1. 1–11–1 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 1 Economics and the Market

2. 1–21–2 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 1: Economics and the Market Studying choice in a world of scarcity Implications of rationality for good decision making Supply and demand Simple rules Markets and social welfare Microeconomics and macroeconomics

3. 1–31–3 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Economics: Studying Choice in a World of Scarcity The Scarcity Principle –Boundless wants cannot be satisfied with limited resources –Therefore, having more of one thing usually means having less of another –Because of scarcity we must make choices

4. 1–41–4 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Economics: Studying Choice in a World of Scarcity (cont.) Economics is the study of how people make choices under conditions of scarcity and of the results of those choices for society Economists assume that people make choices rationally, with a view to maximising the difference between the cost and benefit for them (their net benefit)

5. 1–51–5 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Applying the Cost–Benefit Principle Rational Persons –Have well-defined goals who try to meet those goals as best they can –Seek to maximise their net benefit from the course of action arising from any decision –When benefits and costs can be measured, net benefit is called Economic Surplus – the difference between total benefit and cost

6. 1–61–6 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Economics: Studying Choice in a World of Scarcity The Cost – Benefit Principle –An individual (or a firm or a society) should take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs –The emphasis is on the EXTRA or MARGINAL benefits and costs –Following this rule maximises total net benefit

7. 1–71–7 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank How Do We Define Cost? Opportunity Cost –The value of the next-best alternative that must be forgone to undertake an activity –So if you value an additional hour of pleasurable leisure time at $20, this is the opportunity cost of an additional hour of burdensome work or study –Conversely, if you can earn $20 per hour, this is the opportunity cost of leisure

8. 1–81–8 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Applying the Cost–Benefit Principle Should you walk downtown for a half hour to save $10 on a $25 computer game? The marginal benefit of the walk is $10 If your time is worth $18 per hour, the marginal cost of the half hour walk is $9 The marginal benefit ($10) exceeds the marginal cost ($9) of buying the game downtown

9. 1–91–9 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Cost–Benefit Analysis is a Model or Simplification of How People Think C/B analysis assumes that people make decisions consciously and rationally What if their decisions are unconscious? This does not matter as long as their decisions are consistent with the C/B model Models are abstract constructs (simplified descriptions) that allow us to analyse situations in a logical way

10. 1–10 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Other Abstract Models A computer model of climate change A road map or building plans Simulated crash tests using dummies Analyses of the economy which divide the community into only three parties: –households (consumers) –firms (producers) –the government

11. 1–11 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Four Implications of Rationality Cost and benefits are absolute, not proportional Example which is more valuable: –saving $100 or 5% on a $2000 international air fare or –saving $90 or 50% on a $180 domestic bus fare?

12. 1–12 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Four Implications of Rationality (cont.) Take Account of Opportunity Costs Example: Do frequent flyer points mean that your trip to destination X is costless? –No, because there may be accommodation costs in excess of those at home –No, because going to destination X may preclude you from going to destination Y

13. 1–13 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Four Implications of Rationality (cont.) Costs already incurred or ‘sunk’ are not relevant to your decisions The only costs that should influence a decision about whether or not to take an action are those that we can avoid by not taking that action

14. 1–14 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Sunk Costs are Irrelevant The entry fee to an ‘all you can eat’ restaurant is irrelevant to how much we should eat, once we have entered and paid Since the marginal cost is zero, we should eat up to the point where the marginal benefit of eating is zero Failure to observe this rule will lead to indigestion and regret (negative marginal benefit) through overeating! Emotion of greed has overcome rational thought!

15. 1–15 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Four Implications of Rationality The cost of a course of action is what it adds to our total costs, that is its marginal cost Marginal, not average, costs are relevant

16. 1–16 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Example of the Average–Marginal Distinction Should NASA expand the space shuttle program from three launches per year to four? Assume average benefit = marginal benefit = $6 billion Assume marginal cost exceeds average cost

17. 1–17 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Optimal Number of Launches 0 00 0 1 33 3 2 7 3.5 4 3124 5 4205 8 5326.412 Assume: Average Benefit = Marginal Benefit = $6 billion Total Cost Average Cost No. of Launches ( $ billion) ($ billion/launch) Marginal Cost What is the optimal number of launches?

18. 1–18 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Supply and Demand: An Introduction

19. 1–19 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank What, How, and for Whom? Central Planning Versus the Market Given limited resources and unlimited wants, there are three problems facing all economic systems –What should be produced? –How should it be produced? –For whom will it be produced?

20. 1–20 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Free Markets vs Central Plans In market or capitalist economies these decisions are made by individual households (consumers and owners of factors of production) and firms (producers) who participate in markets as buyers and sellers of factor services and finished goods In centrally planned economies these decisions are made by the authorities In mixed economies, households, firms and government all play a role in decisions

21. 1–21 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Market Demand As price falls, the quantity demanded rises because: Substitutes become less attractive There is a rise in the purchasing power of buyers’ incomes So existing consumers buy more and new consumers enter the market

22. 1–22 The Daily Demand Curve for Pizza Price ($ per slice) Quantity (1000s of slices per day) 4 2 3 81216 Demand

23. 1–23 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Market Supply As prices rise, the quantity supplied increases This is because the benefit to suppliers rises relative to their costs of production These costs include their opportunity costs – the revenue they get from alternative products

24. 1–24 The Daily Supply Curve for Pizza Price ($ per slice) Quantity (1000s of slices per day) 4 2 3 81216 Supply

