Transcript Review Lecture - Leona Craig Art Gallery

13: Final Review
Intro Econ
C.L. Mattoli
Intro
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This will be a final review of intro econ.
We warn that this is by no means all that might
be tested in the final exam.
It is simply meant as a summary of the course,
giving it all in one place with tying threads
among the concepts.
Study the book, the lecture notes, the tutorials,
and the past final exams as a means of
studying for the final exam.
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Mod 1: intro: Chapters 1,2 &
18
Overview
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Chapter 1 introduces the idea of
economics as a social science that tries
to be scientific by employing the scientific
method of research, when it can do that.
We talk about scarcity versus unlimited
self-interested wants.
In Chapter 2 we look at production
possibilities and its frontier (PPF).
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Overview
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Because resources, including the labor hours
available in any given period, are scarce,
only a certain amount of one thing could be
produced in an economy over a given interval
of time. That is maximum production
capacity.
If the economy wants to produce 2 goods, the
scarce resources will have to be divided
among production of the 2 goods.
How that decision is arrived at is a function of
opportunity cost considerations.
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Overview
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The only way to expand a PPF is through
investment in new capital.
To do that it will have to give up producing
consumer goods to produce more capital
goods, which means present sacrifice to get
future benefits, another trade-off of
opportunities
In Chapter 4, international trade, we also
found that an economy can get to a point
beyond the PPF by comparative
advantage in international trade.
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Chapter 1: intro
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There is not an unlimited amount of
anything in the world, so resources
(factors of production) for making things
are scarce.
Economics is the study of choice in the
allocation of scarce resources.
The resources are land, labor, and
capital (equipment). Entrepreneurs, the
people who take the risk and burden of
doing business, are a particularly scarce
resource.
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Chapter 1: intro
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It uses the scientific method to try to come
up with simple theories and equations
(models) that are based on simple
underlying psychology of human beings.
For example, we would expect that people
will be willing to buy more of something, if
the price is decreased.
That becomes a demand curve of
quantity versus price that is downward
sloping.
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Chapter 1: intro
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Models use ceteris paribus, everything else
held constant, many times, so that the affect
of one or a few variables at a time can be
examined.
Thus, for example, downward-sloping
demand assumes that the prices of
substitutes does not change.
Problems in theorizing include: causation
versus correlation. Things might seem to be
related, but it might be only a coincidence.
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Chapter 1: intro
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Then, there is positive versus normative
economics. Positive deals with facts and
verifiable true-false statements.
Normative is subjective and talks of what
it thinks things should be like.
Thus, GDP will increase, if people work
more hours is positive.
Poor people should get more money from
the rich is normative
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Chapter 2: PP & OC
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3 fundamental questions: what, how, and for
whom to produce.
That brings us to our first discussion of
opportunity costs.
Scarcity means that choices must be made,
and to choose one path is to sacrifice taking
another path.
Opportunity cost is then defined as the best
alternative that was sacrificed in choosing to
do what we chose.
For example, give up producing one car to make
20 computers, then, your opportunity cost of
producing 1 computer is 1/20 cars.
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Chapter 2: PP & OC
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Economic analysis also involves marginal
thinking. What is important to dynamic
analysis of a productive economy is change.
Marginal analysis is our first look at change:
additions or subtracting, incremental affects, to a
current situation.
For example, a farmer figures that he can get
$75/acre without fertilizer, and the same land will
yield $100/acre with fertilizer. The incremental
cost of using fertilizer is $20/acre, so by using it,
he will make $100 – $75 – 20 = $5/acre marginal
profit by using fertilizer.
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Chapter 2: PP & OC
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Then, we can finally look at the PPF. The PPF is
the plot of maximum capacity simultaneous
production of 2 (or more) goods or services
(G&S).
With limited resources, we will have different
combinations of producing different numbers of
the pair of good, together.
Those maximums are the PPF (see slide below),
it is an outer boundary line on the production
possibilities set, which are the points inside the
outer boundary (not max capacity).
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Chapter 2: PP & OC
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Points inside the PPF are also possibilities, but
they are not efficient because you could have
produced more of both with your capacity and
trade-offs.
If we produce 2 goods, we have to allocate
some of the fixed resources to both.
For example, we start with 100% of production
in good A, then we begin to allocate a larger
and larger percentage to good B until we have
all of our production in good B.
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Production Possibilities, Graphically
A
Units of Good 2
•The graph describes the
production possibilities for 2
goods or services, with production
of each on the separate axes.
•The Production possibilities set is
contained to the left of the PPF.
•Thus, Points A,B,C,D, and F are
part of the set, while E is
unattainable.
•A, C, and F are on the frontier,
which represents maximum
production, although of different
mixes of goods and services.
•Point E is beyond the
possibilities, given the resources
and technology of the economy in
the period described in the graph.
C
E
B
D
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F
Units of Good 1
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Chapter 2: PP & OC
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We get our first chance to look at
marginal analysis.
That reallocation from only one to 2, in
various proportions, will involve
opportunity cost considerations.
To get that PPF plot, we assume fixed,
fully utilized resources and unchanged
technology.
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Chapter 2: PP & OC
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As happens in cases of other costs,
marginal opportunity costs change.
Thus, PPF is a concave curve because of
the law of increasing opportunity costs.
The more we move from producing one
good to producing more of a second and
less of the first, the sacrifices become
larger and larger.
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Increasing Opportunity cost example
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Consider the choice between producing
automobiles or university degrees (U.D.).
At point A all production is devoted to
autos.
Auto production requires a large amount of
purpose-built equipment, computers, and
some moderately educated labor
University degree production requires
some buildings, computers, and highlyeducated personnel.
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Increasing Opportunity cost example
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To move from A to B we move some
buildings, computers and educated
personnel from auto production to U.D.
production, and sacrifice one grid-unit of
autos to produce about 2 1/3 grid-units of
U.D.’s.
However, to move from B to C we sacrifice
the same amount of autos as in the first
step to produce less U.D.’s.
Even less, in steps from C to D and D to E
(see next slide).
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Autos vs. University Degree production
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Recall that on the PPF, all factors of production are fully
employed, so that by the time we have gone from A to E all of
the capital and laborers have been moved from autos to
university degrees.
However, some of those resources, like unskilled labor and
robots, were better suited to auto making than U.D.
production.
Thus, at first those well-suited to U.D.
production were moved.
However, more and more resources that
were better suited to autos are moved to
U.D.’s and we have to sacrifice more
auto production for incremental U.D.
production.
A
B
C
D
Autos
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U.D.’s
E
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Law of increasing opportunity cost explained
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In this example, because the factors of
