rate system – one currency pegged to another

Free or Floating Exchange Rate Policy – free market forces …

Interest Rate – increase will tend to increase Exchange Rate

Gold and Foreign Currency Reserves – Central bank has them, can

sell off to attract more pounds, increase value of pound, or vise

versa

Either of these steps will only ever make small changes.

Review the Macroeconomic effect of change in exchange rates:

If Value Increases If Value Decreases

Inflation Moderate or reduce Some imports

reduce £

Decrease in AD

May increase Imports & Export £

rise

Increase in AD

Economic

Growth

SR lower domestic

output and

investment, lower AD

SR higher domestic

output and

investment, rise AD

Unemployment Rise because of low AD

Lower as AD increases

Current Balance Decrease Exports,

Increase Imports, Reduce the current

Balance

Increase Exports,

Decrease Imports, Increase the current

Balance

Theory on exchange rate policy and reducing trade deficits

MARSHALL LERNER Condition:

Depreciation / Devaluation of currency…

If combined PED of X and M > 1 …

Results in improvement of trade deficit

If combined PED of X and M < 1 …

Results in worsening of trade deficit

Example of MARSHALL LERNER Condition:



Assume: Exchange rate: £1 = $2

Price Demand Revenue Bal. of

Trade

Exports £100 550 £55,000

–£5,000 Imports £100 600 £60,000

Assume: Depreciate currency to £1 = $1.80 (10%)

PED Price Demand Revenue Bal. of

Trade

Exports 0.6 £100 583 £58,300

–£2,420 Imports 0.8 £110 552 £60,720

1.4 Marshall Lerner Effect satisfied, Deficit reduces

Exports 0.4 £100 572 £57,200

–£5,500 Imports 0.5 £110 570 £62,700

0.9 Marshall Lerner Effect not satisfied, Deficit

rises




at any given price

Law of Demand: If all else remains the same, as prices rise, people will demand less,

and, if prices go down, people will demand more

The Demand Curve – Diagram

Downward sloping – inverse / negative relationship: as price

decreases, quantity demanded increases, and, vise versa

Demand of entire Markets shown the same way


Determinants of Demand (factors that affect Demand)


Prices of other goods (with, or, instead of)

Incomes


Population size or structure

Advertising

Expectations of consumers

Changes in laws

CONSUMER SURPLUS

The area above price level and to the left of the Demand Curve. The amount that

consumers who were willing to spend more, don’t have to spend. The benefit to

consumers of having markets. (The more quantities are available, the less value

consumers place on it.)



Law of Supply: If all else remains the same, as prices rise,

producers will supply more, and, if prices go down, producers will

supply less

The Supply Curve – diagram

Changes in any

of these will

cause Demand Curve to shift,

either inward

or outward



Upward sloping – positive relationship: as price increases,

quantity supplied increases, and, vise versa

Supply of entire Markets shown the same way

Market Supply: add together all Individual Supply Curves

Determinants of Supply (factors that affect Supply)


Costs of Production


Technology

Producers’ Goals


Future expectations

PRODUCER SURPLUS

The area below price level and to the left of the Supply Curve. The

low prices that producers who were willing to sell, don’t have to

sell so low. The benefit to producers of having markets (some

firms receive a higher price than the lowest price they were willing

to supply the market)






EXCESS DEMAND: Market Price below Equilibrium price, Demand

> Supply

EXCESS SUPPLY: Market Price above Equilibrium price, Demand <

Supply


Changes in any

of these will

cause Supply Curve to shift,

either inward

or outward






Equilibrium Price

Market Clearing Price: Equilibrium price. For many different

reasons, Market Price very often does not equal Equilibrium Price

– there could be excess Demand or excess Supply at any time.

Stable equilibrium – where FREE MARKET FORCES push prices

to equilibrium point.

Unstable equilibrium – in some cases, FREE MARKET FORCES

may not be strong enough to push price to equilibrium.



Tutorial

Page 25, Question 2

Price

20

16

12

8

4

10 20 30 40 50 Quantity (millions)

HW for Tuesday: P. 27, Q 6

Price

500

400

300

200

100

100 200 300 400 500 600 700 800 Quantity

(millions)

Price A B C Ttl D Ttl B Ttl

100 500 250 750 1,500 500 2,000 -250 1,750

200 400 230 700 1,330 500 1,830 -230 1,600

300 300 210 650 1,160 500 1,660 -210 1,450

400 200 190 600 990 500 1,490 -190 1,300

500 100 170 550 820 500 1,320 -170 1,150

(a,A) (a,B) (a,C)

(a) (c)



P. 34, Q. 2

(a) A Supply Curve shift to the left (a reduction in Supply) indicates a reduction in earnings. With less profits, producers will

tend to be less willing to supply goods and services.

(b) (i) furthest: 1996, 2002,1994; (ii) least far: 1984, 1978, 1972, 1975

HW for Thursday: P. 36, Q. 5

Price

5

4

3

2

1

10 15 20 25 30 35 40 45 50

Quantity

Price A B C Ttl (c) Ttl

1 10 2 0 12 5 17

2 12 5 3 20 5 25

3 14 8 6 28 5 33

4 16 11 9 36 5 41

5 18 14 12 44 5 49 (b)(i) 1 = 12; (ii) 3.5 = 32

(d) Greater productive efficiency would lead to greater production at lower costs.

This would shift the supply curve to the right and downwards

HW for Thursday: P. 42, Q. 1

Price

30

20

10

10 20 30 40 50 60 70 80 Quantity

(b) Equilibrium price is 20

(c) (i) Excess demand below 20; (ii) Excess supply above 20

(d) (i) 10 = shortage; (ii) 40 = glut; (iii) 22 = glut; (iv) 18 =

shortage; (v) equilibrium

(a) (c)

S

D



Interrelationships in the Market

How events in 1 market lead to changes in another

COMPETITIVE DEMAND / Substitute Goods – Goods that replace

each other

Examples: rice and noodles; beef and pork

An increase in price of one good “C” leads to a decrease in

quantity demanded for that good (movement along D).

This leads to an increase in demand for the substitute good

“D” (D shifts out) and an increase in price (movement along

S)

JOINT DEMAND / Complementary Goods – Goods that are used

together

Examples: cement and sand; DVD’s and DVD players

A decrease in price of one good “A” leads to an increase in

quantity demanded for that good (movement along D)

This leads to an increase in demand for the complementary

good “B” (D shifts out) and an increase in price (movement

along S)



DERIVED DEMAND – Goods needed to produce other goods

Examples: Cars need steel; bread and cakes need flour

An increase in demand for finished good “E” (D shifts out)

results in an increase in demand for good “F” (needed to

produce “E”) (D shifts out) and an increase in price of “F”

(movement along S)

JOINT SUPPLY – One good supplied for producing 2 different

goods

Examples: cows supply us with beef and leather

Increase in demand for finished good “G” (D shifts out)

results in an increase in the price (movement along S).



Producers will increase supply of the resource, leading to an

increase in supply of the other product “H” (S shifts out),

and price will decrease (movement along D)

Elasticities

Elasticity = Effect (responsiveness) on factor “Y” by a change in factor “X”

Price Elasticity of Demand (PED) = Effect on quantity demanded by change in price,

or, responsiveness of quantity demanded to price changes

Elastic = Change in Price causes large change in Quantity

Demanded

Inelastic = Change in Price causes small change in Quantity

Demanded



PED =

Determinants of PED:

Price

Quantity

Quantity

Price X

Quantity

Quantity

Price

Price ÷ OR

OR

Quantity

Quantity

X Price

Price


-0- Perfect Inelasticity No response in quantity demanded


1 Unitary Elasticity % in Q demanded = % in Price


∞ Perfect Elasticity Consumers demand ∞ Q at that price






Noodles & rice, etc; if price of noodles rises, consumers

shift to rice, etc. So, price elasticity for noodles is high.

Salt has few substitutes, so a rise in price will have little

effect on total demand. Price elasticity for salt is low.


Oil: when price rises, with nothing to replace it, people

buy more. But over time, people change driving habits,

buy more efficient cars, take public transportation,

causing quantity demanded to fall

11. Necessities tend to have lower PED

12. Low-priced goods tend to have lower PED

13. Luxury goods tend to have higher PED

14. High-priced goods tend to have higher PED



IMPORTANT: PED along straight Demand curves can be different!

PED at any given point “B” =



PED is important because it affects total spending (expenditure)

on the product, and therefore total income (revenue) received by

the firm. This helps determine whether a company’s total income

(revenue) will increase or decrease when they raise prices.

Total Expenditure (TE) = Q x P

Inelastic products: rise in price results in increase in Total Revenue

Elastic products: rise in price results in decrease in Total Revenue

Example:

Qty Price Qty Price PED TE5 10 50

5 10 4 14 0.50 56 %ΔP ≥ %ΔQ - Inelastic - TR increases5 10 2 14 1.50 28 %ΔP ≤ %ΔQ - Elastic - TR decrease

Original New

Cross Elasticity of Demand (CED) – How demand for good “X”

changes with change in price of another good “Y”

Substitute goods (noodles and rice) have a positive CED. Increase

in price of one (rice) leads to increase in demand of the other

(noodles)

Complementary goods (sand and cement) have a negative CED.

Increases in Price of one (sand) leads to decrease in demand for

the other (cement)



A = ∞ = Elastic


C = 0 = Inelastic

Pri

ce

Quantity


% in price of another good Y P of Y

Q of X

Q of X

P of Y X OR

Q of X

Q of X / P of Y

P of Y OR

CED =



Income Elasticity of Demand – change in demand with change

of consumers’ Income

Demand for most products increases as incomes rise

Inferior goods: Goods where a rise in income causes a decrease in

demand


quantity supplied.






-0- Perfectly

Inelastic





∞ Perfectly Elastic Producers supply ∞ Q at that price



Price

Quantity

Quantity

Price X OR

Quantity

Quantity /

Price

Price

OR

I

Q

Q

I X / OR OR

Q

Q X

I

I

Q

Q

I

I



Elasticity of Demand Tutorial

P 50, Q 1

Elasticity of Supply Tutorial

Review P 62, Table 9.1 Results: 1, 2 & 5 are Income Elastic; 3 & 4 are Income Inelastic

Do Q P 64, Q3 Price

Quantity Quantity Elast of

Supplied Price Supplied Price P / Q x Q / P = Supply

(a) 0 4 3 6 4 / 0 x 3 / 4 = Infinity Perfectly Elastic

(b) 3 6 6 8 6 / 3 x 3 / 6 = 1 Unitary

(c) 6 8 9 10 8 / 6 x 3 / 8 = 1/2 Elastic

(d) 7.5 9 4.5 7 9 / 7.5 x 3 / 9 = 2/5 Elastic

(e) 4.5 7 1.5 5 7 / 4.5 x 3 / 7 = 2/3 Elastic


Calculation

Sample Exam:

3. A

4. D (have one of the students calculate on board) Price Elasticity of Demand =

5. C (have one of the students calculate on board)







An economy is judged by how well it answers the three

questions:

What goods and services it produces?

How well it produces those goods and services?

For whom does it produce those goods and services?

_____________________________

_____________________________

_____________________________

_____________________________

_____________________

M________

Efficiency

P________

Efficiency

T________

Efficiency

A________

Efficiency




_____________________

_____________________________

_____________________________

_____________________________

_____________________________

An economy is judged by how well it answers the three

questions:

What goods and services it produces?

How well it produces those goods and services?

For whom does it produce those goods and services?

Economy is producing on the

PPF

S_______

Efficiency

D________

Efficiency

Market

Efficiency



Competition helps

achieve

Production achieved at the

lowest

possible cost.

Maximum outputs

with

the minimum

inputs

Resources used to

produce

g & s consumers

want

One-time savings that can be

achieved

Ongoing savings that can be

achieved

Productive

Efficiency

Technical

Efficiency

Allocative

Efficiency

Static

Efficiency

Dynamic

Efficiency




1. In the following sentence on price elasticity of demand, Delete the words in

bold which are incorrect.

a. The price elasticity of demand measures the responsiveness of the

quantity demanded / price to a change in the quantity demanded /

the quantity supplied / price.

b. Give the formula for price elasticity of demand.

2. In the mid 1990s, the government in the UK announced that for every 10 per

cent rise in the price of cigarettes, the demand is likely to fall by 6%. If this

information is correct, what is the value of the price elasticity of demand for

cigarettes?

3. In each of the following pairs, decide which of the two items is likely to have

the more elastic demand. Give reasons for your answer.

a. Petrol (all brands) and Esso petrol

b. Holidays abroad and Bread

c. Salt and Clothing

The following table shows the quantity of a product demanded at two different

prices:

P Q

16 25

14 35



4. What is the price elasticity of demand from £16 to £14? Show formula and

calculation.

5. The following diagram shows two demand curves that cross at a price of P0.

Which of the following statements are true?

a. Curve D1 is more inelastic and curve D2 more elastic. True / False

b. Demand is more elastic between P0 and P1 along curve D2 than along

curve D1. True / False

c. For any given change in price there will be a larger proportionate

change in quantity along curve D1 than along curve D2. True / False

6. Answer the following:

a. What is the formula for income elasticity of demand?

b. Which of the following would you expect to have a demand which is

elastic with respect to income? (There is more than one.)

i. Flour. Yes / No / Possibly

ii. Ready-prepared meals for the microwave. Yes / No / Possibly

iii. Champagne. Yes / No / Possibly

iv. Socks. Yes / No / Possibly

v. Designer jeans. Yes / No / Possibly

vi. Electricity. Yes / No / Possibly

vii. Bus journeys. Yes / No / Possibly



The Nature of Production - Efficiency

Productivity is an important part of a business being efficient. Efficiency can mean

different things in business but there are essentially two ways we can look at it.

Productive Efficiency: A business can improve productive efficiency by producing

output at the lowest cost possible. If it can find a way of producing its products cheaper

then it can improve its productive efficiency.

Technical Efficiency: A business can improve its technical efficiency if it could find a

way of using its existing resources to produce more. It may be that it could use machinery

instead of people that do the same job but do it much faster without having to take a break!

Task

Units of

machine

Cost of

machine

per unit

Units of

labour

Cost of

labour

per unit

Output TC

Cost per

unit

(average

cost)

10 £20 5 £15 100

5 £20 10 £15 100

15 £20 7 £15 150

15 £20 8 £15 170

20 £20 1 £15 150

25 £20 4 £15 200

Complete the table calculating the total cost and the average cost.

Having completed the table, which would be the most efficient combination for the

firm to use? Explain your answer.



Questions 17 and 21 are based on the figures in the table below

Output

(000s)

Fixed

Capital

inputs

(£000s)

Variable input cost

(£000s)

Total

Costs

(£000s)

AC

(£000s)

Revenue

(£000s)

Units Labour Materials

10 10 10 10 30 3 50

15 10 15 15 40 2.67 67.5

20 10 20 20 50 2.50 80

25 10 24 25 59 2.36 87.5

30 10 28 30 68 2.27 90

35 10 30 35 75 2.25 87.5

40 10 40 40 90 2.25 80

45 10 50 45 105 2.33 67.5

50 10 60 50 120 2.40 50

17 As output increases from 35 to 40 the firm experiences...

Optimal returns to scale Decreasing returns to scale Increasing Returns to scale Constant returns to scale

18 The Marginal Cost per unit as output rises from 30 to 35 is

A. A £2.25 B. B £1.40 C. C £7.00 D. D £0.70

19 Not shown 20 Not shown 21 Not shown

Output

(000s)

Fixed

Capital

inputs

(£000s)

Variable input cost

(£000s)

Total

Costs

(£000s)

Marginal

Cost

MC

AC

(£000s)

Revenue

(£000s)


10 10 10 10 30 3 50

15 10 15 15 40 2.67 67.5

20 10 20 20 50 2.50 80

25 10 24 25 59 2.36 87.5

30 10 28 30 68 2.27 90

35 10 30 35 75 2.25 87.5

40 10 40 40 90 2.25 80

45 10 50 45 105 2.33 67.5

50 10 60 50 120 2.40 50

B

B



Complete the table below and use the information to answer questions 11 to 15

Quantity FC VC TC AC MC MR TR

0 1000 0 n/a n/a n/a 0

1 400 800

2 600 1600

3 1000 2400

4 1600 3200

5 2400 4000

6 3400 4800

11

The average cost when the level of output is 2 is:

a. 680

b. 650

c. 800

d. 530

12. The average fixed cost when the level of output is 5

a. 800

b. 600

c. 750

d. 200

13. The average cost is lowest:

a. When output is 3

b. When output is 4

c. When output is 5

d. When output is 6

14. The marginal cost of the 6th

unit of output is:

a. 4,400

b. 3,400

c. 1,000

d. 800



15. The profit maximizing level of output is:

a. 3

b. 4

c. 5

d. 6



0 1000 0 n/a n/a n/a 0

1 400 800

2 600 1600

3 1000 2400

4 1600 3200

5 2400 4000

6 3400 4800

11


a. 530

b. 650

c. 680

d. 800


a. 800

b. 600

c. 750

d. 200


a. When output is 3

b. When output is 4

c. When output is 5

d. When output is 6


unit of output is:

a. 800

b. 1,000



c. 3,400

d. 4,400


a. 6

b. 5

c. 4

d. 3





0 1000 0 n/a n/a n/a 0

1 400 800

2 600 1600

3 1000 2400

4 1600 3200

5 2400 4000

6 3400 4800

11


a. 680

b. 650

c. 800

d. 530


a. 800

b. 600

c. 750

d. 200


a. When output is 3

b. When output is 4

c. When output is 5

d. When output is 6


unit of output is:

a. 4,400

b. 3,400

c. 1,000

d. 800




a. 3

b. 4

c. 5

d. 6



0 1000 0 n/a n/a n/a 0

1 400 800

2 600 1600

3 1000 2400

4 1600 3200

5 2400 4000

6 3400 4800

11


a. 530

b. 650

c. 680

d. 800


a. 800

b. 600

c. 750

d. 200


a. When output is 3

b. When output is 4

c. When output is 5

d. When output is 6


unit of output is:

a. 800

b. 1,000

c. 3,400



d. 4,400


a. 6

b. 5

c. 4

d. 3



(from Unit 46, Question 4)

Labour

Total

Product

Average

Product

Marginal

Product

1 8 8

2 24 12 16

3 42 14 18

4 60 15 18

5 70 14 10

6 72 12 2 0

10

20

30

40

50

60

70

80

0 1 2 3 4 5 6 7

Labour

Ou

tpu

t Total Product

Average Product

Marginal Product

Unit 46, Q. 5 , Unit 47, Q. 2 & 4

(Unit 48, Question 1)

Given: Cost of Capital 200 Unit Cost of Labour 50

Labour Quantity TFC TVC TC AFC AVC ATC MC

1 20 200 50 250 10.0 2.5 12.5

2 45 200 100 300 4.4 2.2 6.7 2.0

3 60 200 150 350 3.3 2.5 5.8 3.3

4 70 200 200 400 2.9 2.9 5.7 5.0

0

50

100

150

200

250

300

350

400

450

0 20 40 60 80

Output

Co

sts

TFC

TVC

TC

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

0 20 40 60 80

Output

Co

st

AFC

AVC

ATC

MC



(Unit 48, Question 2)

