PRODUCTION POSSIBILITIES

Transcription

1 Micro Review 1

2 Bikes PRODUCTION POSSIBILITIES How does the PPG graphically demonstrates scarcity, trade-offs, opportunity costs, and efficiency? A B Impossible/Unattainable (given current resources) C G Inefficient/ Unemployment D E Computers Efficient 2

3 The Circular Flow Model 3

4 Supply and Demand are put together to determine equilibrium price and equilibrium quantity Demand Schedule P Qd $5 10 $4 20 $3 30 P $ S Equilibrium Price = $3 (Qd=Qs) Supply Schedule P Qs $5 50 $4 40 $3 30 $ D $2 20 $1 80 o Q $1 10 Equilibrium Quantity is 30 4

5 Consumer and Producer s Surplus P $ $5 4 2 CS Calculate the area of: 1. Consumer Surplus 2. Producer Surplus 3. Total Surplus PS S 1. CS= $25 2. PS= $20 3. Total= $45 1 D Q 5

6 Double Shifts Suppose the demand for sports cars fell at the same time as production technology improved. Use S&D Analysis to show what will happen to PRICE and QUANTITY. If TWO curves shift at the same time, EITHER price or quantity will be indeterminate. 6

7 Government Involvement #1-Price Controls: Floors and Ceilings #2-Import Quotas #3-Subsidies #4-Excise Taxes 7

8 Maximum legal price a seller can charge for a product. Goal: Make affordable by keeping price from reaching Eq. Does this policy help consumers? Result: BLACK MARKETS P $ Price Ceiling Gasoline Shortage (Qd>Qs) S To have an effect, a price ceiling must be below equilibrium Price Ceiling D o Q

9 Price Floor Minimum legal price a seller can sell a product. Goal: Keep price high by keeping price from falling to Eq. P Corn $ S Surplus To have (Qd<Qs) an effect, 4 a price floor must be 3 Price Floor Does this policy help corn producers? above equilibrium 2 1 D o Q

10 Tax Practice 1. CS Before Tax 2. PS Before Tax 3. CS After Tax 4. PS After Tax 5. Tax Revenue for Government 6. Dead Weight Loss due to tax 7. Amount of tax revenue producers pay 10

11 3. Cross-Price Elasticity of Demand Cross-Price elasticity shows how sensitive a product is to a change in price of another good It shows if two goods are substitutes or compliments % change in quantity of product b % change in price of product a P increases 20% Q decreases 15% If coefficient is negative (shows inverse relationship) than the goods are complements If coefficient is positive (shows direct relationship) than the goods are substitutes

12 4. Income-Elasticity of Demand Income elasticity shows how sensitive a product is to a change in INCOME It shows if goods are normal or inferior % change in quantity % change in income Income increases 20%, and quantity decreases 15% then the good is a INFERIOR GOOD If coefficient is negative (shows inverse relationship) than the good is inferior If coefficient is positive (shows direct relationship) than the good is normal Ex: If income falls 10% and quantity falls 20%

13 Utility Maximizing Rule The consumer s money should be spent so that the marginal utility per dollar of each goods equal each other. MUx = MUy P x P y Assume apples cost $1 each and oranges cost $2 each. If the consumer has $7, identify the combination that maximizes utility. 13

14 Three Stages of Returns Stage I: Increasing Marginal Returns MP rising. TP increasing at an increasing rate. Why? Specialization. Total Product Total Product Quantity of Labor Marginal and Average Product Average Product Marginal Product Quantity of Labor 14

15 Three Stages of Returns Stage II: Decreasing Marginal Returns MP Falling. TP increasing at a decreasing rate. Why? Fixed Resources. Each worker adds less and less. Total Product Total Product Quantity of Labor Marginal and Average Product Average Product Marginal Product Quantity of Labor 15

16 Three Stages of Returns Stage III: Negative Marginal Returns MP is negative. TP decreasing. Workers get in each others way Total Product Total Product Quantity of Labor Marginal and Average Product Average Product Marginal Product Quantity of Labor 16

17 Average product and marginal product Costs (dollars) Relationship between Production and Cost Quantity of labor MP MC Why is the MC curve U- shaped? When marginal product is increasing, marginal cost falls. When marginal product falls, marginal costs increase. MP and MC are mirror images of each other. Quantity of output 17

18 Costs (dollars) Avera ma Relationship MP between Production and Cost Quantity of labor Why is the ATC curve U- MC shaped? When the marginal cost is below the average, it pulls ATC the average down. When the marginal cost is above the average, it pulls Quantity of output the average up. The MC curve intersects the ATC curve at its lowest point. Example: The average income in the room is $50,000. An additional (marginal) person enters the room: Bill Gates. If the marginal is greater than the average it pulls it up. Notice that MC can increase but still pull down the average. 18

19 LRATC Simplified The law of diminishing marginal returns doesn t apply in the long run because there are no FIXED RESOURCES. Costs Economies of Scale Constant Returns to Scale Diseconomies of Scale Long Run Average Cost Curve Quantity 19

20 Short-Run Profit Maximization What is the goal of every business? To Maximize Profit!!!!!! To maximum profit firms must make the right output Firms Profit should Maximizing continue to produce until Rule the additional revenue from each new output equals the additional MR=MC cost. Example (Assume the price is $10) Should you produce if the additional cost of another unit is $5 if the additional cost of another unit is $9 if the additional cost of another unit is $11 20

21 Profit Maximizing Rule MR = MC Three Characteristics of MR=MC Rule: 1. Rule applies to ALL markets structures (PC, Monopolies, etc.) 2. The rule applies only if price is above AVC 3. Rule can be restated P = MC for perfectly competitive firms (because MR = P) 21

22 Assume the market demand falls even more. If the price is lowered from $5 to $4 the firm should stop producing. Shut Down Rule: A firm should continue to produce as long as the price is above the AVC When the price falls below AVC then the firm should minimize its losses by shutting down Why? If the price is below AVC the firm is losing more money by producing than the they would have to pay to shut down. 22

23 Side-by-side graph for perfectly completive industry and firm. Is the firm making a profit or a loss? Why? P S P MC $15 $15 ATC MR=D AVC D 5000 Industry Q 8 Firm (price taker) Q 23

24 Cost and Revenue Where is the profit maximization point? How do you know? What output should be produced? What is TR? What is TC? How much is the profit or loss? Where is the Shutdown Point? $ Profit MC MR=P ATC AVC 10 Total Revenue Total Cost

25 Cost and Revenue Marginal Cost and Supply $ When price increases, quantity increases When price decrease, quantity decreases MC AVC = Supply ATC MC above AVC is the supply curve Q 25

26 Perfect Competition in the Long-Run You are a wheat farmer. You learn that there is a more profit in making corn. What do you do in the long run? 26

27 Side-by-side graph for perfectly completive industry and firm in the LONG RUN Is the firm making a profit or a loss? Why? P S P MC ATC $15 $15 MR=D D 5000 Industry Q 8 Firm (price taker) Q 27

28 Firm in Long-Run Equilibrium P Price = MC = Minimum ATC Firm making a normal profit MC ATC $15 TC = TR 8 MR=D There is no incentive to enter or leave the industry Q 28

29 Going from Long-Run to Short-Run 29

30 Firms enter to earn profit so supply increases in the industry Price decreases and quantity increases P S S 1 P MC $15 $15 $10 D Industry Q 8 Firm ATC MR=D Q 30

31 Price falls for the firm because they are price takers. Price decreases and quantity decreases P S S 1 P MC $15 $15 ATC MR=D $10 $10 MR 1 =D 1 D Industry Q 5 8 Firm Q 31

32 New Long Run Equilibrium at $10 Price Zero Economic Profit P S 1 P MC ATC $10 $10 MR 1 =D 1 D Q Industry Firm 32 5 Q

33 Going from Long-Run to Long-Run 33

34 Currently in Long-Run Equilibrium If demand increases, what happens in the short-run and how does it return to the long run? P S P MC ATC $15 $15 MR 1 =D 1 MR=D D 5000 Industry Q 8 Firm Q 34

