ECONOMICS MAE101 EXAM NOTES TRI 1 2023 IMPORTANT FORMULAS MACROECO: Gross domestic product: GDP=C (consumption) + G (government expenditures) + I (investment) + NX (net exports) OR GDP = W (labour) + I (interest) + R (rent) + P (remaining profits) Real GDP: Real GDP= GDP on nominal terms / deflator of GDP Unemployment rate: Unemployment rate= Total number of unemployed / total number of employed Consumer price index (CPI): CPI = cost of products and services for given year / cost of products and services for the determined base year Inflation rate: Inflation rate= (changes in CPI levels / CPI levels last year) x 100 Real Interest Rate: RIR = interest rate in nominal terms – rate of anticipated inflation MICROECO: TOPIC NOTES 1: Economics and Market 10 PRINCIPLES OF ECONOMICS 1. People face trade offs 2. The cost of something is what you give up getting it 3. Rational people think at the margin 4. People respond to incentives 5. Trade can make everyone better off 6. Markets are usually good way to organise economic activity 7. Governments can sometimes improve market outcomes 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 short-run trade-off between inflation and unemployment 2. MICRO AND MACRO ECONOMICS a. Microeconomics: study of how individual households and individual firms make decisions and how they interact in markets. o Focussing on individual markets o Examining how incentives and trade-offs influence buyer and seller behaviour Analysis of pricing mechanism of goods b. Macroeconomics: study of the national economy and the global economy as a whole o Analysis of inflation Persistent rise in Average price level of the total volume of various goods produced by a given country (at aggregate level) Real world examples include: (i) analysis of pricing mechanism of a given goods like the apple (fruit); and (ii) analysis of inflation (i.e. persistent rise in average price level of goods). MICRO AND MACRO ECONOMICS Microeconomics: study of how individual households and individual firms make decisions and how they interact in markets. Focussing on individual markets Examining how incentives and trade-offs influence buyer and seller behaviour - Analysis of pricing mechanism of goods Macroeconomics: study of the national economy and the global economy as a whole Analysis of inflation - Persistent rise in Average price level of the total volume of various goods produced by a given country (at aggregate level) Real world examples include: (i) analysis of pricing mechanism of a given goods like the apple (fruit); and (ii) analysis of inflation (i.e. persistent rise in average price level of goods). Assumption of rationality: we assume that an individual agent is ‘rational’ as he/she always maximises his/her benefit. More precisely: - As a consumer, one will maximise ones utility - As a producer, individual firm will maximise its profit - As a government body, it will maximise country’s welfare and so on Ultimate goal of economics: maximising welfare of a given economy via: - Taking good care of our environment - Poverty alleviation and decreasing income inequality - Providing high quality public goods - Investing in research and development (R&D) Elements of a Competitive Market: - A large number of buyers and sellers that no individual buyer or seller has control over a market - Goods are homogenous in nature - No market barrier, that is, free entry and free exit - The information is perfect - Voluntary exchange and the price mechanism are the key ingredient (so that exchange doesn’t make people worse off) - A government (or institution) exists and enforces property rights Higher price increases the quantity supplied because: - Marginal cost increases - Producers are willing to incur a higher marginal cost, so they increase production SUPPLY Assuming other influences on producers planned sales remain the same: - A supply curve shows the relationship between the quantity supplied of a good and its price - Each point of supply curve tells us the marginal cost of a given goods - Therefore, a seller/producer must charge the minimum price that equals marginal cost, to cover its cost Factors that bring changes in supply: - Price factors of production - Price of related goods produced: substitute or complement - Expected future prices - Number of suppliers - Technology - State of nature Movements vs Shifts in supply curve: If price of the good changes = movements along supply curve - Price rises: quantity supplied increases - Price falls: quantity supplied decreases If any of six factors aforementioned changes = shifts in supply curve - Forces that INCREASE the quantity supplied at every price level: rightward (or downward) shift - Forces that DECREASE quantity supplied at every price level: leftward (or upward) shift in supply curve DEMAND When you demand something: you want it, you can afford it, you plan to buy it Why does higher price decrease the quantity demand? - Substitution effect: as price increases, opportunity cost rises, which lowers consumers incentive to buy the good (they switch to other goods) - Income effect: as price increases relative to income, consumers reduce their consumption of goods and services Assuming other influences on consumers planned purchases remain the same: - A demand curve shows the relationship between the quantity demanded of a good and its price - Each point of demand curve tells us the maximum willingness to pay of a given consumer - the