Given: Cost of Capital 1 Unit Cost of Labour 2

Capital Labour Quantity TFC TVC TC AFC AVC ATC MC

10 0 0 10 0 10 - - -

10 1 8 10 2 12 1.3 0.3 1.5 0.3

10 2 24 10 4 14 0.4 0.2 0.6 0.1

10 3 42 10 6 16 0.2 0.1 0.4 0.1

10 4 60 10 8 18 0.2 0.1 0.3 0.1

10 5 70 10 10 20 0.1 0.1 0.3 0.2

10 6 72 10 12 22 0.1 0.2 0.3 1.0

0

5

10

15

20

25

0 20 40 60 80

Output

Co

st TFC

TVC

TC

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

0 20 40 60 80

Output

Co

st

AFC

AVC

ATC

MC



Questions 17 and 21 are based on the figures in the table below

Output

(000s)

Fixed

Capital

inputs

(£000s)

Variable input cost

(£000s)

Total

Costs

(£000s)

AC

(£000s)

MC

(£000s)

Revenue

(£000s)

MR

(£000s)


10 10 10 10 30 3.00 50.0

15 10 15 15 40 2.67 2.00 67.5 3.50

20 10 20 20 50 2.50 2.00 80.0 2.50

25 10 24 25 59 2.36 1.80 87.5 1.50

30 10 28 30 68 2.27 1.80 90.0 0.50

35 10 30 35 75 2.25 1.40 87.5 -0.50

40 10 40 40 90 2.25 3.00 80.0 -1.50

45 10 50 45 105 2.33 3.00 67.5 -2.50

50 10 60 50 120 2.40 3.00 50.0 -3.50




E. A £2.25 F. B £1.40 G. C £7.00 H. D £0.70

19 Which of the following statements is NOT TRUE at an output of 30 units A. The firm is achieving increasing returns to scale B. This is the profit maximising level of output (between 20 and 25 units) C. This is the revenue maximising level of output D. Average cost is falling

20 The Optimal level of production would be at A. 20 B. 35 C. 35 to 40 D. 15 to 20

21 The Marginal Revenue curve would intersect the Marginal Cost Curve A. At an output of 20 units B. At an output of 30 units C. At an output between 20 and 25 units

B

C

B

B

C



Complete the table below and answer the questions that follow

Output

(000s)

Fixed

Capital

inputs

(£000s)

Variable input cost

(£000s)

Total

Variable

Costs

(£000s)

Total

Costs

(£000s)

AC

(£000s)

MC

(£000s)

Revenue

(£000s)

MR

(£000s)


10 10 10 10 50.00

15 15 15 67.50

20 20 20 80.00

25 24 25 87.50

30 28 30 90.00

35 30 35 87.50

40 40 40 80.00

45 50 45 67.50

50 60 50 50.00




I. A £2.25 J. B £1.40 K. C £7.00 L. D £0.70

3 Which of the following statements is NOT TRUE at an output of 30 units

E. The firm is achieving increasing returns to scale F. This is the profit maximising level of output G. This is the revenue maximising level of output H. Average cost is falling

4 The Optimal level of production would be at

E. 20 F. 35 G. 35 to 40 H. 15 to 20

5 The Marginal Revenue curve would intersect the Marginal Cost Curve

D. At an output of 20 units E. At an output of 30 units F. At an output between 20 and 25 units G. At an output between 15 and 20 units



1. Perfect competition is characterized by all of the following EXCEPT

A) well-informed buyers and sellers with respect to prices.

B) a large number of buyers and sellers.

C) no restrictions on entry into or exit from the industry.

D) considerable advertising by individual firms.

2. A barrier to entry is

A) an open door.

B) the economic term for diseconomies of scale.

C) illegal in most markets.

D) anything that protects a firm from the arrival of new competitors.

3. The demand curve facing a perfectly competitive firm depends on

A) market supply alone.

B) market demand and the market supply curve.

C) market demand and the firm’s supply curve.

D) market demand alone.

4 Which of the following terms would best describe the elasticity facing a perfectly competitive firm?

A) inelastic

B) perfectly inelastic

C) perfectly elastic

D) elastic

5. All of the following pertain to a perfectly competitive market except which one?

A) Consumers can shop for the lowest available price.

B) There is freedom of entry and exit of firms in the industry.

C) Consumers prefer certain brands over others.

D) All firms in the industry are price takers.

6. Which of the following is the best example of a perfectly competitive market?

A) diamonds B) farming



C) soft drinks D) athletic shoes

Use the diagram below to answer Questions 7 – 8

7. If the price a perfectly competitive firm is facing in the market is P2 then the profit-maximizing firm in the short run should produce output

A) B B) C

C) D D) E

8. The short-run shut down price for a perfectly competitive firm is

A) P3 B) P1

C) P2 D) P4

9. A perfectly competitive firm’s marginal-revenue curve

A) moves upward to the right and then declines when MC = MR.

B) is the same as the firmʹs TR curve.

C) is a straight line that coincides with the market demand curve.

D) is the same as the firmʹs demand curve.



Monopolistic Competition / Imperfect Competition

Assumptions:

Many buyers & sellers



Goods can be differentiated

Firms face a downward sloping Demand Curve, so they are not Price Takers

Differentiated products and substitute goods mean they face a higher price elasticity

of demand

In the Long Run:

They will produce where MR = MC;





(tangent)





Slides Slide 1

Economics

Slide 2 Economics

Microeconomics

Studies the behaviour of individual companies and consumers, in the production, distribution and consumption of goods and services

Slide 3 Economics

Macroeconomics

Studies the scientific theory and management of economies and economic systems



Slide 4

Basic Economic Problem

Slide 5 Infinite wants

• People desire to consume goods and services

Slide 6 Finite resources

• Choices must be made about how to use these resources to best try to satisfy the unlimited wants



Slide 7 Basic Economic Problem

Goods

Free Goods: unlimited quantities

Economic Goods: limited in quantity


• Because of the basic economic problem, choices must be made about how to allocate resources

• In a modern economy this allocation is decided by ‘the market’


• Economies must deal with it

• Judged by how well they deal with it

Economy: social organization, decides:

1. What is to be produced

2. How it is to be produced

3. For whom it is to be produced



Slide 10 Economic Systems

Planned or Controlled Market EconomyActors: Government, Consumers,

WorkersConsumers, Producers, Owners of Private Property, and, the Government

Motivation: For the common good Individuals maximize personal gain or

utility; Producers to maximize profits; Government maximize social welfare

Factors of Production:

All (except workers) owned by the State

Most owned by individuals; Government protects their rights and interests

Allocation: All resources allocated by

the State – “Planning Mechanism”

All businesses are free to buy / sell what

they want at prices they choose. Workers can work where they want. People can open their own business. Consumers buy as they like, and can afford.

Competition: None People choose to buy where they want. Businesses are forced to respond.

Mixed Economy: Resources allocated both by government through the planning

mechanism; and, by private sector through market mechanism

Slide 11 Production Possibilities

Basket 1 Basket 2

0 100

10 99

20 98

30 95

40 91

50 87

60 80

70 71

80 60

90 41

100 0

Slide 12 Production Possibility Frontier

0

20

40

60

80

100

120

0 20 40 60 80 100 120




The different combination of goods, or, goods and services an economy could produce if all resources are fully and efficiently used

Services

Goods

Slide 14 Opportunity Cost

• Choices are evaluated

• One choice will be selected as the ‘best’

• All other choices are given up

• Example: You have enough money for a DVD player or an MP3 player. If you choose the DVD player, you give up the opportunity to benefit from having an MP3 player.

• Opportunity cost: The benefit (of the next best alternative) we give up when we choose

Slide 15 Economic Resources

also called

Factors of Production

• Land

• Labour

• Capital

• Entrepreneurs



Slide 16 Opportunity Cost: Questions

• From a range of alternatives you have chosen to study at university in _________ (country).

• What were the other alternatives available to you when you made your choice?

• What was the opportunity cost of your choice?

Slide 17

Normative and Positive Statements

Slide 18 Normative Statements

• Contain a value statement

• Is a statement which shows opinion

• When used in economics, normative statements indicate whether something is desirable or undesirable

Example: The company has done a good job of improving their pollution record



Slide 19 Positive statements

• A statement of what is and what exists

• Is a statement that shows a fact

• When used in economics, positive statements show no indication of approval or disapproval

Example: The company has reduced their levels of polluting emissions by 13% over the last 12 months

Slide 20

Economic Growth

Exam Question Review

Slide 21 The Circular Flow of IncomeA diagram to show National

Income

Households

Firms

Y O

E

Banking Government Overseas

S

I

T

G

M

X

Saving

Investment

Taxes

Government Spending

Imports

Exports

Leakage

Injection

The Five Sector Model

Knowing and understanding this diagram IS required!



Slide 22 Circular Flow

Which one of the following is most likely to increase economic activity in the circular flow of income model? [1]

A Increased taxation

B Increased spending on imports

C Increased government spending

D Increased saving


Which of the following is an injection into the circular flow of income?

A Spending on imports

B Taxes

C Investment

D Saving




Slide 25 Positive Output Gap

With the use of a diagram illustrate how an economy can experience a positive output gap [3]

Slide 26 The Output Gap Diagram

Time

Rate

of G

row

th

Actual GDP

Trend GDP

Slide 27 Nominal vs. Real GDP

In 2005, nominal GDP in the country of Uralla grew by 5%, the consumer price index rose by 2.5% and, as a result of immigration, the population increased from 1,000,000 to

1,005,000. From this information, which of the following statements about Uralla is correct? [1]

A Real per capita GDP increased by exactly by 2.5%

B Real per capita GDP increased by more than 2.5%

C Real per capita GDP increased by less than 2.5%

D Real per capita GDP did not change



Slide 28

Demand

The behaviour of Consumers

Slide 29 Definitions

Demand: The quantity of a good or service consumers would be willing and able to buy at different given prices

Law of Demand: If all else remains the same (ceteris parabis), when the price of goods go down, more people will purchase greater quantities.

Slide 30 Demand Schedule

For example, look at the demand facing a single seller in a market, in this case, a tire seller.

Price (£) Quantity

demanded

40 5

30 15

20 25

10 35



Slide 31 Plot a Demand Curve

Price (£) Quantity

demanded

40 5

30 15

20 25

10 35

Quantity

Pri

ce Demand for Tires

40

30

20

10

0

10 20 30 40

D

Slide 32 Demand Curve

Quantity

Pri

ce Demand for Tires

40

30

20

10

0

10 20 30 40

D

At a price of 30, the

quantity demanded would

be 15, shown as follows…

A drop in price to 20 would

result in an increase in the

quantity demanded to

25.So, a change in price results

in a change in quantity

demanded, represented by

movement along the

Demand Curve.

How would a price of 20 be

shown?

Slide 33 The Demand Curve

The Demand Curve is downward sloping

There is an inverse relationship between priceand quantity demanded

As price decreases, quantity demanded will rise, and the opposite is also true

Market Demand: Add up the Demand Curves

faced by individual sellers



Slide 34 Determinants of Demand

• Price (results in movement along Demand Curve)

• Prices of other goods

• Incomes

• Tastes and fashions

• Population size or structure

• Advertising

• Expectations of consumers

• Changes in laws

Changes in any of these will cause Demand

Curve to shift, either inward or outward


Quantity

Pri

ce Demand for Tires

40

30

20

10

0

10 20 30 40

D

For example, as the Chinese

economy develops, people

are earning more, improving

their standard of living.

As a result, demand for tires

at all prices is increasing.

A change in any other

determinant results in a

change in quantities

demanded at all prices,

represented by a shiftingof the Demand Curve.

So, more people are buying

cars.

D1


Changes in Determinants of Demand:

• Change in Price: “movement along the demand curve resulting in an increase / decrease in quantity demanded”

• Change in any other factor: “causes the demand curve to shift out / in resulting in an increase / decrease in demand”



Slide 37 Consumer Surplus

Price (£)

Quantity Demanded

D

P1

Consider the Demand Curve BCD below. At a price P1,

consumers would purchase 0Q1 quantity.

The area of the triangle P1BC in the diagram is called the

Consumer Surplus, the total benefit to consumers of

a price P1

B

C

Q10

BC on the demand curve represents consumers who would be willing to pay a higher price, but need not.

The market brings them a benefit since they don’t have to pay as much as they

would have been willing to pay

Slide 38

Slide 39

Elasticity

Effect on factor “Y” by a change in factor “X”

or

the responsiveness of “Y” to changes in “X”



Slide 40 Price Elasticity of Demand (PED)

How much quantity demanded (Q) responds to changes in price (P)

•Elastic: Change in P causes larger change in Q

•Inlastic: Change in P causes smaller change in Q

Slide 41 Measuring the value of PED

PED = Percentage change in Quantity

Percentage change in Priceo

r

%ΔQ

%ΔP


-0- Perfectly Inelastic No change in quantity demanded when price changes

0 – 1 Inelastic Less than proportionate response to changes in price

1 Unitary Elasticity Percentage change in quantity = Percentage change in Price

1– ∞ Elastic More than proportionate response to changes in price

∞ Perfectly Elastic Consumers will demand any quantity at the given price

Slide 42 Determinants of PED



3. Necessities have lower PED

4. Low-priced goods have lower PED

5. Luxury goods have higher PED

6. High-priced goods have higher PED




PED and the demand curve

5

5

D

A Perfectly Inelastic Demand Curve looks like this



5

5

D

An Inelastic Demand Curve looks like this



5

5D

A Perfectly Elastic Demand Curve looks like this





5

5

D

An Elastic Demand Curve looks like this



5

5

D

A Unitary Elastic Demand Curve looks like this


But, PED along a demand curve is also different

5

5

Price drops from 7 to 6

PED = (1÷2) (–1÷7)

= 50% ÷ –14%

= –3.57

Elastic

Price drop from 3 to 2

PED = (1 6) (–1 3)

= 16% ÷ –33%

= – .48

Inelastic

D




If a business raises prices,

will it make more money?

It depends on Price Elasticity of Demand!

Total Expenditure (consumers)

=

Total Revenue (firms)

Slide 50

5

5

D

Measuring the value of PED

Total Expenditure & Total Revenue

= £6 x 3.75

= £22.25

TE = TR

= P x Q


Inelastic PED and TE

5

5

D

At a price of £6, notice the area of Total Expenditure

If the seller raises the price, notice the new area of TE

Notice how the blue area is much larger than the yellow




Elastic PED and TE

5

5

D



Notice how the blue area is much smaller than the yellow

Slide 53

Supply


Supply: The quantity of a good or service producers would be willing and able to produce and sell at different given prices.

The Law of Supply: If all else remains the same, as the price of a good increases, more producers will produce greater quantities.



Slide 55 Supply Schedule

Referring to the previous example, look at the choices our tire seller would make at different levels – a Supply Schedule.

Price (£) Quantity

supplied

40 35

30 25

20 15

10 5

Slide 56 Plot a Supply Curve

Price (£) Quantity

supplied

40 35

30 25

20 15

10 5

Quantity

Pri

ce Supply of Tires

40

30

20

10

0

10 20 30 40

S

Slide 57 Supply Curve

Quantity

Pri

ce Supply of Tires

40

30

20

10

0

10 20 30 40


quantity supplied would


A rise in price to 30 would


quantity supplied to 25.

A change in price results in

a change in quantity

supplied, represented by

movement along the

Supply Curve.


shown?

S



Slide 58 The Supply Curve

The Supply Curve is upward sloping

There is a positive relationship between priceand quantity supplied

As price increases, quantity supplied will rise, and the opposite is also true

Market Supply: Add up the Supply Curves of

all the individual sellers

Slide 59 Determinants of Supply

• Price (results in movement along Supply Curve)

• Costs of production

• Price of other goods

• Technology

• Producers’ goals

• Government legislation

• Future expectations

Changes in any of these will cause Supply



For example, if new technologies were introduced into China

which made the production of tires less expensive…

As a result, quantities of tires supplied at all price levels would

increase, causing the Supply Curve for tires to shift outward.

A change in any other determinant results in a change in

quantities supplied at all prices, represented by a shifting of

the Supply Curve.

Producers producing at all price levels would choose to

produce more tires.



Slide 61 The Producer Surplus

Price (£)

Quantity Supplied

S

P1

The area of the triangle P10C in the diagram is called the

Producer Surplus, the total benefit to producers as a

result of market price P1

C

Q10

Those producers benefit because they can sell at a

higher price

Consider the Supply Curve 0CS below. At a price P1, producers would produce 0Q1 quantity.

0C on the supply curve represents producers who would be willing to sell at a lower price, but need not.

Slide 62 Price Elasticity of Supply (PES)

How much quantity supplied (Q) responds to changes in price (P)



Slide 63 Primary Determinants of PES

1. Availability of substitute goods tends to increase PES

2. Time tends to increase PES



Slide 64 Measuring the value of PES

PES = Percentage change in Quantity


r

%ΔQ

%ΔP


-0- Perfectly Inelastic No change in quantity supplied when price changes


1 Unitary Elasticity % in quantity supplied = % in Price


∞ Perfectly Elastic Producers will supply any quantity at the given price

Slide 65

Economics

2nd Term

Slide 66 Economics

1st Term: Microeconomics

2nd Term: Macroeconomics

Definition: The science that deals with…

… the production, distribution

and consumption of goods and services, and…

… the theory and management

of economies or economic systems



Slide 67

Topics to be covered

Slide 68 Macroeconomics

• Introduction

• Economic Growth

• Aggregate Demand & Aggregate Supply

• Consumption, Savings & Investment

• Taxation

• Government Expenditure

• Redistribution of Income & Wealth

• Money & Monetary Policy

Slide 69 Macroeconomics

• Inflation

• Unemployment

• International Trade

• The Balance of Payments

(Continued)



Slide 70

Assessments

Slide 71 Assessments

Economic Growth Essay 10%

Final Exam 70%

Slide 72




Slide 73 Market Price

• Buyers and sellers

• Come together

• A price is “struck”

Slide 74 Equilibrium

Price (£)

Quantity

D

PE

Equilibrium Price (PE) and Equilibrium Quantity (QE) where Demand and Supply Curves intersect

QE

Equilibrium Price is sometimes called the Market Clearing price – at that price, all good would be sold.

