(EFM) Ecomonics for Manager-SEM-I-GTU

7/31/2019 (EFM) Ecomonics for Manager-SEM-I-GTU

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Keyur D Vasava

MBA+Pharmacy

Dist :- Narmada.

Destiny is not a matter of chance, it is a matter of choice. It is

not a thing to be waited for, it is a thing to be achieved.


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(EFM)-SEM-I (GTU)

Economics f or Managers

Module I !!!

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

1) Ten principles of economicsEconomy. . .

. . . The word economy comes f rom a Greek word f or one who manages a

household.

A household and an economy f ace many decisions:

Who will work?

What goods and how many of them should be produced?

What resources should be used in production?

At what pr ice should t he goods be sold?

Society and Scarce Resources:

The management of societys resources is important because resources ar e scarce.

Scarcit y . . . means that society has limited resources and theref ore cannot

produce all t he goods and services people wish to have.

Economics is the study of how societ y manages it s scarce resources.

How people make decisions.

People f ace t radeoff s.

The cost of something is what you give up t o get it .

Rational people think at t he margin.

People respond to incent ives.

How people interact with each other.


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Trade can make everyone bett er of f .

Mar kets are usually a good way to organize economic act ivity.

Governments can somet imes improve economic outcomes.

The forces and trends that af f ect how the economy as a whole works.

The standard of living depends on a count rys product ion.

Prices rise when t he government prints too much money.

Society f aces a short - run t radeof f between inf lat ion and unemployment .

Principle # 1: People Face Tradeof f s

To get one thing, we usually have to give up anot her thing.

Guns v. but t er

Food v. clothing

Leisure t ime v. work

Ef f iciency v. equity

Making decisions r equires t r ading of f one goal against anot her.

Eff iciency v. Equity

Ef f iciencymeans society gets t he most t hat it can f rom its scarce resources. Equitymeans the benef its of t hose resources are dist ribut ed f airly among themembers of societ y.

Principle # 2: The Cost of Something I s What You Give Up t o Get I t .

Decisions require comparing costs and benef its of alternat ives.

Whether to go t o college or to work?

Whether to study or go out on a date? Whether to go t o class or sleep in?

Theopport unity cost of an item is what you give up t o obtain that item.


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LA Laker basketball star Kobe Bryant chose t o skip college and go straight f rom high

school to the pros where he has earned millions of dollars.

Pr inciple # 3: Rat ional People Think at the Margin.

Marginal changesare small, incremental adjustments to an exist ing plan of act ion. People make decisions by compar ing cost s and benef it s at t he margin.

Pr inciple # 4: People Respond t o I ncent ives.

Marginal changes in costs or benef its mot ivate people to respond.

The decision to choose one alt ernative over another occurs when that alt ernat ives

marginal benef its exceed its marginal costs!

Pr inciple # 5: Tr ade Can Make Everyone Bet ter Of f .

People gain f rom t heir ability to trade with one another.

Competit ion results in gains f rom trading.

Trade allows people to specialize in what they do best.

Pr inciple # 6: Markets Are Usually a Good Way to Organize Economic Act ivity.

Amarket economyis an economy that allocat es resources through the decentralizeddecisions of many f irms and households as they interact in markets for goods and

services.

Households decide what to buy and who t o work f or.

Firms decide who t o hire and what to produce.

Adam Smit h made the observat ion t hat households and f irms interacting in markets

act as if guided by an invisible hand.


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Because households and f irms look at prices when deciding what to buy and sell,

they unknowingly take into account t he social costs of t heir act ions.

As a result, prices guide decision makers to r each out comes t hat t end to maximizethe welf are of societ y as a whole.

Principle # 7: Government s Can Somet imes I mprove Market Outcomes.

Market f ailureoccurs when the market f ails to allocat e resources ef f icient ly. When the market f ails (breaks down) government can intervene to promot e

ef f iciency and equity.

Mar ket f ailure may be caused by

Anexternality, which is the impact of one person or f irms act ions on the well- being

of a bystander.

Market power, which is the ability of a single person or f irm to unduly inf luence

market prices.

Principle # 8: The St andard of Living depends on a Countrys Production.

St andard of living may be measured in dif f erent ways:

By comparing personal incomes.

By comparing t he t ot al market value of a nat ions production.

Almost all variat ions in living standards are explained by dif f erences in countries

product ivities.

Productivityis the amount of goods and services produced f rom each hour of aworker s t ime.

St andard of living may be measured in dif f erent ways:

By comparing personal incomes. By comparing t he t ot al market value of a nat ions production.

Principle # 9: Pr ices Rise When t he Government Prints Too Much Money.

I nf lat ion is an increase in the overall level of pr ices in t he economy.

One cause of inf lat ion is the growt h in the quantity of money.

When the government creat es large quant it ies of money, the value of t he money

f alls.


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Principle # 10: Society Faces a Short run Tradeof f between I nf lation and

Unemployment .

The Phillips Curve illustrates t he tradeof f bet ween inf lat ion and unemployment :

Decreases I nf lat ion I ncreases Unemployment

I t s a short - run tradeof f !

Summary

When individuals make decisions, they face tradeof f s among alternative goals.

The cost of any action is measured in terms of f oregone opport unities. Rat ional people make decisions by comparing marginal costs and marginal benef it s.

People change their behavior in response t o the incentives t hey f ace.

Trade can be mutually benef icial.

Markets are usually a good way of coordinat ing trade among people.

Government can potentially improve market out comes if t here is some market f ailure

or if the market out come is inequitable.

Productivity is the ult imat e source of living standards.

Money growth is the ult imat e source of inf lat ion.

Society f aces a short - run tradeof f between inf lation and unemployment .

2) The market f orces of supply and demand Supply and Demand are the two words that economists use most of t en.

Supply and Demand are the f orces that make market economies work!

Modern microeconomics is about supply, demand, and market equilibr ium.

Mar kets and Compet it ion

The terms supply and demand ref er to the behavior of people. . .. . . As they interact with one anot her in markets.

Market: any institut ion, mechanism, or arrangement which f acilitates exchange.

A market is a group of buyers and sellers of a part icular good or service.

Buyers determine demand. . .

Sellers determine supply. . .


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Det erminant s of Demand

- Market price

- Consumer income

- Prices of related goods

- Tast es

- Expectat ions

- Products Own Price

- Consumer I ncome

- Prices of Related Goods

- Tast es

- Expectat ions

- Number of Consumers

- Demographic changes.

Mar ket Supply

- Market supply ref ers t o the sum of all individual supplies f or all sellers of a

part icular good or service.- Graphically, individual supply curves are summed horizontally t o obt ain the

market supply curve.

Det erminant s of Supply

- Market price

- I nput prices

- Technology

- Expectat ions- Number of producers

- Products Own Price

- Weather, natural disast ers & polit ical disrupt ions.

- Taxes.

- Number of sellers.


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Three Steps To Analyzing Changes in Equilibr ium

- Decide whether t he event shif ts t he supply or demand curve (or bot h).

- Decide whether t he curve(s) shif t (s) to t he lef t or to t he right.


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- Examine how t he shif t af f ects equilibrium price and quant it y.

3)Elast icit y and it s applicat ions

I . The Elast icity of Demand

A. Def init ion of elasticity: a measure of t he responsiveness of quant itydemanded or quant ity supplied t o one of it s determinant s.

B. The Price Elast icity of Demand and I ts Determinant s


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1. Def init ion of pr ice elast icity of demand: a measure of how mucht he quantit y demanded of a good responds to a change in the

price of that good, computed as the percentage change in

quant ity demanded divided by the percentage change in price.

2. Det erminant s of Pr ice Elast icity of Demand

- Availability of Close Subst itut es: t he more subst itut es a good has, the more elastic

it s demand.

- Necessit ies versus Luxuries: necessities are more price inelast ic.

- Def init ion of the market: narrowly def ined markets (ice cream) have more elast icdemand than broadly def ined markets (food).

- Time Hor izon: goods tend to have more elastic demand over longer t ime hor izons.

