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ISU / Economics / ECON 105 / What is the difference between scarce and free goods?

What is the difference between scarce and free goods?

What is the difference between scarce and free goods?


School: Illinois State University
Department: Economics
Course: Principles Economics
Professor: Rajeev goel
Term: Fall 2015
Cost: 50
Name: ECO 105 Goel Final Exam Study Guide
Description: This is a compilation of all of the study guides for all of the exams in ECO 105 with Goel. He did not give an official study guide for the final, but said to look back on them all. I believe this can help you perform better on the final exam.
Uploaded: 12/02/2015
30 Pages 81 Views 2 Unlocks


What is the difference between scarce and free goods?

• Definition of Economics

− The study of how scarce resources are allocated among competing  ends/uses

• Micro and Macro Economincs

− Micro: Analysis of small

− Macro: Analysis of large



  |                  |

       Micro           Macro



  |                  | Don't forget about the age old question of How to conduct the allied war effort?

     Positive Statements    Normative Statements

• Scarce and Free Goods

What is the principle of substitution?

− Scarce goods have positive opportunity costs

• Resources are SCARCE when DEMAND EXCEEDS SUPPLY − Free goods have zero opportunity costs


• Positive and Normative Economics


− Positive Statements: Fact based, “what is?”

− Normative Statements: More opinion based, “what should be?”

− See chart under micro/macro

• Fallacies in Economics

State some facts about monopoly.

If you want to learn more check out What are the two types of nucleic acids?



− False-Cause: Caution about cause and effect




− Composition: Caution about generalization Don't forget about the age old question of Define anomie.


• Positive and Negative relationships

− Positive: Both variables move in same direction

− Negative: Variables move in opposition

0 Don't forget about the age old question of What is the most common treatment for adhd?


• Independent and Dependent Variables



− Independent Variable: Changes by itself

• On horizontal (X) axis

− Dependent Variable: Changes as a result of a change in the independent  variable

• On vertical (Y) axis

• Area and Slope

− Area

• Area of a Rectangle = Length x Width

− Example: The total sales of a Business (P x Q) can be expressed as the  Don't forget about the age old question of Define art.

area of a rectangle

P If you want to learn more check out What is the definition of a collective action problem?



• Area of a Triangle = (1/2)Base x Height

− Slope

• Rise/Run

• Positive relation, positive slope

• Negative relation, negative slope


Cost Profit   Sales

• Cannot talk about slope of a curve, it changes as you move along it • Resources: Land, Labor, Capital, Entrepreneurship

− Land (Rent), Labor (Wages), Capital (Interest….Technology),  Entrepreneurship (Profits = Sales – Costs)

− Land and Capital: have one distinguishing characteristic

• Unlike capital, total aggregate supply of land is fixed

− Labor (Characteristics)

• Cannot be bought or sold

• Ability to form unions

• Cares about the kind of work it does

− Entrepreneurship (Characteristics)

• Risk taking ability

• Profits are residual rewards: gets paid after factors (costs) have been  paid

• Scarcity, Choice, Specialization, Exchange

− Scarcity (PPF) —> Choice —> Specialization (LCA) —> Exchange • PPF: Production Possibilities Frontier

• LCA: Law of Comparative Advantage

• Opportunity Costs

− Cost of the Next Best Alternative forgone

• Scarce goods have positive opportunity costs

• Free goods have zero opportunity costs

• The Economic Problem

− Three Economic Questions

• What to Produce?

− Necessities vs. Luxuries

• Luxuries are more responsive to income that is free (available) • How to Produce?

− Labor Intensive vs. Capital Intensive

• Labor Intensive: more workers, fewer machines

• Capital Intensive: more machines, fewer workers

• For Whom to Produce?

− If a business focuses on necessities, they are catering to a bigger  population

− If a business focuses on luxuries, they are catering to a smaller  population

− Prices give the business signal; businesses will focus more on where  they believe the most money can be made

• PPF: Production Possibilities Frontier

− Shows Maximum Combinations of goods and services that an economy can  produce with the Given Resources (i.e.: Land, Labor, Capital,  

Entrepreneurship) and Current Technology 

− Talks about production possibilities, NOT what should (or must) be  produced

− Points on the PPF are attainable and efficient, points beyond the Frontier  are unattainable, and points inside the Frontier are attainable, but  inefficient

− When Resources and/or technology changes, the PPF either shifts or  rotates

Good B





Point A is on the PPF and is                     attainable and efficient

Point Z is beyond the PPF and is  unattainable

Point M is inside the PPF and is  attainable, but it is inefficient

0 Good A

Representation of a SHIFT in the PPF      Representation of a ROTATION in the PPF

Good B

Good B

0 Good A

Good A


• Shape of PPF

− A PPF has a negative slope (due to the positive opportunity cost of  producing a good or service) and is bowed outward (due to the Law of  Increasing Cost)