production are not equally suited to
autos and U.D.’s, the marginal addition of
U.D. production for each equal decrease
of auto production decreases.
In another way of looking at it, the slope of
the line ΔA/ΔU is negative and becomes
more negative as we move down the
curve.
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Law of increasing opportunity cost explained
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We give up producing cars (negative) to
make more U.D.’s (positive), so slope is
negative
In fact, in a case where the factors of
production were equally suited to
production two outputs, the PPF would be
a straight line and a straight line has a
constant slope (Constant opportunity
costs).
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Chapter 2: PP & OC
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To move the PPF out (expand it) means
investing in capital because newer better
capital will allow greater productive
capacity.
New technology is particularly helpful in
moving PPF’s outward.
Another means is by increasing
resources, like finding gold or having an
influx of employable population.
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Chapter 2: PP & OC
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A means of reaching a point above the
PPF is by using comparative advantage
in the production of one good to trade for
another from another economy, in foreign
trade.
Comparative advantage means that one
country can produce a good at a relatively
lower opportunity cost than other
nations.
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Trade and the PPF
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Assume 2 countries that produce the same 2
goods: agricultural products and electronics.
Further assume, for simplicity, that their
resources are equally suited for both
industries, so that the PPF’s of each are linear,
i.e., straight lines instead of curves.
Econ 1 starts at B, producing 60,000 tons of
agricultural goods and 20,000 tons of
electronics. Econ 2 starts at D, producing
30,000 tons agricultural goods and 10,000 tons
electronics.
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Trade and the PPF
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We assume that points along the PPF’s also
describe the consumption possibilities of the
country in a closed self-sufficient system
without trade.
If each specializes, Econ 1 producing only
agriculture, and 2 producing only electronics,
they can trade the excesses and each can go
beyond their PPF’s.
Then, econ 1 will produce 100, 000 tons of
agricultural goods and economy 2 will produce
50,000 tons of electronics.
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International Trading PPF’s
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Econ 1 trades 30,000 tons of agricultural goods for 20,000 tons electronics from Econ 2.
Economy 1 ends up with 70,000 tons of agricultural goods and 20,000 tons of electronics, more than they
would have had on their own.
Similarly, economy 2 ends up with 30,000 ton of agricultural goods and 20,000 tons of electronics, again,
beyond what they could have done on their own
Both move beyond their PPF’s to B’ and D’. See figure, below
Econ 1
Econ 2
A
Ag. 20,000 tons/day
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B’ with trade
B without trade
C
D without trade
D’ with trade
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Electronics
10,000 tons/day
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Chapter 18: Int’l. Trade
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We all specialize in something, and the economy
benefits from specialization: we produce more
than we would, if we all did everything for
ourselves.
We saw that nations can gain from the use of
comparative advantage in international trade.
There is also the concept of absolute advantage.
Absolute advantage means that a nation can
produce something using fewer resources than
any other country.
However, even a nation with absolute advantage
in a number of goods can benefit from trading.
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Mod 2: Markets
Chapter 3: market analysis
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One efficient and effective means of allocation is
by markets.
In markets, there is consumer sovereignty: the
consumer decides what to buy, which ultimately
should determine what will be produced.
The law of demand says that the quantity of a
good that consumers will purchase is an inverse
function of price (quantity demanded
decreases with increasing price) in a given
period of time, ceteris paribus (which means that
prices of substitutes, for example, remain
unchanged).
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Chapter 3: market analysis
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It is based on the behavioral fact that
consumers have a marginal utility for
things that is decreasing.
From all of the individual demand
schedules, intentions to buy, we add up
all quantities at each price to get the total
demand curve for something.
Quantity demanded changes with
changing price, that is a move along a
demand curve.
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Chapter 3: market analysis
Demand curves can be transformed
(shifted) into new demand curves by
non-price factors, like prices of
substitutes, change in number of
buyers, income, tastes and
preferences, and expectations.
 The law of supply says that sellers
are willing to offer more goods at a
higher price, ceteris paribus. It is
upward sloping
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Chapter 3: market analysis
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Changes in the supply curve come from
non-price: number of sellers,
technological change, input prices,
taxes/subsidies, expectations, and prices
of competing goods.
Note: new curves, i.e., new demand or
new supply, always come from non-price
factors. The curves we draw show
quantify as a function of price only.
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Chapter 3: market analysis
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Finally, we need to put supply and
demand together to find out, through
working out surpluses and shortages, an
actual equilibrium price and quantity that
the price system mechanism has used
the forces of the market to ultimately
efficiently determine.
Then, society has maximized the
benefits of some scarce resources.
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Chapter 4: markets in action
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Now that supply and demand have met,
we look at what happens when either the
supply or demand curve changes.
We get new equilibrium price and
quantity, as shown in the next 2 slides.
We can look at what happens when
governments try to fix prices.
We also look at how markets can fail and
lead to not good outcomes.
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Effects of demand shifts on equilibrium
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Diagrams and causal chains
Increase in
demand
Increase in
Equilibrium
price
Increase in
Quantity
supplied
Decrease in
demand
When Haircut demand rises
P
D1
D2
S
Decrease in
Equilibrium
price
Decrease in
Quantity
supplied
When SUV demand falls
P
D2
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D1
S
Q
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Supply Changes
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Causal chain and graphs.
Note there is a mistake in the arrow for price in the
graph in the book on page 92 for decrease in supply
Increase in
supply
P
Decrease in
Equilibrium
price
D
Increase in
Quantity
demanded
S1
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Decrease in
supply
P
S2
Q
D
Increase in
Equilibrium
price
S2
Decrease in
quantity
demand
S1
Q
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Chapter 4: markets in action
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Given those basic facts, what will happen if
the government tries to fix the price of
something, either above or below, floor
(lowest allowed sale price) or ceiling
(highest allowed price), this natural
equilibrium price.
A common example of a ceiling is on
rents. The government might be concerned
that its citizens be able to afford rent, so
they put caps (ceilings) on rental prices.
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Chapter 4: markets in action
That will lead to a shortage, that will
lead to bad behavior, like black
market renting and subletting, bribes,
and, ultimately, inefficiency and
market failure.
 Minimum wages is a common floor,
leading to surplus, to market failure,
to unemployment.
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Chapter 4: markets in action
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Markets can also have failures, even
without the interference of the government
in natural markets affairs.
First, a market might lack competition.
Maybe only one company ever found that
a particular good was profitable, and it
grew into a huge percentage of the
market. What if there is market that no on
cares about, supply-wise? Any sort of lack
of competition is a failure.
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Chapter 4: markets in action
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Governments get involved in trying to
solve these other failures.
For lack of competition, governments
might act to make the few people in the
industry act as though they are in a
competitive market.
For example, that is done with electric and
water utility companies that have to be
