INTERMEDIATE ECONOMICS

INTERMEDIATE ECONOMICS
REV 00 DDG 2413 INTERMEDIATE ECONOMICS DDG INTERMEDIATE ECONOMICS

DDG 2413 INTERMEDIATE ECONOMICS
REV 00 INTRODUCTION DDG INTERMEDIATE ECONOMICS

BASIC OF DEMAND AND SUPPLY
REV 00 BASIC OF DEMAND AND SUPPLY The supply curve slopes upward demonstrating that at higher prices firms will increase output The Supply Curve The supply curve shows how much of a good producers are willing to sell at a given price, holding constant other factors that might affect quantity supplied. This price-quantity relationship can be shown by the equation: DDG INTERMEDIATE ECONOMICS

REV 00 Non-price Determining Variables of Supply Costs of Production Labour Capital Raw Materials Supply - A Review Supply is determined by non-price supply-determining variables such as the cost of labour, capital, and raw materials. Changes in supply are shown by shifting the entire supply curve. Changes in quantity supplied are shown by movements along the supply curve and are caused by a change in the price of the product. DDG INTERMEDIATE ECONOMICS 27

REV 00 Change in Supply The cost of raw materials falls Supply curve shifts right to S’. At P1, produce Q2. At P2, produce Q1. More produced at any price on S’ than on S. P S S’ Q2 P1 P2 Q1 Q0 Q DDG INTERMEDIATE ECONOMICS 31

REV 00 The Demand Curve The demand curve shows how much of a good consumers are willing to buy as the price per unit changes holding non-price factors constant. This price-quantity relationship can be shown by the equation: The demand curve slopes downward demonstrating that consumers are willing to buy more at a lower price as the product becomes relatively cheaper and the consumer’s real income increases. DDG INTERMEDIATE ECONOMICS 8

REV 00 Non-price Determining Variables of Demand Income Consumer Tastes Price of Related Goods Substitutes Complements Demand - A Review Demand is determined by non-price demand-determining variables, such as, income, price of related goods, and tastes. Changes in demand are shown by shifting the entire demand curve. Changes in quantity demanded are shown by movements along the demand curve. DDG INTERMEDIATE ECONOMICS 36

REV 00 Change in Demand Income Increases Demand curve shifts right to D’ At P1, purchase Q2 At P2, purchase Q1 More purchased at any price on D’ than on D P D D’ Q2 Q1 P2 Q0 P1 Q DDG INTERMEDIATE ECONOMICS 41

REV 00 The Market Mechanism The curves intersect at equilibrium, or market- clearing, price. At P0 the quantity supplied is equal to the quantity demanded at Q0 . Characteristics of the equilibrium or market clearing price: QD = QS No shortage No excess supply No pressure on the price to change DDG INTERMEDIATE ECONOMICS 12

REV 00 A Surplus The market price is above equilibrium There is excess supply Producers lower prices Quantity demanded increases and quantity supplied decreases The market continues to adjust until the equilibrium price is reached. DDG INTERMEDIATE ECONOMICS 19

REV 00 DDG INTERMEDIATE ECONOMICS 17

REV 00 Shortage The market price is below equilibrium: There is a shortage Producers raise prices Quantity demanded decreases and quantity supplied increases The market continues to adjust until the new equilibrium price is reached. DDG INTERMEDIATE ECONOMICS 24

REV 00 Quantity Price ($ per unit) S D Assume the price is P2 , then: 1) Qd : Q2 > Qs : Q1 2) Shortage is Q2 – Q1. 3) Producers raise price. 4) Quantity supplied increases and quantity demanded decreases. 5) Equilibrium at P3, Q3 Q3 P3 Q1 Q2 P2 Shortage DDG INTERMEDIATE ECONOMICS 22

REV 00 Changes In Market Equilibrium Equilibrium prices are determined by the relative level of supply and demand. Supply and demand are determined by particular values of supply and demand determining variables. Changes in any one or combination of these variables can cause a change in the equilibrium price and/or quantity. DDG INTERMEDIATE ECONOMICS 26

Elasticities of Supply and Demand
REV 00 Elasticities of Supply and Demand Generally, elasticity is a measure of the sensitivity of one variable to another. It tells us the percentage change in one variable in response to a one percent change in another variable. DDG INTERMEDIATE ECONOMICS 69

Price Elasticity of Demand DDG 2413 INTERMEDIATE ECONOMICS
REV 00 Price Elasticity of Demand Measures the sensitivity of quantity demanded to price changes. It measures the percentage change in the quantity demanded for a good or service that results from a one percent change in the price. The price elasticity of demand is: DDG INTERMEDIATE ECONOMICS 70

demand curve is less elastic
REV 00 Linear Demand Curve Price Q = 8 - 2P Ep = -1 Ep = 0 The lower portion of a downward sloping demand curve is less elastic than the upper portion. 4 8 2 Linear Demand Curve Q = a - bP Q = 8 - 2P Q DDG INTERMEDIATE ECONOMICS 76

REV 00 DDG INTERMEDIATE ECONOMICS

Other Demand Elasticities DDG 2413 INTERMEDIATE ECONOMICS
REV 00 Other Demand Elasticities Income elasticity of demand measures the percentage change in quantity demanded resulting from a one percent change in income. Cross price elasticity of demand measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good. DDG INTERMEDIATE ECONOMICS 79

Elasticities of Supply DDG 2413 INTERMEDIATE ECONOMICS
REV 00 Elasticities of Supply Price elasticity of supply measures the percentage change in quantity supplied resulting from a one percent change in price. The elasticity is usually positive because price and quantity supplied are positively related. Higher price gives producers an incentive to increase output We can refer to elasticity of supply with respect to interest rates, wage rates, and the cost of raw materials. DDG INTERMEDIATE ECONOMICS 84

