Microecon Study Guide 1
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Date Created: 01/26/16
ECON 201 Study Guide Instructor: Dennis O’Dea Chapter 1 – Principles of Economics Principles of Individual Choice - Resources are scarce – unlimited choice is boring! - Everything has an opportunity cost, which means everything is a trade- of o Includes forgone wages, forgone fun, etc. o Remember that decisions are made based on marginal trade-ofs and not gross sum. - Principle four says people do choose wisely to make your resources worth it. o People are maximizers: try to maximize “happiness” o Respond to incentives around them, as much as they know Principles of Interaction - As rational beings, both parties must gain from trade. o If no gain, then could choose diferent option. - Markets move towards equilibrium, the outcome where all most happy with their choice. - Efficiency means using all the resources and not wasting any opportunities. o Competitive markets are (or should be) efficient - Government can intervene when markets are inefficient Principles of economy-wide interactions - Key fact of Macro: one person’s spending is another person’s income - Spending is not always equal to productive capacity – demand determines production - Government afect spending through a) direct spending and b) tax cuts, incentives Models in Economics - Simplified version of reality: only focuses on some things, and excludes all other things o Understand that the model is not reality; purpose is to help clarify our thinking - Ceteris Paribus assumption: all other things remains the same The CircularFlow Diagram Money Households Money Goods Factors services Factor Markets Goods and Factors services Money Firms Money Circular-Flow Diagram o HouseholdsFactor MarketsFirms: Factors, resources o FirmsMarkets for Goods and ServicesHouseholds: Goods and services o HouseholdsMarkets for Goods and ServicesFirmsFactor Markets: Money - Very simple model of transactions: who trades with who, for what. - Missing banks, federal reserve, transaction between firms, distribution of wealth, etc. Trade-ofs: The Production Possibility Frontier (PPF) - Two characteristics: efficient and feasible - Trade-ofs in economy producing only two goods; maximum quantity of one good that can be produced for any given production of other good. - What is being held constant: population, machinery/production, raw materials; no markets - Efficiency is on the frontier/line itself o Below line is feasible but inefficient; above line is not feasible - Trade-of between the two products is the opportunity cost o Cost is the slope; so cost is not constant if the slope is not constant. - First 20 small jets has cost of 5 Dreamliners, but next 20 small jets has cost of 25 Dreamliners!! - Give up consumption today to increase consumption tomorrow o Consumption goods vs capital goods; need to build factories first before producing - Economic growth: PPF shifts to the right/outwards End Section 1 Lecture 2: Economic Models, Supply and Demand - Absolute advantage: when more output can be produced given a certain input - Comparative advantage: when opportunity cost (i.e. per unit) is cheaper How Economists use Models - Positive economics: describes way economy actually works - Normative economics: describes way economy should work - Forecast: a simple prediction of the future; hopefully based on decent model o If forecast is not accurate, it means that the model is missing some information - Keynes: “[The economist] must study the present in the light of the past for the purposes of the future.” Supply and Demand - How a competitive market behaves. o Market: trade in a single, well-defined good. o We will be using markets of free, voluntary exchange. o Competitive = big; lots of buyers and sellers; each individual so small that they will not afect the model as a whole. - Moving parts of the model: consumers and firms o Consumers generate the demand curve: relationship between price of good and willingness to pay/quantity demanded. o Firms generate the supply curve: relationship between price of good and the quantity supplied Demand curve: relationship between consumer’s willingness to pay and the price of the good - Ceteris Paribus: everything in the consumers life that matters to question doesn’t change. - Demand schedule: shows how much of a good or service consumers will want to buy at diferent prices; table of data used to generate demand curve. Demand Curve for Cotton Quantity of Cotton (Billions of Price of Cotton (per lb) pound 7 2.00 8 1.75 9 1.50 10 1.25 11 1.00 13 0.75 14 0.50 o Remember Law of demand: as price falls, quantity demanded will increase. - On graph, quantity on x-axis, price on y-axis. Demand Curve for Cotton 2.00 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.07 8 9 10 11 13 14 Slides vs. shifts - Demand curve is relationship between P and Q. - If P changes, then curve tells us what Q will be i.e. a slide along the curve o Only a change in price will result in a slide along the curve. - If anything else changes (e.g. one of the “constants;” population, wages, etc.), then we need a whole new curve; at every P the Q will be