BEC 5
Economic Concepts
Business cycle-rise and fall of economic activity relative to its LT growth trend.
Macroeconomics - economy as a whole
Microeconomics - studies consumers, suppliers and producers operating in narrow market.
GDP - total mkt value of all final goods and services produced within borders of a nation in a
particular time period. Including the output of foreign-owned factories in the US but excluding the
output of US owned factories operating abroad.
Nominal GDP - no inflation adjustment - measured in today’s prices
Real GDP - adjusted for inflation - base year prices
Real GDP (price index) = (nominal GDP)/ (GDP deflator) x100
Real GDP per capita - used to compare standard of living across countries.
Real GDP per capita = (Real GDP/population)
Economic growth - the increase in real GDP per capita over time
Potential GDP - level of real GDP economy would produce if resources were fully employed
Business Cycle Summary
1) Expansionary Phase - rising economic activity
2) Peak -high point of economic activity
3) Contractionary Phase - falling economic activity and growth (follows a peak)
4) Trough - low point of economic activity
5) Recovery Phase (expansionary) - economic activity begins to increase (follows a trough)
Recession - two consecutive qtrs of falling national output.
Depression - very severe recession
Indicators:
Leading - (before) predict economic activity (money supply, unemployment claims)
Lagging - (after) follow economic activity (prime rate, duration of unemployment)
Coincident - (during)
Reasons for Fluctuations (Why?): bus cycles result from shifts in aggregate demand and/or supply
Change in AD and AS causes a change in price
Change in price causes a change in QD and QS
Aggregate Demand/Supply - dictates price level - line moves
A) Aggregate Demand (AD) Curve (downward slope): max qty of ALL goods and services that
households, firms and got are willing and able to purchase at any given price level.
Aggregate demand = MACROeconomic demand
B) Aggregate Supply (AS) Curve: max qty of ALL goods and services producers are willing and
able to produce at any given price level.
Short-run Aggregate Supply (SRAS): upward sloping, as price level rises firms are willing to
Produce more goods and services
Long-run Aggregate Supply (LRAS): vertical, in long run if all resources are utilized, output
is determined by factors of production.
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BEC 5
Economic Concepts
Aggregate Demand, Supply & Economic Fluctuations page 7-8:
1) Reduction in Demand:
AD
GDP
P
2) Increase in Demand:
AD
GDP
P
3) Reduction of Supply:
SRAS
GDP
P
4) Increase in Supply:
SRAS
GDP
P
Factors that Shift Aggregate Demand not change in price level:
1) Changes in Wealth:
Increase Wealth:
W
Spend
AD ↑ GDP ↑ P ↑
Decrease Wealth:
W
Spend
AD ↓ GDP ↓ P ↓
2) Changes in Real Interest Rates:
Increase in RIR bad: Int
Borrow
Spend ↓
AD ↓ GDP ↓ P ↓
Decrease in RIR:
Int
Borrow
Spend ↑
AD ↑ GDP ↑ P ↑
3) Changes in Expectations about Future Economic Outlook (consumer confidence)
Confident:
Expect
Spend↑ AD ↑ GDP ↑
P ↑
Uncertain:
Expect
Spend ↓ AD ↓ GDP ↓
P↓
4) Changes in Exchange Rates
Appreciated Currencies: Domestic
Exports ↓
Imp AD ↓ GDP ↓
P
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Depreciated Currencies: Domestic
5) Changes in Govt Spending**
Increase:
AD ↑ GDP ↑ P ↑
Decrease:
AD ↓ GDP ↓ P ↓
6) Changes in Consumer Taxes**
Increase Taxes:
Spend
Decrease Taxes:
Spend
**Two main ways govt can control economy
Exports ↑
Economic Concepts
Imp
AD ↑
GDP ↑
P
AD ↓ GDP ↓ P ↓
AD ↑ GDP ↑ P ↑
Multiplier Effect (ripple effect): increase in consumer, firm or govt spending produces multiplied
increase in level of economic activity.
Multiplier = 1/ (1-MPC) = MPS
Change in real GDP = Multiplier x Change in Spending
Marginal Propensity to Save (MPS) = (1-MPC) MPC+MPS = 1 or 100%
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Factors that Shift Short Run AS:
1) Changes in Input (Resource) Prices
Increase in Input Prices bad SRAS
Decrease in Input Prices
SRAS
2) Supply Shocks
Supplies are Plentiful
SRAS
Supplies are Curtailed
SRAS
Economic Concepts
GDP ↓ P ↑
GDP ↑ P ↓
GDP ↑ P ↓
GDP ↓ P ↑
GDP = GDI
Two Methods of Measuring GDP:
1) Expenditure Approach
G Government purchases of goods and services
I Investment spending by businesses
C Consumer spending
E Net Exports (Exports – Imports)
2) Income Approach
I Income of proprietors
P Profits of corporations
I Interest (net)
R Rental Income
A Adjustments for net foreign income and miscellaneous items
T Taxes (indirect business taxes)
E Employee compensation (wages)
D Depreciation (also known as capital consumption allowance)
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Economic Concepts
Net domestic product (NDP) = GDP - depreciation
Gross National product (GNP) - produced by residents in or out of company
Disposable income - Taxes ↓ spending ↑
Unemployment Rate: ratio of # of ppl classified as unemployed to total labor force
Unemployment Rate:
Types of Unemployment
A) Frictional - normal. From workers changing jobs or temporarily laid off
b) Structural - Jobs available in mkt do not correspond to skills of work force and
Unemployed workers font live where jobs are located.
