Summary Principles of Economics 1
Chapter 1: Big Ideas
Incentives: rewards and penalties that motivates behavior.
Big Idea 1: Incentives Matter:
Economists don't think everything is self-interested. Economists thinks that people respond
in a predictable way to incentives of all kind (fame, power, sex, reputation…). Also
benevolence responds to incentives, ex. charities, publicize the name of their donors.
Big Idea 2: Good Institutions Align Self-Interest with the Social Interest:
Under the right conditions markets align self-interest with social-interest, even if they are at
odds. Ex. A u shot prevents you from getting the u but it also reduces the chances that
other people will get the u. The Invisible Hand of Adam Smith. But Markets do not always
align self interest with social interest, for example a rm that does not pay for the pollution it
emits into the air has a too great an incentive to emit pollution. When markets don’t
properly align self-interest with social-interest, the government an improve the situation by
changing incentives with taxes, subsidies or other regulations.
Big Idea 3: Trade-o s are Everywhere:
Drug (Medicine) example: Economist worried that approved pharmaceutical could become
too safe after the Vioxx incident. A drug being too safe has trade-o s: Researching,
developing and testing a new drug cost times and resources. Drug lag and Drug loss:
Drug lag: tests takes time, good drugs delayed just like bad drugs. The longer it takes to
bring new drugs to the market the more people are harmed who could have bene tted if the
new drugs had been approved earlier. You can de because an unsafe drug is approved but
you can also die because a safe drug has not yet been approved
Drug loss: Greater the costs of testing, fewer drugs will be, higher costs mean a higher
hurdle, fewer new drugs, and fewer lives saved. You can die because an unsafe drug is
approved, but you can also die because a safe drug is never developed.
We face trade o s because of scarcity, there are not enough resources in the world to
satisfy all our wants. The Great Economic Problem is how to arrange our scare resources
to satisfy as many of our wants.
Big Idea 3: Opportunity Cost:
The opportunity cost is the value of the opportunities lost. Example: if you are choosing to
now attend university. You are paying 10000€ in tuition fees a year. Is that your opportunity
cost for attending university? No, it’s not. The main opportunity you lose when you attend
university are al the possible things you could have done otherwise. For example, you could
have done a job earning you 25,000€ a year instead.
This concept is important for two reasons:
• If you don’t understand the opportunities you are losing, you won’t recognize the real
trade-o s that you face.
• The most of the time people do respond to changes in opportunity cost, so if you want to
understand their behavior you need to understand opportunity cost.
Big Idea 4: Think on the Margin:
Thinking on the margin is a requirement when you make a trade-o . Constantly weighing
bene ts and costs while making a decision is thinking on the margin. You are thinking in
terms of marginal bene ts and marginal costs (a little bit more or a bit less).
Big Idea 5: Trade makes people Better O :
fi
ff
ff
fi
fl
ff
fl
fi
ff
ff
fl
ff
fi
1
Trade allows us to take advantage of economies of scale, the reduction in costs created
when goods are mass-produced. Since not everyone can produce everything, it’s better o
if they produce what they are best at and trade for everything else. The theory of
comparative advantage says that when people or nations specialize in goods which have
allow opportunity cost, they can trade to mutual advantage.
Big Idea 6: Wealth and Economic Growth are Important:
Wealth brings us ush toilets, antibiotics, higher education, the ability to choose the career
we want, etc…, also it brings women’s right and political liberty, at least in most countries.
Wealth economies lead to richer and more ful lled, happier lives. Money and happiness are
positively correlated in economics.
Big Idea 7: Institutions Matters:
Some countries have more physical and human capitals than others but still they are not as
successful. This is because it’s important that everything is well organized and that
institutions are well aligned in the country’s interest.
The most important institutions for supporting good incentives are:
• Property right
• Political stability
• Honest government
• Dependable legal system
• Competitive and open markets
Big Idea 8: Economic Booms and Busts cannot be Avoided but can be Moderated:
It is impossible to avoid all recessions. Boom and Busts are part of the normal response of
an economy to changing economic conditions. However, all of this can be moderated. Most
economists believe that if the US Federal Reserve had acted more quickly and
appropriated, the great depression would have been shorter and less deep.
Big Idea 9: In ation is caused by Increases in the Supply of Money:
In ation is an increase in the general level of prices. In ation is one of the most common
problems in macroeconomics. When there is too much money circulating in the economy
(the government prints too much), the existing currency loses its value which leads to rising
prices.
Big Idea 10: Central Banking is a Hard Job:
The Federal Reserve is often called on to combat recession. This is a tough job since no
one can perfectly foresee the future and Fed’s decisions are not always correct.
Big Idea 11: Economics is Fun:
Lmao funny laugh
Key Concepts:
Incentives, Scarcity, Great Economic Problem, Opportunity Cost, In ation.
ff
fl
fl
fi
fl
fl
fl
2
Chapter 2: The Power of Trade and Comparative advantage
Three bene ts of Trades:
1. Trade makes people better o when preferences di er.
2. Trade increases productivity through specialization and the division of knowledge.
3. Trade increases productivity through comparative advantage.
Trade and Preferences:
Trades creates value by moving goods from people who value them less to people who
value them more. People with di erent preferences are eventually better o .
Specialization, Productivity and the Division of
Knowledge:
People will only specialize in the production of a single good
when they are con dent that they will be able to trade that
good for the many other goods they want and need. Thus,
as trade develops, so does specialization and specialization
turns out to vastly increase productivity. There is also a
creation of new knowledge ad it is shared and explored.
Absolute Advantage:
A country has an absolute advantage in production if it can produce the same good using
fewer inputs that any other country. But to bene t from a trade, a country does not need an
absolute advantage. Comparative advantage is best explained using a production
possibility frontier. (Mexico and US, computer and t-shirts example).
Production Possibility Frontier (PPF):
Shows all the combination of goods that a country can produce given its productivity and
supply of inputs.
Comparative Advantage:
The ability of an individual or group to carry out a particular economic activity (such as
making a speci c product) more e ciently than another activity.
There is a close connection between opportunity cost and the PPF. Even though Mexico is
less productive than the US in the diagram (pag. 17), Mexico has a lower cost of producing
shirts. Since Mexico has the lowest opportunity cost of producing shirts, we say that
Mexico has a comparative advantage in producing shirts.
ff
ff
fi
ffi
ff
ff
fi
fi
fi
3
Production and Consumption in Mexico and the United States with Trade:
With no trade, Mexico produces and consumes one computer and six shirts, and the
United States produces and consumes 12 Computers and 12 Shirts. With specialization,
Mexico produces zero computers and 12 shirts and the US produces 14 computers and 10
shirts. By trading three shirts for one computer, Mexico increases its consumption by one
computer and one shirt. Thus, everyone can bene t from trade. From the world’s greatest
genius down to the person of below-average ability, no individuals or countries are so
productive or so unproductive that they cannot bene t from the inclusion in the worldwide
division of labour. Trade unites humanity.
