Econ 101
macro vs micro
microeconomics - how households/business make choices
macroeconomics - how individuals, firms/markets, or economy function together
4 core principles of economics
opportunity cost principle - choices have trade offs
opportunity cost - value of next best alternative
part of true cost
ex. college vs getting a job
cost benefit principle - benefits should be greater than costs
incentives shape decisions
associated w any choice
pursue IF benefits > cost
marginal principle - will one more be beneficial?
do until marg benefit = marg cost
interdependence principle - decisions are based on other decisions
yours, other people’s, market’s, etc
SUNK COSTS DO NOT MATTER
sunk cost - resources used that cannot be gotten back
Production possibilities frontier - shows max amount one can produce given resources/tech
Points
on curve → efficient
inside curve → inefficient, but possible
outside curve → unattainable
Opportunity cost = slope
Shape
linear - constant opportunity cost
slope never changes
bowed out - increasing opportunity cost
slope is not constant
shifts
change in tech/resources (efficiency)
Trade advantage
absolute advantage - ability to produce more (or same) with same (or less) resources
comparative advantage - ability to produce good at lower opportunity cost
based on resource allocation
trade
comparative advantage in a good → specialize in production of good
set price btwn opportunity cost of goods
point should be outside the ppf
price
message to buyer/seller
incentive
bundle of info
allocates resources to more valuable area
Demand
demand - relationship btwn price + quantity demanded
consumer
shown by demand schedule
quantity demanded - amount of a good/service consumers are willing/able to pay at a price
market demand - demand by all consumers of a given good/service
add up quantity demanded by individual for each respective price
law of demand - ceteris paribus, price increases → quantity demanded decreases
substitution effect
price increase → consumers shop for cheaper alternatives
income effect
price increase → consumers afford less w the same amount of money
Rational rule for buyers
how many? → one more? → Marg benefit vs price → consider alt → marg benefit ≥ price → buy
Demand = WTP = MB
WTP = willingness to pay
MB = marginal benefit
determinants of demand
income
income increase → demand increase
normal vs inferior goods
normal good - luxury stuff
ex. steak, new cars
income increase → demand increase
inferior good - cheap stuff
ex. cup noodles, used cars
income increase → demand decrease
price of related goods
demand complements - goods bought together
ex. hot dogs and buns
good 1 price increase → demand for good 1 decrease → demand for good 2 decrease
demand substitutes - alternatives
ex. pepsi and coke
good 1 price increase → demand for good 1 decrease → demand for good 2 increase
tastes/preferences
taste increase → demand increase
expectations
expected price increase in future → current demand increase
network effects
some goods more valuable when more people use it
ex. social media
more people have product → demand increase
congestion effects
some goods less valuable when more people use it
ex. amusement park
more people have product → demand decrease
number/type of consumers
more consumers → demand increase
CHANGE IN PRICE OF GOOD IS A MOVEMENT, NOT A SHIFT
Supply
supply - relationship btwn price + quantity supplied
seller
shown by supply table
quantity supplied - amount of a good/service a firm is williing to supply at a price
market supply - supply by all firms/sellers of a given good/service
add up quantity supplied by seller for each respective price
law of supply - ceteris paribus, price increase → quantity supplied increases
Supply = MC
MC = marginal cost
firms sell at a price that is at least what it costs to produce a good/service
determinants of supply
price of inputs
price of inputs increase → supply decrease
technology/human capital changes
human capital - knowledge/skill of workers
productivity increase → marg costs decrease → supply increase
price of complements/substitutes
supply complements - goods produced together
ex. beef and leather