c) Seasonal - around Christmas
d) Cyclical - real GDP is below potential level of output, positive unemployment. Real GDP is
Above potential level of output, negative unemployment. Cyclical unemployment rises
During recession and falls during expansion.
Natural Rate of Unemployment - normal rate of unemployment that fluctuates due to cyclical.
Full Employment - no cyclical unemployment. Does not mean ZERO unemployment because there
is still frictional, structural and seasonal
**Unemployment and national output tend to be opposites.
Inflation - sustained average increase in general prices over time. AD ↑ and/or AS ↓
Deflation - opposite of inflation. Sustained decrease in general prices. AD ↓ and/or AS ↑
Inflation/Deflation rate - % change in consumer price index from one period to the next.
Consumer Price Index (CPI) - measure of overall cost of a fixed basket of goods and services
purchased by avg household. Change in price levels over time
Producer price index (PPI) - same but bought by firms
Change in CPI = Inflation Rate unlikely to get tested on this formula
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Economic Concepts
Causes of Inflation & Deflation
1) Demand-Pull Inflation
AD ↑ GDP ↑ P ↑
Increase in govt spending, decrease in taxes, increase in wealth, increase $supply
2) Cost-Push Inflation
SRAS
GDP ↓ AS ↓profit ↓
Increase in oil prices and increase in nominal wages
SRAS is heavily dependent on profit opportunity
Deflation - P ↓ caused by AD ↓ and/or AS ↑
Phillips Curve: Inflation ↑ unemployment ↓
Inflation has an inverse relationship with purchasing power.
Monetary Assets/Liab: fixed amts regardless of change in price level (cash, AR, notes payable)
P ↑ $ ↓ purchasing power ↓
Nonmonetary Assets/Liab: fluctuate w/ inflation & deflation (building, land, machinery)
P ↑ PP&E ↑
Holding Monetary Assets: lose purchasing power b/c of inflation.
Holding Monetary Liab: purchasing power gain b/c of inflation
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Economic Concepts
Nominal Interest rate - not adjusted for inflation
Real Interest rate = nominal interest rate - inflation rate
Example using great depression on page 19
Money Supply-stock of all liquid assets available for transactions in the economy at any given time.
M1: most conservative. $ used to purchase goods and services
(Currency, checkable deposits and traveler’s checks.)
M2: M1 plus liquid assets that can’t be used as medium of exchange but can be converted easily.
(Certificates of deposits less than $100,000, money mkt, mutual funds and savings accts)
M3: most liberal. All items in M2 and certificates of deposits in excess of $100,000
Monetary Policy - use of money supply to stabilize economy. Fed Reserve uses monetary policy to
increase/decrease money supply in effort to promote price stability and full employment.
(1)Open Market Operations (OMO): purchase and sale of govt securities in open mkt
Expansionary: a) increase in MS:
spend
AD
GDP P
Contractionary b) decrease in MS:
spend
AD
GDP P
(2)Changes in Discount Rate: interest rate Fed charges member banks for overnight loans
Expansionary: a) DR Int
Borrow
MS
Spend AD
GDP P
Contractionary: b) DR Int
Borrow
MS
Spend AD
GDP P
(3)Changes in Required Reserve Ratio (RRR): fraction of total deposits that must be held in reserve
Expansionary: a) RRR MS Spend
AD
GDP
P
Contractionary: b) RRR
MS Spend
AD
GDP
P
Demand for money is inversely (opposite) related to interest rates.
Laws of Supply & Demand
DEMAND
Change in Qty demanded: change in the amt of a good demanded resulting solely from a change in
price. Price Changes First.
Change in Demand: change in the amt of good demanded resulting from a change in something
other than the price of good. Demand changes first.
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Economic Concepts
Substitution Effect: consumers purchase more of a good when its price falls in relation to the price
of other goods. (EX: Coke v Pepsi)
Income Effect: if income remains constant but prices are lowered, people will purchase more of
lower priced products.
Market Demand: total amount of a good all individuals are willing and able to purchase
FACTORS THAT SHIFT DEMAND CURVES
W
changes in Wealth
R
Related Goods (substitutes & complements)
I
consumer Income changes
T
consumer Taste or preference of product
E
changes in consumer Expectations
N
Number of buyers served by market
SUPPLY
Change in Qty Supplied: change in amt producers are willing and able to produce resulting solely
from change in price. Price Changes First.
Change in Supply: change in the am tog good supplied resulting from a change in something other
than the price of the good. Supply changes first.