demand curve reveals the marginal benefit of a given good; it is subject to diminishing return Factors that bring changes in demand: - the price of related goods: o substitute: a good that can be used in place of another good o complement: a good that is used in conjunction with another good - expected future prices - income - expected future income - population - preferences Movements v Shifts of demand curve: If price of the good changes = movements along demand curve - price rises: quantity demanded decreases - price falls: quantity demanded increases If any of six aforementioned factors change = shifts in demand curve - forces that INCREASE the quantity demanded at every price level: rightward (or upward) shift of demand curve - forces hat DECREASE the quantity demanded at every price level: leftward (or downward) shift of the demand curve COMPETITVE MARKET EQUILIBRIUM: A competitive market moves toward its equilibrium because: - price regulates buying and selling plans - price adjusts when plans don’t match Competitive market e.g. Foreign exchange market Demand and Supply in action: P* = equilibrium price Q* = quantity - If demand increases: P rises, Q increases - If demand decreases: P falls, Q decreases - If supply increases: P falls, Q increases If supply decreases: P rises, Q decreases 2: Elasticity and Government Intervention Elasticities: Price elasticity of demand Price elasticity of demand is affected by: - Availability of substitutes - The time horizon under consideration - The nature of the good whether it is a necessity or luxury (determined by the percentage of income spent on the given good) Income elasticity N(i): income elasticity of demand, defined as: = % change in quantity / % change in income - Explains whether the goods are normal (diamond, branded car BMW) or inferior (potato or rice) Total revenue test: - A price cut increases total revenue: elastic demand - A price cut leaves total revenue unchanged: unit elastic demand - A price cut decreases total revenue: inelastic demand Elasticity of supply N(s): elasticity of supply, defined as, = % change in Q supplied / % change in P Price control Price ceiling - Price ceiling policy favours BUYERS - A price ceiling set above the equilibrium price has no effect - A price ceiling set below the equilibrium price has powerful effects on the market i.e., Rent ceiling leads to: - Housing shortage (leads to deadweight loss) - Increased search activities (opportunity cost) - Black market: an illegal market where price exceeds the price ceiling Hence, rent ceiling = inefficient Price floor - Price floor policy favours SELLERS - A price floor set below the equilibrium price has no effect - A price floor set above the equilibrium price has powerful effects on the market i.e., Minimum wage leads to unemployment if it is set above the market equilibrium wage 3: Market and Welfare Analysis Consumer surplus: - Given by the area below the demand curve and above the market price - On graph: area of triangle: ½ x base x height: in e.g. CS= ½ x 1.5 x 30 = 22.5 Producer surplus: - Given by the area below the market price and above the supply curve - In e.g. CS = ½ x 10 x 100 = 500 Competitive market, efficiency and deadweight loss Incidence of tax Deadweight loss from tax Elasticity, deadweight loss and tax revenue Tax on seller and buyer: price wedges 4: Externalities and Market Failure 5: Monopoly and Imperfect Competition 6: Macroeconomic Indicators 7: Open Economy Model: Determination of interest rate and exchange rate 8: AD-AS Model 9: Money and Macroeconomic Policy: Fiscal and monetary policies 10: Trade and Balance of Payments DEFINITIONS - Appreciation: refers to an increase in the value of a currency as measured by the amount of foreign currency it can buy - Asymmetric Information: arises mainly from the fact when price of a product does not provide sufficient information and one party (i.e. seller) has more information that other party (i.e. buyer) - Closed Economy: one that does not interact with other economics in the world; that is, there are no exports, no imports and no capital flows - Competitive Market Equilibrium: a state in a competitive market in which the quantity demanded equals the quantity supplied - Comparative Advantage Theory: a person or nation has a comparative advantage in an activity if they/it can perform an activity at a lower opportunity cost than others; and both persons/countries will gain from trade (provided that trade is feasible) if both of them specialise in producing goods on the basis of comparative advantage; promotes the free trade; explains the basis of trade between two countries or households - Consumer price index (CPI): a measure of the overall cost of the goods and services bought by a typical consumer; used to monitor changes in the cost of living over time - Consumer surplus: the value of a good minus the price paid for it, summed over the quantity bought - Deadweight Loss: the decrease in total surplus that results from an inefficient level of production; borne by society (a social loss) - Depreciation: refers to a decrease in the value of a currency as measured by the amount of foreign currency it can buy - Demand: quantity demanded of a good or service is the amount that consumers plan to buy during a given period of time at a particular price - Economics: economics is the science of choice – the science that explains the choices that rational individuals make and