price of good 1 increase → supply of good 2 increase
supply substitutes - alternative goods a firm can produce w the same resources
ex. sun butter vs peanut butter
price of good 1 increase → supply of good 2 decrease
expectations
expected price increase in the future → current supply decrease
number/type of seller
more sellers → supply increases
CHANGE IN PRICE OF GOOD IS A MOVEMENT, NOT A SHIFT
equilibrium
quantity demanded = quantity supplied
Demand + supply = market
how to find equilibrium
graphically - intersection
algebraically - set Qd = Qs
demand + supply schedules - find where Qd = Qs
Shortage and Supply
Shortage
Quantity demanded > quantity supplied
upward pressure on price
excess demand
surplus
quantity demanded < quantity supplied
downward pressure on price
excess supply
the invisible hand - converging to equilibrium without direct govt intervention
value vs price
value - benefit ppl get from consuming a good/service
price - what ppl pay to consume a good/service
Surpluses
Consumer surplus
WTP - price or MB - price
area under the MB curve + above the price line
Producer surplus
price - MC
area under the price line + above the MC curve
Total/economic surplus
TS = PS + CS
Efficiency
rational rule of markets - produce good if MB ≥ MC
economic efficiency - MC = MB
economic surplus is maximized
market equilibrium
Dead weight loss - market is not efficient
DWL = TS (efficient) - TS (inefficient)
DWL = MB - MC
for all goods under/over produced relative to efficient quantity
Market failure - forces of supply/demand are inefficient → failure to produce efficient level of output
market power
externalities
private information
irrationality
govt regulations
Externality - benefit/cost that affects someone not directly involved with production/consumption of a good/service
private costs/benefits accrued to consumers/producers ≠ total costs/benefits accrued to society
marginal private cost (MPC) ≠ marginal social cost (MSC)
marginal private benefit (MPB) ≠ Marginal social benefit (MSB)
3rd parties affected → TS maximized when MSB = MSC
types of externalities
negative - generate external costs
MSC = MPC + MEC
MEC - marginal external cost
demand = MPB = MSB
supply - MPC
in production
ex. raising cattle → methane → climate change
in consumption
ex. use gasoline → greenhouse gases → climate change
overproduction
positive - generate external benefits
MSB = MPB + MEB
MEB - marginal external benefit
in production
ex. raising bees for honey → bees pollinate flowers
in consumption
ex. get a vaccine → one less person passing on flu → ppl protected
underproduction
evaluating policies
positive analysis - what IS happening, why, or predicitons
normative analysis - what SHOULD happen
value judgement
efficiency or equity
Elasticity
elasticity - responsiveness of one econ variable to a change in another econ variable
slope ≠ elasticity
Demand
how responsive quantity demanded is to change in price
USE ABSOLUTE VALUE
always negative bc of law of demand
Elastic - responsive
> 1
∆ quantity demanded > ∆ price
flatter curve → more elastic
inelastic - not responsive
< 1
∆ quantity demanded < ∆ price
unit elastic - 1:1 responsive
= 1
∆ quantity demanded = ∆ price
Supply
how responsive quantity supplied is to changes in price
Elastic - responsive
> 1
∆ quantity supplied > ∆ price
flatter curve → more elastic
inelastic - not responsive
< 1
∆ quantity supplied < ∆ price
unit elastic - 1:1 responsive
= 1
∆ quantity supplied = ∆ price
Perfectly elastic
elasticity = infinity
infinitely responsive demand/supply to price
Perfectly inelastic
elasticity = 0
demand/supply not responsive to price
Determinants of price elasticity of demand
availability of close substitutes
more substitutes → more elastic
passage of time
more elastic over long time periods
luxuries vs necessities
luxuries = more elastic than necessities
definition of the market
more narrowly defined market → more elastic
willingness to search
more willing to search → more elasticity
Total expenditure
total revenue = P x Q
If demand is price elastic → ∆Q > ∆P → quantity effect dominates
if P increase → TR decrease
If demand is price inelastic → ∆Q < ∆P → price effect dominates
