SV151, Principles of Economics K. Christ 28 November to 2 December 2011 Mankiw’s Ten Principles (Chapter 1) How People Make Decisions 1. People face tradeoffs 2. The cost of something is what you give up to get it 3. Rational people think at the margin 4. People respond to Incentives How People Interact 5. Trade can make everyone better off 6. Markets are usually a good way to organize economic activity 7. Governments can sometimes improve market outcomes How the Economy as a Whole Works 8. A country’s standard of living depends on its ability to produce goods and services 9. Prices rise when the government prints too much money 10. Society faces a short-run trade-off between inflation and unemployment Principle 8: A country’s standard of living depends on its ability to produce goods and services Per Capita Gross Domestic Product Constant 1999 “International” Dollars $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 U.K. France U.S. Japan China India 2000 1990 1980 1970 1960 1950 1940 1930 1920 1910 1900 1890 1880 1870 1860 1850 1840 1830 1820 $0 Brazil Source: Angus Maddison, http://www.ggdc.net/MADDISON/oriindex.htm ; 1990 International Geary-Khamis dollars (adjusted for purchasing power). Principle 8: A country’s standard of living depends on its ability to produce goods and services Per Capita Gross Domestic Product Natural Logs of Constant 1999 “International” Dollars 11.00 http://gregmankiw.blogspot.com/2009/11/ what-makes-nation-rich.html 10.50 10.00 9.50 9.00 8.50 8.00 7.50 7.00 6.50 U.K. France U.S. Japan China India 2000 1990 1980 1970 1960 1950 1940 1930 1920 1910 1900 1890 1880 1870 1860 1850 1840 1830 1820 6.00 Brazil Source: Angus Maddison, http://www.ggdc.net/MADDISON/oriindex.htm ; 1990 International Geary-Khamis dollars (adjusted for purchasing power). Principle 8: A country’s standard of living depends on its ability to produce goods and services … Really? "Too much and too long, we seem to have surrendered personal excellence and community values in the mere accumulation of material things. Our gross national product -- if we should judge America by that -- counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for those who break them. It counts the destruction of our redwoods and the loss of our natural wonder in chaotic sprawl. It counts napalm and the cost of a nuclear warhead, and armored cars for police who fight riots in our streets. It counts Whitman's rifle and Speck's knife, and the television programs which glorify violence in order to sell toys to our children. "Yet the gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages; the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage; neither our wisdom nor our learning; neither our compassion nor our devotion to our country; it measures everything, in short, except that which makes life worthwhile. And it tells us everything about America except why we are proud that we are Americans." Robert F. Kennedy Lawrence, Kansas, March 18, 1968 Ranking Counties … by United Nation’s Human Development Index by per capita GDP COUNTRY 1 Singapore 2 Norway 3 United States 4 Switzerland 5 Netherlands 6 Australia 7 Austria 8 Ireland 9 Canada 10 Sweden 11 Iceland 12 Denmark 13 Belgium 14 Germany 15 United Kingdom 16 Finland 17 France 18 Japan 19 South Korea 20 Spain 21 Italy 22 Greece 23 Slovenia 24 New Zealand 25 Czech Republic 26 Portugal 27 Slovakia 28 Poland 29 Hungary PCGDP 56,694 51,959 46,860 41,950 40,973 39,764 39,761 39,492 39,171 38,204 36,730 36,443 36,274 36,081 35,059 34,918 33,910 33,885 29,997 29,830 29,480 28,496 28,073 27,130 24,950 23,262 22,195 18,981 18,841 COUNTRY 1 Norway 2 Australia 3 Netherlands 4 United States 5 New Zealand 6 Ireland 7 Canada 8 Germany 9 Switzerland 10 Sweden 11 Japan 12 Iceland 13 South Korea 14 Denmark 15 Belgium 16 Austria 17 France 18 Slovenia 19 Finland 20 Spain 21 Italy 22 Singapore 23 Czech Republic 24 United Kingdom 25 Greece 26 Slovakia 27 Hungary 28 Poland 29 Portugal HDI 0.941 0.927 0.909 0.908 0.908 0.907 0.907 0.903 0.901 0.901 0.899 0.896 0.894 0.893 0.885 0.883 0.883 0.882 0.880 0.876 0.873 0.864 0.863 0.862 0.860 0.832 0.814 0.811 0.808 by New Economic Foundation’s “Happy Planet Index” COUNTRY Netherlands Singapore Switzerland Germany HPI 50.6 48.2 48.1 48.1 5 Sweden 6 Austria 7 Finland 8 Belgium 9 Slovenia 10 South Korea 11 Italy 12 France 13 Slovakia 14 United Kingdom 15 Japan 16 Spain 17 Poland 18 Ireland 19 Norway 20 Canada 21 Hungary 22 Czech Republic 23 Iceland 24 Greece 25 Portugal 26 Australia 27 New Zealand 28 Denmark 29 United States 48.0 47.7 47.2 45.4 