principles of macroeconomics · • all economic agents face tradeoffs when making decisions •...

PrinciplesofMacroeconomicsModule1.1

Scarcity,LimitedResourcesandOpportunityCosts

WhatisEconomics?

• Economicsisthestudyofhowpeopleandsocietyallocatescarceresources

• Scarceresources:• Forpeople:Time,Moneyect.• Forfirms:FactorsofProductionà Land,LaborandCapital

• Sincewedon’thaveaninfiniteamountofresources– whatdowedowithwhatwehave?

TradeoffsinDecisions

• Peoplefacetradeoffsindecisionsbecauseofscarceresources• Cannotdoeverything,buyeverything,makeeverything• Needtochoosehowtoallocateourtime,ourmoney,ourresources

• Whenyoumakeonechoice– yougiveuptheotheroption

OpportunityCosts

• OpportunityCost:Whatyougiveuptogetsomething• Example:Howmanytimescanyouhitthesnoozebutton?

Benefit Opportunity Cost

Hititonce MoreSleep Feelrushed inthemorning

Hitittwice MoreSleep Feel rushedSkipbreakfast

Hititthreetimes MoreSleep Feel rushedSkipbreakfastSkipthegym

Hititfourtimes MoreSleep Feel rushedSkipbreakfastSkipthegymLateforwork

OpportunityCost

• OpportunityCostsaresubjectivetotheindividualandchangedependingoncircumstances

• WhatifitwasSaturdaymorningandyouhitthesnoozebutton?

• Benefitsofmoresleepmayoutweighanycostsifyoudon’thavetowakeup!

• Whatifyouworkintheafternoon?

• Youdonothavethesameconstraintsassomeonewhoneedstogotoworkinthemorning!

OpportunityCosts

• OpportunityCostsdrivethedecisionswemakeeveryday• Wefacethemallthetime• Weweighthecostsandbenefitsofeachdecisionsconsciouslyorsubconsciouslyandmakeachoice

• Testyourself:Whatwasarecentdecisionyoumade?Whatdidyougiveupwhenyoumadethatchoice?Whatwastheopportunitycostforyou?

PrinciplesofMacroeconomicsModule1.2

OpportunityCostsandProductionPossibilitiesFrontier

7

ProductionPossibilitiesFrontierProductionpossibilitiesfrontier(PPF)representstheopportunitycostsaneconomyfacesintheproductionoftwogoods.

Alleconomieshavescarceresources-- needtodecidehowtoallocatethoseresourcestoproducegoods.

Ifyouproducemoreofonegood– needtoproducelessoftheother(withnochangeinavailableresources)

8

UnderstandingthePPFCurve

• Economyonlyproducestwogoods

• Snapshotintimeofproduction

• Limitedresourcescanbeusedintheproductionofbothgoods

9

GoodX

GoodY

PPFExampleConsideraneconomythatproducestwogoods:Leatherjacketsandleatherboots.

• DrawthePPFcurveforthiseconomy

• Aswemovefromonepointtothenext– calculatethechangeinthenumberofbootsproducedandthenumberofjacketsproduced.

• Whatdoesthistellyouabouthowopportunitycostschange?

A B C D EBoots 0 20 40 60 80

Jackets 100 90 70 40 0

10

PPFExampleA B C D E

Boots 0 20 40 60 80

Jackets 100 90 70 40 0

ΔBoots +20 +20 +20 +20

ΔJackets - 10 - 20 - 30 - 40

AswemovealongthePPFcurve:OpportunityCostchanges

• O.C.RISES asgiveupmoreofthegoodthatisSCARCE

• O.C.isLOWERwhenthegoodisinrelativeABUNDANCE

11

PPFExample

Supposenowthatthereisashortageinrubber.- Whathappensinthebootindustry?- Whathappensinthejacketindustry?

12

PPFExerciseWithashortageinrubber,thisaffectstheproductionofbootsrelativelymorethantheproductionofjackets

BiasshiftofPPF

Ifthereisachangeinresources– needtoconsidertheimpactthishasonbothindustries– equalorbias?