REV 00 CONSUMER BEHAVIOUR DDG INTERMEDIATE ECONOMICS

REV 00 Consumer Behaviour There are three steps involved in the study of consumer behavior. 1) We will study consumer preferences. To describe how and why people prefer one good to another. 2) Then we will turn to budget constraints. People have limited incomes. 3) Finally, we will combine consumer preferences and budget constraints to determine consumer choices. What combination of goods will consumers buy to maximise their satisfaction? DDG INTERMEDIATE ECONOMICS 8

REV 00 Consumer Preferences Market Baskets A market basket is a collection of one or more commodities. One market basket may be preferred over another market basket containing a different combination of goods. Three basic assumptions : 1) Preferences are complete. 2) Preferences are transitive. 3) Consumers always prefer more of any good to less. DDG INTERMEDIATE ECONOMICS 10

REV 00 Market Basket Units of Food Units of Clothing A 20 30 B 10 50 D 40 20 E 30 40 G 10 20 H 10 40 DDG INTERMEDIATE ECONOMICS 12

REV 00 The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A. Combination B,A, & D yield the same satisfaction E is preferred to U1 U1 is preferred to H & G DDG INTERMEDIATE ECONOMICS

REV 00 Indifference Curves Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person. Indifference curves slope downward to the right. If it sloped upward it would violate the assumption that more of any commodity is preferred to less. Any market basket lying above and to the right of an indifference curve is preferred to any market basket that lies on the indifference curve. Finally, indifference curves cannot cross. This would violate the assumption that more is preferred to less. DDG INTERMEDIATE ECONOMICS 13

REV 00 Indifference Maps Market basket A is preferred to B. Market basket B is preferred to D. An indifference map is a set of indifference curves that describes a person’s preferences for all combinations of two commodities. Each indifference curve in the map shows the market baskets among which the person is indifferent. DDG INTERMEDIATE ECONOMICS 20

Marginal Rate of Substitution DDG 2413 INTERMEDIATE ECONOMICS
REV 00 Marginal Rate of Substitution The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good. It is measured by the slope of the indifference curve. DDG INTERMEDIATE ECONOMICS 29

REV 00 Utility Numerical score representing the satisfaction that a consumer gets from a given market basket. If buying 3 bars of chocolate makes you happier than buying 1 shirt , then we say that the chocolates give you more utility than the shirt. DDG INTERMEDIATE ECONOMICS 103

REV 00 Utility Functions Assume: The utility function for food (F) and clothing (C) U(F,C) = F + 2C Market Baskets F units C units U(F,C) = F + 2C A (3) = B (4) = C (4) = 12 - The consumer is indifferent to A & B The consumer prefers A & B to C DDG INTERMEDIATE ECONOMICS

Utility Functions & Indifference Curves
REV 00 Utility Functions & Indifference Curves Clothing (units per week) A B C Assume: U = FC Market Basket U = FC C = 2.5(10) A = 5(5) B = 10(2.5) U1 = 25 U2 = 50 (Preferred to U1) U3 = 100 (Preferred to U2) 15 10 5 Food (units per week) 5 10 15 DDG INTERMEDIATE ECONOMICS 42 54

REV 00 Consumer Preferences Ordinal Versus Cardinal Utility Ordinal Utility Function: places market baskets in the order of most preferred to least preferred, but it does not indicate how much one market basket is preferred to another. Cardinal Utility Function: utility function describing the extent to which one market basket is preferred to another. DDG INTERMEDIATE ECONOMICS 27

REV 00 Budget Constraints Preferences do not explain all of consumer behaviour. Budget constraints also limit an individual’s ability to consume in light of the prices they must pay for various goods and services. The Budget Line The budget line indicates all combinations of two commodities for which total money spent equals total income. DDG INTERMEDIATE ECONOMICS 42 46

REV 00 The Budget Line Let F equal the amount of food purchased, and C is the amount of clothing. Price of food = Pf and price of clothing = Pc Then Pf F is the amount of money spent on food, and Pc C is the amount of money spent on clothing. The budget line then can be written: DDG INTERMEDIATE ECONOMICS 42 48

REV 00 DDG INTERMEDIATE ECONOMICS 12 50

REV 00 Consumer Choice Consumers choose a combination of goods that will maximise the satisfaction they can achieve, given the limited budget available to them. The maximising market basket must satisfy two conditions: 1) It must be located on the budget line. 2) Must give the consumer the most preferred combination of goods and services. DDG INTERMEDIATE ECONOMICS 68

maximize satisfaction DDG 2413 INTERMEDIATE ECONOMICS
REV 00 Point B does not maximize satisfaction because the MRS (-(-10/10) = 1 is greater than the price ratio (1/2). Market basket D cannot be attained given the current budget constraint. DDG INTERMEDIATE ECONOMICS

Marginal Utility and Consumer Choice
REV 00 Marginal Utility and Consumer Choice Marginal Utility Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good. Diminishing Marginal Utility The principle of diminishing marginal utility states that as more and more of a good is consumed, consuming additional amounts will yield smaller and smaller additions to utility. DDG INTERMEDIATE ECONOMICS 107

Equal Marginal Principle
REV 00 Equal Marginal Principle The equation for utility maximisation: Total utility is maximised when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good. This is referred to as the equal marginal principle. DDG INTERMEDIATE ECONOMICS 116

INDIVIDUAL AND MARKET DEMAND
REV 00 INDIVIDUAL AND MARKET DEMAND DDG INTERMEDIATE ECONOMICS

REV 00 Individual Demand Assume: I = $20 PC = $2 PF = $2, $1, $.50 Price Changes The impact of a change in the price of food can be illustrated using indifference curves. Three separate indifference curves are tangent to each budget line. DDG INTERMEDIATE ECONOMICS 4

The price-consumption curve traces out the utility maximizing
REV 00 The price-consumption curve traces out the utility maximizing market basket for the various prices for food. Individual Demand relates the quantity of a good that a consumer will buy to the price of that good. DDG INTERMEDIATE ECONOMICS

