Business cycle
(economic, boom-bust cycle)
The term business cycle refers
to economy-wide fluctuations
in production, trade, and
general economic activity.
https://www.investopedia.com/
terms/b/businesscycle.asp
The business cycle is the downward and upward
movement of gross domestic product (GDP)
around its long-term growth trend.
8,00
7,00
growth trend, potential GDP
6,00
5,00
4,00
real GDP
3,00
2,00
1,00
0,00
1
2
3
czas
4
5
6
7
Classification by periods
In the mid-20th century, Joseph Schumpeter and others
proposed a typology of business cycles according to their
periodicity, so that a number of particular cycles were named
after their discoverers or proposers:
• the Kitchin inventory cycle is a short business cycle of
about 40 months (3 to 5 years) (discovered in the 1920s by
Joseph Kitchin);
• the Juglar fixed-investment cycle of 7 to 11 years
(identified in 1862 by Clément Juglar, often identified as
"the" business cycle)
• the Kuznets infrastructural investment cycle of 15 to 25
years (identified in 1930 by Simon Kuznets – also called
"building cycle")
• the Kondratiev wave or long technological cycle of 45 to
60 years (after the Soviet economist Nikolai Kondratiev).
the Kondratiev wave
1. (1600–1780) The wave of the Financial-agricultural
revolution
2. (1780–1880) The wave of the Industrial revolution
3. (1880–1940) The wave of the Technical revolution
4. (1940–1985) The wave of the Scientific-technical
revolution
5. (1985–2015) The wave of the Information and
telecommunications revolution
6. (2015–2035?) The hypothetical wave of the postinformational technological revolution.
Politically based business cycle
The political business cycle is an alternative
theory stating that when an administration of
any hue is elected, it initially adopts a
contractionary policy to reduce inflation and
gain a reputation for economic competence.
It then adopts an expansionary policy in the
lead up to the next election, hoping to
achieve simultaneously low inflation and
unemployment on election day.
The length of a business cycle is the period of time
containing a single boom and contraction in
sequence.
These fluctuations typically involve shifts over time
between periods of relatively rapid economic
growth (expansions or booms), and periods of
relative stagnation or decline (contractions or
recessions).
depression
Business Cycle Phases
Business cycles are identified as having 4
phases (or 2 phases and 2 turning points):
1. expansion,
The act or process of
2. boom
expanding.
•
peak, The highest value reached by some
quantity in a time period.
3. recession
4. depression
•
contraction, A period
of economic decline or
negative growth.
trough. The lowest turning point of a business
cycle
Measuring and Dating Business
Cycles
• The severity of a recession is measured by the
three D's: depth, diffusion, and duration.
• In analogous fashion, the strength of an
expansion is determined by how pronounced,
pervasive, and persistent it turns out to be.
These three P's correspond to the three D's of
recession.
• An expansion begins at the trough (or bottom)
of a business cycle and continues until the next
peak, while a recession starts at that peak and
continues until the following trough.
KEY TAKEAWAYS
• Business cycles are comprised of concerted cyclical
upswings and downswings in the broad measures of
economic activity—output, employment, income, and
sales.
• The alternating phases of the business cycle are
expansions and contractions (also called recessions).
Recessions start at the peak of the business cycle—
when an expansion ends—and end at the trough of the
business cycle, when the next expansion begins.
• The severity of a recession is measured by the three
D’s: depth, diffusion, and duration, and the strength of
an expansion by how pronounced, pervasive and
persistent it is.
economic indicator
• An economic indicator (or business indicator) is a statistic
about the economy. Economic indicators allow analysis of
economic performance and predictions of future
performance.
• Examples within these categories include:
–
–
–
–
–
–
–
–
–
–
–
Unemployment rate
Quits rate
Housing starts
Consumer price index (a measure for inflation)
Industrial production
Bankruptcies
Gross domestic product
Broadband Internet penetration
Retail sales
Stock market prices
Money supply changes
Lagging and Leading Indicators
• Lagging indicators
Lagging indicators are indicators that usually change after
the economy as a whole does.
Statistics that report the status of the economy a few
months in the past are called lagging economic
indicators.
One such lagging indicator is the average length of unemployment. If
unemployed workers have remained out of work for a long time, we may
infer that the economy has been slow.
• Leading indicator
Leading indicators are indicators that usually change before
the economy as a whole changes.
For example, the number of jobless claims, provides a timely look at the
health of the economy. When jobless claims rise, it is a sign of a
weakening economy. When they fall, it is an indication that companies
are more confident about their prospects for growth.
Economic performance:
Product of the society
• “Measuring smth means knowing
smth about it; if one can’t express
smth in numbers, it means our
Lord Kelvin (William Thomson)
knowledge isn’t sufficient.”
1824 – 1907, UK
• National economic performance is
reflected by the amount of goods
and service (in money units)
produced during the accounting
27.06.2022
21
period (e.g. a year).
• Business cycles are usually measured
by considering the growth rate of real
gross domestic product.
• Gross Domestic Product (GDP) is the
market value of all officially recognized
final goods and services produced
within a country in a given period.
Gross domestic product (GDP)
• Monetary value of final goods and services
produced during the accounting period (e.g. a
year) by production factors situated on the
territory of the country no matter who their
owner is.
Gross National Product (or Income)
– total value of goods and services
produced by production factors owned
by the nation.
27.06.2022
Czech GDP
includes output of
Czech and foreign
companies on the
Czech territory.
GDP is the sum of
Consumption (C),
Investment (I),
Government Spending (G)
and Net Exports (X – M):
Y = C + I + G + (X - M).
• C (consumption) is normally the largest GDP
component in the economy, consisting of private
(household final consumption expenditure) in the
economy.
• I (investment) includes, for instance, business
investment in equipment, but does not include
exchanges of existing assets.
• G (government spending) is the sum of government
expenditures on final goods and services. It includes
salaries of public servants, purchase of weapons for
the military, and any investment expenditure by a
government.
• X (exports) represents gross exports. GDP captures
the amount a country produces, including goods and
services produced for other nations' consumption,
therefore exports are added.
• M (imports) represents gross imports.
GDP can be calculated through the
expenditures, income, or output approach.
expenditure approach
• The total spending on all final goods and services (Consumption
goods and services (C) + Gross Investments (I) + Government
Purchases (G) + (Exports (X) - Imports (M)) GDP = C + I + G +
(X-M).
income approach
• GDP based on the income approach is calculated by adding up
the factor incomes to the factors of production in the society.
• GDP = National Income (NY) + Indirect Business Taxes (IBT) +
Capital Consumption Allowance and Depreciation (CCA) + Net
Factor Payments to the rest of the world (NFP)
output approach
• GDP is calculated using the output approach by summing the
value of sales of goods and adjusting (subtracting) for the
purchase of intermediate goods to produce the goods sold.It is
also called "net product" or "value added" method.
Nominal vs. real GDP
• Nominal GDP is calculated in current prices;
– Therefore these indicators are incomparable in
time; the solution is calculating GDP in basic
prices.
1995
27.06.2022
>
=
<
2009
26
Deflator
• Is a complex price index. Incorporates price
changes of all goods and services in the
economy.
Price level 2009
Deflator = --------------------------------Price level 1995
PQ

D
P Q
1
1
0
1
5 1

3 1
5
Deflator = -------------- = 1,67 = 167 %
3
27.06.2022
27
Real GDP
• One can use deflator to calculate the real
GDP
Nominal GDP in current 2009 prices
Real GDP 2009 = -----------------------------------------------Deflator 2009/1995
5
Real GDP 2009 = ------------- = 2,99 PLN
1,67
=
1995
27.06.2022
2009
28
GDP
• Is an important indicator of economic
activity,
• Shows if the country is a developed or
developing,
• Enables getting support from international
organizations.
• Is generally (however mistakenly)
regarded to be an indicator of well-being.
27.06.2022
29
GDP critiques
HDP = C + Ig + G + Ex-Im
• GDP reflects only those human activities,
which are part of market transactions.
• GDP ignores everything beyond money
exchange.
– E.g. environmental services are not traded in
the market.
Yearly environmental
services = 500 x GDP
27.06.2022
30
GDP critiques
• Omits goods and services produced for own
consumption
• Omits goods and services produced on the black
market
– Illegal activities as drug dealing, prostitution, media piracy,
etc.
27.06.2022
31
GDP critiques
• GDP makes no difference between
productive and destructive activities.
– It grows before and after the war, it goes up in
connection with natural disasters, divorces,
criminal activity, environmental pollution and
abatement, etc.
27.06.2022
32
Alternative indicators
• e.g. Net Economic Welfare (NEW) – is an
adjusted measure of well-being improving
some shortcomings of GDP.