necessarily large and cannot easily exist in
great multiplicity.
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Chapter 4: markets in action
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It would be difficult to offer citizens of a town
an option to buy water from 100 companies,
because there would have to be 100 main
water lines running through the whole town.
Externalities are external affects by or on
markets. They can be good or bad.
Pollution is an example of bad. A steel
producer pollutes the atmosphere. People
get sick, everything, including the water, gets
dirty, and there is a large cost to society.
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Chapter 4: markets in action
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By taxing bad or regulating that the
producer must buy and install pollution
control, the cost will rise, the offer price will
rise, and the market price and quantity will
be a new equilibrium, with higher price and
lower quantity, as the supply curve is
shifted against a fixed demand curve.
A positive externality is something that
benefits people who do not buy the
product.
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Chapter 4: markets in action
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Inoculation of children against bad
diseases benefits the people whose
children go to school with them. Since
most are inoculated, the others are fairly
well protected against being with someone
with the disease.
Those who benefit are free-riders.
Free rides give the government another
reason to get involved in the economy.
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Chapter 4: markets in action
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Public works is a function performed by a
government wherein without intervention,
the things would likely not get done.
These are things, like interstate highways,
national defense, or community parks.
If you asked people to contribute to such
things as they saw fit, most would
probably try to get away with paying
nothing and still getting the benefit of
everyone else's payment.
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Chapter 4: markets in action
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It is another general behavior of human
beings.
A debatable failure is the income
inequality issue.
Some argue that markets are inefficient in
that people’s incomes vary so widely;
others would argue that that is just the
market making efficient use an pricing of
what it has got.
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Chapter 5: Elasticity
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So, since we have talked about how supply
and demand relate quantities to prices, and
that both curves can change, it would be nice
to know how things might change.
Percentage change of one thing with unit
percentage change of another variable is
called elasticity.
Price elasticity of demand tells how demand
will change with price changes. That will be
interesting information for producers.
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Chapter 5: Elasticity
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It is always a negative number
(downward sloping curve), so we usually
just drop the minus sign.
A downward sloping demand curve will
show ranges of the different types of
elasticity, with elastic towards higher
prices and with inelastic range towards the
bottom of price.
Income elasticity of demand looks at how
demand varies with a person’s income.
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Chapter 5: Elasticity
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There is a division: inferior goods have
negative elasticity, while normal good have
a positive elasticity.
Inferior goods, formerly called necessities,
have e negative change versus income. As
income rises, people buy better food, and
buy a car instead of taking a bus.
Normal goods, formerly called luxuries,
have an increase when people earn more
money.
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Chapter 5: Elasticity
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Price elastic of demand has to do with
substitutes and budgets versus wants
and needs.
If something is elastic, that means that
changes in price will lead to bigger
changes in quantity demanded.
Inelastic means that there is no choice,
we have to have the good or we don’t care
much about the price.
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Chapter 5: Elasticity
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Cross-elasticity of demand looks at
change in quantity demanded of one good
versus change in price of another good.
Then, we have a division: substitutes and
complements. It can be positive or
negative, depending.
For a substitute, the increase of the
price of a competitor will give you more
business, so cross elasticity for
substitutes is positive.
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Chapter 5: Elasticity
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If a complement, like French fries with a
hamburger, an increase in the price of one
will cause the quantity demanded of the other
to drop, so it is negative.
Price elasticity affects the shares that
supplier and consumer will pay of an excise
tax slapped onto the price of a good.
If demand is perfectly inelastic, the consumer
will bear the whole cost. If it is perfectly
elastic, the supplier will pay all of the tax.
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Chapter 5: Elasticity
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In between, an upward-sloping supply
curve will shift upward by the tax. Price
will move up the old downward sloping
demand curve to a new price. However,
the change in the market equilibrium price
will not be as large as the tax added, and
consumer and producer will share the tax
burden.
That phenomenon is called tax incidence.
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Elasticity and Taxation
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When demand is other than
perfectly elastic (vertical) it will
have a downward slope.
Because of the downward
slope, the burden will shift from
totally on the buyer to a split
between buyer and seller.
Thus, of T = Tax, the added
cost, the part that is shifted to
the buyer is the difference
between what he paid before
and what he is paying now,
which change in price is less
than the added cost = T
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Change in
market price
= ΔP
T – ΔP
Buyer
Seller
Total
Tax = T
54
Elasticity and Taxation
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In the diagram, we also
show what happens
when supply is more
inelastic (blue lines).
Then, the part of the tax
shifted to the buyer is
less, the more inelastic
the supply for the same
tax.
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Change in
market price
= ΔP
T – ΔP
Buyer
Seller
Total
Tax = T
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Mod 3: Business, Company &
Industry Analysis
Chapter 6: Production costs.
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People are in business to make profits,
which depend on revenues and costs.
They are self-interested.
Economics adds a cost to normal
accounting profits: implicit, opportunity
costs, to arrive at economic profit.
Opportunity costs arise again. We have
the opportunity costs associated with
doing a business or taking our time and
money and doing something else.
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Chapter 6: Production costs.
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To look at production and costs, we divide
time into a long-run, over which
everything can be changed in the
production operation, including scope, and
the short-run, over which at least one
input to the production process is fixed
and cannot be changed.
The production function is the
relationship between the maximum output
that can be achieved with various
quantities of inputs.
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Chapter 6: Production costs.
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Then, another marginal concept, marginal
product, which is the change in output
with a change in unit input of labor
(variable input).
Marginal product curves will slope
upward, peak out, and turn downward
because of the law of diminishing
returns.
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Chapter 6: Production costs.
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Returns diminish as more variable inputs are
added to a fixed input, the extra output at
each addition will be less and less.
The first employ gets you in business. The
second employee shares tasks with the first
in such as way as to more than double output
of just one. The third helps, but it gets to a
point where the added efficiency is gone, and
they just start to get into each other ways.
It is a short-run law.
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Chapter 6: Production costs.
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Total (short-run) costs can be divided into fixed
costs, which are paid no matter how many
units produced, build a minimum cost into the
business, and variable costs that vary with
units. TC=TFC+TVC.
Average costs are costs per unit.
ATC=AFC+AVC. They are more interesting.
Then, we can talk about marginal costs (MC)
as the additional cost incurred by producing
one more marginal unit of production. They
are the most interesting of all, and they tell how
to run the business.
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Chapter 6: Production costs.