13

KeyTakeaway

• Alleconomicagentsfacetradeoffswhenmakingdecisions

• Whatevertheychoosecomeswithanopportunitycost– whattheycouldotherwisedowiththeirtime,money,resources

• ApplythisconcepttounderstandhowaneconomymakeschoicesbetweentheproductionofgoodsinthePPF

14

PrinciplesofMacroeconomicsModule1.3

Comparativeadvantage,specialization,andtrade

15

Howcanwesatisfyourneeds/wants?

1.EconomicSelf-sufficiency:Produceallofthegoodsweneed/wanttoconsumeourselves

2.SpecializationandTrade: ProduceonegoodthatwehaveaComparativeAdvantageinandtradewithothersforwhatweneed

GAINSFROMTRADE:WecanCONSUMEMOREwhileworkingthesameamount.

16

TradeExerciseTimetoProduceOneUnit Amount ProducedinOneDay

(8hrsofwork)

Bread Sweaters Bread Sweaters

Seamstress 60minutes =1loaf

120minutes =1sweater

Baker 20minutes=1loaf

60minutes=1sweater

Howmuchbreadandsweaterscaneachagentproduceinonedayofwork?

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TradeExercise

• Whoisbetteratproducingbread?

• Whoisbetteratproducingsweaters?

• Iftheysplittheirtimeevenlybetweenproducingbothgoods,howmuchcantheyconsume(notrade)?

TimetoProduceOneUnit Amount ProducedinOneDay(8hrsofwork)

Bread Sweaters Bread Sweaters

Seamstress 60minutes –1loaf

120minutes –1sweater

(60/60)*8hrs =8loaves

(60/120)* 8hrs=4sweaters

Baker 20minutes–1loaf

60minutes– 1sweater

(60/30)*8hrs=24loaves

(60/60)*8hrs=8sweaters

18

EconomicSelf-Sufficiency

19

TradeExerciseBasedonopportunitycost:• Seamstress hasaloweropportunitycostinmakingsweaters• Fortheseamstress,ifsheproducesonemoresweater,shegivesupbaking2loavesofbreadinthattime

• Baker hasaloweropportunitycostinbakingbread• Forthebakerifheproducesonemoreloafofbread,hegivesupmaking3sweatersinthattime

OpportunityCostdeterminesspecialization

Amount ProducedinOneDay OpportunityCostBread Sweaters Bread Sweaters

Seamstress 8loaves 4sweaters ½ Sweater 2Breads

Baker 24loaves 8sweaters 1/3Sweater 3Breads

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TradeExerciseWhathappens ifthebakerandseamstresswanttotrade?

Supposetheagentsagreethat:• Bakerwillspend5hoursonbread,3hoursonsweaters• Seamstresswillspend8hoursonsweaters

Howmuchdotheyproduce?Howmuchwilltheyconsume?Willtheygainfromthetrade?

21

TradeExercise

Whatiftheyagreetotrade2sweatersfor5loavesofbread?

Howmuchwilltheyconsume?

AMOUNTPRODUCEDBread Sweaters

Seamstress 0 (60/120)*8hrs=4sweaters

Baker (60/20)*5hrs =15loaves

(60/60)*3hrs=3sweaters

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TradeExercise

Hastheseamstressgainedfromthistrade?Hasthebakergainedfromthistrade?

AMOUNTCONSUMEDBread Sweaters

Seamstress 0 bread+5bread=5bread

4sweaters– 2sweaters=2sweaters

Baker 15bread- 5bread=10bread

3sweaters+2sweaters=5sweaters

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WithTrade

24

15

3

10

5

Produce

Consume

Produce

Consume

ComparativeAdvantageAgentwiththeloweropportunitycostinproducingthegoodwill

haveacomparativeadvantageinitsproduction

OpportunityCostsBread Sweaters

Seamstress 1 morebread=½sweater 1moresweater =2breadCOMPARATIVEADVANTAGE

Baker 1morebread=1/3sweaterCOMPARATIVEADVANTAGE

1moresweater =3bread

• Nosingleagentcanhaveacomparativeadvantageinbothgoods.

• Aslongastheopportunitycostsbetweentwoagentsdiffer– bothcangainfromtrade.