Comparative advantage and Wages:
Ultimately it’s the productivity of labor that determines the wage rate. Specialization and
trade let workers make the most of what they have. According to the example above,
workers in the US often fear trade because they think that they cannot compete with lowwage workers in other countries. Meanwhile, workers in the low-wage countries fear trade
because they think that they cannot compete with high-productivity countries like the US.
The di erence in wages re ect di erences in productivity.
Trade and Globalization:
Not everyone bene ts from increased trade. In our simple model, workers within a country
can easily switch between the shirt and computer sectors. In the real world, workers in the
sector with increased demand will see their wages rise while workers in there sector with
decreased demand will see falling wages.
Takeaway:
Specialization creates enormous increases in productivity. Without trade, the knowledge
used by an entire economy is approximately equal to the knowledge used by one brain.
With specialization and trade, the total sum of knowledge used in an economy increases
tremendously and far exceeds that of any one brain.
Key Concepts:
- Absolute advantage p. 16
- Production Possibility Frontier p. 16
- Comparative Advantage p. 17
fi
fi
ff
fl
fi
ff
4
Chapter 3: Supply and Demand
Demand Curve: A function that shows the quality
demanded at di erent prices
If the price of oil was $55 per barrel, the quantity
demanded would be 5 million barrels of oil per day.
If the price was $20 per barrel, what would the
quantity demanded be? It would be 25 millions
barrels, according to the demand curve.
Quantity Demanded: The quantity that buyers are
willing and able to buy at a particular price.
The demand for oil depends on the value of oil in
di erent uses. When the price of oil is high, oil will
be used only in its higher-valued uses. As the price
of oil falls, oil will also be used in lower-valued uses.
(Higher value=airline ights; lower value=manufacturing of rubber duck toys).
Two ways to read a demand curve:
1. Horizontal Reading: At a price of $20 per barrel, buyers are willing to buy 25 million
barrels of oil per day. ( g. 1)
2. Vertical Reading: The maximum price that demanders are willing to pay to purchase 25
million barrels of oil per day is $20 per barrel.
In summary, a demand curve
is a function that shows the
quantity that demanders are
willing and able to pay at
di erent prices. The lower the
prices, the greater the
quantity demanded. This is
often called the “law of
demand”.
Consumer Surplus: The consumer gain from exchange, or the di erence between the
maximum price a consumer is willing to pay for a certain quantity and the market price.
Total Consumer Surplus: Measured by the area beneath the demand curve and above the
price
ff
fi
fl
ff
ff
ff
5
What Shifts the Demand Curve?:
1. An increase in demand shifts the
demand curve outward, up and to the
right.
2. A decrease in demand shifts the
demand curve inward, down and to
the left.
It’s also important to understand what
kind of things will increase or decrease
demand.
Important Demand Shifters:
Income: When people get richer, they buy more stu . When an increase in income
increases the demand for a good, we say that it is a normal good. Most goods are
normal, for example cars and electronics. An inferior good is a good for which demand
decreases when income increases, for example instant ramen.
Population: When there are more people, there is more demand.
Price of Substitutes: If two goods are substitutes, a decrease in the price of one good
leads to a decrease in demand for the other good.
Price of Complements: If two goods are complements, a decrease in the price of one
good leads to an increase in the demand for the other good, and vice-versa.
Expectations: The expectations of a reduction in the future oil supply increases the
demand today. Future assumptions can a ect demand.
Tastes: Fashion trends keep changing, that can a ect demand. The environmental
movement has made people more aware of climate change and how the consumption of
oil adds carbon dioxide to the atmosphere. As a result, the demand for hybrid cars has
increased, more people are recycling, and considering to install solar panel. There are
changes in tastes and preferences, another example is the demand for bandanas in
1970’s, it was very high, but today its almost impossible to see anyone wearing them.
The Supply Curve: A function that shows
the quantity supplied at di erent prices.
Quantity Supplied: The amount of a good
that sellers are willing and able to sell at a
particular price.
The supply curve for oil is a function
showing the quantity of oil supplied at
di erent prices. If the price of oil was $20
per barrel, the quantity of oil supplied
would be 30 million barrels of oil per day.
The same way, suppliers would be willing
and able to sell 50 million barrels of oil at
$55.
As with the demand curve, you can read a
supply curve in two ways.
1. Horizontal Reading: At a price of $20 per barrel, suppliers are willing to sell 30 million
barrels of oil per day.
2. Vertical Reading: To produce 30 million barrels of oil a day, suppliers must be paid at
least $20 per barrel.
ff
ff
ff
ff
ff
6
Producer Surplus: The producer gain from the exchange, or the di erence between the
market price and the minimum price at which a product would be willing to sell at a
particular quantity.
Total Producer Surplus: Measured by the area above the supply curve and below the
price.
What Shifts the Supply Curve:
Technological Innovation and changes
in the price of inputs: Improvements in
technology can reduce costs and
increase supply.
Taxes and Subsidies: With a $10 tax,
suppliers require a $10 higher price to
sell the same quantity. The subsidy is a
reverse of Tax
Expectations: Suppliers who expect
that prices will increase in the future
have an incentive to sell less today so
that they can store goods for future
sales.
Entry or Exit of Producers: Trade barriers/agreements a ect supply.
Changes in opportunity: You have to take into account opportunity cost as that a ects
the supply curve. Producers may choose to change their eld which shifts the supply
curve.
ff
ff
fi
ff
7
Chapter 4: Equilibrium: How Supply and Demand Determine Prices
Price is determined by supply and demand. Equilibrium occurs when the quantity
demanded equals the quantity supplied. In the diagram below, the quantity demanded
quals the quantity supplied only when the price is $30 and the quantity exchanged is 65;
hence, $30 is the equilibrium price and 65 is the equilibrium quantity.
Surplus: A situation in which the quantity supplied is greater than the quantity demanded.
Shortage: A situation in which the quantity demanded is greater than the quantity
supplied
Equilibrium Price: The price at which the quantity demanded is equal to the quantity
supplied.
Surplus Drives Prices DOWN and Shortage Drives Prices UP:
Surplus DOWN: When there is a surplus, sellers have an incentive to decrease their price
and buyers have an incentive to o er lower prices. The prices decreases at $30 the quantity
demanded equals the quantity supplied and there is no longer an incentive for price to fall.
Shortage UP: When there is a shortage, sellers have an incentive to o er higher prices. The
price increases until at $30 the quantity supplied equals the quantity demanded and there is
no longer an incentive for the price to rise.
ff
ff
8
Who competes with whom?
Sellers want higher prices and buyers want lower prices so the person in the street often
thinks that sellers compete against buyers. However, economists understands that sellers
compete with sellers and buyers compete with buyer. If the market is competitive don’t
blame the seller if you can’t achieve the ideal price, blame the other buyers outbidding you.