• NEW = GDP +
+ value of the free time
+ black market production value
+ goods and services for own consumption
+…
– natural resource depletion
– non-productive commercials
– commuting expenses
–…
27.06.2022
33
GDP: conclusion
• GDP is an important indicator of economic
activity.
• GDP growth, however, doesn’t necessarily
mean that the nation is better off.
27.06.2022
34
Homework
• Limitations of GDP as a measure of the
quality of life (standard of living) for a
given country
What is the difference between
Economic Growth and Development?
• Having economic growth without economic development
is possible.
• Economic growth in an economy is the increase in a
country’s total output or Gross Domestic Product (GDP). It
is the increase in a country’s production.
• A country’s economic development is usually indicated by
an increase in citizens’ quality of life. ‘Quality of life’ is
often measured using the Human Development Index,
which is an economic model that considers intrinsic
personal factors not considered in economic growth, such
as literacy rates, life expectancy and poverty rates.
Growth Occurs When
• There is a discovery of new mineral/metal
deposits.
• There is an increase in the number of people
in the workforce or the quality of the
workforce improves. Example: training and
education.
• There is an increase in capital and
machinery.
• There is an improvement in technology.
Measures of economic
development will look at:
• An increase in real income per head –
GDP per capita.
• The increase in levels of literacy and
education standards.
• Improvement in the quality and availability
of housing.
• Improvement in levels of environmental
standards.
• Increased life expectancy.
Difference between Economic
Growth and Economic Development
• Economic Growth is an increase in the country’s output.
• Growth does not take into account the depletion of
natural resources which might lead to pollution,
congestion & disease.
• Development is an improvement in factors such as
health, education, literacy rates and a decline in poverty
levels.
• Development alleviates people from low standards of
living into proper employment with suitable shelter.
Development, however, is concerned with sustainability
which means meeting the needs of the present without
compromising future needs.
Policy Responses to
Recession
• Strategies favored for moving an economy out of a
recession vary depending on which economic school the
policymakers follow.
• Monetarists would favor the use of expansionary
monetary policy, while Keynesian economists may
advocate increased government spending to spark
economic growth.
• Supply-side economists may suggest tax cuts to
promote business capital investment. When interest
rates reach the boundary of an interest rate of zero
percent (zero interest-rate policy) conventional monetary
policy can no longer be used and government must use
other measures to stimulate recovery.
When the economy is not at a STEADY state,
the government and monetary authorities
have FISCAL and MONETARY policy mechanisms, at their disposal to help move the economy back to a steady state growth trajectory
– to move the economy back to consistent
growth.
Central banks use monetary policy measures to
facilitate consistent economic growth, while the
government uses fiscal policy.
fiscal policy
– government policy that attempts to influence the
direction of the economy through changes in
government spending or taxes.
monetary policy
• The process by which the central bank, or monetary
authority manages the supply of money, or trading in
foreign exchange markets.
 two kinds of tools to influence a country's economy
If the economy needs to be
slowed, enacted policies are
referred to as being
CONTRACTIONARY and if the
economy needs to be stimulated
the policy prescription is
EXPANSIONARY.
When the economy is producing less
than potential output,
EXPANSIONARY
FISCAL or/and MONETARY POLICY
can be used to employ idle resources
and boost output.
Expansionary Policy
• Expansionary fiscal policy involves an increase in
government spending, a reduction in taxes, or a
combination of the two. It is usually undertaken during
recessions. Fiscal authorities will increase government
spending in order to revive the economy.
• Expansionary monetary policy relies on the central
bank increasing availability of loanable funds through
three mechanisms:
– open market operations,
– discount rate,
– the reserve ratio.
As the supply of loanable funds increases, the interest
rate is expected to decrease and thereby increase the
desire to borrow funds for consumption and investment
purposes.
When the economy needs to be slowed,
CONTRACTIONARY
FISCAL or/and MONETARY POLICY
can be used.
Contractionary Policy
• Contractionary fiscal policy is opposite of the
action taken in an expansionary purpose, and
involves a decrease in government spending, an
increase in taxes, or a combination of the two.
• Contractionary monetary policy is the
opposite of expansionary monetary policy and
occurs when the supply of loanable funds is
limited, to reduce the access and availability to
relatively inexpensive credit.
• The effects of fiscal policy can be limited BY CROWDING
OUT (effect).
• The crowding out effect is an economic theory arguing that
rising public sector spending drives down or even eliminates
private sector spending.
• Crowding out occurs when government spending simply
replaces private sector output instead of adding additional
output to the economy. Crowding out also occurs when
government spending raises interest rates, which limits
investment.
• https://www.investopedia.com/terms/c/crowdingouteffect.asp
TEST
Business cycles typically follow this
pattern:
1.
2.
3.
4.
expansion, peak, contraction, trough.
trough, expansion, contraction, peak
peak, trough, expansion, contraction
contraction, trough, peak, expansion
An expansion in the business cycle
ends when which of the following
occurs?
1. The economy hits a peak and enters into
a recession.
2. The economy reaches a cyclical trough.
3. The economy hits a trough and enters
into a recession.
4. The economy begins to grow following a
trough.
Which of these variables has a
negative relationship with GDP
growth?
1.Unemployment
2.Credit expansion
3.Business profit
4.Employment
What type of policy would a central
bank or government engage in to
stimulate an economy?
1.Expansionary
2.Fiscal
3.Contractionary
4.Monetary
Which of the following is a list of
the components of GDP?
1.Consumption, government expenditure,
investment and net exports
2.Government expenditure, investment,
savings, and imports
3.Government expenditure, consumption,
and private sector spending
4.Investment, private sector spending,
consumption and net exports
A statistic that reports the status of
the economy a few months in the
past is known as what?
1.
2.
3.
4.
a lagging indicator
a leading indicator
a business cycle indicator
an index indicator
• Change in official interest rates
• The central bank provides funds to the banking system and charges
interest. Given its monopoly power over the issuing of money, the
central bank can fully determine this interest rate.
• Affects banks and money-market interest rates
• The change in the official interest rates affects directly money-market
interest rates and, indirectly, lending and deposit rates, which are set
by banks to their customers.
• Affects expectations
• Expectations of future official interest-rate changes affect medium
and long-term interest rates. In particular, longer-term interest rates
depend in part on market expectations about the future course of
short-term rates.
• Monetary policy can also guide economic agents’ expectations of
future inflation and thus influence price developments. A central bank
with a high degree of credibility firmly anchors expectations of price
stability. In this case, economic agents do not have to increase their
prices for fear of higher inflation or reduce them for fear of deflation.
Affects asset prices
• The impact on financing conditions in the economy and on market
expectations triggered by monetary policy actions may lead to adjustments
in asset prices and the exchange rate. Changes in the exchange rate can
affect inflation directly, insofar as imported goods are directly used in
consumption, but they may also work through other channels.
Affects saving and investment decisions
• Changes in interest rates affect saving and investment decisions of
households and firms. For example, everything else being equal, higher
interest rates make it less attractive to take out loans for financing
consumption or investment.
• In addition, consumption and investment are also affected by movements in
asset prices via wealth effects and effects on the value of collateral. For
example, as equity prices rise, share-owning households become wealthier
and may choose to increase their consumption. Conversely, when equity
prices fall, households may reduce consumption.
• Asset prices can also have impact on aggregate demand via the value of
collateral that allows borrowers to get more loans and/or to reduce the risk
premia demanded by lenders/banks.
• Affects the supply of credit
• For example, higher interest rates increase the risk of
borrowers being unable to pay back their loans. Banks may cut
back on the amount of funds they lend to households and firms.
This may also reduce the consumption and investment by
households and firms respectively.
• Leads to changes in aggregate demand and prices
• Changes in consumption and investment will change the level
of domestic demand for goods and services relative to domestic
supply. When demand exceeds supply, upward price pressure
is likely to occur. In addition, changes in aggregate demand
may translate into tighter or looser conditions in labour and
intermediate product markets. This in turn can affect price and
wage-setting in the respective market.
• Affects the supply of bank loans
• Changes in policy rates can affect banks’ marginal cost for
obtaining external finance differently, depending on the level of
a bank’s own resources, or bank capital. This channel is
particularly relevant in bad times such as a financial crisis,
when capital is scarcer and banks find it more difficult to raise
capital.
• In addition to the traditional bank lending channel, which
focuses on the quantity of loans supplied, a risk-taking channel
may exist when banks’ incentive to bear risk related to the
provision of loans is affected. The risk-taking channel is thought
to operate mainly via two mechanisms. First, low interest rates
boost asset and collateral values. This, in conjunction with the
belief that the increase in asset values is sustainable, leads
both borrowers and banks to accept higher risks. Second, low
interest rates make riskier assets more attractive, as agents
search for higher yields. In the case of banks, these two effects
usually translate into a softening of credit standards, which can
Putting things into historical perspective
The world before Keynes
• Fluctuations of the economic cycle are an “act of Providence”
• Government intervention is needed solely to ensure the basic
state functions (yet, state budget were often in deficit)
• There is no anti-cyclical fiscal policy
• Generally, lower government intervention in economy allows for
(significantly according to current standards) lower fiscal
redistribution (lower expenditure and less taxes – but higher
custom fees because of protectionist attitudes)
• Money supply linked to gold, prices are remarkably stable over
the long run
• Forex rates are derived from gold, there are no exchange rate
fluctuations, changes are decided administratively
• Interest rates reflect the true content of there are – price of
money, they are solely determined by the market as a result of
demand and supply for/of credit
• Central banks (as understood today) did not exist.