35 Demand Increases The price increases and quantity increases Profit is made in the short-run P S P MC $20 $20 $15 $15 ATC MR 1 =D 1 MR=D D 1 D 5000 Industry Q 8 Firm 9 Q 35

36 Firms enter to earn profit so supply increases in the industry Price Returns to $15 P S S 1 P MC $20 $20 $15 $15 ATC MR 1 =D 1 MR=D D 1 D Industry Q 8 Firm 9 Q 36

37 Back to Long-Run Equilibrium The only thing that changed from long-run to long-run is quantity in the industry P S 1 P MC ATC $15 $15 MR=D D 1 D 7000 Industry Q 8 Firm Q 37

38 Productive Efficiency The production of a good in a least costly way. (Minimum amount of resources are being used) Graphically it is where Price = Minimum ATC 38

39 Allocative Efficiency Producers are allocating resources to make the products most wanted by society. Graphically it is where Price = MC Why? Price represents the benefit people get from a product. 39

40 Price What if the firm makes 15 units? MC $5 MR The marginal benefit to $3 society is greater the marginal cost. Not enough produced. Society wants more Underallocation Quantity of resources 40

41 Price What if the firm makes 22 units? $7 MC $5 MR The marginal benefit to society is less than the marginal cost. Too much Produced. Society wants less Overallocation of Quantity resources 41

42 Price Long-Run Equilibrium MC ATC P D=MR P = Minimum ATC = MC EXTREMELY EFFICIENT!!!! Q Quantity 42

43 Drawing Monopolies 43

44 Good news 1.Only one graph because the firm IS the industry. 2.The cost curves are the same 3.The MR= MC rule still applies 4.Shut down rule still applies 44

45 The Main Difference Monopolies (and all Imperfectly competitive firms) have downward sloping demand curve. Which means, to sell more a firm must lower its price. This changes MR THE MARGINAL REVENUE DOESN T EQUAL THE PRICE! 45

46 Demand and Marginal Revenue Curves What happens to TR when MR hits zero? P $ TR $ D Q MR Total Revenue is at it s peak when MR hits zero TR Q 46

47 Elastic and Inelastic Range Total Revenue Test If price falls and TR increases then demand is elastic. Total Revenue Test If price falls and TR falls then demand is inelastic. P $15 10 TR 5 $ Elastic Inelastic D Q MR TR A monopoly will only produce in the elastic range Q 47

48 What output should this monopoly produce? MR = MC How much is the TR, TC and Profit or Loss? P $9 8 MC ATC 7 6 Profit =$6 5 4 D 3 2 MR Q 48

49 Conclusion: A monopolists produces where MR=MC, buts charges the price consumer are willing to pay identified by the demand curve. P $ MC ATC D MR Q 49

50 What if cost are higher? How much is the TR, TC, and Profit or Loss? P MC ATC $ MR Q AVC D TR= $90 TC= $100 Loss=$10 50

51 Identify and Calculate: TR= TC= Profit/Loss= Profit/Loss per Unit= P MC $70 $56 $14 $2 $ Q ATC D MR 51

52 Are Monopolies Efficient? 52

53 Monopolies vs. Perfect Competition P S = MC P pc CS PS In perfect competition, CS and PS are maximized. D Q pc Q 53

54 Monopolies vs. Perfect Competition P S = MC P m P pc At MR=MC, A monopolist will produce less and charge a higher price D Q m Q pc MR Q 54

55 Monopolies vs. Perfect Competition P Where is CS and PS for a monopoly? S = MC P m CS PS Total surplus falls. Now there is DEADWEIGHT LOSS Monopolies underproduce and over charge, decreasing CS and increasing PS. Q m MR D Q 55

56 Are Monopolies Productively Efficient? Does Price = Min ATC? P $ No. They are not producing at the lowest cost (min ATC) MC MR Q ATC D 56

57 Are Monopolies Allocatively Efficiency? Does Price = MC? P $ No. Price is greater. The monopoly is under producing. Monopolies are NOT efficient! D MC MR Q ATC 57

58 Regulating Monopolies 58

59 Why Regulate? Why would the government regulate an monopoly? 1. To keep prices low 2. To make monopolies efficient How do they regulate? Use Price controls: Price Ceilings Why don t taxes work? Taxes limit supply and that s the problem 59

60 Where should the government place the price ceiling? 1.Socially Optimal Price P = MC (Allocative Efficiency) OR 2. Fair-Return Price (Break Even) P = ATC (Normal Profit) 60

61 P Regulating Monopolies Where does the firm produce if it is unregulated? MC P m ATC D MR Q m Q 61

62 Regulating Monopolies Socially Price Optimal Ceiling at = Allocative Socially Optimal Efficiency P MC P m P so ATC D MR Q m Q so Q 62

63 Regulating Monopolies Fair Return Price Ceiling means at no Fair economic Return profit P MC P m P so P fr ATC D MR Q m Q so Q fr Q 63

64 Regulating Monopolies P P m P so P fr Unregulated Socially Optimal MR MC Fair Return ATC D Q m Q so Q fr Q 64

65 Regulating a Natural Monopoly What happens if the government sets a price ceiling to get the socially optimal quantity? P The firm would make a loss and would require a subsidy P so MC ATC MR Q socially optimal D Q 65

66 Drawing Monopolistic Competition 66

67 Monopolistic Competition is made up of prices makers so MR is less than Demand In the short-run, it is the same graph as a P monopoly making profit MC ATC P 1 In the long-run, new firms will enter, driving down the DEMAND for firms already in the market. Q 1 MR Q D 67

68 Firms enter so demand falls until there is no economic profit P MC ATC P 1 D MR Q 1 Q 68

69 Firms enter so demand falls until there is no economic profit Price and quantity falls and TR=TC P MC ATC P LR D Q LR MR Q 69

70 LONG-RUN EQUILIBRIUM Quantity where MR =MC up to Price = ATC P MC ATC P LR D Q LR MR Q 70

71 What happens when there is a loss? In the short-run, the graph is the same as a monopoly making a loss ATC P MC P 1 In the long-run, firms will leave, driving up the DEMAND for firms already in the market. Q 1 MR Q D 71

72 Firms leave so demand increases until there is no economic profit P MC ATC P 1 D MR Q 1 Q 72

73 Firms leave so demand increases until there is no economic profit Price and quantity increase and TR=TC P P LR MC ATC D Q LR MR Q 73

74 Are Monopolistically Competitive Firms Efficient? 74

75 LONG-RUN EQUILIBRIUM Not Allocatively Efficient because P MC Not Productively Efficient because not producing at Minimum ATC P MC ATC P LR D MR Q LR Q Socially Optimal Q 75

76 LONG-RUN EQUILIBRIUM This firm also has EXCESS CAPACITY P MC ATC P LR D MR Q LR Q Socially Optimal Q 76

77 Excess Capacity Given current resources, the firm can produce at the lowest costs (minimum ATC) but they decide not to. The gap between the minimum ATC output and the profit maximizing output. Not the amount underproduced 77

78 LONG-RUN EQUILIBRIUM The firm can produce at a lower cost but it holds back production to maximize profit P MC ATC P LR Excess Capacity MR D Q LR Q Prod Efficient Q 78

79 Oligopoly

80 Game Theory The study of how people behave in strategic situations An understanding of game theory helps firms in an oligopoly maximize profit.