A free market maximize producer plus consumer surplus (the gains from trade):
• The equilibrium quantity is the quantity at which the quantity demanded is equal to the
quantity supplied;
• There are potential gains from trade so long as buyers are willing to pay more than sellers
are willing to accept;
• There are unexploited gains from trade at any quantity less than the equilibrium quantity;
• If the quantity supplied exceeds the equilibrium quantity, it costs the sellers more to
produce a product than it is worth to buyers (additionally, the resources would only be
wasted, and it would be better to spend them on production of something people really
are willing to pay for);
• E ective use of the limited number of resources means to produce neither too little, nor
too much of a good.
A free market maximizes the gains from
trade, when:
1. The supply of goods is bought by the
buyers with the highest willingness to pay
2. The supply of goods is sold by the sellers
with the lowest costs
3. Between buyers and sellers, there are no
unexploited gains from trade and no
wasteful trades.
Under the right condition, self interest leads
to a bene cial order, rather than chaos.
In Panel A: Unexploited gains from trade
exist when quantity is below the equilibrium
quantity. Buyers are willing to pay $57 for the
24th unit and sellers are willing to sell the
24th unit for $15, so not trading the 24th unit
leaves $42 in unexploited gains from trade.
Only at the equilibrium quantity are there no
unexploited gains from trade.
In Panel B: Resources are wasted at
quantities greater than the equilibrium
quantity. Sellers are willing to sell the 95th
unit for $50 but buyers are willing to pay only
$15 so selling the 95th unit wastes $35 in
resources. Only at equilibrium quantity are
there no wasted resources.
If price drop and the supplied quantity
increases (e.g due to technological
advances), there will at rst be a surplus
(excess supply) - but only temporary.
fi
fi
ff
9
Surplus Supply: Sellers are willing to sell more at the old price than demanders are willing
to buy. Competition between sellers pushes the prices down, the prices fall, and the
quantity demanded will increase until the new equilibrium price and quantity is met. A
decrease in supply will raise the market price and reduce the market quantity, having the
opposite e ects to an increase supply
Increase/Decrease in Demand: The same logic applies when there is an increase/
decrease in demand: If demand increases, the price and quantity point. A decrease in
demand will tend to decrease price and quantity
Terminology: Demand Compared with Quantity Demanded and Supply
Compared with Quantity Supplied:
ff
10
A. Increase in quantity demanded is a movement along a xed demand curve (and
is always caused by changes in supply)
B. Increase in demand is a shift of the entire demand curve (up and to the right)
C. Increase in supply is a shift of the entire supply curve (down and to the right)
D. Increase in quantity supplied is a movement along a xed supply curve caused
by a shift in the demand curve.
Comparing Panel A and C shows that shifts in the supply curve create changes in
quantity demanded.
Comparing Panel B and D shows that shifts in the demand curve created changes
in the quantity supplied.
fi
fi
11
Chapter 7: The Price System: Signals, Speculations, and Predictions
Price: Price is a signal wrapped up in an incentive, because prices convey important
information, and they create an incentive to respond to that information in socially useful
ways.
One market can in uence another, and
ultimately, an entire series of markets are t
together in a global economy. Prices are the
key force integrating markets and motivating
entrepreneurs.
The primary theme: The price system
creates rich connections between markets
and enables societies to mobilize vast
amount of knowledge toward common ends
- yet without a central planner.
Markets Link the World: To bring just one
product from start to end requires
cooperative e orts of millions, as illustrated
in the rose-example given in the book. This
immense cooperation to bring a product from point/state A to point/state B is voluntary and
undirected. Each part of the process is people acting in their own self-interest.
Markets Link to One Another: Shifs in supply and demand in one market ripple across the
worldwide market, changing distant people and products in unforeseeable ways
Entrepreneurs are constantly on the lookout for ways to lower costs, and their cost-cutting
measures link markets that at rst seem like they are completely unrelated. For example:
the moving of the rose business from the USA to Kenya, due to higher oil prices. It was no
longer bene cial to grow roses in American greenhouses, as the increased costs would
exceed the costs of production in Kenya combined with the transportation costs.
When these things occur, entrepreneurs will look to alternative ways to utilize resources,
which can then cause additional chain e ects.
Solving the Great Economic Problem:
The great economic problem is to arrange our limited resources to satisfy as many of our
wants as possible. To economize on scarcity, low-value uses must be substituted by other
means, whilst the high-value uses must be maintained (whereas there are few substitutes).
• Central planning approaches fail because of problems relating to information and
incentives (companies have the incentive to promote allocation to their use, even if it is of
“low-value”) (impossible to acquire all this information e ectively)
• Ideally, each user of the product would compare the value of their use with the value of
alternative uses, and have the incentive to give it up if it is of lesser value; this is what the
price system accomplishes.
In a free market, the price of product X is equal to the value of product X in its next highestvalue use.
The equilibrium price slits the uses of a good into 2:
• High-value, satis ed demands
• Low-value, unsatis ed demands
• The value of the highest-value unsatis ed demand is equal to the market price (just
below) (increased availability would incentive the market to satisfy the highest-value
unsatis ed demand)
ff
fi
ff
fi
fi
fi
fl
fi
ff
fi
fi
12
Information issue by collapsing all the
information into the price (Hayek)
The price system also solves the incentive
problem, since it’s in a consumer’s interest
to pay attention to prices. When the price
of a product increases, consumers have an
incentive to look for substitutes. In doing
so, consumers free up the product so that
it can be used elsewhere in the economy
where it is of higher value, e.g. oil; asphalt
versus jet fuel. In other words, the markets,
guided by prices, works as if an “invisible
had” guides the process (Adam Smith).
A Price is a Signal Wrapped up in an
Incentive:
Prices are incentives, signals and
predictions:
1. When the price increases, users are
incentivized to economize by using less
or by looking for substitutes
2. An increase in the price is also a signal
to suppliers to invest more in
exploration, look for alternatives,
increase recycling, etc.
Speculation
Speculation is the attempt to pro t from future price changes, i.e buying/stocking up on a
product for a low price, and selling it when the price is high.
• With speculation, preparations are made in case of disruption, resulting in more smoothed
prices - Speculations will raise prices today, but lower prices in the future, as the
disruption will not imbalance the market to the same extent
• It will cause an increase in unsatis ed demands now, however it is compensated by
having an increase in satis ed demands in the future (which exceeds the unsatis ed
demands in the present)
• Speculation is never guaranteed to be correct, which can have devastating e ects for the
company/individual speculating.
Futures: Standardized contracts to buy or sell speci ed quantities of a commodity of
nancial instrument at a speci ed price with delivery set at a speci ed time in the future.
Most future contracts are settled in cash (cash settlement).
Signal Watching: Speculators can push up the futures price of a product, which created da
signal that tells others that people with their own money on the line believe that supply
disruptions may soon occur.
E.g futures prices for oil, currencies, and many commodities can be found in a newspaper
or online, so anyone who wants to forecast events in the Middle East can bene t from
reading price signals
fi
fi
fi
ff
fi
fi
fi
fi
fi
13
fi
fi
When a consumer compares the price of product X to the value of product X for a speci c
task Y, he is comparing the opportunity
cost.
