study guide economics comprehensive exam...

Study Guide Economics Comprehensive Exam 2014

What is economics?

o The study of how society manages its scarce resources

o The social science concerned with the efficient use of scarce resources to achieve maximum

satisfaction of economic wants

The Basic Economic Problem

o There are four interrelated problems involving resource allocation in an economy:

1) Resources are scarce

2) Scarce resources are used to make good and services

3) Scarce resources have alternative uses

Economic Problem (in a nutshell)

o The economic problem arises because unlimited wants exceed scarce resources.

Marginal Analysis

o In economics, the term marginal means additional

Factors of Production

o Definition: another term for economic resources, which are used to produce goods and

services and which are in limited supply.

o Three main factors of production

1) Land

2) Capital (physical) includes technology and component parts

3) Labor: includes enterprise or entrepreneurship. Both mental (human capital) and

physical.

Land

o In economics, “land” means any natural resource used in production

o Includes the earth’s surface as well as what is beneath it, such as oil and coal, and what is

naturally found on it.

Capital

o Definition: Any human-made (manufacture) good used to produce other goods and/or

services.

o Examples: offices, factories, machinery, railways, tools, ect.

Capital vs. Consumer goods

o Capital goods are of value for what they can produce

o Consumer goods are of value for the satisfaction they can provide to their owners

Labor

o Definition: all human effort, both mental and physical. Involved in producing goods and

services.

o The term “human capital” refers to the education, training, and experience of workers.

More human capital = greater capability of producing

Opportunity cost

o Definition: the next best alternative forgone

Production Possibilities Curve or Frontier

o Definition: a curve that shows the max output of 2 types of products and the combination of

these products that can be produces with existing resources and technology.


Four Key Assumptions

o Only 2 goods can be produced

o Full employment of resources

o Fixed resources ( ceteris paribus)

o Fixed economy

Per Unit Opportunity Cost

o How much each marginal unit costs:

Utility and Diminishing Marginal Unity:

o Diminishing Marginal Unity: proposition that as a person increases consumption of a good-

while keeping consumption of other goods constant- there is a decline in the marginal utility

(additional satisfaction) the person derives from consuming each additional unit of that

good.

Marginal Analysis Example

o Decision criterion: stop consuming where marginal benefit >= marginal cost

Three Fundamental Questions Concerning Resource Allocation

o Because of the basic economic problem, every economy must answer:

1) What should be produced?

2) How should it be produced?

3) For whom should it be produced?

Centrally Planned Economy

o Definition: An economy in which the government makes the crucial decisions, in which land

and capital are state-owned, and in which resources are allocated by directives.

Market Economy

o Definition: An economy in which consumers determine what is produced, in which

resources are allocated by the price mechanism, and in which land and capital are privately

owned.

Mixed Economy:

o Definition: An economy in which both private and public sectors play an important role.

Advantages of a Market Economy

o Responsive to consumer demand; consumers said to be sovereign

o Choice for consumers, firms, and workers

o Profit motive and competition promote efficiency.

Firms that produce what consumers want at low prices earn high profits.

o High income provides incentive for hard work and risk taking

Demand

o Demand is the willingness and ability to buy a product.

Demand and Price

o Quantity demanded an price are inversely related (i.e. law of demand)

Effects of Price Changes on Demand

o A decline in price leads to an increase in quantity demanded, while an increase in price leads

to the opposite.


Changes in the quantity demanded are caused by price changes and are distinct from

changes in demand.

Quantity Demanded vs. Demand

o Quantity demanded is a specific number of products where demand is just the willingness

and ability to buy a product.

Why does the law of demand occur?

o The substitution effect: if the price goes up for a product, consumers buy less of that

product and more of another substitute product and vice versa.

o The income effect: if the price goes down for a product, the purchasing power increases for

consumers allowing them to purchase more.

o Law of diminishing marginal utility (satisfaction): as you consume more units of any good,

the additional satisfaction from each additional unit will eventually start to decrease. The

more you buy the less satisfaction you get from each unit.