81 Game Theory Matrix You and your partner are competing firms. You have one of two choices: Price High or Price Low. Without talking, write down your choice High Firm 2 Low Firm 1 High Low Both High = $20 Each High = 0 Low = $30 Low = $30 High = 0 Both Low= $10 each

82 Game Theory Matrix Notice that you have an incentive to collude but also an incentive to cheat on your agreement High Firm 2 Low Firm 1 High Low Both High = $20 Each High = 0 Low = $30 Low = $30 High = 0 Both Low= $10 each

83 Dominant Strategy The Dominant Strategy is the best move to make regardless of what your opponent does What is each firm s dominate strategy? High Firm 2 Low No Dominant Strategy Firm 1 High $100, $50 $50, $90 Low $80, $40 $20, $10

84 Oligopoly Graphs

85 Because firms are interdependent There are 3 types of Oligopolies 1. Price Leadership (no graph) 2. Colluding Oligopoly 3. Non Colluding Oligopoly

86 Colluding Oligopolies

87 Cartel = Colluding Oligopoly A cartel is a group of producers that create an agreement to fix prices high. 1. Cartels set price and output at an agreed upon level 2. Firms require identical or highly similar demand and costs 3. Cartel must have a way to punish cheaters 4. Together they act as a monopoly

88 Firms in a colluding oligopoly act as a monopoly and share the profit P MC ATC D MR Q

89 #3. Non-Colluding Oligopolies

90 Kinked Demand Curve Model The kinked demand curve model shows how noncollusive firms are interdependent If firms are NOT colluding they are likely to react to competitor s pricing in two ways: 1. Match price-if one firm cuts it s prices, then the other firms follow suit causing inelastic demand 2. Ignore change-if one firm raises prices, others maintain same price causing elastic demand

91 If this firm increases it s price, other firms will ignore it and keep prices the same As the only firm with high prices, Qd for this firm will decrease a lot P P 1 P e Q 1 Q e D Q

92 If this firm decreases it s price, other firms will match it and lower their prices Since all firms have lower prices, Qd for this firm will increase only a little P P 1 P e P 2 Q 1 Q e Q 2 D Q

93 Where is Marginal Revenue? MR has a vertical gap at the kink. The result is that MC can move and Qe won t change. Price is sticky. P P e MC Q MR D Q

94 The Resource Market (aka: The Factor Market or Input Market) 94

95 Perfectly Competitive Labor Market and Firm Wage S L Wage $10? 5000 Industry D L Q Firm Q

96 Marginal Resource Cost (MRC) The additional cost of an additional resource (worker). In perfectly competitive labor markets the MRC equals the wage set by the market and is constant. Ex: The MRC of an unskilled worker is $8.75. Another way to calculate MRC is: Marginal Resource Cost = Change in Total Cost Change in Inputs 96

97 Marginal Revenue Product The additional revenue generated by an additional worker (resource). In perfectly competitive product markets the MRP equals the marginal product of the resource times the price of the product. Ex: If the Marginal Product of the 3 rd worker is 5 and the price of the good is constant at $20 the MRP is. $100 Another way to calculate MRP is: Marginal Revenue Product = Change in Total Revenue Change in Inputs 97

98 Side-by-side graph showing Market and Firm Wage S L Wage W E S L =MRC Q E Industry D L Q Q e Firm D L =MRP Q

99 Who demands labor? FIRMS demand labor. Demand for labor shows the quantities of workers that firms will hire at different wage rates. Market Demand for Labor is the sum of each firm s MRP. Wage As wage falls, Qd increases. As wage increases, Qd falls. DL Quantity of Workers 99

100 Who supplies labor? Individuals supply labor. Supply of labor is the number of workers that are willing to work at different wage rates. Higher wages give workers incentives to leave other industries or give up leisure activities. Wage Labor Supply As wage increases, Qs increases. As wage decreases, Qs decreases. Quantity of Workers 100

101 Equilibrium Wage (the price of labor) is set by the market. EX: Supply and Demand for Carpenters Wage Labor Supply $30hr Labor Demand = MRP Quantity of Workers 101

102 102 Individual Firms Wage S L =MRC D L =MRP Q e Q

103 Yesterday's Activity Units of Labor Total Product (Output) Marginal Product (MP) Product Price Price = $10 MRP Wage = $ Shows how many workers a firm is willing and able to hire at different wages. 103

104 Use the following data: Units of Labor Total Product (Output) Marginal Product (MP) Product Price Price = $10 MRP Wage = $ Demand for this resource Plotting the MRP/Demand curve 104

105 Demand=MRP Wage Rate $ Why is it downward sloping? Because of the law of diminishing marginal returns Each additional resource is less productive and therefore is worth less than the previous one D=MRP Quantity of Workers Q 105

106 Demand=MRP Wage Rate $ This model applies to land, labor, and capital Notice the inverse relationship between wage and quantity of resources demand D=MRP Quantity of Workers Q 106

107 What happens if demand for the product Wage Rate $100 increases? MRP increases causing demand to shift right D 1 =MRP 1 D=MRP Quantity of Workers Q 107

108 3 Shifters of Resource Demand 1.) Changes in the Demand for the Product Price increase of the product increases MRP and demand for the resource. 2.) Changes in Productivity Technological Advances increase Marginal Product and therefore MRP/Demand. 3.) Changes in Price of Other Resources Substitute Resources Ex: What happens to the demand for assembly line workers if price of robots falls? Complementary Resources Ex: What happens to the demand nails if the price of lumber increases significantly? 108

109 3 Shifters of Resource Demand Identify the Resource and Shifter (ceteris paribus): 1. Increase in demand for microprocessors leads to a(n) in the demand for processor assemblers. 2. Increase in the price for plastic piping causes the demand for copper piping to. 3. Increase in demand for small homes (compared to big homes) leads to a(n) the demand for lumber. 4. For shipping companies, in price of trains leads to decrease in demand for trucks. 5. Decrease in price of sugar leads to a(n) in the demand for aluminum for soda producers. 6. Substantial increase in education and training leads to an in demand for skilled labor. 109

110 3 Shifters of Resource Demand Identify the Resource and Shifter (ceteris paribus): 1. Increase in demand for microprocessors leads to a(n) increase in the demand for processor assemblers. 2. Increase in the price for plastic piping causes the demand for copper piping to. increase 3. Increase in demand for small homes (compared to big homes) leads to a(n) decrease the demand for lumber. 4. For shipping companies, decrease in price of trains leads to decrease in demand for trucks. 5. Decrease in price of sugar leads to a(n) increase in the demand for aluminum for soda producers. 6. Substantial increase in education and training leads to an increase in demand for skilled labor. 110

111 Resource Supply Shifters Supply Shifters for Labor 1. Number of qualified workers Education, training, & abilities required 2. Government regulation/licensing Ex: What if waiters had to obtain a license to serve food? 3. Personal values regarding leisure time and societal roles. Ex: Why did the US Labor supply increase during WWII? Why do some occupations get paid more than others?

112 Wage is set by the market Demand/MRP falls Wage S L Wage W E S L =MRC Q E Industry D L Q Q e Firm D L =MRP Q

113 What happens to the wage and quantity in the market and firm if new workers enter the industry? Wage S L Wage W E S L =MRC Q E Industry D L Q Q e Firm D L =MRP Q

114 What happens to the wage and quantity in the market and firm if new workers enter the industry? Wage S L S L1 Wage W E W 1 S L =MRC S L1 =MRC1 Q E Q 1 Industry D L Q Q e Q 1 Firm D L =MRP Q

115 Minimum Wage Assume the government was interest in increasing the federal minimum wage to $12 an hour Do you support this new law? Why or why not 115

116 Wage Fast Food Cooks S $12 $8 $6 The government wants to help workers because the equilibrium wage is too low D Q Labor 116

117 Wage Fast Food Cooks S $12 $8 $6 Government sets up a WAGE FLOOR. Where? D Q Labor 117

118 Wage Minimum Wage S $12 $8 Above Equilibrium! $ D Q Labor 118

119 Wage Minimum Wage Surplus of workers (Unemployment) S $12 $8 $6 What s the result? Q demanded falls. Q supplied increases D Q Labor 119

120 Assume that this firm CAN T wage discriminate and must pay each worker the same wage. Wage rate (per hour) Acme Coal Mining Co. Number of Workers Marginal Resource Cost $ MRC doesn t $ equal wage

