EC140 Pre Midterm

Chapters: 1, 2, & 2 Appendix 3, 5, 6, 8, 9. (more focus on chapters 5 and 6, then 8,9 then rest)

What is Economics?

• Studies how society uses scarce resources to satisfy unlimited human wants

• Economics is a social science

• Examines issues and problems from a social perspective, not personal perspective

Key Idea: Scarcity

• People and societies face trade-offs

• So they must make choices

• But making choices leads to costs

• These costs are known as opportunity costs

Opportunity Cost

Definition: The best/highest alternative forgone

Ex. Suppose you have 3 activities (hiking, skiing, studying), if you choose to study, your opportunity cost of studying is the highest(in value) of skiing or hiking

Includes direct costs + indirect costs

• Direct costs: Aka explicit costs are costs paid for out of pocket or paid directly in cash

• Indirect costs: also known as implicit costs are not paid to anyone in cash but are forgone costs - ex. when a firm decides to operate a business and invests $5000, an indirect cost is the interest forgone if the $5000 was invested

Scarcity vs. Poverty

• They are not the same

• The poor and the wealthy alike face scarcity

• Need is not a microeconomic/macroeconomic concept

Equity

The benefits from society’s resources are distributed fairly among its members

Efficiency

Society getting the most it can from its scarce resources

Margin

A choice at the margin is a decision to engage in one more unit of an activity

Incentive

A motivation to perform a particular activity

Sunk cost

A cost that has already been incurred and cannot be recovered

Positive Statement

• A description of what is, can be proven true or false by examining facts

• Ex. There are 5000 students enrolled in first year uni

Normative Statement

• A description of what ought to be, a value judgement (not necessarily true of false)

• Ex. People should not be gay.

Model

• Description of how cause and effect work in some part of the economy

Factors of Production

• Also known as inputs/economic resources (ex. land, labour, capital)

Circular flow diagram

Inner Flow vs. Outer Flow

Gross Domestic Product (GDP)

The mv of all final goods/services produced (and income earned) within a country in a given period of time (such as a year) valued at market prices.

Nominal GDP

Ex. a 2-good economy that products laptops and ipads

• Laptops ($15, 1000 count)

• Ipads ($5, 2000 count)

• Nominal GDP = $15 × 1000 + $5 × 2000 = 25,000

Essentially, this is the sum of price x quantity of all products

Important facts about GDP

• GDP is a

  • Production concept

  • Flow variable (a variable with a time dimension

• GDP does not include

  • Intermediate goods (ex. car engine in a car) - only final goods

  • Used or second hand goods

  • Non-marketed goods and services

  • Financial Assets

• GDP Excludes

  • Used or second hand goodsh

Intermediate goods

Goods intended for resale or processing (ex. paper used in a greeting card)

• Card is considered a final good so if we were to include intermediate goods in the definition of GDP, we could be overestimating the value of GDP

How do we measure GDP

• For the economy as a whole, total expenditures must equal total income received. GDP measures these two things:

• Expenditure approach

  • The total sum of expenditures on all final goods and services.
    Adds up all that is spent to buy up this year's output.

• Income approach

  • The total sum of all factor income payments.

  • The reason that GDP can perform the trick of measuring both total income and total expenditure is that these two things are really the same.

Expenditure Approach

Y (GDP) = C (personal consumption expenditures) + I (investment expenditures) + G (government expenditures) + NX (net exports)

• Y = C + I + G + NX

Consumption Expenditures (C)

• Includes spending by domestic households on final goods and services including those produced abroad

• Excludes the expenditure on new homes, which is counted as part of investment

• Accounts for 60% of GDP

• Constitutes the largest component of GDP

Investment Expenditures

• The purchase of goods that will be used in the future to produce more goods and services

• Sum of purchases of:

  • Capital equipment

  • Inventories

  • Structures

Inventories

• Finished or semi-finished goods

• Changes to inventories can be positive or negative

• Inventory change is included as a expenditure item when we compute GDP

Government Expenditures (G)

G - Government Purchases

• Spending on goods and services by local, territorial, provincial and federal governments

• Does not include:

  • Transfer payments

    • Examples - unemployment insurance, CPP, OAS and welfare

  • Transfer payments do not alter the economy's production

Net Exports (NX)

• NX = purchases of domestically produced goods by foreigners (exports) - domestic purchases for foreign goods (imports)

