ECONOMICS
CRUNCH KIT
BASICS OF ECONOMICS
• § Human wants are unlimited, but goods are scarce
• § There are no free lunches; you can never get
something truly free (due to the cost of time, and
other costs)
• § To get one thing, we must give up another
• § Humans behave rationally in economics
• § The full cost of an action includes its opportunity cost
• § Opportunity cost: value of the next-best alternative
RATIONALITY
• § Marginal cost: cost of producing/consuming
‘‘one more’’
• § Marginal benefit: benefit of
producing/consuming ‘‘one more’’
• § Rational agents will produce or consume a good
until marginal cost = marginal benefit/revenue
(MC = MR)
• § Rational consumers maximize their utility, or
satisfaction; rational firms maximize their profits
POSITIVE VS. NORMATIVE
• § Positive: ‘‘What is’’ (taxes are 20%)
• § Normative: ‘‘What should be’’ (taxes should
be lower)
MICRO VS. MACRO
• § Microeconomics: focuses on individual
decision making; works its way up from
individuals to markets to economies
• § Macroeconomics: focuses on the economy
as a whole; tracks economy wide variables;
takes a top-down approach
COMPARATIVE ADVANTAGE
• § Comparative advantage: being able to produce a
good at a lower opportunity cost than anyone else
• § Absolute advantage: being able to produce a good
more
• efficiently than everyone else
• § An individual can have an absolute advantage in
everything, but NOT a comparative advantage in
everything
• § Agents should specialize in what they have a
comparative advantage for, and then everyone will
benefit from trade
THE PRODUCTION POSSIBILITIES
FRONTIER (PPF)
• A PPF shows all of the ways an economy can
produce goods
• § Each axis features a good; the PPF measure
trade-offs between these two goods
• § All points outside the curve are impossible
to produce at
• § Points inside the curve are possible but
inefficient and do not use all available
resources
PARETO EFFICIENCY
• Something is Pareto efficient if it is impossible
to improve well-being without hurting
someone else
• § Pareto efficiency provides no way to judge
the superiority of one distribution versus
another
PERFECTLY COMPETITIVE MARKETS
• § The good being sold must be highly
standardized
• § Large number of buyers and sellers
• § Everyone is well informed about the market
price
• § No barriers to entry exist; new firms enter
easily
• § Everyone is a price taker
DEMAND
• § Law of demand: the quantity demanded of a
good decreases when the price increases and vice
versa
• § Demand: this relationship between prices and
quantities for a particular market
• § Quantity demanded: the amount demanded at
a given price
• § Demand can shift due to consumer income,
substitutes and complements, the number of
consumers, and consumer preferences and
expectations
SUPPLY
• § Law of supply: the quantity supplied of a good
increases when the price increases and vice versa
• § Supply: relationship between prices and
quantities for a particular market
• § Quantity supplied: the amount supplied at a
given price
• § Supply can shift due to changes in factor costs,
technology, expectations of future prices, number
of producers, and government regulations
ELASTICITY
• § Percent change in quantity over percentage change in
price
• § Price elastic demand: goods with close substitutes,
luxuries
• § Price inelastic demand: necessities
• § Price elastic supply: long run
• § Price inelastic supply: short run, scarce good
• § Factors affecting demand elasticity: substitutes,
necessities, scope of market, time horizon
• § Factors affecting supply elasticity: scarcity of inputs,
presence of barriers to entry, time horizon
MICROECONOMIC EQUILIBRIUM
• § Equilibrium: intersection of supply and demand
• § Consumer surplus: difference between how
much consumers are willing to pay and the
market price
• § Producer surplus: difference between the price
at which firms are willing to sell and the market
price
• § Market equilibrium maximizes consumer and
producer
THREE FUNDAMENTAL QUESTIONS OF
ECONOMICS
• How much should be produced?
• Who should produce the good?
• Who should receive the good?