Prediction Markets: A prediction market is a speculative market designed so that prices
can be interpreted as probabilities and used to make prediction
The best known prediction market is the Iowa Electronics Market. The Iowa market let
trader use real money to buy and sell “shares” of political candidates, essentially meaning
that the market price for a share that candidate X wins is the speculated prediction of the
election.
Chapter 11: Costs and Profit Maximization Under Competition
To maximize pro t, these questions must be answered:
1. What price to set?
2. What quantity to produce?
3. When to enter and exit the industry?
What Price to Set?
Usually the prices are set by the market. Pricing is easy; you can’t sell any of your products
at a price above the market price and you can sell all your products at the market price (no
reason to price it lower than the market price). The market price will be a maximization of
your pro ts as it is the equilibrium of supply and demand.
If there are plenty of substitutes for your product, the demand for your product is most likely
perfectly elastic ( at) at the world price.
• A perfectly elastic demand curve for rm output is a reasonable approximation when the
product being sold is similar across di erent rms and there are many buyers and sellers,
each small relative to the total market
ELASTICITY = Price Sensitivity = How Sensitive the Demand is to Price Changes
Demand curves are more elastic in the long run
• The long run is the time after all exit or entry has occurred
• The short run is the period before exit entry can occur
There are sometimes many potential sellers, so a perfectly elastic demand curve can be a
reasonable assumption even in a market with a few rms, at least in the long run
Economists say that an industry is competitive when rms don’t have much in uence
over the price of their product; under these following conditions:
1. The product sold is similar across sellers (little di erentiation)
2. There are many buyers and sellers that make up small shares of the total market
3. There are many potential sellers (such as new rms establishing if a monopolist has
unfair prices)
Firms have a lot of in uence on the price of their product when: They sell a product that
there are few or no other sellers of, including potential sellers
Maximizing Pro t
Sunk Costs: are costs that has already been incurred and that cannot be recovered. E.g
$15 dollars for a ticket for a bad lm, they money is gone, so ignore the cost and do
the only thing that can be changed, walk out.
Fixed Costs: are costs that do not vary with output. E.g paying rent for the land that the
rms utilized
Variable Costs: are costs that vary with output. E.g costs for electricity, maintenance,
storage, transportation, etc. as they will vary depending on output - less output
equals less transportation
fl
fi
fi
ff
fi
fi
fi
ff
fi
fl
fi
fl
fi
fi
fi
14
Opportunity Costs: Total costs include explicit money costs and implicit opportunity costs;
the costs of foregone alternatives
Explicit Costs: ate the costs that require actual monetary spending (a monetary outlay), e.g
buying goods for your retail store, rent, electricity, etc.
Implicit Costs: are costs that does not require monetary spending, e.g trade-o s of
investing your savings into a production versus interest rates from continued saving
The economic de nition of pro t di ers from the accounting de nition of pro t because
accountants typically don’t take into account all opportunity costs. -Economic pro ts are
typically less than account pro ts
Economic pro ts is total revenue - total costs including implicit costs [TR - (TC + IC)]
Accounting pro ts is total revenue - explicit costs (TR - TC)
What quantity to produce?
Pro t = π = Total revenue − Total cost (TR - TC
Total Revenue (TR) = Price x Quantity Sold (P x Q
Total Cost (TC) = Fixed Costs + Variable Costs (FC+VC
Total cost is the cost of producing a given quantity of output. Total costs are harder to
determine, as they include opportunity costs, not just money costs. Understanding the pro t
maximization decision requires us to distinguish among many different costs - not just total
costs, but also average costs, marginal costs, xed costs, and a few others.
Fixed Costs: are costs that do not vary with output. E.g paying rent for the land that the
rms utilized
Variable Costs: are costs that vary with output. E.g costs for electricity, maintenance,
storage, transportation, etc. as they will vary depending on output - less output
equals less transportation
Pro t is the di erence between total revenue and total cost. To nd the maximum pro t,
one method is to look for the quantity that maximized TR - TC.
• Instead of looking at total revenue and total cost, one can also compare the increase in
revenue from selling an additional product (marginal revenue), to the increase in cost from
selling an additional product (marginal cost)
• Producers wants to increase production as long as marginal revenue > marginal cost,
which means that the halting point (stop) should be the place where marginal revenue =
marginal cost.
Marginal Revenue (MR) = Total Revenue / Quantity (TR / Q
Marginal Cost (MC): is the
change in total cost from
producing an additional unit
The extra cost related to
additional production are marginal
costs. It is vital to avoid a
situation where marginal costs
exceed marginal revenue, as that
provides a loss. Marginal costs
will increase and become
exponentially high at a certain
point, as either maximum
capacity is reached, the price is
pushed down too much by
fi
fi
fi
ff
fi
fi
fi
)
)
)
)
fi
ff
fi
fi
.
fi
fi
fi
ff
fi
fi
fi
15
increasing supply, or having an excess surplus that there is no demand for.
In the example, the pro t-maximizing quantity is 8, as MC = MR. Additional production would
lead to MC exceeding MR. The pro t-maximizing quantity is where MR = MC
• If MR = P, the pro t-maximizing quantity is where P = MC.
• Pro t-maximization in competitive industries is therefore: P = MC = MR
• Even though the additional unit resulting in pro t-maximization does not provide additional
pro t, it is “just the right” point between too little and too muc
As price changes, so does the pro t-maximizing quantity:
If the product price increases signi cantly, the rm will expand production until it is once
again maximizing pro t when P = M
Pro ts and the Average Cost Curv
Even if a rm maximizes pro ts, it can still have low pro ts or losses. The average cost of
production is total costs divided by quantity. The average cost of production is the cost per
barrel, that is, the total cost of producing barrels dived by Quantity
Average Cost (AC) = Total Cost / Quantity (TC / Q)
The graph below shows the relation between price, marginal cost and average cos
Pro t = Total Revenue - Total Cost (TR - TC)
Pro t = [(TR/Q) - (TC/Q)] x
TR = P x
AC = TC /
Pro t = (P - AC) x
When marginal cost is below average cost, the average cost curve is falling, and when
marginal cost is above average cost, the average cost curve is rising, so AC and MC must
meet at the minimum of the AC curve,
t
.
.
h
fi
fi
fi
fi
e
C
fi
fi
fi
Q
fi
fi
Q
fi
Q
fi
Q
fi
fi
fi
fi
fi
fi
16
Always draw the MC
curve rising through
the minimum point of
the AC curve.
What is the lowest
price per barrel that
will give the rm a
pro t? (No loss)
Assuming that
P=MC at all times:
1. When P > AC,
the rm is
making a pro
2. When P < AC,
the rm is
making a los
When should the rm enter of exit the industry?