• Law of Increasing Costs

− Law of Increasing Cost: As you produce more of a good (or service) its  Opportunity Cost per unit goes up

• This is the economic reason for the PPF being Bowed Outward • Law of Diminishing Returns

− Law of Diminishing Returns: As one input (land, labor, capital,  entrepreneurship) is increased in equal increments, holding all other inputs  the same, the additions to output will eventually decrease

• Markets

− Markets are established arrangements where buying and selling of goods  (and services) takes place

• Eliminates once in a lifetime transactions (example: garage sales) − Local vs. National Markets

− Daily and Monthly Markets

− Goods Markets

• Walmart

− Factor Markets

• Bank

• Real-estate  

− How has the internet changed markets?

• Allows buyers and sellers to come together that wouldn’t normally have  the opportunity to

− Isolated transaction is not a market

• Circular Flow of Economic Activity

• Relative and Money Prices

− Money Prices: Price of a good (or service) in the unit of currency − Relative Prices: Price of a good (or service) in terms of another good (or  service)

• Can be seen as a Frame of Reference

• Can also be relative to some other good at another time

− Microeconomics focuses on Relative Price: Frame of Reference − Macroeconomics focuses on Money Price: Rate of Inflation − Example:

MP1          MP2        RP1 RP2      Car $8,000      $20,000          10 Bikes          20 Bikes       Bike $800       $1,000                       1/10 Car         1/20 Car • While both Money Prices have increased from period 1 to 2 only the  

Relative Price of cars has increased. The Relative Price of bikes, on the  other hand, has decreased over the same period

• Money Price and Relative Price do not necessarily move in the same  direction

• ** Marginal Analysis

− “What happens when one more?”

− Rational Economic Agents make decisions at the margin: undertake those  activities whose Marginal Benefits EXCEEDS Marginal Costs 

− Think about economic “irrationality”

• The Principle of Substitution

− Principle of Substitution: nearly every good (or service) has a substitute • Example: Coke and Pepsi, Air and Car Travel

• Specialization/The Law of Comparative Advantage

− Law of Comparative Advantage (LCA)

• REVIEW: Scarcity(PPF) —> Choice —> Specialization (LCA) —> Exchange

• Focuses on specialization

• It is better for individuals to specialize in those activities in which their  Comparative Advantage over other activities is the greatest, or their  comparative disadvantage is the least

• Distinction between Comparative vs. Absolute Advantage • REMEMBER Opportunity Cost is always in terms of something else • Example:                                               Opp. Cost Lawns    Opp. Cost Pages

Lawn/Day          Pages/Day              (in pages)            (in lawns) Jack        2      20                                 10             2/20 = .1^ Jill        8      50 50/8 = 6.25^            8/25 = .16 _ = Higher opportunity cost      ^ = Lower opportunity cost

• Although, Jill has an absolute advantage in both, her comparative  advantage is in mowing lawns

• Jill should mow, and Jack should type because it is his least disadvantage • Doctrine of Invisible Hand: Adam Smith (Father of Modern Economics, 1700s) − When economic agents (buyers and sellers) act in their self interest, without any interference by the government, they end up promoting well  being of society

− Invisible hand emphasizes “Hands-off” Government

− It has less relevance in the modern world as all governments interfere to  varying degrees in their economies

− Limitations of Invisible Hand (case for government intervention) • Income Distribution: reveals what percentage of individuals are at  different wage levels

• Role of Government:

− Public Goods: nonrivalry in consumption, nonexclusion

• Many people can use these at the same time

− Example: Mt. Rushmore, National Defense

− Externalities: private costs/benefits ≠ social costs/benefits

• Example: Congestion/pollution; pollution from oil company  effecting people living around it and if the government steps in to  regulate it

• Monopoly: in general, is not a bad thing

− Example of how a monopoly can be bad: If there is only one producer  of a life saving drug they cannot charge an outrageous price

• Macroeconomic Instability: The government steps in to help out

• Demand

− Demand: The amount people are prepared to buy under specified  circumstances during a specified time period

− Law of Demand: There is a negative (inverse) relationship between the  price of a good and its Quantity Demanded, Holding other factors constant − Demand Curve: Shows the various Quantities Demanded at different prices,  Holding other factors constant 

− Real world behavior is not necessarily a straight line (Example: D1)





Q (Units)

− A negative price and negative quantity don’t have economic meaning • Individual and Market Demand

− The Market Demand curve is the Horizontal Sum(adding QD) of Individual  Demand

    Individual Market               Market Demand

$/Meal $/Meal $/Meal A B DA+B



5 5 5



3 3 3 DA DB

2 3 3




4 3



5 3

7 3



• Individual and Market Demand (cont.)