Supply and Price

o Definition of supply: the willingness and ability to sell a product.

o Quantity supplied and price are directly related (i.e. law of supply)

Higher price= increase quantity supplied

Firms earn greater profits with higher prices because they are able to cover costs more

easily.

Effect of Price Change on Supply:

o A decline in price leads to a decrease in quantity supplied, while a rise in price leads to the

opposite.

Changes in quantity supplied are caused by price changes and are distinct from

changes in supply.

Equilibrium Price

o Definition: The price where quantity demanded and quantity supplied are equal; sometimes

called the market clearing price.

o Simply the point where demand and supply curves intercept.

Disequilibrium

o Definition: a situation where quantity demanded and quantity supplied are not equal

o Surplus: quantity supplied exceeds quantity demanded.

o Shortage: quantity demanded exceeds quantity supplied.

Causes of Changes in Demand

o Disposable income

o Prices of related products

o Tastes and preferences

Advertising

Seasonal factors (e.g. weather)

o Number of consumers

population

o Expectations about future prices


Disposable Income

o Definition: The income after taxes have been deducted.

o An increase in disposable income raises consumers purchasing power

Normal good: product whose demand increases when income increases and vice versa.

Inferior good: product whose demand decreases when income increases and vice versa.

Prices of Related Products

o Changes in demand can be caused by changes in prices of a substitute of a complementary

good.

Substitute: products that can be used in place of another

Complement: a product that is used in conjunction with another.

Tastes and Preferences: Advertising

o A successful ad campaign will increase demand for a product.

Causes of Change in Supply

o Costs of production

Prices and availability of inputs

- Productivity

- Weather conditions

- Disasters and wars

- Discovery or depletion of resources

Improvements in technology

Opportunity cost of alternative production

o Number of sellers

Expectations about future profits

o Government action

Taxes

Subsidies

Changes in Costs of Production

o If it costs more to produce a product, suppliers will want a higher price for it.

o Two basic reasons for change in costs:

A change in the price of any of the factors of production

A change in productivity of factors of production

Taxes and Subsidies

o Increases in taxes are like increases in cots and so will reduce supply; opposite true of tax

decreases.

o A subsidy given to producers (or consumers) provides a financial incentive for them to

supply more (or purchase more); opposite true if subsidy deceases.

MB >= MC

Consumer Surplus

o Definition: an economic measurement of consumer satisfaction, which is calculated by

taking the difference between what consumers are willing to pay for a good relative to its

market price.


o CS= max. willingness to pay- price

= MB/MU-MC

Producer Surplus

o Definition: an economic measure of the difference between the amount that a produce

receives for a good and the minimum amount that a producer is willing to accept of a good.

o PS= price- min willingness to accept

= MB/MU-MC

Consumer/ Producer Surplus

o Consumer surplus: area of triangle about equilibrium price and below the demand curve

with a length equal to that equilibrium supply

o Producer surplus: area of triangle below price and above supply curve with a length equal to

the equilibrium quantity.

Price Elasticity of Demand (PED)

o Definition: the sensitivity of quantity demanded to a change in price

o

Magnitude of PED

o Elastic Demand: PED greater than one (in absolute value)

o Inelastic Demand: PED between zero and one (in absolute value)

Factors Determining Degree of Elasticity

o Availability of substitutes (lots of substitutes – inelastic; monopoly- elastic)

o Other factors:

Proportion of income spend on product (little- inelastic; large-elastic)

Necessity or luxury (necessity- inelastic; luxury- elastic)

Addictiveness (inelastic)

Whether purchase can be postponed ( elastic- long postponement)

Market definition

Time period under consideration

o PED may also change over time (e.g. luxury items become necessities)

Other Degrees of Elasticity

o Perfectly elastic demand: when a change in price caused a complete change in QD.

o Perfectly inelastic demand: when QD doesn’t change when price changes.

o Unit elasticity of demand: when percent change in price results in equal percent change in

QD. PED= -1

Price Elasticity of Supply (PES)

o Definition: The sensitivity of quantity supplied to change in price

o

Magnitude of PES

o Elastic Supply: PES greater than one

o Inelastic Supply: PES between zero and one


Perfectly Elastic Supply: when a change in price causes a complete change in quantity supplied:

PES= infinity

Perfectly Inelastic Supply: when quantity supplied doesn’t change when price changes; PES=0

Unit Elasticity of Supply: when the percent change in price results in an equal percent change in

quantity supplied; PES=1

What factors of production are employed

o Influenced by:

The product produced

Factor productivity

Relative cost

Substitutable Factors

o When they are substitutes, a rise in productivity or fall in cost of one may result in a change

in the combination of resources.

o Example: a fall in price of capital might lead to replacement of workers with machines.