ECONOMIC AND ACCOUNTING
PROFIT
• § Total revenue: amount a firm receives from selling its
goods
• § Total cost: costs of a firm supplying its goods
• § Accounting cost: actual monetary cost
• § Accounting profit: straight monetary profit earned
• § Economic cost: both monetary (accounting) cost and
the opportunity cost of the resources used
• § Economic profit: monetary profit minus opportunity
cost; always equal to zero in the long run
FIRMS AND COSTS
• § Fixed costs: costs that a firm must pay regardless of
how
• much it produces (rent, utilities); only fixed in short run
• § Variable costs: costs that change with the amount
produced
• § Average cost: the sum of fixed costs and total
variable costs, divided by the total number of units
produced
• § After a certain point, marginal costs stop decreasing
and begin increasing-----this is called diminishing
returns to scale
• § In the long run, all costs are variable
PRICE CONTROLS
• § Price ceilings set a maximum; price floors set a minimum
• § Deadweight loss: lost efficiency due the market not being
in equilibrium
• § Binding price controls ALWAYS have deadweight losses
• § Price controls transfer surplus from consumers to
producers or vice versa
• § Taxes distort the market, transferring surplus from the
market to the government at the expense of efficiency
• § The more inelastic party always bears more of the tax
• § Revenue equals price times quantity
MARKET FAILURES
• § A market failure is when competitive
markets fail to produce socially desirable
outcomes
• § Two types discussed here are externalities
and public goods
EXTERNALITIES
• § Externalities are costs or benefits that affect a
third party uninvolved in the activity or
transaction in question
• § Individuals do not factor externalities into their
decisions since they do not pay the costs or reap
the rewards
• § Negative externalities harm third parties; the
tendency is to overproduce them
• § Positive externalities benefit third parties; there
are not enough of them
PROPERTY
• § Coase Theorem: private parties can resolve the inefficiencies
created by externalities as long as property rights are clearly
defined and all parties can negotiate with each other
• § A rival good, when it is consumed, can no longer be consumed by
anyone else
• § People have limited access to excludable goods
• § Private goods are both rival and excludable
• § Public goods are neither
• § Collective goods are non-rival and excludable
• § Common resources are non-excludable and rival
• § The tragedy of the commons occurs when people overuse a
resource because no one owns it
MARKET POWER
• § A firm with a downward sloping demand
curve has market power; they can choose
their price
• § The combinations of price and quantity
available to choose from are determined by
the market demand
MONOPOLY
• § Market with only one firm
• § Produce less than what consumers demand,
and sell it at higher than the market price; results
in contrived scarcity
• § Arise due to the presence of barriers to entry
• § Price discrimination: charging different
customers different prices; a monopoly can
capture more of the consumer surplus for the
firm
OLIGOPOLY
• § Market with only a few firms
• § Collusion: when firms cooperate to
artificially raise market prices by restricting
supply
• § Cartel: group of firms that collude
• § Cartels often break up due to an incentive to
cheat
MONOPOLISTIC COMPETITION
• § Firms compete through product
differentiation, not price competition
• § Few barriers to entry exist
• “BRAND” MONOPOLY, but not product
monopoly
INSTITUTIONS, ORGANIZATIONS, AND
GOVERNMENT
• § Institutions: formal or informal rules that guide
human interactions
• § Organizations are like institutions but more formal
• § Governments can tax their citizens and use force
• § Pork barrel politics: elected officials tend to steer
money to their constituents by introducing projects
• § Logrolling: vote trading among elected officials
• § Rent seeking: socially unproductive activities that
simply direct economic benefits
GROSS DOMESTIC PRODUCT (GDP)
• § Market value of all final goods and services produced
within a country in a given period of time; four components
• § GDP = Y = C + I + G + NX
• § Consumption: consumer spending on final goods
• § Investment: value of all money spent on capital or
technology
• § Government expenditures
• § Net exports: exports minus imports
• § Business cycle: fluctuations in GDP over recessions and
expansions
• § Average labor productivity: GDP divided by the total
number of workers employed
MACROECONOMIC MODELLING
• § Circular flow model: households own factors of production; firms
rent factors and produce goods, which households buy; two
markets: goods market and factor market
• § Aggregate demand (AD): quantity of goods demanded by an
economy at different price levels, slopes downward
• § Aggregate supply (AS): potential supply of goods and services in
an economy at different price levels
• § Short run aggregate supply (SRAS): slopes upwards
• § Long run aggregate supply (LRAS); fixed at full employment
output; vertical line; independent of price level
• § Short run equilibrium: intersection of SRAS and AD; long run