Market Supply: total amt of a good all producers are willing and able to produce
FACTORS THAT SHIFT SUPPLY CURVES
E
price Expectations of supplying firm
C
production Costs
O
price or demand of Other goods
S
Subsidies or Taxes
T
production Technology
Market Equilibrium: point where supply and demand curves meet.
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Economic Concepts
Price Elasticity of Demand = % change in qty demanded
% change in price
Measurement of Price Elasticity of Demand (2):
1) Point Method: measures the price elasticity of demand at a particular point on the demand
curve.
% Change in = (new demand) - (old demand)
Qty
(old demand)
=Price elasticity of demand
**Answer will be in absolute value
divided by
% Change in
Price
(new price)-(old price)
(old price)
2) Midpoint Method: measure the price elasticity of demand between any 2 points on the D curve.
(Q2 – Q1)/ (Q2 – Q1) = price elasticity of demand (in absolute value)
(P2 – P1)/ (P2 – P1)
Price Inelasticity: absolute price elasticity of demand < 1.0
Price Change will NOT cause a demand change - junky
Price Elasticity: absolute price elasticity of demand > 1.0
Price change WILL cause a demand change.
Unit Elasticity: absolute price elasticity of demand = 1.0
For every % Change in price, the change for demand will be equal and opposite.
Product demand is more elastic w/ more substitutes available but is inelastic if few substitutes are
available. The longer the time period, the more product demand becomes elastic b/c more choices
are available.
Economic Costs are accounting (explicit) costs plus opportunity (implicit) costs.
In the Long run, all resource inputs are variable.
Market Structures (from most to least competitive)
1) Perfect (Pure) competition: very competitive, no individual firm can influence the market price
of its product nor shift the market supply sufficiently to make a good more scarce or abundant.
-Large # of suppliers and customers
-Very little product differentiation
-No barriers to entry
-Firms are price takers
*To maximize short run profits, competitive firms must produce at the output rate where
Price=marginal revenue=marginal cost.
Marginal revenue: additional revenue brought in by producing one additional unit.
Marginal cost: cost of producing one additional unit.
2) Monopolistic Competition: many sellers compete to sell differentiated product in a market into
which the entry of new sellers is possible. (Ex. Starbucks)
-Numerous firms with differentiated products
-few barriers to entry
-ability of firms to have some influence over price and market
-significant non-price competition in the market
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Economic Concepts
3) Oligopoly: market structure in which few sellers dominate the sales of a product and entry of
new sellers is difficult or impossible.
-relatively new firms with differentiated products
-fairly significant barriers to entry
-kinked demand curve (firms match price cuts of competitors but ignore price increases)
4) Monopoly: concentration of supply in hands of a single firm.
-single firm with a unique product
-significant barriers to entry
-ability of firm to set output and prices
-no substitute products
-firm is price setter
-will maximize profits where MR=MC but P>MR
Cartels: firms acting together to coordinate output decisions and control prices as if they were a
monopoly.
Primary Activities: involved in direct manufacture, delivery and support of products
(EX: handling raw materials, manufacturing process, taking orders for product, advertising)
Support Activities: performed by support staff (procurement of materials, mgmt. of employees,
Accounting, financing, strategic planning, etc...)
Vertical Integration: seek to control supplier via backward integration and customer (through
distribution) via forward integration
Michael Porter’s Five Forces that affect competitive environment:
1) Barriers to Entry
2) Market Competitiveness
3) Existence of Substitute Products
4) Bargaining Power of Customers
5) Bargaining Power of Suppliers
Risk-chance of financial loss or uncertainty
Return-total gain or loss experienced on behalf of the owner of an asset over a period of time.
Risk Preferences
1) Risk-Indifferent Behavior: (less common) increase in level of risk would not result in an
increase in mgmts’ RRR
2) Risk-Averse Behavior: (most common) increase in level of risk would result in an increase in
mgmts’ RRR
3) Risk-Seeking: (less common) increase in level of risk would result in decrease in mgmts’ RRR
Low certainty equivalent=low tolerance for risk
Mid certainty equivalent=indifferent
High certainty equivalent=high tolerance for risk
Diversifiable Risk (non-market risk, unsystematic or firm-specific risk)
Portion of an asset’s risk associated with random causes that can be eliminated through
Diversification. Type of risk attributable to firm-specific risk (strikes, lawsuits)
No diversifiable Risk (market or systematic risk)
Attributable to market factors that affect all firms and can’t be eliminated via diversification
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D
U
N
S
Economic Concepts
Diversifiable Risk
Unsystematic Risk (non-market/firm-specific)
No diversifiable Risk
Systematic Risk (market)
Types of Risk
Interest Rate Risk (yield risk): variable interest rates
Market Risk: risk exposure as a result of operating within an economy
Default Risk: risk that debtors may not repay principal or interest
Economic Exposure: potential that PV of CF could increase/decrease due to exchange rates
1) Transaction Exposure: individual transaction
2) Economic exposure: CF
3) Translation Exposure: financial statements
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