− Principle of Substitution: nearly every good (or service) has a substitute • Example: Coke and Pepsi, Air and Car Travel

• Factors that Shift the Demand Curve (other than price)

− Price of Related Goods

• Substitutes or Complements

− Substitutes example: Coke and Pepsi

− Complements example: Sugar and Coffee

− Consumer Income

• Normal and Inferior Goods

• Most goods are normal goods: Income increases, Demand increases • Inferior goods: Income increases, Demand decreases

− Example: Ramen Noodles

− Consumer Preferences

− Number of Buyers

− Buyers’ Expectations

• Movement vs. Shift in a Curve (Applies to both demand and supply curve) − When the Price of the Good Changes, there is a Movement along the  Demand (or Supply) curve. Called Change in Quantity Demanded/Supplied − When Factors Other Than the Price of the good change, there is a shift in  the Demand (or Supply) curve. Called Change in Demand/Supply 

       Movement Shift 














D2 S1























• Supply

− Supply: Quantity Supplied of a good or service is the amount of the good or  service offered for sale at a given price, Holding other Factors Constant − The Supply Curve (or supply schedule): Of a particular good or service  shows the various Quantities Supplied at different prices, Holding other  Factors Constant 

− The Supply Curve is generally positively sloped

• Factors Shifting the Supply Curve

− Prices of Other Goods: Other goods the seller is either producing or can  produce

− Prices of Relevant Resources

− Technology

− Number of Sellers

− Seller’s Expectations

• *** Market Equilibrium

− Market Equilibrium: Is at the the intersection of Demand and Supply Curves − Gives Equilibrium price and quantity

− Equilibrium price is that price at which the Quantity Demanded of a good  equals it Quantity Supply



  P1   EP   P2








Q 5

− Characteristics

• Quantity Demanded = Quantity Supplied

• No shortage or surplus: The market clears • Equilibrium price is stable: No tendency to rise or fall − Effect on Market EQ of an increase in income: P ⇑ , Q ⇓ − Effect of increase in technology: P ⇓, Q ⇑

• *** Market Equilibrium (cont.)

− Effect on Market EQ of an increase in the number sellers and a  simultaneous decrease in the number of buyers: P ⇓, Q depends on amount • Elasticity: A measure of a variable's sensitivity to a change in another variable • Price Elasticity of Demand (ED)

− Responsiveness of Quantity Demanded of a good to changes in its price − ED = %ΔQD ⎟ %ΔP

• Ratio of percentages; Does not have a unit

• ED, while always negative, is sometimes taken in absolute value for  interpretation

− ED = 1 (Unit elastic demand)

− ED > 1 (Elastic demand)

− ED < 1 (Inelastic demand)

− Price Elasticity of Demand Determinants

• Availability of Substitutes

− More substitutes, more elastic demand

• Relative importance of the good in consumer’s budget

• Time to adjust to price changes

• Necessities (ED < 1) vs. Luxuries (ED > 1)

• Total Revenue Test

− Total Revenue (SALES) = P x Q

− If P ⇑ and TR ⇓ then ED > 1 (elastic)

− If P ⇑ and TR ⇑ then ED < 1 (inelastic)

− If P changes but TR doesn’t change then ED = 1 (unit elastic) − Useful for businesses considering raising prices

• Elasticity and Slope

− The more horizontal the curve (demand or supply), the more elastic and  vice versa

     Perfectly Elastic            Perfectly Inelastic

$ 0

ED = -∞ D



$ 0

ED = 0



$ $

ES = ∞


0 0



• Income Elasticity of Demand (EI)

ES = 0



− Responsiveness of Quantity Demanded of a good to changes in income − EI= %ΔQD ⎟ %Δ I (No absolute value)

• Example:  EI  =  0.8  Normal and Necessity

• Example:  EI  =  1.3 Normal and Luxury

− EI >  0 = Normal Good (Positive)

− EI <  0 = Inferior Good (Negative)

− EI <  1 = Necessity

− EI <  0 = Luxury

• Cross-Price Elasticity of Demand (EXY)

− Responsiveness of Quantity Demanded of a good to changes in price of  another good

− EXY = %ΔQD (of X) ⎟ %Δ P(of Y) (No absolute value)

− EXY >  0   X and Y are substitutes

− EXY <  0   X and Y are complements

− EXY =  0   X and Y are unrelated

− Example:

• X, Y, and Z are all goods.  