Slide 75 Excess Supply

Price (£)

Quantity

D

PE

When Market Price (PM) is above PE this results in excess supply – surpluses

QE

PM

QD QS

Surplus



Slide 76 Excess Demand

Price (£)

Quantity

D

PE

When Market Price (PM) is below PE this results in excess demand – shortages

QE

PM

QDQS

Shortage

Slide 77 Stable / Unstable Equilibrium

Stable Equilibrium: Free market forces push market price toward Equilibrium

Unstable Equilibrium: Free market forces are not strong enough to push the market price to Equilibrium

Slide 78 Exam Problem

Which of the following actions could cause a higher price and a lower quantity consumed?A. An outward shift of the demand curveB. An inward shift of the supply curveC. An inward shift of the demand curveD. An outward shift of the supply curve



Slide 79

Slide 80

Interrelationships between Markets

Goods that affect other goods

Slide 81 COMPETITIVE DEMAND

Substitute goods

• Increase in price of one leads to a decrease in quantity demanded

• This leads to an increase in Demand for the substitute good, which leads to a rise in price



Slide 82

Pri

ce

Quantity

Market for Good "B"

Pri

ce

Quantity

Market for Good "A"

JOINT DEMAND

Complementary goods

• Decrease in price of one leads to an increase in quantity demanded

• This leads to an increase in Demand for the complementary good, which leads to a rise in price

Slide 83 Cross Elasticity of Demand

(CED) OR (XED)

XED = %ΔQ of X

%ΔP of Y

How demand for good “X” changes when the price of good “Y” changes

Substitute goods have a positive CED

Complementary goods have a negative CED

Slide 84

Pri

ce

Quantity

Market for Good "E"

Pri

ce

Quantity

Market for Good “F"

DERIVED DEMAND• An increase in Demand for finished good “E”

• Results in an increase in Demand for the good “F” needed to produce “E”, which leads to a rise in price



Slide 85

Pri

ce

Quantity

Market for Good "H"

JOINT SUPPLY• An increase in Demand for finished good “G”

• Results in an increase in Supply of the resource “H” needed to produce “G”, which leads to a lowering of price

Slide 86 Income Elasticity of Demand (YED)

YED = %ΔQ

%ΔY

How demand for a good changes when income (Y) changes

Most goods in general have a positive YED

Goods with a negative YED are called “Inferior Goods”

Slide 87

Economic Efficiency &

Market Failure



Slide 88 Economic Efficiency

EFFICIENCY

•MARKET Efficiency

•PRODUCTIVE Efficiency

•TECHNICAL Efficiency

•ALLOCATIVE / ECONOMIC Efficiency

•STATIC Efficiency

•DYNAMIC Efficiency

Slide 89


•Production Possibility Frontier (PPF)

•Competition

•To achieve MARKET Efficiency, there must be


Economic Efficiency

Slide 90


•Producing at lowest possible cost

•Can be achieved if production achieves …


Economic Efficiency



Slide 91


•Maximum output (production)

•Minimum input (resources)

Economic Efficiency

Slide 92

•ALLOCATIVE or ECONOMIC Efficiency

•Resources are being used to produce goods and services that people most want

•STATIC EFFICIENCY

•DYNAMIC EFFICIENCY

Economic Efficiency

Slide 93 Market Failure

MARKET FAILURE represents INEFFICIENCY

•Lack of COMPETITION

•EXTERNALITIES

•FACTOR IMMOBILITY

•INFORMATION FAILURE

•INEQUALITY / INEQUITY



Slide 94


Governments take action to deal with market failure

Slide 95 Market Stabilization

Wide price fluctuations lead to market failure

•Prices too high – consumers won’t buy

•Prices too low – producers won’t sell

•Make it difficult to identify the “signal”


Specific steps governments take:•Price Controls•Buffer Stock Schemes•Subsidies•Taxes



Slide 97 Price Controls

Price

Quantity

D

S

PE

Maximum Price (belowthe market price) results in Excess Demand.

Minimum Price (abovethe market price) results in Excess Supply.

PMax

PMin

Slide 98 Commodities

• Mostly agriculture & mining products

• Generally traded worldwide, but each economy faces its own market conditions

• Large Price fluctuations for various reasons– Bumper crops

– Crop failures

– Weather and other natural phenomenon

– Political situations

• Steep, inelastic Supply & Demand curves

• Small shifts create large changes in price

Slide 99 Buffer Stock Scheme

Price

Quantity

D

S

PI

Government sets the intervention price, say PI

If market price is belowPI, say PB…

PB

Government buys large

quantities, pushing Demand curve out until it reaches PI.

This creates a Buffer stock.

DI




Price

Quantity

D

S

PI

Assume the same intervention price, PI

If market price is above PI, say PA …PA

Government sells large

quantities from Buffer Stock, pushing Supply curve

out until it reaches PI

SA

Slide 101 Taxes

Price

Quantity

D

S

STax

Tax per unit

Totalcost

of Tax

Tax causes suppliers to offer less units for sale

at every price

Tax is vertical distance between supply curves

Tax increases prices and decreases amounts

available – but at what cost?

Paid by Consumers

Paid by Producers

Slide 102 Subsidies

Price

Quantity

D

S

SSubsidy

Totalcost

of subsidy

Subsidies encourage suppliers to sell more

at every price

Subsidy is vertical distance between the

two supply curves

Subsidies reduce prices and increase amounts


Benefits to Consumers

Benefits to Producers

Subsidy per unit



Slide 103


Slide 104 The Role of the Market

• Demand

• Supply

• Price Determination

• Interrelationships between markets

• Elasticities

The Market Mechanism


Consumer

All powerful

Free to spend

Choose

Maximize utility

Producer / Firms

Serve consumers

Maximize profits

Owners of Factors of Production

Maximize return

Maximizing behaviour




The Functions of Price in an Economy

•Rationing

•Signaling

•Incentives


An Economy is judged by how well it answers these three questions:

•What it produces (goods and services);

•How well it produces them (how well it uses resources); and,

•For whom does it produce them

Slide 108




Slide 109 Production in the Short Run

Supply – the quantity producers would be willing and able to produce

Examine the behaviour of producers

Short Run – at least one factor cannot change

(generally the factory)

Long Run – all factors can change – technology unchanged

Long Long Run – technology changes

The Law of Diminishing Returns:

In the short run, too many inputs lead to inefficiency.


Economies of Scale:

If producers are operating at lower levels of output, they can become more efficient by increasing their production levels.

Diseconomies of Scale:

At very large production levels, further increasing production begins leading to inefficiency.

Study Labour

Slide 111 Returns to Scale

What happens to output as inputs increase?

Increasing Returns Increasing inputs leads to

greater increases in

outputs

Greater

efficiency

Constant Returns Increasing inputs leads to

equal increases in outputs

Decreasing Returns Increasing inputs leads to

lower increases in outputs

Lower

efficiency

Returns to Scale Explanation Effect




Total Product (TP) =

Marginal Product (MP) =

Average Product (AP) =

Quantity of output, based on given inputs, over time

Quantity of output per unit of input

Additional output produced by adding one additional unit of input

Slide 113 Production Calculations

Labour Inputs

Total Product

(L) (TP)

1 5

2 10

3 18

4 28

5 36

6 39

7 40

Each time another worker

is added, output increases.

But the increase in output

changes as work becomes

more, then less efficient.

Marginal Product

(MP)

5

8

10

8

3

1

Marginal Product:

additional output produced

by adding an additional

worker.

Average Product:

average quantity of

goods produced by each

worker.

Average Product

(AP)

5.0

5.0

6.0

7.0

7.2

6.5

5.7

Production Schedule

Slide 114 Production Diagrams

Total Product

Diagram of TP

At first, TP increases at a faster rate –

increasing returns to scale.

Then, increases begin to slow down –

diminishing returns to scale.Output

La

bo

ur

TP

Output

La

bo

ur

AP

MP

Average Product and Marginal Product

Diagram of AP and MP

MP is at its highest where

diminishing returns to scale set in

Note: both curves rise, then decline,

first MP then AP



Slide 115 The Production Function

(Cost of Production)

Q = L + C

Where: Q = Quantity produced

L = Labour

C = Capital

OUTPUTS

INPUTS

Slide 116 Production in the Short Run – Costs

“Costs” in Economics include all economic costs facing the company and its owners:

•Materials;

•Labour;

•Management;

•Equipment;

•Cost of Buildings

•Owners’ time;

•Earnings on cash;

•Goodwill;

•Opportunity cost;

•Normal profits

These are unique to EconomicsThe same in Business and Economics


Costs are grouped according to their behaviour

•Fixed Costs: Costs that do not change in the relevant range; generally the cost of capital (e.g. factory)

•Variable Costs: Costs that change with changes in outputs; includes materials, supplies and labour




Costs are summarized as follows:

Total Cost (TC) = Fixed Costs (TFC) + Variable Costs (TVC)

Average Cost (AC) = Total Cost (TC) Units of output (Q)

Marginal Cost (MC) = The cost of one additional unit of output

= ΔTC ÷ ΔQ

Slide 119 Production in the Short Run Problems

In lesson exercise


Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40

1 6

2 11

3 15

4 60

5 66

Given … Complete the table, beginning with Fixed Cost



Slide 121

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40

1 6

2 11

3 15

4 60

5 66

Production in the Short Run Problems

Fixed costs remain the same at all levels of output – they’re fixed!

40

40

40

40

40

Given … Complete the table, beginning with Fixed Cost

Slide 122

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40

1 40 6

2 40 11

3 40 15

4 40 60

5 40 66


Fill in: Total Cost = Total Fixed Cost + Total Variable Cost

40

46

51

55

Slide 123

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40 40

1 40 6 46

2 40 11 51

3 40 15 55

4 40 60

5 40 66


Calculate Variable Cost: Total Cost – Total Fixed Cost

20

26



Slide 124

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40 40

1 40 6 46

2 40 11 51

3 40 15 55

4 40 20 60

5 40 26 66


Calculate Average Fixed Cost: Total Fixed Cost ÷ Output

40.0

20.0

13.3

10.0

8.0

Slide 125

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40 40

1 40 6 46 40.0

2 40 11 51 20.0

3 40 15 55 13.3

4 40 60 10.0

5 40 66 8.0


Calculate Average Variable Cost: Total Variable Cost ÷ Output

6.0

5.5

5.0

5.0

5.2

Slide 126

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40 40

1 40 6 46 40.0 6.0

2 40 11 51 20.0 5.5

3 40 15 55 13.3 5.0

4 40 60 10.0 5.0

5 40 66 8.0 5.2


Calculate Average Cost: Total Cost ÷ Output

46.0

25.5

18.3

15.0

13.2



Slide 127

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40 40

1 40 6 46 40.0 6.0 46.0

2 40 11 51 20.0 5.5 25.5

3 40 15 55 13.3 5.0 18.3

4 40 60 10.0 5.0 15.0

5 40 66 8.0 5.2 13.2


Calculate Marginal Cost: Increase in Total Cost at each output level

6

5

4

5

6

Slide 128 Cost Calculations

Output

Total

Fixed

Costs

Total

Variable

Costs

Total

Cost

(Q) (TFC) (TVC) (TC)

0 200 0 200

1 200 100 300

2 200 170 370

3 200 220 420

4 200 255 455

5 200 275 475

6 200 295 495

7 200 320 520

8 200 360 560

9 200 425 625

10 200 525 725

Marginal

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Total

Cost

(MC) (AFC) (AVC) (ATC)

100

70

50

35

20

20

25

40

65

100

200

100

67

50

40

33

29

25

22

20

100

85

73

64

55

49

46

45

47

53

300

185

140

114

95

83

74

70

69

73

Slide 129 Fixed Costs

Output

Total

Fixed

Costs

Average

Fixed

Cost

(Q) (TFC) (AFC)

0 200

1 200 200

2 200 100

3 200 67

4 200 50

5 200 40

6 200 33

7 200 29

8 200 25

9 200 22

10 200 20

Total Fixed Costs

0

50

100

150

200

250

0 2 4 6 8 10 12

Average Fixed Costs

0

50

100

150

200

250

0 2 4 6 8 10 12



Slide 130 Variable Costs

Output

Total

Variable

Costs

Average

Variable

Cost

(Q) (TVC) (AVC)

0 0

1 100 100

2 170 85

3 220 73

4 255 64

5 275 55

6 295 49

7 320 46

8 360 45

9 425 47

10 525 53

Total Variable Costs

0

100

200

300

400

500

600

0 2 4 6 8 10 12

Average Variable Costs

0

20

40

60

80

100

120

0 2 4 6 8 10 12

Slide 131 Total Costs

Output

Total

Cost

Average

Total

Cost

(Q) (TC) (ATC)

0 200

1 300 300

2 370 185

3 420 140

4 455 114

5 475 95

6 495 83

7 520 74

8 560 70

9 625 69

10 725 73

Total Costs

0

100

200

300

400

500

600

700

800

0 2 4 6 8 10 12

Average Total Costs

0

50

100

150

200

250

300

350

0 2 4 6 8 10 12

Slide 132 Cost Analysis

0

100

200

300

400

500

600

700

800

0 2 4 6 8 10 12

TC

V C

FC

0

50

100

150

200

250

300

350

0 2 4 6 8 10 12

MC

ATC

AVC

AFC

•MC and AC curves are “U” shaped

•The bottom of the MC curve is where diminishing returns set in

•MC crosses the AVC and AC curves at their lowest points,

where they are stable, neither going down nor rising




0

50

100

150

200

250

300

350

0 2 4 6 8 10 12

MC

ATC

AVC

AFC

MC starts rising where MP starts decreasing …

Output

La

bo

ur

AP

MP

… where diminishing returns to scale set in.


0

50

100

150

200

250

300

350

0 2 4 6 8 10 12

MC

ATC

AVC

AFC

Where to produce?

Where MC starts rising?

(diminishing returns to scale set in)

Even if MC is rising, if adding one

more unit of output is reducing AC,

it’s more efficient.

So, even if MC is rising, as long as

MC is less than AC, AC is falling,

producer will continue producing

more.

The optimum level of output is the point where AC is at its lowest, and is

neither decreasing nor rising.

At that point, AC = MC – This is the Optimal Level of Production


Output

Total

Fixed

Costs

Total

Variable

Costs

Total

Cost


0 200 0 200

1 200 100 300

2 200 170 370

3 200 220 420

4 200 255 455

5 200 275 475

6 200 295 495

7 200 320 520

8 200 360 560

9 200 425 625

10 200 525 725

Marginal

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Total

Cost


100

70

50

35

20

20

25

40

65

100

200

100

67

50

40

33

29

25

22

20

100

85

73

64

55

49

46

45

47

53

300

185

140

114

95

83

74

70

69

73



Slide 136

Objectives of Firms

Slide 137 Objectives of Firms

Firms are controlled …

by whom?

Small

Businesses:

Single / few owners

Large

Companies:

Directors appoint Management

Trade Unions represent Workers

State sets laws and regulations

Consumer organizations

Shareholders elect Directors

Slide 138 Managerial Theory

Firms

Owners Management

Profits

•Working conditions

•Salaries & benefits

•Power

Profits

AND

Managerial theoryassumes a separation between Ownership

and Control

AND

•Increases in

company’s value



Slide 139 Behavioural Theory

Firms

•Decision-making by different groups

•Different groups compete for power

•Each group sets its own minimum goals

•…and they “go” from there…

Slide 140 Review of Costs

0

50

100

150

200

250

300

350

0 2 4 6 8 10 12

MC

ATC

AVC

AFC



0

100

200

300

400

500

600

700

800

0 2 4 6 8 10 12

•The optimum level of output is where MC is upward sloping and

intersects with AC

Slide 141 Revenues

Using cost data from “Production in the Short Run”, add revenue.

Assume a selling price of 75 per unit.

Output

Total

Revenue

Marginal

Revenue

(Q) (TR) (MR)

0 0

1 75 75

2 150 75

3 225 75

4 300 75

5 375 75

6 450 75

7 525 75

8 600 75

9 675 75

10 750 75

Total Revenue & Total Cost

Curves

0

100

200

300

400

500

600

700

800

0 2 4 6 8 10 12

Marginal Revenue & Marginal Cost

Curves

0

20

40

60

80

100

120

0 2 4 6 8 10 12



Slide 142 Short Run Profit Maximization

If goal of a firm in the Short Run

is to earn the maximum profit …

Total Revenue & Total Cost Curves

0

100

200

300

400

500

600

700

800

0 2 4 6 8 10 12

On the diagramc, they should

produce where TR is the

greatest distance above TC

… about here …

… they should produce where

Sales are greater than Costs

by the maximum amount …


Where is “here”?

TR & TC Curves

0

100

200

300

400

500

600

700

800

0 2 4 6 8 10 12

At this place, the tangents

of both curves are parallel.

It means the slopes of

both curves are equal…

Or, both curves’ slopes are

changing at the same rate…

In other words, where marginal

revenue and marginal costs are

equal, or, ….

MR & MC Curves

0

20

40

60

80

100

120

0 2 4 6 8 10 12

… where MR and MC curves intersect.


One other detail about the

TR & TC Curve diagram …

TR & TC Curves

0

100

200

300

400

500

600

700

800

0 2 4 6 8 10 12

Notice where the TR & TC

Curves intersect…

Before that point, costs

exceed revenues. Only after

that point do revenues

exceed costs. We call that

point the “Break Even Point”,

where the firm is neither

making nor losing money.



Slide 145 Economic Theory

Theories

Classical Keynesian

As we said in the first lesson, Economics is a science, and as such, there are different theories about how consumers, businesses

and governments will behave under different conditions.

There are two main “schools of thought” about Economics.

•Assume owners control

•Short run profit maximizers

•As long as firms cover variable

costs, will continue producing

•Adjust prices and output

based on market conditions

•Long run profit maximizers

•Cost plus pricing – ATC (based

on full capacity) plus a profit

•Assumes consumers do not like

frequent price changes

•Continue to produce even with

losses

Slide 146 Economic Theory

Theories

Classical Keynesian

As we said in the first lesson, Economics is a science, and as such, there are different theories about how consumers, businesses

and governments will behave under different conditions.

There are two main “schools of thought” about Economics.

•Assume owners control

•Short run profit maximizers

•As long as firms cover variable

costs, will continue producing

•Adjust prices and output

based on market conditions

•Long run profit maximizers

•Cost plus pricing – ATC (based

on full capacity) plus a profit

•Assumes consumers do not like

frequent price changes

•Continue to produce even with

losses

Slide 147 Goals of Firms

A profit maximizing company has fixed costs of £10. Its variable costs increase at a constant rate with output. The variable cost of producing each unit is £1. Explain whether it will produce:

Units

Total

Revenue

a) 10 £30

b) 15 £25

c) 20 £22

d) 25 £30

Fixed

Costs

Variable

Costs

Total

Costs

£10 £10 £20

£10 £15 £25

£10 £20 £30

£10 £25 £35

Produce

Don’t

Produce

What are its choices?