Putting things into historical perspective
ctd
The world according to Keynes …
– The government’s primary role is to ensure that
economic growth is stable. The government has the
right and the obligation to make use, for that
purpose, of both the fiscal and monetary policies
– In case of economic decline, the government can and
is supposed to increase spending (and run budget
deficits) to stimulate the economy …
– However, in case of the growth phase of the
economic cycle, governments must run a budget
surplus and repay debts, accumulated in the crisis
time
– The stability of domestic prices should get the priority
to the stability of foreign exchange rate
Economic Policy
Lecture 1,2
Introduction:
A Framework for Economic Policy Analysis
Dr Izabela Szamrej-Baran
Office hours:
I (odd) week: Tuesday 10.15-11.45
II (even) week: Wednesday 10.15-11.45
Economic policy
refers to the actions that governments take
in the economic field. It covers the systems
for setting levels of taxation, gvt budgets,
the money supply and interest rates as
well as the labor market, national
ownership, and many other areas of gvt
interventions into the economy.
Course content
Evaluation test
Project – Oxford Debate (together) or Game project (5-7 persons)
Presentation – (?)
Evaluation test
• The written test to check the results in terms of the
achievement of knowledge and skills.
• The test consists of two parts: one is the test questions, the
second - open questions. The test involves knowledge of
the content of the course program.
• Final grade is assessed on the basis of:
– Test results (50%), which check the effects in terms of knowledge
and skills
– Presentation (30%) – 2-4 persons - which check the effects in terms
of knowledge, skills and competences
– Project (20%), which check the effects in terms of skills and
competences
• Active participation in classes can increase the grade.
Project
• GAME?
• Economic/ environmental/ IT / sustainable
development
• 5-7 persons/team
• Ex. Waste management for kids/students
• OXFORD DEBATE?
Presentation
• Presentations must be created in *.ppt or *.pptx format
(Microsoft Office 2010 compatible) or PDF format
• Each slide must have a good layout; not be too busy,
wordy, crowded etc.
• The presentation must use a theme or modified theme
• The title slide must show the subject and presenter’s
name
• At least 4 different research references or websites are
required from internet or library. The final slide must
include a bibliography that lists all your sources.
• Time of presentation: 20-25 minutes max
•
Upload your presentation on Teams
Literature
•
•
European Observatory on Health Systems and Policies (www.euro.who.int)
This site ‘supports and promotes evidence-based health policy-making through
analysis of the dynamics of health care systems in Europe’. It publishes: countrybased reports; a newsletter; observatory studies; policy briefings; and a quarterly
magazine providing a forum for debate on health policy in Europe.
•
Eurostat (ec.europa.eu/eurostat) Eurostat is the statistical office of the European
Union. It provides national and regional data, and analyses of a wide range of policyrelevant topics, including: the economy; education; fiscal trends; health; housing;
income and living conditions; labour markets, unemployment and migration; and
poverty and social exclusion.
•
•
Eurydice (eacea.ec.europa.eu)
This network is part of the European Union’s Educational, Audiovisual and Cultural
Exchange Agency. It supports and facilitates cooperation in the fields of education
and culture, training and lifelong learning by undertaking research and providing
information on education systems and policies across 33 European countries. It
publishes: profiles of national education systems; national and comparative studies;
and key statistical data. It also hosts the Eurypedia site, which is described as ‘an
encyclopaedia on national education systems’ that consists of: national profiles; over
5000 articles; news on the latest reforms; and information organised by topic and
educational level.
•
•
UN Economic Commission for Europe (www.unece.org)
This is a statistical database with time-series data on 56 countries (geographical
Europe plus the United States). Its ‘Gender Statistics’ field provides indicators on:
population; families and households; education; health; and work and the economy.
Some of its statistics are in read-only formats, but there are also reports accessible
• Non-governmental Sources: Academic Journals
•
•
•
•
•
•
•
•
•
•
•
•
•
• Comparative European Politics
• Discover Society
• European Journal of Criminology
• European Journal on Criminal Policy and Research
• European Journal of Homelessness
• European Journal on Housing Policy
• European Journal of Social Security
• European Journal of Social Work
• European Societies
• Housing Studies
• Journal of European Social Policy
• Journal of European Public Policy
• Journal of International and Comparative Social Policy
Sources on International economic policy
•Intergovernmental Sources: Websites
•International Labour Office (www.ilo.org)
•Organisation for Economic Co-operation and
Development (www.oecd.org)
•https://data.oecd.org/
•https://stats.oecd.org/
•United Nations Children’s Fund (www.unicef.org)
•UNdata (data.un.org)
•United Nations Human Development Reports
(www.hdr.undp.org)
•United Nations Research Institute for Social
Development (www.unrisd.org)
•World Bank (www.worldbank.org)
•World Development Indicators
(www.data.worldbank.org)
•World Health Organization (www.who.int)
Key Sources on European and
International economic data
Sources on the European Union
• Intergovernmental Sources: Websites
Cordis (http://cordis.europa.eu/home_en.html)
• Cordis is the European Commission’s ‘primary public
repository and portal to disseminate information on all EUfunded research projects’. Includes: education and training;
employment issues; the environment, and healthcare. It
publishes: briefings; reports; and report summaries.
European Centre for Social Welfare Policy and Research
(www.euro.centre.org)
• The European Centre is a UN-affiliated organisation
researching many different aspects of economic policy,
including: ageing; civil society and volunteering; education,
families and human capital; healthcare; income, poverty and
social inclusion; labour markets; pensions and social security,
and tax and benefits. It publishes: policy briefings; reports;
and book synopses.
European Commission (www.ec.europa.eu)
• This site provides detailed synopses of the legislation and social policies of
the European Union including those on: children’s rights; criminal justice;
disabilities; diversity and non-discrimination; education and training; health;
pensions; poverty; social inclusion; and social protection. These are
published as: commission directives; country profiles; policy strategies;
programmes; and reports.
European Foundation for the Improvement of Living and Working Conditions
(www.eurofound.europa.eu)
• Eurofound is an EU agency ‘whose role is to provide knowledge in the area
of social and work-related policies’. Its current research areas include:
increasing labour-market participation and combating unemployment;
improving working conditions; developing industrial relations; and improving
standards of living and cohesion. It publishes: a newsletter (Eurofound
News); reports; and report summaries.
European Observatory on Homelessness (www.feantsaresearch.org)
• Supported by the European Commission, this site focuses on homelessness
and housing exclusion in the EU. It publishes the European Journal of
Economic analysis vs economic policy Outline
What is Economic Policy?
Functions of EP
Types of EP
Stabilization policy
Keynesian vs. Neoliberal theory
EP Actors, Goals and Tools
Motivation
The Questions of EP
•
•
•
•
Q1: Why should gvt intervene? Market failures
Q2: How should gvt intervene? Tools
Q3: What are the effects of gvt intervention? Gvt failure
Q4: Why is gvt acting this way?
Economy
• The word economy comes from the Greek word
oikonomos, which means “one who manages a
household.”
• At first, this origin might seem peculiar. But in
fact, households and economies have much in
common.
• The management of society’s resources is
important because resources are scarce.
• Scarcity means that society has limited
resources and therefore cannot produce all the
goods and services people wish to have.
Economics
16
Scarcity and Choice
Scarce Goods
o Food
Limited Resources
(bread, milk, meat, eggs,
o
vegetables, coffee, etc.)
o Clothing
(shirts, pants, blouses, shoes, o
socks, coats, sweaters, etc.)
o
o Household (tables, chairs, rugs, beds,
goods
dressers, television sets, etc.)
Land
(various degrees of fertility)
Natural
(rivers, trees, minerals,
Resources
oceans, etc.)
Machines and other
human-made physical resources
o Education
o Non-human animal resources
o
o
o
o
o
o
o Technology (physical and scientific
“recipes”)
National defense
Leisure time
Entertainment
Clean air
Pleasant
(trees, lakes, rivers,
environment open spaces, etc.)
o Pleasant working conditions
o Human
resources
(the knowledge, skill,
and talent of individuals)
Scarcity and Choice
• Scarcity and poverty are not the same thing.
– The absence of poverty implies some basic level
of need has been met.
– An absence of scarcity would imply that all of our
desires for goods are fully satisfied.