− EYZ = 0.8

− EYX = 0.5

• EYZ and EYX are both substitutes

− EXZ = -1.1

• EXZ are complements

• Price Elasticity of Supply (ES)

− Responsiveness of Quantity Supplied of a good to changes in its price − ES = %ΔQS  ⎟ %Δ P (No absolute value)

− ES Depends on (i) time the seller has time to respond; and (ii) availability of  inputs

• ES =  0   (inelastic) immediate run: no time to alter inputs

• ** ES >  0  (somewhat elastic) Short Run: time to alter some, but not all  inputs

• ** ES >>  0    (most elastic) Long Run: time to alter all inputs • Applications of Elasticity (Tax Burden and Sales)

− Tax Burden: The party (buyer or seller) with greater unresponsiveness bears  greater tax burden

− Price Changes: With inelastic Demands, firms can afford to raise prices  without worrying about revenue losses


• Consumer Behavior

− Preferences: Consumers’ likes and dislikes about goods and services,  independent of price and income considerations

− Utility: The satisfaction a consumer gets from consuming goods and  services

− Satisfaction can be negative

− Measure satisfaction in utils

− Marginal Utility (MU): Extra satisfaction from consuming one more unit of a  good or service (change in utility / change in consumption)

− Law of Diminishing Marginal Utility: As you consume more of a good,  holding the consumption of everything else the same, the additions to  satisfaction (i.e. MU)

− Demand and Utility

• Focusses on the Households and Goods Market exchange

• Two questions of Demand and Utility

− Where does the Demand curve come from?

− What constitutes a best buy?

− *** Consumer Equilibrium

• In consumer equilibrium, the consumer is consuming the set of goods  and services that maximizes satisfaction

• Consumer’s income and prices of the goods are assumed to be given • Unless prices and/or income change, a consumer in equilibrium has no  incentive to change the satisfaction maximizing bundle of goods and  services

• Conditions for Consumer Equilibrium (optimizing consumption rule) − All income is spent AND

− MUa / Pa = MUb / Pb = …

• Points along the demand curve are consistent with consumer  equilibrium. The demand curve results from consumer’s efforts to  maximize satisfaction

• Example: A consumer spends all his income of $1,000 on two goods:  food and clothing. The respective prices are Pf= $10 and Pc= $20. The  marginal utilities are: MUf= 50 and MUc=200. Is the consumer  maximizing satisfaction? If not, what should the consumer do to  maximize satisfaction?

MUc / Pc  = 200/20 = 10 MUf / Pf  = 50/10 = 5

Satisfaction is not maximized; to maximize it the consumer should  increase Clothes and decrease Food

− Consumer Surplus

• Consumer surplus: is a measure of consumer’s well being

• Consumer surplus is the difference between a consumer’s willingness to  pay for a good and what the consumer actually pays

• Graphically it is the area of the triangle below the demand curve and  above price

• Costs and Productivity

− Economic Costs vs. Accounting Costs

• Explicit Costs: Costs incurred when money changes hands  

• Implicit Costs: Money does not change hands, but some alternative is  sacrificed

• Economic Costs = Explicit + Implicit

• Accounting Costs = Explicit Costs

− Profits: Economics vs. Accounting

• Economic Profits = TR (sales) – (Explicit + Implicit)

• Accounting Profits = TR – Explicit Costs

• Normal Profits = TR = Explicit + Implicit

• This is the Break-even case of zero economic profit

− Productivity  

• Marginal Physical Product: Extra output from one more input                            (Change in Q / Change in Input)

− Law of Diminishing Returns: As you increase one input in equal increments,  holding all other inputs the same, its MPP will go down

− * There is a negative relationship between MPP and MC

− Example:  

Labor (L) Output (Q)         (Δ in Q / Δ in Input (L))

1 15   10 / 1 = 10 MPPL

2 25  

− *** Least-cost Production: MPPk / Pk = MPPL / PL = …     K = Capital − K.L.E.M.: Capital, Labor, Energy, Material

− For cost minimization

Example: The price of capital Pk is $100 per machine hour and its marginal  product (MMPk) is 1,000 units. The price of labor (i.e. PL or wage rate) is

$25 per hour and the marginal product of labor (MMPL) is 250 units. Is the  firm minimizing its production costs? If not, what should it do so that coasts  are minimized?

(MMPL / PL) = 250/25 = 10 (MMPk / Pk) = 1000/100 = 10 Cost is minimized because MPPk / Pk = MPPL / PL

Profits cannot be maximized unless costs are minimized

− Costs

• Fixed Costs (FC): Implies Short-Run 

• Variable Costs (VC): Change with production

• Total Costs (TC): FC + VC

• Long Run: All costs are variable

• Average Fixed Costs (AFC) = FC/Q

• Average Variable Costs (AVC) = VC/Q

• Average Total Costs (ATC) = (TC/Q) = AFC + AVC

• Marginal Costs (MC) = (Change in TC / Change in Q) =                                (Change in VC / Change in Q)

− Features of Long Run Costs

• Every long run is a sequence of short runs

• The firm has all the options in the long run that it did in the short run  plus more