diferent i.e. a shift of the whole curve Supply Curve: relationship between curve’s willingness to sell and the price of the good - Ceteris Paribus: technology, costs, competitors, everything that isn’t price, remains the same - Supply schedule: how much of good will be supplied at diferent prices o Law of supply: as cost goes up, the quantity supplied will go up; firms will want to take advantage of higher prices by selling more. Supply Curve for Cotton Quantity of Cotton (Billions of Price of Cotton (per lb) pound 7 0.70 8 0.90 9 1.10 10 1.40 11 1.70 13 2.00 14 2.40 Supply Curve of Cotton 3.00 2.50 2.00 1.50 1.00 0.50 0.00 7 8 9 10 11 13 14 - Equilibrium in a competitive market: when the quantity demanded of a good equals the quantity supplied of the good; determined by changing the price (Q =DQ ). S - Price at which this takes place is the equilibrium price, or market- clearing price. Why does the market tend to be at equilibrium? - Market is most stable at equilibrium. - Surplus: At certain price, quantity supplied will exceed quantity demanded. Firms will lower their prices in order to sell before their competitors. - Shortage: At certain price, quantity demanded will exceed quantity supplied. More demand will lead to competitors producing more of the good at a higher price. o Competition on both sides results in shift towards equilibrium. Market Equilibrium - Principle of interaction: market equilibrium is stable; must be intersection of supply and demand curve. If price changes, then one of the curves must have shifted. o E.g. technology improvements improves supply/shifts supply curve to the right - *Changing a variable only shifts one of the curves, everything else remains the same! - If equilibrium changes, then curves must have changed o Price is the way consumers and firms talk to each other Lecture 3: macroeconomics, GDP Brief History of Macro th th - Classical economics (end 19 cent-early 20 cent): Marshallian economics o Supply and demand model for all economic aspects of world o Self-regulation, efficient (no surplus or shortage) and clear markets; unemployment cannot exist. o Competitive: unemployment does not exist – everyone wanting to work would be working o Everything was at peace until the Great Depression attacked - Keynesian Economics: theory about how productive capacity and actual spending get out of sync; use government tools to correct gap. o According to Keynesian Economics; Great Depression caused by fall in spending o Fiscal Policy: Presidential/congressional spending and taxing powers to manipulate economy o Monetary policy: Banks changing quantity of money in circulation. - Neo-Classical model emerged in late 60s under Milton Friedman – can’t do as much in the long-run as hoped; stresses response of rational, forward-thinking individuals to the government policy o Many results contradictory to Keynesian, e.g. absence of government intervention - Many arguments in Macro are “Keynesians” vs “Neo-classicals” o Keynesian constructed to explain short run (6-8 months)/business cycles o Business cycles - Recession/contraction – depression/expansion cycle; peaktroughrecoverprosperity/expansionpeak - Cycles used to measure growth from peak-to-peak or trough-to-troughs - Problems: wasteful because not all workers/resources are being used o Inefficiency is bad because pain of economy is very unbalanced; greater part of burden falls on the more vulnerable workers in the economy - Recession efects ability of workers to hold and find jobs; makes economy inefficient o Workers who lose jobs are most directly harmed - Policy eforts undertaken to reduce severity of recessions are stabilization policies o Also called counter cyclical policies o Reminder: Fiscal policy or monetary policy - Countercyclical policy: in bad times need expansionary policy; good times need contractionary policy Inflation - Micro S&D only explains relative price changes, but if all prices change (including wage) then micro is not helpful. - Price going up = inflation. - Price going down = deflation. o Annual percent change is the inflation rate - Price stability achieved when only slow change in aggregate price level e.g. 1-2% - Prices depend on amount of money in economy i.e. not anything real, so who’s actually harmed? People holding the money; purchasing power decreases/people can buy less stuf with their dollar. o People who owe others cash gain. o Leads to uncertainty - To determine whether prices are going up or down, need to determine which prices are important - Short run: changes in prices will follow business cycle (might say price stability is something that government should try to achieve) - Long run: Inflation is always and everywhere wherever there is money as a result of the government. International Imbalances (trade is something that we will not focus on) - Open economy: economy that trades goods and services with other countries - Trade deficit: imports>exports - Trade surplus: exports>imports o Trade deficit/surplus isn’t necessarily good or badthis determined by GDP An Expanded CircularFlow Diagram Government purchases of goods and services Government Government borrowing Consumer Government