• We may someday eliminate poverty, but
scarcity will always be with us.
Ten Principles of Economics
How People Make Decisions
• 1. People face trade-offs.
• 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.
Ex. 1. Incentives matter
Indicate how each of the following changes would influence the
incentive of a decision maker to undertake the action described.
a. A change in the meeting time of the introductory economics
course from 11:00 a.m. to 7:30 a.m. on one's decision to attend
the lectures
b. A reduction in the number of exam questions that relate
directly to the text on the student's decision to read the text
c. An increase in the price of beef on one's decision to buy steak
d. An increase in the rental rates of apartments on one's
decision to build additional rental housing units
21
An example of a positive economic statement: „
„Government-provided healthcare increases public expenditures."
This statement is fact-based and has no value judgment
attached to it. Its validity can be proven (or disproven) by
studying healthcare spending where governments provide
healthcare.
An example of a normative economic statement is:
"The government should provide basic healthcare to all citizens."
It is value-based, rooted in personal perspective, and satisfies
the requirement of what "should" be.
[Important: Both positive and normative economic statements are
required in order to create the policies of a country, region,
22
industrial sector, institution, or business.]
• POLLY: Minimum-wage laws cause
unemployment.
• NORMA: The government should raise the
minimum wage
Assignment 1
Label each of the following propositions as descriptive or
normative and defend your choice:
• a. Energy efficiency programs have created jobs.
• b. Money spent on protecting endangered species is
wasted.
• c. Fisheries must be privatized to survive.
• d. Raising transport costs lower suburban land values.
• e. Birth control programs are counterproductive.
• f. Lower tax rates encourage more work and more
• saving
• 7 minutes
24
Assignment 2:
1. Which of the following are positive economic
statements and which are normative?
(a) The speed limit should be lowered to 55
miles per hour on interstate highways to
reduce the number of deaths and
accidents.
(b) Higher gasoline prices cause the quantity
of gasoline that consumers buy to increase.
(c) A comparison of costs and benefits should
not be used to assess environmental
regulations.
(d) Taxes on alcohol result in less drinking
and driving.
Economic analysis
Economic analysis examines the individual or
aggregate decisions of private economic
agents about what they produce, exchange
and consume. Economic analysis does not
usually examine the behaviour of ‘public’
economic agents.
It does not address questions about the extent
to which government replaces the market –
and vice versa – or the degree to which
government is necessary for the market or
reinforces it.
Economic policy
refers to the actions that governments take
in the economic field. It covers the systems
for setting levels of taxation, gvt budgets,
the money supply and interest rates as
well as the labor market, national
ownership, and many other areas of gvt
interventions into the economy.
EconomicPolicy complements EconomicAnalysis
• Just as in EA it is essential to understand
government action, drawing from the discipline of
EP, in the latter it is equally crucial to understand
the functioning of the private economic system,
borrowing this knowledge from EA.
• EP can serve as a guide to public action only with
the help of a variety of disciplines: in addition to
EA, these include philosophy, political science,
constitutional and administrative law, statistics,
econometrics and many others.
An
overview
of the
discipline
of
economic
policy
Planning
• Planning means taking coordinated and consistent
economic policy decisions. The need for coordinated
action is a consequence of at least 3 factors:
(1) a variety of instruments are available to achieve the
various possible objectives.
(2) The existence of multiple objectives and the fact
that each instrument can influence more than one
means that in general policy problems are
interdependent.
(3) Policy problems are intertemporal: the solution of a
problem in the present is tied to the solution of the
same problem in subsequent periods.
Target and Instruments
• the 2 elements of a plan: targets (or
objectives) and instruments.
• a target/goal is an economic policy aim that
we can usually measure in terms of an
economic variable, such as income or
employment.
• An instrument is a ‘lever’ – represented by
another variable – that policymakers can use
to achieve the target – i.e. to change the
value of an objective variable in the desired
way.
Difference between goal,
objective and target
• Goals and objectives are ‘direction setting
outcomes based’ statements.
• Goals are higher order general statements of
desired economic, social and environmental
outcomes than objectives.
• Objectives describe the measurable contribution
of (e.g. the transport system) to achieving the
goals.
• Targets are specific desired outcomes that
support achievement of the objectives.
• Some common business goals are: grow
profitability, maximize net income, improve
customer loyalty and etc.
• !Notice the brevity of these statements.!
• Ex. if an organization has a goal to “grow
revenues”, an objective to achieve the
goal may be “introduce 2 new products by
2022 Q3.” „increase revenue by 10% in
2022, reduce overhead costs by 5% by
2022”.
• !Notice how the objectives are more
specific and provide more detail.!
Give 3 examples of economic,
social and environmental goals
Economic goals:
• A diverse and resilient economy
• Higher levels of productivity and economic efficiency
• Increased trade or exports
• More competitive industries.
Social goals:
• Fairer distribution of income
• Improved public safety in the city centre
• Social cohesion and inclusion
• Equity between geographic areas (e.g., in access to services and jobs).
Environmental goals:
• Preserving healthy landscapes, such as clean air, land and waterways.
• Reducing the loss of habitat and biodiversity
• Increasing the efficient use of energy and water resources
• Protecting sites with heritage, indigenous and cultural values
Objectives vs outcomes
• Objectives are specific statements of outcomes
that a jurisdiction is aiming to achieve.
Objectives support the high-level goals.
• The difference: Objectives are statements about
desired outcomes. Outcomes are the end
results that are achieved by meeting the
objectives.
• Example: reducing fatalities from road trauma is an
objective; the number of fatalities is an outcome.
Reducing greenhouse gas emissions is an
objective; the level of greenhouse gas emissions is
an outcome.
Targets and KPIs
• A key performance indicator (KPI) is a
measure that enables monitoring of
performance in terms of progress towards a
specific, defined objective.
• A target is the desired level of performance
for a specific performance indicator.
• Performance indicators and targets are
mechanisms to operationalise objectives.
• Targets should be measurable and realistic, but
challenging.
Ideally targets and KPIs should:
• Be expressed in quantitative terms
• Cover attributes that are important and that reflect
a broader perspective
• Not be biased towards a particular alternative
• Be based on analysis and established practices to
ensure that targets are realistic.
• Be simple and easy to convey - The language
used to express targets and KPIs should be nontechnical and straightforward, capable of being
understood easily by the public.
Each objective should have at least one KPI and
EP Goals
Policy is generally directed to achieve particular
objectives, like targets for inflation, unemployment, or
economic growth.
These are referred to as the policy goals: the
outcomes which the EP aims to achieve.
There are 3 major goals of economic policy:
• Economic growth
• Full employment
• Price stability
In other words gvt wants to: stabilize markets,
promote economic prosperity, ensure business
development, and promote employment.
Government goals
•
•
•
•
•
•
•
•
•
Influence Aggregate Demand or Supply
Economic growth
But there are often
trade-offs…
Clean environment
Efficiency
Equitable distribution of income/wealth
Full employment
Price stability
Stabilization of business cycle fluctuations
…
27.06.2022
41
EP Tools
To achieve these goals, governments use policy
tools which are under the control of the
government. These generally include the
interest rate and money supply, tax and
government spending, tariffs, exchange rates,
labor market regulations, and many other
aspects of government.
A variable can be defined as a policy instrument if the
following 3 conditions are satisfied:
(1) Policymakers can control the variable; that is, they
can decide what value it should have and fix it directly
with their own actions (controllability).
(2) The variable whose value has been fixed by
policymakers has an influence on other variables,
which are assigned the role of targets (effectiveness).
(3) It must be possible to distinguish the variable from
other instruments in terms of its degree of
controllability and effectiveness: two instruments with
the same effects on all targets are not really two
separate instruments (separability or independence).
Government Tools
• Government policies
• Laws
• State budget – taxes and expenditures
• Money supply
• Interest rates and foreign exchange rates
• Donations
• Business and citizen restrictions
• Public goods
27.06.2022
44
• …
Example of tools: Gvt wants to increase
education level of low-income individuals:
• Increase direct provision of education
in low income districts
• Give vouchers to low-income families
• Increase incentives through tax
breaks/credits
• Mandate longer schooling days/
change in class sizes / changes in
organization of curriculum, etc.
• Which is not a goal of economic policy?
a)Increase mortgages payments
b)Economic growth
c)Full employment
d)Price stability
• The task of keeping the general price level
from increasing or decreasing, is the
definition of what?
a)Economic growth
b)Full employment
c)Mortgage increases
d)Price stability
EP actors (Policymakers)
EP is often influenced by international
institutions like the International Monetary
Fund or World Bank or EU or even NATO.
Public sector:
Government, trias politica principle: a
legislature, an executive, and a judiciary.
Autonomous actors: Central Bank.
Private sector: trade unions, Polish
Confederation „Lewiatan” and other
employers associations.