• All exports are considered final goods and counted in GDP

• Imports contribute to another country’s GDP not to the domestic country’s GDP

Income Approach

• measures GDP by adding together to incomes earned by all the factors that went into producing GDP:

• Compensation of Employees

  • Wages, salaries and benefits

  • Makes up to 51% of GDP

• Gross operating Surplus

  • income of corporation and government business enterprises

• Gross Mixed income

  • Income paid to unincorporated businesses

  • Examples of unincorporated businesses include sole proprietorships and partnerships

• Taxes less subsidies

  • Taxes include indirect taxes such as a sales tax or an excise tax

    • Taxes are added to GDP because their value is included in the market value of goods

• Statistical Discrepancy

  • = GDP income based

Gross National Product (GNP)

GNP = GDP (Foreign investment income paid to foreigners) + Foreign investment income received by Canadians

• Ex. A Canadian engineer may earn income by working on a dam building project in Pakistan

GNP vs. GDP

GNP (canada): output produced by a country’s domestic residents (ex. Canadians) at home and abroad

GDP (rest of world): includes output produced within the borders of Canada both by foreigners and domestic residents

Nominal GDP

Measures to value of the economy’s production of goods and services in current year prices (changes overtime because price and quantity change)

Real GDP

• To obtain a measure of the amount produced that is not affected by changes in prices, we use real GDP

• Real GDP is the production of goods and services valued at constant prices

• Real GDP for year 1

  • year 1 prices x year one quantities

• Real GDP for year 2

  • year 1 prices x year 2 quantities

GDP Deflator

price index that tells us how much prices rise in a specific year

Formula for GDP Deflator

Inflation Rate

• Percent change in the GDP deflator from one year to the next

• [final value - initial value]/initial value x 100

GDP ignores:

• Size of the population

• Consumption of leisure

• Non-marketed economics activities

• Environmental quality

Consumer price index (CPI)

• A measure of the overall cost of the goods and services bought by a typical consumer

• Used to monitor changes in the cost of living over time

• When the consumer price index rises, a typical family has to spend more to maintain the same standard of living

CPI Formula

Inflation

• An increase in the overall level of prices in the economy, usually expressed as an annual percentage change in a price index

Deflation

• A decrease in the overall level of prices

Disinflation

• A decrease in the rate of inflation 

Finding CPI example

Three biases in measuring the CPI

• Commodity substitution bias: Prices change unproportionally, people shift to cheaper substitutes

• New goods bias: introduction of new good gives consumers more variety of choice → increases value of the dollar

• Unmeasured quality change: when quality of good deteriorates, value of dollar falls and when quality of a good increases, value of a dollar increases

GDP Deflator vs. Consumer Price Index

GDP Deflator

• Includes all goods and services produced domestically

• Does not include imports

• Does not have a fixed basket

Consumer Price Index

• Includes all goods and services bought by consumers

• Does include imports

• Does have a fixed basket and is revised by Statistics Canada only occasionally

Market for loanable funds

Nominal Interest rate vs. Real Interest rate

Nominal: has not been corrected for inflation

Real: correct for inflation

Government Policies that increase saving

• lower tax rate on interest income and dividends

• lower capital gains tax

• increase in the amount individuals can contribute to deferred RRSPs

• Economists assume people respond to saving incentives

Tax policies to increase savings (graph)

Government Policies to Increase investment (graph)

Crowding out

• decrease in investment that results from government borrowing

National Savings

• The source of the supply of loanable funds is composed of private saving and public saving 

Grim Consequences of government deficits (graph)

Facts about the deficit: We owe it ourselves

• Some people have argued that government deficits are not a problem if we owe the government debt to ourselves

• However this is not the case

Deficits Arising from Recessions (Cyclical Effects)

• During recessions, government revenues decline

• Debit arises for capital expenditures

Government Budget Deficits and Surpluses

• One of the most pressing policy issues of the past 20 years has been the size of the government budget deficit

Government Debt

The sum of all past budget deficits minus the sum of all past budget surpluses

What is unemployment measured by

Labour Force Survey (LFS)

• Determines employed, unemployed, not in labour force

Types of unemployment

Frictional unemployment (search employment): results from workers taking extra time to search for jobs suiting their interests and skills

Structural unemployment: # of jobs available are