• The long run ATC will envelope (touch from below) the SRATCs − LRAC

• Economies of Scale: ATC falls with output increase

• Diseconomies of Scale:  ATC rises with output increase

• Constant Return to Scale: ATC stays constant with output change

• Minimum Efficient Scale (MES): Where LRATC is minimized; a large MES  acts as a (built in) Barrier to Entry of new firms

• Perfect Competition

− Characteristics

• Large number of buyers and sellers

• Perfect information about Price and Quantity

• Homogeneous product

• No barrier to entry and exit of firms

• No buyer or seller is large enough to influence the price

− Price Takers and Price Searchers

• Perfectly competitive Firms are PRICE TAKERS:     Firms take price as given -> Horizontal demand curve -> P = MR • All Non-Competitive Firms are PRICE SEARCHERS -> Negative Sloping  Demand Curve -> P > MR

− Price and Marginal Revenue (MR)

• Total Revenue (TR): Sales = P x Q

• Marginal Revenue (MR): Extra revenue from selling one or more unit of  a good or service: (Change in TR / Change in Q)

− Profit Maximization

• *** Profit Maximization Rule: MC = MR

− Applies to all firms

• Shut Down Rule:  

− P > AVC (or TR > VC): Do not shut down

− P < AVC (or TR < VC): Shut down

• Applies in Short Run (SR) only

− SR and LR Profit max. under P.C.

• In the Short Run, a perfectly competitive firm might shut down, make  profits or make losses

• In the Long Run, a perfectly competitive firm makes normal Profits (i.e.  Break Even)

• Long Run Profit Maximization (Equilibrium) under Perfect Competition • Long Run Perfect Competition

− Characteristics of Long Run Equilibrium (Profit Maximization) under  Perfect Competition

• *Firms make normal Profit

− *Due to freedom of entry and exit of firms

• Firms produce at lowest points on ATC: economic efficiency, no  wastage

− Producer Surplus

• Measure of seller’s well-being

• Difference between what a seller receives for a good and the minimum  the seller is willing to receive

• Graphically, the area above the supply curve and below the price • Together, consumer surplus and producer surplus provide a measure of  social welfare

• Monopoly

− Monopoly Characteristics

• One seller, many buyers

• No close substitutes for the product

• Price Searcher (Maker)  P > MR

• Barriers to entry of rivals

• For a monopoly, the firm and industry are one and the same − Barriers to Entry

• Economies of Scale

• Patents

• Exclusive Ownership of raw materials

• Public Franchises

• Licensing

− Facts About Monopoly

• Monopolist need not produce where ATC are minimized

• In Monopoly: P > MC (Since P > MR for Price Searchers and MC = MR) • Monopolists produce where demand is elastic

• Monopolists DO NOT charge the highest possible price

• There is no supply curve of a monopolist

• Unlike a P.C. Firm, a monopolist can continue to earn profits in the LR  (Due to Entry Barriers)

• Comparing P.C. and Monopoly

− The Efficiency of Competition

• Economic Efficiency: When society’s resources cannot be reallocated to  make Everyone better off

− Equity – Efficiency Tradeoff

• Economic Equity: When resources are allocated according to a widely  accepted fair criteria

• In general, there is the classic tradeoff between Equity and Efficiency:  You have one or the other

− Pros and Cons of Monopoly

• Pros

− Might encourage technical change

• Cons

− **Contrived (Artificial) Scarcity: Monopolist deliberately reduces  output to raise the price (Pm > Pc ; Qm < Qc)

− Monopoly leads to Deadweight Loss (i.e. loss in consumer surplus  and producer surplus, it measures lost gains from trade)

− Pros and Cons of Competition

• Pros

− Economic Efficiency

− Customer receives the lowest price

• Cons

− MIGHT lead to inequalities

− MIGHT NOT be efficient in the presence of externalities  

− MIGHT NOT be Conducive (Receptive) to high rates of technical  change

Exam 3 Study Guide 


• Economic Growth: LR increase in the total goods and services produced by the  economy

• Long term effects on the economy

− Economic Growth can also be represented by an outward shift on the PPF − Business Cycle: SR upward and downward movements in the output of an  economy  

• Business cycle has short lived effects on the economy

• Four Phases of Business Cycle

− Downturn/Recession/Depression (More Severe)

− Trough

− Expansion (Recovery)

− Peak

− Recession occurs when the real output in the economy declines for 6  months or more  

− Depression is a severe downturn in the economic activity for a long period • Unemployment

− Labor Force: Number of people employed + Number unemployed − Unemployment Rate: Number of persons unemployed / number of people  in the labor force

− Natural Rate of Unemployment: That unemployment rate at which there is  an approximate balance between the number of unfiled jobs and the  number of qualified job seekers

− *Natural rate of unemployment is also referred to as full employment • Inflation  