REV 00 Assume: Pf = $1, Pc = $2, I = $10, $20, $30 Income Changes The impact of a change in income can be illustrated using indifference curves. An increase in income, with the prices fixed, causes consumers to alter their choice of market basket. An increase in income, from $10 to $20 to $30, with the prices fixed, shifts the consumer’s demand curve to the right. DDG INTERMEDIATE ECONOMICS 4

Income and Substitution Effects
REV 00 Income and Substitution Effects A fall in the price of a good has two effects: Substitution & Income Substitution Effect Consumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is now relatively more expensive. Income Effect Consumers experience an increase in real purchasing power when the price of one good falls. DDG INTERMEDIATE ECONOMICS

Income and Substitution Effects: Normal Good
REV 00 Income and Substitution Effects: Normal Good Clothing (units per month) C2 F2 T U2 B When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B. R F1 S C1 A U1 E Total Effect Substitution Effect D The substitution effect,F1E, (from point A to D), changes the relative prices but keeps real income (satisfaction) constant. The income effect, EF2, ( from D to B) keeps relative prices constant but increases purchasing power. Income Effect Food (units per month) O DDG INTERMEDIATE ECONOMICS

From Individual to Market Demand DDG 2413 INTERMEDIATE ECONOMICS
REV 00 Market Demand From Individual to Market Demand Market Demand Curves A curve that relates the quantity of a good that all consumers in a market buy to the price of that good. DDG INTERMEDIATE ECONOMICS

summing the consumer’s DDG 2413 INTERMEDIATE ECONOMICS
REV 00 The market demand curve is obtained by summing the consumer’s demand curves DDG INTERMEDIATE ECONOMICS

REV 00 Elasticity of Demand Recall: Price elasticity of demand measures the percentage change in the quantity demanded resulting from a one percent change in price. DDG INTERMEDIATE ECONOMICS

tickets is the sum of the DDG 2413 INTERMEDIATE ECONOMICS
REV 00 Consumer Surplus The difference between the maximum amount a consumer is willing to pay for a good and the amount actually paid. The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually. DDG INTERMEDIATE ECONOMICS

Empirical Estimation of Demand
REV 00 Empirical Estimation of Demand The most direct way to obtain information about demand is through interviews where consumers are asked how much of a product they would be willing to buy at a given price. Problem Consumers maybe lack of information or interest, or be mislead by the interviewer. In direct marketing experiments, actual sales offers are posed to potential customers and the responses of customers are observed. The statistical approach to demand estimation Properly applied, the statistical approach to demand estimation can enable one to sort out the effects of variables on the quantity demanded of a product. “Least-squares” regression is one approach. DDG INTERMEDIATE ECONOMICS

REV 00 PRODUCTION DDG INTERMEDIATE ECONOMICS

The Technology of Production
REV 00 The Technology of Production The Production Process Combining inputs or factors of production to achieve an output Categories of Inputs (factors of production) Labour Materials Capital DDG INTERMEDIATE ECONOMICS 4

REV 00 Production Function: Indicates the highest output that a firm can produce for every specified combination of inputs given the state of technology. Shows what is technically feasible when the firm operates efficiently. The production function for two inputs: Q = F(K,L) where Q = Output, K = Capital, L = Labour Assumptions Food producer has two inputs : Labour (L) & Capital (K) DDG INTERMEDIATE ECONOMICS 6

REV 00 Isoquants Observations: 1) For any level of K, output increases with more L. 2) For any level of L, output increases with more K. 3) Various combinations of inputs produce the same output. Isoquants Curves showing all possible combinations of inputs that yield the same output DDG INTERMEDIATE ECONOMICS 7

Production Function for Food
REV 00 Production Function for Food 1 20 40 55 65 75 2 60 85 90 3 100 105 4 110 115 5 120 Capital Input Labour Input Labour per year 1 2 3 4 5 Q = 55 A D B 75 90 C E Capital per year The Isoquant Map The isoquants are derived from the production function for output of of 55, 75, and 90. DDG INTERMEDIATE ECONOMICS 9

Production with One Variable Input (Labor)
REV 00 Production with One Variable Input (Labor) Amount Amount Total Average Marginal of Labour (L) of Capital (K) Output (Q) Product Product DDG INTERMEDIATE ECONOMICS 17

REV 00 Observations: 1) With additional workers, output (Q) increases, reaches a maximum, and then decreases. 2) The average product of labour (AP), or output per worker, increases and then decreases. 3) The marginal product of labour (MP), or output of the additional worker, increases rapidly initially and then decreases and becomes negative. DDG INTERMEDIATE ECONOMICS 18

REV 00 A: slope of tangent = MP (20) B: slope of OB = AP (20) C: slope of OC= MP & AP Observations: Left of E: MP > AP & AP is increasing Right of E: MP < AP & AP is decreasing E: MP = AP & AP is at its maximum DDG INTERMEDIATE ECONOMICS

The Law of Diminishing Marginal Returns
REV 00 The Law of Diminishing Marginal Returns As the use of an input increases in equal increments, a point will be reached at which the resulting additions to output decreases (i.e. MP declines). When the labour input is small, MP increases due to specialisation. When the labour input is large, MP decreases due to inefficiencies. DDG INTERMEDIATE ECONOMICS 31

Production with Two Variable Inputs
REV 00 Production with Two Variable Inputs In the long run both labor and capital are variable and both experience diminishing returns. There is a relationship between production and productivity. Long-run production K& L are variable. Isoquants analyse and compare the different combinations of K & L and output DDG INTERMEDIATE ECONOMICS 53

Marginal Rate of Technical Substitution
REV 00 Marginal Rate of Technical Substitution Capital per year Q1 =55 Q2 =75 Q3 =90 5 1 2 2/3 1/3 4 Isoquants are downward sloping and convex like indifference curves. 3 2 1 1 2 3 4 5 Labour per month DDG INTERMEDIATE ECONOMICS 60