if P increase → TR increase
elasticity on a linear demand curve
linear demand curve
upper half → elastic
lower half → inelastic
middle point → unit elastic
total revenue curve
middle → total revenue is maximized
lower quantities
price decrease + TR increase
quantity effect
higher quantities
price decrease + TR decrease
price effect
income elasticity of demand
how quantity demanded responds to changes in income
normal good
> 0 (positive)
luxuries
E > 1
income elastic
necessities
0 < E < 1
income inelastic
inferior goods
< 0 (negative)
cross-price elasticity of demand
how quantity demanded responds to change in the price of another good
substitutes in consumption
E > 0
P of x increases → consume more of y
complements in consumption
E < 0
price of x increases → consume less of y
Determinants of the price elasticity of supply
availability of inputs
increased availability of inputs → elasticity increases
inventories
more stuff firms have → elasticity increases
extra capacity
more excess capacity → higher price elasticity
ease of entry/exit
easier to enter/exit market → higher elasticity
time
supply is more elastic over time
Price ceilings
max legal price in a market
ex. rent control
price always below equilibrium
shortage
consequences
shortages
secondary markets (ex. resellers)
consumers who can find/purchase are better off
prices are lower
consumers who cannot purchase good/service are worse off
producers are worse off
lower profits
price floors
minimum legal price in a market
ex. minimum wages
price always above equilibrium
surplus
Consequences
surplus
producers who can still sell good/service are better off
producers who can no longer sell good/service are worse off
consumers are worse off
quota
legal max on quantity bought/sold in a market
taxes
per unit taxes - help govt raise revenues to be spent on public goods
put a wedge btwn price buyers pay + price sellers recieve
difference goes to govt
decrease quantity sold in market
buyers pay more
sales tax
Pb = Ps + tax
Pb = demand curve
sellers get less
excise tax
Ps = Pb - tax
Ps = supply curve
implementing taxes on buyers leads to same outcome as putting taxes on sellers
formulas
TR = tax x Qtax
CS = ½ (Pmax - Pb) x Qtax
PS = ½ (Ps - Pmin) x Qtax
DWL = TS0 - TStax
Tax burden
falls on side of market that is more inelastic
Buyers
(Pb - P)/tax
Sellers
(P - Ps)/tax
Subsidies
payments made by govt to producer/consumer
effect will be the same no matter who its given to
buyers
Pb = Ps - subsidy
sellers
Ps = Pb + subsidy
increase quantity sold in market
Coase Theorem
private bargaining → efficient outcomes regardless of who holds property rights
applies only in absence of transaction cost
govt solutions to externalities
pigovian taxes/subsidies
tax - MEC
subsidy - MEB
4 categories of goods
excludable - product/service ppl are prevented from using if they don’t pay
non excludable - product/service ppl cannot be stopped from using
rival - consumption of goods prevents others from buying them
private goods (excludable)
ex. candy bar
common resources (non-excludable)
ex. apple trees in quad
non rival - consumption of goods does not prevent others from buying them
artificially scarce goods (excludable)
ex. HBO, netflix
public goods (non-excludable)
ex. roads
public goods
problem
free riding
solution
central protection w mandated payments
common resources
problem
tragedy of commons
aka overuse
solution
assign property rights
make excludable
MIDTERM 2
macroeconomics
study of economy as a whole
Gross Domestic Product (GDP)
market value of all final goods/services produced in a country in a year
not quantities, but what output is worth at market prices
goods are bought for use by final user
NOT INTERMEDIATE GOODS
intermediate goods - goods that are made for something else (ex. ink for a marker)
avoid double counting
measure production
not sales
produced within a country’s borders
ex. an american company produces a car in mexico → value of car counted as part of Mexico’s GDP
used to measure the economy
grey bars on a GDP graph = recessions
Ways to calculate GDP
Methods
value added approach
add up additional value created in each stage of the production process.