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KeyTakeaway• Tradeandspecializationmakeeveryonebetteroffbecause– consumemorewithoutworkingmore

• Tradecanbebeneficialevenwhenoneeconomicagentismuchbetteratproducingbothgoods

• Todeterminewhichgoodsaneconomicagentwillproduce– needtounderstandcomparativeadvantage(or)opportunitycostinproducingeachgood

26

Supply and Demand ModelPrinciples of Macroeconomics

Module 1.4 (A)

What are competitive markets?CompetitiveMarkets:

– Bringtogetherthedecentralizeddecisionsofbuyersandsellers– DecentralizedDecisionsofBuyers:

• Drivethemtotrytogetthelowestpossiblepriceforthegoodstheywant

– DecentralizedDecisionsofSellers:• Drivethemtotrytogetthehighestpossiblepriceforthegoodstheyareselling

Whenthesedecisionscometogether– competitivemarketsyield:– Bestpossiblepricefortheproduct– Producedatthelowestpossiblecost– Mostefficientallocationofresources

What are competitive markets?CompetitiveMarkets:

– Bringtogetherthedecentralizeddecisionsofbuyersandsellers– DecentralizedDecisionsofBuyers:

• Drivethemtotrytogetthelowestpossiblepriceforthegoodstheywant

– DecentralizedDecisionsofSellers:• Drivethemtotrytogetthehighestpossiblepriceforthegoodstheyareselling

Whenthesedecisionscometogether– competitivemarketsyield:– Bestpossiblepricefortheproduct– Producedatthelowestpossiblecost– Mostefficientallocationofresources

What are competitive markets?FundamentalAssumptionsofSupply+DemandModel:

1.OperatingunderPerfectCompetition• Lotsofbuyersandsellers• Goodssoldareidentical• Nocosttoenteringorleavingthemarket

2.Equalaccesstoinformation3.Externalitiesdonotexist

Nosingleeconomicagentcanunilaterallyexertanypricecontrol

What are competitive markets?FundamentalAssumptionsofSupply+DemandModel:

1.OperatingunderPerfectCompetition• Lotsofbuyersandsellers• Goodssoldareidentical• Nocosttoenteringorleavingthemarket

2.Equalaccesstoinformation3.Externalitiesdonotexist

Nosingleeconomicagentcanunilaterallyexertanypricecontrol

What are competitive markets?FundamentalAssumptionsofSupply+DemandModel:

1.OperatingunderPerfectCompetition• Lotsofbuyersandsellers• Goodssoldareidentical• Nocosttoenteringorleavingthemarket

2.Equalaccesstoinformation3.Externalitiesdonotexist

Nosingleeconomicagentcanunilaterallyexertanypricecontrol

What is Demand?

• Demandcomesfromthebuyerofagood/service

• Eachbuyeristryingtogetthelowestpricepossibleforthegood/servicethattheywantQuantityDemanded:Amountofthe

goodbuyerswanttobuyateachpricepoint

What is Demand?

DemandSchedule:givesthequantitydemandedateachprice

Price QuantityDemanded

$5 13$6 12$7 10

What is Demand?• Fromthedemandschedule,wecandeterminethedemand

curve

• DemandCurve:Relationshipbetweenpriceofthegoodandamountpeoplewanttobuyofthegood(quantitydemanded)

• LawofDemand:Aspriceofagooddeclines,peoplewanttobuymoreofit

Qdemanded

Price

Demand

$7

$6

$5

101213

Changes in DemandMovementalongthedemandcurve:• Priceofthegoodhaschangedbutthereisnochangeinthe

willingnessofbuyerstobuythegood

• Pricechanges– movetoanewpointonthedemandcurve(fromAtoB)

Qdemanded

Price

Demand

$7

$5

1013

A

B

Changes in DemandShiftinthedemandcurve:• Somefactorhaschangedthatdirectlyimpactsbuyers’

willingnesstobuythegood

• Demandcurveshifts– ateachpricepointthereisnowanewquantitydemanded

Qdemanded

Price

D.1

$7

1015

A B

D.2

Factors that Shift Demand1.ChangeinIncome

• NormalGoodsSallyjustreceivedaraiseatwork.ShenowbuysStarbuck’s

lattesonherwaytowork.

• InferiorGoodsAfterreceivingherraise,Sallynolongerbuyscoffeeatthegas

stationonherwaytowork.