The main tasks of economic policymakers
can be grouped into 6 categories:
• 1. Set and enforce the rules of the economic game.
• 2. Tax and spend. Government spending amounts
to about one-half of GDP in European countries
and one-third in the UK, the US, and Japan.
• 3. Issue and manage the currency.
• 4. Produce goods and services.
• 5. Fix problems or pretend to.
• 6. Negotiate with other countries.
Functions of EP
1. Allocative Function: This function revolves
around the budget of the government. This means,
that a government needs to decide how to spend
money in a way that will benefit an economy. Some
examples include funding health care and creating
jobs.
Resource allocation means the economic
management of natural resources.
The allocation function is that part of government
tax and expenditure policy which is concerned with
influencing the provision of goods and services in
Functions of EP
2. Stabilization Function. This is the function
that helps control interest rates and inflation.
This function also works to help the
employement rate by moving towards full
employement. An ex. is when gvt works to
increase employement rates and help wages
by decreasing interest rates. Why? As interest
rates increase an economy begins to plummet.
When it plummets business tend to hire less
employees and decrease the wages they pay.
Functions of EP
3. Distributive function. Revolves around
taxes. It is important when it comes to the
decision of what taxation level is
appriopriate for each economic level.
Ex. income taxes affect those individuals in
the wealthy class much more than those
who make less money. Improvements in
health care facilities benefit the sick, the old,
and those about to have children.
• Which one is not a function of economic
policy?
a)Allocative
b)Substantial
c)Stabilization
d)Distributive
Types of economic policy
Examples of the kinds of economic policies include:
• Macroeconomic stabilization policy, which attempts to
keep the money supply growing at a rate that does not
result in excessive inflation, and attempts to smooth
out the business cycle.
• Policies designed to create economic growth
• Policies related to development economics
• Policies dealing with the redistribution of income,
property and/or wealth
• As well as: regulatory policy, anti-trust policy, industrial
policy and technology-based economic development
policy.
Why should we be interested in
Economic Policy?
Economic Policies Are Everywhere
Economic policies constantly affect our everyday life:
• Through price interventions:
• Through regulation:
Stakes are extremely large because of broad scope of
policies:
• Tax reforms immediately affect millions
• Government directly employs almost one third of polish
workforce
Why government cares for
economy?
„Government intervention in the economy is inevitable
because there are certain roles and responsibilities
that cannot be assumed by the private sector.“
The spending decisions of consumers and business
are made for reasons other than obtaining a
desirable macro equilibrium.
There is no reason to expect that consumers and
business will spend the amount necessary to
achieve and maintain full employment.
27.06.2022
60
WHAT ARE THE ECONOMIC
FUNCTIONS OF
GOVERNMENT?
27.06.2022
61
• 1. Maintain the Legal and Social Framework
– Define and enforce property rights.
– Establish a monetary system.
• 2. Maintain Competition
– Create and enforce antitrust laws, and regulate
natural monopolies.
• 3. Provide Public Goods and Services
– Public goods and services are those that
markets will not provide in sufficient quantities.
• 4. Correct for Externalities
• 5. Stabilize the Economy
• 6. Redistribute Income
Conventional wisdom
• governments are there to intervene to stabilize the
economy
• governments are there to implement political
priorities
• governments are there to promote economic growth
• governments are there to correct market failures
Q1: Why should gvt intervene?
Fundamental theorems of welfare economics:
• Competitive markets are Pareto-efficient
• Any efficient allocation can be reached by a
competitive equilibrium
Then why gvt intervention?
4 main reasons:
• 1. Creation/Denifition of markets
• 2. Correction of market failures
• 3. Solutions to limited rationality of individuals
• 4. Redistribution
Imagine that Anil and Bala are deciding how to deal with
pest insects that destroy the crops they cultivate in their
adjacent fields. Each has two feasible strategies:
• The first is to use an inexpensive chemical called
Terminator. It kills every insect for miles around.
Terminator also leaks into the water supply that they
both use.
• The second is to use integrated pest control (IPC)
instead of a chemical. A farmer using IPC introduces
beneficial insects to the farm. The beneficial insects
eat the pest insects.
If just one of them chooses Terminator, the damage is
quite limited. If they both choose it, water contamination
becomes a serious problem, and they need to buy a
costly filtering system.
• There is often more than one Pareto-efficient
allocation: In the pest-control game there are three.
• The Pareto criterion does not tell us which of the
Pareto-efficient allocations is better: It does not give us
any ranking of (I, I), (I, T) and (T, I).
• If an allocation is Pareto efficient, this does not mean
we should approve of it: Anil playing IPC and Bala free
riding by playing Terminator is Pareto efficient, but we
(and Anil) may think this is unfair. Pareto efficiency has
nothing to do with fairness.
• Allocation (T, I) is Pareto efficient and (T, T) is not (it is
Pareto inefficient): But the Pareto criterion does NOT
tell us which is better.
Pareto efficiency or Pareto optimality
An allocation of resources is Pareto efficient when it is
impossible to make any one individual better off without
making at least one individual worse off.
The boxed points
represent feasible choices,
and smaller values are
preferred to larger ones.
Point C is not on the
Pareto frontier because it
is dominated by both
point A and point B.
Points A and B are not
strictly dominated by any
other, and hence do lie on
the frontier.
Example of a Pareto frontier
Pareto efficiency
Pareto efficiency is
said to occur when it is
impossible to make one
party better off without
making someone worse
off.
Pareto improvement is
said to occur when at
least one individual
becomes better off
without anyone
becoming worse off.
Q1: Why should gvt intervene?
Fundamental theorems of welfare economics:
• Competitive markets are Pareto-efficient
• Any efficient allocation can be reached by a
competitive equilibrium
Then why gvt intervention?
4 main reasons:
• 1. Creation/Denifition of markets
• 2. Correction of market failures
• 3. Solutions to limited rationality of individuals
• 4. Redistribution
1. Creation/Prohibition of markets
Markets do not exist ex abstracto
• Markets need secure property rights: police/justice to
ensure that private contracts are enforceable
– Gvt intervention is critical on a larger scale when
exchanges become impersonal
– Secure property rights favor development of credit markets
• Gvt might restrict/prevent the existence of markets
on moral/ethical grounds
– Ex1: Prohibition of market for organs
– Ex2: Should we legalize marijuana?
2. Market failures
•
•
•
•
can be viewed as scenarios where individuals’ pursuit of pure selfishness
leads to results that are not efficient and can be improved upon from the
societal point of view.
Common forms of market failure mainly include externalities, nonexcludability, non-rivalry, or public goods but can also include information
asymmetries, non-competitive markets.
Some types of government policy interventions, however, such as taxes,
subsidies, bailouts, wage and price controls, and regulations, including
attempts to correct market failure, may lead to an inefficient allocation of
resources known as government failure.
The bottom line is that when market failures exist, government intervention
may be appropriated; however, with or without government intervention,
either way, if a market failure exists the outcome is not Pareto efficient.
2. Market failures
Private market provides a Pareto efficient outcome
under three conditions: no externalities, perfect
information and perfect competition.
When these conditions do not hold → Market failure
Main sources of market failures:
1.positive and negative externalities
2.lack of public goods
3.asymmetric information
4.imperfect competition
5.environmental concerns,
6.underprovision of merit goods, overprovision of
demerit goods
2.1 Externalities were defined as impacts that affect the
well-being of those outside of a market transaction.
An externality is a cost or benefit that affects an
otherwise uninvolved party who did not choose to be
subject to the cost or benefit.
An externality is an effect on a third party that is caused
by the consumption or production of a good or service.
Externalities: my consumption affects you but I do not
make or receive payment to account for this.
Ex: In environmental economics, externalities are
usually associated with pollution or a scarcity of natural
resources, that is not included in the production costs of
some material or good.
85
POSITIVE VS NEGATIVE
EXTERNALITIES
A positive externality is a positive spillover that results
from the consumption or production, 1.ex. although
public education may only directly affect students and
schools, an educated population may provide positive
effects on society as a whole. 2.ex. a landowner who
buys and plants trees. In addition to benefits to the
owner, the trees provide benefits to those who
appreciate the scenery and to society as a whole
because they absorb carbon dioxide and provide
habitat for wildlife. Social Benefit > Private Benefit
A negative externality is a negative spillover effect on
third parties. For example, secondhand smoke may
negatively impact the health of people, even if they 86do
not directly engage in smoking. Social Cost > Private Cost
What are the external, or social, costs of motor vehicle use? Automobiles are
considered to be the largest source of several major air pollutants including
carbon monoxide and nitrogen oxides. According to the U.S. EPA,
transportation accounts for about 13 percent of global greenhouse gas
emissions.1 The World Health Organization estimates that over one million
deaths occur each year due to accidents on the world’s roads.2 Additional
external costs include the destruction of natural habitats from building roads
and parking lots, the disposal of vehicles and parts, military costs associated
with securing petroleum supplies, and noise pollution
• If goods or services have negative
externalities, then we will get market
failure. This is because individuals fail to
take into account the costs to other
people.
