ECONOMICSwhy study it?

Social ScienceEfficiencyScarcity

Economics and Policy

• Positive economics (what is going on?)

• Normative economics (what should be going on?)

efficiency

• Economic systems and fundamentals of economic efficiency– What? How? And For Whom? (productive and

allocative efficiency)– Capitalism, Socialism, and Communism

Frameworks of analysis within economics

• MACRO- – Unit of analysis: economy as a whole– Variables of interest include inflation,

unemployment, output…

• MICRO-– Unit of analysis: individual economic agents:

consumers, firms…– Variables of interest include costs of

production, individual demands, prices…

Economic cost

• Opportunity cost (just how costly is this class to you or to me?)

• Does the benefit of taking this class outweigh the cost?

• Marginal analysis

Specialization and gains from trade• Specialization and division of labor• Resource composition

– Capital– Labor– Human capital– Land (inclusive of natural resources)

• Production process (state of technology)• Absolute and comparative advantage principles

– Relative cost

• Why no complete specialization?[US trade example: BEA (www.bea.gov)]– Consumer preferences– Increasing opportunity cost (marginal cost)

Should government influence our comparative advantage? Can it do so?

• Can frequent changes in terms of trade reduce incentives to accumulate human capital (Can some of this be seen in the US economy today?)

• Asian economies of the 70’s, 80’s and early 90’s

• Recent aid from German government to AMD

Markets

• Defining a market– Product definition (and competition)– Geographical boundaries (internet, shipping

cost reduction – globalization and outsourcing)

• Market forces: Buyers (demand) versus Sellers (supply)– Price and quantity as the outcome

demand

• Quantity = f (price, other factors)• Price and the Law of Demand • Other factors

– Income (normal versus inferior)– Related in consumption goods

• Substitutes• Complements

– Expectations about the future– OTHER FACTORS ………

supply

• Quantity = f ( price, other factors)• Price and the Law of Supply• Other factors

– Costs of Production (MC, and price as MB)– Goods related in production

• Substitutes: (agricultural products)– Note, identical to costs of production since is based on

opportunity cost concept

• Complements: (like gold and silver)

– Producer expectations of future prices

• Other factors…

Market equilibrium

• Qs = Qd

• Shortage and surplus as unstable states and the stability property of the equilibrium

• Market efficiency

• Shifts in demand and supply

• Roles of Prices

• Is the equilibrium really efficient?– Productive and allocative efficiency

Market example: ForEx

• How can the US run a trade deficit consistently? Or, differently put, can one live on credit forever?

Demand for the dollardifferent economic agents that purchase the dollar:

•Foreigners who wish to purchase US goods or services, foreign tourists who wish to travel to the US (US exports)

•Foreigners who wish to invest in the US (higher US interest rate, attractive US stock market returns)

Supply of the dollardifferent economic agents that sell the dollar:

•US consumers/firms that want to purchase foreign goods or services, US tourists who wish to travel abroad (US imports)•US residents who wish to invest abroad (higher interest rates abroad, etc.)

The dollar will appreciate if demand exceeds supply at the current exchange rate. Note that when you purchase a foreign made product, the cost of the production of that product is paid in foreign currency, hence somewhere between the production process and your purchase someone would have to convert your currency into that foreign currency in order to pay for the production.

Demand and supply: the USD

• US trade deficit -> sale of USD ->dollar depreciation

• US borrowing from abroad -> purchases of USD -> appreciation of the USD

• 1990’s and the post 9/11framework

• US balance of payments: BEA

Who is more flexible? Elasticity of demand

• Elasticity of demand = %(Quantity demanded)/%(Price)• Elasticity as a measure of responsiveness of demand• Inelastic and elastic ranges; marginal revenue• Elasticity and revenue maximization• Comparing demands in terms of their relative elasticities• What makes demand relatively less elastic?

– Gasoline here– Health care– Health care insurance and elasticity of demand (moral hazard)

• Sales Tax and elasticity of demand?– Who really pays sales tax and why?– Excise tax

Elasticity long and short run

• Are our demands more flexible from the long-run perspective?– Defining short and long run in economics– Demand for gasoline– Demand for cars (capital goods in general,

like PCs at GSU)

Other types of elasticity of demand

• Income elasticity of demand

• Cross price elasticities

When Markets Fail

• Externalities (bad and good)– Internalizing external costs through taxation

• Public goods– Non-excludability – Non-rivalry

• Lack of certain institutions or mechanisms– Asymmetry of information

• Used car market• eBay and emergence of a correcting mechanism (a local

public good)

Role of government in a market based economy

• INSTITUTIONS…………– Just think of how many different institutions

set up and maintained by various government levels make this very class possible…

– Institutions at the micro and macro levels• Property rights and well functional legal system• Contract enforcement• Business culture

– Negative institutions can also emerge (corruption is a good example)

Consumer Behavior

• Utility function– Assumption of rationality – Total utility versus marginal utility– Diminishing marginal utility

• DMU and consumption choice– MU per dollar spent

• DMU and progressive income taxation• What if the Law of DMU is violated?