A. Comput ing the Price Elast icit y of Demand

1. Formula

Price elasticity of demand =% change in quantity demanded

% change in price

2. Example: the price of ice cream r ises by 10% and quant itydemanded falls by 20%.

Pr ice elast icity of demand = (20%)/ (10%) = 2

3. Because there is an inverse relat ionship bet ween price andquant ity demanded (t he price of ice cream rose by 10% and the

quant ity demanded fell by 20%), the price elast icity of demand is

somet imes report ed as a negative number. We will ignore the

minus sign and concent rat e on the absolut e value of the elasticity.


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B. The Midpoint Method: A Bet ter Way to Calculate Percent age Changesand Elast icity

1. Because we use percentage changes in calculat ing the priceelasticity of demand, the elast icity calculated by going f rom point

A t o point B on a demand curve will be dif f erent than an elasticity

calculated by going f rom point B to point A.

a. A way around this is called t he midpoint met hod.

b. Using the midpoint met hod involves calculat ing thepercent age change in eit her pr ice or quant ity demanded bydividing the change in the variable by t he midpoint between

the init ial and f inal levels rather t han by the init ial level

itself .

c. Example: t he price r ises f rom $4 t o $6 and quant itydemanded f alls f rom 120 t o 80.

% change in price = (6 - 4)/ 5 100% = 40%

% change in quant ity demanded = (120- 80)/ 100 =

40%

Price elast icity of demand = 40/ 40 = 1

C. The Variet y of Demand Curves

1. Classif icat ion of Elast icity

d. When t he elast icity is greater than one, the demand isconsidered to be elast ic.

Price elasticity of demand =(Q - Q ) /[(Q + Q ) / 2]

(P - P ) / [(P +P ) / 2]

2 1 1 2

2 1 1 2


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e. When t he elast icity is less than one, the demand isconsidered t o be inelast ic.

f . When t he elast icity is equal t o one, the demand is said tohave unit elast icity.

2. Slope of demand curve: in general, the f latter the demands curve

t hat passes through a given point, the more elastic the demand.


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I I . The Elast icity of Supply

A. The Price Elast icity of Supply and I t s Determinant s

1. Def init ion of pr ice elast icity of supply: a measure of how mucht he quantit y supplied of a good responds to a change in the pr ice

of t hat good, computed as the percent age change in quantity

supplied divided by t he percentage change in price.

2. Det erminant s of t he Price Elast icity of Supply

a. Flexibility of sellers: goods t hat are somewhat f ixed insupply (beachfront property) have inelast ic supplies.

b. Time hor izon: supply is usually more inelast ic in the shortrun than in the long run.

B. Comput ing the Price Elast icit y of Supply

1. Formula

2. Example: the price of milk increases f rom $2. 85 per gallon to$3. 15 per gallon and the quant ity supplied rises f rom 9, 000 t o

11 , 000 gallons per month.

% change in price = (3. 15 2. 85)/ 3. 00 100% = 10%

% change in quant ity supplied = (11, 000 - 9, 000)/ 10, 000 100% = 20%

Price elast icity of supply = (20%)/ (10%) = 2

Price elasticity of supply =% change in quantity supplied

% change in price


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C. The Variet y of Supply Curves

1. Slope of Supply Curve: in general, the f lat t er t he supply curvet hat passes through a given point, the more elastic the supply.

2. Extreme Cases

a. When t he elast icity is equal t o zero, t he supply is

perf ect ly inelastic and is a vert ical line.


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b. When t he elast icity is inf inite, t he supply is perf ectly

elast ic and is a horizontal line.


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D. Application of Elast icity- Examine whet her the supply or demand curve shift s.

- Determine the direct ion of the shif t of the curve.

- Use supply and demand diagram to see how the market equilibr ium changes.

The concept of elast icity has an ext raordinarily wide range of applicat ions in

economics. I n part icular, an understanding of elasticity is f undamental in

underst anding t he response of supply and demand in a market .

Some common uses of elast icit y include:

Ef f ect of changing price on firm revenue.

Analysis of incidence of t he tax burden and other government policies.

I ncome elasticity of demand can be used as an indicator of industry healt h,

f uture consumption patt erns and as a guide to f irms investment decisions. Ef f ect of international tr ade and terms of trade ef f ects.

Analysis of consumption and saving behavior. .

Analysis of advert ising on consumer demand for part icular goods.


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4) The cost s and economics of product ion:

The Cost s of Production

TOTAL REVENUE, TOTAL COST , AND PROFI T

Total Revenue

The money a f irm receives f rom t he sale of its output.

TR = P Q

We saw this is chapter 5

Total Cost

The market value of all t he inputs (resources) a f irm uses in product ion.

Explicit and I mplicit Costs

A f irms cost of production includes explicit costs and implicit costs.

Explicit cost s are costs that require a direct out lay of money by t he

f irms owner(s).

I mplicit costs are costs t hat do not require an out lay of money by the

firm I f some of the resources used in production are provided by the

owner(s) of the f irm, the f irm may not have to pay for them.

The market value of such resources is the implicit cost.

I mplicit costs are included in t ot al cost.

Economic Prof it versus Accounting Prof it

Economists measure a f irms economic prof it as total revenue minus total cost,

which includes both explicit and implicit costs.

Account ants measure t he accounting prof it as the f irms total revenue minus

only t he f irms explicit costs.

As a result , accounting prof it exceeds economic prof it


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Economic Prof it and Firm Sust ainabilit y

Non- negat ive economic prof it is essent ial for t he long- run viability of a f irm

Hungry Helens Cookies earns

total revenue of $700 per hour and has

total explicit costs of $ 650 per hour (f or labor and raw materials) and

Total implicit costs of $110 per hour (in wages Helen could have earned

as a comput er programmer)

Account ing prof it = $ 50 per hour. This indicat es short - run f inancial

viability

Economic prof it = $60 per hour. This indicat es a dire long- run fut ure.

Dissatisf ied with the $50 per hour prof it, Helen will event ually shut

down the f irm and take a programming job


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Measur ing the costs of product ion

Cost s are def ined as those expenses f aced by a business in the process of supplying

goods and services to consumers. I n the short run (where there are f ixed andvariable f actors of production) we make a dist inct ion bet ween f ixed and variable

costs. Examples of each are given below.

VARI ABLE COSTS

These are costs that vary direct ly wit h output since more variable units are required

to increase output . Examples are the costs of essential raw materials and

component s, the wages of part - t ime staf f or employees paid by the hour, the costs

of electr icit y and gas and depreciat ion of capital input s due t o wear and tear. Totalvariable cost rises as output increases.

Average variable cost (AVC) = Total Variable Costs (TVC) / Output (Q) AVC depends

on the cost of employing variable f actors compared to the average product ivity of

these f actors (usually labor product ivity). I f additional units of labor can be hired at

a const ant cost there will be an inverse relat ionship bet ween average product and

average variable cost . Theref ore, when average product is maximized, AVC will be

minimized.


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Average Costs

The average cost is also called t he per- unit cost. Average costs can be det ermined by dividing the f irms t ot al costs by the

quantity of output it produces.

Average Costs

AFCFC

Q

Fixed cost

Quantity

AVC

VC

Q

Variable cost

Quantity

ATCTC

Q

Total cost

Quantity


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Marginal Cost

Marginal cost (MC) is the increase in t ot al cost (TC) t hat arises f rom an extra

unit of product ion.

The increase in cost that arises f rom an ext ra unit of production is ent irely

due t o the use of addit ional raw materials and labor

Theref ore, marginal cost can also be def ined as t he increase in total variable

cost (VC) t hat arises f rom an ext ra unit of production.


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Economies and Diseconomies of Scale

Economies of scale ref er to t he propert y whereby long- run average t otal

cost f alls as t he quant it y of output increases.

Diseconomies of scale ref er t o t he property whereby long- run average

t ot al cost r ises as the quant ity of output increases.

Const ant ret urns to scale ref ers to t he propert y whereby long- run

average tot al cost stays the same as t he quant ity of out put increases

Summary

The goal of f irms is to maximize prof it , which equals tot al revenue minus

t ot al cost .

When analyzing a f irms behavior, it is impor tant t o include all t he

opport unit y costs of product ion.

Some oppor tunity costs are explicit while other opport unit y costs are

implicit .

A f irms cost s ref lect its product ion process.

