First Picture
The Production Possibilities Frontier
Tradeoffs in Pictures
Quantity of
Computers
Produced
D
3,000
C
2,200
2,000
A
B
1,000
0
Feasible
but Inefficient
300
600 700
Infeasible Pts
Production
Possibilities
Frontier
 Efficient
Points
1,000
Quantity of
Cars Produced
Second Picture
Supply and Demand
Price of
Ice-Cream
Cone
Supply
$3.00
Equilibrium
2.50
2.00
1.50
1.00
Demand
0.50
0
1 2 3 4 5 6 7 8 9 10 11 12
Quantity of
Ice-Cream
Cones
Supply
and
Demand
on
Parade
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
An Increase in Demand
Price of
Ice-Cream
Cone
1. Hot weather increases
the demand for ice cream...
Supply
$2.50
New equilibrium
2.00
2. ...resulting
in a higher
price...
Initial
equilibrium
D2
D1
0
3. ...and a higher
quantity sold.
7
10
Quantity of
Ice-Cream Cones
A Decrease in Supply
Price of
Ice-Cream
Cone
S2
1. An earthquake reduces
the supply of ice cream...
S1
New
equilibrium
$2.50
2.00
Initial equilibrium
2. ...resulting
in a higher
price...
Demand
0
1 2 3 4
7 8 9 10 11 12 13
3. ...and a lower
quantity sold.
Quantity of
Ice-Cream Cones
Elastic Demand: Quantity demanded
responds dramatically to price
Price
 Elasticity is greater than 1
1. A 22% $5
increase
in price... 4
Demand
Quantity
50
100
2. ...leads to a 67% decrease in quantity.
Inelastic Supply: Quantity doesn’t
respond much to price
Price
Elasticity is less than 1
Supply
1. A 22% $5
increase
in price... 4
Quantity
100 110
2. ...leads to a 10% increase in quantity.
Consumer Surplus and Producer Surplus
Price
A
D
Equilibrium
price
Supply
Consumer
surplus
E
Producer
surplus
B
Demand
C
0
Equilibrium
quantity
Quantity
Efficiency of Competitive Market
Equilibrium … and the Tax Wedge
Price
Supply
Value
to
buyers
Cost
to
sellers
Cost
to
sellers
0
Value
to
buyers
Demand
Equilibrium
quantity
Value to buyers is greater
than cost to sellers.
Value to buyers is less
than cost to sellers.
Quantity
Remember
MR = MC
and market price is the marginal
revenue of a price-taking
competitive firm
MR = P = MC
The Effects of a Tariff
Deadweight Loss
Price
of Steel
Domestic
supply
A
Deadweight loss
B
Price with
tariff
C
Price without
tariff G
0
D
Q 1S
E
Imports
with tariff
Q 2S
Tariff
F
Domestic
demand
Q 2D Q 1D
Imports without tariff
World
price
Quantity
of Steel
GDP: Real and Nominal
• Gross Domestic Product (GDP): the market value
of all final goods and services produced within a
country during a year.
GDP = C + I + G + Ex – Im
= C + I + G + NX
• Real GDP adjusts for inflation
Nominal GDP = $GDP = P x Q
$ GDP = GDP Deflator x Real GDP
Real GDP = Q = $GDP/P
= Nominal GDP divided by
(deflated by) the GDP Price Deflator
Foreign Exchange Rate: Appreciation and
Depreciation
• A currency appreciates when it buys more of a
foreign currency.
– Appreciation makes foreign goods cheaper.
– Appreciation  Imports Up and Exports Down.
• A currency depreciates when it buys less of a
foreign currency.
– Depreciation makes foreign goods more expensive.
– Depreciation  Imports Down and Exports Up.
Current Account vs. Financial Account
• The balance of payments must balance
Current Account + Financial Account = 0
– If we buy more goods and services from
foreigners than they buy from us, we have to
borrow the difference
 sell them our IOUs.
Capital inflows help finance domestic investment
and the government’s deficit
Interest Rates: Nominal and Real
• Nominal Interest Rate (i): the interest rate
observed in the market.
• Real Interest Rate (r): the nominal rate
adjusted for inflation ().
Real Interest Rate = Nominal Interest Rate
– Inflation Rate
r=i-
• Low real interest rates spur business investment
spending (the I in C + I + G + NX)
Imports and Exports
The demand for imports depends on current
economic activity, Y
IM = IMa + mpi Y


“mpi” is the marginal propensity to import
Exports are exogenously determined

they depend on conditions in foreign economies, not our
economy

Net exports is NX = EX – (IMa + mpi Y) or
NX = NXa – mpi Y

Net expects decrease as the economy expands
Demand-Side Equilibrium and the Multiplier
At equilibrium: Y = C + I + G + NX = AE
Increase in Y = Spending Multiplier x {Increase in
Autonomous Spending}
Multiplier = 1/(mps + mpi)