121 Monopsony If the firm can t wage discriminate, where is MRC? Wage MRC S L W E D L =MRP Q E

122 Market Failures and the Role of the Government 122

123 The Four Market Failures We will focus on four different market failures: 1. Public Goods 2. Externalities (third person side effects) 3. Monopolies 4. Unfair distribution of income In each of the above situations, the government step in to allocate resources efficiently. 123

124 Market Failure #1: PUBLIC GOODS

125 Public Goods Why must the government provide public goods and services? It is impractical for the free-market to provided these goods because there is little opportunity to earn profit. This is due to the Free-Rider Problem Free Riders are individuals that benefit without paying. 125

126 What s wrong with Free Riders? Free-Riders keep firms from making profits. If left to the free market, essential services would be under produced. To solve the problem, the government can: 1. Find new ways to punish free-riders. 2. Use tax dollars to provide the service to everyone. 126

127 Supply and Demand for Public Parks Price $ The Demand is the equal to the marginal benefit to society 3 1 D=MSB Quantity of Parks

128 Price Supply and Demand for Public Parks $ The supply is the public good s marginal cost to society 1. What if the government made 1 park? 2. What if the government made 4 parks? D=MSB Quantity of Parks MSB = MSC S=MSC

129 Market Failure #2: EXTERNALITIES 129

130 What are Externalities? An externality is a third-person side effect. There are EXTERNAL benefits or external costs to someone other than the original decision maker. Why are Externalities Market Failures? The free market fails to include external costs or external benefits. With no government involvement there would be too much of some goods and too little of others. Example: Smoking Cigarettes. The free market assumes that the cost of smoking is fully paid by people who smoke. The government recognizes external costs and makes policies to limit smoking. 130

131 Negative Externalities (aka: Spillover Costs) Situation that results in a COST for a different person other than the original decision maker. The costs spillover to other people or society. Example: Zoram is a chemical company that pollutes the air when it produces its good. Zoram only looks at its INTERNAL costs. The firms ignores the social cost of pollution So, the firm s marginal cost curve is its supply curve When you factor in EXTERNAL costs, Zoram is producing too much of its product. The government recognizes this and limits production. 131

132 Market for Cigarettes The marginal private cost doesn t include the P costs to society. Supply = Marginal Private Cost D=MSB Q Q Free Market 132

133 Market for Cigarettes What will the MC/Supply look like when EXTERNAL cost are factor in? P Supply = Marginal Social Cost Supply = Marginal Private Cost Q Optimal D=MSB Q Q Free Market 133

134 P Market for Cigarettes If the market produces Q FM why is it a market failure? S =MSC Overallocation Q Optimal S=MPC At Q FM the MSC is greater than the MSB. Too much is being produced D=MSB Q Q Free Market 134

135 Market for Cigarettes What should the government do to fix a negative P externality? S =MSC S=MPC Solution: Tax the amount of the externality (Per Unit Tax) Q Optimal D=MSB Q Q Free Market 135

136 Market for Cigarettes What should the government do to fix a negative P externality? S =MSC =MPC MSB = MSC S=MPC Solution: Tax the amount of the externality (Per Unit Tax) Q Optimal D=MSB Q Q Free Market 136

137 Positive Externalities (aka: Spillover Benefits) Situations that result in a BENEFIT for someone other than the original decision maker. The benefits spillover to other people or society. (EX: Flu Vaccines, Education, Home Renovation) Example: A mom decides to get a flu vaccine for her child Mom only looks at the INTERNAL benefits. She ignores the social benefits of a healthier society. So, her private marginal benefit is her demand When you factor in EXTERNAL benefits the marginal benefit and demand would be greater. The government recognizes this and subsidizes flu shots. 137

138 Market for Flu Shots The marginal private benefit doesn t include P the additional benefits to society. S = MSC D=Marginal Private Benefit Q Q Free Market 138

139 Market for Flu Shots What will the MB/D look like when EXTERNAL P benefits are factor in? S = MSC D=Marginal Social Benefit D=Marginal Private Benefit Q Q FM Q Optimal 139

140 P Market for Flu Shots If the market produces Q FM why is it a market failure? S = MSC D=Marginal Social Benefit D=MSB Q FM Q Optimal Q 140

141 Market for Flu Shots P At Q FM the MSC is less than the MSB. Too little is being produced S = MSC Underallocation D=Marginal Social Benefit Q FM Q Optimal Q 141

142 P Market for Flu Shots What should the government do to fix a negative externality? Subsidize the amount of the externality (Per Unit Subsidy) S = MSC D=MSB =MPB D=MPB Q Q FM Q Optimal 142

143 Market Failure #3 Monopolies 143

144 Monopoly Monopoly Review 1. Draw a monopoly making a profit. Label price, output, and profit. 2. Identify three specific reasons why monopolies are bad. 3. Label the Fair Return price and output. 4. Label the Socially Optimal price and output. 5. Explain why taxing a monopoly is a bad idea. 144

145 Monopoly P Unregulated Socially Optimal $ Profit =$5 MC MR ATC Fair Return D Q 145

146 Market Failure #4 Unfair Distribution of Wealth Net Worth over $2.3 billion 146

147 Percent of Income The Lorenz Curve Lorenz Curve (actual distribution) Perfect Equality Percent of Families The size of the banana shows the degree of income inequality. 147

148 Percent of Income The Lorenz Curve After Distribution Perfect Equality Percent of Families The banana gets smaller when the government redistributes income 148

149 MACRO Review 149

150 For all countries there are three major economic goals: 1. Promote Economic Growth 2. Limit Unemployment 3. Keep Prices Stable (Limit Inflation) In this unit we will analyze how each of these are measured. 150

151 Goal #1 Promote Economic Growth How does a country measure economic growth? 151

152 How can you measure growth from year to year? % Change in GDP = Year 2 - Year 1 Year 1 X 100 Mordor s GDP in 2007 was $4000 Mordor s GDP in 2008 was $5000 What is the % Change in GDP? Transylvania s GDP in 2007 was $2,000 Transylvania s GDP in 2008 was $2,100 What is the % Change in GDP? 152

153 Calculating GDP Two Ways of calculating GDP: 1. Expenditures Approach-Add up all the spending on final goods and services produced in a given year. 2. Income Approach-Add up all the income that resulted from selling all final goods and services produced in a given year. Both ways generate the same amount since every dollar spent is a dollar of income. 153

154 Expenditures Approach Four components of GDP: 1. Consumer Spending Ex: $5 Little Caesar's Pizza 2. Investments -When businesses put money back into their own business. Ex: Machinery or tools 3. Government Spending Ex: Bombs or tanks, NOT social security 4. Net Exports -Exports (X) Imports (M) Ex: Value of 3 Ford Focuses minus 2 Hondas GDP = C + I + G + X n 154

155 Real vs. Nominal GDP Nominal GDP is GDP measured in current prices. It does not account for inflation from year to year. Real GDP is GDP expressed in constant, or unchanging, dollars. Real GDP adjusts for inflation. REAL GDP IS THE BEST MEASURE OF ECONOMIC GROWTH! 155

156 Does GDP accurately measure standard of living? Standard of living (or quality of life) can be measured, in part, by how well the economy is doing But it needs to be adjusted to reflect the size of the nation s population. Real GDP per capita (per person) Real GDP per capita is real GDP divided by the total population. It identifies on average how many products each person makes. Real GDP per capita is the best measure of a nation s standard of living. 156

157 THE BUSINESS CYCLE 157

158 THE BUSINESS CYCLE The national economy fluctuates resulting in periods of boom and bust. Inflation Unemployment Full employment A Recession is 6 month period of decline in output, income, employment, and trade. (If really bad then depression) 158

159 Goal #2 Limit Unemployment 159

160 What is Unemployment? The Unemployment rate The percent of people in the labor force who want a job but are not working. Unemployment rate # unemployed = x # in labor force 100 Who is in the Labor Force? Above 16 years old Able and willing to work Not institutionalized (jails, hospitals) Not in military, in school full time, or retired Why is a stay at home mom not unemployed? 160