A t ypical f irms product ion funct ion gets f lat t er as the quant ity ofinput increases, displaying t he propert y of diminishing marginal

product.

A f irms total costs are divided between f ixed and variable costs.

Fixed costs do not change when t he f irm alters the quant ity of

out put produced; variable cost s do change as the f irm alters

quant it y of output produced.

Average tot al cost is t ot al cost divided by t he quant it y of output .

Marginal cost is the amount by which total cost would rise if out put

were increased by one unit . The marginal cost always r ises with t he quant it y of out put .

Average cost f irst f alls as output increases and then rises.

The average- t otal- cost curve is U- shaped.

The marginal- cost curve always crosses the average- total- cost curve at

t he minimum of ATC.

A f irms costs of t en depend on the t ime horizon being considered.

I n part icular , many costs are f ixed in the short run but variable in t he

long run.


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Module I I !!!

1) Fir ms in compet it ive mar ket s:

Compet it ive Market

Lots of buyers and sellers dealing in ident ical goods.

Sellers can f reely ent er or leave.

What I s A Competit ive Market?

A perf ectly compet it ive market has the f ollowing characterist ics:

1) There are many buyers and sellers in t he market .2) The goods of f ered by the various sellers are the same (identical).3) Firms can freely enter or exit the market .4) I nf ormat ion is perf ect. Buyers and sellers know all pr ices of f ered,. . .

As a result of these charact erist ics, t he perf ectly compet it ive market has t he

f ollowing out comes:

The actions of any single buyer or seller in the market have no impact

on the market pr ice.


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Each buyer and seller takes the market price as given.

Ex: Gasoline, f ish, eggs, pencils, tomatoes, et c.

Buyers and sellers must accept the price determined by the market. No

single seller has market power (t he power to inf luence t he market

price).

The Revenue of a Compet it ive Firm

Total revenue f or a f irm is t he market price times t he quant ity sold.

TR = P Q


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The Revenue of a Compet it ive Firm

Marginal revenue is the change in total revenue when an addit ional unit is sold.MR = TR / Q

1. Only in a compet it ive market, marginal revenue equals the price of the good.This is because a f irm in a compet it ive market can sell as much as it wants at

the constant market price.

2. I f a monopolist or oligopolist ic sells more, t his causes the pr ice of the good tof all. Ex1: Think of crude oil price and OPEC. Ex2: Consider a downward sloping

demand curve.

Prof it Maximizat ion and t he Competit ive Firms Supply Curve

The goal of a compet it ive f irm is to maximize prof it .

This means that the f irm wants t o produce the quantity that maximizes the

dif f erence between total revenue and total cost.

Prof it maximizat ion occurs at the quant ity where marginal revenue equals

marginal cost.

When MR > MC, prof it is increasing, so must produce more.

When MR < MC, prof it is decreasing, so must produce less.

When MR = MC, profit is constant, so t his is t he point where prof it is

maximized.


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2)Monopoly

Monopoly means one seller.

I n perf ect compet it ion many sellers were pr ice takers. Any one seller could not

inf luence the pr ice of the product in the market . The competit ive f irm could only

choose what amount to sell.

A monopoly f irm will have to det ermine both how much to sell and at what pr ice. Let s

look at t hese ideas a lit t le more on t he f ollowing f ew slides.

Monopoly

For a monopoly f irm t he demand is the same as the market demand we see in

compet it ion. The demand downward sloping to t he right , what is called less than

perf ect ly elast ic.

Since t he monopolist is t he only seller, it is natural t hey face the market demand

curve.

The situat ion of monopoly is of ten called imperf ect competit ion.

Sources of monopoly

1) Exclusive control of an input DeBeers is an example

2) Economies of scale the case of a nat ural monopoly. The idea here is that AC can

be pushed really low by one f irm and it then makes sense f or only one f irm to serve

the market.

3) Pat ents protect ing inventions f or a t ime may give monopoly power.

4) Net work economies Microsof t Windows is an example of the idea once enoughpeople use a product somet imes using another t ype of product becomes less

f unct ional.

5) Granted by government

Maximize prof it

Since the monopolist is the only seller in the market , the monopolist must

decide


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1) What price t o charge and

2) How much to sell.

When t he monopolist sells, she is worried about prof it . The goal is to maximize

prof it . But , in order t o maximize prof it , t he pat tern of revenues and costs at

various out put levels must be understood. The Pat tern of cost was the topic of

an earlier section.

Problems of monopoly

The problems of monopoly are higher price and less output t han in compet it ion.

Moreover,

1) The higher price means those who st ill buy have less money t o spend onother t hings c and d are surplus areas that consumer used to have f or ot her

t hings but now pays to monopoly.

2) Those who no longer buy must be worse of f Because they get less than what

t hey were at their libert y to purchase under compet it ion area e represent s

t he value of lost out put t o the consumers and is part of t he deadweight loss of

monopoly.

Monopoly: a f irm t hat is t he sole seller of a product without close substit ut es.

Compet it ive f irm: pr ice taker

Monopolist: pr ice maker

Why Monopolies Arise?

1. Key r esource owned by single f irm.2. Government grant ed restr iction.3. I ncreasing ret urns to scale (natural monopoly).


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Monopoly versus competit ive market s

While monopoly and perf ect compet it ion mark the extremes of market structures.

there is some similar it y. The cost f unct ions are t he same. Both monopolies and

perf ect ly compet it ive companies minimize cost and maximize prof it . The shut down

decisions are t he same. Bot h are assumed to have perf ectly competit ive f actors

markets. There are dist inctions, some of the more important of which are as f ollows:

Marginal revenue and price - I n a perf ect ly compet it ive market price equals

marginal revenue. I n a monopolist ic market marginal revenue is less than price.

Product dif f erent iation: There is zero product dif f erent iat ion in a perf ectlycompet it ive market. Every product is perf ectly homogeneous and a perf ect

subst itut e f or any other. With a monopoly, there is great to absolut e product

dif f erent iat ion in t he sense that there is no available subst itut e for a

monopolized good. The monopolist is the sole supplier of the good in quest ion. A

customer eit her buys from the monopolizing ent ity on its terms or does

without .

Number of competitors: PC market s are populat ed by an inf inite number of

buyers and sellers. Monopoly involves a single seller.

Barriers to Entry - Barriers to entry are f actors and circumstances that

prevent entr y into market by would- be compet itors and limit new companies

f rom operat ing and expanding within the market . PC markets have f ree ent ry

and exit. There are no barr iers t o ent ry, exit or compet it ion. Monopolies have

relat ively high barr iers to entr y. The barr iers must be strong enough to

prevent or discourage any potent ial competitor f rom entering t he market.

Elast icity of Demand - The price elasticity of demand is the percentage change

of demand caused by a one percent change of relat ive price. A successf ul

monopoly would have a relat ively inelastic demand curve. A low coef f icient of

elasticity is indicat ive of ef f ective barr iers t o ent ry. A PC company has a

perf ect ly elast ic demand curve. The coef f icient of elast icity f or a perf ect ly

compet it ive demand curve is inf inite.

Excess Prof its- Excess or posit ive prof its are prof it more than the normal

expected return on investment. A PC company can make excess prof it s in the

short t erm but excess prof its att ract compet itors which can enter t he market

f reely and decrease prices, event ually reducing excess prof its to zero. A


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monopoly can preserve excess prof it s because barriers to entry prevent

compet itors f rom entering the market .

Prof it Maximizat ion - A PC company maximizes prof its by producing such that

price equals marginal costs. A monopoly maximizes prof it s by producing where

marginal revenue equals marginal costs. The rules are not equivalent . The

demand curve f or a PC company is perf ectly elast ic - f lat . The demand curve

is ident ical to t he average revenue curve and the pr ice line. Since the average

revenue curve is constant t he marginal revenue curve is also constant and

equals the demand curve, Average revenue is the same as pr ice (AR = TR/ Q =

P x Q/ Q = P). Thus the pr ice line is also ident ical t o the demand curve. I n

sum, D = AR = MR = P.

P- Max quant ity, pr ice and prof it - I f a monopolist obtains cont rol of a

f ormerly perf ect ly competit ive industry, t he monopolist would increase prices,

reduce production, and realize posit ive economic prof its.