Complementary Factors

o When they are compliments, a rise in productivity or fall in cost of one may increase use of

all factors.

o Example: a fall in cost of aircraft may cause an airline to fly to more destinations, increasing

employment of pilots and cabin crew.

Influence on Demand for Capital

o The QD of capital obviously depends on price

o Demand is a function of:

The price of other factors of production when substitutable or complementary

Profits (high profits incentivize investment)

Corporate tax rates (low rates increase retained earnings)

Market interest rates (low rates reduce borrowing and opportunity costs)

Technological advancements

Household income and confidence levels

Price Maximizing Rule for Combining Resources

o

MRP= marginal revenue product MRC= marginal resource cost

o This means that the firm is hiring where MRP=MRC for each resource x and y

Marginal Cost

o Additional costs of an additional unit of output

o Example: If the product of 2 or more units of output increase total cost from $100 to $120

the MC is $10

o

The Nature of Profit

o Total profit is the positive difference between total revenue and total cost

o Profit= Revenue- Cost


o Profit per unit , or profit margin, is the positive difference between average revenue (i.e.

Price) and average cost (i.e. unit cost)

o Profit= (P*Q)- (ATC*Q)

o Per unit profit= p-ATC

Profit Maximization

o Profit is maximized when the positive gap between revenue and cost is greatest.

Effects of an Increase in Profits

o Profits provide incentive for entrepreneurial activities, encouraging more firms to enter a

competitive market; losses have the opposite effect.

o They also provide firms with financing:

Retained earnings to update capital equipment and expand the business

External funding from shareholder and/or banks

Ways of Increasing Profit

o Reducing costs of production

Eliminating waste or inefficiency

Increasing productivity of factors ( training workers, for example, may increase costs in

the short run, but in the long run, average costs fall and revenue rises with improving

quality)

Improving economies of scale through merger with another firm

o Increasing revenue

Successful advertising

Economies of Scale

o Definition: lower long- run average costs (LRAC’s) resulting from a firm’s growing size.

o Its firms change their scale of operation, their average costs change.

Diseconomies of Scale

o Definition: higher long- run average costs resulting from a firm’s growing too large.

o Main reasons:

Difficulties controlling the firm because management become too complex; increases in

admin costs and makes the firm slow to changes in market conditions

Communication problems among employees

Poor industrial relations because workers may lack motivation increasing the risk of

strikes and other industrial action

Tight factor markets

The Law of Diminishing Marginal Returns: As variable resources (workers) are added to fixed

resources (machinery, tools, ect.) the additional output produced from each new worker will

eventually fall.

Characters of Perfect Competition

o Numerous buyers and sellers

A single buyer or supplier cannot influence price; they are price takers

o Low degree of market concentration

Each firm has insignificant market share


o Low barriers to entry and exit

o Homogeneous products

No branding or advertising

Consumers indifferent to source

Behavior of Perfectly Competitive Firms

o Will not raise price for fear of losing all sales

o No incentive to lower price because can sell any quantity; price taker

o Profits will equal zero economic profit, or normal profit, in the long run

o Supernormal profits can exist only in short run because of low barriers to entry

The Competitive Firm is a Price Taker: price is set by the industry

o Marginal revenue is constant: Total revenue increases at a constant rate. MR equals average

revenue.

Shut Down Rule

o A firm should continue to produce as long as the price is above the AVC

o When the price falls below AVC, then the firm should minimize its losses by shutting down

o Why? If the price is below AVC, the firm is losing more money by producing than it would

have to pay to shut down.