First marginal cost and marginal product
are inversely related.
The marginal-average rule says that when
the marginal is below the average, the
average will fall with the marginal change.
When it is above, the average will become
larger.
The M-A rule results in MC cuts the AVC
and ATC curves at their minimums. We
include the picture in the next slide.
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AC & MC Data

Average and marginal
costs are shown for MAT
ATM’s.
MAT ATM's
Q
MC
AFC
AVC
AC
1
50
100.00
50.00
150.00
2
34
50.00
42.00
92.00
3
24
33.33
36.00
69.33
4
19
25.00
31.75
56.75
5
23
20.00
30.00
50.00
6
30
16.67
30.00
46.67
7
38
14.29
31.14
45.43
8
48
12.50
33.25
45.75
9
59
11.11
36.11
47.22
10
75
10.00
40.00
50.00
AFC
11
95
9.09
45.00
54.09
14
12
117
8.33
51.00
59.33
Average and Marginal Costs vs.
Output
160.00
Unit Cost($)
140.00
MC
120.00
100.00
80.00
ATC
60.00
AVC
40.00
20.00
0.00
0
2
4
6
8
Quantity
10
12
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Chapter 6: Production costs





In the long-run, the LR ATC curve is built up of all of
the possible SR ATC curves. (See next slide). The
general form will be U-shaped.
The U-shaped curve has 3 distinct regions.
The downward sloping part is economies of scale,
which comes from a increasing efficiency of larger
scale of production.
The flat middle region is constant returns to scale.
The upward sloping region is diseconomies of scale
where bigger becomes not better but more
cumbersome to manage. (see second next slide).
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Long run average cost curves

We might imagine a more comprehensive case of more
possibilities in the long run, as shown in the graph below.
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Long run Possibilities

In the long run there can be economies of scale, constant returns to
scale, and even diseconomies of scale as size becomes too bulky and
unmanageable.
35
Cost
30
Economies of scale
Diseconomies of scale
25
20
Constant returns
to scale
15
10
5
0
0
20
40
60
80
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100
120
Output
66
Chapter 7: Perfect competition



We want competitive markets because we
can have confidence in price and quality.
We don’t want producers to take advantage
of us and make excessive profits.
Perfect competition is an ideal, not reality,
but we can learn from looking at this
idealism.
There are a number of market structures
that depend on how many suppliers,
uniformity of product, and ease of entry/exit.
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Chapter 7: Perfect competition



Markets can vary from one supplier, a
monopolist, who decides what profit he will
make.
In an oligopolistic market, there are few
suppliers, and they could collude to set the
price.
In monopolistic competition, people, like
restaurants and exclusive boutiques try to
distinguish themselves from their competitors
so as to be like a mini-monopoly.
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Chapter 7: Perfect competition


Finally, perfect competition is characterized by
many indistinguishable firms with
indistinguishable products and ease of
entry/exit.
As a result, firms are price takers because they
have no control over the price set by the
interaction of total demand with total supply.
Each, effectively, faces a horizontal demand
curve, completely elastic, because people can
just go next door and buy the same exact
product. (See next slide for summary)
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Comparative Market Structures
Structure
# of sellers
Product
Entry
Examples
Perfect
Competition
Large
Homogeneous
Very easy
Small crops,
commodities
markets
Monopolistic
competition
Large
Differentiable
Easy
Restaurants,
motels, clothing
or other types
of boutiques
Oligopoly
Few
Usually
differentiable;
can be homo
Difficult
Airlines,
Automobile
manufacturing,
oil production
Monopoly
One
Unique
Extremely
difficult
Public utilities
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Chapter 7: Perfect competition