161 3 Types of Unemployment #1. Frictional Unemployment Temporarily unemployed or being between jobs. Individuals are qualified workers with transferable skills but they aren t working. Examples: High school or college graduates looking for jobs. Individuals that were fired and are looking for a better job. You re Fired! 161

162 3 Types of Unemployment Seasonal Unemployment This is a specific type of frictional unemployment which is due to time of year and the nature of the job. These jobs will come back Examples: Professional Santa Clause Impersonators Construction workers in Michigan 162

163 3 Types of Unemployment #2. Structural Unemployment Changes in the structure of the labor force make some skills obsolete. Workers DO NOT have transferable skills and these jobs will never come back. Workers must learn new skills to get a job. The permanent loss of these jobs is called creative destruction. (Why?) Examples: VCR repairmen Carriage makers 163

164 3 Types of Unemployment Technological Unemployment Type of structural unemployment where automation and machinery replace workers causing unemployment Examples: Auto assemblers fired as robots take over production Producers of Capital Goods (tractors) fire assemblers 164

165 #3 Cyclical Unemployment Unemployment that results from economic downturns (recessions). As demand for goods and services falls, demand for labor falls and workers are fired. Examples: 3 Types of Unemployment Steel workers laid off during recessions. Restaurant owners fire waiters after months of poor sales due to recession. This sucks! 165

166 The Natural Rate an Full Employment Two of the of the three types of unemployment are unavoidable: Frictional unemployment Structural unemployment Together they make up the natural rate of unemployment (NRU). We are at full employment if we have only the natural rate of unemployment. This is the normal amount of unemployment that we SHOULD have. The number of jobs seekers equals the number of jobs vacancies. 166

167 The Natural Rate an Full Employment In other words Full employment means NO Cyclical unemployment! Economists generally agree that an unemployment rate of around 4 to 6 percent is normal. 4-6% Unemployment = Full Employment Currently the U.S. is at % California is at % 167

168 Criticisms of the Unemployment Rate What is wrong with the unemployment rate? It can misdiagnose the actual unemployment rate because of the following: Disgruntled job seekers- Some people are no longer looking for a job because they have given up. Part-Time Workers- Someone who wants more shifts but can t get them is still considered employed. Race/Age Inequalities- Hispanics 5.8% for January African American- 8.9% for January Teenagers- 15.3% for January Illegal Labor- Many people work under the table. 168

169 Goal #3 LIMIT INFLATION Country and Time- Zimbabwe, 2008 Annual Inflation Rate- 79,600,000,000% Time for Prices to Double hours

170 What is Inflation? Inflation is rising general level of prices Inflation reduces the purchasing power of money Examples: It takes $2 to buy what $1 bought in 1982 It takes $6 to buy what $1 bought in 1961 When inflation occurs, each dollar of income will buy fewer goods than before.

171 Hurt by Inflation Make a T-Chart Helped by Inflation Lenders-People who lend money (at fixed interest rates) People with fixed incomes Savers Debtors-People who borrow money A business where the price of the product increases faster than the price of resources Cost-of-Living-Adjustment (COLA) Some works have salaries that mirror inflation. They negotiated wages that rise with inflation

172 Measuring Inflation Consumer Price Index (CPI)

173 Consumer Price Index (CPI) The most commonly used measurement inflation for consumers is the Consumer Price Index Here is how it works: The base year is given an index of 100 To compare, each year is given an index # as well CPI = Price of market basket Price of market basket in base year x Market Basket: Movie is $6 & Pizza is $14 Total = $20 (Index of Base Year = 100) 2009 Market Basket: Movie is $8 & Pizza is $17 Total = $25 (Index of 125 ) This means inflation increased 25% b/w 97 & 09 Items that cost $100 in 97 cost $125 in 09

174 CPI vs. GDP Deflator The GDP deflator measures the prices of all goods produced, whereas the CPI measures prices of only the goods and services bought by consumers. An increase in the price of goods bought by firms or the government will show up in the GDP deflator but not in the CPI. The GDP deflator includes only those goods and services produced domestically. Imported goods are not a part of GDP and therefore don t show up in the GDP deflator. GDP Deflator Nominal GDP = Real GDP x 100 If the nominal GDP in 09 was 25 and the real GDP (compared to a base year) was 20 how much is the GDP Deflator?

175 Problems with the CPI 1. Substitution Bias- As prices increase for the fixed market basket, consumers buy less of these products and more substitutes that may not be part of the market basket. (Result: CPI may be higher than what consumers are really paying) 2. New Products- The CPI market basket may not include the newest consumer products. (Result: CPI measures prices but not the increase in choices) 3. Product Quality- The CPI ignores both improvements and decline in product quality. (Result: CPI may suggest that prices stay the same though the economic well being has improved significantly)

176 Calculating CPI Year Units of Output Price Per Unit $ Nominal, GDP Real, GDP CPI/ GDP Deflator (Year 1 as Base Year) Inflation Rate Make year one the base year CPI Price of market basket in = the particular year Price of the same market basket in base year x 100

177 Calculating CPI Year Units of Output Price Per Unit $ Nominal, GDP $ Real, GDP $ CPI/ GDP Deflator (Year 1 as Base Year) Inflation Rate N/A 25% 20% 33.33% -50% % Change in Prices = Inflation Rate Year 2 - Year 1 Year 1 X 100

178 Calculating GDP Deflator GDP Deflator Nominal GDP = Real GDP x 100 Nominal GDP Deflator (Real GDP) = 100

179 Calculations 1. In an economy, Real GDP (base year = 1996) is $100 billion and the Nominal GDP is $150 billion. Calculate the GDP deflator. 2. In an economy, Real GDP (base year = 1996) is $125 billion and the Nominal GDP is $150 billion. Calculate the GDP deflator. 3. In an economy, Real GDP for year 2002 (base year = 1996) is $200 billion and the GDP deflator 2002 (base year = 1996) is 120. Calculate the Nominal GDP for In an economy, Nominal GDP for year 2005 (base year = 1996) is $60 billion and the GDP deflator 2005 (base year = 1996) is 120. Calculate the Real GDP for 2005.

180 3 Causes of Inflation 1. The Government Prints TOO MUCH Money (The Quantity Theory) Governments that keep printing money to pay debts end up with hyperinflation. There are more rich people but the same amount of products. Result: Banks refuse to lend and GDP falls Examples: Bolivia, Peru, Brazil Germany after WWI

181 3 Causes of Inflation 2. DEMAND-PULL INFLATION Too many dollars chasing too few goods DEMAND PULLS UP PRICES!!! Demand increases but supply stays the same. What is the result? A Shortage driving prices up An overheated economy with excessive spending but same amount of goods.

182 3 Causes of Inflation 3. COST-PUSH INFLATION Higher production costs increase prices A negative supply shock increases the costs of production and forces producers to increase prices. Examples: Hurricane Katrina destroyed oil refineries and causes gas prices to go up. Companies that use gas increase their prices.