44.5 44.4 44.0 43.9 43.5 43.3 43.3 43.2 42.8 42.6 40.4 39.4 38.9 38.3 38.1 37.6 37.5 36.6 36.2 35.5 30.7 1 2 3 4 Principle 1: People face trade-offs Principle 2: The cost of something is what you give up to get it Using a PPF to illustrate Principles 1 and 2 Figure 1 12 Figure 1: A 10 a. B List all points that are efficient. C b. c. List all points that are possible but inefficient. Good y 8 If the current allocation is {10,7}, what is the opportunity cost of a 4 unit increase in x? e. If the current allocation is {10,4}, what is the opportunity cost of a 3 unit increase in y? 6 G F 4 If allocations are denoted as {x,y}, and the current allocation is {6,9}, what is the opportunity cost of an 4 unit increase in x? d. E D H 2 I 0 2 4 6 8 10 12 14 16 12 14 16 Good x Figure 2 14 B 12 Why do we normally presume that an allocation such as point E is superior to an allocation such as point A? 10 Good y f. A C 8 6 Figure 2: 4 g. If an economy is initially at point A (on the black PPF) and economic growth occurs as indicated in the y sector of the economy, what is the opportunity cost of a movement from A to C? 2 0 2 4 6 8 Good x 10 Principle 3: Rational people think at the margin Level of Activity Total Benefits Total Costs Net Benefits Marginal Benefits Marginal Costs 50 Total Costs 40 Total Benefits 30 20 0 0 0 0 1 12 4 8 12 4 2 22 8 14 10 4 3 30 12 18 8 4 25 4 36 16 20 6 4 20 5 40 20 20 4 4 10 6 42 24 18 2 4 5 7 42 28 14 0 4 8 40 32 8 -2 4 9 36 36 0 -4 4 15 10 30 40 -10 -6 4 10 10 Level 0 0 1 2 3 4 5 6 7 8 9 10 -5 0 1 2 3 4 5 6 7 8 9 10 15 Level 0 -10 -15 Marginal Costs Level 5 0 0 -5 -10 Net Benefits 1 2 3 4 5 6 7 8 9 10 Marginal Benefits The Stimulus Debate, 2008 – 2009 Washington, February 13, 2008: President Bush, surrounded by members of Congress and Cabinet members, signs the Economic Stimulus Act of 2008, a $150 billion package of tax rebates that centered on rebate checks of $600 to $1,800 for most taxpayers. Denver, February 17, 2009: President Obama signs the American Recovery and Reinvestment Act, a $787 billion fiscal stimulus package comprised of tax cuts and new shortterm spending intended to help pull the U.S. economy out of recession. Thinking Like an Economist “The essential lesson from this example is that you can’t deduce the effect of a tax rebate or some other policy by just looking at outcomes. You have to think hard about what else was going on, and where the economy was heading in the absence of policy.”* John Taylor, Stanford University: The Economic Stimulus Act of 2008 did not work Taylor, John B. 2009. “The Lack of an Empirical Rationale for a Revival of Discretionary Fiscal Policy.” American Economic Review Papers and Proceedings 99 (May): 550-555. Mark Zandi Moody’s Analytics: The Economic Stimulus Act of 2008 worked Zandi, Mark. 2010. “Perspectives on the Economy.” Testimony before the House Budget Committee, July 1. http://www.economy.com/mark-zandi/ * Christina D. Romer, “What do we know about the effects of fiscal policy? Separating Evidence from Ideology” Talk given at Hamilton College, November 7, 2011. Available at: http://www.econ.berkeley.edu/~cromer/Written%20Version%20of%20Effects%20of%20Fiscal%20Policy.pdf Congressional Budget Office: Estimated Impact of the American Recovery and Reinvestment Act (ARRA) on Employment and Economic Output as of September 2009 (November 2009) CBO estimates that in the third quarter of calendar year 2009, an additional 600,000 to 1.6 million people were employed in the United States, and real (inflation-adjusted) gross domestic product (GDP) was 1.2 percent to 3.2 percent higher, than would have been the case in the absence of ARRA. Those ranges are intended to reflect the uncertainty of such estimates and to encompass most economists’ views on the effects of fiscal stimulus. Disagreeable Economists Economic Methodology Models: Simplified Representations of Reality Abstract thinking Observation and data collection Econometrics: Application of Statistical Methods to Economic Questions Testing and analysis Microeconomics: The study of how agents make decisions and how they interact in markets. Macroeconomics: The study of economy-wide phenomena, such as economic growth, cyclical fluctuations, price behavior and resource employment. Tradeoffs, Incentives, Economic and Sociological Explanations, … August 15, 2002: “Take August Off” Average Number of Paid Holidays and Vacation Days per Year Sweden France Japan United States Orvar Löfgren Lunds University 32 30 25 16 Lester Thurow MIT Edward Prescott Arizona State Two Contrasting Approaches