£10 £10

£0 £10

£8 £10

£15 £10



Slide 148


Slide 149 ReviewProduction in the Short Run

Average Fixed Costs

0

50

100

150

200

250

0 2 4 6 8 10 12

•AFC curve is downward sloping

•AVC curve slopes downwards

then upwards

Due to Economies of Scale and Diseconomies of Scale


0

20

40

60

80

100

120

0 2 4 6 8 10 12


•ATC curve starts moving up

where “Diminishing Returns to

Scale” sets in

Average Total Costs

0

50

100

150

200

250

300

350

0 2 4 6 8 10 12




Total Revenue, Total Cost

0

100

200

300

400

500

600

700

800

0 2 4 6 8 10 12

•Firms maximize profits where

the distance between TR and

TC are the greatest

•This is the place where MR and

MC intersect

Marginal Revenue, Marginal Cost

0

20

40

60

80

100

120

0 2 4 6 8 10 12

•One final point: Changes in

Price or Costs will affect the

profit maximizing level of

output•For example, increases in costs

will cause the MC curve to shift

upwards, reducing profit

maximization output

Slide 152 Production in the Long Run

• In the Long Run, all factors are variable

Long Run Average Costs

• The curve starts out with the firm having Economies of Scale

• Then the firm produces at maximum efficiency level – Constant Returns to Scale


• Finally the firm begins experiencing Diseconomies of Scale


Slide 153 Production in the Long Run

• The maximum level of efficiency

• The optimum level of output in the long run• The Minimum Efficiency Scale (MES)




Slide 154 Attainable

LRAC – lowest possible average costs a firm can achieve

Long Run Average Cost Curve

Actual cost will be inside and above the LRAC

Average costs never below the LRAC

Increases in production lead to movement along the LRAC

Slide 155 Long Run Economies of Scale(Large Firms)

• Technical: Use equipment more efficiently

Indivisibility

Source of Productive EfficiencyFirm may also experience Technical

Diseconomies of Scale

• Specialization: Employ more specialists

In small firm, may be indivisibility

• Purchasing: Buying larger quantities

• Financial: More sources of funds – lower cost

Slide 156 Long Run Diseconomies of Scale(Large Firms)

• Mainly due to management problems

• As firms grow, more difficult for management to control activities

• Centralization / Decentralization



Slide 157 Shifts in the LRAC

• ExternalEconomies of Scale:

Downward Shift:

• Savings from growth in industry

• Better roads & transportation

• Better qualified workers – lower training costs

• Government training programmes

• New technologies

Upward Shift:

• Taxation

• ExternalDiseconomies of Scale:

• Generally means industries expanding too quickly

Slide 158 Relationship between LRAC and SRAC

LRAC and SRAC Curves

Slide 159

Growth of Firms & Mergers



Slide 160

Growth of Firms & Mergers

Long run – reach the level where Economies of Scale set in

Economists say: no direct link

between size and efficiency

Slide 161 Long Run Average Cost Curve

In the long run, when all factors are variable, firms benefit from

increasing their size

Long Run Average Cost Curve

Increases in sales lead to lower long run average costs

Slide 162 Growth of Firms & Mergers

Reasons for growth:

Take advantage of Economies of Scale

Better able to affect their market

Reduce risks



Slide 163 Advantages of different sizes

Large firms:

Small firms:

Economies of Scale

High barriers to entry (difficult for other firms to reach their size)

Low barriers to entry

Operate at MES

Some lower costs

Offer better service – local

Slide 164 Methods of Growth

• Internal: increasing sales

• External:

• Merger

• Amalgamation

• Takeover

2 or more companies join together

Slide 165 Reasons / motivation to choose

Merger, Amalgamation or Takeover

• Time and Money

• Asset Stripping

• Rewards to Management



Slide 166 Types of Mergers

• Horizontal merger

– Same industry, same stage of production

• Vertical merger

– Same industry, different stage of production

– Forward integration: manufacturer acquires its customer

– Backward integration: manufacturer acquires its supplier

• Conglomerate – different industries

Slide 167 Notes about Mergers

• Not clear they increase economic efficiency

• Productive efficiency may increase, if average cost reduces (E of S)

• Those E of S often involve loss of jobs

• Allocative efficiency may increase

• Tend to reduce competition in the market

• Asset stripping controversial

Slide 168

Monopoly

The only producer / supplier in an industry

A monopoly is the industry



Slide 169 Monopoly

• The only producer

• Barriers to entry high

• Government

• Resources

• Competitive practices

• No close substitutes

Slide 170 Monopoly

Barriers:

• Government

• Resources

• Competitive practices

• No close substitutes

Slide 171 Natural Monopoly

Defined:

Cost of producing the product is lower (due to economies of scale) if there is just a single producer



Slide 172 Natural Monopoly

Economies of Scale:

• Purchasing

• Marketing

• Technical

• Managerial / Specialization

• Financial

Examples: telephone, power, water, etc.

Slide 173 Monopolies

•Can remain if barriers to entry remain high

•Can charge higher price

•May not have lowest possible costs

–May not maximize profits

•Likely to have abnormal profits

Slide 174

Monopoly

Average and marginal revenue under monopoly



Slide 175 Revenues for a firm facing a downward-sloping demand curve

Q(units)

P = AR(£)

TR(£)

MR(£)

1 8 8

6

2 7 14

4

3 6 18

2

4 5 20

0

5 4 20

–2

6 3 18

–4

7 2 14


Q(units)

P = AR(£)

TR(£)

MR(£)

1 8 8

6

2 7 14

4

3 6 18

2

4 5 20

0

5 4 20

–2

6 3 18

–4

7 2 14


Q(units)

P = AR(£)

TR(£)

MR(£)

1 8 8

6

2 7 14

4

3 6 18

2

4 5 20

0

5 4 20

–2

6 3 18

–4

7 2 14



Slide 178

fig-4

-2

0

2

4

6

8

1 2 3 4 5 6 7

AR and MR for a firm facing a downward-slopingD curve Q

(units

)12

34

567

P =AR(£)

87

65

432

ARAR, M

R (

£)

Quantity

Slide 179

fig-4

-2

0

2

4

6

8

1 2 3 4 5 6 7

Q(units

)12

34

567

P =AR(£)

87

65

432

TR(£)

814

1820

201814

MR(£)

64

20

-2-4

MR

AR, M

R (

£)

Quantity

AR and MR for a firm facing a downward-slopingD curve

AR

Slide 180

fig-4

-2

0

2

4

6

8

1 2 3 4 5 6 7

Elasticity = -1

Elastic

Inelastic

AR, M

R (

£)

Quantity

AR and MR for a firm facing a downward-slopingD curve

MR

AR



Slide 181

Monopoly

Profit-maximising price and output

Slide 182

fig

-8

-4

0

4

8

12

16

20

24

1 2 3 4 5 6 7

TR

Quantity

Profit Maximizing Level

(£)

Slide 183

fig

-8

-4

0

4

8

12

16

20

24

1 2 3 4 5 6 7

TR

TC

Quantity

(£)

Break Even PointsProfit Maximizing Level of Output




Slide 184

fig

-4

0

4

8

12

16

1 2 3 4 5 6 7Quantity

Cost

s and r

evenue (

£)

Profit Maximizing LevelMC

Slide 185

fig

-4

0

4

8

12

16

1 2 3 4 5 6 7Quantity

Cost

s and r

evenue (

£)

e

MR

MC

Profit-maximisingoutput


Slide 186

fig

-4

0

4

8

12

16

1 2 3 4 5 6 7Quantity

Cost

s and r

evenue (

£)

MR

MC

Measuring Maximum Profit



Slide 187

fig

-4

0

4

8

12

16

1 2 3 4 5 6 7Quantity

Cost

s and r

evenue (

£)

MR

AR

Measuring Maximum ProfitMC

Slide 188

fig

6.00

4.50ABNORMAL PROFIT

MR

Quantity

Cost

s and r

evenue (

£)

AC

AR

b

a

Abnormal profit =£1.50 x 3 = £4.50

Measuring Maximum ProfitMC

-4

0

4

8

12

16

1 2 3 4 5 6 7

Slide 189

Monopoly

Comparison of monopoly with perfect competition

(a) same industry MC curve



Slide 190

AR = D

MC

MR

£

Q O Q1

P1

Monopoly

Perfect Competition & Monopoly(same MC curve)

Slide 191 £

Q O

MC ( = supply under

perfect competition)

Q1

MR

P1

P2

Q2

AR = D

Comparison withPerfect competition

Perfect Competition & Monopoly(same MC curve)

Slide 192

Oligopoly



Slide 193 Characteristics of Oligopoly

•A few major firms in the market

• Could still be many smaller suppliers

•Firms are interdependent

–Actions of one firm can affect others

•There are barriers to entry

•There are abnormal profits

Slide 194

•Price rigidity

–Fewer price changes, even when costs change

•Non-price competition

–Compete in different ways: 4 P’s; Branding

•Firms watch each other and act together

–Sometimes “collusion”

•AC curve more “L” shaped than “U” shaped

Characteristics of Oligopoly

Slide 195 Oligopolist’s Demand Curve

•If one Oligopolist increases price

–No other firms will follow

–Price raising firm will lose customers

–(High PED)

•If one Oligopolist lowers price

–Other firms will follow

–Price raising firm will not gain many customers

–(Low PED)

•Hence, Oligopolists are interdependent



Slide 196

Oligopoly

“Kinked” demand curve theory

Slide 197

fig

£

QO

P1

Q1

Current priceand quantity

are the starting point of the

demand curve

Oligopolist’s Demand Curve

Slide 198 £

QO

P1

Q1

D

If a firm in oligopoly raises its price, the

others will not follow.

Oligopolies are price elastic above the market price.




Slide 199 £

QO

P1

Q1

D

If a firm in oligopoly lowers its price, the others will follow.

So oligopolies are price inelastic below

the market price.


Slide 200 £

QO

P1

Q1

D

Price elastic above the market price.

Price inelastic below the market price.


The Kinked Demand Curve

Slide 201 £

QO

P1

Q1

MR

D = AR

Stable price under conditions of a kinked demand curve

MC1

MC2

When costs riseoligopolies still will

not raise prices.



Slide 202 Oligopoly

Collusion:

•A secret agreement

•Between two or more people / companies

•To get some advantage

Cartel:

•A group formed especially to regulate price and output in some industry

Oligopolists sometimes form cartels

Slide 203 Oligopoly

If no Collusion or Cartels:

Game Theory

Slide 204

Oligopoly

Example of oligopoly



Slide 205

1985

(%)

2002

(%)

Bass

Allied Lyons (Carlsberg)

Grand Met (Watneys)

Whitbread

Scottish and Newcastle

Courage

Others

22

13

12

11

10

9

23

100

Scottish–Courage

Interbrew UK

Coors

Carlsberg–Tetley

Diageo (Guinness)

Others

27

20

18

12

7

16

100

Market shares of the

largest brewers

Slide 206

1985

(%)

2002

(%)

Bass


Grand Met (Watneys)

Whitbread


Courage

Others

22

13

12

11

10

9

23

100

Scottish–Courage

Interbrew UK

Coors

Carlsberg–Tetley

Diageo (Guinness)

Others

27

20

18

12

7

16

100


largest brewers

Slide 207

Introduction to Macroeconomics



Slide 208 National Economic PerformanceA measure of how the economy is doing

4 basic areas to judge

• Economic Growth

• Unemployment

• Inflation

• Current Balance (Trade)


• Economic Growth

– Rate of change in national output

– GDP

– RECESSION, DEPRESSION


• Unemployment

– A waste of a resource

– Linked to Economic Growth




• Inflation

– Ongoing rising of general price levels

– Prices of what you want go up

– Value of savings goes down

– Some inflation is ok, too much is bad

– Linked to Economic Growth and Unemployment


• The Current Balance– The balancing of Imports and Exports

– Exports bring money into the economy

– Imports send money out of the country

– Exports lead to trade surpluses

– Imports lead to trade deficits

– Linked to Economic Growth and Inflation


4 basic areas to judge

• Economic Growth

• Unemployment

• Inflation

• Current Balance (Trade)

Trade-offs

Desired outcome

Increasing

Decreasing

Keep low

Balanced



Slide 214 The Circular Flow of Income

1. Factors of Production

2. Rent, wages, interest & profits

National Income “Y”

3. Produce goods & services

National Output “O”

4. Spending on goods & services

National Expenditure “E”

Households

Firms

A diagram to show National

Income

Y, O and E are equal – National Income

Equilibrium

The Two Sector Model

Slide 215 The Circular Flow of IncomeA diagram to show National

Income

Households

Firms

Y O

E

Banking Government Overseas

S

I

T

G

M

X

Saving

Investment

Taxes

Government Spending

Imports

Exports

Leakage

Injection

The Two Sector ModelThe Five Sector Model

The Multiplier Effect

Slide 216 Paradox of Thrift

Paradox (n) – contrary to common opinion

Thrift (n) – managing and saving money

Common opinion – saving is good for everyone

The Paradox of Thrift – if everyone saves, the leakage would cause the economy to shrink, making everyone worse off



Slide 217 Measuring National Income

• Gross Domestic Product (GDP) most often used

• GDP = the value (at market price) of all goods and services produced in the economy

• GDP also includes Indirect taxes


Other measures:

• Gross Value Added (GVA) at basic cost

GVA = GDP – indirect taxes + subsidies

• Gross National Product (GNP) at market price

GNP = GDP + income on overseas

investments – income of foreign

investments in the UK


All calculations exclude Transfer Payments:

• Government payouts

• Student loans

• Second hand sales

• Any other transfer payments where there are no goods or services produced



Slide 220 Reasons to produce National Income

statistics:

• Help economists to understand an economy

• To judge economic performance

• To judge economic welfare

• To forecast changes and plan for them

• To compare: over time; and, between countries

Slide 221 Possible errors in calculating National

Income statistics:

• Accuracy

• Too many statistics

• Too many changes

• Hidden activities: avoid tax; illegal; informal

• Self-produced goods and services

• The Public (Government) sector – nothing bought or sold

Slide 222 Problems with comparing National

Income over time:

• Prices change (Inflation)

• Presentation – calculation methods change

• Population changes – use “per capita”

• Changes in quality affect price comparisons

• Consumption / Investment

• Externalities – not measured

• Income distribution not considered



Slide 223 Problems with comparing National

Income between countries:

• Basic differences in economies

• Income distributions

• Use exchange rates that compare standards of living

– Purchasing Power Parity (PPP)

–A typical basket of goods

• Different living conditions / costs

Slide 224 The Multiplier Effect

• Assume an injection takes place

– enters the economy

– continues circulating

– each time it adds to national income

• Injections add a much more to the economy than the value of the initial injection

• Same is true in reverse

Slide 225

Economic Growth



Slide 226 Economic Growth

The change in potential output

Production Possibility Frontier diagram

• Economic Growth v. Recovery

The Output Gap

• GDP growth rate

• GDP trend

• Positive, Negative Output Gaps


Combination of goods and services economy could produce if all resources

fully and efficiently used

Services

Goods

A = Inefficient

A

B = Maximum efficiencyB

Slide 228 Business Cycle Diagram

Time

Rate

of G

row

th

Actual GDP

Trend GDP

Notice the gaps between Actual GDP and Trend GDP

These are called Output Gaps



Slide 229 What Causes or Creates Output

Gaps?

• Economies rarely operate at full efficiency

• Ups and downs in economic performance create the shape of Actual GDP

• During peaks, an economy operates closest to full efficiency, closest to the PPF

• During other times, it is moving toward or away from full efficiency

• Recovery is not economic growth

Slide 230 Business Cycle Diagram

Time

Rate

of G

row

th

Actual GDP

Trend GDP

Economy is not using all its resources fully – Point A on

the PPF diagram

Economy is probably using all its resources fully and

efficiently – Point B on the PPF diagram


Combination of goods and services economy could produce if all resources

fully and efficiently used

Services

Goods

A = Inefficient

A

B = Maximum efficiencyB

C = Impossible given the current resources …

C

Only if new resources are introduced …

= a new PPF …

= Economic Growth



Slide 232 What Causes or Creates Economic

Growth?

• Increases in Inputs

• New efficiencies in use of Inputs


Growth?

“Land”

• Increase in use of natural resources

• New discovery of natural resources

• Tends to help developing countries more than

developed countries


Growth?

“Labour”

Increased labour force leads to Economic Growth:

• Demographics – e.g. younger workforce

• Participation – e.g. women in the workforce

• Immigration – Might affect output

– Might not affect economic welfare (more people)




Growth?

“Capital”

• Must increase over time to sustain Economic Growth

• Investments should be targeted to growth industries


Growth?

Technological Progress

Increases Economic Growth in two (2) ways:

1. Decreases average cost of production

2. Creates new products which consumers then buy

Slide 237 Efficiency

The way resources are used to produce goods and services

Markets promote efficiency




Arguments for

• Improved standard of living

• Crime reduction

• Improved working environment

• Improved environment

• Reduction / elimination of absolute poverty


Arguments against

• Problems with national income statistics

• Negative externalities

• Growth unsustainable

• Using up of natural resources

• Increased inequality

Slide 240 Problem with comparing

Often, the amount of goods that can be purchased in different countries is very different, because of the following:

• Standard of living

• Exchange rates of currencies

• Cultural differences



Slide 241 Problem with comparing

Examples:

• Levels of education and development

• Types of housing and relative costs

• Differences in type of food consumed

• Different life styles

• Governments’ control over currencies and exchange rates

Slide 242 Purchasing Power Parity

A method of comparing, based on:

• Availability of goods

• Demand for goods

• Differences exchange rates

(Parity: treating something as equal)


Calculation:

Where:

S = exchange rate of currency 1 to currency 2






But the example is a bit simple:

• There are differences between what people use in one country compared with another country

• So, PPP is based on a “typical” basket of goods purchased by a “typical” household during a “typical” month,

• In different countries

Slide 245 Couldn’t it be made easier??

Isn’t there something that everybody uses?

Slide 246 The Big Mac© Index

• Compares the price of a McDonald’s Big Mac© in different countries

• An informal way of measuring purchasing power parity

• Also a way of measuring how much exchange rates affect the same product



Slide 247 Human Development Index

A way to measure a country’s development


• Life expectancy


• Income

Based on a minimum and maximum for each aspect


A way to measure a country’s development


• Life expectancy


• Income




Slide 250 Nominal vs. Real

Certain economics statistics have problems in comparing, because of inflation

Nominal: “in name only” means, as is

Real: means, as adjusted for inflation

Example:

• Nominal GDP: 8%

• Inflation Rate: 3%

• Real GDP: 5%

Slide 251

Aggregate Supply

Slide 252 Aggregate Supply

The supply of everything produced within the economy

Measured at different price levels



Slide 253 Aggregate Supply – Long Run

Produce as much as resources will allow

Factors of Production have Limitations: resources; capacity; labour; etc.