The perfect competitive firm will have max
profits when MR (marginal revenue) equals
MC.
We saw that MC cut the ATC at its minimum,
so that is the minimum of unit cost.
Marginal revenue is equal to the extra
revenue from one more unit of output MR =
ΔTR/ΔQ.
In a perfectly competitive industry, the MR
will always equal market price per unit, and
the TR will be on a straight line with constant
slope = MR.
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Marginal Revenue = Marginal cost





Max profits will occur at MC = MR, Profit = TR –
TC.
ΔProfit/ΔQ = ΔTR/ΔQ – ΔTC/ΔQ = MR – MC.
That equation tells us that profit will increase
(ΔProfit/ΔQ > 0) if MR > MC.
Profit will stop increasing (ΔProfit/ΔQ = 0)
when MR=MC
And profit will begin to decrease (ΔProfit/ΔQ < 0)
after that point when MC > MR.
Then, we have the MR=MC Rule which says
that maximum profits or minimum loss will occur
at the point where MR=MC.
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Competition and Policy



In chapter 4, we saw that lack of competition
can lead to market failures that result in
inefficient outcomes.
On the other hand, perfectly competitive
markets will lead to maximum efficiency.
In that regard, governments around the world
have devoted much regulation and legislation
to promote efficiency by encouraging
competition and to discourage anticompetitive behavior through legal and
financial penalties.
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Chapter 7: Perfect competition



The SR supply curve of a firm will
ultimately be its marginal cost curve, and
the industry supply will be the sum of
them.
A firm will be able to stay in business
when revenues are at least equal to costs,
or zero economic profit or above.
If profits are above ZEP, other firms will
enter; if they fall below, firms will leave,
and prices will be bid up to normal (ZEP).
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Chapter 7: Perfect competition
In the long run all suppliers will have
either exited or moved to the
minimum on the LR ATC curve, and
there will be an intersection of all
curves. (See slide below.)
 The LR supply curve will depend on
the type of industry, decreasing cost
as industry grows, flat costs or
increasing costs: down, horizontal,
upward sloping.

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A Typical Firm in Long-run Equilibrium


P = MR = SRMC = SRATC = LRAC.
In LR equilibrium, firms will operate at the
minimum of LRAC.
Causal Chain
SRMC
Entry/Exit
Of Firms
SRATC
LRAC
MR
Zero LR
Economic Profits
Long-Run
Equilibrium
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Mod 4: The macro economy
Chapter 11: Measuring the economy




National income accounting measures
aggregate numbers of economies.
One popular measure of aggregate economic
activity is GDP, which is all the new
production made inside a country for final
users.
There are many other accounts.
It uses the concept of value added so as not
to count intermediate goods that go into
some other final good, like CPU’s that are put
into computers.
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4-Sector Model
Product Markets
Foreign
Economies
$ paid
exports
Government
Businesses
Surplus
Deficit
$ paid
imports
HH
Financial markets
Factor Markets
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Chapter 11: Measuring the economy



One common way to measure GDP is the
expenditure approach. It adds up C, I, and G
spending on all products, then, adds X to other
countries and subtracts out M because some of the
spending was on imports. GDP = C+I+G+(X –
M).
Shortcomings of GDP it misses non-market and
illegal transactions, quality, distribution, neglect
of leisure time, and economic bads.
GDP must be adjusted for price changes, GDPdeflator, to get output, real GDP: nominal GDP =
Price index x real GDP.
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Chapter 12: Cycles and growth.




There is the long-term trend of growth of an
economy and the shorter-term cycle around the
trend: the business cycle.
The 4 phases of the cycle are peak, recession,
trough, expansion.
We look at indicators of activity: leading,
lagging and coincident, to find out where we are
in a cycle.
Changes in total spending, AD, determine
business cycles. Also supply shocks can do it.
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Chapter 12: Cycles and growth.




Then the GDP gap is the difference between
actual and full-employment real GDP.
The aggregate production function is the
output per worker versus quantity of
production factors per worker.
Factor accumulation and technological
change determine LT growth.
Savings is used to pay for investment.
There is a perfect savings rate that leads to
the perfect amount of capital, called the
golden rule.
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Golden rule in a nut shell



The PPF (capacity to produce) can
expand only through producing more
capital goods.
S is used to buy I; S comes out of DI and
means less C.
Capital goods wear out and need to be
replaced, so some capital spending is for
replacement.
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Golden rule in a nut shell



There will be a maximal capital/person to
make a maximal productive capacity.
We need enough S to get to the level of
capital accumulation per worker and
maintain it through all the wearing out.
That maximal amount of capital that needs
replacement each year as it wears out is
the golden rule amount of capital leading
to the golden rule savings rate.
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Chapter 12: Cycles and growth.



The Solow model of growth says we need
more factors of production per person to
grow.
It assumes that technological change
comes from outside the system.
The exogenous growth model adds
technology growth as a result of
development of a knowledge base within
the framework of the economy.
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Chapter 12: Cycles and growth.