− Inflation: General increase in prices  

− Deflation: General decrease in prices

− Hyperinflation: Very rapid and accelerated rate of inflation

− Rate of Inflation: The rate at which the price level (measured by a price  index) is changing

• Measuring Inflation

− Price Index: Shows the cost of buying the same market basket of goods in  different years as a percentage of its cost in some base year

− CPI (Consumer Price Index): Measures the level of consumer prices paid by  households over time. Narrow measure

− GDP (Gross Domestic Product) Deflator: Measures the level of Prices of all  final goods and services (consumer goods, investment goods, and  Government) produced by the economy. Broad measure

• Effects of Inflation

− Inflation redistributes income (affecting the standard of living) • Redistributes income away from people who have underestimated it − Inflation creates inefficiencies  

• Businesses focus more on anticipating inflation than on more productive  efforts

− Inflation spurts speculation

• Inflation creates uncertainty so that Adam Smith’s invisible hand works  less efficiently  


• Measuring GDP

− **1. GDP = C + I + G + (X – M)

• C = Personal consumption expenditures

• I = Investment spending

• G = Government purchases (including: federal, state, and local govt’s.) • Net Exports

− X = Exports

− M = Imports

• Foreign Savings = M – X

− 2. GDP = Compensation of Employees + Proprietor’s Income +               Rental Income + Corporate Profits + Interest + Depreciation +              Indirect Bus. Tax

− GDI (Gross Domestic Income): Approximate sum of all income earned by  factors of production

− 3. GDP = Total Sales – Purchases (i.e. the sum of the value added of all  industries)

− Net Output or Value Added: Value of industry output minus the value of  purchases from other industries

• Omissions from GDP

− Nonmarketed goods and services (i.e. Household production) − Illegal Activities (i.e. Illegal gambling)

− Value of Leisure

− Transfer Payments: Payments to recipients who have not earned them  through the sale of their production factors and who have not supplied  current goods and services in exchange for these payments (i.e. subsidies,  grants)

• Real and Normal GDP

− Real GDP: Removes the effect of rising prices on nominal GDP − Real GDP per Capita = (Real GDP / Population)

• The best measure of living standards

• GNP (Gross National Product)

− GNP: The final output produced by U.S. residents whether in the U.S. or  abroad

− In contrast, GDP includes goods and services produced by labor and capital  in the U.S., whether or not suppliers are residents of the U.S.

− NNP (Net National Product): GNP – Depreciation  

− National Income: NNP – Indirect Bus Taxes (= Payments made to all factors)

• PPP (Purchasing Power Parity): A rate for converting one economy’s output  into the prices of another country. It is the exchange rate between two  currencies that equates the real buying power of both currencies ECONOMIC GROWTH 

• Economic Growth  

− Growth Rate or Real GDP: Shows the extent to which the total output of  the economy is increasing

− Growth Rate or Real GDP per Capita: Shows the extent to which the  economic well-being of the average person is increasing

− Paul Romer

• Productivity

− Labor Productivity: output per unit of labor (average product of labor) − Capital Productivity: output per unit of capital (average product of capital) − Total Factor Productivity (TFP): output per unit of combined labor and  capital input

− The growth rate of TFP is approximately the growth rate of real output  minus the growth rate of combine factor inputs

• Per Capita Production Function: Shows the relationship between Real GDP per  Capita and the capital stock per capita

Q/L (Real  



• Neoclassical Growth Model (Solow, 1950s): explains economic growth by  virtue of capital accumulation, population growth, and unexplained technical  progress

− Endogenous Growth Theory/Neo-Schumpeterian (Romer): Base  explanation of technological progress on the desire for profit

− Innovations may be product innovations or process innovations − Current innovations make future innovations easier

• Factors Generating Economic Growth

− Human Knowledge

− Saving and Investing

− Political Stability

− Government Consumption

− International Trade


• SR Production Function: Shows the output produced with a given amount of  employment when capital and technology are fixed

− Real wages are money wages divided by the Price level, W/P • Natural Level of Output (Real GDP): That level corresponding to equality in the  Demand and Supply of Labor

• Natural Rate of Unemployment: The rate at which the labor force is in balance;  number of jobs available = number of job seekers

• Aggregate Supply (AS)

− AS curve shows the amount of Real GDP Firms in the economy are prepared  to supply at different Price levels

• Aggregate Demand (AD)

− AD Curve shows the Real GDP that households, businesses, government,  and foreigners are prepared to buy at different prices

− Three major factors cause AD to be negatively sloped: The real balance  effect, that interest rate, and the foreign trade effect

• Real Balance Effect: Occurs when desired consumption falls as increases  in the price level reduce the purchasing power of money

• Interest Rate Effect: Occurs when increases in the price level push up  interest rates in credit markets, which lowers real investment