REV 00 Returns to Scale Measuring the relationship between the scale (size) of a firm and output. Increasing returns to scale: output more than doubles when all inputs are doubled Constant returns to scale: output doubles when all inputs are doubled Decreasing returns to scale: output less than doubles when all inputs are doubled DDG INTERMEDIATE ECONOMICS 74

REV 00 COST OF PRODUCTION DDG INTERMEDIATE ECONOMICS

Measuring Cost: Which Costs Matter?
REV 00 Measuring Cost: Which Costs Matter? Economic Cost Accounting Cost Opportunity Cost Sunk Costs Fixed Cost Variable Cost DDG INTERMEDIATE ECONOMICS 6

A Firm’s Short-Run Costs ($)
REV 00 A Firm’s Short-Run Costs ($) Rate of Fixed Variable Total Marginal Average Average Average Output Cost Cost Cost Cost Fixed Variable Total (FC) (VC) (TC) (MC) Cost Cost Cost (AFC) (AVC) (ATC) DDG INTERMEDIATE ECONOMICS 13

REV 00 Cost in the Short Run Marginal Cost (MC) is the cost of expanding output by one unit. Since fixed cost has no impact on marginal cost, it can be written as: Average Total Cost (ATC) is the cost per unit of output, or average fixed cost (AFC) plus average variable cost (AVC). This can be written: DDG INTERMEDIATE ECONOMICS 14

increasing & decreasing returns. DDG 2413 INTERMEDIATE ECONOMICS
REV 00 Total cost is the vertical sum of FC and VC. Variable cost increases with production and the rate varies with increasing & decreasing returns. Fixed cost does not vary with output DDG INTERMEDIATE ECONOMICS

Long-Run Average Cost (LAC) DDG 2413 INTERMEDIATE ECONOMICS
REV 00 Cost in the Long Run Long-Run Average Cost (LAC) Constant Returns to Scale If input is doubled, output will double and average cost is constant at all levels of output. Increasing Returns to Scale If input is doubled, output will more than double and average cost decreases at all levels of output. Decreasing Returns to Scale If input is doubled, the increase in output is less than twice as large and average cost increases with output. DDG INTERMEDIATE ECONOMICS 43

REV 00 In the long-run: Firms experience increasing and decreasing returns to scale and therefore long-run average cost is “U” shaped. Long-run marginal cost leads long-run average cost: If LMC < LAC, LAC will fall If LMC > LAC, LAC will rise Therefore, LMC = LAC at the minimum of LAC DDG INTERMEDIATE ECONOMICS

The Relationship Between Short-Run and Long-Run Cost
REV 00 The Relationship Between Short-Run and Long-Run Cost With many plant sizes with minimum SAC = $10 the LAC = LMC and is a straight line Long-Run Cost with Constant Returns to Scale If the output is Q1 a manager would chose the small plant SAC1 and SAC $8. Point B is on the LAC because it is a least cost plant for a given output. Long-Run Cost with Economies and Diseconomies of Scale DDG INTERMEDIATE ECONOMICS

The User Cost of Capital The Cost Minimising Input Choice
REV 00 The User Cost of Capital Sum of the annual cost of owning and using a capital asset, equal to economic depreciation plus forgone interest. The Cost Minimising Input Choice Assumptions Two Inputs: Labour (L) & Capital (K) Price of labour: wage rate (w) The price of capital R = depreciation rate + interest rate DDG INTERMEDIATE ECONOMICS 43

REV 00 The Isocost Line C = wL + rK Isocost: A line showing all combinations of L & K that can be purchased for the same cost. Rewriting C as linear: K = C/r - (w/r)L Slope of the isocost: is the ratio of the wage rate to rental cost of capital. This shows the rate at which capital can be substituted for labour with no change in cost. DDG INTERMEDIATE ECONOMICS 44

Cost Minimisation with Varying Output Levels
REV 00 Cost Minimisation with Varying Output Levels This analysis is to see how the firm’s costs depend on its output level. To do we this determine the firm’s cost-minimising input quantities for each output level and then calculate the resulting cost. Example : Given w = $10/ hour; r = $20/ hour; L = 50; K = 25. Each isocost is given by the following equation : C = wL + rk. DDG INTERMEDIATE ECONOMICS 65

REV 00 Expansion Path The expansion path illustrates the least-cost combinations of labour and capital that can be used to produce each level of output in the long-run. A firm’s expansion path shows the minimum cost combinations of labour and capital at each level of output. A Firm’s Expansion Path A Firm’s Long-Run Total Cost Curve DDG INTERMEDIATE ECONOMICS 65

REV 00 Economies of Scope Economies of scope exist when the joint output of a single firm is greater than the output that could be achieved by two different firms each producing a single output. What are the advantages of joint production? Consider an automobile company producing cars and tractors Advantages Both use capital and labour. The firms share management resources. Both use the same labor skills and type of machinery. DDG INTERMEDIATE ECONOMICS

REV 00 Learning Curve Hours of labour per machine lot The learning curve measures the impact of worker’s experience on the costs of production. It describes the relationship between a firm’s cumulative output and amount of inputs needed to produce a unit of output. The horizontal axis measures the cumulative number of hours of machine tools the firm has produced The vertical axis measures the number of hours of labour needed to produce each lot. Cumulative number of machine lots produced DDG INTERMEDIATE ECONOMICS

REV 00 PERFECT COMPETITION DDG INTERMEDIATE ECONOMICS

Perfectly Competitive Markets
REV 00 Perfectly Competitive Markets Characteristics of Perfectly Competitive Markets Price taking The individual firm sells a very small share of the total market output and, therefore, cannot influence market price. The individual consumer buys too small a share of industry output to have any impact on market price. Product homogeneity The products of all firms are perfect substitutes. Free entry and exit Buyers can easily switch from one supplier to another. Suppliers can easily enter or exit a market. DDG INTERMEDIATE ECONOMICS 4