Supply Curve - in a perf ectly compet it ive market there is a well def ined supply

f unct ion with a one t o one relat ionship bet ween price and quantity supplied. I n a

monopolist ic market no such supply relat ionship exists. A monopolist cannot

t race a short t erm supply curve because f or a given price there is not a unique

quant ity supplied. As Pindyck and Rubenf eld note a change in demand "can lead

t o changes in prices with no change in out put , changes in output with no change

in price or both. " Monopolies produce where marginal r evenue equals marginal

costs. For a specif ic demand curve the supply "curve" would be t he

price/ quantity combination at the point where marginal revenue equals marginal

cost. I f the demand curve shif t ed the marginal revenue curve would shif t as

well and a new equilibr ium and supply "point" would be established. The locus of

t hese points would not be a supply curve in any convent ional sense.


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3)Oligopoly

An oligopolyis a market f orm in which a market or indust ry is dominated by a small

number of sellers (oligopolists)

Because t here are f ew sellers, each oligopolist is likely to be aware of the actions ofthe others. The decisions of one f irm inf luence, and are inf luenced by, the decisions

of other f irms. St rat egic planning by oligopolists needs to take into account the likely

responses of the other market part icipant s.

Characteristics

Prof it maximizat ion condit ions:An oligopoly maximizes prof it s by producing where

marginal revenue equals marginal costs.

Ability to set price: Oligopolies are price set t ers rather t han price takers.

Entry and exit: Barr iers t o entry are high.The most important barr iers are economies

of scale, patents, access to expensive and complex technology, and strat egic actions

by incumbent f irms designed t o discourage or dest roy nascent f irms. Addit ional

sources of barriers to entr y of t en result f rom government regulation f avoring exist ing

f irms making it dif f icult f or new f irms t o enter the market.


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Number of f irms: "Few" a "handf ul" of sellers. There are so f ew f irms t hat t he

actions of one f irm can inf luence the act ions of the other f irms.

Long run prof it s: Oligopolies can ret ain long run abnormal profit s. High barr iers of

entry prevent sideline f irms from ent ering market to capture excess profits.

Product dif f erent iation: Product may be homogeneous (steel) or dif f erentiat ed

(aut omobiles).

Perf ect knowledge: Assumpt ions about per f ect knowledge vary but the knowledge of

various economic actors can be generally described as select ive. Oligopolies have

perf ect knowledge of their own cost and demand f unctions but their int er- f irm

informat ion may be incomplete. Buyers have only imperf ect knowledge as to price, cost

and product qualit y.

I nter dependence:The dist inctive f eat ure of an oligopoly is interdependence.Oligopolies

are typically composed of a f ew large f irms. Each f irm is so large that its act ions

af f ect market conditions. Theref ore the compet ing f irms will be aware of a f irm' s

market act ions and will respond appropriat ely. This means that in contemplating a

market act ion, a f irm must t ake into considerat ion t he possible reactions of all

compet ing f irms and t he f irm' s countermoves

Strategy

Oligopolists have to make crit ical strat egic decisions, such as:

Whether t o compete with rivals, or collude wit h them.

Whether to raise or lower price, or keep price constant.

Whet her to be the f irst f irm to implement a new st rategy, or whether to wait

and see what rivals do. The advantages of going f irst or going second are

respect ively called 1st and 2nd- mover advantage. Somet imes it pays t o go f irst

because a f irm can generat e head- start prof it s. 2nd mover advant age occurs

when it pays to wait and see what new strategies are launched by rivals, andt hen try to improve on them or f ind ways to undermine them.

The advantages of oligopolies

However, oligopolies may provide the f ollowing benef it s:

1. Oligopolies may adopt a highly competit ive strat egy, in which case they cangenerat e similar benef its to more competit ive market str uctures, such as lower


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prices. Even though there are a f ew f irms, making the market uncompet it ive,

their behaviour may be highly compet it ive.

2.

Oligopolist s may be dynamically ef f icient in terms of innovat ion and newproduct and process development. The super- normal prof it s they generat e may

be used t o innovate, in which case the consumer may gain.

3. Pr ice stability may br ing advant ages to consumers and the macro- economybecause it helps consumers plan ahead and stabilises their expenditure, which

may help stabilise the trade cycle.

4)Monopolist ic compet it ion

On one ext reme is the Perf ect Compet it ion model

On the other ext reme is the Monopoly Model

Monopolistic Competit ion & Oligopoly are compet it ive scenarios t hat lie bet ween

these two ext remes

Theref ore, compet it ive feat ures of Monopolist ic Competit ion and Oligopoly will

emulat e eit her Perf ect Compet it ion or Monopoly

Power to set prices somewhat like a monopoly

Face competit ion like perf ect compet it ion


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Large number of f irms

- - Each f irm has relat ively small market share

- - Each f irm must be sensit ive to average market price of its product

- - Collusion is not possible due to the number of f irms

No barriers to entry or exit

Product Dif f erentiat ion

Each f irm makes a product t hat is slight ly dif f erent f rom the product s of

compet ing f irms.

- - Close subst itutes but no perf ect subst itutes

- - An attempt to increase price will normally results in a lower volume sold

Compet it ion on Quality, Price, Marketing

- - Quality is design, reliability, service provided t o buyer and ease of access

to product

- - Pr ice downward sloping demand curve

- - Market ing f irm must market = promot ion, distr ibut ion, packaging


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How much is the industry dominated or not dominated by f ew suppliers

- - Geographical scope nat ional, regional, globalAn industry can be almost perf ect ly compet it ive on a nat ional scope, but

almost a monopoly locally e. g. Concrete Mixing

- - Barriers to entry and exit industr ies may appear concent rat ed but f ew

barr iers exist t o prevent entry: e. g a communit y with only one restaurant - there is

no barrier to ot her restaurant s coming in

The f our- f irm concent rat ion rat io The percent age of the value of total

market revenue accounted f or by the f our largest f irms in the industry

- - A low concent rat ion rat io indicates a high degree of compet it ion

- - A high concentrat ion rat io indicates an absence of competit ion

The Herf indahl- Hirschman I ndex the square of the percentage market share

of each f irm summed over t he largest 50 f irms in the indust ry (or all of the

f irms if there is less than 50)

- - I n perf ect compet ition, t he HHI is small

- - I n monopoly, the HHI is 10, 000 (100 squared)

- - A popular measure with t he Just ice Dept in t he 1980s

HHI < 1000 characterized competit ive markets

HHI > 1800 would bring Justice Dept challenge

To proposed mergers

Examples of Monopolist ic Competit ion

Banks Sport ing Goods

Radio St at ions Fish and Seaf ood

Clothing Jewelry

Comput ers Healt h Spas

Frozen Foods Apparel Stores

Canned Goods Convenience St ores

Monopolistic Competit ion

Since t he Monopolist ic Compet itor prices at demand where MR=MC, the f irm

may have

1. excess production capacity, and is

2. Operat ing below its ef f icient scale where ATC is minimum

Markup The amount by which price exceeds MC


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Price Discrimination

Question Does pr ice discriminat ion raise or lower prof it ?

Pr ice discr iminat ion selling the same good or service at a number of dif f erent

prices.

Basically an illegal act ivity under the Clayton Act unless t here is a cost justif ication

f or the price discriminat ion

Answer Price discriminat ion is a market ing means t o increase economic prof it

Met hods of price discriminat ion

- - Discriminat e among groups of buyers

Works when dif f erent buying groups are willing to pay dif f erent pr ices (on the

average) f or t he same good or service

Example: Air line t ravel pr ices t arget business t ravelers vs leisure t ime

travelers

- - Discriminator is advance notice, shorter t he notice, the higher t he price

Met hods of discrimination

- - Discriminat e among units f irm charges the same price to all customers but t hereare volume discounts

The key idea is to f igure a way t o charge those increment al buyers who are

willing to pay more a higher pr ice

Result Consumer Surplus is conver ted t o Producer Surplus

Some Examples of Price Discriminat ion

Doctors of ten charge rich pat ient s more than poor pat ients

They may have one pr ice f or t hose wit h insurance and another

price f or t hose without insurance Movies in the evening cost more t han those in the ear ly af ternoon

Senior citizen, youth, and st udent discounts

New and used cars

Youth f airs on air lines

Evening meals in restaurant s of t en cost more than the same meal at

lunch


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Perf ect Pr ice discrimination occurs when a f irm f igures out how to ext ract the

entire consumer surplus

Once t he f irm has t he entire consumer surplus, the MR curve becomes theDemand Curve

At that point , the f irm ext racts even more economic prof it by increasing

production to the point where

MR (D) = MC

Eff iciency When the f irm increases out put to t he point where MC = D, the

ef f icient quant ity is produced, but

The producer has taken all t he consumer surplus, and

Since there is ample economic prof it , the f irm may be induced to spend money

(increase costs) to protect its economic profit (rent seeking and is usuallypolitical in nature)


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Module I I I !!!