Suggestions for macroeconomic policy
include trying to dampen cycles. The
reason is that unemployment increases
in downturns, and inflation tends to
increase in upturns.
Pursue policies that allow an economy to
achieve its highest potential LT growth.
That will also entail microeconomic policy
measures.
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Chapter 13: Inflation & unemployment



So, lets look more closely at inflation and
unemployment, two big concerns of
people and their governments.
There are a number of inflation measures,
like CPI.
Since aggregate inflation measures use an
average consumer basket of G&S they
will be imperfect for all cases. There is no
accounting for quality. Unchanged
weightings ignore demand changes with
price changes of substitutes.
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Chapter 13: Inflation & unemployment




Inflation shrinks purchasing power of income
but it can increase wealth in investment
assets, like real estate, stocks, and art, which
tend to increase at paces faster than inflation,
so those without much wealth suffer the most.
Interest rates are, in fact, composed of a real
rate plus inflation (plus other factors that
depend on risk, and length of maturity of the
investment).
The largest factor in investment, I, is interest
rate, and the inflation part, when it is high and
volatile discourages business and HH
investment.
Inflation can be demand pull or cost push.
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Cost-push & Demand-pull Inflation
The important thing to talk about when talking about
graphs like these is that a curve moves and there is a new
intersection, equilibrium.
Cost-push
Demand Pull
Price
Level
AS
P2
P1
AD2
AD1
Q1
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Q2
Real GDP
89
Chapter 13: Inflation & unemployment



Unemployment is not a simple definition,
either.
There are seasonal variations, like farm
workers or people who work at winter
resorts.
Frictional unemployment has to do with
imperfect information leading to
temporary job-personnel mismatching.
People either must or want to change their
jobs.
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Chapter 13: Inflation & unemployment


Structural unemployment has to do with
evolution of the economic system and
society: things change, and there is no
longer need for certain jobs, like horsecarriage drivers. We need newer things
like a person who can do maintenance on
robots.
Cyclical unemployment is the variation
over recession and expansions. When the
economy is good, more businesses hire;
when it is bad, they fire.
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Chapter 13: Inflation & unemployment



Then, full employment is defined,
practically, as employment with seasonal,
frictional and structural but without cyclical
unemployment, as the putative zero
unemployment rate.
Full employment is also known as the natural
rate of unemployment or non-accelerating
inflation rate of unemployment (NAIRU), and
it will change over time.
Things that can change the full employment
unemployment rate are changing composition
of the workforce, the interaction of tax and
welfare systems, and hysteresis.
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Chapter 13: Inflation & unemployment



Hysteresis just means that the full
employment unemployment rate changes
with changes in employment.
When the economy comes out of recession,
for example, the insiders bid up wages to the
point that the company cannot afford as
many new people as it could at the end of the
last peak.
On the other hand, when people sit around
unemployed their skills dull, and it might be
hard to get a job when things pick up.
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Mod 5:
Macroeconomic Analysis
Chapter 14: simple macro model



Classical macroeconomic thinking was
dominated by Say’s Law, which said that
supply creates its own demand: production
creates just enough income to purchase it all.
It is based on the assumption that all prices,
including wages, are flexible, so that if it
didn’t work out, prices would drop, the
aggregate market would clear, and everyone
would remain employed.
Keynes put emphasis on the demand side
and said that aggregate expenditures =
C+I+G+(X – M) might not be enough for full
employment.
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Chapter 14: simple macro model



C and I are the major parts. C is more
stable because people tend to maintain
their lifestyles.
C depends on DI, personal income after
tax, which is split into C+S. C and S are
determined by MPC and MPS.
Non-income factors that affect C are
expectations, wealth, the price level and
interest rates.
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Chapter 14: simple macro model



The 2 main factors affecting I are expectations
of future returns and interest rates. Other
factors include technological change, capacity
utilization, and taxes.
G are autonomous expenditures, not varying in
a systematic way, depending on political
decisions.
G is a crucial in the Keynes policy prescription,
in that the government can use its expenditures
to kick start the economy and ride on the
multiplier effect for its expenditures.
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Chapter 14: simple macro model



X an M are affected by external economic
conditions and internal, respectively, and
both are also affected by exchange rates
and terms of trade.
At any given time, firms will be offering a
quantity of their products, based on their
expectations of demand, at certain prices
that they feel will be accepted and that will
earn them a reasonable profit. This is AS.
The willingness to purchase G&S is AD.
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Chapter 14: simple macro model


If AD is not big enough to take AS, then,
firms will experience unintended
inventory accumulation, and AS will be
adjusted for the next period.
Keynes believed that, at least when an
economy is operating below full
employment, that changes in the
equilibrium will be change in employment,
not a drop in prices and remaining
unemployment.
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Chapter 14: simple macro model



Keynes believed that prices are sticky,
especially labor. It is easier to lay off workers
than to ask them all to take a pay cut.
The Keynes cure for that state is for
government to increase spending to start the
economy out of recession.
The spending increase in G is enhanced by a
multiplier effect: the initial earnings get respent, and re-spent, and re-spent… and add
to demand, so a little government spending
can go a long way to increasing overall AD.
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The Keynes Cross

The AD line crosses the 45o-angle line, Y = RGDP =
Output: AD=output.
The multiplier effect makes output increase by more
than the initial addition to spending.
AD
Aggregate Demand

AD
ΔAD
45o
∆Output
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Real GDP
101
Chapter 14: simple macro model



The downward sloping of AD, real GDP
versus price level, is for different reasons
than a market’s demand curve.
The real balances (wealth) effect,
interest rate effect and net exports
effect affect C, I and X – M, respectively,
and cause AD to slope down.
Non-price level determinants of any of
the components will shift AD.
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Chapter 14: simple macro model




AS can shift from resource costs,
technology, tax/subsidies, and regulations,
which change production costs.
In the mid-range, cost push inflation is
shift left of AS, while demand pull
inflation comes from right shift of AD.
We can then look at interactions of
changes in AD and AS. The business
cycle is shifts of AD and AS over time.
AS meets AD in the next slide.
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Changes in AD-AS Equilibrium
Full
employment
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Chapter 15: monetary of financial system