Income method
add up income generate by production
Expenditure method
add up spending on goods/services
Formula
Y = C + I + G + NX
Y = GDP/Output/Income
C = consumption spending
household spending on goods/services
I = investment spending
firms spending on physical capital goods
businesses spending on themselves
factories, buildings, machinery, etc
also changes in inventories
goods produced BUT not sold
G = govt spending
govt purchases of goods/services
paying workers, buying tar for roads, buying trucks for park service, pay interest on debt, tax credits, SNAP benefits, etc
NOT transfer payments
govt writing checks to ppl
NX = net exports
exports - imports (X - M)
add in any money spent by foreigners on things produced in US
subtract anything that consumers, businesses, or govt purchased that produced abroad
GDP per Capita
GDP per person
GDP/population
allows to conceptualize very large number + compare living standards across countries
Gross National Product (GNP)
value of final goods/services produced by americans
not necessarily within US borders
World Happiness Index
alternative measure of well-being
Nominal vs Real GDP
nominal GDP
value of all final goods/services measured in current year prices
Real GDP
value of all final goods/services measured in constant prices
base year specified
chain weighting
calculating real GDP growth btwn 2 years → average prices btwn 2 years
use quantity of current year x prices of base year
Circular Flow Model
2 sides
households
provide inputs to businesses
get paid in income (wages, profits)
use it to spend on goods/services
buy outputs from businesses
businesses
use inputs from households → outputs
interacting in 2 markets
inputs
labor/physical capital
outputs
goods/services
the rule of 70
amount of time it takes GDP to double is 70/g
g = annual growth rate
answer = years to double
Calculating growth rates
economic growth model
economic growth = increasing real GDP per capita
standard of living
how to increase output
more labor (L)
ex. workers
more physical capital (K)
equipment, factories, buildings, etc
more human capital (H)
knowledge/skills of workers
tech progress
combining inputs to make outputs
Production function
Y = f (L, H, K)
assume constant returns to scale
ex. double inputs → double outputs
output per worker
Y/L = f (K/L, H/L)
Aggregate production function
horizontal axis - physical capital per worker (K/L)
vertical axis - RGDP per worker (Y/L)
aka output per worker
more physical capiral per worker → more output per worker
over time, slope gets smaller and smaller
increasing amount of workers using the same amount of capital → oversaturation → production levels off
Movement
change in physical capital per worker → movement along curve
increases get smaller and smaller the more physical capital per worker we already have
diminishing marginal returns
Shifting
change in human capital (skills)
change in technology
Technological process = key to economic growth
ideas
can be freely shared
nonrival
just bc youre using an idea doesnt mean somebody else cant
do not depreciate w use
don’t wear out
promote other ideas
nonexcludable
why do economies fail to grow?
govt/institutions
Unemployment
Classifying population
Working Age Population (P)
16+ years old
In labor force (LF)
#employed - #unemployed
not in labor force (NLF)
not working/seeking work
Employed (E)
anyone w a job
includes part time
Unemployed (U)
not working but seeking work
Definitions
Labor Force Participation Rate
LF/P x 100
employment population ratio
E/P x 100
unemployment rate
U/LF x 100
natural (equilibrium) rate of unemployment
rate of unemployment when economy operating at capacity
frictional + structural
underemployment
people are employed but work part time instead of full time
working a job far below education, training, or skill level
still count as employed in U-6
missed in U-3
marginally attached workers
people who want to work and looked for a job but have not looked in the past 4 weeks
discouraged workers
people who wanted to work but stopped searching for jobs
not in labor force for U-3
counted in U-6
Types of unemployment
frictional
unemployment due to time spent searching for a good job match
structural
unemployment bc of mismatch btwn skills of workers vs skills needed by employers
OR from wages above equilibrium level
excess supply of labor
OR location (ex outsourcing)
cyclical
unemployment bc of recessions
Inflation
growth in price levels
Inflation rate
hyperinflation
extreme rapid increase in prices
costs of expected inflation
shoe-leather costs
increased costs of transactions caused by inflation
menu costs
real cost of changing listed prices
confuses signals that prices send
do people actually want more stuff?
should producers produce more?