Profit Maximizing Rule: MR=MC

o Three characteristics of MR=MC rule:

1) Rule applies to ALL market structures (PC, Monopolies, ect.)

2) The rule applies only if price is above AVC.

3) Rule can be restated P=MC for perfectly competitive firms because MR=P

In the Long-run (with Perfect Competition)

o Firms will enter if there is profit

o Firms will leave if there is loss

o So ALL firms break even, making NO economic profit (no economic profit= normal profit)

o In long-run equilibrium, a perfectly competitive firm is extremely efficient.

Characteristics of Monopoly

o Firm= Industry; 100% market share

o High barriers to entry and exit

o A price maker; its output is the industry’s output, so changes in supply affect market price.

Behavior of Monopoly

o Barriers to entry mean firms can earn supernormal profits in long run

o However, demand curve still downward sloping, so firm ahs to set price level that will

maximize revenue and profit.

Costs of Production: Increasing in productivity and advances in technology would reduce a firm’s

costs of production, which can be fixed or variable in nature.

o Total cost= fixed costs + variable costs

o Average total, fixed, and variable costs= each cost divided by the output

Fixed costs: Costs that do not change with output in the short run; overheads or indirect costs.

o Examples: building rent, certain utilities, and interest payments on loans

Variable costs: costs that change with output; direct costs


o Examples: production/sales of cars would involve increased expenditure on component

parts, electricity, and wages.

Profit maximizing rule for combining resources

o

o This means that the firm is hiring where MRP=MRC for each resource x and y.

Productive Efficiency:

o Price= minimum ATC

o Only true with perfect competition in the long run, zero economic profit.

Allocative Efficiency:

o Price= MC (marginal cost)

o Relevant to perfect competition, not monopoly

Main Functions of Money

o Medium of Exchange: Allows people to buy and sell products.

o Products are exchanged for money, and that money is used to buy other products

Products Money Products

o Unit of Account (measure of value): it can be used to place a value on an item

Prices are a measure of value and signal what buyers and sellers believe items are

worth relative to each other.

o Standard for deferred payment: it allows people to borrow and lend and to determine the

amount to be repaid in the future.

Specialization and Opportunity cost

o Absolute Advantage: the ability to produce a good using fewer inputs than another producer

or to make more using the same inputs.

o Comparative Advantage: the ability to produce a good at a lower opportunity cost than

another producer.

Banks

o Main Types:

Commercial Banks: make profits by accepting deposits (i.e. for savings and

checking), lending, and facilitating transactions

Central banks: Government owned banks that provide banking services to the

government and to commercial banks.

Investment Banks: Bankers to large firms, accepting deposits, lending, and managing

the issuance of securities

o Functions of Central banks:

Acts as a banker to the government (i.e. Treasury receipts and payments).

Operates as a banker to commercial banks (i.e. interbank transactions)

Acts as a lender of last resort (directly lends to banks short of cash)

Manages the national debt

Holds the country’s reserves of foreign currency and gold

Issues bank notes

Implements the government’s monetary policy


Controls the banking system

Stock exchanges

o Besides borrowing, public companies can sell shares to generate finance.

IPO’s: new shares

Secondary market: traded shares previously owned

Dividends and Yields

o Yields: dividend per share/ market price of share

Influences on spending

o Income: gross/nominal, real disposable

o Wealth (or amount of assets)

o Confidence/ expectations

o Rate of interest: generally higher interest incentivizes saving

o Advances in technology: new technologies increase spending as consumers adopt products

that embody them

Influences on saving

o Income: saving increases as income increases

o Wealth: makes it easier to save

o Rate of interest: for all but target savers increase spending

o Tax treatment

o Range/ quality of financial institutions

o Age structures: young and old save less than others

o Social attitudes/pension schemes

Influences on borrowing

o Availability of loans and overdrafts: tight credit markets limit borrowing

o Rate of Interest: higher interest increases borrowing costs and in turn reduces borrowing

and spending

o Confidence/expectations

o Social attitudes

Average propensity to consume

o Proportion of income spent

o Calculated as consumption divided by disposable income

Saving

o Unspent disposable income

As disposable income rises, percent and absolute amounts of savings increase.

o Average propensity to save

Sometimes referred to as savings ratio

Calculated as savings divided by disposable income

Changes in demand for labor

o If demand for labor increases, earnings are likely to rise

o Causes for increased demand

Increased demand for the good or service (i.e. derived demand)


A rise in labor productivity (higher productivity increases profits

A rise in the price of capital, if possible for firms to substitute labor for capital in the

production process.