REV 00 Profit Maximisation Do firms maximise profits? Possibility of other objectives Revenue maximisation Dividend maximisation Short-run profit maximisation DDG INTERMEDIATE ECONOMICS 5

MR, MC and Profit Maximisation
REV 00 MR, MC and Profit Maximisation Marginal revenue is the additional revenue from producing one more unit of output. Marginal cost is the additional cost from producing one more unit of output. Profits are maximised when MC = MR. DDG INTERMEDIATE ECONOMICS

Short-Run Equilibrium
REV 00 Short-Run Equilibrium When a firm is said to be at equilibrium in the short-run, there are three profits levels: a) Economic profits or Supernormal profits b) Break-even or Normal profits c) Economic loss or Subnormal profits DDG INTERMEDIATE ECONOMICS

REV 00 Firm will produce Q* as long as P>AVC. DDG INTERMEDIATE ECONOMICS

The Efficiency of a Competitive Market
REV 00 The Efficiency of a Competitive Market When do competitive markets generate an inefficient allocation of resources or market failure? 1) Externalities Costs or benefits that do not show up as part of the market price (e.g. pollution) 2) Lack of Information Imperfect information prevents consumers from making utility-maximising decisions. Government intervention in these markets can increase efficiency. Government intervention without a market failure creates inefficiency or deadweight loss. DDG INTERMEDIATE ECONOMICS 30

REV 00 Minimum Prices Periodically government policy seeks to raise prices above market-clearing levels. We will investigate this by looking at a price floor and the minimum wage. DDG INTERMEDIATE ECONOMICS 49

Price Supports and Production Quotas
REV 00 Price Supports and Production Quotas Price Supports Much of agricultural policy is based on a system of price supports. This is support price is set above the equilibrium price and the government buys the surplus. This is often combined with incentives to reduce or restrict production. Production Quotas The government can also cause the price of a good to rise by reducing supply. DDG INTERMEDIATE ECONOMICS 63

GENERAL EQUILIBRIUM AND WELFARE
REV 00 GENERAL EQUILIBRIUM AND WELFARE DDG INTERMEDIATE ECONOMICS

General Equilibrium Analysis
REV 00 General Equilibrium Analysis Partial equilibrium analysis presumes that activity in one market is independent of other markets. General equilibrium analysis determines the prices and quantity in all markets simultaneously and takes the feedback effect into account. A feedback effect is a price or quantity adjustment in one market caused by price and quantity adjustments in related markets. DDG INTERMEDIATE ECONOMICS 4

REV 00 DDG INTERMEDIATE ECONOMICS

Efficiency in Exchange
REV 00 Efficiency in Exchange Exchange increases efficiency until no one can be made better off without making someone else worse off (Pareto efficiency). The Advantages of Trade Trade between two parties is mutually beneficial. Assumptions Two consumers (countries) Two goods Both people know each others preferences Exchanging goods involves zero transaction costs The Edgeworth Box Diagram Which trades can occur and which allocation will be efficient can be illustrated using a diagram called an Edgeworth Box. DDG INTERMEDIATE ECONOMICS 25

REV 00 Equity and Efficiency Is an efficient allocation also an equitable allocation? Economists and others disagree about how to define and quantify equity. The Utility Possibilities Frontier Indicates the level of satisfaction that each of two people achieve when they have traded to an efficient outcome on the contract curve. all allocations that are efficient. DDG INTERMEDIATE ECONOMICS 69

Efficiency in Production
REV 00 Efficiency in Production Assume Fixed total supplies of two inputs; labour and capital Produce two products; food and clothing Many people own and sell inputs for income Income is distributed between food and clothing Observations Linkage between supply and demand (income and expenditures) Changes in the price of one input triggers changes in income and demand which establishes a feedback effect. Use general equilibrium analysis with feedback effects Production in the Edgeworth Box The Edgeworth box can be used to measure inputs to the production process. DDG INTERMEDIATE ECONOMICS 85

REV 00 IS – LM MODEL DDG INTERMEDIATE ECONOMICS

The FE Line : Equilibrium in the Labour Market
REV 00 The FE Line : Equilibrium in the Labour Market The full-employment (FE) line represents labour market equilibrium. When the labour market is in equilibrium, employment equals its full-employment level, , and output equals its full-employment level, , regardless of the value of the real interest rate. Thus the FE line is vertical at Y = . DDG INTERMEDIATE ECONOMICS

REV 00 IS Curve A downward slopping curve that shows the value of the real interest rate that clears the good market for any given value of output. DDG INTERMEDIATE ECONOMICS

REV 00 LM Curve An upward-sloping curve that shows the value of the real interest rate that clears the asset market for any given value of output. DDG INTERMEDIATE ECONOMICS

General Equilibrium in the Complete IS-LM Model
REV 00 General Equilibrium in the Complete IS-LM Model The economy is in general equilibrium when quantities supplied equal quantities demanded in every market. DDG INTERMEDIATE ECONOMICS

Price Adjustment and Attainment of General Equilibrium
REV 00 Price Adjustment and Attainment of General Equilibrium The Effects of a Monetary Expansion DDG INTERMEDIATE ECONOMICS

Aggregate Demand and Aggregate Supply
REV 00 Aggregate Demand and Aggregate Supply Aggregate Demand (AD) Curve The AD curve shows the relation between the aggregate quantity of goods demanded, Cd+ Id +G, and the price level, P. The AD curve slopes downward, as does the demand curve for a single product. DDG INTERMEDIATE ECONOMICS

REV 00 Aggregate Supply (AS) Curve The AS curve shows the relationship between the price level and the aggregate amount of output that firms supply. The short-run AS curve is a horizontal line. DDG INTERMEDIATE ECONOMICS