(Production Possibility Frontier)

So, the LRAS Curve is the outer limit of what economy can produce

Slide 254 Shifts in LRAS

• Likely shifts over time

– Technology

– Training & Education

• Shift of PPF represents shift of LRAS

Slide 255 LRAS Curve

Outer limit of what can be produced

On a diagram, a portion of LRAS Curve must be vertical

Price

Levels

LRAS

0 Real Output



Slide 256 Shape of LRAS

• All economists agree on the previous

• Disagree in the area of Labour:

– Excess Labour / unemployment

– Changes in wage rates


Classical Economists:

• Labour market functions perfectly

• Excess labour leads to drop in wage rate

• Unemployed tend to get jobs

• Market moves back to relative equilibrium

– Adaptive expectations – clears gradually

– Rational expectations – clears quickly

• Classical LRAS vertical

Slide 258 Classical LRAS Curve

Labour market clears

Vertical

Price

Levels

LRAS

0 Real Output




Keynesian Economists:• Labour market does not function perfectly

• Wage rates tend not to fall

– Skilled workers keep their wage rates

– Labour unions fight drops in wage rates

–Minimum wage laws / Unemployment benefits

–Workers can move around

• Moderate Keynesians: wage rate may temporarily drop


Keynesian Economists:• Unemployed tend to remain out of work for longer

periods of time

• Market will not clear – “sticky downwards”

• This affects Aggregate Demand

• Too many out of work – “Mass Unemployment”

• Stay unemployed until some force pushes demand for labour back up

• When they begin returning, increased output unlikely to lead to higher price levels

Slide 261 Keynesian LRAS Curve

Full employment –Vertical

Mass unemployment –Horizontal

When workers begin returning to work, price levels will slowly rise

Price

Levels

LRAS

0 Real Output



Slide 262

Business Cycle Diagram

Time

Rate

of G

row

th

Actual GDP

Trend GDP

Positive Output Gap

Negative Output Gap

Slide 263

Aggregate Demand

Slide 264 Aggregate Demand

The demand for everything produced within the economy

• Relationship between:

– Price Levels

– Real Expenditure (adjusted for Inflation)

– Adjustment based on Retail Price Index



Slide 265 The Aggregate Demand Curve

Price

Levels

AD

0 Real Output

At higher price levels, lower quantities of G&S will be purchased


Reminder:

National Income (Y) =

National Output (O) =

National Expenditure (E)


Components of the Circular Flow diagram:

E National Expenditure

C Consumption

I Investment

G Government Spending

X Exports

M Imports

E = C + I + G + (X – M)




E = C + I + G + (X – M)

Analysis: anything that causes a change in any of these different components will cause a change in National Expenditure

Slide 269 Consumption (C)

Influenced by Inflation and the Interest Rate (IR)

• If prices rise…

• Consumers need more money to buy…

• So they borrow…

• The supply of money is limited…

• Borrowing increases the demand for money…

• So the interest rate (the Price of money) rises

• In the end, consumers buy less

Slide 270 Investment (I)

Influenced by Inflation and IR

• Companies borrow money for Investment

• Rises in prices lead to rises in Interest Rate

• Marginal Efficiency of Capital Theory

• Investment affected by changes in IR



Slide 271 Government Spending (G)

Affected by political decisions

Changes in Government Spending affect AD

Slide 272 Exports (X) and Imports (M)

Influenced by Inflation

• Higher domestic prices lead to:

– Lower Exports (our goods too expensive)

– Higher Imports (their goods are cheaper)

• Trade Deficits

• Lower domestic prices lead to:

– Higher Exports (our goods are affordable)

– Lower Imports (their goods too expensive)

• Trade Surpluses

Slide 273 Movement along the AD Curve

• As Price levels rise, the quantity of G&S purchased falls because:

– Increases in IR reduce C and I; and,

– Higher prices reduce X’s and increase M’s



Slide 274 Shifts in the AD Curve

From anything besides changes in price levels…

• Consumption: increases in C are caused by:

– Lower IR

– Lower Unemployment rate

– Rises in the stock market (the wealth factor)

–New technologies

– Lower savings

– Lower income taxes



• Investment: increases in I, caused by:

– Increased confidence by businesses in the economy

– Lower IR

– Increased company profits

– Fall in company taxes



• Increases in Government Spending (G)





• Imports and Exports: A fall in the Exchange Rate

– Exports become more competitive abroad

– Imports become less competitive at home

– Exports (X) rise

– Imports (M) fall

Slide 278 The Multiplier Effect

Recall the Circular Flow of Income diagram:

Every Injection into the economy…

• Pays for goods & services…

• Purchases more materials & labour…

• Returned to households: salaries & profits

• Circulates through the economy again and again…

• The Multiplier Effect

Slide 279 Leakages

Money taken out of the circular flow

• Savings (banking sector)

• Taxation (government sector)

• Imports (overseas sector)



Slide 280 The Shape of the AD Curve

According to Keynesian economists…

Weak link between prices and aggregate demand

• Price levels – little effect on IR

• IR changes – little effect on C and I

• Main determinant of I is prior profits

The Aggregate Demand Curve is more steep

Slide 281 The Shape of the AD Curve

According to Classical economists…

Strong link between prices and aggregate demand

• Price levels – strong effect on IR

• IR changes – Strong effect on C and I

The Aggregate Demand Curve is more flat

Slide 282

Equilibrium Output



Slide 283


• rises in unemployment lead to quick wage cuts

• pushes output back to full employment levels


• unemployed do not reduce wage expectations

• remain out of work much longer

Long Run Equilibrium

Slide 284 Long Run EquilibriumClassical Economists

Economy moves to dis-equilibrium

Temporary over-employment & over-output

SRAS shifts left due to increased costs

New equilibrium, higher prices

AD

LRAS

Price

Levels

0 Real Output

What happens when Aggregate Demand increases

AD1

Slide 285 Long Run EquilibriumClassical Economists

Creates increased output

Causes price levels to drop

AD

LRAS

Price

Levels

0 Real Output

What happens when Aggregate Supply rises

LRAS1



Slide 286 Long Run EquilibriumKeynesian Economists

• All periods of dis-equilibrium depend on the situation in the economy

• Specifically unemployment

• And the effect of unemployment on the demand for goods and services (AD)


If economy is at full employment

Shift causes rise in prices only, no output change

AD

LRAS

Price

Levels

0 Real Output

What happens when Aggregate Demand rises

AD1


If in period of mass unemployment

Shift increases output with no effect on prices

AD

LRASPrice

Levels

0 Real Output

AD1





If in period of some unemployment

Shift causes rising prices and increased output

AD

LRASPrice

Levels

0 Real Output

AD1



If in period of full employment

Shift causes large increase in output, and big

drop in prices

AD

Price

Levels

0 Real Output

LRAS LRAS1

What happens when Aggregate Supply increases


If economy is not at full employment

Shift causes output to increase, and small drop in prices

AD

Price

Levels

0 Real Output

LRAS LRAS1





If at mass unemployment

Shift will have no effect at all on the economy

AD

Price

Levels

0 Real Output

LRAS LRAS1


Slide 293 Shift in Both Aggregate Demand and Aggregate Supply

Increased Investment shifts AD outward,

Also shifts AS out

Causes increased output with little effect on prices

AD

LRAS

Price

Levels

0 Real Output

AD1

LRAS1

Slide 294

Consumption and Savings



Slide 295

Savings (S) Income which is not spent

Consumption (C)Spending on goods and

services over a period of time

Slide 296 Consumer goods

Durable goods

They last (are used) a long time

Usually more expensive

Often bought on credit

Non-durable goods

When consumed they’re gone

Slide 297 Consumption and saving

• Two formulas to help understand consumption and saving in an economy:

Average Propensity to Consume (APC)

Marginal Propensity to Consume (MPC)



Slide 298 Consumption and saving

• APC = consumption = C

income Y

• MPC = change in consumption = ∆C

change in income ∆Y

Slide 299 Consumption and saving (example)

Year 1 Year 2

Disposable Income £100billion £110billion

Consumption £80billion £85billion

APC = 0.8 0.77

MPC = 0.5

Slide 300 Consumption Function –Determinants of consumption

Disposable Income

Wealth

Inflation

Interest Rates

Availability of Credit

Expectations

Unemployment

Taxation

Technological Development



Slide 301 Determinants of consumption and saving

Wealth

• If a household’s wealth increases, C increases – the wealth effect

• Two main ways wealth increases:

Increase in house prices

Increase in the stock market (shares)

Slide 302

Inflation – Affects C in two opposite ways:

A. Increases C: consumers make big purchases sooner, to avoid higher prices

B. Decreases C: consumers save more, because inflation is reducing the value of what they’ve saved

Determinants of consumption and saving


Interest rate (IR)

• Households often borrow to consume, especially durable goods

• Higher IR increases cost of borrowing, so households reduce consumption

• Higher IR increases monthly payments (homes, other debts) so consumers have less money to spend




Availability of credit

• Governments can limit borrowing: the amount that can be borrowed; the number of loans –reduces consumption

• When limits removed, households can increase borrowing, increase consumption


Expectations (“consumer confidence”)

• When consumers have positive view of the future economy, consumption increases

• When consumers have a negative view of the future economy, consumption decreases


Unemployment

• Decrease leads to increased consumption

Taxation

• Decrease leads to increased consumption

Technological development

• Leads to increased consumption

Age

• Young consume more / Older consume less



Slide 307

Savings

Ongoing accumulation of previous amounts saved – a

flow concept

Save / SavingIncome not spent is saved

Slide 308 Savings

• Two formulas:

Average Propensity to Save (APS)

Marginal Propensity to Save (MPS)

Slide 309 Savings

• APS = saving = S

income Y

• MPS = change in saving = ∆S

change in income ∆Y

Note: APC + APS = 1

Increase in savings increases investment

Increase in savings reduces consumption

Higher earners have higher MPS, lower MPC



Slide 310 Savings Function –Determinants of savings

Disposable Income

Wealth

Inflation

Interest Rates

Availability of Credit

Expectations

Age

Slide 311 Economic Theories on Consumption and Savings

Keynes noted:

Primary relationship between current income and current consumption

Most important:

1) Short-term income

2) Availability of Credit

Consumption function relatively stable

Changes in wealth & IR have little effect


Based on this, Keynes believed:

Increased wealth leads to stagnant economy

Redistributing income from rich to poor would overall increase total consumption




Life Cycle Hypothesis:

Current consumption based on likely income over one’s lifetime

Not current income

Example: Compare manual worker with professional


Permanent Income Hypothesis:

Milton Friedman

Permanent Income: Average income over one’s lifetime, not current income

Rise in wealth increases C over life

Rise in IR lowers C over life – it lowers value of investments and wealth – lowers Permanent Income

Lifetime APC = 1

Slide 315

Investment



Slide 316 Investment

Additions to the capital stock of the economy i.e. factories, machines,

offices etc.

Slide 317 Gross and net investment

• Capital stock wears out, losing value over time

• This is depreciation (or capital consumption)

• Gross investment is the value of investment

• Net investment is Gross investment minus depreciation

Slide 318 Marginal efficiency of capital

• Firms invest to make profit (a return on capital)

• Rate of return on investment is called marginal efficiency of capital (MEC)

• Investment (I) depends on IR – firms only invest in projects where MEC > IR



Slide 319 Marginal Efficiency of Capital and Interest Rates (IR)

• An increase in IR leads to a decrease in investment

• A decrease in IR leads to an increase in investment

Slide 320 Planned investment schedule

0

5

10

15

20

25

0 4 8 12 16 20

Planned investment $billions

Inte

res

t ra

te %

Slide 321

• Cost of capital goods

• Technological change

• Government policy

• Business expectations for the future

• The Accelerator Theory

What causes shifts in planned investment?



Slide 322

Cost of capital goods

• If cost of capital goods rises, MEC will fall

• So, increase in cost of capital goods leads to reduced investment, and investment schedule shifts inwards


Slide 323

Technological change

• New technology makes capital equipment more productive, so MEC will rise

• So, technological improvements lead to increased investment, and the investment schedule shifts outwards


Slide 324

Government policy

• Governments make decisions regarding the business environment, which affect firms decisions to make investments

• Government policy that encourages greater investment causes the investment schedule to shift outwards




Slide 325

Business expectations for the future

• Managers base their estimates of MEC in part on their expectations

• Positive expectations lead to increased investment, shifting the investment schedule outwards

• Negative expectations …


Slide 326 The Accelerator Theory

• Planned investment depends on the rate of change in real output

• If real output increases, firms need more capital, so investment increases

• If real output decreases, a firms’ capital equipment is enough, so no new investment

Slide 327 The Accelerator Theory

• So, in periods of rapid economic growth, investment will grow quickly (accelerate), and in periods of economic slowdown, investment will decrease quickly (decelerate)



Slide 328

Taxation

Slide 329 Fiscal Policy

• Policies used (adopted) by government

• To control and direct the economy

• Taxation

• Government Spending

Slide 330 Canons/characteristics of taxation

Cost of collection should be low compared to the yield of the tax

Timing of collection and the amount should be clear and certain

Timing and means of payment should be convenient Taxes should be set according to an individuals’

ability to pay



Slide 331 Canons/characteristics of taxation

• Modern economists have added some additional characteristics (canons):

Leads to the least loss of economic efficiency

Compatible with foreign tax systems

Automatically adjusts to changes in the price level

Slide 332 Reasons for Taxation

• Pay for government spending

• Correct market failure (Externalities)

• Manage economy

• Redistribute Income

Slide 333 Methods of Taxation

Direct tax

• A tax levied directly on an individual or organisation

Indirect tax

• A tax on a good or service



Slide 334 Tax systems

Taxes can be classified by behaviour:

• Progressive

• Regressive

• Proportional


Progressive• The proportion (%) of income paid in tax rises as income rises

Example• A shopkeeper earning £10,000 pays £1,500 (15%) of their

income in tax• A nurse earning £25,000 pays £5,000 (20%) of their income in

tax• A lawyer earning £50,000 pays £12,500 (25%) of their income

in tax

Slide 336 Progressive tax system

O

Tota

l tax

paid

(T)

Total income (Y)

Progressive




Regressive• The proportion (%) of income paid in tax decreases as income

rises

Example

• A shopkeeper earning £10,000 pays £2,500 (25%) of their income in tax

• A nurse earning £25,000 pays £5,000 (20%) of their income in tax

• A lawyer earning £50,000 pays £7,500 (15%) of their income in tax

Slide 338 Regressive tax system

O

Tota

l tax

paid

(T)

Total income (Y)

Regressive


Proportional (flat tax)• The proportion (%) of income paid in tax remains the same as

income rises

Example

• A shopkeeper earning £10,000 pays £2,000 (20%) of their income in tax

• A nurse earning £25,000 pays £5,000 (20%) of their income in tax

• A lawyer earning £50,000 pays £10,000 (20%) of their income in tax



Slide 340 Proportional tax system

O

Tota

l tax

paid

(T)

Total income (Y)

Proportional

Slide 341 Taxation in the UK

Income tax• Largest source of government income

• Tax on an individuals income

• Tax allowance: a minimum amount allowed before paying any income tax; any income earned over that limit (tax threshold) is known as taxable income

• Taxable income is then split into tax bands


National insurance contributions (NIC’s)• A tax to pay for social welfare i.e. pensions and

unemployment allowances • Collected from an individuals income




Corporation tax

• Tax on company profits

• 28% of profits paid in tax

• Companies can claim tax allowances to lower their

tax payment i.e. investment allowances


Capital gains tax • Tax on profits from sale of assets

• (Excludes most goods, services and residences

• Gain (profit) is calculated

• Added to personal income

• Taxed like Income Tax


Inheritance tax• A tax on the value of assets left by someone who

dies • The first £250,000 is not taxed (tax allowance)• Amounts above tax allowance are taxed at 40%




Excise Duties• Taxes on fuel, alcohol, tobacco and betting• Based on volume (quantity) sold• Amount of tax prescribed by law


Value Added Tax (VAT)• A tax on expenditure

• Added to the cost of products

• Some goods have no VAT, such as food, water, children’s clothes, books and public transport

• Home heating fuels (gas, electric, heating oil and coal) are taxed at 5%

• Other goods taxed at 17.5%


Council tax • By local governments to pay for local services i.e. garbage

collection, traffic management, street cleaning etc.• Based on the value of an individual’s home: the higher the

home’s value, the higher the rate

Business rates• By local governments • Based on the value of business property; the higher the value

of their property the more they pay



Slide 349 Incentive effect

Tax can have an effect on incentives

• Income effect, is where tax reduces incomes and so people choose to work more

• Substitution effect, is where tax reduces incomes and so the opportunity cost of leisure is reduced and therefore people choose to work less

Slide 350

Government Expenditure

Slide 351 Government Expenditure

• Governments in most countries spend money in many different areas

• In the 20th Century in the UK, government spending (as a % of GDP) rose from about 12% in 1900 to about 40% by 2000



Slide 352 Types of Government Spending

Produced

by:

Paid for

by: Examples:

Public

Sector

Public

Sector

Public libraries, Hospitals

Private

Sector

Public

Sector

Doctors, School buildings

Public

Sector

Private

Sector

Postal service

Slide 353 Government Expenditure

• Three largest areas of G in the UK:

Social protection: unemployment allowance, pensions, etc.

Health care: UK’s National Health Service (NHS)

Education: schools and colleges

Slide 354 Government expenditure

• Other significant areas of G:Social servicesTransportation Industry, agriculture, employment and training National defence Public order and safety i.e. police, fire servicesHousing and the environment National debt interest payments



Slide 355 Government Spending

Factors affecting government decisions:

• Public & Merit Goods: economy doesn’t provide

• Efficiency: Health care – reduce costs

• Equity:

–Health care, elderly: high costs, low funds

– Education: help poor

Slide 356 Public goods

• Goods that can be used by everyone

• Being used by one person does not reduce the amount available for others

• No person can be excluded

• Examples: national defence, police, street lighting and prisons

Slide 357 Merit goods

• A good good, e.g. defence, police, courts, education

• create positive externalities i.e. health care and education

• Underprovided by the market:

– benefits will not be felt for many years



Slide 358 Demerit goods

• A good that is overprovided by the market

• Consumption of demerit goods creates negative externalities i.e. alcohol & cigarettes

Slide 359 Provision of public and merit goods

• Markets under-provide public and merit goods(Market Failure)

• Government can intervene to correct:

Directly provide: government provides goods free of charge e.g. roads or education

Subsidised provision: government pays part of the cost, e.g. university education or medicine

Regulation: provided by private sector, and government forces people to buy e.g. car insurance

Slide 360 Government Spending

If government spending is too high:

• Privatization

• Outsourcing

• Internal market within public sector

• Partnerships between public and private

• Stop funding certain programs



Slide 361 Reasons for Public v. Private

+ Productive efficiency / economies of scale

– Governments tend to be inefficient

– Lack of competition, choices

+ Price of government services supported by tax revenues – Private sector pricing may be too expensive

Slide 362

Fiscal policy

The use of government spending, taxation & borrowing to affect

aggregate demand in an economy

Slide 363 Fiscal policy

• In the 20th Century, UK has generally had a higher level of government spending than tax revenues (budget deficits)

• This represents borrowed funds, known as the public sector net cash requirement (PSNCR)

• The total level of money borrowed is known as the National Debt




• Some times tax revenues are greater than government spending (budget surplus)

• So government can repay some of the borrowed money – a negative PSNCR

• The national debt then decreases


• Every year in March UK government presents the Budget

• The Budget shows plans for government spending, taxation and borrowing (fiscal policy) for the coming year

Slide 366 Fiscal Policy and the Economy

Decrease in T or increase in G:

• Shift Aggregate Demand out

• May shift Aggregate Supply out

• Increase Economic Growth

• Decrease Unemployment

• May cause Inflation

• May reduce Exports, increase Imports (a net leakage)



Slide 367

Redistribution of Income and Wealth

Slide 368 Income and Wealth

In market economy, distribution of income and wealth not likely to be efficient or equitable

Can create poverty:

•Relative poverty – below average

•Absolute poverty – unable to provide basic needs

Slide 369

LORENZ CURVE



Slide 370 Income Distribution

• If income of 20% lowest earning households represented 20% of national income, and...

• If income of 20% highest earning households represented 20% of national income, and so on...

• Income would be evenly distributed between the different groups


On a table it would look like this:

Household

Earnings

Percent of National

Income

Lowest Fifth 20.0%

Second Fifth 20.0%

Third Fifth 20.0%

Fourth Fifth 20.0%

Top Fifth 20.0%


On a graph, it would look like this:

0%

20%

40%

60%

80%

100%

120%

0% 20% 40% 60% 80% 100% 120%

% o

f In

co

me

% of Households




• In a free market economy, income among households will always be different

• It is much more unevenly distributed between the different groups

• For example…

Slide 374 Income Distribution in the USA

Household

Earnings

Percent of National

Income

Lowest Fifth

(under $6,391*)4.3%

Second Fifth

($6,392* - $11,955*)10.3%

Third Fifth

($11,956* - $18,122*)16.9%

Fourth Fifth

($18,122* - $26,334*)24.7%

Top Fifth

($26,335* and over)43.9%

* Earnings per year. Source: U.S. Bureau of Census


On a graph, it looks like this:

0%

20%

40%

60%

80%

100%

120%

0% 20% 40% 60% 80% 100% 120%

% o

f In

co

me

% of Households

This red curve is called the

LORENZ CURVE



Slide 376 The LORENZ CURVE

• Shows the difference in income distributions between different groups in society

• As the distance between the line of even distribution and the LORENZ CURVE increases, it

means income is becoming more unevenly

distributed

Slide 377 The LORENZ CURVE

Slide 378 Redistribution of Income and Wealth

Law of Diminishing Marginal Utility:

Additional satisfaction decreases the more the good is consumed

Suggests: Redistributing from rich to poor would increase overall combined utility in an economy



Slide 379

Methods of redistributing:

Taxation: Progressive taxes

Government Spending: social security; national insurance; housing grants; distribute clothing; etc.