Entry, exit and shutdown decisions
Firms seek pro ts, so in the long run rms will:
1. Enter the industry when P > A
2. Exit the industry when P < A
3. Neither enter or exit when P = AC (zero pro ts)
A. Zero/Normal pro ts occur when P = AC. At this price the rm is covering all of its
costs, including enough to pay labor and capital/ nance their ordinary opportunity
costs. The rm does, however, not make any excess pro ts. Average cost includes
wages and payments to capital, so even when the rm earns “zero pro ts”, labor and
capital are being paid enough to keep them in the industry.
Short-Run Shutdown Decisions:
If P < AC, the rm is making a loss so it wants to exit the industry, but exit typically cannot
occur immediately. Fixed costs such as rent contracts cannot be terminated immediately.
Therefore, the rm wants to keep the operations going until they are no longer committed to
the xed costs. In this scenario, by not shutting down, the rm is able to cover all of its
variable costs and some of its xed costs, which is better than not producing anything as
well as paying xed costs.
Total Costs (TC) = Fixed Costs + Variable Costs (FC + VC
In the short-run, xed costs have to be paid no matter how much output the rm produces.
Thus the rm should shut down immediately only if TR < VC, alternatively P < VC, or dividing
both sides by Q as before, the rm should shut down immediately only if:
Price < (Variable Costs / Quantity) [VC/Q] = Average Variable Costs (AVC
AVC = Variable Costs / Quantity (VC/Q
Shut down immediately if: P < VC/Q -> P < AV
)
fi
fi
)
fi
fi
fi
fi
fi
C
fi
)
fi
fi
C
fi
C
fi
fi
fi
fi
fi
fi
t
fi
fi
s
fi
fi
fi
fi
fi
fi
fi
17
Entry, exit, and industry supply curve
1. Increasing cost industry is an industry in which industry costs increases with greater
output - shown with an upward sloped supply curve. As seen below, when the prices
increases, so does the opportunity to pro t-maximize by expanding along the MC curve
until P = MC, effectively increasing the industry supply/output as industry costs increase
with it.
fi
s
18
fi
fi
The AVC curve gets closer
and closer to the AC curve as
Q increase:
As production increases, the
MC curve will exponentially
increase. At some point, the
xed costs will make up less
and less of the total costs, as
they are more or less static
unless they are expanded on,
i.e buying more land to expand
the production facility. The
variable costs will however
increase ad production
increases (more electricity,
labor, etc.), reaching a point
where they are higher or equal to
the xed costs.
3. Decreasing cost industry is an industry in which industry costs decrease with an increase
in output; shown with a downward sloped supply curve
A. It becomes cheaper to produce the product in a place where there are already a
lot of producers of the same, and environment is laid out for production of this
good
Key Concepts: long run, p. 197 short run, p. 197 total revenue, p. 197 total cost, p. 197
explicit cost, p. 198 implicit cost, p. 198 economic pro t, p. 198 accounting pro t, p. 198 xed
costs, p. 199 variable costs, p. 199 marginal revenue, MR, p. 199 marginal cost, MC, p. 199
average cost, p. 202 zero (normal) pro ts, p. 204 increasing cost industry, p. 206 constant
cost industry, p. 206 decreasing cost industry, p. 206
fi
fi
.
fi
fi
fl
fi
19
fi
fi
fi
2. Constant cost industry is an industry in
which industry costs do not change with
greater output - shown with a at supply
curve. In a constant cost industry, when
the industry expands, it does not push
up the price of its inputs and thus
industry costs do not increase.
A. As the industry is so
competitive, the rms are forced
to price their services at near
average cost and earn zero or
normal pro ts, as they would
lose business otherwise. In a
constant cost industry, an
increase in demand will raise the
prices in the short run as each
rm moves up its MC curve.
However, the expansion of old
rms will quickly push the price
back down to average cost.
Chapter 12: Competition and the Invisible Hand
Invisible Hand property 1: Says that by producing P = MC, the self-interested, pro tseeking behavior of entrepreneurs results in the minimization of the total industry costs of
production even though no entrepreneurs intends this result.
Every rm in the same industry faces
the same prices, thus in a competitive
market with N rms, the following is
true:
P = MC1 = MC2 = … = MCN
The way to minimize the total costs of
production is to produce just so
much on each farm that the marginal
costs of production are equalized,
MC1 = MC2. In the example
provided, the cost-minimizing way to
produce 200 bushels is to produce 75
bushels on farm 1 and 125 bushels
on farm 2.
If one person is the owner, he can
“central plan” and allocate
productions across the two farms so
that the marginal costs are equal, and
thus the total costs of production are
minimized - however, a “centralized
planner” is not necessary due to the
invisible hand.
• In pursuit of self-interest (pro t), they end up minimizing the total costs of production
• The invisible hand property 1 says that even though no actor in a market economy
intends to do so, in a free market P=MC1=MC2=…=MCN and, as a result, the total
industry costs of production are minimized.
Without free trade, the total costs of producing cannot be at a minimum, since the
unconnected producers will face di erent prices, and thus have di erent marginal costs.
Invisible Hand Property 2: Says that entry and exit decisions not only work to eliminate
pro ts, they work to ensure that labor and capital move across industries to optimally
balance production so that the greatest use is made of our limited resources.
Creative Destruction: That the pro t rate in all competitive industries tends toward the
same level is just a tendency. In pursuit of pro t, entrepreneurs are always trying to discover
new and better products and processes which is why new pro table and unpro table
industries appear constantly.
The Elimination Principle: Above-normal pro ts are eliminated by entry and below-normal
pro ts are eliminated by exit - a general feature of competitive markets. Perhaps even more
importantly, the elimination principle tells us that to earn above-normal pro ts, a rm must
innovate.
The Invisible Hand works with competitive markets:
The Invisible Hand works only in certain circumstances, stated below
1. The prices have to accurately signal costs and bene ts, which isn’t always the case
2. If markets aren’t competitive, the invisible hand doesn’t work either
3. Self-interest doesn’t always align with the social interest.
fi
fi
fi
fi
ff
fi
fi
fi
fi
fi
ff
fi
fi
fi
fi
fi
20
Chapter 14: Price Discrimination and Pricing Strategy
A rm with market power can use price discrimination to increase pro t.
Price Discrimination: Selling the same product at di erent prices to di erent customers
The most obvious form of price discrimination is when a rm sets di erent prices in di erent
markets. Examples: price can be discriminated by actual physical markets, by each
customer’s willingness to pay for the good, or price discrimination based upon the time of
buying a service/product in correlation to the use date
The demand curve in Arica is much lower and more elastic (price sensitive) the in Europe
because, on average, Africans are poorer than Europeans. If GSK wants to set a single
world price, it should lower the price in Europe and raise the price in Africa, setting a price
somewhere between the pro t-maximizing price in Europe and the pro t-maximizing price
in Africa. By doing this, GSK reduced their pro t in Europe, and by raising the price in
Africa, they also reduced their pro t in Africa. Thus, pro t at the single price must be less
than when GSK sets to di erent prices earning the combined pro t.