1) Measur ing a nat ions income

The Economys I ncome and Expendit ure

- When judging whether t he economy is doing well or poor ly, it is nat ural to

look at the total income t hat everyone in the economy is earning.

- To have this number make sense, it is also best to look at income per person.

- For an economy as a whole, income must equal expendit ure because:

- Every transact ion has a buyer and a seller .

- Every dollar of spending by some buyer is a dollar of income f or some

seller.

- Says Law- Supply creates it s own demand

- This process can be seen using a Circular Flow Diagram.

Gross Domest ic Product

- Gross domestic product (GDP) is a measure of the income and expendit ures of

an economy.

- I t is the tot al market value of all f inal goods and services produced within a

country in a given period of t ime.

-How much is the current GDP?


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The Measurement of GDP

GDP is:

- t he market value

- of all f inal goods and services

- produced wit hin a country

- in a given period of t ime.

What I s Counted and Not Count ed in GDP?

- GDP includes all items produced in the economy and sold legally in market s.

- GDP excludes services that are produced and consumed at home and thatnever enter the marketplace.

- Caring labor, the work t hat is normally produced by women.

- Because GDP does not count it , it diminishes its importance.

- GDP also excludes black market it ems, such as illegal drugs.

Ot her Measures of I ncome

- Gross Nat ional Product (GNP)

- Net Nat ional Product (NNP)

- National I ncome- Personal I ncome

- Disposable Personal I ncome

The Components of GDP

GDP (Y) is the sum of t he f ollowing:

- Consumption (C)

- I nvestment (I )

- Government Purchases (G)

- Net Export s (NX)

Y = C + I + G + NX


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Measuring Economic Growth

- We use real GDP to calculate t he economic growt h rat e.- The economic growth rate is the percentage change in the quant ity of

goods and services produced f rom one year to the next .

- We measure economic growth so we can make:

- Economic welfare comparisons

- I nt ernat ional welf are comparisons

- Business cycle f orecast s

Business Cycle Forecasts

- Real GDP is used to measure business cycle f luctuat ions.- These f luctuations are probably accurately t imed but the changes in

real GDP probably overstat e the changes in t otal product ion and peoples

welf are caused by business cycles.

Real versus Nominal GDP

- Nominal GDP values the production of goods and services at current pr ices.

- Real GDP values the production of goods and services at constant prices.


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2)Measur ing t he cost of living

Measur ing the Cost of Living;

- I nf lat ion ref ers to a sit uat ion in which the economys overall price level is

rising.

- The inf lation rate is the percent age change in t he price level f rom the

previous period.

The Consumer Price I ndex

- The consumer price index (CPI ) is a measure of t he overall cost of the goods

and services bought by a t ypical consumer.

- The Bureau of Labor St at ist ics reports the CPI each month.

- I t is used to monitor changes in the cost of living over t ime.

Example of CPI in Act ion

- CPI is also called the Consumer Pr ice I ndex.

- Try and f igure how t he CPI is biased.

Problems in Measur ing the Cost of Living

The CPI is an accurat e measure of the selected goods that make up t he typical

bundle, but it is not a perf ect measure of the cost of living.

- Subst itut ion bias

- I ntroduction of new goods

- Unmeasured qualit y changes

- Because of these problems the CPI tends to overstate t he t rue cost of living

f or most individuals.

The Consumer Price I ndex

- When t he CPI r ises, t he typical f amily has to spend more dollars to maint ain

t he same standard of living.

- Cost of Living f or US cit ies

- CPI f or Honolulu and USA cit ies 1940- 2002

- Housing Cost s 1995- 2002


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How the Consumer Price I ndex I s Calculat ed

- Fix the Basket: Determine what prices are most important to t he typicalconsumer.

- The Bureau of Labor St at ist ics (BLS) ident if ies a market basket of

goods and services the t ypical consumer buys.

- The BLS conducts monthly consumer surveys to set t he weights for the

prices of those goods and services.

- Find the Pr ices: Find t he prices of each of t he goods and services in t he

basket f or each point in t ime.

- Compute the Basket s Cost: Use the dat a on prices to calculate the cost ofthe basket of goods and services at dif f erent t imes.

- Choose a Base Year and Compute t he I ndex:

- Designate one year as the base year, making it t he benchmark against

which other years are compared.

- Compute the index by dividing the price of t he basket in one year by

the price in the base year and mult iplying by 100.

- Compute the inf lat ion rate: The inf lat ion rat e is t he percentage change in

the price index f rom t he preceding period.


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Other Price I ndexes

- The BLS calculates other prices indexes:

- The index f or dif f erent regions within t he country.

- The producer price index, which measures the cost of a basket of

goods and services bought by f irms rat her than consumers.


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Real and Nominal I nt erest Rates

I nter est represent s a payment in the f ut ure for a t ransf er of money in the past .

- The nominal interest rate is the int erest rate not corr ect ed for inf lation.u I t is t he int erest rat e that a bank pays.

- The real interest rate is the nominal interest rate that is corr ected f or

inf lat ion.

Real interest rate = (Nominal interest r ate I nf lation rate)

- You borrowed $1, 000 f or one year.

- Nominal int erest rate was 15%.

- During the year inf lation was 10%.

Real interest rate = Nominal interest r ate I nf lation

= 15% - 10% = 5%

3) Pr oduct ion and gr owt h, Concept s of GDP, GNP, PPPProduct ion and Growth

- A count rys st andard of living depends on it s abilit y to produce goods and

services.


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- Wit hin a country there are large changes in t he st andard of living over t ime.

- I n t he United St ates over the past cent ury, average income as measured by

real GDP per person has grown by about 2 percent per year.

- Productivity ref ers t o the amount of goods and services produced f or each

hour of a workers t ime.

- A nat ions standard of living is determined by t he productivity of its workers.

- A f ishing tale- Throw Net f ishing, how productive is it ? Bring t he throw net !

Economic Growt h around the World

- Living standards, as measured by real GDP per person, vary signif icant ly

among nat ions.- The poorest countr ies have average levels of income t hat have not been seen

in t he United States f or many decades.

Compounding and the Rule of 70

- Annual growt h rat es that seem small become large when compounded for many

years.

- Compounding ref ers to t he accumulat ion of a growt h rate over a period of

t ime.

According to the rule of 70, if some variable grows at a rate of x percent per year,

then that variable doubles in approximat ely 70/ x years.


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$5, 000 invest ed at 7 percent interest per year, will double in size in 10 years

How Product ivity is Det ermined

- The inputs used to produce goods and services are called the f actors of

product ion.

The f actors of production directly determine productivity

Government Policies That Raise Productivity and Living St andards

- Encourage saving and invest ment .

- Encourage investment f rom abroad- Encourage educat ion and training.

- Establish secure propert y r ights and maintain polit ical stability.

- Promote free trade.

- Cont rol populat ion growt h.

- Promote research and development.

The I mportance of Saving and I nvestment

There is def init ely a link between investment t oday and growt h in the fut ure.


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- As the stock of capital rises, the extra output produced f rom an addit ional

unit of capital falls; t his property is called diminishing ret urns.- Because of diminishing ret urns, an increase in the saving rat e leads to higher

growt h only for a while.

- Thus small countr ies can grow f aster than big countr ies.

- The catch- up ef f ect ref ers to t he condit ion t hat , other things being equal, it

is easier f or a count ry to grow f ast if it st arts out relat ively poor.

- Once t he country becomes richer, diminishing ret urns set s in.