Changes in supply of labor

o A decrease in the supply of labor for a particular occupation or sector would be expected to

raise the wage rate

o Causes for decreased supply:

A fall in labor force

A rise in qualifications or length of training required to do a job

A reduction in the wage or non-wage benefits in other jobs (i.e. opportunity cost)

Public goods

o Because of the free-rider problem, private sector firms may have no incentive to produce

certain public goods

o Free-rider problem: impossible to exclude non-payers from enjoying benefits of public

goods (i.e. defense and roads)

o So governments produce them or pay private sector firms to make them, raising finance

through taxation

Uses of public expenditure

o Governments spend money on:

Public goods

Promoting merit good

Discouraging consumption of demerit goods

Regulating industries to benefit consumers

Supporting vulnerable groups

Helping private sector industries

Managing economic growth, including promotion of employment

Financing public expenditure

o Governments finance spending by:

Taxing income, purchases, imports, ect.

Borrowing from the private sector or from foreign governments

Privatizing state-owned enterprises

Marginal resource cost (MRC) =

Marginal revenue product (MRP) =

MRP=MRC (MR=MC) (profit maximization)

Allocative Efficiency: price equals marginal cost; maximize consumer satisfaction

Productive Efficiency: firms produce at lowest possible cost per unit (price= min ATC)

Dynamic Efficiency: resources used efficiently over a period of time (i.e. firms continue to adapt

and innovate or else perish= shift PPC)

Government’s macroeconomic aims

o Microeconomics is the study of household and firm behavior.


o Macroeconomics is the study of entire economies.

o Government aims for economies are:

Full employment

Price stability- deals with inflation

Economic growth

Redistribution of income

Stability of balance of payments- exports and imports

Full employment

o Definition: people who are willing and able to work find employment

o Labor force excludes:

Children

Retirees

Full time students

Homemakers

disabled

Unemployment

o Unemployment rate: the percentage of the labor force that is willing and able to work but

that is without jobs. Calculated using: unemployed/ labor force

o Full employment is often considered to be above zero percent because even in a strong

economy, some workers will be between jobs.

Economic growth

o Definition: a short-run increase in the output (or real GDP) of an economy; in the long run,

an increase in productive potential.

o Growth occurs when there is a rise in the quantity and/or quality of factors of production.

Aggregate demand and supply

o Aggregate demand: total demand for an economy’s products; equals C + I + G + (X-M)

C- consumer spending

I- investment

G- government spending

X- exports

M- imports

o Aggregate supply: total output of producers in an economy

Perfectly elastic with unemployed resources, as more can be produced without rise

in costs and prices.

More inelastic with full employment because firms will compete for resources,

which will push up costs and prices.

Price indices

o Definition: a measure of the change in general price level of a basket of goods/services over

time.

o Governments tack price indices because price stability is often a macroeconomic aim.

o The consumer price index, or CPI, measures prices of average household expenditures.


Main types of inflation

o Cost-push: rising prices caused by higher costs of production (i.e. labor, raw materials, sales

taxes)

o Demand-pull: rising prices caused by excess demand (increase in part of AD equation)

o Monetary: form of demand-pull inflation where rising prices caused by excessive growth of

money supply.