spending Taxes transfers rivate savings Households Wages, profit, interest, rent Factor Markets nancial Markets Wages, profit, GDP interest, rent Borrowing and stock Investment Firms issues by firms Exports and sales of stock Rest of the world Foreign lending and Imports purchases of stock - Expanded circular-flow diagram now includes government, rest of world, financial markets, firm-to-firm purchases Gross Domestic Product - GDP - GDP includes all the stuf that changes hands in the circular flow; all value produced in the country o Could be measured in the spending direction or the income direction. Includes foreign firms operating locally o *Circular flow means all should be the same i.e. all spending is income - National Income Accounting Identity: Y = C + I + G + (X-M) o Y: Income received o C: Consumption spending o I: Investment spending o G: Government spending o X: Exports o M: Imports (X-M) tells whether we have trade surplus or trade deficit - This is the most important equation to remember because understanding all the components helps us to understand why the GDP is what it is. - Gross domestic product or GDP measures total value of all final goods/services; does not include the value of intermediate goods. o Value of intermediate goods included in value of final goods o Aggregate spending = aggregate income; spending and income may be used interchangeably because they must be the same. - Aggregate spending – sum of consumer spending, investment spending, government purchases of goods/services, and exports minus imports; total spending on domestically produced final goods/services in economy. End of Lecture 3 Calculating GDP - 1. Add the value added of all producers - 2. Add all spending on domestically produced final goods/services o Results in equation GDP = C + I + G + X – M - 3. Add all income paid to factors of production o Include: domestically produced final goods, new construction of structures (apartments, buildings), changes to inventories o Does not include: intermediate goods/services, inputs, used goods, financial assets like stocks/bonds, foreign-produced goods and services o Inventory: Include in GDP when products are added to inventory, not @sale - Value added per firm = value of sales – cost of intermediate goods o Value of intermediary goods are already included in the final price - Real GDP is calculated with the prices of same year same quantity. - Per-capita GDP used to compare quality of life or productivity of citizens in country. o GDP divided by number of people o GDP will be larger value for bigger economies/countries (e.g. US vs Sweden) - Nominal GDP measured using today’s prices; P x Q of any given year. o Makes comparing GDP over time difficult (did output rise or just prices)need a way to measure only Q o P is “aggregate price level,” the Macro P - What are problems that arise when we correct GDP to account for changes in price level (nominal GDP)? rises in quality are hard to measure End of Lecture 4 Review - GDP is a sum of value added by all firms, or sum of payments to all factors o Measure market value of all economic activity Price Indexes and the Aggregate Price Level - Aggregate price level is measure of overall level of prices in economy - To measure, economists calculate the cost of purchasing a market basket o Cost of basket changing = price level goes up - Price index is ratio of current cost of market basket to the cost in a base year, multiplied by 100 (to get percent) o Cost of market basket∈given year , also remember is usually Cost of market basket∈baseyear newer year to previous year. Same with inflation o If index goes up, prices rising; index goes down, prices falling - Not all products have same importance – may have more of one product in market basket - Inflation rate: yearly percentage change in price index; typically based on Consumer Price Index or CPI; the most common measure of aggregate price level. - CPI does not take into account that the distribution may change based on the changes in the prices of component e.g. housing o CPI tends to make inflation look larger than it actually is. o Inflation rate: diferent in price indexes divided by base price index x 100 - Directly and immediately impacts Americans because many payments are tied/indexed to the CPI; amount paid rises or falls when CPI rises or falls. - Chained dollars: method of calculating changes in CPI using average between growth rate from early base year and late base year; probably more accurate because smaller estimates of inflation. o More accurate because less efects of inflation - When good in CPI undergoes unaccounted for quality improvements, inflation will be overestimated o Quality of product goes up even though price stays the same – value is understated; inflation will be overstated. - Producer price index is similar to CPI but for goods purchased by firms o Real GDP may not change that much even if CPI drastically changes, but nominal GDP will give away the drop in price level. - Economists use GDP deflator to measure price level by calculating ratio of nominal GDP to real GDP Unemployment Rate - Employment: # people currently employed in economy, full