equilibrium is at the intersection of all three curves
UNEMPLOYMENT
• § Labor force: all individuals 16 or over, not in prison or armed
forces, and actively looking for work or has a job
• § Employment rate: percentage of labor force with a job
• § Participation rate: percentage of population in the labor force
• § Structural unemployment: unemployment due to large shifts in
economy; mismatch between skills demanded and skills supplied
• § Cyclical unemployment: caused by the business cycle
• § Frictional unemployment: natural unemployment due to timelag
between jobs
• § Unemployment rate calculated every month by the BLS
• § Natural rate of unemployment: never 100%; structural + frictional
unemployment
• § Okun’s Law: for every 1% increase in unemployment, GDP drops
by 2%
MONEY
• § A medium of exchange, unit of account, and
store of value
• § Commodity money: money with intrinsic value
• § Fiat money: intrinsically worthless; declared
valuable by gov’t
• § Inflation: rise in price level; decrease in
purchasing power of money; measured by the CPI
and GDP deflator
• § Liquidity: how easily an asset can be converted
into currency
THE FINANCIAL SYSTEM
• § Savings: income that is not spent
• § Investment: purchase of new capital
equipment
• § Bond: a certificate of indebtedness
• § Stock: ownership of a portion of a company
• § Net capital outflow: domestic purchase of
foreign capital minus foreign purchase of
domestic assets
FISCAL POLICY
• § Government spending or taxes to influence
AD
• § Contractionary: increasing taxes, decreasing
spending
• § Expansionary: decreasing taxes, increasing
spending
MONETARY POLICY
• § Open market operations: buying or selling securities,
done by the FOMC
• § Reserve ratio: fraction of deposits banks must keep in
reserve; adjusted by Board of Governors
• § Discount rate: interest rate the Fed charges to
member banks; adjusted by Board of Governors
• § Contractionary: selling securities, increasing reserve
ratio, increasing discount rate
• § Expansionary: buying securities, decreasing reserve
ratio, decreasing discount rate
• § Quantity theory of money: MV = PY or MV = PQ
THE ECONOMICS OF RUSSIA
• § Russia transformed into a planned economy after the Russian Civil War
• § The Soviet Union, an economic union of 15 nations, operated under
strict bureaucratic planning
• § Flawed planning mechanisms caused chronic shortage
• § Mikhail Gorbachev launched perestroika, restructuring of the
communist system, but worsened the economy
• § Gorbachev was ousted and the Soviet Union collapsed in 1991
• § Boris Yeltsin, Russia’s first elected president, successfully privatized most
of the economy
• § Vladimir Putin entered office as global oil prices rose and the Russian
economy prospered
• § Dmitri Medvedev entered office shortly before the 2008 global financial
crisis
• § He pursued ‘‘modernization’’ efforts
Economists
• Michael Boskin
– In 1996, assigned to head a committee to review the
methods used to calculate CPI
• Michael Edelstein
– Constructed the ‘‘marginal’’ and ‘‘strong’’ set of
standards to gauge the effect of empire ion the British
economy
• Stanley Engerman
– Estimated profitability of the slave trade
• Milton Friedman
– Most famous advocate of monetary policy (instead
of Kenyesian policy)
• John Maynard Keynes
– Proposed fiscal policy as a way to smooth out the
business cycle; his theories put to the test in the Great
Depression; wrote 1936 book
– The General Theory of Employment, Interest, and
Money
• Simon Kuznets
– Commissioned by the U.S. Department of Commerce
to develop a system to measure national output
• Joseph Schumpeter
– Described the impact of entrepreneurs as ‘‘creative
destruction’’
• Adam Smith
– Father of classical economics; wrote the 1776 book
– An Inquiry into the Nature and Causes of the Wealth
of Nations
• Okun, Arthur
– One of President Kennedy’s chief economic
advisors in the early 1960s; articulated OKUN’S
LAW
– Every 1% that the unemployment rate is off from
the natural rate of unemployment, the output gap
deviated by 2%
• Pareto, Vilfredo
– Italian economist (1848-1923); first came up with
the concept that an outcome was efficient only if
there was no way to improve someone’s wellbeing without reducing someone else’s well-being
COMMENTARY:
• Aslund, Anders
– Two-thirds of national employment must be private
• Colton, Tim
– Bureaucratic planners were unable to anticipate the need
for computerization
• Gontmakher, Evgeny
– Russia’s economic woes are ‘‘a result of incorrect economy
policy, oil dependence, and rampant corruption.’’
• Hanson, Philip
– Noted that rising global prices of oil and gas indirectly
fueled Russian economic growth (with negative
consequences)
• Kornai, Janos
– The distinction between national and regional firms in the
Soviet Union was meaningless: ‘‘Servility and a heads
down mentality prevailed’’
RUSSIANS
• Gaidar, Yegor
– Primary author of the “shock therapy” reform
enacted by Boris Yeltsin, acting prime minister of
Russia under Yeltsin
• Gontmakher, Evgeny
– Analyst; commented on Russia’s experience with
the resource curse. He stated, “This is all a result
of incorrect economic policy, oil dependence, and
rampant corruption, Until the system changes,
these problems will persist.”