183 The Wage-Price Spiral A Perpetual Process: 1.Workers demand raises 2.Owners increase prices to pay for raises 3. High prices cause workers to demand higher raises 4. Owners increase prices to pay for higher raises 5. High prices cause workers to demand higher raises 6. Owners increase prices to pay for higher raises

184 Unit 3: Aggregate Demand and Supply and Fiscal Policy 184

185 Price Level Aggregate Demand Curve AD is the demand by consumers, businesses, government, and foreign countries What definitely doesn t shift the curve? Changes in price level cause a move along the curve AD = C + I + G + Xn Real domestic output (GDP R ) 185

186 Shifters of Aggregate Demand GDP = C + I + G + X n 186

187 Aggregate Supply Curve Price Level AS AS is the production of all the firms in the economy Real domestic output (GDP R ) 187

188 Long run Aggregate Supply In Long Run, price level increases but GDP doesn t Price level LRAS Long-run Aggregate Supply Full-Employment (Trend Line) Q Y GDP R We also assume that in the long run the economy will be producing at full employment. 188

189 Shifters Aggregate Supply I. R. A. P.

190 Shifters of Aggregate Supply 1. Change in Inflationary Expectations If an increase in AD leads people to expect higher prices in the future. This increases labor and resource costs and decreases AS. (If people expect lower prices ) 2. Change in Resource Prices Prices of Domestic and Imported Resources (Increase in price of Canadian lumber ) (Decrease in price of Chinese steel ) Supply Shocks (Negative Supply shock ) (Positive Supply shock ) 190

191 Shifters of Aggregate Supply 3. Change in Actions of the Government (NOT Government Spending) Taxes on Producers (Lower corporate taxes ) Subsides for Domestic Producers (Lower subsidies for domestic farmers ) Government Regulations (EPA inspections required to operate a farm ) 4. Change in Productivity Technology (Computer virus that destroy half the computers ) (The advent of a teleportation machine ) 191

192 Inflationary and Recessionary Gaps 192

193 Price Level Inflationary Gap Output is high and unemployment is less than NRU LRAS AS PL 1 Actual GDP above potential GDP AD 1 Q Y Q 1 GDP R 193

194 Example: Assume the price of oil increases drastically. What happens to PL and Output? Price Level LRAS AS 1 AS PL 1 PL e Stagflation Stagnate Economy + Inflation AD Q 1 Q Y GDP R 194

195 Recessionary Gap Output low and unemployment is more than NRU Price Level LRAS AS 1 PL 1 Actual GDP below potential GDP AD Q 1 Q Y GDP R 195

196 Classical Adam Smith vs. Keynesian John Maynard Keynes

197 Debates Over Aggregate Supply Classical Theory 1. A change in AD will not change output even in the short run because prices of resources (wages) are very flexible. 2. AS is vertical so AD can t increase without causing inflation. Price level AS Recessions caused by a fall in AD are temporary. Price level will fall and economy will fix itself. No Government Involvement Required AD AD 1 Q f Real domestic output, GDP 197

198 Debates Over Aggregate Supply Keynesian Theory 1. A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. 2. Increase in AD during a recession puts no pressure on prices Price level AS AD Q f Real domestic output, GDP 198

199 Debates Over Aggregate Supply Keynesian Theory 1. A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. 2. Increase in AD during a recession puts no pressure on prices Price level AS Sticky Wages prevents wages to fall. The government should increase spending to close the gap AD 1 AD Q 1 Q f Real domestic output, GDP 199

200 Debates Over Aggregate Supply Keynesian Theory 1. A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible. 2. Increase in AD during a recession puts no pressure on prices Price level AS When there is high unemployment, an increase in AD doesn t lead to higher prices until you get close to full employment AD AD AD Q 1 Q f Real domestic output, GDP 200

201 Three Ranges of Aggregate Supply 1. Keynesian Range- Horizontal at low output 2. Intermediate Range- Upward sloping 3. Classical Range- Vertical at Physical Capacity Price level Keynesian Range AS Classical Range Intermediate Range Q f 201 Real domestic output, GDP

202 The Phillips Curve Shows tradeoff between inflation and unemployment. What happens to inflation and unemployment when AD increase?

203 Short Run Phillips Curve When the economy is overheating, there is low unemployment but high inflation Inflation 5% When there is a recession, unemployment is high but inflation is low 1% 2% 9% SRPC Unemployment 203

204 Short Run Phillips Curve What happens when AS falls causing stagflation? Increase in unemployment and inflation Inflation 5% 1% 2% 9% SRPC 1 SRPC Unemployment 204

205 Short Run vs. Long Run What happens when AD increases? Inflation 5% 3% What happens in the long run? Long Run Phillips Curve In the long run, wages and resource prices increase. AS falls. SRPC shifts right. 1% SRPC SRPC 1 2% 5% 9% Unemployment 205

206 Short Run vs. Long Run In the long run there is no tradeoff between inflation and unemployment Inflation Long Run Phillips Curve 5% 3% The LRPC is vertical at the Natural Rate of Unemployment 1% 2% 5% 9% Unemployment 206

207 Short Run vs. Long Run Inflation What happens when AD falls? 5% 3% 1% What happens in the long run? Long Run Phillips Curve In the long run wages fall and there is no tradeoff between inflation and unemployment SRPC SRPC 1 2% 5% 9% Unemployment 207

208 AD/AS and the Phillips Curve

209 AD/AS and the Phillips Curve Show what happens on both graphs if AD increases Price Level LRAS AS Inflation LRPC PL e AD 1 AD SRPC Q Y GDP R U Y Unemployment 209

210 Price Level AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC with the recessionary gap. What happens when AD falls? LRAS AS Inflation LRPC PL e AD AD 1 SRPC Q Y GDP R U Y Unemployment 210

211 Price Level AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC at full employment. What happens when AS falls? LRAS AS 1 AS Inflation LRPC PL e AD SRPC 1 SRPC Q Y GDP R U Y Unemployment 211

212 Price Level AD/AS and the Phillips Curve Correctly draw the LRPC and SRPC with an recessionary gap. What happens when AS goes up? LRAS AS Inflation LRPC PL e AS 1 SRPC AD SRPC 1 Q Y GDP R U Y Unemployment 212

213 Fiscal Policy 213

214 Two Types of Fiscal Policy Discretionary Fiscal Policy- Congress creates a new bill that is designed to change AD through government spending or taxation. Problem is time lags due to bureaucracy. Takes time for Congress to act. Ex: In a recession, Congress increase spending. Non-Discretionary Fiscal Policy AKA: Automatic Stabilizers Permanent spending or taxation laws enacted to work counter cyclically to stabilize the economy Ex: Welfare, Unemployment, Min. Wage, etc. When there is high unemployment, unemployment benefits to citizens increase consumer spending. 214

215 Contractionary Fiscal Policy (The BRAKE) Laws that reduce inflation, decrease GDP (Close a Inflationary Gap) Decrease Government Spending Tax Increases Combinations of the Two Laws that reduce unemployment and increase GDP (Close a Recessionary Gap) Increase Government Spending Decrease Taxes on consumers Combinations of the Two Expansionary Fiscal Policy (The GAS) How much should the Government Spend? 215

216 Marginal Propensity to Consume Marginal Propensity to Consume (MPC) How much people consume rather than save when there is an change in income. It is always expressed as a fraction (decimal). MPC= Change in Consumption Change in Income Examples: 1. If you received $100 and spent $ If you received $100 and spent $ If you received $100 and spent $

217 Marginal Propensity to Save Marginal Propensity to Save (MPS) How much people save rather than consume when there is an change in income. It is also always expressed as a fraction (decimal) MPS= Change in Saving Change in Income Examples: 1. If you received $100 and save $ If you received $100 your MPC is.7 what is your MPS? 217

218 MPS = 1 - MPC Why is this true? Because people can either save or consume 218

219 How is Spending Multiplied? Assume the MPC is.5 for everyone Assume the Super Bowl comes to town and there is an increase of $100 in Ashley s restaurant. Ashley now has $100 more income. She saves $50 and spends $50 at Carl s Salon Car now has $50 more income He saves $25 and spends $25 at Dan s fruit stand Dan now has $25 more income. This continues until every penny is spent or saved Change in GDP = Multiplier x Initial Change in Spending 219

220 Calculating the Spending Multiplier If the MPC is.5 how much is the multiplier? 1 1 Simple = or Multiplier MPS 1 - MPC If the multiplier is 4, how much will an initial increase of $5 in Government spending increase the GDP? How much will a decrease of $3 in spending decrease GDP? Change in GDP = Multiplier x initial change in spending 220

221 The Multiplier Effect Let s practice calculating the spending multiplier 1 1 Simple = or Multiplier MPS 1 - MPC 1. If MPC is.9, what is multiplier? 2. If MPC is.8, what is multiplier? 3. If MPC is.5, and consumption increased $2M. How much will GDP increase? 4. If MPC is 0 and investment increases $2M. How much will GDP increase? Conclusion: As the Marginal Propensity to Consumer falls, the Multiplier Effect is less 221