• To achieve a more socially efficient
outcome, the government could try to tax
the good with negative externalities. This
means that consumers pay close to the full
social cost.
Which of the following is an example of an
individual who is not involved in a transaction but
is bearing some cost?
a) An individual exposed to secondhand
smoke
b) A producer of aluminum
c) A consumer of aluminum
d) A smoker
Consider an individual who decides to
pursue higher education. Who might
experience positive externalities from
this decision?
a) Members of society who benefit from a
more productive community
b) The student who benefits from increased
economic opportunities
c) The university which benefits from
increased tuition and fees
d) All of these answers
Externalities & Public Goods
Markets do not provide optimally public
goods or externality-producing goods.
– Too much of negative externality-generating goods, e.g.
pollution;
– too little of positive externality-generating goods (charitable
giving)
Public Goods: goods that are non rival & non
excludable in consumption
– Free riding and therefore too little public goods are
produced
free rider - one who obtains benefit from a public good without
paying for it directly.
Public goods are goods where the total cost of production does
not increase with the number of consumers. Ex. a lighthouse has
a fixed cost of production that is the same, whether one ship or
one hundred ships use its light.
Public goods can be underproduced; there is little incentive, from
a private standpoint, to provide a lighthouse because one can wait
for someone else to provide it, and then use its light without
incurring a cost.
Free rider problem - someone benefiting from resources or goods
and services without paying for the cost of the benefit
93
Definition matrix of goods
Rivalry occurs when one person’s
consuming a unit of a good means
no one else can consume it./
nonexcludable good: a good that
is available to all users, under
conditions in which it is impossible,
or at least difficult, to exclude
potential users.
Rivalrous
Non-rivalrous
Excludable
Non-excludable
Private goods
food, clothing, cars,
parking spaces
Common goods
(Common-pool
resources)
fish stocks, timber, coal,
air, water
Market quantities exchanged are
optimal, in the sense that larger
quantities would have marginal
costs greater than marginal benefits
and smaller quantities would have
marginal benefits greater than
marginal costs.
Markets will fail to allocate these
goods properly at a point in time
and over (require government regulation).
Club goods
cinemas, private parks,
satellite television
Public goods
free-to-air television, air,
national defense
Market quantities are likely to be
optimal apart from indivisibilities
that might lead to natural
monopolies. Congestion might
Markets will fail to produce such
goods, since nonexcludability94
enables users to avoid paying,
hence profit cannot be generated
Public vs. Private goods
• A private good is the opposite of a public
good. Examples of private goods include
food, airplane rides and cell phones.
Private goods are less likely to experience
the free rider problem because a private
good has to be purchased - it is not readily
available for free. A company's goal in
producing a private good is to make a
profit. Without the incentive created by
revenue, a company is unlikely to want to 95
27.06.2022
A town provides public transportation in the
form of 350 bicycles. The bicycles are
placed around town and free for anyone
to use. However, within four days all of
the bicycles are stolen for private use.
This is an example of:
a) The free-rider problem
b) A pure public good
c) Excludability
d) Non-rivalrous consumption
A good that is non excludable and rival
would belong to which category of
goods?
a)
b)
c)
d)
Public goods
Common goods
Private goods
Club goods
Which of the following are the two
characteristics of a private good?
a)
b)
c)
d)
It is excludable and rival.
It is non-excludable and non-rival.
It is non-excludable and rival.
It is excludable but non-rival.
1. Which of the following describes a free rider problem?
a. Four roommates want to buy a new couch, but can’t afford it. If there
were a fifth roommate, they could afford it, but there isn’t.
b. Four roommates want to buy a new couch. They need all four to afford
it but if all four split the use of it, none of them will get enough value from
the couch to be worth their share of the cost.
c. Four roommates want to buy a couch, but aren’t sure who will get to
keep it once they go their separate ways. The cost of having to figure that
out ahead of time disincentivizes them from buying the couch.
d. Four roommates want to buy a couch, but each figures that if he or she
just lets the other three pay for it, he or she will still be able to use it once
it's bought. They don’t buy the couch.
2. What is the result of the free rider problem?
a. Public goods are underprovided.
b. Public goods are overprovided.
c. Public goods are arbitrarily priced.
d. People who should pay for public goods get them for free.
2.3. Asymmetric information
different information between two parties,
leads to the following - adverse selection,
moral hazards, and market failure
The imperfect information causes an
imbalance of power.
• EX. when you are trying to negotiate your
salary, you will not know the maximum
your employer is willing to pay and your
employer will not know the minimum you
will be willing to accept.
2.3. Asymmetric information
When some agents have more information than
others, markets fail
• Ex. 1: Used cars (market for lemons, Akerlof
1970) Seller knows the quality of the car,
buyers do not → Uncertainty makes sellers of
good cars withdraw from the market
• Ex. 2: Adverse selection in health insurance
Healthy people drop out of private market
→Mandated coverage could make everyone
better
• Ex. 3: Capital markets (credit constraints)
• Ex.4: Labour markets
2.4. Imperfect Competition
• Abuse of monopoly power: imperfect
markets restrict output in an attempt to
maximize profit.
• When markets are not competitive, there
is role for gvt regulation
• Ex: natural monopolies such as electricity
Ideal market model:
5 traits (attributes) of perfect
competition (1)
• Numerous small producers and
consumers: none of them is capable of
influencing the price.
– If any of them increases the price,
consumers will easily switch to the
substitute.
• Homogenic product: product parameters =
are alike.
27.06.2022
The agriculture market is very
close to perfect competition.
However, it is not totally the
103
same…
Ideal market model:
5 traits of perfect competition (2)
• No entrance or exit barriers: neither
producers nor consumers have problems
with entering or leaving the market. If the
firm stops generating profit, the
entrepreneur would easily leave.
• Independent market agents: neither firms
nor customers can agree on common
behavior strategy and therefore influence
the price.
• Perfect information: firms and consumers
have a perfect overview of prices and other
market conditions and therefore act
27.06.2022
104
Ideal market model:
perfect competition
• In perfect competition conditions the invisible
hand of market does work; source allocation
is efficient and the economy is on its
production possibility frontier.
• Price is independent from the firm’s actions:
the firm is capable of selling all its stock
without influencing the price; demand is
perfectly elastic.
27.06.2022
105
Imperfect competition:
• Imperfect competition exists there, where
sellers have certain control over the price
of their output (market power).
– This, however, doesn’t necessarily mean that
the control is absolute: its extent depends on
the type of imperfect competition.
• Main types of imperfect competition:
– monopoly,
– oligopoly, and
– monopolistic competition.
106
Monopoly:
opposing perfect competition
• It is an extreme case: one seller with the
total control over industry branch.
• Pure monopolies are rare today, before all, due to
antimonopoly laws. Reasons for their existence:
– Legal barriers (patents, licences - Microsoft),
protectionist policy, high entrance barriers (ČEZ),
geographic location.
• Natural monopoly
– Is the case when the only one big firm with the
lowest AC is capable of satisfying market demand
instead of many smaller firms. Exists in branches
with wide returns to scale possibilities.
107
Imperfect competition:
Common traits (1)
• Differentiated product:
– One product differs from competitive ones.
• Significant market shares of firms:
• The firm can influence price and quantity supplied.
• Entrance and exit barriers:
•
•
•
•
Legal restrictions
Customer loyalty
Ads – not all products can be sold
Existing returns to scale and diminishing costs
27.06.2022
108
Imperfect competition:
Common traits(2)
• Unfair competition: firms can agree on
the common strategy – cartel
agreements
• Insufficient information
– Neither firms, nor consumers have the
complete overview of prices and market
conditions; uncertainty exists.
27.06.2022
109
2.4. Imperfect Competition
• Abuse of monopoly power: imperfect
markets restrict output in an attempt to
maximize profit.
• When markets are not competitive, there
is role for gvt regulation
• Ex: natural monopolies such as electricity
2.6 Merit and demerit goods
• Underproduction of merit goods: a merit good is
a private good that society believes is under
consumed, often with positive externalities. For
example, education, healthcare, and sports
centers are considered merit goods.
• Overprovision of demerit goods: a demerit good
is a private good that society believes is over
consumed, often with negative externalities.
For example, cigarettes, alcohol, and weapons
are considered demerit goods.
Which of the following is NOT a
reason for market failure?
a)
b)
c)
d)
Abundance of public goods
Externalities
Environmental concerns
Abuse of monopoly power
When a market fails, the government
usually intervenes depending on the
reason for the failure.