Legislation: minimum wages; equal pay laws; sick pay; pensions; medical insurance; retraining programs


Slide 380

Costs to economy of redistribution:

Benefits some but not all

Taxpayers lose use of funds paid


Slide 381

Classical economists:

Taxes are a disincentive

Unemployment benefits and equal employment laws create higher wages which means less people employed

High taxes create flight of capital

All economists oppose redistributing

income and wealth




Slide 382

All economists oppose redistributing

income and wealth


Supply-side Economists:

Gap between poor and rich should be increased

Poor would be better off if economy could grow in hands of wealthy, and benefits would trickle down to them

Slide 383 What effects will these changes have on distribution of income?

Income Tax Sales Tax

Basic Rate

%

High Rate % VAT%

1977 33 83 8

1987 25 60 15

1997 22 40 17.5

2007 20 40 17.5

Slide 384

Money and Monetary Policy



Slide 385 Money

• A medium of exchange

• A unit of account

• A store of value

• A standard for deferred payment

Slide 386 Forms of Money

• Cash

• Current accounts: Money saved in banks, that can be immediately withdrawn as cash

• Near Monies: money saved in “deposit“ accounts, that require notice to be withdrawn

• Non-money financial assets: all assets that can be converted into money i.e. houses, cars, shares

Slide 387 Monetary Policy

Interest Rate

• Nominal Interest Rate

• Real Interest Rate




In the UK, the Central Bank sets the Interest Rate

• The Bank Base Rate – the basic rate

• Banks base all their other interest rates on this rate

– Savings accounts

– Bank loans

Changing the Interest Rate can affect:

• The amount of borrowing from banks

• The amount of money circulating in the economy


The primary method used to control inflation

• Inflation comes with economic growth

• Raising IR only moderates inflation, rarely reduces


Raising Interest Rate causes drop in AD:

• Less purchases of Durable Goods

• Less purchases of homes

• Less wealth

– Drop in value of assets

– Drop in Government Bond prices

• Less investment in new projects




Raising Interest Rate causes (cont’d):

• Less output, which increases Unemployment

• Exchange Rate / Balance of Payment– Increase in demand for local currency

– Increase in local currency’s value

– Increase in Exchange Rate

– Increase in price of local goods

– Decrease in Exports

– Increase in Imports

– Decrease in Expenditure, decrease in AD


• “Tightening” Monetary Policy – increase IR

• “Loosening” Monetary Policy – reduce IR

Slide 393

Price

Levels

0 Real Output

Effectiveness of Monetary Policy in controlling Inflation

Classical Economists:

A rise in Interest Rate

Causes a drop in AD

Which causes a drop in Price Levels

No change in output levels

Effective Policy

AD

LRAS

AD1



Slide 394

Price

Levels

0 Real Output


Keynesian Economists:

Depends on economy

If near full employment

Rise IR drop in AD

Leads to drop in Price Levels, and…

Some drop in Output

Mostly effective

AD

LRAS

AD1

Slide 395

Price

Levels

0 Real Output


Keynesian Economists:

Depends on economyIf closer to mass

unemployment

Rise IR drop in ADLittle effect on Price

Levels, but a big drop in Output…

And a big increase in Unemployment

Ineffective

AD

LRAS

AD1

Slide 396

Rate of

Interest

0 Money

Operations of Monetary Policy

Interest Rate will affect the Money Supply

A raise in Interest Rate

Causes a drop in the money supply

D



Slide 397 Operations of Monetary Policy

Other steps to affect Money Supply:

Open Market Operations

• Selling or buying government debt (bonds):

– Selling bonds removes money from circulation in the economy

– Buying bonds injects money into the economy



Reserve Asset Rates:

– When money is deposited into savings, banks then lend the money, creating Investments

– But banks must hold some money in reserve

– The percent banks must hold in reserve

• Reducing RAR increases lending

• Increases money supply + Credit Multiplier



Rules and regulations that affect banking credit policies, by influencing things such as home sales or purchases, etc.




Money Supply and the Budget Deficit:

To finance PSNCR:

• Government may sell bonds

• Borrowing to spend

• No change to Money Supply

• Just affects IR


Money Supply and the Budget Deficit:

To finance PSNCR:

• Government may print more money

• Increasing the Money Supply

Slide 402 Limitations of Monetary Policy

• Money Supply not always easy to measure

• Data not easy to produce

• Link between IR and Money Supply not always clear

• Unexpected events



Slide 403

Inflation

Slide 404 Inflation

Inflation

–A rise in general price levels over a long period of time

Deflation:

–A lowering of general price levels, or

–A slow down in economic output

Slide 405 Inflation

Measured by:

The Retail Price Index

• A typical basket of goods

• A weighted average calculation

• Subject to inaccuracy



Slide 406 Problems during

Inflationary Periods

Consumers unclear about what’s a fair price

– “Shoe Leather costs”



Consumers have less cash

– Put more in savings

– Interest rate is higher

–Must consider the opportunity cost



“Menu Costs”

– Prices of everything are constantly changing

–Difficult to plan on what to buy





“Redistributional Costs”

– Transfer from borrowers to lenders

– Savers lose if Inflation rate is greater than Nominal Interest Rate



Creates Unemployment and lowers growth

– Increases costs of production

–Reduces Investment

• Which decreases the likeliness of long-term growth



Anticipated / Unanticipated Inflation

– Inflation mostly Unanticipated

–Difficult for consumers to plan



Slide 412

Inflation

The Causes of Inflation

Slide 413

The Causes of Inflation

Imported Inflation

– Increases in the prices of imported goods

• Consumer goods

• Raw materials

Slide 414 The Causes of Inflation

Demand-Pull Inflation:

Too much spending in relation to output

Causes AD to shift out

Price

Levels

0 Real Output

AD

LRAS




Cost-Push Inflation:

Costs increase

SRAS shifts in

Results in higher price levels

Price

Levels

0 Real Output

AD

LRAS

SRAS

SRAS2



Workers seek wage raises, increase costs again

They spend more, pushing out AD

Results in higher price levels

Price

Levels

0 Real Output

AD

LRAS

SRAS

SRAS2

SRAS3

AD2


“Monetarist” Economists:

Inflation is Demand-Pull

Sustained (long-term) Inflation

Caused by increases in the money supply

Causes AD to shift out, directly and indirectly (the Multiplier effect)




“Monetarist” Economists:

The Fisher Formulation of the Quantity Theory of Money

M V P T

M = money supply

V = velocity

P = prices

T = number of transactions

==


M V P T

An increase in M

Causes an immediate fall in V

Then, additional money begins to be spent

Causing a gradual increase in incomes

V increases back to standard

This results in slow rise in P

(Demand-Pull inflation)

==


M V P T

As prices rise, real income (adjusted for inflation) begins to fall

V and income return to equilibrium

Finally, P remains at higher levels

Together, this is called the Monetary Transmission Mechanism

Increase in MS leads to increase in AD

Leads to rise in SRAS, shift back to LRAS

==



Slide 421 Stagflation

Rising costs shift the SRAS up

Which increases price levels

If economy is below full employment:

Stagflation – workers can’t pay higher prices

Workers may demand higher wages, but

If MS is fixed, they may not get raises

Workers will stay out of work for some time

Then, begin returning to full employment

Slide 422 Counter-Inflation Policy

• Monetary Policy

• Fiscal Policy

• Exchange Rate Policy

• Prices and Incomes Policy


Monetary Policy:

Raising Interest Rate causes:

– Less spending on Durables, Investment

– Lower values of stocks, homes (wealth)

–Raising of the exchange rate

–AD shifts inwards (diagram)

– Succeeds when economic growth slows

»Not popular




Fiscal Policy:Demand-Pull Inflation:

–Government will reduce spending

–Causes AD to shift in (diagram)


–Reduce or not increase indirect taxes, prices in government sectors

–Reduce Corporate Taxes

–Argued – only change money supply


Exchange Rate Policy:


• Controlling the exchange rate

–Directly

– Indirectly, through changes in Interest Rate


Prices and Incomes Policy:

Directly control or freeze prices & wages

Some say this can work for a short time



Slide 427

Unemployment

Slide 428 The Labour Market

Real w

age r

ate

OEmployment

DFirms

SWorkers

WE

QE

Slide 429

The demand for labour is downward sloping

Marginal revenue product (MRP) – the value of labour to firms

As more workers enter the market,

MRP of labour declines

The Labour Market



Slide 430

Cyclical

Classical

Frictional

Structural

Seasonal

Types of Unemployment

•Considered Involuntary

•Workers have no choice

•(In boom times, there’s no cyclical unemployment)

•Considered Voluntary

•Workers refuse opportunities for jobs

Slide 431

Cyclical / Demand-deficient unemployment:

• Demand for labour declines

• Happens when the economy is in a Negative Output Gap period

Unemployment when the Labour Market is in Disequilibrium

Slide 432

Classical / Real Wage unemployment:

• Wage level above equilibrium

• Factors keep them from going down (“sticky downward”)

• Market fails to “clear” because:

– Unemployment benefits too high

– Minimum wages

– Unions

Unemployment when the Labour Market is in Disequilibrium



Slide 433

Frictional unemployment:

• Workers lose jobs,

• Spend a short time looking for work

Unemployment when the Labour Market is in Equilibrium

Slide 434

Structural unemployment:

• Economy doesn’t provide enough jobs

• Types of Structural Unemployment:

–Regional

– Sectoral

– Technical

Unemployment when the Labour Market is in Equilibrium

Slide 435

“Full employment” means …

… when there is no involuntary unemployment

… in other words, when there’s no

cyclical unemployment

… in other words, when economy reaches the

highest positive output gap

The natural rate of unemployment is the percentage of voluntarily unemployed

Unemployment



Slide 436 Natural Rate of Unemployment

Real w

age r

ate

OEmployment

DFirms

Workers

WE

QE

S(Labour Force)

QF

Natural Rate of Unemployment =QEQF

0QF

Slide 437

According to Classical economists:

• Short run unemployment is temporary

• … Wages will fall

• … Labour market moves back to equilibrium

• In the long run, unemployment will be

Voluntary

Unemployment

Slide 438

O Real output

P3

SRAS1

P1

Y1

AD1

AD2

Price

Levels

/

Inflation

Y2

Inflation and Unemployment Analysed using AS/AD Model

SRAS2

P2



Slide 439

Unemployment

Slide 440

• A.W. Phillips studied the rate of growth of money wages and unemployment from 1861 – 1957

• Money Wages = wages not adjusted for inflation

Relationship between Unemployment and Inflation?

Slide 441 Results of study



Slide 442

• Findings indicated that when raises were high, unemployment was low

• Growth of money wages linked to inflation …

… in inflation times, workers seek higher raises

• There is a trade-off between inflation and unemployment

The Phillips Curve

Slide 443 The Phillips Curve

Wage growth % (Inflation)

Unemployment (%)

There is an inverse relationship between inflation and unemployment.

If a government wants to reduce unemployment, it will have to accept

a trade-off of higher inflation.

1.5%

6%4%

2.5%

PC1


• Problem:

• In the 1970s, inflation and unemployment were rising at the same time – ‘stagflation’

• Was Phillips Curve theory wrong?

• Or, was the Phillips Curve moving?

• Or, …?




Inflation

Unemployment

Long Run

Phillips Curve

PC3PC2PC1

7%

2.0%

1.0%

There is a fall in unemployment, but at a cost of higher inflation.

3.0% Workers expecting higher inflation seek higher wages. If granted, costs rise, firms

start to reduce the labour force, and unemployment moves back up.

4%

To counter the rise in unemployment, government once again injects resources into

the economy – the result is a short-term fall in unemployment but higher inflation.

The long run Phillips Curve is vertical at the natural rate of unemployment. The

Expectations Augmented Phillips Curve.

This higher inflation fuels further expectation of higher inflation and so the

process continues.

Assume an inflation rate of 1% but very high unemployment at 7%. Government

takes measures to reduce unemploymentby an expansionary fiscal policy (pushing

AD to the right)


Wage growth % (Inflation)

Unemployment (%)

An inward shift of the Phillips Curve would result in lower

unemployment levels associated with higher inflation.

1.5%

6%4%PC1

3.0%

PC2

Slide 447

The unemployment rate that is sustained with or without a change in inflation

Unemployment tends to return to the Natural Rate of Unemployment

Natural Rate of Unemploymentis also called

Non-accelerating Inflation Rate of Unemployment

Or the NAIRU



Slide 448

• The P curve helps explain why there is a curve in the Keynesian LRAS curve

• Keynesians: in high unemployment times, it takes a long time for the labour market to clear

• They don’t believe in the natural rate of unemployment

Economic Theory

Slide 449

• Neo-Classicals: people see inflation coming

• Immediately adapt (Theory of Rational Expectations)

• Do not believe in Short Run Phillips Curve

Economic Theory

Slide 450

Cyclical (involuntary) unemployment:

• Use Demand policies (increase AD)

–But need to be careful about inflation

• Classical Economists (vertical LRAS):

– Economy will return to full employment

–Demand policies not necessary

–Warn they may be damaging

Unemployment Policies



Slide 451

Classical (real wage) unemployment:

• Keynsians: Reduce unemployment benefits, pay companies to hire unemployed, give other benefits to low wage workers

• Classical Economists: agree, add reducing Union power, reducing minimum wage


Other types of Unemployment (voluntary) –use Supply Side policies:

Slide 452

Regional Structural unemployment:

• Keynesians: Government provide financial incentives for business to relocate

• Classicals: Leave it to the free market forces (cheap land and labour costs are incentive enough for businesses to relocate)



Slide 453

Industrial Structural unemployment:

• Keynesians: Government provide worker retraining programmes

• Classicals: Lower benefits and redundancies





Slide 454

Increase growth rate of the entire economy:

(assumes this will increase number of jobs)

• Keynesians: Increase investment in physical and human capital

• Classicals: Lower tax rates; privatizing; increasing competition; deregulation


Anther solution: Reduce the Natural Rate of Unemployment

Slide 455

International Trade

Trade Policies

and

Exchange Rate Policies

Slide 456 International Trade

Reasons for International Trade

Availability – some goods only produced in certain countries i.e. oil, diamonds

Product differentiation – provides more choice for consumers

Price – some countries can produce goods relatively cheaper than others (absolute and comparative advantage)




Economic Theories:

Absolute Advantage

• Adam Smith

• Based on lower production (labour) costs


Economic Theories:

Relative / Comparative Advantage

• David Ricardo

• Even if one country has absolute advantage

• Countries can benefit from trade

• Based on Opportunity Costs

• Countries specialize and trade

Slide 459 Example of the Value of Trade

• Tom gives up 40 fish to catch 30 crabs

• His opportunity cost for 1 fish is 3/4 crab

• And his opportunity cost for 1 crab is 4/3 fish

• Hank gives up 10 fish to catch 20 crabs

• His opportunity cost for 1 fish is 2 crabs

• And his opportunity cost for 1 crab is 1/2 fish




Tom Hank

0

5

10

15

20

25

30

35

0 10 20 30 40 50

0

5

10

15

20

25

0 10 20

Tom is more efficient at producing both – he has an Absolute Advantage

Fish Fish

Crab

s

Crab

s

Evaluate Opportunity Cost:

Fish: 3/4 Crabs 2 Crabs

Crabs: 4/3 Fish 1/2 Fish

Tom and Hank should specialize and trade

Slide 461 Production and Consumption Without Trade

Tom Production Consumption

Quantity of fish 28 28

Quantity of crabs 9 9

Hank Production Consumption



Both together Production Consumption



Slide 462 Production and Consumption after Specialization and Trade

Tom Production Consumption



Hank Production Consumption



Both together Production Consumption






• With specialization, both Tom and Hank are better off

• And together they are more productive as an economy

• Based on comparative advantage


Assumptions of Comparative Advantage:

• No transportation costs

• No economies of scale

• Two economies, 2 goods

• Goods are homogeneous

• Factors of production perfectly mobile

• No tariffs or other barriers

• Perfect knowledge


The Non-Price theory of trade:

For non-homogeneous goods, other thingsdetermine trading practices:

• Design

• Reliability

• Availability

• Image



Slide 466 Trade Policies

Countries benefit from free trade:

• Efficiencies (Comparative Advantage)

• Economies of scale

• Greater choices

• Enhances competition

Slide 467 Globalisation

Process of integrating world economies

Benefits:

• Price affordability

• Give poorer countries a way to develop

Disadvantages:

• Puts local workers out of work

• May destroy the environment

…Controversial…

Slide 468 Protectionism

Reasons for Protectionism:

• “Infant industry”

• Protect or preserve jobs

• Dumping

• Unfair competition




Methods of protecting local industry:

• Tariffs

• Quotas

• Subsidies

• Administrative Restrictions

• Embargoes

Slide 470 GlobalisationProtectionism

Restricting trade to protect local industry

Tariffs:

• Tax (Duty) on imported goods

Quotas:

• Limits on the quantities of imported goods allowed in the country

Slide 471 GlobalisationProtectionism

Restricting trade to protect local industry

Subsidies:

• Direct payments to local producers

Administrative Restrictions:

• Rules designed to make trading more difficult

Embargoes:

• Complete ban on trading




Tariffs: Tax (Duty) on imported goods

Price

Quantity

SDomestic

DDomestic

QD

PD

Normal market conditions for any Domestic goodAssume international price is lower (unlimited supply)Local producers will sell 0QL

and QLQI will be imported

SWorldPW

QL QI

The loss of QLQD could destroy local producers To protect its industry, the government imposes a tariff

SWorld

+ Tariff

PWT Local producers will sell 0QLT

and QLTQIT will be imported

QLT QIT0

Local producers will gain sales, and at higher pricesAnd government gains tax revenues on imported goodsFinally, remember consumer surplus and produce surplus


Quotas: A limit on quantities imported

Price

Quantity

SDomestic

DDomestic

QD

PD

Assume the same international situation

SWorldPW

QL QI

Government acts again, imposing a quota to protect

local industry

Reduced imports raise the price in the market

QLQ QIQ0

Local producers gain sales (at higher prices)And the shaded area represents a “windfall profit”

PQ


Subsidies: Direct payments to local producers

Price

Quantity

SDomestic

DDomestic

QD

PD

Again, assume the same market situation

SWorldPW

QL QI

Government makes direct payments to local industrySubsidies lower production costs, pushing the Supply

curve out to the right

QS0

Local producers gain sales from importers, at prices

higher than the world price

PS

SDomestic

+Subsidy




Administrative restrictions:

• A series of rules or laws

• Makes importing extremely difficult

• Examples: registration; inspections; quarantines; etc.