222 Price level Fiscal Policy Practice Congress uses discretionary fiscal policy to the manipulate the following economy (MPC =.8) P 1 LRAS AS $500 $1000FE Real GDP (billions) 1. What type of gap? 2. Contractionary or Expansionary needed? 3. What are two options to fix the gap? 4. How much initial government spending is needed to close gap? AD 2 AD 1 $100 Billion 222

223 Price level Fiscal Policy Practice Congress uses discretionary fiscal policy to the manipulate the following economy (MPC =.5) P 2 LRAS AS 1. What type of gap? 2. Contractionary or Expansionary needed? 3. What are two options to fix the gap? 4. How much needed to close gap? $80FE $100 AD 1 AD Real GDP (billions) -$10 Billion 223

224 What about taxing? The multiplier effect also applies when the government cuts or increases taxes. But, changing taxes has less of an impact of changing GDP. Why? Expansionary Policy (Cutting Taxes) Assume the MPC is.75 so the multiplier is 4 If the government cuts taxes by $4 million how much will consumer spending increase? NOT 16 Million!! When they get the tax cut, consumers will save $1 million and spend $3 million. The $3 million is the amount magnified in the economy. $3 x 4 = $12 Million increase in consumer spending.224

225 Unit 4: Money and Monetary Policy 225

226 The Money Market (Supply and Demand for Money) 226

227 Rate of interest, i (percent) THE DEMAND FOR MONEY As interest rate increases the quantity demanded for money falls People put money into stocks or bonds instead of hold it due to higher opportunity cost D money Amount of money demanded (billions of dollars) 227

228 Rate of interest, i (percent) Why are Price Level and interest rates directly related? When Price Level increases, people need more money. The demand for money increases. So i increases D money D Amount of money demanded (billions of dollars) 228

229 Rate of interest, i (percent) THE SUPPLY OF MONEY In the U.S. the Money Supply is set by the Board of Governors of the Federal Reserve System (FED) S money i e The FED is a nonpartisan government office that sets and adjusting the money supply to adjust the economy This is called Monetary Policy Amount of money demanded (billions of dollars) D money 229

230 Rate of interest, i (percent) Decreasing the Money Supply S m1 S m i e If there is a decrease in supply, a temporary shortage of money will occur at 5% interest. Shortage drives up the price to acquire money (the interest rate) Decreased money supply Amount of money demanded (billions of dollars) D m Increased interest rate How does this affect AD? Decreased investment Decreased AD 230

231 Rate of interest, i (percent) Increase money supply Increasing the Money Supply S m S m1 Amount of money demanded (billions of dollars) If there is a increase in supply, a temporary surplus of money will occur at 5% interest. Surplus drives down the price to acquire money (the interest rate). D m Decreases interest rate How does this affect AD? Increases investment Increases AD 231

232 Showing the Effects of Monetary Policy Graphically The Keynesian 3 Step Transmission 232

233 Showing the Effects of Monetary Policy Graphically Three Related Graphs: Money Market Investment Demand AD/AS 233

234 Interest Rate (i) S&D of Money S M S M1 Interest Rate (i) Investment Demand 10% 10% 5% 5% 2% D M 2% D I PL PL 1 PL e AD/AS Q e Q 1 Quantity M AS AD AD 1 GDP R Quantity of Investment The FED increases the money supply to stimulate the economy 1. Interest Rates Decreases 2. Investment Increases 3. AD, GDP and PL Increases 234

235 THE FED Monetary Policy 235

236 THE FEDERAL RESERVE AND THE BANKING SYSTEM The FED regulates the economy by adjusting the money supply by 1. Setting Reserve Requirements (Ratios) 2. Lending Money to Banks & Thrifts Discount Rate 3. Open Market Operations Buying and selling Bonds The FED is now chaired by Ben Bernanke 236

237 Tools to adjust the Money Supply 237

238 The Reserve Requirement The Reserve Requirement or reserve ratio is the percent of deposits that banks must hold in reserve (The percent they can NOT loan out). Example: Reserve ratio =.10 or 10% You deposit $1000 in the bank The bank must hold $100. It lends $900 out to Bob. Bob deposits the $900 in his bank. Bob s bank must hold $90. It loans out $810 to Jill. Jill deposits $810 in her bank. SO FAR, an increase of $1000 has cause the CREATION of another $1710 (Bob s $900 + Jill s $810) This demonstrates the MONEY MULTIPLIER 238

239 The Discount Rate The Discount Rate is the interest rate that the FED charges commercial banks. Example: If Banks of America needs $10 million, they borrow it from the U.S. Treasury (which the FED controls) but they must pay it bank with 3% interest. To increase the Money supply, the FED should DECRAESE the Discount Rate (Easy Money Policy). To decrease the Money supply, the FED should the Discount Rate (Tight Money Policy). INCREASE 239

240 Open market Operations Open Market Operations is when the FED buys or sells government bonds (securities). This is the most widely used monetary policy and the most often tested. To increase the Money supply, the FED should BUY government securities. To decrease the Money supply, the FED should SELL government securities. How are you going to remember? FED You When the government sells bonds, you give them money. This decreases the money supply. 240

241 Real and Nominal Interest Rates 241

242 Nominal vs. Real Interest Rates Example: You lend out $100 with 20% interest. Prices are expected to increased 15% In a year you get paid back $120. What is the nominal and what is the real interest rate? The Nominal interest rate is 20% The Real interest rate was only 5% In reality, you get paid back an amount with less purchasing power. Nominal Interest Rates- the percentage increase in money that the borrower pays including inflation. Nominal = real interest rate + expected inflation Real Interest Rates-The percentage increase in purchasing power that a borrower pays. (adjusted for inflation) Real = nominal interest rate - expected inflation 242

243 Loanable Funds Market 243

244 Loanable Funds Market The private sector supply and demand of loanable money. This shows the effect on REAL INTEREST RATE Demand- Inverse relationship between real interest rate and quantity loans demanded Supply- Direct relationship between real interest rate and quantity loans supplied What is the result of deficit spending? Government borrows from private sector Increasing demand for loanable funds Increases the REAL interest rate. SO This IS the Crowding Out Effect!! 244

245 The Phillips Curve Shows relationship between inflation and unemployment. What happens to inflation and unemployment when AD increase? 245

246 Annual rate of inflation (percent) THE SHORT RUN PHILLIPS CURVE Inverse relationship between inflation and unemployment Unemployment rate (percent) PC 246

247 Annual rate of inflation (percent) THE SHORT RUN PHILLIPS CURVE Showing Stagflation More inflation AND unemployment PC Unemployment rate (percent) PC 247

248 Annual rate of inflation (percent) THE LONG RUN PHILLIPS CURVE NO tradeoff between inflation and unemployment PC Unemployment rate (percent) 248

249 THE LONG RUN PHILLIPS CURVE Annual rate of inflation (percent) PC An increase in prices temporarily increases profit and lowers unemployment In the long run wages increase and unemployment returns to the natural rate (4%) Unemployment rate (percent) 249

250 International Trade Why do people trade? 250

251 Why do people trade? 1. Assume people didn t trade. What things would you have to go without? Everything you don t produce yourself! (Clothes, car, cell phone, bananas, heath care, etc) The Point: Everyone specializes in the production of goods and services and trades it to others 2. What would life be like if cities couldn t trade with cities or states couldn t trade with states? Limiting trade would reduce people s choices and makes the worse off. The Point: More access to trade means more choices and a higher standard of living. 251

252 Absolute and Comparative Advantage 252

253 Per Unit Opportunity Cost Review Per Unit Opportunity Cost = Opportunity Cost Units Gained Assume it costs you $50 to produce 5 t-shirts. What is your PER UNIT cost for each shirt? $10 per shirt Now, take money our of the equation. Instead of producing 5 shirts you could have made 10 hats. 1. What is your PER UNIT OPPORTUNITY COST for each shirt in terms of hats given up? 1 shirt costs 2 hats 2. What is your PER UNIT OPPORTUNITY COST for each hat in terms of shirts given up? 1 hat costs a half of a shirt 253