Qdemanded

Priceoflattes

D.1

$4.50

01

A

D.2

B

Factors that Shift Demand2.ChangeinPriceofRelatedGoods

• Compliments:Goodsthatareconsumedtogether• Ifthepriceofhotdogsincreases,peoplewilldemand(orbuy)lesshotdogbuns

• PriceofGoodAincreases:DemandforGoodBdecreases• PriceofGoodAdecreases:DemandforGoodBincreases

Qdemanded

PriceofHotDogBuns

D.1

$1.50

56D.2

AB

Factors that Shift Demand2.ChangeinPriceofRelatedGoods

• Substitutes: Goodsthatcanbeconsumedintheplaceofanothergood

• Ifthepriceofhotdogsincreases,peoplewilldemand(orbuy)morehamburgers

• PriceofGoodAincreases:DemandforGoodBincreases• PriceofGoodAdecreases:DemandforGoodBdecreases

Qdemanded

PriceofHamburgers

$4.00

78

BA

Factors that Shift Demand3.ChangeinTastesandPreferences

Asitgetscolderoutinthewintermonths,peopleprefer tobuysweatersandjackets.Demandforsweaters increases.4.ChangeinNumberofBuyers

Aslaptopsbecomemorepopularandeasytouse,morepeoplebuythem.Demandforlaptopsincreases.5.ChangeinFutureExpectations

FuturePriceoftheGood:Ifpeopleexpectdiscountedpricesduetoretailersholidaysales,theywillwaittobuythegoods

FutureIncome:Ifacollegestudentsecuresajobthathewillstartinafewmonths,hewillfeelmoreconfidentbuyinganexpensivesuittoday.

What is Supply?

• Supply comes from the seller of a good/service

• Each seller is trying to get the highest price possible for the good/service that they produce

• Quantity Supplied: Amount of the good sellers are willing to sell at each price point

What is Supply?

SupplySchedule:givesthequantitysuppliedateachprice

Price QuantitySupplied

$5 10$6 12$7 13

What is Supply?• Fromthesupplyschedule,wecandeterminethesupplycurve

• SupplyCurve:Relationshipbetweenpriceofthegoodandamountfirmsarewillingtosellofthegood(quantitysupplied)

• LawofSupply:Aspriceofagoodincreases,peoplewanttosellmoreofit

Qsupplied

Price Supply

$7

$6

$5

101213

Changes in SupplyMovementalongthesupplycurve:• Priceofthegoodhaschangedbutthereisnochangeinthe

costofproductionorwillingnesstosellbythefirm

• Pricechanges– movetoanewpointonthesupplycurve(fromAtoB)

Qsupplied

PriceSupply

$7

$5

1013

B

A

Changes in SupplyShiftinthesupplycurve:• Somefactorhaschangedthatdirectlyimpactssellers’

willingnesstosell/producethegood(or)theircostofproduction

• Supplycurveshifts– ateachpricepointthereisnowanewquantitysupplied

Qsupplied

Price S.1

$7

1015

A B

S.2

Factors that Shift Supply1. ChangeinPriceofInputs

Ifthepriceofwoodincreases,thecostofproducingtableswouldincrease.Supplywoulddecrease ateachpricepoint.

Qsupplied

S.2

$100

100150

B A

PriceofTables S.1

Factors that Shift Supply2.ChangeinProductionTechnology

Thereplacementofworkerswithrobotsincarproduction.Supplyincreasesateachpricepoint.

3.ChangeinNumberofSellersMoresellersmeansmoreproductionateachpricepoint.Supplyincreases.

4.ChangeInFutureExpectationsFuturePriceoftheGood:Expectpricetoriseinthefuture– produce/sell

morethenFuturePriceofInputs:Expectinputstobemoreexpensive– produce/sell

moretoday

Key Takeaway• Demandisdeterminedbythebuyersofagood.Buyeralwayswanttogetthelowestpricetheycan!Hence,demandisdownwardsloping

• Supplyisdeterminedbythesellersofthegood.Sellersalwayswanttogetthehighestpricetheycan!Hence,supplyisupwardsloping

• Certainfactorsaffecteachofthecurvesandcausethemtoshift.Theshiftscomefromanunderlyingchangetothe“willingnesstobuy”or“willingnesstosell”.