Principles of Price Discrimination
1. If the demand curves are di erent, it is more pro table to set di erent prices in di erent
markets, than a single price that covers all markets.
A. Therefore, GSK wants to price discriminate, however, by doing that, they
encourage drug smuggling - which hurts GSK’s pro ts
2. To maximize pro ts, the monopolist should set higher prices in markets with more
inelastic demand.
3. Arbitrage makes it di cult for a rm to set di erent prices in di erent markets, thereby
reducing the pro t from price discrimination.
A. Arbitrage: Taking advantage of price di erences for the same good in di erent
markets by buying low in one market and selling high in another market
To succeed at price discrimination, the monopolist must prevent arbitrage. Arbitrage can e.g
be prevented through the usage of electronic tracking, bar codes or physical appearance
di erences (red pills vs blue pills)
Price Discrimination is common: Businesses care about how much customers are willing
to pay, which is the basis they use for their price discrimination. Airlines set prices
ff
ff
ff
ff
fi
fi
ff
fi
ff
ff
fi
fi
ff
fi
fi
fi
ff
ff
fi
fi
fi
ff
ff
ffi
fi
fi
fi
ff
21
according to characteristics that are correlated with the willingness to pay. New attractive
products will usually always be highly priced to bene t o the most interested customers.
Perfect Price Discrimination (PPD): Under perfect price discrimination (PPD), each
customer is charged their maximum willingness to pay. A monopolist with PPD results in
zero consumer surplus, as every consumer is charged their maximum.
Is Price Discrimination Bad? Price discrimination is bad if the total output with price
discrimination falls or stays the same, but if the output increases under price discrimination,
the total surplus will usually increase.
• Price discrimination has additional bene ts in industries with high xed costs: E.g
The reason there are more drugs to treat common diseases is because the market is
larger; it costs the same to develop a drug for a rare or a common disease, but the
revenue are much greater for the drug that treats a common disease. Thus, the larger the
market, the more pro table is to develop a drug for that market.
Tying: Occurs when to use one good, the consumer must use a second good that is sold
(only) by the same rm.
Firms can price-discriminate by trying two goods and carefully setting their prices.
The printer itself is cheap, so that it meets the consumers with a low willingness to pay
those that use printers.
Ink cartridges are expensive, which meet the consumers with an high willingness to pay,
those that use printers a lot.
Bundling: Is requiring that products be bought together in a bundle or package.
When individuals purchases are expensive, whilst the bundle is much more coste cient, more customers can be more inclined to spend a little more for additional
components; ref. O ce Bundle.
fi
ff
fi
fi
fi
fi
ffi
ffi
22
Chapter 27: The Wealth of Nations and Economic Growth
Economic growth and quality of life. There is a strong correlation between a country’s GDP
per capita and infant survival, as it is with many other bene ts that come with economic
growth. Just about any standard indicator of societal well-being tends to increase with
wealth.
Key Facts about the wealth of nations and economic growth
1. Fact 1: GDP per capita varies enormously among nations. 75% of the world’s
population (5b) lives in a country with a GDP per capita less than average (most of the
world’s population is poor relative to the US). The distribution of GDP per capita is also
not balanced within each nation.
2. Fact 2: Everyone used to bee poor. For most of recorded human history, there was no
long-run growth in real per capita GDP.
3. Growth rate is the percentage change in a variable over a given period such as a year.
When we refer to economic growth, we mean the growth rate of real per capita GDP
4. Fact 3: There are growth miracles and growth disasters.
In principle, economic growth can occur everywhere, and it can be exponentially fast; so
fast that it can surpass top nations within a much shorter time window. Growth is not
automatic, and some countries show few signs that they have started the growth path,
whilst others have fallen o the growth path, such as Argentina.
The Factors of Production
Physical Capital: Is the stock of tools, including machines, structures and equipment more capital means more productivity.
Human Capital: Is the productive knowledge and skills that workers acquire through
education, training, and experience. It is produced by an investment of time and other
resources. Human capital is the knowledge and skills that a person needs to understand
and to make productive use of technology an technological knowledge.
Technological Knowledge: Is knowledge about how the world works that is used to
produce goods and services - e.g. genetics, chemistry, physics. Technological knowledge is
fi
ff
23
potentially boundless, and it is possible to advance even if human capital is relatively
constant.
Organization: Human Capital, Physical Capital and Technological Knowledge must be
organized to produce valuable goods and services. Factors of production do not develop
themselves; they must be produced and organized to be productive.
The key to producing and organizing the factors of production are institutions that create
appropriate incentives.
Institutions: Are the “rules of the game” that shape human interaction and structure
economic incentives within a society.
Institution of Economic Growth
1. Property rights: Under communal property, e ort is divorced from payment, meaning
that there is little incentive to work. Communal property actually incentivizes free riding;
consuming resourced without contributing to the resource’s upkeep
2. Honest Government: E.g when property rights exist on paper - but only paper - it has
no value. Corruption is like a heavy tax that bleeds resources away from productive
entrepreneurs. Corruption can cause a poverty trap as few people want to be
entrepreneurs since their hard work can be taken away from them - thus there is no
wealth to steal.
3. Political Stability: Who wants to invest in the future when civil war threatens to wash
away all plans? Civil war, military dictatorship, and anarchy can destroy the institutions
necessary for economic growth.
4. A Dependable Legal System: If there exists no reliable record of true ownership, there
processes can take a long time, hindering e.g. the establishment of stores
5. Competitive and open markets: Failure to organize capital e ciently (factors of
production) has a huge e ect on the wealth of nations.
ffi
ff
ff
24
Chapter 29: Savings Investment, and the Financial System
The bankruptcy of the investment bank Lehman in 2009 shook the nancial system, having
assets worth $691 billion - it was an important nancial intermediary that worked to
transform savings into investments
Savings: Is income that is not spent on the consumption of goods
Investments: Is the purchase of new capital, such as tools, machinery, and factories
Savings are necessary for capital accumulation, and the more capital an economy can
invest, the greater GDP per capita.
The supple of Savings
Four major factors that determine the supply of savings:
1. Smoothing consumption
2. Impatience
3. Marketing and psychological factos
4. Interest rates
1. Smoothing Consumption: The desire to smooth consumption over time is a reason to
save and, also a reason to borrow. Savings are necessary to nance the capital
accumulation that generated high standards of living; no savings results in dried up
investment, declining economic growth, and the standard of living drops.
2. Impatience: Time preference is the desire to have goods and services sooner rather
than later (all else being equal). The more impatient a person, the more likely that
person’s savings rate is low. Impatience is re ected in any economic situation where
people compare costs and bene ts over time.
3. Marketing and Psychological Factors: Marketing matters, even for savings.
Individuals are more likely to save if it is perceived as the natural or default alternative.
Simple psychological changes, in combination with marketing and promotion, can
change how people save for their retirement.
4. Interest Rates: Higher interest rates usually cal forth more savings (individually and by
more people). Interest rate is a market price, and it has the same properties of market
prices.