Embargoes:

• Complete ban on imports

• Can be against a company or a country

• Can be on one product or all products

• Examples: oil; high-technology products; etc.


Economists would always argue against protection, favouring market forces



Slide 478

Balance of Payments

In business and international trade, money never exchanges

hands

Slide 479 Balance of Payments

A financial record

Financial dealings between countries

Composed of two accounts:

• Current Account

• Capital Account

Slide 480

Current Account

• The value of goods and services exchanged

Capital Account

• Flows of monetary assets, including savings and investments

Balance of Payments



Slide 481 Current Account

Divided into two groups:

Visibles

Invisibles+

=

Current Balance


Visibles:

• Trade in goods

• Exports are “positive”

• Imports are “negative”

• The “Balance of Trade” = difference between visible exports and visible imports

Slide 483 Balance of Payments Account

Will always be “in balance”

• Goods and services (current account) are “paid for” with increases in a liability (capital account)

• Investments in foreign companies (capital account) are “paid for” with increases in a liability (capital account)



Slide 484 Example – UK Balance of Payments Account

Current Acct Capital Acct

Import goods from China -10 million -10 million

Export goods to China +7 million +7 million

Purchase a China factory +25 million

Due to Investors -25 million

Balance of Payments -3 million -3 million


Surpluses:

• More exports than imports

• Lending money to foreign countries

Deficits:

• More imports than exports

• Borrowing money from foreign countries

Slide 486 Current Account Theories

• Small, short-term Current Account deficitsor surpluses are not a problem

• Large, long-term Current Account deficitsor surpluses could be a problem




Large, long-term CA deficits (from imports):

• If economy strong, foreign institutions will continue, and country can benefit, but…

• If too high, and for too long a period, foreign institutions may begin to doubt repayment, may stop selling (lending money)


Large, long-term CA surpluses (from exports):

• Can be seen as economic strength, but…

• Reduces what is available for domestic consumers

• Can cause problems between trading nations

Slide 489 Exchange Rate Systems

Fixed exchange rate system

• Our currency “pegged” to another country’s

Free / Floating exchange rate system

• Free market forces (demand and supply)



Slide 490 Ways to affect Exchange Rate

Interest Rate

• Increase in interest rate…

• Will increase exchange rate


Gold and Foreign Currency Reserves

• Held by Central Bank

• Selling them in the market attracts more domestic currency, increasing the value

Any of these steps only make small changes in a country’s exchange rate


Interest Rate

Gold and Foreign Currency Reserves

• Both policies affect the world demand for our country’s currency

• Both policies only make small changes in a country’s exchange rate



Slide 493 Effect of

Increases in Exchange Rate

Can reduce or moderate Inflation

• Decrease in Exports

• Increase in Imports

• Decrease in AD

Slide 494 Effect of


Can moderate or reduce Economic Growth

• Decrease short term domestic output and investment

• Decrease in AD

Slide 495 Effect of


Can increase Unemployment

• Decrease in AD



Slide 496 Effect of


Can decrease the Current Balance

• Decrease in Exports

• Increase in Imports

Slide 497 Economic Theory and Reducing

Trade Deficits by Exchange Rate Policies

MARSHALL LERNER Condition:

Effect of Depreciating currency…

If combined PED of X and M > 1 …

• Trade deficit will decrease (improve)

If combined PED of X and M < 1 …

• Trade deficit will increase (get worse)

Slide 498 Example of

Marshall Lerner Condition



Slide 499

Oligopoly

Slide 500

Oligopoly

Two examples of oligopoly

Slide 501

1985

(%)

2002

(%)

Bass


Grand Met (Watneys)

Whitbread


Courage

Others

22

13

12

11

10

9

23

100

Scottish–Courage

Interbrew UK

Coors

Carlsberg–Tetley

Diageo (Guinness)

Others

27

20

18

12

7

16

100


largest brewers



Slide 502

1985

(%)

2002

(%)

Bass


Grand Met (Watneys)

Whitbread


Courage

Others

22

13

12

11

10

9

23

100

Scottish–Courage

Interbrew UK

Coors

Carlsberg–Tetley

Diageo (Guinness)

Others

27

20

18

12

7

16

100


largest brewers

Slide 503

0

5

10

15

20

25

30

35

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02

$ per barrel Actual price

Yom Kippur

War: Arab oil

embargo

First oil from

North Sea

Revolution

in Iran

Iraq invades

Iran OPEC’s first

quotas

Cease-fire in

Iran-Iraq war Recession

in Far East

Iraq invades

Kuwait

New OPEC

quotas

World-wide

recovery

World-wide

slowdown

Impending

war

with Iraq

Oil prices

Slide 504

0

5

10

15

20

25

30

35

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02

$ per barrel Actual priceCost in 1973 prices

Yom Kippur

War: Arab oil

embargo

First oil from

North Sea

Revolution

in Iran

Iraq invades

Iran OPEC’s first

quotas

Cease-fire in

Iran-Iraq war Recession

in Far East

Iraq invades

Kuwait

New OPEC

quotas

World-wide

recovery

World-wide

slowdown

Impending

war

with Iraq

Oil prices



Slide 505

Oligopoly

A profit-maximising cartel

Slide 506 £

Q O

Industry D = AR

Profit-maximising cartel

Slide 507 £

Q O

Industry D = AR

Industry MC

Industry MR

Q1

P1

Profit-maximising cartel



Slide 508

Oligopoly

Price leadership

(assumption of fixed market share)

Slide 509 £

Q O

MR leader

AR = D leader

AR = D market

Price leader aiming to maximise profits for a given market share

Assume constantmarket share

for leader

Slide 510 £

Q O

AR = D market

MC

MR leader

PL

QT

AR = D leader

QL

l t

Price leader aiming to maximise profits for a given market share



Slide 511

Oligopoly

Game theory

Slide 512 Profits for firms A and B at different prices

£2.00 £1.80

£2.00

£1.80

X’s price

Y’s price

A B

C D

£10m each

£8m each£12m for Y

£5m for X

£5m for Y

£12m for X

Slide 513 The prisoners' dilemma

Not confess Confess

Not

confess

Confess

Amanda's alternatives

Nigel's

alternatives

A B

C D

Each gets

1 year

Each gets3 years

Nigel gets3 months

Amanda gets

10 years

Nigel gets10 years

Amanda gets

3 months



Slide 514

Oligopoly

A decision tree

Slide 515

Boeingdecides

A decision tree

Boeing –£10m

Airbus –£10m(1)

Boeing +£30m

Airbus +£50m(2)

Boeing +£50m

Airbus +£30m(3)

Boeing –£10m

Airbus –£10m(4)

Airbusdecides

B2

Airbusdecides

B1

A

Slide 516

Oligopoly

Kinked demand curve theory



Slide 517 Kinked demand for a firm under

oligopoly£

QO

P1

Q1

Current priceand quantitygive one point

on demand curve

Slide 518 £

QO

P1

Q1

D

D

Kinked demand for a firm under oligopoly

Slide 519 £

QO

P1

Q1

MC2

MC1

MR

a

bD = AR

Stable price under conditions of a kinked demand curve



Slide 520

Perfect

Competition

Slide 521

Perfect competition

Short-run equilibrium of firm and industry (profit maximising)

Slide 522

O

£

(b) Firm

Q (thousands)

O

(a) Industry

P

Q (millions)

S

D

Pe

MC

ARD = AR

= MR

Qe

AC

AC

Short-run equilibrium of industry and firm under perfect competition



Slide 523

Perfect competitionOptimum position for a loss-making firm

Slide 524

Qe

P1

D1 = AR1

= MR1

AR1

O O

(a) Industry

P £

Q (millions)

S

D

(b) Firm

MC AC

AC

Q (thousands)

Loss minimising under perfect competition

Slide 525 Short-run shut-down point

O O

(a) Industry

P £

P2

Q (millions)

S

D2

(b) Firm

AR2

D2 = AR2

= MR2

MC AC

AVC

Q (thousands)



Slide 526

Perfect competitionShort-run supply curve of the firm

Slide 527

O O

(a) Industry

P £

P1

Q (millions)

S

D1

(b) Firm

D1 = MR1

MC

P2

D2 = MR2

D2

P3

D3 = MR3

D3

Q (thousands)

Deriving the short-run supply curve

a

b

c

= S

Slide 528

Perfect competitionThe industry

supply curve



Slide 529

O O

(a) Industry

P £

P1

Q (millions)

S

D1

(b) Firm

D1 = MR1

S

a

P2

D2 = MR2

D2

b

P3

D3 = MR3

D3

c

Q (thousands)

Deriving the industry short-run supply curve

Slide 530

Perfect competitionLong-run equilibrium

Slide 531

O O

(a) Industry

P £

Q (millions)

S1

D

(b) Firm

LRAC

PL

P1

QL

Se

AR1 D1

ARL DL

Q (thousands)

Long-run equilibrium under perfect competitionNew firms enter Supernormal profits

Profits returnto normal



Slide 532 £

Q O

(SR)AC

(SR)MC

LRAC

AR = MR

DL

LRAC = (SR)AC = (SR)MC = MR = AR

Long-run equilibrium of the firm under perfect competition

Slide 533

Perfect competitionLong-run industry supply curves

Slide 534 P

Q O

Various long-run industry supply curves under perfect competition

Long-run S

S1

D1

S2

D2

a

(a) Constant industry costs

b

c



Slide 535

Long-run S

P

Q O

S1

D1

S2

D2

a


(b) Increasing industry costs: external diseconomies of scale

b

c

Slide 536

Long-run S

P

Q O

S1

D1

S2

D2

a


(c) Decreasing industry costs: external economies of scale

b

c

Slide 537

Market Structures



Slide 538 Market Structures

• Type of market structure influences how a firm behaves:

– Pricing

– Supply

– Barriers to Entry

– Efficiency

– Competition

Slide 539 Market Structures

• Degree of competition in the industry

• High levels of competition – Perfect competition

• Limited competition – Monopoly

• Degrees of competition in between

Slide 540 Market Structure

• Determinants of market structure

– Freedom of entry and exit

– Nature of the product – homogenous (identical), differentiated?

– Control over supply/output

– Control over price

– Barriers to entry




• Perfect Competition:– Free entry and exit to industry

– Homogenous product – identical so no consumer preference

– Large number of buyers and sellers – no individual seller can influence price

– Sellers are price takers – have to accept the market price

– Perfect information available to buyers and sellers


• Examples of perfect competition:

– Financial markets – stock exchange, currency markets, bond markets?

–Agriculture?

• To what extent?


• Advantages of Perfect Competition:

• High degree of competition helps allocate resources to most efficient use

• Price = marginal costs

• Normal profit made in the long run

• Firms operate at maximum efficiency

• Consumers benefit




• What happens in a competitive environment?– New idea? – firm makes short term abnormal profit– Other firms enter the industry to take advantage of

abnormal profit– Supply increases – price falls– Long run – normal profit made– Choice for consumer– Price sufficient for normal profit to be made but no more!


• Imperfect or Monopolistic Competition– Many buyers and sellers– Products differentiated– Relatively free entry and exit– Each firm may have a tiny ‘monopoly’ because of the

differentiation of their product– Firm has some control over price– Examples – restaurants, professions – solicitors, etc.,

building firms – plasterers, plumbers, etc.


• Oligopoly – Competition amongst the few– Industry dominated by small number of large firms– Many firms may make up the industry– High barriers to entry– Products could be highly differentiated – branding or homogenous– Non–price competition– Price stability within the market - kinked demand curve?– Potential for collusion?– Abnormal profits– High degree of interdependence between firms




• Examples of oligopolistic structures:– Supermarkets

– Banking industry

– Chemicals

– Oil

– Medicinal drugs

– Broadcasting


• Measuring Oligopoly:• Concentration ratio – the proportion of market share

accounted for by top X number of firms:

– E.g. 5 firm concentration ratio of 80% - means top 5 five firms account for 80% of market share

– 3 firm CR of 72% - top 3 firms account for 72% of market share


• Duopoly:• Industry dominated by two large firms

• Possibility of price leader emerging – rival will follow price leaders pricing decisions

• High barriers to entry

• Abnormal profits likely




• Monopoly:

• Pure monopoly – industry is the firm!

• Actual monopoly – where firm has >25% market share

• Natural Monopoly – high fixed costs – gas, electricity, water, telecommunications, rail


• Monopoly:– High barriers to entry

– Firm controls price OR output/supply

– Abnormal profits in long run

– Possibility of price discrimination

– Consumer choice limited

– Prices in excess of MC


• Advantages and disadvantages of monopoly:• Advantages:

– May be appropriate if natural monopoly– Encourages R&D– Encourages innovation– Development of some products not likely without some

guarantee of monopoly in production– Economies of scale can be gained – consumer may benefit




• Disadvantages:

– Exploitation of consumer – higher prices

– Potential for supply to be limited - less choice

– Potential for inefficiency –

X-inefficiency – complacency over controls on costs


Kinked Demand CurvePrice

Quantity

D = elastic

D = Inelastic

£5

100

Kinked D Curve

The intention of this slide is to demonstrate the principle of the kinked demand curve. The slide starts with the vertical and horizontal axes. A demand curve appears – relatively elastic and a price of £5 and q 100 appear. The explanation at this point would imply asking students what would happen if the producer increased price but nobody else in the industry followed? Hopefully students will see that the demand would fall significantly. By this stage students should be aware of the impact on total revenue as a result of this action. The next assumption rests on the firm facing an inelastic demand curve; in this case the firm believes that firms will follow suit in reducing price – the effect is to lead to only a small gain in sales – total revenue would again fall. Assuming the two characteristics would suggest a kinked demand curve and price stability existing in the industry with the likely outcome being non-price comptition.



Slide 555

Monopolistic

Competition

Slide 556

Monopolistic competitionEquilibrium of the firm:

short run

Slide 557 £

Q O Qs

AR = D

MC

AC

MR

Short-run equilibrium of the firmunder monopolistic competition

Ps

ACs



Slide 558

Monopolistic competitionEquilibrium of the firm:

long run

Slide 559 Long-run equilibrium of the firmunder monopolistic competition

ARL = DL

MRL

£

Q O QL

PL

LRAC

LRMC

Slide 560

Monopolistic competitionComparison with perfect competition (long run)



Slide 561

Q2

P2DL under perfect

competition

Long run equilibrium of the firm under perfect andmonopolistic competition

£

QO

P1

LRAC

DL under monopolistic

competition

Q1

Slide 562

Demand

The behaviour of Consumers


Demand: The quantity of a good or service consumers would be willing and able to buy at different given prices

Law of Demand: If all else remains the same (ceteris parabis), when the price of goods go down, more people will purchase greater quantities.



Slide 564 Demand Schedule

For example, look at the demand facing a single seller in a market, in this case, a tire seller.

Price (£) Quantity

demanded

40 5

30 15

20 25

10 35

Slide 565 Plot a Demand Curve

Price (£) Quantity

demanded

40 5

30 15

20 25

10 35

Quantity

Pri

ce Demand for Tires

40

30

20

10

0

10 20 30 40

D


Quantity

Pri

ce Demand for Tires

40

30

20

10

0

10 20 30 40

D


quantity demanded would


A drop in price to 20 would


quantity demanded to

25.So, a change in price results

in a change in quantity

demanded, represented by

movement along the

Demand Curve.


shown?




The Demand Curve is downward sloping

There is an inverse relationship between priceand quantity demanded

As price decreases, quantity demanded will rise, and the opposite is also true

Market Demand: Add up the Demand Curves

faced by individual sellers

Slide 568 Determinants of Demand

• Price (results in movement along Demand Curve)

• Prices of other goods

• Incomes

• Tastes and fashions

• Population size or structure

• Advertising

• Expectations of consumers

• Changes in laws

Changes in any of these will cause Demand



Quantity

Pri

ce Demand for Tires

40

30

20

10

0

10 20 30 40

D

For example, as the Chinese

economy develops, people

are earning more, improving

their standard of living.

As a result, demand for tires

at all prices is increasing.

A change in any other

determinant results in a

change in quantities

demanded at all prices,

represented by a shiftingof the Demand Curve.

So, more people are buying

cars.

D1




Changes in Determinants of Demand:

• Change in Price: “movement along the demand curve resulting in an increase / decrease in quantity demanded”

• Change in any other factor: “causes the demand curve to shift out / in resulting in an increase / decrease in demand”

Slide 571 Consumer Surplus

Price (£)

Quantity Demanded

D

P1

Consider the Demand Curve BCD below. At a price P1,

consumers would purchase 0Q1 quantity.

The area of the triangle P1BC in the diagram is called the

Consumer Surplus, the total benefit to consumers of

a price P1

B

C

Q10

BC on the demand curve represents consumers who would be willing to pay a higher price, but need not.

The market brings them a benefit since they don’t have to pay as much as they

would have been willing to pay

Slide 572

Supply




Supply: The quantity of a good or service producers would be willing and able to produce and sell at different given prices.

The Law of Supply: If all else remains the same, as the price of a good increases, more producers will produce greater quantities.

Slide 574 Supply Schedule

Referring to the previous example, look at the choices our tire seller would make at different levels – a Supply Schedule.

Price (£) Quantity

supplied

40 35

30 25

20 15

10 5

Slide 575 Plot a Supply Curve

Price (£) Quantity

supplied

40 35

30 25

20 15

10 5

Quantity

Pri

ce Supply of Tires

40

30

20

10

0

10 20 30 40

S



Slide 576 Supply Curve

Quantity

Pri

ce Supply of Tires

40

30

20

10

0

10 20 30 40


quantity supplied would


A rise in price to 30 would


quantity supplied to 25.

A change in price results in

a change in quantity

supplied, represented by

movement along the

Supply Curve.


shown?

S


The Supply Curve is upward sloping

There is a positive relationship between priceand quantity supplied

As price increases, quantity supplied will rise, and the opposite is also true

Market Supply: Add up the Supply Curves of

all the individual sellers

Slide 578 Determinants of Supply

• Price (results in movement along Supply Curve)

• Costs of production

• Price of other goods

• Technology

• Producers’ goals

• Government legislation

• Future expectations

Changes in any of these will cause Supply





For example, if new technologies were introduced into China

which made the production of tires less expensive…

As a result, quantities of tires supplied at all price levels would

increase, causing the Supply Curve for tires to shift outward.

A change in any other determinant results in a change in

quantities supplied at all prices, represented by a shifting of

the Supply Curve.

Producers producing at all price levels would choose to

produce more tires.

Slide 580 The Producer Surplus

Price (£)

Quantity Supplied

S

P1

The area of the triangle P10C in the diagram is called the

Producer Surplus, the total benefit to producers as a

result of market price P1

C

Q10

Those producers benefit because they can sell at a

higher price

Consider the Supply Curve 0CS below. At a price P1, producers would produce 0Q1 quantity.

0C on the supply curve represents producers who would be willing to sell at a lower price, but need not.

Slide 581




Slide 582 Market Price

• Buyers and sellers

• Come together

• A price is “struck”

Slide 583 Equilibrium

Price (£)

Quantity

D

PE

Equilibrium Price (PE) and Equilibrium Quantity (QE) where Demand and Supply Curves intersect

QE

Equilibrium Price is sometimes called the Market Clearing price – at that price, all good would be sold.