Cost- push inflation: see Attachment ___

Negative consequences of inflation

o Causes fall in value/function of money

Higher inflation rate- greater fall in purchasing power of money; especially a

problem with hyperinflation because all functions of money are affected.

o Redistributes income haphazardly

Borrowers likely to benefit, while savers likely to lose

o Imposes extra costs on firms

Administrative costs to estimate future prices of good and their inputs.

o Creates uncertainty

Hard for firms and households to judge the right price to be paid today; also makes

planning for the future problematic

o Harms country’s balance of payments and economic growth

If country’s inflation rate is above that of rivals, domestic products will become less

competitive.

o Lenders are generally hurt by unanticipated inflation

Interest rates on bank loans are set based on expected inflation

o Savers are also generally hurt by unanticipated inflation

Certain types of interest-bearing accounts pay interest based on expected inflation

Retirees on fixed income experience reduced purchasing power

Nominal GDP vs. Real GDP

o GDP- gross domestic product or the amount of output in a given time period

o Nominal variable= real variable-inflation

Fall in Inflation= rise in price but at a slower rate

Price up and quantity down= stagflation

Money market diagram: see Attachment ___

Positive consequences of inflation

o Inflation may be beneficial if it is of a demand-pull, low, and stable nature and is below that

of rival countries

Encourages firms to expand because of certainty

Reduces burden of debt for firms and households

Reduces real-wage costs of firms and hence unemployment.

o Borrowers generally are helped by unanticipated inflation.

Interest rates on bonds and bank loans are often set based upon expected inflation.


Full and part-time work

o Some workers work part time, and they are treated as part of the labor force.

o Reason include:

To accommodate children’s schedules

To care for elderly relatives

To pursue other interests

Because full-time work is not available

Changes in employment and unemployment

o Increase in employment decreases unemployment only if unemployed fill some new jobs

o Both employment and unemployment might increase if the labor force grows faster than

jobs.

o Reasons why unemployment might fall without increase in employment:

Retirement

Full-time education

Emigration

Stop seeking work

Labor force participation and employment rate

o Labor force participation rate = percent of people economically active and pat of labor force

Wages on offer

Social attitudes to working women

Provisions of care for children and elderly

Social attitudes/provisions for disabled

Proportion of college students

o Employment rate= percent of working age employed

Wages on offer

Social attitudes to working women

Provisions of care for children and elderly

Social attitudes/provisions for disabled

Proportion of college students

Preferred retirement age

Level of economic activity

Causes of unemployment

o Frictional unemployment

Time between jobs caused by:

Searching for acceptable job

Casually waiting for the “gig” (e.g. Actors and migrant workers)

Seasonal factors (e.g. construction and tourism)

o Structural unemployment

Decline of industries or occupations:

Long-term changes in supply/demand from global completion, rival goods or

substitutability of capital for labor


o Cyclical unemployment

Lack of aggregate demand, or recession.

Consequences of unemployment

o Existence of unemployed makes it easier for firms to recruit labor and expand

o Unemployment could dampen inflationary pressures by keeping down wages

o Generally costs exceed benefits.

Negative effects on economy

o Lower tax revenue

o Pressure on government expenditure

Unemployment/social security benefits

Health care

Crime protection

o Unemployment imposes opportunity costs

Economy forgoes producing goods and services

Tax money spent on benefits, ect. could have been spent on higher education, ect.

GDP- Gross Domestic Product

o Definition: total output produced in a country

o Three measures:

Output: value added to output by each firm at each sate of production (e.g. steel

and tire inputs part of auto sale)

Income: all income earned producing output (so excl. transfer payments)

Expenditure: all expenditure on country’s finished output (AD=C+I+G+(X-M))

GDP Expenditure

o Definition: total spending (AD=C+I+G+(X-M)) on final goods and services in an economy in a

given period.

o Does not include:

Intermediate goods

Purchases of used goods

Financial transactions

Non-market transaction

Nominal and real GDP

o Nominal GDP has not been adjusted for inflation, while real GDP has.

;

GDP deflator

o Definition: index measure of overall inflation in an economy.

GDP deflator= (nominal GDP/real GDP)*100

Real GDP per capita

o The extent to which real GDP growth improves living standards over time depends on

population growth.

o Real GDP per head, or per capita = real GDP/population

o Living standards improve only if real GDP growth exceeds population growth


Positive consequences of economic growth

o An increase in output can improve standards of people.