There are 3 reasons people borrow:
1. Individuals wants to smooth consumption: Through borrowing, more people will be
able to attend i.e university, as well as being able to spread out the sacri ces
2. Borrowing is necessary to nance large investments: Many new businesses cannot
get a proper start without borrowing. More generally, businesses borrow to nance large
projects
fi
fi
fi
fi
fi
fl
fi
fi
25
3. The Interest Rate: The quantity of funds that people want to borrow depends on the
cost of the loan, or the interest rate.
Equilibrium in the market for loanable
funds:
The market for loanable funds occurs when
suppliers of loanable funds (saver) trade
with demanders of loanable funds
(borrowers). Trading in the market for
loanable funds determines the equilibrium
interest rate. In equilibrium, the quantity of
funds supplied equals the quantity of funds
demanded.
Shifts in Supply and Demand: Changed in
economic conditions will shift the supply or
demand curve and change the equilibrium
interest rate and quantity of savings. An
increase in the supply of savings causes the
equilibrium interest rate to fall, and the
quantity of savings to increase.
Temporary Investment Tax Credit: An investment tax credit grievers rms that invest in
plants and equipment a tax break
The Role of Intermediaries
1. Banks: Banks receive savings from many individuals, pay them interest, and then load
these funds to borrowers, charging them interest. Banks participate in the process of
economic growth, because the bank oversees a process by which our savings are
turned into productive investments and also pay a role in the payments system.
2. The Bond Market: A bond is a sophisticated IOU that documents who owes you how
much and when payment must be made. Instead of borrowing from a bank, a
corporation can borrow directly from the public, e.g. a relative. When a member of the
public lends money to a corporation, the corporation acknowledges its debt by issuing
a bond. The advantage of bond nance is that large sums of money can be raised and
invested in long-lived assets, and the money can be paid back over a long period of
time. All bonds involve a risk that the borrower will be unable to pay; default risk
A. Collateral: Something of value that by agreement becomes the property of the
lender if the borrower defaults (like a deposit)
B. Crowding Out: The decrease in private consumption and investment that
occurs when government borrows more
C. T-Bonds: US Treasury bonds 30-year bonds that pay interest every 6 months
D. T-Notes: Bonds with maturities ranging from 2 to 10 Yeats that also pay interest
every 6 months
E. T-Bills: Bonds with maturities of a few days to 26 weeks that pay only at
maturity. A bond that pays only at maturity is also called a zero-coupon bond or
a discount bond since these bonds sell at a discount to their face value
Bond Pricing Key Factors
1. Equally Risky assets must have the same rate of return (arbitrage principle)
2. The Interest rates and bond prices move in opposite directions
The Stock Market: A stock or a share is a certi cate of ownership in a corporation. Owners
have a claim to the rm’s pro ts, however, the pro t is what is left after everyone else has
been paid. Shareholders can directly bene t if the rm pays out its pro t in dividends, or
indirectly if the rm reinvests its pro ts in a way that increases the value of the stock.
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
fi
26
What Happens when Intermediation Fails?
1. Insecure Property Rights: Some government do not o er secure property rights to
savers, meaning that the saved funds are not immune to con scation, freezes, or other
restrictions. Individuals will therefore be reluctant to invest in intermediaries like banks.
2. Control on Interest Rates: An interest rate control will cause a misallocation of savings
and a loss of potential gains from exchange. Investment, determined by the supply of
savings, will fall below what it would be at the market equilibrium
3. Politicized Lending and Government-Owned Banks: Government-owned banks are
useful to authoritarian regimes that use the banks to direct capital to political
supporters, which means that the allocation is not as e cient as it can be.
4. Bank Failures and Panic: Systematic problems in the banking systems usually lead to
large-scale economic crises, due to the ripple e ects. Therefore, bank failures can often
be followed by many small business failures.
Owners Equity: The value of the asset minus the debt, E = V - D. The ratio of debt to equity
is called the leverage ratio (D/E).
Insolvent Firm: Has liabilities that exceeds its assets (can occur if the assets fall in value to
a lower value than the debt)
Securization: The seller of a secured asset gets up-front cash while the buyer gets the right
to a stream of future payments. Sometimes mortgage loans are “securitized” or bundled
together and sold on the market as nancial assets
The Shadow Banking System: In a commercial bank the money comes from depositors,
and they typically have some source of legally guaranteed funding. Due to the insurance,
depositors are less likely to panic if “trouble arises”. The shadow banking system included
investment banks, hedge funds, money market funds, and a variety of other complex
nancial entities. They behave like banks, but they are less heavily regulated and monitored,
and their short term sources of funds are not government guaranteed.
fi
ff
ffi
ff
fi
fi
27
ff
fi
Initial Public O ering (IPO): The rst time a corporation sells stock to the public in order to
raise capital
Chapter 19: Public Goods and the Tragedy of the Commons
This chapter starts with a story about how the world could have ended on September 29,
2004. It refers to an asteroid known as the Armageddon which almost collided with earth. In
today’s age, we have something known as asteroid defense. Asteroid defense is a public
good because even those that don’t pay for it, bene t from it. It’s not like the whole world
will decide that it’s better to just get hit by an asteroid because you are a freerider unwilling
to pay. Instead, someone else will pay more.
There are 4 important terms:
1. Excludable: A good is excludable if
people who don’t pay for can be easily
prevented from using the good. E.g.
Jeans (If you don’t pay, you can’t wear
it)
2. Nonexcludable: A good is non
excludable if people who don’t pay
cannot be easily prevented from using
it. E.g. National Defense
3. Rival: If the use of one good by a
person leads to a reduction in the
ability of another person to use the
same good. E.g Hamburger (If a person
eats half of it, your ability to eat it decrease to half as well)
4. Nonrival: If one person’s use of the good does not reduce the ability of another person
to use the same good. E.g. Public WiFi (All can use it)
There are 4 types of goods
1. Public Goods: Goods that are non excludable and nontrivial E.g. Street Lights
2. Private Goods: Goods that are excludable and Rival E.g. Airplane rides
3. Common Resources: Goods that are non excludable but rival. E.g. Public Roads
4. Club Goods: Goods that are excludable but nonrival E.g. Digital Music
Free Rider: A free rider is somebody that enjoys the bene ts of a public good without
paying a share of the costs. This is very common for goods like street lights, where even if a
non-tax payee drives through a lit street, he is bene tting from it.
A forced rider: Somebody who pays a share of the costs of a public good but does not
enjoy the bene ts. E.g. If you pay tax in Estonia for public defense but live in South Korea.
Entrepreneurs are always looking for ways to turn non-excludable, non-rival goods into club
goods. An example is of advertisement on radios and television. Even though they are public
goods and can be o ered to anyone, money can still be made o of them by private
entrepreneurs through advertisement revenue.
Tragedy of the Commons: The tendency of any resources that is unowned and hence
nonexcludable to be overused and under maintained. Overexploitation and
undermaintenance of the common resource
How do you solve the tragedy of the commons?