Money has changed from things like beaver
pelts, seashells and precious metals
(commodity money) to paper fiat money
over the last several thousand years.
To be money, a thing must have the
following features: store of value, medium of
exchange, and unit of account.
It must have liquidity and be accepted by
everyone for any transaction
Other desirable features are scarcity,
portability, and divisibility.
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Chapter 15: monetary of financial system



Demand for money is formed from:
transactions, precautionary and speculative
motives.
Demand is inversely related to interest
rates.
When interest rates go up, people will want
less money: those who have extra will invest
it in bonds, for example, and some who need
to borrow will not because rates are too high.
And conversely.
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Chapter 15: monetary of financial system




Money supply definitions are numerous
and have some variation depending on
where you get the definitions.
The RBA makes money, and banks and
the RBA, together, create more.
The money base is currency in circulation
plus bank deposits at the RBA.
M1 is currency in the hands of the nonbank public plus checking account
deposits at banks.
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Chapter 15: monetary of financial system



M3 adds all other bank deposits of the
non-bank public plus M1.
Broad money is M3 plus the public’s
deposits at NBFI’s less currency and bank
deposits of NBFI’s.
The equilibrium interest rate is where
MD meets MS, and MS is fairly well fixed,
but can be changed by the RBA and
banks.
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MS meets MD & causal chains
Excess
Money
Demand
People
Sell
Bonds
Excess
Money
Supply
People
buy
bonds
Bond price
Falls
Rates rise
Bond prices
Up
Rates fall
Surplus
MD
MS
Shortage
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Chapter 15: monetary of financial system




Thus, the government can affect supply,
which affects interest rates.
Interest rates affect the quantity of money
demanded. I is affected. Thus, AD is already
affected.
When new equilibrium comes between
changed AD and stationary AS, prices and/or
employment might be affected.
We show causal chains and graphs in the
next few slides.
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The Causal Chain
Change in
Money
Policy
Change in
Price, GDP,
Employment
Change in
Money
Supply
Change in
Aggregate
Demand
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Change in
Interest
Rates
Change in
Investment
111
Graphical Chains
MS
Investment vs. Rates
Real GDP vs. Price level
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112
The Australian financial system.


At the base is the RBA, which is in charge
of system stability, monetary policy, and
the payments system (ESA’s). It also acts
as banker for the government.
Banks are plugged into the RBA. They
have capital and liquidity requirements, but
they can create money through fractional
reserve banking, which was invented by
goldsmiths, along with the first paper
money several hundred years ago in Italy.
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The Australian financial system.



They are used by the RBA to change MS
through open-market operations. They are
also financial intermediaries for other
intermediaries: NBFI’s.
There are also a few other types of
financial companies, like money market
funds and registered financial
corporations.
Those are financial institutions.
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The Australian financial system.


Then, there are financial markets where
ST MM instruments are traded, interbank or wholesale, stocks (corporate
equity certificates), bills (short-term debt
certificates), and bonds (LT debt
certificates) are brought to initial market
and traded (secondary market).
The foreign exchange markets deal with
the supply and demand for AUD versus
other countries’ currencies.
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The Australian financial system.


Financial and foreign exchange markets
are all about allocating savings to
investment and laying off risk. Financial
futures allow for further risk reduction.
The final layer of risk reduction and
speculation mechanisms in the system are
options, which are the right but not the
obligation to buy or sell something at a given
price by a specific future date. They allow
protection with the ability to profit if things
go the other way.
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Mod 6:
Macroeconomic Policy
Chapter 16: monetary policy
Monetary policy, managing the
money supply, will try to have a stable
currency which comes with low
inflation, stable economic growth, and
low unemployment.
 In Australia, the RBA has a stated
goal of keeping inflation in the 23% range, expecting the rest to
follow.

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Chapter 16: monetary policy
It achieves that goal by setting
targets for the overnight, inter-bank
cash rate that it wants the markets
to obey, or it will assist through
open market operations to change
MS to get its target.
 It has been found, through
international experiment, that it is
easier to set or target rates than to
manage MS.

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Open market operations
RBA
RBA sells
Securities; banks
Buy; bank deposits
at RBA decline
RBA buys
Securities; banks
Sell; deposits at
RBA increase
Banks
Banks have less money
They decrease loans
Raise interest rates
Banks have more money
They increase loans
Interest rates decline
Public
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Chapter 16: monetary policy
The Keynes view of policy is an
active role.
 The assumption of monetarists is
that money velocity is predictable
when it has been changing, in reality,
due to financial deregulation and
innovation over the past 30 years.
 Money velocity is how many times
the same dollar bill gets used in
transactions in a year.

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Chapter 16: monetary policy


Monetarists argue that it is better to stick
with target growth of the money supply
and not get involved with micromanagement because time lags might
lead to the wrong thing at the wrong time,
timing-wise.
The differences between what
Keynesians and monetarists believe
about policy transmission is shown in
the next slide.
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The Causal Chain: monetarist vs. Keynes
Monetarist Chain
Short circuit
Change in
Money
Policy
Change in
Price, GDP,
Employment
Extended, Keynes Route
Change in
Money
Supply
Change in
Aggregate
Demand
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2008
Change in
Interest
Rates
Change in
Investment
123
AD-AD response example


Suppose that the RBA tightens credit.
Then, AD will shift left, as shown, below.
Real GDP vs. Price level
AD1
AD2
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RBA in FX



Because the AUD is free floating, the RBA no
longer has need to be too involved in the FX
markets.
It will however engage in smoothing
operations, when the markets are
excessively volatile or testing, if it thinks that
there is too much speculative pressure on the
AUD.
Operations in the FX markets can also have
an affect on MS.
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Chapter 17: Fiscal policy