to Social Science Inquiry Methodological Individualism “…every complex social situation, institution, or event is the result of a particular configuration of individuals, their dispositions, situation, beliefs, and physical resources and environments … we shall not have arrived at rock-bottom explanations of such large-scale phenomena until we have deduced an account of them from statements about the dispositions, beliefs, resources and interrelations of individuals.” J.W. N. Watkins “Historical Explanation in the Social Sciences” (1957) “All social or collective phenomena, such as institutions, are to be endogenized and explained in terms of individual human action.” Malcom Rutherford Institutions in Economics (1994) Holism (i) “Society is the ‘whole’ which is more than the sum of its parts”; (ii) “Society affects the individual’s aims”; and (iii) “the social set up influences and constrains the individual’s behavior” Joseph Agassi “Methodological Individualism” British Journal of Sociology (1960) “… holism is concerned with the social influences that bear on individual action. The individual is seen as socialized, as having internalized the norms and values of the society he inhabits. The holist focuses attention on how social ‘forces’ (institutions, social conventions, etc.) condition individual behavior.” Malcom Rutherford Institutions in Economics (1994) Interdependence and Gains from Trade An Illustration of Comparative Advantage and Gains from Trade “Technology” and Opportunity Cost: Production Requirements Farmer Rancher Opportunity Cost Meat Potatoes 1 Unit of Meat 1 Unit of Potatoes 60 min./oz. 20 min./oz. 15 min./oz. 10 min./oz. 4 units potatoes 2 units potatoes ¼ unit meat ½ unit meat Production and Consumption without Trade: Production Farmer Rancher Consumption Meat Potatoes Meat Potatoes 4 12 16 24 4 12 16 24 Assumes 8 hours of production and perfect diversification in production (4 hours devoted to the production of each good. Production and Consumption with Trade based upon Comparative Advantage Production Farmer Rancher Consumption Meat Potatoes Meat Potatoes 0 18 32 12 5 13 17 27 Trading price: 3 units of potatoes = 1 unit of meat. Pattern of Trade: Farmer exchanges 15 units of potatoes for 5 units of meat from the rancher. Comparative Advantage and International Trade An Illustration of Comparative Advantage and Gains from Trade “Technology” and Opportunity Cost: Production Requirements Eq. Guinea United States Opportunity Cost Tractors Yams 1 Tractor 1 Yam 200,000 hours 200 hours 5 hours 1 hour 40,000 yams 200 yams 1/40,000 tractor 1/200 tractor United States Equitorial Guinea Tractors Tractors Expanded consumption possibilities made possible by trade Yams Equatorial Guinea’s opportunity cost: 1 tractor = 40,000 yams Yams U.S. opportunity cost: 1 tractor = 200 yams Comparative Advantage and International Trade An Illustration of Comparative Advantage and Gains from Trade “Technology” and Opportunity Cost: Production Requirements Eq. Guinea United States Opportunity Cost Tractors Yams 1 Tractor 1 Yam 200,000 hours 200 hours 5 hours 1 hour 40,000 yams 200 yams 1/40,000 tractor 1/200 tractor Production and Consumption without Trade: Production Tractors Yams Eq. Guinea United States Production Assumptions: 50 500,000 2,000,000 100,000,000 Consumption Tractors 50 500,000 Yams 2,000,000 100,000,000 Eq. Guinea distributes 20 million hours equally between production of tractors and yams. U.S. distributes 200 million hours equally between production of tractors and yams. Production and Consumption with Trade based upon Comparative Advantage Production Eq. Guinea United States Consumption Tractors Yams 0 505,000 4,000,000 99,000,000 Tractors 100 504,900 Trading price: 20,000 yams = 1 tractor. Pattern of Trade: Eq. Guinea exchanges 2 million yams for 100 tractors from the U.S. Yams 2,000,000 101,000,000 Significance of International Trade in the U.S. Economy, 1929 – 2007 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% Exports as a Percentage of GDP Source: Bureau of Economic Analysis, http://www.bea.doc.gov Imports as a Percentage of GDP 2007 2004 2001 1998 1995 1992 1989 1986 1983 1980 1977 1974 1971 1968 1965 1962 1959 1956 1953 1950 1947 1944 1941 1938 1935 1932 1929 0% Trade Position of the U.S. Economy, 1929 – 2007 6% 4% 2% 0% -2% -4% Net Exports as a Percentage of GDP (Left Scale) Source: Bureau of Economic Analysis, http://www.bea.doc.gov 2007 2004 2001 1998 1995 1992 1989 1986 1983 1980 1977 1974 1971 1968 1965 1962 1959 1956 1953 1950 1947 1944 1941 1938 1935 1932 1929 -6%