• Shatalin, Stanislav and Grigory Yavlinsky
– Economists and Gorbachev advisors; helped
produce the 500 Day Plan
• Chubias, Anatoly
• economist; Yeltsin’s first privatization czar;
started the program
• Polevanov, Vladimir
– Russia’s Minister of Privatization during Boris
Yeltsin’s presidency who halted Yeltsin’s second
stage of privatization, advocated renationalization
of some firms
PERCENTAGES -20% to 10%
• -17%
– (111) Percent growth of the Soviet Union’s GDP by the time of
its collapse in 1991
• -0.2%
– (119) Percent growth of Russia’s GDP in 2009
• 2%
– (118) Percent growth of Russia’s oil production in 2007
• 3%
– (111, 118) Percent growth of Russia’s GDP in 1989
– Percent growth of Russia’s oil production in 2006
• 5%
– (118) Percent growth in Russia’s oil production in 2005
PERCENTAGES -10% to 10%
• 6%
– (119) Russia’s unemployment rate in 2008
• 9.7%
– (72) The United States’ unemployment rate in August 2009
• 10%
– (110, 118, 119)
– Yearly percent decline in Russia’s production between
1989 and 1991
– Percent growth in Russia’s oil production in 2004
– Increase in Russia’s real disposable income between 1999
and 2008
10% - 25%
• 12%
– Russia’s unemployment rate in 1999
– Percent of Russians living on subsistence minimum in 2008
• 13%
– Flat income tax rate imposed by Vladimir Putin during his
first term (2000-2004)
• 16%
– (86, 119) Decline in the United States’ CPI from 1920 to
1922
– Percent decline in Russia’s industrial output between
October 2008 and February 2009, according to Bank of
America Securities-Merrill Lynch
10% - 25%
• 19%
– (118) Percent of Russia’s oil coming from state-owned
firms in 2004
• 20%
• (114) Average percent of shares sold by each firm during Boris
Yeltsin’s voucher program
• 24%
– (117) Russia’s tax rate on profits after Vladimir Putin’s tax
cuts
• 25%
– (86, 114) Decline in the CPI from 1929 to 1933
– Percent of insider ownership allowed under Boris Yeltsin’s
voucher program
25% - 50%
• 28%
– (119) Decline in Russian government revenue by the first
quarter of 2009
• 29%
– (114) Percent of shares that had to be sold during the
voucher program under Boris Yeltsin’s decree
• 35%
– (117) Russia’s tax rate on profits before Vladimir Putin’s tax
cuts
• 41%
– (119) Percent of Russians living at subsistence minimum in
1999
• 50%
– (118) Percent of Russia’s oil coming from state-owned
firms in 2008
50% - 215%
• 66%
– (72) The United States’ current labor force participation
rate
• 70%
– (119) Percent decline in the value of Russia’s stock market
between June 2008 and January 209
• 75%
– (115) Percent of Russia’s large and mid-sized firms
privatized by 1996
• 90%
– (115) Percent of Russia’s industrial output privatized by
1996
50% - 215%
• 99%
– (107) The Soviet Union’s literacy rate at the time
of its collapse
• 100%
– (111) The Soviet Union’s inflation rate at the end
of 1991 Economics Power Guide | 134
• 245%
– (112) Average percent increase in prices the day
after Boris Yeltsin freed prices on January 2, 1992
FISCAL & MONETARY POLICY TERMS
• Contractionary policy
– Policy meant to fight inflation and decrease aggregate
demand
• Discount rate
– Interest rate the Federal Reserve charges for loans to its
member banks
• Expansionary policy
– Policy meant to fight recession and increase aggregate
demand
• Federal funds rate
– Interest rates banks charge on loans to each other; based
on the discount rate but not set by the Federal Reserve
FISCAL & MONETARY POLICY TERMS
• Fiscal policy
– Government taxation and spending policy choices meant
to influence the economy
• Monetary policy
– Policies set by a central bank (for us, the Federal Reserve)
to accelerate or slow down the economy by increasing or
decreasing the money supply, respectively
• Open market operations
– The trading of government securities by the Federal
Reserve to adjust the size of the money supply
• Reserve ratio
– The amount of each deposit banks must hold in reserve
FORMULAS
• Average Total Costs
• Total fixed costs + total variable costs
total number of units produced
• CPI
• Basket price in year t
basket price in base yr
x
• GDP Deflator
• Nominal GDP
Real GDP
x
100
100
FORMULAS
• GDP
• C+I+G+X
• General Profit Maximizing Condition
• MR = MC
• Money Multiplier
•
1
RR
THE FEDERAL RESERVE
• Chairman of the Board of Governors
– Head of the Federal Reserve; appointed every four
years; current chairman is
– Ben Bernanke
• Federal Reserve (the Fed)
– The central bank of the United States; sets monetary
policy to help determine the money supply
• Federal Open Market Committee
– Trades government securities, or debt, on the open
market in order to alter the money supply and conduct
day-to-day monetary policy; consists of the Federal
Reserve Board plus
– The President of the New York District Bank and the
presidents of four other district banks
THE FEDERAL RESERVE
• Federal Reserve Board of Governors
– Governing body of the Federal Reserve; consists of
seven governors appointed by Congress to 14-year
terms with one term expiring every two years
• Federal Advisory Council
– Consists of up to 13 bankers, with one commercial
banker representing each district in the Federal
Reserve system; purely advisory body with no
policymaking power
THE FEDERAL RESERVE
• 4
– The number of years in the term of the Fed Chairman
• 7
– The number of members of the Federal Reserve’s
Board of Governors
• 12
– The number of Federal Reserve Banks
• 14
– The number of years in a term for a member of the
Fed’s Board of Governors
• 25
– The total number of Federal Reserve Banks + branches
UNEMPLOYMENT
• Cyclical unemployment
– Results from economic downturn (BAD for
ECONOMY!)