I nvestment f rom Abroad

I nvestment f rom abroad takes several f orms:

- Foreign Direct I nvestment

- Capital investment owned and operated by a f oreign ent it y.

- Foreign Portf olio I nvestment

- I nvestments f inanced with foreign money but operat ed by domestic

residents.

Educat ion

- For a countrys long- run growth, education is at least as important as

investment in physical capital.

- Human Capital

- I n t he United St at es, each year of schooling raises a persons wage on

average by about 10 percent.

- Thus, one way t he government can enhance the standard of living is to

provide schools.

Propert y Rights and Political Stability

- Propert y right s ref er to t he ability of people to exercise author ity over t he

resources they own.

- An economy- wide respect f or property rights is an import ant

prerequisit e f or t he price syst em to work.

- I t is necessary f or invest ors to f eel that their investment s are secure.

- Napst er anyone?


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Free Trade

- Trade is, in some ways, a type of t echnology.- A count ry t hat eliminates trade restr ict ions will experience t he same kind of

economic growth that would occur af t er a major t echnological advance.

- Remember globalizat ion?

Control of Populat ion Growt h

- Populat ion is a key determinant of a countrys labor f orce.

- Large populat ions tend to produce great er total GDP.

- However, GDP per person is a bet ter measure of economic well- being,

and high populat ion growth reduces GDP per person.

- Thomas Malt hus theory of populat ion growth and economic well- being.

Research and Development, Epilogue

- The advance of technological knowledge has led t o higher standards of living.

- Most t echnological advance comes from privat e research by f irms and

individual inventors.

- Government can encourage the development of new technologies through

research grants, tax breaks, and t he patent system.

- There are pros and cons to product ivity gains though, show Solman DVD video

on productivity.

Product ivity and Bat hrooms

- This is a tale of the self - cleaning bathroom.

- Think about what productivity means in t erms of goods and services, jobs and

wages.

- Journal Question- Can you t hink ot her examples where there was a major

innovat ion that has impacted jobs?

4. The monet ar y syst em, Money gr owt h and inf lat ion

The History of Money

- First, there was bart er

- Then, t here was Commodity money

- This money t akes t he form of a commodity with intrinsic value.

- Examples: Gold, silver, cigaret tes.

- Finally t here was Fiat money is used as money because of government decree.


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- I t does not have intr insic value, it has value because of decree.

- Examples: Coins, currency, check deposits.

- Money Museum of Richmond Federal Reserve Bank- Money Museum of San Francisco Federal Reserve Bank

The Meaning of Money

Money is the set of assets in the economy that people regular ly use to buy goods and

services f rom other people.

Three Functions of Money

- Money has three f unct ions in t he economy:

- Medium of exchange

- Unit of account

- Store of value

Money in t he U. S. Economy

- Currency is the paper bills and coins in the hands of the public.

- Demand deposits are balances in bank accounts that depositors can access on

demand by writ ing a check.


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Where I s All The Currency?

- I n 1998 there was about $460 billion of U.S. currency outstanding.

- That is $ 2, 240 in curr ency per adult.

- Who is holding all this currency?

- Currency held abroad

- Currency held by illegal ent it ies

The Federal Reserve

- The Federal Reserve (Fed) serves as the nat ions cent ral bank.

- I t is designed to oversee the banking syst em.- I t regulates t he quant ity of money in t he economy.

- I t was creat ed in 1914 to restore conf idence in the nations banking

system.

- Online Tour of the Federal Reserve Syst em

The Federal Reserve System

- The Str uct ure of t he Federal Reserve System:

- The primary element s in the Federal Reserve Syst em are:

1) The Board of Governors

2) The Regional Federal Reserve Banks3) The Federal Open Market Commit t ee


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Three Pr imary Funct ions of the Fed

- Regulat es banks t o ensure t hey follow f ederal laws int ended to promote saf e

and sound banking pract ices.

- Act s as a bankers bank, making loans to banks and as a lender of last

resort.

- Conducts monetary policy by controlling the money supply.

Feds Tools of Monetary Control

- The Fed has three tools in its monetary toolbox:

- Open- market operat ions

- Changing the reserve requirement- Changing the discount rate

Problems in Controlling t he Money Supply

- The Feds control of the money supply is not precise.

- The Fed must wrest le with two problems that ar ise due to f ractional- reserve

banking.

- The Fed does not control the amount of money that households choose

to hold as deposit s in banks.

- The Fed does not control the amount of money that bankers choose tolend.

Banks and The Money Supply

Banks can inf luence the quantit y of demand deposit s in the economy and t he money

supply.

- Reserves are deposits that banks have received but have not loaned out .

- I n a f ractional reserve banking syst em, banks hold a f raction of the money

deposited as reserves and lend out the rest .- When a bank makes a loan f rom it s reserves, the money supply increases

Money Creat ion

- The money supply is af f ected by t he amount deposited in banks and the

amount t hat banks loan.

- Deposits into a bank are r ecorded as bot h assets and liabilit ies.

- The f raction of tot al deposit s that a bank has to keep as reserves is

called the reserve rat io.


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- Loans become an asset to t he bank.


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The Money Mult iplier

The money mult iplier is the reciprocal of the reserve rat io:

M = 1/ R

- With a reserve requirement , R = 20% or 1/ 5,

- The mult iplier is 5.

- Problem of Bank Runs- it s a wonderf ul lif e!

Federal Deposit I nsurance Corporat ion (FDI C)

I nf lat ion

I nf lat ion is an increase in the overall level of prices.

Historical aspect s

- Over the past sixt y years, prices have risen on average about 5 percent per

year.

- Def lation, meaning decreasing average prices, occurred in the U.S. in the

ninet eenth cent ury.

- Hyperinf lation ref ers to high rat es of inf lation such as Germany experienced

in t he 1920s.


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- I n t he 1970s pr ices rose by 7 percent per year.

- During the 1990s, pr ices rose at an average rat e of 2 percent per year.

The Classical Theory of I nf lat ion

- The quantity theory of money is used to explain the long- run determinants of

the price level and t he inf lat ion rate.

- I nf lat ion is an economy- wide phenomenon that concerns the value of the

economys medium of exchange.

- When t he overall price level r ises, t he value of money f alls.


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The Quant ity Theory of Money

- How t he price level is determined and why it might change over t ime is called

the quant ity t heory of money.

- The quantity of money available in the economy det ermines the value of

money.

- The primary cause of inf lat ion is the growth in the quant ity of money.


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The Equilibrium Price Level, I nf lat ion Rate, and the Quant ity Theory of Money

- The velocity of money is relat ively stable over t ime.

- When t he Fed changes the quant it y of money, it causes proport ionat e changes

in the nominal value of output (P x Y).

- Because money is neut ral, money does not af f ect output .

- When t he Fed alt ers t he money supply and induces parallel changes in the

nominal value of output, t hese changes are also ref lected in changes in the

price level.

- When t he Fed increases the money supply rapidly, the result is a high rat e of

inf lat ion.

Hyperinf lation

- Hyperinf lation is inf lat ion that exceeds 50 percent per month.

- Hyperinf lat ion occurs in some count ries because the government pr ints too

much money t o pay f or it s spending.


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The Cost s of I nf lation

- Shoeleather costs

- Menu costs

- Relative pr ice variability

- Tax distort ions

- Conf usion and inconvenience

- Arbitrary redist ribut ion of wealt h

Shoeleather Costs

- Shoeleather costs are t he resources wasted when inf lat ion encourages people

to reduce their money holdings.

- I nf lat ion reduces t he real value of money, so people have an incent ive to

minimize t heir cash holdings.

- Less cash requires more f requent t r ips t o the bank to wit hdraw money f rom

interest - bearing accounts.

- The act ual cost of reducing your money holdings is the t ime and convenience

you must sacrif ice to keep less money on hand.

- Also, extra tr ips to the bank take t ime away f rom productive act ivit ies.


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Menu Costs

- Menu costs are the costs of adjusting pr ices.- During inf lat ionary t imes, it is necessary to updat e pr ice list s and ot her

posted prices.

- This is a resource- consuming process that t akes away f rom ot her productive

activit ies.

Relative- Price Variabilit y

- I nf lat ion distorts relative prices.