REV 00 Equilibrium in the AD - AS Model DDG INTERMEDIATE ECONOMICS

MACROECONOMIC STABILISATION POLICY
REV 00 MACROECONOMIC STABILISATION POLICY DDG INTERMEDIATE ECONOMICS

REV 00 Classical Model Classicals vs. Keynesians 1. The Classical approach a. The economy works well on its own; the “invisible hand” leads people, acting in their own best interests, to maximise the general welfare b. Wages and prices adjust rapidly to get to equilibrium c. Result: Government should have only a limited role in the economy 2. The Keynesian approach a. The Great Depression: Classical theory failed because high unemployment was persistent b. Keynes: Persistent unemployment occurs because wages and prices adjust slowly, so markets remain out of equilibrium for long periods c. Conclusion: Government should intervene to restore full employment DDG INTERMEDIATE ECONOMICS

REV 00 Money Neutrality Characterises an economy in which changes in the nominal money supply change the price level proportionally but have no effect on real variables. The basic classical model predicts neutrality; the classical model with misperceptions and the Keynesian model predict that neutrality holds in the long run but not in the short-run. DDG INTERMEDIATE ECONOMICS

Monetary Neutrality in the AD-AS Framework
REV 00 Monetary Neutrality in the AD-AS Framework DDG INTERMEDIATE ECONOMICS

REV 00 Real Wage Rigidity From the Keynesian perspective, the apparent tendency of real wages to move too little over the business cycle to keep the quantity of labour supplied equal to the quantity of labour demanded. Various explanations have been offered for why real wages might be rigid, even in the face of an excess supply of labour. There are legal and institutional factors that keep wages high, such as the minimum-wage law and union contracts. This policy might reduce the firm’s turnover costs The workers who are paid well may have greater incentives to work hard and effectively DDG INTERMEDIATE ECONOMICS

REV 00 Price Stickiness Price stickiness is the tendency of prices to adjust slowly to changes in the economy 1. The data suggests that money is not neutral, so Keynesians reject the classical model (without misperceptions) 2. Keynesians developed the idea of price stickiness to explain why money isn’t neutral 3. An alternative version of the Keynesian model assumes that nominal wages are sticky, rather than prices; that model also suggests that money isn’t neutral Sources of price stickiness: Monopolistic competition and Menu costs DDG INTERMEDIATE ECONOMICS

Monetary and Fiscal Policy in the Keynesian Model
REV 00 Monetary and Fiscal Policy in the Keynesian Model Monetary Policy in the Keynesian IS-LM Model The Keynesian FE line differs from the classical model in two respects The Keynesian level of full employment occurs where the efficiency wage line intersects the labour demand curve, not where labour supply equals labour demand, as in the classical model Changes in labour supply don’t affect the FE line in the Keynesian model; they do in the classical model Since prices are sticky in the short run in the Keynesian model, the price level doesn’t adjust to restore general equilibrium Keynesians assume that when not in general equilibrium, the economy lies at the intersection of the IS and LM curves, and may be off the FE line This represents the assumption that firms meet the demand for their products by adjusting employment DDG INTERMEDIATE ECONOMICS

REV 00 Monetary Policy in the Keynesian AD-AS Framework The main difference between the Keynesian and classical approaches is the speed of price adjustment The classical model has fast price adjustment, so the SRAS curve is irrelevant In the Keynesian model, the short-run aggregate supply (SRAS) curve is horizontal, because monopolistically competitive firms face menu costs The effect of a 10% increase in money supply is to shift the AD curve up by 10% Thus output rises in the short run to where the SRAS curve intersects the AD curve In the long run the price level rises, causing the SRAS curve to shift up such that it intersects the AD and LRAS curves So in the Keynesian model, money is not neutral in the short run, but it is neutral in the long run DDG INTERMEDIATE ECONOMICS

REV 00 Fiscal Policy The effect of increased government purchases DDG INTERMEDIATE ECONOMICS

REV 00 The Keynesian Theory of Business Cycles and Macroeconomic Stabilization Keynesian Business Cycle Theory Keynesians think aggregate demand shocks are the primary source of business cycle fluctuations Aggregate demand shocks are shocks to the IS or LM curves, such as fiscal policy, changes in desired investment arising from changes in the expected future marginal product of capital, changes in consumer confidence that affect desired saving, and changes in money demand or supply DDG INTERMEDIATE ECONOMICS

REV 00 A recession is caused by a shift of the aggregate demand curve to the left, either from the IS curve shifting down, or the LM curve shifting up The Keynesian theory fits certain business cycle facts There are recurrent fluctuations in output Employment fluctuates in the same direction as output Money is procyclical and leading Investment and durable goods spending is procyclical and volatile DDG INTERMEDIATE ECONOMICS

A Recession Arising from an Aggregate Demand Shock
REV 00 A Recession Arising from an Aggregate Demand Shock DDG INTERMEDIATE ECONOMICS

REV 00 Macroeconomic Stabilisation Keynesians favor government actions to stabilise the economy Recessions are undesirable because the unemployed are hurt Using monetary or fiscal policy to restore general equilibrium has the advantage of acting quickly, rather than waiting some time for the price level to decline But the price level is higher in the long run when using policy than it would be if the government took no action The choice of monetary or fiscal policy affects the composition of spending An increase in government purchases crowds out consumption and investment spending, because of a higher real interest rate Tax burdens are also higher when government purchases increase, further reducing consumption DDG INTERMEDIATE ECONOMICS

REV 00 Stabilization Policy in the Keynesian Model DDG INTERMEDIATE ECONOMICS

INFLATION AND UNEMPLOYMENT
REV 00 INFLATION AND UNEMPLOYMENT DDG INTERMEDIATE ECONOMICS

REV 00 Philip Curve Unemployment and Inflation: Is There a Trade-off? Many people think there is a trade-off between inflation and unemployment The idea originated in 1958 when A.W. Phillips showed a negative relationship between unemployment and nominal wage growth in Britain Since then economists have looked at the relationship between unemployment and inflation In the 1950s and 1960s many nations seemed to have a negative relationship between the two variables The United States appears to be on one Phillips curve in the 1960s DDG INTERMEDIATE ECONOMICS