• Foreign Trade Effect: Occurs when a rise in the Domestic Price level  lowers the Aggregate Quantity Demanded by pushing down net exports  (X – M)

• Classical Model: an increase in prices should have no effect on the real output  supplied in an economy if Prices, wages, and other costs are all rising at the  same rate when wages and prices are flexible, AS is vertical at the natural level  of output

Price  level



• Keynesian Model: When wages are sticky (inflexible), falling prices raise real  wages and firms reduce their employment and output. AS, therefore, has a  positive slope





Wages Inflexible Prices Flexible

− Money: Functions of Money 

• Medium of exchange

• Unit of value

• Standard of deferred payment

• Store of value

− Types of money 

• Commodity money: whose value as a commodity is as great as its value  as money

• Fiat money: government created money whose value or cost as a  commodity is much less than its value as money

− M1: Currency, demand deposits at commercial banks held by nonbanking  public, travelers’ checks and other checkable deposits

− M2: M1 plus savings and small time deposits, money-market mutual fund  shares and other highly liquid assets

− Bond Prices and Interest Rate: Because bonds promise a fixed payment in  the future, the lower the current price of bonds, the higher is the interest  rate yielded

− Liquidity: The ease and speed with which an asset can be converted into a  medium of exchange without risk of loss

− Liquidity Preference (LP): shows the demand for money as the nominal  interest rate changes, ceteris paribus

− The nominal interest rate is the opportunity cost of holding money − Nominal Interest Rate = Real Interest Rate + Inflation Rate

− Money demand is inversely related with nominal interest rate − Value of money (“valuable” means low prices): 1/P

− ** Equation of Exchange: MV = PQ

• M = Money Supply (M1, M2)

• V = Velocity of circulation (how many times, dollar bill changes hands) • P = P level (CPI, GDP Deflator)

• Q = RGDP

− Money and Prices: The Classical Theory

• The classical theory assumes that V is fixed 

• If (A) M increases while Q stays the same, M and P grow at the same  rate

• If (B) M and Q both increase, the rate of inflation equals the growth rate  of M minus the growth rate of Q


− Commercial Banks: Backs that have been chartered either by a state agency  or by the U.S. Treasury’s Comptroller of currency to make loans and receive  deposits

− Balance Sheet: Summarizes the current financial position of a firm by  comparing the firm’s assets and liabilities

− Assets: Anything of value that is owned

− Liabilities: Anything owed to other economic agents

− Net Worth: Assets – Liabilities  

− Reserves: Are the funds that the bank uses to satisfy cash demands of its  customers

− Federal Reserve System

• Functions of the FED (Federal Reserve)

• 1 Controls the nation’s money supply

• 2 Responsible for the orderly working of the nation’s banking system.  Supervises private banks, serves as bankers’ bank, clears checks, fills  currency needs of private banks and acts as a lender of last resort to  banks needing to borrow reserves

• Reserve Requirements: Rules that state the amount of reserves that a  bank must keep on hand to back bank deposits

− Banks can create money when 

• Demand deposits are used as money

• Banks make loans out of excess reserves

− Multiple Expansion Deposits of money supply occurs when an increase in  reserves causes an expansion of the money supply that is greater than the  serve increase

• One bank can lend out only its excess reserves. However, the banking  system as a whole can lend out a multiple of excess reserves

• Real world expansion of money supply is limited due to cash leakages  and excess reserves

− Banking Regulation

• Restrictions on interest payments on deposits

• Deposit Insurance: FDIC

• Restrictions on permissible activities

• Capital requirements

• Inspection and control of riskiness

• Entry restrictions

− **Monetary Base: Sum of reserves on deposits at the FED, all vault cash  and the currency in circulation

• Smaller than the Money supply


− Basic Facts

• No inflationary trend before 1930s

• Persistent inflationary trend since 1930s

• Inflation since the Great Depression has been variable

• Money and prices are positively associated (MV = PQ)

• Inflation and interest rates are positively associated

− Demand side inflation: occurs when AD increases and pills prices up. At a  macro level demand-side inflation is associated with rising output and  falling unemployment

− Supply side inflation: occurs when AS decreases and pushes prices up.  Supply side inflation is associated with falling output and rising  unemployment

− To individual firms, moderate demand-side inflation look like supply side  inflation. To determine whether inflation is demand side or supply side, we  must know the source of rising prices

− MV = PQ

• Money = Money Supply

• V = Velocity of circulation

• P = Price level

• Q = Output or RGDP

− The rapid growth of MS, well in excess of the growth of Real output, has  cause most economists to conclude that sustained inflation is a monetary  phenomenon

− Inflation and Interest Rates

• Normal Interest Rates = Real Interest Rate + Inflation Rate • Changes in nominal interest rates are primarily determined by changes  in inflationary expectations 