Policies to overcome market failure
Possible government responses include:
•
•
•
•
•
•
•
•
legislation - enacting specific laws. For example, banning smoking in
restaurants, or making high school attendance mandatory.
direct provision of merit and public goods - governments control the supply
of goods that have positive externalities. For example, by supplying high
amounts of education, parks, or libraries.
taxation - placing taxes on certain goods to discourage use and internalize
external costs. For example, placing a ‘sin-tax' on tobacco products, and
subsequently increasing the cost of tobacco consumption.
subsidies - reducing the price of a good based on the public benefit that is
gained. For example, lowering college tuition because society benefits from
more educated workers. Subsidies are most appropriate to encourage
behavior that has positive externalities.
tradable permits - permits that allow firms to produce a certain amount of
something, commonly pollution. Firms can trade permits with other firms to
increase or decrease what they can produce. This is the basis behind capand-trade, an attempt to reduce of pollution.
extension of property rights - creates privatization for certain non-private
goods like lakes, rivers, and beaches to create a market for pollution. Then,
individuals get fined for polluting certain areas.
advertising - encourages or discourages consumption.
international cooperation among governments - governments work together
on issues that affect the future of the environment.
Government failure
• occurs when possible interventions are not
analyzed before action is taken regarding
market inadequacies.
• also known as non-market failure, is the
public sector version of market failure.
• The market fails and government intervention
causes a more inefficient allocation of goods
and resources than would occur without the
intervention.
• Economic crowding out effect
• Inefficient government regulation contributes to
market and government failure.
Economic Crowding Out
• occurs when the government expands its
borrowing to pay for increased expenditure
or tax cuts. The expanded borrowing is in
excess of its revenue which crowds out
private sector investment due to higher
interest rates.
• Government spending also crowds out
private spending.
http://www.investopedia.com/video/play/crowding-out-effect/
https://www.youtube.com/watch?v=7da2Yy0zXPY
Q4: Why is gvt acting this way?
Sometimes, what seems to be the optimal set of
policies are not the ones that gvt pursues.
Why?
1. Optimal policies are not always implementable:
• Collective choice problems
• First-best policies are not always credible
• First-best policies are costly or dicult to implement:
information, administration, etc
These limitations leads to implementation of secondbest policies
Q4. 2.Government failure
Policymakers'objective & social optimum
might differ
Politicians & administration are not a vacuum.
They have interests & preferences of their own
• Lobbying
• Rent-seeking
• Special interests
Structure of gvt (incentives of policymakers)
matters!
Reasons for
government failure
•
•
•
•
•
•
•
•
Lack of incentives
Poor information,
Political interference
No consistency.
Moral hazard.
Regulatory capture
Unintended consequences.
Special interest groups.
Examples of government failure
• White elephant projects. Concorde
supersonic airliner was a joint venture
between British and French government.
• Tax leads to fly-tipping. A tax on rubbish
is a policy to overcome market failure.
• Common Agricultural Policy.
• Prohibition strengthened the mafia.
Schools of Economic
Thought
Introduction
Macroeconomic stabilization policy
attempts to stimulate an economy out of recession or
constrain the money supply to prevent excessive inflation.
Most factors of macroeconomic stabilization policy can be
divided into either fiscal policy or monetary policy.
Fiscal stance
• The fiscal stance of a government refers to how its level of spending and
taxation impact on aggregate demand and economic growth. Higher taxes
and a budget surplus is seen as fiscal consolidation or deflationary stance. A
budget deficit has an expansionary impact.
A fiscal stance can be expansionary, neutral or deflationary.
• Expansionary stance: If the government has higher government spending
than tax revenues, we say the fiscal stance is ‘expansionary’ as this tends to
increase aggregate demand. For example, if the government cut income tax,
households will increase spending.
• Deflationary stance or ‘Fiscal consolidation’. If government spending is less
than taxation revenue, then the fiscal stance is deflationary. The government
is reducing domestic demand by increasing tax (reducing consumer
spending) and/or cutting government spending.
How to measure fiscal stance?
• The actual Deficit/surplus. A simple measure is to consider the actual budget
position. A deficit implies spending greater than tax (expansionary). A surplus
implies tax greater than spending (deflationary).
• Cyclically adjusted deficit. During a recession, tax revenues fall and spending on
unemployment benefits rise (known as automatic stabilisers). Taking out this
cyclical component leaves what the government is actually doing in terms of
discretionary fiscal policy. For example, at the start of the Great Depression, the
UK government increased taxes and cut spending (deflationary fiscal policy).
Government borrowing still rose because of the recession. But, the fiscal stance
was deflationary.
• Primary budget deficit. The primary budget deficit ignores interest payments on
previous debt. If a government has a primary surplus, then this may be
deflationary. For example, in the aftermath of the Greek crisis 2012-14, the EU
stated Greece needed to pursue a primary budget surplus. The actual budget
deficit was still high because of the substantial interest repayments but to achieve
even this primary budget surplus required harsh spending cuts.
Fiscal policy, often tied to Keynesian economics, uses
government spending and taxes to guide the economy.
• Fiscal stance: The size of the deficit or surplus
• Tax policy: The taxes used to collect government income.
• Government spending
Monetary policy controls the value of currency by lowering the
supply of money to control inflation and raising it to stimulate
economic growth.
• Interest rates,
• Incomes policies and price controls that aim at imposing nonmonetary controls on inflation
• Reserve requirements which affect the money multiplier
Introduction
• One point of contention among economists is the causes of business cycles
and recessions. And if you disagree on the causes, chances are that you
disagree on the solutions.
• we’re going to explore two of the major business cycle theories – Keynesian,
and Austrian (wider – neoliberal) – and what their proponents think we
ought to do about recessions.
Economic theories
• Keynesian Economics - an economic theory of total spending in the economy
and its effects on output and inflation.
• Neoliberalism - policy model of social studies and economics that transfers
control of economic factors to the private sector from the public sector.
Keynes versus Hayek
• John Maynard Keynes and Friedrich Hayek are two of the giants of the economics profession.
This topic compares and contrasts their views.
• Their scholarly work represents alternative theories and ideas about the central issues of our
day, including economic instability, central planning, and the operation of the political
process.
1883-1946
1899-1992
'Keynesian Economics'
an economic theory of total spending in the economy and its effects on
output and inflation. It was developed by the British economist John
Maynard Keynes during the 1930s in an attempt to understand the Great
Depression. Keynes advocated increased government expenditures and
lower taxes to stimulate demand and pull the global economy out of the
depression. KE is associated with influencing aggregate demand through
activist stabilization and economic intervention policies by the government.
KE is considered a "demand-side" theory that focuses on changes in the
economy over the short run.
The key component of the Keynesian theory is aggregate demand and the
assumption that nominal wages are sticky.
Aggregate demand (Y) and sticky wages
Y=C+I+G+NX
Y↓then C↓, I ↓, G ↓
Remedium: G↑
In the Keynesian model, typically, nominal wages are sticky. Think of a wage as just
another price. It's the price of labor. In a typical market if demand falls, then the
price falls and the market clears. If that were true in the labor market, a drop in
aggregate demand would mean wage cuts not people losing jobs, but wages are
unlike many other prices. They don't always adjust so quickly hence we say they are
sticky.
Why is that? Well, there may be a long term contract, there may be a law such as
the minimum wage law or sometimes it's just worker morale.
if the flow of AD expenditure into an economy slows down because wages cannot be
cut, then workers have to be laid off and that will lower the flow of aggregate
demand expenditure all the more because there's lower employment, lower
production, less being consumed, less being invested.
Keynesians tend to favor activist monetary and fiscal policies.
Central banks should expand the money supply to help maintain that flow of
nominal expenditure. They should lower interest rates and have easy
conditions for credit.
Keynesians also tend to favor a lot of government deficit spending. That is,
governments should spend more, start new Public Works programs, try to put
people to work and fund those programs by borrowing money even if the
revenue isn't there from the economy right now.
The government is doing everything possible to restore that flow of aggregate
demand.
So what are some of the problems in Keynesian
theory?
First, Keynesian economics doesn't always explain why aggregate demand fell
in the first place. In this sense Keynesian economics may rely on some other
mechanisms.
Furthermore, sometimes what Keynesians call aggregate demand problems—
they may be aggregate demand problems on the surface, but beneath that
there's some deeper maybe hidden sectoral problem in the economy or slow
growth or productivity is the actual problem. So there's some deeper malady
and the weak aggregate demand is just a kind of symptom. So just jacking up
aggregate demand—even if it's a good short-run protection—it may not
always be the best way of solving your problem.
Stagflation
Another problem—Keynesian economics predicts that you either have high
unemployment or high inflation, but not both at the same time. During
America's downturn of the late 1970s, there was a kind of stagflation—high
inflation and high unemployment together. That wasn't what the Keynesians
had predicted and during those years a lot of economists actually turned away
from Keynesian ways of thinking.