Supply, Demand and Market Equilibrium

Principles of MacroeconomicsModule 1.4 (B)

Market Equilibrium

Supply

Demand

Quantity

Price

P*

Q*

Market Equilibrium

Supply

Demand

Quantity

Price

P*

Qd Qs

P

SURPLUS

Market Equilibrium

Supply

Demand

Quantity

Price

P*

Qd Qs

P

SHORTAGE

Test your UnderstandingConsiderthemarketfororanges.Drawoutthesupplyanddemandcurvesbasedonthefollowingsupplyanddemandschedule:

1. Drawoutthesupplyanddemandcurvesbasedonthisinformation.Whereistheequilibriumpriceandquantity?

2. SupposethereisanexceptionallycoldwinterinFloridawithfrostsruiningmanygroves.Whathappenstothismarket?Illustrateandexplain.

3. Whathappensifthepriceofapplesfalls?Illustrateandexplain.4. Whatifbothscenarioshappensimultaneously?

Price QD QS

$5 10 50

$4 20 40

$3 30 30

$2 40 20

$1 50 10

$0 60 0

Test your Understanding1. Drawoutthesupplyanddemandcurvesbasedonthisinformation.Where isthe

equilibriumpriceandquantity?

Supply

DemandQuantity

Price

$3

30

A

Test your Understanding2.Suppose there isanexceptionallycoldwinter inFloridawithfrosts ruiningmanygroves.Whathappens tothismarket? Illustrate.

S.1

DemandQuantity

Price

$3

30

A

S.2

B$4

25

Test your Understanding3.Whathappensifthepriceofapplesfalls?Illustrateandexplain.

S.1

D.1Quantity

Price

$3

30

A

D.2

B’$2

25

Test your Understanding4.Whatifbothscenarioshappensimultaneously?

S.1

D.1

Quantity

Price

$3

30

A

D.2

B'

10

S.2

B

C

Definitedecreaseinequilibriumquantity

Ambiguouschangeinequilibrium

price

Simultaneous Shifts in Both CurvesSIMULTANEOUS

SHIFTS DemandIncreases

SupplyIncreases

AmbiguousEffectonPrice

QuantityIncreases

S.1

D.1Quantity

Price

Q.1

A

D.2

B

Q.2

S.2

Inthemarketforsweaters:- Winteriscomingandit’sgoingtobeacoldone!(IncreaseinDemand)

- Woolbecomescheaper(IncreaseinSupply)

Simultaneous Shifts in Both Curves

SIMULTANEOUSSHIFTS DemandIncreases

SupplyDecreases

Priceincreases

AmbiguousEffectonQuantity

S.1

D.1Quantity

Price

P.1 AD.2

BP.2

S.2

Inthemarketforcoffee:- FDAsayscoffeecanhelppeoplestayhealthy(IncreaseinDemand)

- AdroughtinEcuadordestroysthecoffeecrops(DecreaseinSupply)

Simultaneous Shifts in Both Curves

SIMULTANEOUSSHIFTS DemandDecreases

SupplyDecreases

AmbiguousEffectonPrice

QuantityDecreases

S.1

D.1

Quantity

Price

Q.1

A

D.2

B

Q.2

S.2

Inthemarketforsnowboards:- Skiinggearisnowcheaperthansnowboardinggear(DecreaseinDemand)

- Afewmajorproducersofsnowboardsdecidetoshifttheirbusinessfocustootherproducts(DecreaseinSupply)

Simultaneous Shifts in Both CurvesSIMULTANEOUS

SHIFTS DemandDecreases

SupplyIncreases

Pricedecreases

AmbiguousEffectonQuantity

S.1

D.1

Quantity

Price

P.1A

D.2

BP.2

S.2

Inthemarketforelectriccars:- Gaspricesfall,peopleprefertokeeptheiroldcars(DecreaseinDemand)

- Innovationsinproductionmakeitcheaperforcompaniestomakeelectriccars(IncreaseinSupply)

Key Takeaway

•MarketEquilibriumbringstogetherthedecentralizeddecisionsofbuyersandsellers• Becauseeachagentislookingoutfortheirownbestinterest– wegettheoptimalresultsinthemodel• ShiftsintheSorDcurvemustcomefromachangeinoneofthefactorsthatchangeeither“willingnesstosell”or“willingnesstobuy”• S-DGraphiscriticalinhelpingusfindequilibriumandanalyze/understandchangesinthemarket.