− Because future inflation is more important than current inflation in  the lending-borrowing context

• Short-term interest rates are less affected by inflationary expectations  because the lending period is short

• Long term interest rates are significantly affected by inflationary  expectations

− Inflation Expectations

• Adaptive Expectations are expectations that we form from past  experience and modify only gradually as experience unfolds • Rational Expectations are expectations that we form by using all  available information, relying on past experience But Also on the effects  of present and future policy actions

• 1974 Robert Lucas

− Monetary Growth and Interest Rates

• Effect on interest rates of a one-shot increase in the MS  

• SR vs. LR effects

• An increase in the MS can initially lower interest rates, but the resulting  increase in prices and output pushes interest rates back up in the LR • Effect on interest rates of a continuous increase in the MS • In the LR an increase in the monetary growth raises the nominal interest  rate but not the real interest rate

− Ratification of Supply side inflation results when the government increase  the MS to prevent adverse supply side shocks from rising unemployment • AD is shifted to counter the effects of AS shifts to leave output and  unemployment unchanged, but at higher prices

− The Wage/Price Spiral occurs when higher prices push wages higher and  then higher wages push prices higher, or vice versa. This spiral is sustained  by the monetary authorities ratifying the resulting supply-side inflation by  increasing the MS

− Inflation causes us to engage in economically unproductive activities – investment in precious metals  

− Inflation reduces gains on long term investment capital

− Reduces economic growth  

− Inflation causes price system distortions


− Unemployment Under Classical Model

• Labor Market EQ is determined at the intersection of Labor Demand and  Labor Supply curves

• At the EQ real wage, there will be Frictional Unemployment • Frictional Unemployment: The unemployment associated with the  changing of jobs

− Unemployment Under Keynesian Model

• Implicit Contract: an agreement between employer and employees  concerning conditions of pay, employment and unemployment that is  unwritten but understood by both parties

− Implicit contracts explain how wages can remain steady during  periods of high unemployment

• Structural Unemployment: Results from the LR decrease of certain  industries in response to rising costs, changes in consumer preferences  or technical change

• Cyclical Unemployment: unemployment associated with general  downturns in economy  

− Note that there will still be frictional unemployment in the Keynesian  model

− Phillips Curve

• Keynesian Model 

• Phillips Curve: When wages and prices are not flexible, we would expect  a negative relation between unemployment and inflation

− New Phillips Curve

• SR Philips Curve: has a negative relation between inflation and  unemployment. When inflationary expectations are constant

• New Phillips Curve: There is a different SR Phillips Curve for different  expected inflation rates  

• An increase inflationary expectations causes the SR Phillips curve to shift  up

• Recall that inflationary expectations can either be from adaptive  expectations or rational expectations

− Stagflation

• Stagflation: the combination of high unemployment and high inflation • Origins of Stagflation:

− Full employment policies: pursuit of full employment goals during a  period of adverse supply shocks sets off a W/P Spiral [Ratification of  supply side inflation]

• Unemployment compensation


− Federal Reserve Policy

• Open Market Sales and Purchases 

− Open market purchases increase the monetary base; open market  sales lower the monetary base

• Open market operations are flexible because they can be transacted  quickly and in almost any desired amount

• Open market operations are powerful because they have a magnified  impact on the MS as banks create new money from new reserves • Monetary base: Vault Cash + Currency in Circulation + Deposits at the  FED

• Increase in reserve requirements reduce the MS; reductions in reserve  requirements increase the MS. This is seldom used for monetary policy • Setting the Discount Rate: Interest rate charged to banks by the FED • Federal Funds Rate: Interest rate on overnight loans among financial  institutions

• Other instruments of control 

− Moral suasions: persuade banks to voluntarily follow policy − Selective credit controls: consume credit card restrictions

• Margin credit: Restrictions on borrowing against stock

− Monetary Policy: The deliberate control of the MS and, in some cases,  credit conditions for the purposes of achieving macroeconomic goal such as  a certain level of unemployment or inflation

− FED controls money and credit by:

• Controlling the monetary base thru open market operations • Adjusting reserve requirements

• Setting the discount rate

• Targeting the federal funds rate

• Applying moral persuasion

• Imposing selective credit controls

− Effectiveness of Monetary Policy

• Problems of monetary control 

− The FED does not have direct control over MS, it can only control the  monetary base

− The MS itself will depend upon the reserve/deposit ratio that banks  hold, which depends partly on the reserve requirements imposed by  the FED as well as on the excess reserves desired by banks, and the  public’s desired currency/deposit ratio

− *Monetarism: Prescribes that MS must expand at a constant rate roughly  equal to the LR growth of RGDP. In other words, monetarists recommend a  constant money growth rule

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