25. 1–25 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Market Equilibrium Occurs where the demand curve intersects the supply curve: the quantity demanded = the quantity supplied and no pressure for price to change At prices above this point the quantity supplied exceeds the quantity demanded (there is excess supply) and prices fall At prices below this point there is excess demand and prices rise

26. 1–26 The Equilibrium Price and Quantity of Pizza Price ($ per slice) Quantity (1000s of slices per day) 4 2 3 81216 Supply Demand Equilibrium at $3 Quantity Demanded = Quantity Supplied

27. 1–27 Excess Supply: Prices Fall Price ($ per slice) Quantity (1000s of slices per day) 4 2 3 81216 Supply Demand Excess supply = 8000 slices/day

28. 1–28 Excess Demand: Prices Rise Price ($ per slice) Quantity (1000s of slices per day) 4 2 3 816 Excess demand = 8000 slices per day Supply Demand

29. 1–29 Graphing Supply and Demand and Finding the Equilibrium Price and Quantity Price ($ per slice) Quantity (1000s of slices per day) 5 2 3 4 1 4 102 Demand 0 68 Supply 2.50 5 The Equilibrium Price = $2.50 The Equilibrium Quantity = 5

30. 1–30 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Predicting and Explaining Changes in Prices and Quantities Distinguishing Between –A change in the quantity demanded (a movement along the demand curve that occurs in response to a change in price) and –A change in demand (a shift of the entire demand curve)

31. 1–31 An Increase in Quantity Demanded vs an Increase in Demand Price ($/can) Quantity (1000s of cans/day) 5 2 3 4 1 4 122 6 0 D D Increase in quantity demanded

32. 1–32 An Increase in Quantity Demanded vs an Increase in Demand Price ($/can) Quantity (1000s of cans/day) 5 2 3 1 4 12 6 0 Increase in demand D D D’

33. 1–33 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Predicting and Explaining Changes in Prices and Quantities Change in the quantity supplied –A movement along the supply curve that occurs in response to a change in price Change in supply –A shift of the entire supply curve

34. 1–34 An Increase in Quantity Supplied vs an Increase in Supply Price ($/can) Quantity (1000s of cans/day) 5 2 3 4 1 4 102 6 068 S S Increase in quantity supplied

35. 1–35 An Increase in Quantity Supplied vs an Increase in Supply Price ($/can) Quantity (1000s of cans/day) 5 2 3 4 1 4 102 6 S 068 S S’ Increase in supply

36. 1–36 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Factors Changing Demand Change in price of complement Change in price of substitute Change in income Change in population of potential buyers Change in expectations of future prices

37. 1–37 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Factors Changing Supply Change in cost of inputs Change in technology Change in number of suppliers Change in expectations of future prices Change in profitability of other industries competing for resources

38. 1–38 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Markets and Social Welfare If prices reflect marginal benefits (MB) to buyers and marginal costs (MC) to society, free market equilibrium is good for the community This is because Price = MB = MC and consumers are getting as much of the commodity as they are willing to pay for Price controls prevent this

39. 1–39 Price Controls in the Pizza Market Price ($ per slice) Quantity (1000s of slices per day) Supply Demand Excess demand = 8000 slices per day 4 Price ceiling = 2 3 81216

40. 1–40 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Price Ceilings Price ceiling causes production to fall from 12 to 8, a reduction of 4 units On average, these 4 units cost $2.50 each to make, or $10 in total (4 x 2.5) On average, consumers value these 4 units at $3.50 each or $14 in total (4 x 3.5) So the price ceilings have caused a loss of economic surplus to the community of $4: we saved $10 by not making them, but lost $14!

41. 1–41 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Cash on the Table: Buyers In the absence of price ceilings, the price is $3 and the quantity is 12 units Price ceilings deprive consumers of 4 units, which they value at $3.50 each or $14 Without price ceilings, consumers would have paid $12 ($3 x 4) for them So price ceilings have deprived consumers of a surplus (cash on the table) of $2, or $0.50 per unit

42. 1–42 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Cash on the Table: Sellers Sellers have also lost profits on 4 units Without price ceilings they received $3 per unit on 4 units which, on average, cost $2.50 to make, a profit of $0.50 per unit They have lost profits (cash on the table) of $2 (4 x $0.50) So the price ceilings have imposed a social loss of $4, $2 on buyers and $2 on sellers

43. 1–43 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank When is the Market Efficient? When all of the costs of producing the good or service are borne directly by the seller, so that costs to producers reflect costs to the community When all benefits from the good or service accrue directly to buyers, so that benefits to buyers reflect benefits to the community

44. 1–44 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank When is the Market Inefficient? Smart For One, Dumb For All –When some costs of production fall on people other than those who produce the commodity –When some of the benefits of the commodity fall on people other than those who consume the commodity

45. 1–45 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Inefficient Markets Example: Environmental Pollution –The market is in equilibrium: Sellers’ MC = MB –However, sellers’ MC underestimates the cost to society of producing the good –Therefore, the market produces more than the efficient amount and there is no incentive for producers and consumers to alter their behaviour

46. 1–46 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint ® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Inefficient Markets Example: Vaccinations –The market is in equilibrium: Buyers’ MB = MC –Buyers’ MB underestimates the benefits to society of consuming the vaccinations –The market produces less than the efficient amount of vaccinations and there is no incentive for producers and consumers to alter their behaviour