• Frictional unemployment
– Results from the time lag between when workers
leave one job and they when find a new job; exists
even in the healthiest and wealthiest of economies
(GOOD for ECONOMY!)
• Labor force
– The total number of persons aged 16 and over
either working or actively seeking employment
(excluding those in prison or in the military)
• Okun’s law
UNEMPLOYMENT
– Sugests that every 1% increase in unemployment
above the natural rate of unemployment results in a
2% drop in GDP
• Participation rate
– Percentage of the total population eligible for the labor
force that is currently in the labor force (employed or
actively seeking employment)
• Structural unemployment
– Results from fundamental changes in the economy,
such as improving technology or shifting consumer
preferences----- leading to a mismatch of skills offered
by labor and skills desired by firms (GOOD for ECON)
UNEMPLOYMENT
• The NATURAL UNEMPLOYMENT RATE
– Frictional unemployment + structural unemployment
COMPETITION
• price elasticity of demand
– a measurement of the sensitivity of quantity demanded to a change in market
price
• complements
– related goods, such that when the price of one good falls, demand for the other
rises
• substitutes
– related goods, such that when the price of one good falls, demand for the other
falls
• normal good
– a good the demand for which increases as the income of its consumers increases
• inferior good
– a good the demand for which decreases as the income of its consumers increases
• firm
– an organization that produces a good or service for sale to the market
COMPETITION
• monopoly
– a market that has only one producer, with high barriers to entry
• natural monopoly
– a special monopoly that arises when two producers cannot both
exist and be profitable; competition actually makes prices
higher and quality lower; often regulated or run by the
government
• oligopoly
– a market with only a few producers and high barriers to entry;
firms in an oligopoly; sometimes form cartels and collude;
because they face the prisoner’s dilemma and possibility of
price war, they depend on price leadership
• Monopolistic competition
– a market structure with many producers each aiming to
differentiate its product, hoping to obtain a small amount of
monopoly power (brand monopoly; advertise and engage in
non-price competition
COMPETITION
• Economies of Scale
– Advantages which accrue from increasing
size/scale of production
• Price discrimination
– Occurs when firms maximize profits by charging
different consumers different prices for the same
goods and services by offering coupons, discounts,
etc.
• Perfect competition
– a market with many producers and consumers,
perfect information, and no barriers; price takers ;
can only control quantity
ECONOMICS OF RUSSIA
• Corporatization
– Practice of holding managers accountable to a board of directors,
separation of ownership and management
• The DUTCH DISEASE
– Negative effects caused by a large inflow of foreign currency,
associated with the discovery of natural resources and subsequent
decline of the manufacturing sector
• Gazprom
– State-controlled Russian natural gas firm, world’s largest natural gas
extractor
• Loans for shares
– auction of 12 blue-chip companies to a group of commercial banks,
transferred much of the Russian economy to a small group of oligarchs
and tainted the image of privatization for the public
ECONOMICS OF RUSSIA
• Perestroika
– Mikhail Gorbachev’s effort to restructure the communist
economy
• Resource curse
– Negative effects of finding abundant natural resources
• Shock therapy
– Reform plan developed by American economist Jeffrey Sachs,
tried in Poland, championed by Yegor Gaidar, adopted by Boris
Yeltsin; emphasized stabilization, liberalization, and privatization
• Socialism
– A theoretical state between the overthrow of capitalism and
establishment of communism, advocates public ownership of
property and social welfare