In recent years, command and control, and more recently, tradable allowances have been
used to solve the tragedy of the commons problem. As well as that, ITQ’s (Individual
transferable quotas) - just like pollution allowances are used.
ff
fi
fi
fi
ff
fi
28
Chapter 32: Business Fluctuations: Aggregate Demand and Supply
Business Fluctuations (business cycles): are uctuations in the growth rate of real GDP
around its long-term trend growth rate.
Recession: Recession is a signi cant, widespread decline in real income and employment Recessions are a concern because they increase unemployment dramatically, in a time
when all kinds of resources are not fully employed.
The model of aggregate demand and aggregate supply (AD/AS) shows how unexpected
economic disturbance or “shock” can temporary increase/decrease the economy’s rate of
growth.
How does an economy respond to these two types of shocks?
1. Real shocks (aggregate supply shocks)
2. Aggregate demand shocks
The AD/AS model have 3 curves:
• The aggregate demand curve (AD)
• The long-run aggregate supply curve (LRAS)
• The short-run aggregate supply curve (SRAS)
The Aggregate Demand Curve: The aggregate demand curve shows all the combinations
of in ation and real growth that are consistent with a speci ed rate of spending growth
(M+v).
•
•
•
•
Spending growth = In ation + Real Growth
M + v = P + Yr OR M + v = In ation + Real Growth
M is the growth rate of the money supply
v is growth in velocity (how quickly money is turning over)
P is the growth rate of prices, the in ation rate (π)
Yr is the growth rate of real GDP which we simplify and call real growth
Shifts in the Aggregate Demand
Curve:
Increased spending must ow into
either a higher in ation rate or a
higher growth rate (M or v
respectively). In other words, an
increase in spending growth can be
caused by either an increase in M or
v
The Long-Run Aggregate Supply
Curve (LRAS)
The Solow growth rate: is an
economy’s potential growth rate, the
rate of economic growth that would
occur given exible prices and the
existing real factors of production capital, labor and ideas.
LRAS is a vertical line at the Solow growth rate
fi
fl
fl
fi
fl
fl
fl
fl
fl
fl
29
In the RBC framework, business
uctuations are simply changes in
economic growth in the short run driven by
real shocks.
Real Shocks: Rapid changes in economic
conditions that increase or diminish the
productivity of capital and labor, which in
turn in uences GDP and employment.
Short-Run Aggregate Supply Curve: The
SRAS is upward-sloping, meaning that in
the short run an increase in aggregate
demand will increase both the in ation rate
and the growth rate, and a decrease in
demand will decrease both the in ation
rate and the growth rate.
Menu Costs: The costs of changing prices
In the long run, unexepectd in ation always turns
into expected in ation and the SRAS curve shifts
up and to the left. In the long-run, the in ation rate
is found where the LRAS curve intersect the AD
curve. The SRAS curve is always moving towards
the point where the LRAS curve intersect the new
AD curve.
fl
fl
fl
fl
fl
fl
30
fl
fl
Shifts in the long-run aggregate supply
curve
Putting the AD and LRAS curve together
makes it possible to explain how
businesses uctuation can be used by real
shocks (often called the “real business
cycle” (RCB) model). They are called real
shocks or productivity shocks because
they increase or decrease an economy’s
fundamental ability to produce goods and
services and thus, they increase or
decrease the Solow growth rate.
Shocks to the component of aggregate demand
• Changes in M (growth rate of money supply) can create AD shocks
• Changes in v (velocity) can be broken into changes in C, I, G, or NX
• Changes in v can be thought of as
increasing or decreasing the spending rate,
holding the money supply constant.
Why Changes in Velocity of Money Supply
(v) tend to be temporary: A decrease in
consumer spending reduces AD and the rate
of in ation in this period, however, in the longrun, consumer spending will return to its
normal rate, and when it does, AD and
in ation will return as well
Other Shocks
1. Wealth Shocks can also increase or
decrease AD
2. Taxes are another important shifter of C
and I
National Spending Identity: Y = C + I + G + NX
fl
fl
31
Fiscal Policy: Federal government policy on taxes, spending, and borrowing that is
designed to in uence business uctuations
There are two general categories whereas scal policy is used to ght a recession
1. The government spends more money
2. The government cuts taxes, giving people more money to spend
Fiscal Policy: The Best Case (Increased
government spending)
During a recession, whereas C falls, and v falls, the
short-run e ects will be noticeable. In the longrun, prices and wages will become “unstuck”, fear
will pass, and C will return to its normal growth
rate so the economy will return to where it was.
The government has some control over G, so if C
falls, they can increase G to compensate. Increase
In G means that the government is spending more
money, and thus, commanding more real
resources. The money used must come from taxes
or increased borrowing, and that will mean
reduced aggregate demand from some quarters,
thereby making the increase in G less e ective.
The Multiplier: In the best-case scenario, the
increase in G does not have to be as large as the
fall in C in order to restore the economy, because
as G increases, so does C. Since the increase in C
multiplies the e ect of expansionary scal policy
on AD, this e ect is called the multiplier e ect.
Limits to Fiscal Policy: There are 4 major limits to
scal policy, and 3 of them have to do with the
di culty of using scal policy to shift aggregate
demand (AD)
1. Crowding out: If government spending
crowds out or leads to less private spending,
then the increase in AD is reduced or
neutralized on net
2. A drop in the bucket: The economy is so large
that government can rarely increase spending
enough to have a large impact
3. A matter of timing: It can be di cult to time
scal policy so that the AD curve shifts at just the right moments
A. Recognition lag: the problem must be recognized
B. Legislative lag: congress must propose and pass a plan
C. Implementation lag: bureaucracies must implement the plan
D. E ectiveness lag: the plan takes time to work
fi
fi
ff
ff
fi
fl
ffi
fi
ff
fl
ff
ff
ffi
32
ff
fi
fi
Chapter 37: Fiscal Policy
E. Evaluation and adjustment lag: did the plan work? Have conditions changed?
4. Real Shocks: Shifting AD does not help much to combat real shocks.
Tax Rebate: A given check, and does not increase the incentive to invest or work
Ricardian Equivalence: If people save their tax cut instead of spending it, the aggregate
demand curve does not shift to the right and there are no systematic macroeconomic
e ects, also known as the Ricardian equivalence
Automatic Stabilizers: Automatic stabilizers are changes in scal policy that stimulate AD
in a recession without the need for explicit action by policymakers
Fiscal policy does not work well to combat real shocks: If the recession is not caused
by a fall in C, but by a real shock that reduces the productivity of capital and labor, shifting
the long-run aggregate supply curve to the left. Fiscal policy (and monetary policy) is most
e ective when the relevant shock is to aggregate demand and there are many unemployed
resources
Fiscal policy is most likely to matter when:
1. The economy needs a short-run boost, even at the expense of the long-run
2. The problem is a de ciency in aggregate demand rather than a real shock
3. Many resources are unemployed
fi
fi
ff
ff
33