- Consumer decisions are dist orted, and markets are less able to allocate

resources to their best use.

I nf lat ion- I nduced Tax Distort ion

- I nf lat ion exaggerates the size of capit al gains and increases t he tax burden

on this type of income.

- Wit h progressive t axat ion, capital gains are taxed more heavily.

- The income tax t reats the nominal interest earned on savings as income, even

though part of the nominal interest rate merely compensat es f or inf lat ion.

- The af t er- tax real interest rat e f alls, making saving less att ract ive.


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Conf usion and I nconvenience

- When t he Fed increases the money supply and creat es inf lat ion, it erodes thereal value of the unit of account .

- I nf lat ion causes dollars at dif f erent t imes to have dif f erent real values.

- Theref ore, with rising prices, it is more diff icult to compare real revenues,

costs, and prof its over t ime.

Arbit rary Redistr ibut ion of Wealth

- Unexpected inf lat ion redistribut es wealt h among the populat ion in a way that

has nothing to do with either merit or need.- These redistributions occur because many loans in the economy are specif ied

in terms of the unit of account money.

5. Open-economy macr oeconomics Basic concept s

Open and Closed Economies

- A closed economy is one that does not interact wit h ot her economies in the

world.

- There are no exports, no imports, and no capital f lows.

- An open economy is one t hat interacts freely with other economies around t he

world.

An Open Economy

- An open economy interacts wit h ot her countries in two ways.

- I t buys and sells goods and services in world product market s.

- I t buys and sells capital assets in world f inancial markets.

The Flow of Goods: Exports, I mports, N et Exports

- Export s are domestically produced goods and services that are sold abroad.

- I mports are f oreign produced goods and services that are sold domestically.


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- When a U. S. resident buys stock in Telmex, the Mexican phone company, the

purchase raises U. S. net f oreign invest ment.

- When a Japanese resident buys a bond issued by the U.S. government , the

purchase reduces the U. S. net f oreign invest ment .

Variables that I nf luence Net Foreign I nvest ment

- The real inter est rates being paid on f oreign assets.

- The real interest rat es being paid on domestic asset s.

- The perceived economic and polit ical risks of holding assets abroad.

- The government policies that af f ect f oreign ownership of domestic asset s.

The Equality of Net Export s and Net Foreign I nvest ment

- Net export s (NX) and net f oreign investment (NFI ) are closely linked.

- For an economy as a whole, NX and NFI must balance each ot her so t hat:

NFI = NX

- This holds true because every transact ion that af f ects one side must

also af f ect the other side by the same amount.

Nominal Exchange Rat es

- The nominal exchange rat e is t he rate at which a person can t rade the

currency of one country f or the currency of another.

- The nominal exchange rat e is expressed in two ways:

- I n units of f oreign currency per one U.S. dollar.

- And in unit s of U. S. dollars per one unit of t he f oreign currency.

- Assume the exchange rate between the Japanese yen and U.S. dollar is 80

yen to one dollar .

- One U.S. dollar t rades f or eighty yen.


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- One yen t rades f or 1/ 80 (=0. 0125) of a dollar.

- I f a dollar buys more foreign currency, there is an appreciat ion of the dollar.

- I f it buys less there is a depreciation of the dollar.

Purchasing- Power Parit y

- The purchasing- power parity theory is the simplest and most widely accepted

theory explaining t he variat ion of currency exchange rates.

Basic Logic of Purchasing- Power Parit y

- The theory of purchasing- power par ity is based on a pr inciple called the law

of one price.

- According to the law of one pr ice, a good must sell for t he same price in all

locat ions.

- I f the law of one price were not t rue, unexploited prof it opport unit ies would

exist.


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- The process of taking advantage of dif f erences in prices in dif f erent markets

is called arbit rage.

Br ief Video on German Hyperinf lat ion

- This video shows how the DM price of bread increased almost daily during the

German hyperinf lat ion of the 1920s.

Module I V!!!

1) Aggr egat e demand and aggr egat e supply

What is aggregate demand?

- Sum of all possible buyers f or all possible new and Finished products

- Households


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- Businesses

- Government

- Ot her countr ies (f oreign component)

Looks and behaves just like a normal demand curve

- Negat ively sloped, increase is a shif t to the r ight, decrease is a shift to t he

left

What about aggregate supply?

I t is the measure of all levels of output at the Various price levels

- Upward sloping

- Labeled AS inst ead of just S f or supply

- Behaves the same as supply

- I ncrease in AS is a shif t to the right

- Decrease in AS is a shif t t o lef t

- Can analyze Aggregate supply in the short run

(SRAS) or t he long run (LRAS)

Aggregate Demand

The sum of all expendit ure in the economy over a period of t ime

Macro concept WHOLE economy

Formula:

AD = C+I +G+(X- M)

C= Consumpt ion Spending

I = I nvestment Spending

G = Government Spending

(X- M) = dif f erence between spending on imports and receipt s from

exports (Balance of Payments)


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Aggregate Demand Curve

Shows the overall level of spending at dif f erent price levels

Not e I nf lat ion used f or t he vert ical axis f ollows f rom new t hinking on t he

derivation of AD curves f rom the likes of David Romer @ University of

Calif ornia Assumes Central Banks do not t arget t he money supply but short

term interest r ates

Why does it slope down f rom lef t to right?

Assume Bank of England set s short t erm int erest rat es

Assume a rise in the pr ice level will be met by a rise in int erest rat es

Any increase in int erest rates will raise the cost of borrowing:

Consumption spending will f all

I nvestment will f all

I nternat ional compet it iveness will decrease exports f all, imports

rise

Theref ore a r ise in the price level leads to lower levels of aggregate demand

The AD diagram:

I nf lat ion on t he vert ical axis assume an initial target rate of 2. 0% (as

measured by the HI CP or CPI )

Real GDP or Real Nat ional I ncome or Real Output on the vert ical axis (shownby the init ialY)


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Consumption Expenditure

Exogenous f actors af f ect ing consumpt ion:

Tax rates

I ncomes short t erm and expected income over lif et ime

Wage increases

Credit I nterest rates

Wealth

Propert y

Shares

Savings

Bonds

I nvestment Expenditure

Spending on:

Machinery

Equipment

Buildings

I nf rast ructure

I nf luenced by:

Expected rates of ret urn

I nterest rates

Expectat ions of f ut ure sales


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Expectat ions of f ut ure inf lation rates

Government Spending

Def ense

Health

Social Welf are

Educat ion

Foreign Aid

Regions

I ndustry

Law and Order

I mport Spending (negat ive)

Goods and services bought f rom abroad represents an out f low of f unds f rom

the UK (reduces AD)

Export Earnings (Posit ive)

Goods and services sold abroad represents a f low of f unds into the UK

(raises AD)


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OR.

Aggregate demand curve

a curve that shows the quant it y of goods and services that households, f irms,

and the government want to buy at each price level

Aggregate supply curve

A curve that shows the quant ity of goods and services that f irms choose t o

produce and sell at each pr ice level

Aggregate Demand

Why does the aggregate demand curve slopes downward? I n other words, why does a

f all in the price level increases the quantity of goods and services demanded?

There are three reasons:

1. The Wealth Eff ect: Consumers are wealthier, which st imulates the demand f orconsumpt ion goods


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2. The I nterest Rate Ef f ect : I nterest rat es f all, which st imulat es the demandf or invest ment goods

3.

The Real Exchange Rat e Ef f ect: The exchange rat e depreciat es whichst imulates t he demand for net exports

Aggregate Supply

Why does the aggregate supply curve slope upwards?

There arethree reasons

1. The Sticky Wage Theory- - This t heory is at the foundat ion of New Keynesianeconomics. The reason f or st icky wage is t hat in labour market , nominal wage

is ent ered int o a contract of various lengt hs, t hus f irms cannot adjust nominal

wages inst antaneously.

2. The Sticky Price Theory- - This is a derivat ive f rom St icky Wage Theory. Asf irms cannot adjust wages in t he short run, t heir cost of production remains

constant and thus pr ice will remain const ant in the short run.

3. The Mispercept ion Theory


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2) The inf luence of monet ar y and f iscal policy on aggregat e demand

Aggregate Demand

Many f actors inf luence aggregate demand besides monet ary and f iscal policy.