REV 00 This suggested that policymakers could choose the combination of unemployment and inflation they most desired But the relationship fell apart in the following three decades The 1970s were a particularly bad period, with both high inflation and high unemployment, inconsistent with the Phillips curve DDG INTERMEDIATE ECONOMICS

The Expectations-Augmented Phillips Curve
REV 00 The Expectations-Augmented Phillips Curve Friedman and Phelps: The cyclical unemployment rate (the difference between actual and natural unemployment rates) depends only on unanticipated inflation (the difference between actual and expected inflation) This theory was made before the Phillips curve began breaking down in the 1970s It suggests that the relationship between inflation and the unemployment rate isn’t stable DDG INTERMEDIATE ECONOMICS

REV 00 Ongoing inflation in the extended classical model Unanticipated inflation in the extended classical model DDG INTERMEDIATE ECONOMICS

The Long-Run Philips Curve
REV 00 The Long-Run Philips Curve Long run: u = for both Keynesians and Classicals The long-run Phillips curve is vertical, since when  = e, u = Changes in the level of money supply have no long-run real effects; changes in the growth rate of money supply have no long-run real effects, either Even though expansionary policy may reduce unemployment only temporarily, policymakers may want to do so if, for example, timing economic booms right before elections helps them (or their political allies) get reelected DDG INTERMEDIATE ECONOMICS

Problem of Unemployment
REV 00 Problem of Unemployment The Costs of Unemployment Loss in output from idle resources Workers lose income Society pays for unemployment benefits and makes up lost tax revenue Using Okun’s Law (each percentage point of cyclical unemployment is associated with a loss equal to 2% of full-employment output), if full-employment output is $7.5 trillion, each percentage point of unemployment sustained for one year costs $150 billion DDG INTERMEDIATE ECONOMICS

REV 00 Personal or psychological cost to workers and their families Especially important for those with long spells of unemployment There are some offsetting factors Unemployment leads to increased job search and acquiring new skills, which may lead to increased future output Unemployed workers have increased leisure time, though most wouldn’t feel that the increased leisure compensated them for being unemployed DDG INTERMEDIATE ECONOMICS

The Problem of Inflation
REV 00 The Problem of Inflation Perfectly anticipated inflation No effects if all prices and wages keep up with inflation Even returns on assets may rise exactly with inflation Shoe-leather costs: People spend resources to economise on currency holdings; the estimated cost of 10% inflation is 0.3% of GNP Menu costs: the costs of changing prices (but technology may mitigate this somewhat) Unanticipated inflation The costs of hyperinflation DDG INTERMEDIATE ECONOMICS

OPEN ECONOMY – FIXED EXCHANGE RATES
REV 00 OPEN ECONOMY – FIXED EXCHANGE RATES DDG INTERMEDIATE ECONOMICS

REV 00 Exchange Rate Nominal Exchange Rates The nominal exchange rate tells you how much foreign currency you can obtain with one unit of the domestic currency For example, if the nominal exchange rate is 110 yen per dollar, one dollar can be exchanged for 110 yen Transactions between currencies take place in the foreign exchange market Denote the nominal exchange rate (or simply, exchange rate) as enom in units of the foreign currency per unit of domestic currency DDG INTERMEDIATE ECONOMICS

REV 00 Under a flexible-exchange-rate system or floating-exchange-rate system, exchange rates are determined by supply and demand and may change every day; this is the current system for major currencies In the past, many currencies operated under a fixed-exchange-rate system, in which exchange rates were determined by governments The exchange rates were fixed because the central banks in those countries offered to buy or sell the currencies at the fixed exchange rate Examples include the gold standard, which operated in the late 1800s and early 1900s, and the Bretton Woods system, which was in place from 1944 until the early 1970s Even today, though major currencies are in a flexible-exchange-rate system, some smaller countries fix their exchange rates DDG INTERMEDIATE ECONOMICS

REV 00 Real Exchange Rates The real exchange rate tells you how much of a foreign good you can get in exchange for one unit of a domestic good If the nominal exchange rate is 110 yen per dollar, and it costs 1100 yen to buy a hamburger in Tokyo compared to 2 dollars in New York, the price of a U.S. hamburger relative to a Japanese hamburger is 0.2 Japanese hamburgers per U.S. hamburger The real exchange rate is the price of domestic goods relative to foreign goods, or e = enomP/PFor DDG INTERMEDIATE ECONOMICS

Terminology for Changes in Exchange Rates
REV 00 Terminology for Changes in Exchange Rates Types of exchange rate system Exchange rate increases (currency strengthens) Exchange rate decreases (currency weakens) Flexible exchange rates Appreciation Depreciation Fixed exchange rates Revaluation Devaluation DDG INTERMEDIATE ECONOMICS

Macroeconomics Determinant of the Exchange Rates and Net Export Demand
REV 00 Macroeconomics Determinant of the Exchange Rates and Net Export Demand Look at how changes in real output or the real interest rate are linked to the exchange rate and net exports, to develop an open-economy IS-LM model Effects of changes in output (income) A rise in domestic output (income) raises demand for goods and services, including imports, so net exports decline To increase purchases of imports, people must sell the domestic currency to buy foreign currency, increasing the supply of foreign currency, which reduces the exchange rate DDG INTERMEDIATE ECONOMICS

REV 00 The opposite occurs if foreign output (income) rises Domestic net exports rise The exchange rate appreciates Effects of changes in real interest rates A rise in the domestic real interest rate (with the foreign real interest rate held constant) causes foreigners want to buy domestic assets, increasing the demand for domestic currency and raising the exchange rate The rise in the exchange rate leads to a decline in net exports The opposite occurs if the foreign real interest rate rises The exchange rate depreciates DDG INTERMEDIATE ECONOMICS