or part time - Unemployment: # people actively looking for work but not employed - Labor force: sum of employed and unemployed - Labor force participation rate: percentage of population aged 16 or older in labor force o Labor force divided by population 16 or older - Unemployment rate is percentage of total # people in labor force who are unemployed o # unemployed workers divided by labor force - More categorizations of workers. o Marginally attached workers would like to be employed and have looked for a job recently, but are not currently looking for work o Discouraged workers are nonworking people who are capable of working but have given up looking for a job due to state of job market. o Underemployment: # people who work part time because cannot find full-time jobs - If a large number of people give up looking for work, the unemployment rate will fall The Nature of Unemployment - Workers spending time looking for employment are engaged in the job search - Frictional unemployment is due to time workers spend in job search (e.g. just got out of college) o Lots of people being firedmore searchers at one time - Structural unemployment is when there are more people searching for jobs in a labor market than there are available jobs at the current wage (e.g. old industry going out of style, skill mismatch) o Efficiency wages: wages employers set above equilibrium wage as an incentive for better performance, but leads to structural unemployment Labor demand falls when wages are higher while labor supply increases o Side efects of government policies: designed to help workers who lose their jobs; however may lead to structural unemployment as unintended side efect (people may prefer government policies to actually working) o Good because signals the rise of new industries/market growth Structural Unemployment TheEffect of a Minimum Wageon theLabor Market Wage Rate Structural unemployment WF Minimum wage WE Q Q Q Quantity of D E S Labor - Wages are on the y-axis, quantity is on the x-axis o Diference in quantity at a certain wage above the equilibrium price gives the number of people in structural unemployment o May be caused by skill-mismatch, new vs old industries, institutions of the labor market (worker protections, unemployment insurance, etc.) End of lecture 5 10/20 – Unemployment and Inflation, Growth - Everything left over is cyclical unemployment i.e. unemployment due to recession/boom - Minimum wage: government-mandated floor on the price of labor - Unions: bargaining for all firm’s workers collectively (collective bargaining); unions can often win higher wages from employers than if employers bargained individually o Has same efect as minimum wage (that is above equilibrium) - Natural rate of unemployment: normal unemployment rate around which actual unemployment rate fluctuates. Sum of frictional and structural unemployment. o Natural unemployment = frictional unemployment + structural unemployment - Cyclical unemployment is a deviation in actual rate of unemployment from natural rate. o Not necessarily a healthy thing – this we’d like to get rid of o Actual unemployment = natural unemployment + cyclical unemployment - Full Employment: when actual unemployment = natural unemployment Structural unemployment - Higher minimum wage actually leads to higher unemployment - Unemployment tends to be higher in Europe than the US because: unemployment benefits in Europe are more generous (people may be less motivated to find a job) Inflation and Disinflation - Prices going up = inflation; prices going down = disinflation o If unemployment too low, then growth and therefore inflation would be very high - Real wage is the wage rate divided by the price level (“real stuf” your wage represents) o Real interest rate: is nominal interest rate minus rate of inflation Real rate = Nominal Rate – Inflation Rate If someone borrows from you and ofer to pay 10% but meantime has 20% inflation, you lose money! o Real interest rate is what you should look at. o Danger is not knowing what the interest rate will be in the future - Nominal interest rate is interest rate expressed in dollar terms - Shoe-leather costs are increased costs of transactions caused by inflation (consumer side) o When you search longer for goods you’re not sure if price is good one - Menu cost is real cost of changing a listed price (firm side) o Printing new menus; time and energy - Unit-of-account costs are from way inflation makes money a less reliable unit of measurement - Reallocations of Wealth: some will win and some will lose from inflation, meaning that wealth is being transferred (maybe unintentionally) - Inflation winners: anyone owing money, workers, relatively poor o Losers: anyone owed money, people on fixed incomes, relatively wealthy o Inflation transfers money from the rich to the poor - Disinflation: process of bringing inflation rate down o Problem with deflation is that it halts investment/spending – more beneficial to hold onto money (because it is gaining value) - When prices are rising, wages will rise. o Likewise, investment tends to fall when deflation happens. 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