254 Per Unit Opportunity Cost Review Ronald McDonald can produce 20 pizzas or 200 burgers Papa John can produce 100 pizzas or 200 burgers 1. What is Ronald s opportunity cost for one pizza in terms of burgers given up? 1 pizza cost 10 burgers 2. What is Ronald s opportunity cost for one burger in terms of pizza given up? 1 burger costs 1/10 pizza 3. What is Papa John s opportunity cost for one pizza in terms of burgers given up? 1 pizza costs 2 burgers 4. What is Papa John s opportunity cost for one burger in terms of pizza given up? 1 burger costs 1/2 pizza Ronald has a COMPARATIVE ADVANTGE in the production of burgers Papa John has a COMPARATIVE ADVANTAGE in the production of pizza 254

255 Absolute and Comparative Advantage Absolute Advantage The producer that can produce the most output OR requires the least amount of inputs (resources) Ex: Papa John has an absolute advantage in pizzas because he can produce 100 and Ronald can only make 20. Comparative Advantage The producer with the lowest opportunity cost. Ex: Ronald has a comparative advantage in burgers because he has a lowest PER UNIT opportunity cost. Countries should trade if they have a relatively lower opportunity cost. They should specialize in the good that is cheaper for them to produce. 255

256 Benefits of Specialize and Trade 256

257 Sugar (tons) Sugar (tons) S W International Trade Trade: 1 Wheat for 1.5 Sugar USA The US Specializes and makes ONLY Wheat Wheat (tons) Wheat (tons) Brazil Brazil Makes ONLY Sugar S W

258 Sugar (tons) Sugar (tons) TRADE SHIFTS THE PPC! International Trade USA Brazil 35 AFTER TRADE AFTER TRADE Wheat (tons) Wheat (tons) 258

259 Sugar (tons) Sugar (tons) Wheat Sugar USA Brazil Which country should EXPORT 30 Wheat? Which country should IMPORT 25 Wheat? (1W costs 1S) (1S costs 1W) (1W costs 2S) (1S costs 1/2W) Which country has a comparative advantage in wheat? 1. Which country should EXPORT Sugar? Wheat (tons) Wheat (tons) 259

260 Output Questions: OOO= Output: Other goes Over 260

261 Input Questions: IOU= Input: Other goes Under 261

262 Term of Trade 262

263 Pineapples Radios Kenya India (1P costs 1/3R) (1R costs 3 P) (1P costs 1R) (1R costs 1P) Kenya wants Radios If the terms of trade for 1 radio is greater than 3 pineapples then Kenya is worse off and should make radios on their own. India wants Pineapples If the terms of trade for 1 radio is less than 1 pineapple then India is worse off and should make pineapples on their own. What terms of trade benefit both countries?

264 Pineapples Radios Kenya India (1P costs 1/3R) (1R costs 3 P) (1P costs 1R) (1R costs 1P) Trading 1 radio for 2 pineapples will benefit both If Kenya produces radios by themselves, they give up 3 Pineapples for each radio. If they can trade 2 pineapples for each radio they are better off. If India produces pineapples by themselves, they give up 1 pineapple for one radio. If they can get 2 pineapples for one radio they are better off. The countries trade at a lower opportunity cost than if they made the products themselves!

265 International Trade and Finance 265

266 Closed vs. Open Economies A closed economy focuses only on the domestic price and the open economy trades for the lower world price. Export Goods & Services 16% of American GDP. US Exports have doubled as a percent of GDP since

267 Balance of Trade vs. Balance of Payments

268 Balance of Trade Net Exports (X N ) = Exports Imports Trade Surplus = Exporting more than is imported Trade Deficit (aka. trade gap) = Exporting less than is imported

269 Balance of Payments (BOP) Balance of trade includes only goods and service but balance of payments considers ALL international transactions. The balance of payments is a broader measure of international trade. Details: The BOP summary is within a given year Prepared in the domestic country s currency Ex. If accounting the BOP of the U.S. it would be in the Dollar. The balance of payments is made up of two accounts. The current account and the capital account.

270 Current Account The Current Account is made up of three parts: 1. Trades in Goods and Services (Net Exports)- Difference between a nation s exports of goods and services and its imports of goods and services Ex: Toys imported from China, US cars exported to Mexico 2. Investment Income- income from the factors of productions including payments made to foreign investors. Ex: Money earned by Japanese car producers in the US 3. Net Transfers- Money flows from the private or public sectors Ex: donations, aids and grants, official assistance

271 Capital (Financial) Account The Capital Account measures the purchase and sale of financial assets abroad. Purchases of things that stay in the foreign country. Examples: US company buys a hotel in Russia A Korean company sells a factory in Ohio Dividends earned by Chinese citizens in the New York Stock Exchange (NYSE) Australian company owns local Mall

272 Current or Capital Account? Identify if the examples are counted in the current or capital account and determine if it is a credit or debit for the US. 1. Bill, an American, invests $20 million in a ski resort in Canada 2. A Korean company sells vests to the US Military 3. A US company, Boeing, sells twenty 747s to France 4. A Chinese company buys a shopping mall in San Diego 5. An illegal immigrant sends a portion of his earning to his family 6. An German investor buys $50,000 US Treasury Bonds 7. Italian tourists spend 5 million in the US while American tourists spend 8 million in Italy.

273 Current or Capital Account? Identify if the examples are counted in the current or capital account and determine if it is a credit or debit for the US. 1. Capital Account (financial asset), Debit 2. Current Account (trade of goods/services), Debit 3. Current Account (trade of goods/services), Credit 4. Capital Account (financial asset), Credit 5. Current Account (net transfer), Debit 6. Capital Account (financial asset), Credit 7. Current Account (net transfer), Debit

274 Practice 1. U.S. income increases relative to other countries. Does the balance of payments move toward a deficit or a surplus? - Imports are cheaper - Americans import more - Net exports (X n ) decrease - The current account balance decreases and moves toward a deficit. 2. If the U.S. dollar depreciates relative to other countries does the balance of payments move toward a deficit or a surplus? - US exports are desirable - America exports more - Net exports (X n ) increase - The current account balance decreases and moves toward a surplus.

275 Foreign Exchange (aka. FOREX) Exchange Rate = Relative Price of Currencies

276 Exchange Rates In the FOREX market we only look at two countries/currencies at a time Ex: US Dollars and British Pounds We examine the price of one currency in terms of the other currency. Ex:$2 = 1 The Exchange Rate depends on which currency you are converting. The price of one US Dollar in terms of Pounds is 1 Dollar = 1/$2 =.5 The price of one Pound in terms of Dollars is 1 Pound = $2/ 1 = $2

277 What happens if you need more dollar to buy one pound (the price for a pound increases)? Ex: From $2= 1 to $5= 1 The U.S. Dollar DEPRECIATES relative to the Pound. Depreciation The loss of value of a country's currency with respect to a foreign currency More units of dollars are needed to buy a single unit of the other currency. The dollar is said to be Weaker

278 What happens if you need less dollar to buy one pound (the price for a pound decreases)? Ex: From $2= 1 to $1= 4 The U.S. Dollar APPRECIATES relative to the Pound. Appreciation The increase of value of a country's currency with respect to a foreign currency Less units of dollars are needed to buy a single unit of the other currency. The dollar is said to be Stronger

279 S&D for the US Dollars Price of US Dollars Pound Dollar$ Equilibrium: $1 = 1 Supply by Americans 2 /1$ 1 /1$ US Dollar appreciates US Dollar depreciates 1 /4$ Demand by British Quantity of US Dollars Q

280 FOREX Supply and Demand Simplified Imagine a huge table with all the different currencies from every country This is the Foreign Exchange Market! Just like at a product market, you can t take things without paying. If you demand one currency, you must supply your currency. Ex: If Canadians what Russian Rubles. The demand for Rubles in the FOREX market will increase and the supply of Canadian Dollars will increase.