In sum, Keynesian economics is really important. It's central to the modern
understanding of macroeconomics. That said, there are also some significant
limitations to Keynesian ways of understanding the world.
Questions
1. Which of the following is not a component of aggregate demand? *
•
•
•
•
•
a. Consumption.
b. Net exports.
c. Interest rates.
d. Investment.
e. Government spending.
2. Which of the following is a reason for sticky wages? *
•
•
•
•
•
a. Fiscal policy.
b. Monetary policy.
c. Aggregate demand.
d. Long-term contracts.
e. All of the above.
3. According to Keynesian business cycle theory, what should the government
do in response to a recession? *
•
•
•
•
•
•
a. Cut government spending.
b. Increase government spending.
c. Increase interest rates.
d. Expand the money supply.
e. a and d only.
f. b and d only.
4. What are some problems with Keynesian business cycle theory? *
•
•
•
•
•
a. It does not predict stagflation.
b. Falling aggregate demand may be a symptom, not cause, of recession.
c. Wages are only sticky during recessions.
d. a and b only.
e. b and c only.
What is 'Neoliberalism'
It takes from the basic principles of neoclassical economics, suggesting that
governments must limit subsidies, make reforms to tax laws in order to
expand the tax base, reduce deficit spending, limit protectionism, and open
markets up to trade.
Neoliberalism supports fiscal austerity, deregulation, free trade, privatization
and greatly reduced government spending.
Neoliberlism is often associated with laissez-faire economics, a policy that
prescribes a minimal amount of government interference in the economic
issues of individuals and society.
Most scholars began to associate the term with Friedrich Hayek (Austrian
school of economy) and Milton Friedman (monetarism).
The Austrian school of economic thought
• According to the Hayekians view, the primary source of economic instability
is government intervention and that a more hands-off policy would result in
more stability, investment, and long-term growth.
• emphasizes market price signals and how they communicate decentralized
information in an economy. The Austrian business cycle theory focuses on
how central banks can distort those price signals.
• When central banks increase the money supply, (inflation goes up). This
pushes market interest rates down and credit becomes easier to obtain.
According to the Austrians, the market has been distorted in this scenario by
central bank interference.
• Now imagine you’re an entrepreneur. Interest rates are around 5%. There
are a lot of investments that would be appealing to you if interest rates were
just a little lower. Now let’s say that, due to an increase in the money supply,
interest rates drop to 1% and you make your investments.
• According Austrian business cycle theory, these investments only seem more
profitable because the market price signal has been distorted. But many
entrepreneurs will have invested in building more homes, factories, etc.
• It will turn out that the demand for those homes and factories wasn’t
actually that high. Investments will be liquidated. Workers will be laid off. So
we have a boom full of malinvestment, followed by a bust.
• Interest rates can lower through market forces, but it’s a
result of consumer saving – not the central bank’s actions.
So under “normal” circumstances, the lower interest rates
would be a signal to entrepreneurs that it’s a good time to
invest in these projects. The problem, according to the
Austrians, is that consumers haven’t been saving more
when interest rates lower from the central bank
interference. The demand isn’t there because savings in the
economy are insufficient.
Where does the Austrian theory fall short?
• It doesn’t explain how so many entrepreneurs are tricked by the central
bank.
• It also doesn’t really deal with why busts are so painful. It may have to
borrow from other theories (e.g., monetarist or Keynesian) to deal with the
high unemployment we see during recessions.
• It also implies that consumption and investment move in opposite
directions. However, the data shows that they tend to move together.
Austrian theory does explain some features of booms and busts, but it
remains to be seen whether it can be a more fundamental explanation.
1. According to the Austrian theory of business cycles, how does the central bank distort price
signals?
•
•
•
•
a. By increasing velocity, the central bank creates the illusion of greater consumer demand for short-term goods.
b. By increasing velocity, the central bank creates the illusion of lower consumer demand for investment goods.
c. By increasing inflation, the central bank causes interest rates to fall, falsely signaling an increase in consumer savings.
d. By increasing inflation, the central bank causes interest rates to rise, falsely signaling a decrease in consumer savings.
2. According to the Austrian theory of business cycles, how does the boom part of the business
cycle lead to the bust? *
• a. Malinvestments made in response to distorted price signals fail when met with insufficient consumer demand.
• b. The decrease in interest rates caused by distorted price signals creates an excess of consumer demand.
• c. Overconfidence caused by the boom leads entrepreneurs to further invest in short-term goods, past the amount
required to meet consumer demand.
• d. The increased production of short-term goods caused by distorted price signals is met with insufficient consumer
demand.
• e. a and c only.
3. What is the Austrian solution to business cycles? *
•
•
•
•
•
a. Reduce long-term investments.
b. Tie the central bank down to a stable rate of inflation.
c. Account for distortions in price signals caused by the central bank.
d. Limited government that doesn’t interfere with market price signals.
e. a and c only.
Keynes vs Hayek Videos
• Russell Roberts, a Professor of Economics at George Mason
University and filmmaker John Papola developed two rap videos that
highlight the alternative views of Keynes and Hayek in an
entertaining manner.
• “Fear the Boom and Bust”:
http://www.youtube.com/watch?v=d0nERTFo-Sk
• “Fight of the Century: Keynes vs. Hayek Round Two” :
http://www.youtube.com/watch?v=GTQnarzmTOc
• Assignment 1
• Try to note the sentences for Keynes and Hayek while watching a
video
• Match sentences with Keynes's theory or neoliberal views ()
• Homework: In the lyrics of both songs, highlight in one color the
fragments closely related to Keynes' views, and in the other color –
Hayek’s – lyrics will be on Teams
Questions for Thought:
Assignment 2. In the main chorus of the Keynes-Hayek rap lyrics, Keynes states
“I want to steer markets” and Hayek replies “I want them set free.”
These statements are referring to the tendency of …
(a) Keynesians to favor government intervention and
central planning and Hayekians to favor free markets.
(b) Keynesians to favor restrictive fiscal policy
and Hayekians to favor expansionary fiscal policy.
(c) Keynesians to favor budget deficits
and Hayekians to insist on budget surpluses.
Questions for Thought:
Assignment 3. Adam Smith:
“The man of system is apt to be very wise in his own conceit. He seems to imagine
that he can arrange the different members of a great society with as much ease
as the hand arranges the different pieces upon a chess-board; he does not
consider that the pieces upon the chess-board have not another principle of
motion besides that which the hand impresses upon them; but that, in the great
chess-board of human society, every single piece has a principle of motion of its
own, although different from that which the legislature might choose to impress
upon it. If those two principles coincide and act in the same direction, the game of
human society will go on easily and harmoniously, and is very likely to be happy
and successful. If they are opposite or different, the game will go on miserably,
and the society must be at all times in the highest degree of disorder.”
Does this quote indicate that Smith was a Keynesian or Hayekian? Explain
Assignment 4
• According to Keynes, when the economy is in the recession, increased
government spending can bring the economy back to full employement. This
spending could be on conducting a war with the military or on financing
public works projects. Heyekians would alternatively argue that bulding and
dropping bombs only destroy valuable resources. Why would a Keynesian
view a war stimulating?
Conclusion
Keynesians
• Keynesians argue that government policy is an effective tool that will help
maintain aggregate demand at a level consistent with full employment and
thereby help promote economic stability.
• The Keynesian view holds that government intervention is needed not only to keep the
macroeconomy on track but also to correct market failures and ensure an equitable
distribution of income.
• Keynesians argue that the job of the economist is to derive ideal solutions and once
developed, political decision-makers can be expected to adopt them.
According to the Hayekians view
• the primary source of economic instability is government intervention and that a more hands-off
policy would result in more stability, investment, and long-term growth.
• Hayekians argue that government planners do not have sufficient information to
direct the economy and their efforts to do so will do more damage than good.
• According to Hayekians, decentralized decision-making, directed by market prices, will be a
more reliable method of directing resources into productive projects and away from ones that
are counterproductive.
• the proper role of government is simply to provide the rule of law, enforce
contracts, and protect property rights, leaving the rest to market forces.
• Hayekians argue that incentives exert a major impact on how government works
and that political incentives will often result in government failure and impede the
adoption of sound policies.
Conclusion
• While there are many different schools of thought in economics, they can be
grouped roughly into
• (1) those that view market outcomes as often problematic and government
interventions as effective and
• (2) those that alternatively view market outcomes as generally efficient and
government interventions as suffering from various shortcomings.
Keynesian vs. Neoliberal theory
• Keynesian Theory
https://www.youtube.com/watch?v=KJ_qcvp1OB4
• Neoliberalism explained
https://www.youtube.com/watch?v=2_ruEbn4jU0
• Globalization and Neoliberalism
https://www.youtube.com/watch?v=uwGgLfu5aGs
• Neoliberalism as a Water Balloon
https://www.youtube.com/watch?v=XIUWZnnHz2g
Thank you