how those choices change as we cope with scarcity - Economic Profit (EP): defined as firms total revenue (TR) minus explicit cost (EC) minus implicit cost (IC); hence EP=TR-EC-IC - Elasticity of Supply: measures the responsiveness of the quantity supplied to a change in price - Equilibrium Price: the price at which the quantity demanded equals the quantity supplied - Equilibrium Quantity: the quantity bought and sold at the equilibrium price - Externalities: an externality is a cost or benefit imposed on third parties (mostly people other than the buyers and sellers of a given good) - Firm: an institution that hires productive resources and that organises those resources to produce and sell goods and services. The objective of the firm is to maximise the economic profit. - Gross Domestic Product (GDP): a measure of the total income and expenditures of an economy; the total market value of all final goods and services produced within a country in a given period of time o Nominal GDP: values the production of goods and services at current prices (prices at the time of observing the goods) o Real GDP: values the production of goods and services at constant prices (prices at a fixed time) - Homogenous: same kind, alike - Inflation: refers to a situation in which the economy’s overall price level is rising - Inflation rate: the percentage change in the price level from the previous period (price levels typically measured using the CPI) - Inflationary Gap: a macroeconomic equilibrium in which real GFP exceeds potential GDP and this difference is called an inflationary gap - Interest: represents a payment in the future for a transfer of money in the past o Nominal interest rate: the interest rate usually reported and not ‘corrected’ for inflation. The interest rate that the bank pays o Real interest rate: the nominal interest rate corrected for the effects of inflation - Labour force: the sum of the employed and the employed - Labour force participation rate: the percentage of the adult population that is in the labour force (labour force/adult populated, X100) - Lack Of Competition: firms without competitors tend to restrict supply through collusion, which raises prices to maximise their profits. However, such behaviour (known as rent seeking behaviour) of firms lead to non-optimal allocation - Law of Supply: other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied - Law of Demand: other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded - Marginal cost: refers to the increase in production costs generated by the production of additional product units - Market Failure: refers to a situation in which the price system fails to operate efficiently, creating a problem for society - Monetary Policy: explained as actions taken by the central bank (typicaly thought to be independent from the government) to influence interest rates, economic activity and prices in the economy - Monopoly: a market where there is only one producer but a large number of buyers - Net foreign investment (NFI): refers to the purchase of foreign assets by domestic residents (i.e., capital (K) outflow) minus the purchase of domestic assets by foreigners (i.e., capital (K) inflow) NFI= K Outflow – K Inflow - Nominal Exchange Rate: the rate at which a person can trade the currency of one country for the currency of another - Open Economy: one that interacts freely with other economics around the world - Opportunity Cost: the highest valued alternative foregone - Price ceiling: a government regulation that makes it illegal to charge a price higher than a specified level is called a price ceiling/price cap - Price Elasticity of Demand: a units-free measure of the responsiveness of the quantity demanded to a change in price. In other words, how much percentage change in quantity demanded occurs due to one percentage change in price. - Price Floor: a government regulation that makes it illegal to charge a price lower than a specified level is called a price floor - Price mechanism: the price mechanism emerges when competition associates with the freedom of individual buyers and sellers to determine the price at which they are willing to exchange - Producer Surplus: the price received for a good minus its marginal cost, summed over the quantity sold - Public goods: a good or service that the government, rather than the market, must provide if it is to be made available in sufficient quantity - Real Exchange Rate: the rate at which a person can trade the goods and services of one country for the goods and services of another - Recessionary Gap: a macroeconomic equilibrium in which potential GDP exceeds real GDP i.e., the real GDP is less than the potential GDP and this difference is called recessionary gap - Scarcity: society has unlimited wants and limited resources; forces different agents to make choices - Supply: quantity supplied of a good or service is the amount that producers plan to sell during a given period of time at a particular price - Total Revenue Test: the method of estimating the Price Elasticity of Demand by observing the change in Total Revenue that results from a change in price - Trade balance (net exports) (NX): the value of a nations exports minus the value of its imports - Trade-offs: scarcity presents us with this where you have to make different choices - Unemployment rate: calculated as the percentage of the labour force that is unemployed (number of unemployed/labour force, X100)