redistribution
actual inflation is higher than expected…
borrowers better off
lenders worse off
actual inflation is lower than expected…
lenders better off
borrowers worse off
Consumer Price Index (CPI)
measures cost of purchasing a market basket of a typical household’s consumption
meanings
100 = base year
> 100 = prices in t > prices in b
< 100 = prices in t < prices in b
challenges
substitution bias
ppl switch away from things that get pricier
quality bias
higher price might mean a better product
new product bias
new, cheaper options aren’t in basket yet
leads to CPI slightly overstating inflation consumers face
Personal Consumption Expenditure Deflator (PCE deflator)
used by federal reserve
similar to CPI w continuously updated basket
GDP deflator
a measure of price level of things produced in the economy
GDP deflator in base year = 100
nominal = real
meaning
100 = base year
> 100 = prices in t > prices in b
< 100 = prices in t < prices in b
producer price index (PPI)
measures prices producers face
can be early warning of increase in consumer prices
real vs nominal
nominal
measured in that years dollars
real
adjusted for changes in price level
measures purchasing power in base year dollars
real wage
nominal wage/price index x 100
real income
nominal income/price index x 100
real interest rate
nominal rate - inflation rate
interest rate = return to savings & cost of borrowing
money vs wealth vs income
money
assets people use to buy things
cash/checking deposits
wealth
everything you own - everything you owe
measured at a point in time
income
earnings over a period of time
history of money
barter economies
trade goods/services directly for other goods/services
needs double coincidence of wants
2 parties each have an item the other person wants
trade w commodity money
has intrinsic value
ex. gold/silver
trade w paper money
IOU
backed by a commodity
trade w fiat money
no intrinsic value
valuable bc ppl think its valuable
Functions of money
medium of exchange
sellers are willing to accept in exchange for goods/services
unit of account
way to measure value
each good has a single price
store of value
money has to stay valuable over time
Banks
main function
pool savings from many savers
spread risk of lending across many borrowers
solve info problems
provide payment services
create long term loans from short term deposits
fractional reserve banks
banks have to keep some fraction of deposits on reserve at all times
can loan out rest
in depth explanation
Depositors can ask for a certain amount
ex. 1k
the bank has a fraction of it in the vault
ex. 100
the other part is involved in car loans, mortgages, business loans, etc that pay back over years
ex. 900
Owns
fraction in reserves (in the vault)
fraction in loans
Owes
deposits
banks cannot pay back all depositors at once if everybody comes to claim their money
bank runs
a bunch of people try to withdraw money all at once
FDIC provides deposit insurance
What if banks don’t have enough in reserves?
borrow from other banks → pay fed funds rate
borrow from Fed → pay discount rate
discount rate = ceiling on fed funds rate
What if banks have excess reserves?
loan to other banks → earn FFR
earn interest on reserves held by FED
only some institutions
loan to FED in an overnight reverse repurchase agreement
price floor on FFR
Stocks and bonds
Bond
IOU
company/govt issue bonds to borrow money
promise to pay back w interest
treasury bonds
issued by govt when it spends more than brings in on revenue
Stock
partial ownership of a firm
have a say in how company is run
get paid dividends
company is more valuable when they sell stock → can make money
Business cycle
short run fluctuations in economic activity
stages
peak
high point of econ activity
trough
low point of econ activity
recession
declining econ activity
peak → trough
expansion
increasing econ activity
torugh → peak
continues until adverse shock
potential output
level of output occurring when resources fully employed
what we can sustainable produce given current resources/technology
long run economic growth → growth in country’s potential output
the output gap
difference btwn actual and potential output
actual - potential
measured as percentage of potential output
meaning
< 0 = economy producing less than potential
> 0 = economy producing more than potential
Leading Indicators
variables that tend to predict future path of economy
gives sense of where economy is headed