I n part icular , desired spending by households and business f irms determines

t he overall demand for goods and services.

When desired spending changes, aggregate demand shif ts, causing short - run

f luct uat ions in output and employment.

Monetary and f iscal policy is somet imes used to of f set those shif ts and

stabilize the economy.

HOW MONETARY POLI CY I NFLUENCES AGGREGATE DEMAN D

The aggregat e demand curve slopes downward f or three reasons:

The wealth eff ect

The int erest - rate ef f ect

The exchange- rate ef f ect

For t he U. S. economy, t he most import ant reason f or t he downward slope of

t he aggregate- demand curve is t he interest - rat e ef f ect .

The Theory of Liquidity Pref erence

Keynes developed the theory of liquidity pref erence in order to explain what

f actors determine the economys interest rate.

According to the theory, t he interest rate adjusts to balance the supply and

demand f or money.

Money Supply

The money supply is controlled by t he Fed t hrough:

Open- market operat ions

Changing t he reserve requirements

Changing t he discount rat e


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Because it is f ixed by t he Fed, the quantit y of money supplied does not

depend on the int erest rate.

The f ixed money supply is represent ed by a vert ical supply curve.

Money Demand

Money demand is determined by several f actors.

According to the theory of liquidity pref erence, one of t he most

important f actors is the interest rate.

People choose to hold money instead of ot her assets that of f er

higher rat es of ret urn because money can be used to buy goods

and services.

The opport unity cost of holding money is the interest that could

be earned on interest- earning assets.

An increase in t he int erest rat e raises t he opportunity cost of

holding money.

As a result , t he quant ity of money demanded is reduced.

Equilibr ium in t he Money Mar ket

According to the theory of liquidity pref erence:

The int erest rat e adjusts to balance the supply and demand f or

money.

There is one interest rate, called t he equilibrium int erest rate,

at which the quantity of money demanded equals the quant it y of

money supplied.

Assume t he f ollowing about t he economy:

The price level is stuck at some level.

For any given price level, the interest rate adjusts to balance the

supply and demand for money.

The level of output responds to the aggregat e demand f or goods

and services.


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Adj ustment to Changes in Ms

I N PAST CHAPTERS, WE LEARN ED THAT I NDI VI DUALS REBALANCE THEI RPORTFOLI OS BY ADJUSTI NG THEI R SPENDI NG.

ESM SPEND I T C ADP

EDM SPEND LESS C AD P

I N LI QUI DI TY PREFERENCE THEORY, I NDI VI DUALS REBALANCE THEI R PORTFOLI O BY

EI THER SPENDI NG OR LENDI NG AND WE WI LL ASSUME THE PRI CE LEVEL CONSTAN T.

ESM SPEND I T C AD

LEND I T R I AND NX AD

EDM SPEND LESS C AD

LEND LESS R I AND NX AD

The Downward Slope of t he Aggregate Demand Curve

The price level is one det erminant of t he quant ity of money demanded.

A higher price level increases the quantit y of money demanded for any given

interest rate.

Higher money demand leads to a higher int erest rate.

The quantit y of goods and services demanded f alls.


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HOW FI SCAL POLI CY I NFLUENCES AGGREGATE DEMAND

Fiscal policy ref ers t o t he governments choices regarding the overall level of

government purchases or taxes.

Fiscal policy inf luences saving, investment, and growth in the long run.

I n t he short run, f iscal policy primarily af f ects the aggregate demand.

Changes in Government Purchases

When policymakers change t he money supply or t axes, the ef f ect on aggregat edemand is indirectthrough t he spending decisions of f irms or households.

When t he government alters it s own purchases of goods or services, it shif ts

the aggregate- demand curve direct ly.

There are two macroeconomic ef f ects f rom the change in government

purchases:

The mult iplier ef f ect

The crowding- out ef f ect


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The Mult iplier Ef f ect

Government purchases are said to have a mult iplier ef f ect on aggregate

demand.

Each dollar spent by the government can raise the aggregate demand f or

goods and services by more t han a dollar .

The mult iplier ef f ect ref ers to the additional shif ts in aggregate demand t hat

result when expansionary f iscal policy increases income and thereby increases

consumer spending.

A Formula f or the Spending Mult iplier

The formula for the mult iplier is:

Multiplier = 1/ (1 - MPC)

An important number in this formula is t he marginal propensit y t o consume

(MPC).

I t is t he f raction of ext ra income that a household consumes rat her

than saves.

I f the MPC is 3/ 4, then the mult iplier will be:

Multiplier = 1/ (1 - 3/ 4) = 4

I n this case, a $ 20 billion increase in government spending generat es $80

billion of increased demand for goods and services.


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The Crowding- Out Ef f ect

Fiscal policy may not af f ect t he economy as st rongly as predicted by t he

mult iplier.

An increase in government purchases causes the interest rat e t o rise.

A higher int erest rate reduces investment spending.

This reduction in demand that results when a f iscal expansion raises the

interest rat e is called the crowding- out ef f ect .

The crowding- out ef f ect tends to dampen the ef f ects of f iscal policy on

aggregate demand.

When t he government increases its purchases by $ 20 billion, t he aggregate

demand f or goods and services could r ise by more or less than $20 billion,

depending on whether t he mult iplier ef f ect or t he crowding- out ef f ect is

larger.


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3) The shor t -r un t r ade-of f between inf lat ion and Unemployment

Unemployment and I nf lat ion

- The nat ural rat e of unemployment depends on various f eatures of t he labor

market.

- Examples include minimum- wage laws, t he market power of unions, the role of

ef f iciency wages, and the ef f ectiveness of job search.

- The inf lat ion rate depends pr imarily on growth in the quant ity of money,

controlled by the Fed.

- The misery index, one measure of t he health of the economy, addstogether the inf lat ion rate and unemployment rate.

- Society f aces a short - run tradeof f between unemployment and inf lat ion.

- I f policymakers expand aggregat e demand, t hey can lower unemployment , but

only at t he cost of higher inf lat ion.

- I f they cont ract aggregat e demand, t hey can lower inf lation, but at the cost

of temporar ily higher unemployment.

The Phillips Curve

- The Phillips curve illustrates the short - run relat ionship between inf lat ion and

unemployment.


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Aggregate Demand, Aggregate Supply, and the Phillips Curve

- The Phillips curve shows t he short - run combinat ions of unemployment and

inflat ion that arise as shif ts in the aggregate demand curve move the economy

along the short - run aggregat e supply curve.

- The greater t he aggregat e demand for goods and services, t he great er is t he

economys out put, and t he higher is the overall price level.

- A higher level of out put results in a lower level of unemployment.

The Long- Run Phillips Curve

- I n t he 1960s, Friedman and Phelps concluded t hat inf lat ion and unemployment

are unrelat ed in the long run.

- As a result , the long- run Phillips curve is vert ical at t he natural rat e

of unemployment.

- Monet ary policy could be ef f ect ive in the short run but not in the long

run.


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Expectat ions and the Short - Run Phillips Curve

- Expected inf lat ion measures how much people expect t he overall price level t o

change.

- I n t he long run, expected inf lat ion adjust s t o changes in act ual inf lat ion.

- The Feds ability to create unexpected inf lation exists only in the short run.

- Once people ant icipate inf lat ion, the only way t o get unemployment

below t he natural rat e is f or actual inf lat ion t o be above t he ant icipated

rate.


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Shif ts in t he Phillips Curve: The Role of Supply Shocks

- Histor ical event s have shown that the short - run Phillips curve can shif t due to

changes in expectat ions.

- The short - run Phillips curve also shif ts because of shocks to aggregat e

supply.

- Maj or adverse changes in aggregate supply can worsen the short - runt radeof f between unemployment and inf lat ion.

- An adverse supply shock gives policymakers a less f avorable t radeoff

bet ween inf lat ion and unemployment.


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- A supply shock is an event t hat directly af f ects f irms costs of product ion and

t hus the prices t hey charge.

- I t shif ts t he economys aggregate supply curve. . .

- and as a result, t he Phillips curve.

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!The end!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

Keyur D vasava

(EFM) Ecomonics for Manager-SEM-I-GTU

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