Slide 584 Excess Supply

Price (£)

Quantity

D

PE

When Market Price (PM) is above PE this results in excess supply – surpluses

QE

PM

QD QS

Surplus



Slide 585 Excess Demand

Price (£)

Quantity

D

PE

When Market Price (PM) is below PE this results in excess demand – shortages

QE

PM

QDQS

Shortage

Slide 586 Stable / Unstable Equilibrium

Stable Equilibrium: Free market forces push market price toward Equilibrium

Unstable Equilibrium: Free market forces are not strong enough to push the market price to Equilibrium


Which of the following actions could cause a higher price and a lower quantity consumed?A. An outward shift of the demand curveB. An inward shift of the supply curveC. An inward shift of the demand curveD. An outward shift of the supply curve



Slide 588

P

Q

D

PE

QE

P1

Q1

QS

Shortage

Rail Travel Market

Slide 589

P

Q

D

PE

QE

P1

Q1

QS

Shortage

Rail Travel Market

D1


Price (£)

Quantity

D

£10

100

D1

150

Increases in: incomes, population, adverts, etc

Increases demand, causes the demand curve to shift outward, results in increased quantities demanded at all prices




Price (£)

Quantity

D

£10

100 150

Increase in quantity demanded as represented by movement along the demand curve

£7

Changes in Price

Slide 592

Price (£)

Quantity

D

£10

100 150Change in price

£7

Movement along the demand curve

Slide 593

Price (£)

Quantity

D

£10

100

D1

150

Shift out



Slide 594

Price (£)

Quantity

D

£10

100

D1

50

Shift in

Slide 595

Price (£)

Quantity

D

£10

100

D1D2

50 150

Slide 596

Price £

Quantity

S

£4

300

S1

200

S2

400




Price (£)

Quantity

S

£5

100

S1

50

Decreases in costs of production, advances in technology, etc

Producers will increase the quantities produced at all prices, increasing supply, causing the supply curve to shift outward

Slide 598

Price (£)

Quantity

S S1

Slide 599

Price

Quantity

SS1



Slide 600

Demand and Supply

Practice Questions

3 minutes for each question

Slide 601 1. If there were a decrease in the general income level in the UK, the likely result on the market for foreign holidays would be:

A. an increase in price and increase in quantity B. a decrease in price and decrease in quantity C. a decrease in price and increase in quantity D.an increase in price and decrease in quantity

Slide 602 2.



Slide 603 3.

Slide 604 4. If the government gives schools subsidies on education, this will most likely result in:A. An increase in price and increase in quantity

B. A decrease in price and decrease in quantity C. A decrease in price and increase in quantity D.An increase in price and decrease in quantity

Slide 605 5. In the diagram below, Consumer Surplus is represented by:A. BECB. EDF

C. AEBD.AED



Slide 606 6. When the supply curve shifts outwards, what is the effect on equilibrium price and quantity?A. Price increases, quantity decreases

B. Price decreases, quantity increasesC. Price increases, quantity increases D.Price decreases, quantity decreases

Slide 607 7. When the government taxes suppliers for the goods they sell, what effect does it have on the market?A. The supply curve shifts outwards

B. The demand curve shifts outwardsC. The supply curve shifts inwardsD.The demand curve shifts inwards

Slide 608 8. Which of the following would be most likely to cause an inward shift of the demand curve for ski equipment?

A. The coming of summerB. The coming of winterC. An increase in the price of ski equipmentD.An inward shift of the supply curve



Slide 609 1. Demand for a good is zero at £200. It then rises to 50 million units at £100 and 75 million at £50.

a) Draw the demand curve for prices between £0 and

£200.b) Shade the area of consumer surplus at a price of £60.c) Is the consumer surplus larger or smaller at a price of

£40 compared to £60? Explain your answer.

Slide 610 3. If there were a decrease in the price of DVD players, the likely result on the market for DVDs would be:A. an increase in price and increase in quantity

B. a decrease in price and decrease in quantity C. a decrease in price and increase in quantity D.an increase in price and decrease in quantity

Slide 611

Interrelationships between Markets

Goods that affect other goods



Slide 612 COMPETITIVE DEMAND

Substitute goods

• Increase in price of one leads to a decrease in quantity demanded

• This leads to an increase in Demand for the substitute good, which leads to a rise in price

Slide 613

Pri

ce

Quantity

Market for Good "B"

Pri

ce

Quantity

Market for Good "A"

JOINT DEMAND

Complementary goods

• Decrease in price of one leads to an increase in quantity demanded

• This leads to an increase in Demand for the complementary good, which leads to a rise in price

Slide 614

Pri

ce

Quantity

Market for Good "E"

Pri

ce

Quantity

Market for Good “F"

DERIVED DEMAND• An increase in Demand for finished good “E”

• Results in an increase in Demand for the good “F” needed to produce “E”, which leads to a rise in price



Slide 615

Pri

ce

Quantity

Market for Good "H"

JOINT SUPPLY• An increase in Demand for finished good “G”

• Results in an increase in Supply of the resource “H” needed to produce “G”, which leads to a lowering of price

Slide 616

Elasticity

Effect on factor “Y” by a change in factor “X”

or

the responsiveness of “Y” to changes in “X”

Slide 617 Price Elasticity of Demand (PED)

How much quantity demanded (Q) responds to changes in price (P)






PED = Percentage change in Quantity


r

%ΔQ

%ΔP


-0- Perfectly Inelastic No change in quantity demanded when price changes


1 Unitary Elasticity Percentage change in quantity = Percentage change in Price


∞ Perfectly Elastic Consumers will demand any quantity at the given price

Slide 619 Determinants of PED



3. Necessities have lower PED

4. Low-priced goods have lower PED

5. Luxury goods have higher PED

6. High-priced goods have higher PED



5

5

D

A Perfectly Inelastic Demand Curve looks like this





5

5

D

An Inelastic Demand Curve looks like this



5

5D

A Perfectly Elastic Demand Curve looks like this



5

5

D

An Elastic Demand Curve looks like this





5

5

D

A Unitary Elastic Demand Curve looks like this


But, PED along a demand curve is also different

5

5

Price drops from 7 to 6

PED = (1÷2) (–1÷7)

= 50% ÷ –14%

= –3.57

Elastic

Price drop from 3 to 2

PED = (1 6) (–1 3)

= 16% ÷ –33%

= – .48

Inelastic

D


If a business raises prices,

will it make more money?

It depends on Price Elasticity of Demand!

Total Expenditure (consumers)

=

Total Revenue (firms)



Slide 627

5

5

D

Measuring the value of PED

Total Expenditure & Total Revenue

= £6 x 3.75

= £22.25

TE = TR

= P x Q


Inelastic PED and TE

5

5

D



Notice how the blue area is much larger than the yellow


Elastic PED and TE

5

5

D



Notice how the blue area is much smaller than the yellow



Slide 630 Cross Elasticity of Demand

(CED) OR (XED)

XED = %ΔQ of X

%ΔP of Y

How demand for good “X” changes when the price of good “Y” changes

Substitute goods have a positive CED

Complementary goods have a negative CED

Slide 631 Income Elasticity of Demand (YED)

YED = %ΔQ

%ΔY

How demand for a good changes when income (Y) changes

Most goods in general have a positive YED

Goods with a negative YED are called “Inferior Goods”

Slide 632 Price Elasticity of Supply (PES)

How much quantity supplied (Q) responds to changes in price (P)





Slide 633 Primary Determinants of PES

1. Availability of substitute goods tends to increase PES

2. Time tends to increase PES

Slide 634 Measuring the value of PES

PES = Percentage change in Quantity


r

%ΔQ

%ΔP


-0- Perfectly Inelastic No change in quantity supplied when price changes


1 Unitary Elasticity % in quantity supplied = % in Price


∞ Perfectly Elastic Producers will supply any quantity at the given price

Slide 635

Elasticity

Practice Problems



Slide 636


Quantity Price Quantity Price

a) 100 5 120 3

b) 20 8 25 7

c) 12 3 16 0

d) 150 12 200 10

e) 45 6 45 8

f) 32 24 40 2

PED Value Elasticity-0.5 Inelastic

-2.0 Elastic-0.3 Inelastic

-2.0 Elastic0.0 Perf. Inel.

-0.3 Inelastic

Elasticity Exercise


Assuming the price of cigarettes increases by 10% and the quantity demanded decreases by 3%, what is the price elasticity of demand? Comment on the results. [5 marks]

PED = %ΔQ %ΔP [1]

= -3% 10%

= -0.3 [2]

The PED for cigarettes is inelastic.

Slide 638

Economic Efficiency &

Market Failure



Slide 639



• Demand

• Supply

• Price Determination

• Interrelationships between markets

• Elasticities

The Market Mechanism


Consumer

All powerful

Free to spend

Choose

Maximize utility

Producer / Firms

Serve consumers

Maximize profits

Owners of Factors of Production

Maximize return

Maximizing behaviour




The Functions of Price in an Economy

•Rationing

•Signaling

•Incentives


An Economy is judged by how well it answers these three questions:

•What it produces (goods and services);

•How well it produces them (how well it uses resources); and,

•For whom does it produce them


EFFICIENCY




•ALLOCATIVE / ECONOMIC Efficiency

•STATIC Efficiency

•DYNAMIC Efficiency



Slide 645


•Production Possibility Frontier (PPF)

•Competition

•To achieve MARKET Efficiency, there must be


Economic Efficiency

Slide 646


•Producing at lowest possible cost

•Can be achieved if production achieves …


Economic Efficiency

Slide 647


•Maximum output (production)

•Minimum input (resources)

Economic Efficiency



Slide 648

•ALLOCATIVE or ECONOMIC Efficiency

•Resources are being used to produce goods and services that people most want

•STATIC EFFICIENCY

•DYNAMIC EFFICIENCY

Economic Efficiency

Slide 649 Market Failure

MARKET FAILURE represents INEFFICIENCY

•Lack of COMPETITION

•EXTERNALITIES

•FACTOR IMMOBILITY

•INFORMATION FAILURE

•INEQUALITY / INEQUITY

Slide 650


Governments take action to deal with market failure




Wide price fluctuations lead to market failure

•Prices too high – consumers won’t buy

•Prices too low – producers won’t sell

•Make it difficult to identify the “signal”


Specific steps governments take:•Price Controls•Buffer Stock Schemes•Subsidies•Taxes

Slide 653 Price Controls

Price

Quantity

D

S

PE

Maximum Price (belowthe market price) results in Excess Demand.

Minimum Price (abovethe market price) results in Excess Supply.

PMax

PMin



Slide 654 Commodities

• Mostly agriculture & mining products

• Generally traded worldwide, but each economy faces its own market conditions

• Large Price fluctuations for various reasons– Bumper crops

– Crop failures

– Weather and other natural phenomenon

– Political situations

• Steep, inelastic Supply & Demand curves

• Small shifts create large changes in price


Price

Quantity

D

S

PI

Government sets the intervention price, say PI

If market price is below PI, say PB…

PB

Government buys large

quantities, pushing Demand curve out until it reaches PI.

This creates a Buffer stock.

DI


Price

Quantity

D

S

PI

Assume the same intervention price, PI

If market price is above PI, say PA …PA

Government sells large

quantities from Buffer Stock, pushing Supply curve out

until it reaches PI

SA



Slide 657 Taxes

Price

Quantity

D

S

STax

Tax per unit

Totalcost

of Tax

Tax causes suppliers to offer less units for sale

at every price

Tax is vertical distance between supply curves

Tax increases prices and decreases amounts


Paid by Consumers

Paid by Producers

Slide 658 Subsidies

Price

Quantity

D

S

SSubsidy

Totalcost

of subsidy

Subsidies encourage suppliers to sell more

at every price

Subsidy is vertical distance between the

two supply curves

Subsidies reduce prices and increase amounts


Benefits to Consumers

Benefits to Producers

Subsidy per unit

Slide 659


Calculations




Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40

1 6

2 11

3 15

4 60

5 66

Given …

Unit 39, Question 3

Complete the table

Slide 661

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40

1 6

2 11

3 15

4 60

5 66


Unit 39, Question 3

Fixed costs remain the same at all levels of output – they’re fixed!

40

40

40

40

40

Slide 662

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40

1 40 6

2 40 11

3 40 15

4 40 60

5 40 66


Unit 39, Question 3

Fill in: Total Cost = Total Fixed Cost + Total Variable Cost

40

46

51

55



Slide 663

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40 40

1 40 6 46

2 40 11 51

3 40 15 55

4 40 60

5 40 66


Unit 39, Question 3

Calculate Variable Cost: Total Cost – Total Fixed Cost

20

26

Slide 664

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40 40

1 40 6 46

2 40 11 51

3 40 15 55

4 40 20 60

5 40 26 66


Unit 39, Question 3

Calculate Average Fixed Cost: Total Fixed Cost ÷ Output

40.0

20.0

13.3

10.0

8.0

Slide 665

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40 40

1 40 6 46 40.0

2 40 11 51 20.0

3 40 15 55 13.3

4 40 60 10.0

5 40 66 8.0


Unit 39, Question 3

Calculate Average Variable Cost: Total Variable Cost ÷ Output

6.0

5.5

5.0

5.0

5.2



Slide 666

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40 40

1 40 6 46 40.0 6.0

2 40 11 51 20.0 5.5

3 40 15 55 13.3 5.0

4 40 60 10.0 5.0

5 40 66 8.0 5.2


Unit 39, Question 3

Calculate Average Cost: Total Cost ÷ Output

46.0

25.5

18.3

15.0

13.2

Slide 667

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40 40

1 40 6 46 40.0 6.0 46.0

2 40 11 51 20.0 5.5 25.5

3 40 15 55 13.3 5.0 18.3

4 40 60 10.0 5.0 15.0

5 40 66 8.0 5.2 13.2


Unit 39, Question 3

Calculate Marginal Cost: Increase in Total Cost at each output level

6

5

4

5

6

Slide 668

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Cost

Marginal

Cost

0 40

1 6

2 11

3 15

4 60

5 66


Unit 39, Question 3



Slide 669 Production Calculations

Labour Inputs

Total Product

(L) (TP)

1 5

2 10

3 18

4 28

5 36

6 39

7 40

Each time an additional

worker is added, more

output can be produced.

Marginal Product

(MP)

5

8

10

8

3

1

Marginal Product: additional output produced by adding

an additional worker.

Average Product: the average quantity of goods

produced by each worker.

Average Product

(AP)

5.0

5.0

6.0

7.0

7.2

6.5

5.7

Production schedule

Slide 670 Production Diagrams

Total Product

TP increases at a faster rate until

about midway – increasing returns to

scale.

Then it begins to slow down –

diminishing returns to scale.Output

La

bo

ur

TP

Output

La

bo

ur

AP

MP

Average Product and Marginal Product

MP is at its highest where diminishing

returns to scale set in

Note: both curves rise, then decline,

first MP then AP

Slide 671 The Production Function

Q = L + C

Where Q = Quantity produced,

L = Labour, and

C = Capital

OUTPUTS

INPUTS




“Costs” in Economics include all economic costs facing the company and its owners:

•Materials;

•Labour;

•Management;

•Equipment;

•Cost of Buildings;

•Owners’ time;

•Earnings on cash;

•Goodwill;

•Opportunity cost;

•Normal profits

These are unique to EconomicsThe same in Business and Economics


Costs are also categorized by their behaviour

•Fixed Costs: Costs that do not change in the relevant range; generally the cost of capital

•Variable Costs: Costs that change with changes in outputs; include cost of materials, supplies and labour


Costs are summarized as follows:

Total Cost (TC) = Fixed Costs (TFC) + Variable Costs (TVC)

Average Cost (AC) = Total Cost (TC) Units of output (Q)

Marginal Cost (MC) = The cost of one additional unit of output

= ΔTC ÷ ΔQ




Output

Total

Fixed

Costs

Total

Variable

Costs

Total

Cost


0 200 0 200

1 200 100 300

2 200 170 370

3 200 220 420

4 200 255 455

5 200 275 475

6 200 295 495

7 200 320 520

8 200 360 560

9 200 425 625

10 200 525 725

Marginal

Cost

Average

Fixed

Cost

Average

Variable

Cost

Average

Total

Cost


100

70

50

35

20

20

25

40

65

100

200

100

67

50

40

33

29

25

22

20

100

85

73

64

55

49

46

45

47

53

300

185

140

114

95

83

74

70

69

73

Slide 676 Fixed Costs

Output

Total

Fixed

Costs

Average

Fixed

Cost

(Q) (TFC) (AFC)

0 200

1 200 200

2 200 100

3 200 67

4 200 50

5 200 40

6 200 33

7 200 29

8 200 25

9 200 22

10 200 20

Total Fixed Costs

0

50

100

150

200

250

0 2 4 6 8 10 12

Average Fixed Costs

0

50

100

150

200

250

0 2 4 6 8 10 12

Slide 677 Variable Costs

Output

Total

Variable

Costs

Average

Variable

Cost

(Q) (TVC) (AVC)

0 0

1 100 100

2 170 85

3 220 73

4 255 64

5 275 55

6 295 49

7 320 46

8 360 45

9 425 47

10 525 53

Total Variable Costs

0

100

200

300

400

500

600

0 2 4 6 8 10 12


0

20

40

60

80

100

120

0 2 4 6 8 10 12



Slide 678 Total Costs

Output

Total

Cost

Average

Total

Cost

(Q) (TC) (ATC)

0 200

1 300 300

2 370 185

3 420 140

4 455 114

5 475 95

6 495 83

7 520 74

8 560 70

9 625 69

10 725 73

Total Costs

0

100

200

300

400

500

600

700

800

0 2 4 6 8 10 12

Average Total Costs

0

50

100

150

200

250

300

350

0 2 4 6 8 10 12


0

100

200

300

400

500

600

700

800

0 2 4 6 8 10 12

TC

V C

FC

0

50

100

150

200

250

300

350

0 2 4 6 8 10 12

MC

ATC

AVC

AFC



•MC crosses the AC and AVC curves at their lowest points, where they are stable, neither going down nor rising


0

50

100

150

200

250

300

350

0 2 4 6 8 10 12

MC

ATC

AVC

AFC

•MC starts rising where MP starts decreasing

Output

La

bo

ur

AP

MP



Slide 681

Monopolistic competition

Slide 682 Monopolistic competition

Characteristics / Assumptions

• Large number of buyers & sellers

• No or low barriers to entry

• Short run profit maximizers

• Goods can be differentiated

• So firms are not price takers

• Downward sloping Demand Curve

The same

as Perfect

Competition


• Short run profit maximizers

• Produce where MR = MC

• Firms are not price takers

• Products can be differentiated

• Firms will have short run abnormal profits

Equilibrium of the firm: short run



Slide 684 £

Q O Qs

AR = D

MC

AC

MR

Short-run equilibrium of firmin monopolistic competition

Ps

ACs


Equilibrium of the firm: long run

•More firms will enter the market

•Demand Curve (AR) will shift inwards

–Marginal Revenue Curve will follow

•Reach long run equilibrium:

MR = MC

AR = AC

•In the long run no abnormal profits

Slide 686 Long-run equilibrium of firmin monopolistic competition

ARL = DL

MRL

£

Q O QL

PL

LRAC

LRMC



Slide 687

Monopolistic competition

Comparison with perfect competition (long run)

Slide 688

fig Q2

P2 DL under perfect

competition

Long run equilibrium perfect and monopolistic competition£

QO

P1

LRAC

DL under monopolistic

competition

Q1

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