tend to change first
examples
business confidence
consumer confidence
stock market
Lagging Indicators
variables that tend to follow business cycle movements w delay
examples
unemployment
inflation
Indicators
Real GDP
broadest measure of economic activity
measures total size of eocnomy
incomplete when first released
Real GDI
cross check on GDP
adds up total income
more reliable than GDP
Nonfarm Payrolls
tell if labor market is improving
how many jobs are created each month
tracks number of workers on business payrolls
Unemployment rate
indicator of excess capcity
share of labor force that wants a job but can’t find one
Initial unemployment claims
timely indicator
how many people lost jobs + applied for unemployment insurance during previous week
business confidence
what managers are planning
Supply Management’s Purchasing Manager’s Index
Consumer Confidence
what consumers are thinking
asks regular people how optimistic they are about the economy
Iinflation rate
whats happening with prices
CPI → how much economy wide prices are growing
employment cost index
whats happening with wages
how fast wages/benefits are rising
leading indicator of inflationary pressure
stock market
future expected profits of business
“predicted 9 out of the last 5 recessions”
Aggregate Demand
curve that shows relationship btwn price level and total quantity of output buyers collectively plan to purchase
buyers = consumers, businesses, govt, foreigners
movement
changes in price level
Wealth effect
price increase → savings worth less → C decreases
Fed Channel
price increase → Fed raises real IR → I and C decrease
International Trade effect
price increase → US goods look pricier → NX decrease
Shifts
change in spending
increase → AD shifts right
decrease → AD shifts left
Shifters of AD
Consumption
Wealth
wealth increases → C increases
Consumer confidence/expectations
expect higher prices in future → current C increases
Taxes + govt assistance
can only spend disposable income Yd
Yd = Y - taxes + transfers
Redistribution to people more likely to spend
marginal propensity to consume (MPC)
fraction of one’s disposable income that is spent
lower incomes → higher MPC
Monetary Policy
central bank’s control of money supply + IR to achieve macro policy goals
Who: The Federal Reserve (FED)
created in 1913
board of governers in DC + 12 district banks
independent
governers appointed by president + confirmed by senate
Why: Dual mandate
maintain price stability
2% inflation target
promoting max sustainable employment
How: Interest Rates
steers short term investment rates
IR change spending → shift AD
Tools to set a target inflation rate (2%)
set IR paid on reserves
rate for FED borrowing from banks
set rate or return for overnight reverse repurchase agreements
rate for FED borrowing from banks
set discount rate
rate at which banks borrow from FED
rate for FED borrowing from banks
open market operations
buying/selling of govt bonds on open market
Federal Open Market Committee (FOMC)
meets 8 times a year → announces new IR target
Look at
inflation rates
output gaps
Steering fed funds rate
Fed has 2% inflation target → targets Fed funds rate to achieve it
Taylor Rule
Fed rule of thumb
FFR - inflation = neutral real rate + 0.5 ( inflation -2%) + output gap
FFR = nominal short term interest rate
Recommended FFR is above today’s FFR → raise
Recommended FFR is below today’s FFR → cut
neutral real rate
interest rate that supports max sustainable employment
0.5 ( inflation -2%)
how far inflation is from 2% target
inflation father away → raise rates
output gap
output (Y) > potential output (Yp) → raise rates
Why do we care about IR?
FFR rises → other IR rise
borrowing cost increases
saving pays more
Fed raises target FFR → mortgage, car loan, savings rates rise → spending changes
households
saving vs spending
return to savings increases → spend less (C decreases) → AD decrease
firms
borrowing to invest
cost of borrowing increases → investment decreases → AD decrease
The rest of the world
the value of the dollar
USD appreciates → increase imports + decrease exports → NX decreases → AD decrease
All 3 → AD shifts left
Expansionary vs Contractionary monetary policy
expansionary
used for negative output gaps (Yo < Yp)
IR falls
AD shifts right → economy pushed up to LR equilibrium
contractionary
used for positive output gaps (Yo > Yp)
IR rises
AD shifts left → economy pushed down to LR equilibrium