Productionfirms

• Assumption of profit maximization

• Do firms really maximize profits?– Principal-agent problem and the size of the

firm• Conflict of interests and correcting mechanisms

– Stocks and options as reward to workers/executives– External debt

Production

• Production function or Total ProductOutput = f (inputs, technology) = TP

• Marginal Product – change in output resulting from a change in an input– MPL, MPK

• Diminishing Marginal Product– Choice of the combination of inputs

• MP of input per dollar (long-run production)

• Long-run versus Short-run (assumption about capital, why not labor?)

Production and costs in the short-run

• Cost of labor – Wage (w)• Cost of capital - ?

– Defining user cost of capital (r)• Total cost of production

TC (Q) = w L + r K

Other inputs can be included (oil, land… furthermore we assume homogeneous labor and capital)

• Fixed cost versus variable cost • Sunk cost (stock price at the time of purchase)

Costs of production in short-run

• Average costsATC = AVC + AFC

• Marginal costChange in total cost of change in outputMarginal cost as a function of Marginal product of labor

(in our simple case)– diminishing marginal product and rising

marginal cost

• AVC = wage / APL• Relationship between MC and ATC, AVC

Profit maximization

In equilibrium, a profit maximizing firm will select to produce the level of output at which the wage rate is equal to the value of the marginal product of labor, in other words the marginal cost of a unit of labor (wage) is equal to the marginal benefit of that unit of labor expressed as the change in total revenues.

Production and costs in the long-run

• Full flexibility• LRAC (to LRAC from S-R AC)

– Deriving LRAC from SR AC– Economies of scale

• Increased specialization• Use of indivisible inputs (trade mark…)

– Constant returns to scale– Diseconomies of scale

• Principal-agent problem and size of business• Possible increase in input costs due to increased demand

• Long term cost improvements– Technological progress– Learning by doing

market structure

monopoly Perfectcompetition

oligopoly mc

Perfect competition and the internetAssumptions:

- number of firms- Ease of entry and exit- Perfect information- Identical transaction costs- Homogeneous good

Consequences of these assumptions:- Competition along one dimension – the price- Lack of collusion- Horizontal demand and MR – price taking behavior - MC as the supply curve

Shut down and break even price levels – cost diagram in the short-run- K-Mart example

Long-run and cost structure of the industry

Market Supply Curve

• Individual firm’s supply curve – MC– Recall that P=MR, and profit maximization requires

MR=MC

• Market supply curve is the horizontal summation of individual curves

Adjustment to a change in demand

Industry Demand Increases

SHORT-RUN– Each firm expands output– The number of firms remains the same

• Recall that changing the number of firms requires changes in capital stock

LONG-RUN– Positive economic profits attract entry: number of

firms increases

• Entry of new firms and the impact on costs of production

– Does building more fast food restaurants around the campus change the cost of low-skilled labor?

– Does an increased demand for computer programmers change the cost of training a software engineer?

Note that MC, ATC, AVC are all functions of input costs (if labor is the only variable input then: MC = wage/MPL, and AVC = wage/APL)

Increasing Cost Industry– Industry expansion rises the demand for inputs, and as a result

the cost of those inputs increases, and thus the price (equilibrium) at which the firms earn zero economic profits also increases

• Diseconomies of scale in the production of inputs• Inelastic supply of inputs• Lack of substitutability of inputs

Decreasing Cost Industry– Industry expansion rises the demand for inputs, and as a result

the cost of those inputs declines, and thus the price at which the firms earn zero economic profits decreases

• Economies of scale in the production of inputs (adjustments in the educational system in the 1990 as a result of increased demand for software engineers)

Constant Cost Industry– Industry expansion does not affect input costs

MONOPOLY

• Monopoly diagram and profit maximization

• Social costs of monopoly

• Price discrimination

• Natural monopoly

Monopolistic Competition

• Product differentiation

• Large number of firms differentiated products

• Entry/Exit

• Diagram and equilibrium outcome

OLIGOPOLY

• Barriers to entry and formation of oligopolies

• Strategic interdependence

• Understanding an Oligopoly– Kinked Demand Model– Cournot Duopoly Model– Game Theoretical Approach

Game Theory

• Modeling decisions as strategies in an interactive game

• Simultaneous move games and matrix form– Nash Equilibrium and Best Response

Strategies– Dominant Strategies

• Sequential move games and tree form approach– Entry deterrence game

Monopoly, Oligopoly and Anti-trust

• Sherman Act

• Clayton Act

• http://www.usdoj.gov/atr/foia/divisionmanual/ch2.htm

• Price discrimination

Public Sector

Government role in the economy:

• Institutional support

• Provision of public goods and services

• Correction of externalities

• Economic policies (stabilization and development)

General government f inal consumption expenditure (% of GDP)

14.23

26.91

16.67

21.27 21.52

23.40

0.00

5.00

10.00

15.00

20.00

25.00

30.00

United States Sw eden RussianFederation

Norw ay Finland France

General government f inal consumptionexpenditure (% of GDP)

Data for 2001, source: World Bank

How do we pay for the government?

• Taxes and user fees– Income tax– Sales tax

• Excise tax

– Property tax– Value added tax

• Fiscal Federalism: US example

Taxes and Incentives

• Income tax– Marriage neutrality– Labor force participation– Impact on revenues of government– Impact on population growth– Savings and investment (capital gains

taxation and IRAs)