Better living conditions

More luxury products

Higher education and skilled jobs

Lower unemployment

Greater life expectancy

o Higher output and income increase government tax revenue

Reduce poverty

Increase health care provision

Raise educational standards

Negative consequences of economic growth

o Pollution

o Inflation

o Net impact of growth influenced by its rate, means adopted to achieve it, and distribution of

its benefits.

o Sustainable growth (and avoidance of high inflation) can occur only if AS increases in

tandem with AD.

Economic growth rate

o Sustainable economic growth rates between 3 and 4 percent of GDP

o Stable rates preferable to high and variable rates

o Recession defined as negative growth for two consecutive quarters.

Nominal vs. real numbers

o Any nominal variable (GDP growth rate, interest rate, ect.) reported in percent terms can be

converted to a real rate by subtraction the inflation rate.

Nominal # - inflation = real #

Measure of living standards

o Real GDP per capita (real GDP/ population)

o Other measures:

Number of people or households that own given consumer goods (i.e. cars,

computers, mobile phones, TVs, ect.)

Number of patients per doctor

Enrollment in higher education

Adult literacy rate

Average food intake per person

Conduct of free elections

Failure to account for all costs and benefits

o Consumption and production of some products may affect people not directly involved (i.e.

external costs and benefits to third parties)

o In such cases the benefits and costs exceed the benefits and costs ot consumers and

producers, or the private benefits and costs.


Socially optimal output

o The level of output that will cause the maximum benefit to a society will occur when the

social benefit of the last unit produced is equal to the social cost of that unit.

Externalities

o Externality: the uncompensated impact of one person’s actions on the well-being of a

bystander.

Negative externalities and demerit goods (i.e. pollution and cigarettes)

Positive externalities and merit goods (i.e. education and preventive health case

such as vaccines)

Merit goods

o Definition: a good whose benefit to consumers and others is undervalued by them and so is

under-produced and under-consumed

o Examples: education, healthcare, and library services

o To stimulate consumption of such goods, governments may:

Produce them

Pay private firms to produce them

Inform consumers of their benefits

Make consumption compulsory

Fiscal policy

o Definition: changes in government spending and taxation.

o Expansionary policy: increasing spending and/or decreasing taxes.

o Contractionary policy: decreasing spending and/or increasing taxes.

o A budget deficit is when a government’s expenditure is higher than its revenues; a surplus is

the opposite.

Monetary policy

o The main monetary policy measure involves manipulation of interest rates.

o Interest rate rises, or contractionary monetary policy:

Households to spend less because of more expensive borrowing costs and of greater

incentive to save

Firms to invest less because they expect lower consumption and because borrowing

and opportunity costs will have risen.

Money supply

o Central banks may also implement monetary policy by changing the money supply.

o Printing more money, buying back government bonds, or encouraging commercial banks to

lend more increases aggregate demand.

o Decreasing the money supply reduces aggregate demand.

Supply-side policies

o Supply-side policies are intended to increase aggregate supply and hence to increase

productive potential.

o Such polices seek to increase the quantity and/or quality of resources and raise efficiency of

markets.


Improving education and training, which increases labor productivity and lowers

production costs

Cutting direct taxes, which lowers costs

Government aims and supply-side policies

o In the long run, supply-side policies have the potential to benefit all government

macroeconomic aims

o Policies:

Increase productive potential/efficiency

Improves balance of payments because better quality and cheaper products

increase exports and reduce imports.

Improve education and training

Increases aggregate demand through government spending.

Reduces unemployment by making workers more productive and

occupationally mobile.

Aims of government taxation

o Raise revenue for expenditure

o Discourage consumption of demerit goods

o Increase costs of firms to minimize negative externalities

o Influence aggregate demand

Main types of taxes

o Direct

Income: individual’s earnings from employment and investment.

Corporate: firm’s profits

Capital gains: sales of stocks, homes, or other investments

Inheritance

o Indirect

Sales

Excise: fixed amount per demerit good and levied by federal governments

Customs: imported goods

Property: local/state tax on homes, cars, ect.

Nature of taxation

o Progressive: higher percentage of income or wealth from rich.

o Regressive: lower percentage income or wealth from rich.

o Proportional or flat: same percentage of income or wealth from rich and poor.