IS – LM Model for Open Economy
REV 00 IS – LM Model for Open Economy Only the IS curve is affected by having an open economy instead of a closed economy; the LM curve and FE line are the same Note that we don’t use the AD-AS model because we need to know what happens to the real interest rate, which has an important impact on the exchange rate The IS curve is affected because net exports are part of the demand for goods The IS curve remains downward sloping Any factor that shifts the closed-economy IS curve shifts the open-economy IS curve in the same way Factors that change net exports (given domestic output and the domestic real interest rate) shift the IS curve Factors that increase net exports shift the IS curve up and to the right Factors that decrease net exports shift the IS curve down and to the left DDG INTERMEDIATE ECONOMICS

Derivation of the IS Curve in An Open Economy
REV 00 Derivation of the IS Curve in An Open Economy DDG INTERMEDIATE ECONOMICS

Fixing the Exchange Rate
REV 00 Fixing the Exchange Rate Fixed-exchange-rate systems are important historically The United States has been on a flexible-exchange-rate system since the early 1970s But fixed exchange rates are still used by many countries There are two key questions we’d like to answer How does the use of a fixed-exchange-rate system affect an economy and macroeconomic policy? Which is the better system, flexible or fixed exchange rates? Fixing the exchange rate The government sets the exchange rate, perhaps in agreement with other countries What happens if the official rate differs from the rate determined by supply and demand? DDG INTERMEDIATE ECONOMICS

An Overvalued Exchange Rate An Undervalued Exchange Rate
REV 00 An Overvalued Exchange Rate An Undervalued Exchange Rate DDG INTERMEDIATE ECONOMICS

Monetary Policy and the Fixed Exchange Rate
REV 00 Monetary Policy and the Fixed Exchange Rate The best way for a country to make the fundamental value of a currency equal the official rate is through the use of monetary policy For an overvalued currency, a monetary contraction is desirable In a Keynesian model, a monetary contraction causes a real (and nominal) exchange rate appreciation in the short run and a nominal exchange rate appreciation in the long run (with no long-run effect on the real exchange rate) Conversely, a monetary expansion causes a nominal exchange rate depreciation in both the short run and the long run Plotting the relationship between the money supply and the nominal exchange rate shows the level of the money supply for which the fundamental value of the exchange rate equals the official rate DDG INTERMEDIATE ECONOMICS

Determination of the Money Supply under Fixed Exchange Rates
REV 00 Determination of the Money Supply under Fixed Exchange Rates Coordinated Monetary Expansion DDG INTERMEDIATE ECONOMICS

OPEN ECONOMY – FLEXIBLE EXCHANGE RATES
REV 00 OPEN ECONOMY – FLEXIBLE EXCHANGE RATES DDG INTERMEDIATE ECONOMICS

REV 00 Fiscal Expansion Two key questions How do fiscal and monetary policy affect a country’s real exchange rate and net exports? How do the macroeconomic policies of one country affect the economies of other countries? Three steps in analysing these questions Use the domestic economy’s IS-LM diagram to see the effects on domestic output and the domestic real interest rate See how changes in the domestic real interest rate and output affect the exchange rate and net exports Use the foreign economy’s IS-LM diagram to see the effects of domestic policy on foreign output and the foreign real interest rate DDG INTERMEDIATE ECONOMICS

REV 00 Effects of an Increase in Domestic Government Purchases Domestic Country Foreign Country DDG INTERMEDIATE ECONOMICS

REV 00 Monetary Contraction We can also use the open-economy IS-LM model to study the effects of monetary policy when exchange rates are flexible. Effects of a Decrease in the Domestic Money Supply Domestic Country DDG INTERMEDIATE ECONOMICS

REV 00 Foreign Country DDG INTERMEDIATE ECONOMICS

Fixed versus Flexible Exchange Rate
REV 00 Fixed versus Flexible Exchange Rate Flexible-exchange-rate systems also have problems, because the volatility of exchange rates introduces uncertainty into international transactions There are two major benefits of fixed exchange rates Stable exchange rates make international trades easier and less costly Fixed exchange rates help discipline monetary policy, making it impossible for a country to engage in expansionary policy; the result may be lower inflation in the long run DDG INTERMEDIATE ECONOMICS

REV 00 But there are some disadvantages to fixed exchange rates They take away a country’s ability to use expansionary monetary policy to combat recessions Disagreement among countries about the conduct of monetary policy may lead to the breakdown of the system Which system is better may thus depend on the circumstances If large benefits can be gained from increased trade and integration, and when countries can coordinate their monetary policies closely, then fixed exchange rates may be desirable Countries that value having independent monetary policies, either because they face different macroeconomic shocks or hold different views about the costs of unemployment and inflation than other countries, should have a floating exchange rate DDG INTERMEDIATE ECONOMICS

REV 00 Currency Unions Under a currency union, countries agree to share a common currency They often cooperate economically and politically as well, as was the case with the 13 original U.S. colonies To work effectively, a currency union must have just one central bank Since countries don’t usually want to give up control over monetary policy by not having their own central banks, currency unions are very rare But a currency union has advantages over fixed exchange rates because having a single currency reduces the costs of trading goods and assets across countries and because speculative attacks on a national currency can no longer occur DDG INTERMEDIATE ECONOMICS

REV 00 But the major disadvantage of a currency union is that all countries share a common monetary policy, a problem that also arises with fixed exchange rates Thus if one country is in recession while another is concerned about inflation, monetary policy can’t help both, whereas with flexible exchange rates, the countries could have monetary policies that help their particular situation DDG INTERMEDIATE ECONOMICS

INTERMEDIATE ECONOMICS

Similar presentations

Presentation on theme: "INTERMEDIATE ECONOMICS"— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

INTERMEDIATE ECONOMICS

Similar presentations

Presentation on theme: "INTERMEDIATE ECONOMICS"— Presentation transcript:

Similar presentations

About project

Feedback