Governments are needed by society, at least
for the creation of public goods and services
(public works).
So, to pay for those expenditures, it needs
revenues.
That is basically the beginning of fiscal policy.
Then, there is discretionary fiscal policy is
supposed to be used to influence the
economy.
Governments can use taxes, subsidies, or
spending to affect economic activity.
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Chapter 17: Fiscal policy



If a government uses G to affect the
economy, there will be a multiplier effect of,
theoretically, AD = G/MPS. If it uses
taxes, the affect will be AD =
MPCDI/MPS.
To get the whole multiplier amount in actual
change in equilibrium AS meets AD, we must
be in the flat range of AS.
If we are in neo-classical, it will be part
increased RGDP and prices; if in the
classical, increased AD will just get increased
prices.
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Chapter 17: Fiscal policy


Since governments often spend more than
they take in in revenues, they can run
budget deficits, which has brought many
people around the world to make
governments act more fiscally responsible
and balance their budget.
Still, even a balanced budget can affect
the economy, but when we combine
changes from taxes and spending, from
above, we get a balanced budget
multiplier of 1.
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Chapter 17: Fiscal policy



Since taxes and spending, like
unemployment and welfare benefits will
automatically experience some changes in
the business cycle, some counteractive
fiscal policy to moderate the business
cycle is built in.
Beyond that, some governments build in
more, in automatic stabilizer policy to
specifically to counteract some of the affects
of ups and downs of the cycle.
An alternative approach to the demand-side
policy from above, there is supply-side
theory.
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Chapter 17: Fiscal policy



Supply-siders do things to foster growth of
supply by cutting regulations, contributing to
R&D for technological development, helping to
reducing costs of resources, decreasing taxes on
income and investment, and other subsidies.
Then, more quantity will be supplied at every
price, AS moves right, and the intersection with
demand will be at higher real GDP and lower
prices.
Other things governments can do are use GST to
tax consumption rather than income, which
encourages workers and savers.
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Chapter 17: Fiscal policy
It can create job networks to fight
unemployment.
 Domestic debt held by domestics is just
money out of one pocket into another.
 Government spending should focus on
accumulating public capital, that way the
debt is balanced against assets of the
people.

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Lecture
End of lecture part.
 Read the summary at home; it will
help.
 The description of the final exam is at
the back of the slides along with
review scheduling.

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In sum
Summary




Economics is based on psychology, logic
and a little math.
Scare resources must be allocated. There
are financial and opportunity costs.
The PPF shows the possibilities for
allocation to the supply side.
People want, so producers produce to
satisfy them and make a profit to satisfy
themselves. Consumers have sovereignty,
and they have decreasing marginal utility
for things.
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Summary


We look at psychology for the underlying
behavioral motivations of people in
economic circumstances as buyers or
sellers.
We use logic to set up causal chains, so
that we can imagine the chain of events
that relate one thing that happens in an
economy to ultimate logical outcomes.
Thus, we develop logical relationships
among variables.
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Summary


We use math to characterize those logical
relationships as best we can. Indeed, we rely
mostly on graphical analysis as the
mathematical framework. Actual equations are
so complicated as too be next to impossible, in
many cases, anyway.
For example, imagine trying to find the demand
schedule for hotdogs in New York City. We
would have to survey several million people or
some representative sample of people, ask them
how many hotdogs they would buy at various
prices, and in the end, would we really know the
demand?
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Summary




We looked at supply and demand in markets
as means of allocating the resources in.
Elasticity measures how demand and supply
change with various variables, which is a
good thing to know for producers.
Diminishing returns leads to marginal product
that peaks, leads to MC curves that cut ATC
at the minimum and become supply curves.
Then, MC=MR is where supply meets
demand.
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Summary


We apply these concepts to the aggregate
economy, using different psychology, and
analyzed AD, AS, MD, and MS. An we also
look at the ancillary affects: inflation and
unemployment, which are important variables
to society.
We looked at how markets can fail and how
governments try to get involved in them.
They can use tax, subsidy, public goods, and
regulation to do things and to change things
in individual or more general markets.
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Summary



We finished by looking at how else the
government becomes involved in the more
general economy.
It makes and controls the money, which is used
as the means to effect transactions in an
economy, so it has monetary policy that can
affect money supply, interest rates, and the
general economy.
Fiscal policy can be used to have government
expenditures and taxes that promote effective
use of economic resources to make good growth
with low inflation and unemployment, and
accumulate public capital.
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Marginal summary
Marginal
utility
Marginal
cost =
marginal
benefit
Decreasing Market
marginal
exactly
utility
clears
Law of
Demand
Marginals
Marginal
Marginal Marginal
Marginal
product
cost (MC) revenue (MR) propensity
(MP)
to
consume/s
ave
Decreasing Inversely Demand
% extra
marginal
related to curve for
DI spent
product
MP
perfect
and saved
competition
Equilibrium Law of
Above
MC = MR for
of S&D
Diminishing AVC it is max profits
returns
the supply
curve
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Used in
multiplier
for G and
tax cuts
141
Examination
The final examination will consist of one, two hour
paper requiring answers that draw from the study
material, text and assessments. It will contain three
sections; multiple choice questions, short answer
questions and extended response type questions,
with the following breakdown of marks.
Structure of the final examination

Question type
Number of questions
Weighting
Compulsory multiple
choice
20
25%
Compulsory short answers
3
15%
Extended response
questions
2 (of a possible 4)
30%
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Examination
Please note: the format of the examination will be
similar to that of past years. However, compared to
previous examinations, there will be fewer questions
and the time allowed has been reduced to two
hours.
 Sample questions will be provided on the course
home page on USQStudyDesk.
Past examination
 Copies of past examination papers and suggested
answers can be found on the course home page via
USQConnect study desk.

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END