Tax incidence

o Tax incidence= distribution of burden of indirect tax between producers and consumers

o Elasticity of demand and supply dictate precise distribution

With more inelastic demand, consumers pay a greater proportion

With more inelastic supply, producers pay a greater proportion

Elasticity and tax incidence: elastic Demand (See Attachment ___)

Elasticity and tax incidence: inelastic supply (See Attachment ___)


Balance of payments

o Definition: record of all economic transactions between residents of a country and the rest

of the world during a particular period.

o Transactions involve households, firms, and government and include:

Exchange of goods and services

Income

Aid

Investment

Sections of balance of payments

o Current account: trade in goods and services, investment income, and current transfers.

o Capital account: financial investment

Money crossing borders for direct or portfolio investment:

Direct: purchase, sale, or set up of businesses or other physical assets.

Portfolio: purchase or sale of shares or bonds

o Financial account: recording of assets and liabilities related to capital account

Current account

o Trade in goods: exports and imports of goods

Export revenues < import expenditure= trade in goods deficit

Export revenues > import expenditure= trade in goods surplus

o Trade in services: exports and imports of services (i.e. banking, travel, ect.)

o Income: compensation of employees and investment income

o Current transfers: transfers of money or goods as gifts, ect.

International trade

o Definition: exchange of goods and services between countries.

o Although there are extra costs (i.e. transport and foreign exchange) and risks, the benefits

include:

Wider markets

Economies of scale

Higher profits

o Countries often tax, or place tariffs on, imported goods.

Changes in exports and imports

o Factors that influence value of country’s exports and imports:

Inflation rate (higher rate reduces exports)

Exchange rate (drop increases exports)

Quality

Marketing

Domestic/foreign GDP (higher incomes may increase imports)

Trade restrictions

Causes of current account deficit

o Factors that affect changes in exports and imports also can cause CA deficit


o Examples (in which imports rise):

Increase in GDP – and hence income – may cause a cyclical CA deficit

High exchange rate decreases competitiveness of exports

Structural deficit: reduced quality, poor marketing, reduced productivity, input or

output inflation

Exchange rates

o Definition: price of one currency in terms of another currency.

o Since countries have many trading partners, each of which has a unique currency, exchange-

rate indexes are used.

Effects of exchange –rate changes on export and import prices

o A rise in a country’s exchange rate (i.e. it is more expensive) would increase export prices

and lower import prices.

Fixed exchange rate

o Definition: value is fixed by central bank against value of other currency(ies).

Decrease in value: devaluation

Increase in value: revaluation

o If the exchange value is falling, CB could buy the currency or raise interest rates

Pro: creates certainty for firms

Cons: requires substantial reserves of foreign currencies; may require other

macroeconomic policies to offset.

Floating exchange rate

o Definition: value is determined by market forces

Decrease in value: depreciation

Increase in value: appreciation

o May help to eliminate growing current account deficit automatically

If demand for imports rises while for exports it falls, the supply of currency will rise

(as households/firms sell it to buy foreign currency) and demand will fall.

Value of currency then falls, reducing export prices and increasing import prices.

Factors affecting demand for a domestic currency

o Foreigners buying goods/services

o Foreign-based firms repatriating funds

o Foreign firms paying interest/dividends

o Workers abroad sending money home

o Foreign firms buying domestic firms

o Foreigners buying shares, saving in banks, or lending domestically

o Foreign governments holding reserves

o speculating

Factors affecting supply of a domestic currency

o Buying foreign goods/services

o Foreign firms or workers based domestically repatriating funds abroad

o Paying interest/dividends to foreign firms


o … and so on (just the opposite of the factors affecting demand from the above bullets)

Consequences of a change in the exchange rate

o Besides affecting exports and imports a change in exchange rates could affect economic

growth, employment, and inflation.

o Example: falling rate lowers export prices and so increases demand for domestic goods

If economy below capacity, increase in AD will increase output and employment

If at full capacity, inflation will occur

Higher-priced imported raw material or finished goods with inelastic demand may

also cause inflation

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