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SUMMARY/REVISION
NOTES

Main Reference: Economics, 19th Edition
By: Samuelson & Nordhaus
Jean Christine A
...

Economic efficiency = requires that an economy produce the highest combination of quantity
and quality of goods and services given its technology and scarce resources
...


MICROECONOMICS & MACROECONOMICS
•
•
•
•

•

Microeconomics is the branch of economics which is concerned with the behaviour of
individual entities such as markets, firms and households
...

Macroeconomics is concerned with the overall performance of the economy
...
The theory developed an analysis of what causes
business cycles, with alternating spells of high unemployment and high inflation
...


POSITIVE & NORMATIVE ECONOMICS
•
•

Positive Economics describes the facts of an economy
...


THE THREE PROBLEMS OF ECONOMIC ORGANIZATION
•
•
•

What commodities are produced and in what quantities?
How are goods produced?
For whom are goods produced?

MARKET, COMMAND AND MIXED ECONOMIES
•
•

•

Market economy is one in which individuals and private firms make the major decisions about
production and consumption
...


INPUTS AND OUTPUTS
•

•
•

Inputs are commodities or services that are used to produce goods and services
...
Also known as factors of production
...

Factors of production: Land, labor and capital
...

Points outside the frontier indicate that production is infeasible or unattainable
...
e
...

Societies are sometimes inside their PPF because of macroeconomic business cycles or
microeconomic market failure
...
A
society can also be inside its PPF if markets fail because prices do not reflect social priorities
such as environmental degradation from air and water pollution
...


OPPORTUNITY COSTS
•
•

Refers to the foregone opportunity
...
The opportunity
cost of a decision is the good the value of the good or service foregone
...

Efficiency means that the economy is on the frontier rather than inside the PPF
...

Substitution is the law of life in a full-employment economy and the production possibility
frontier depicts the menu of society’s choices
...
The reason why an economy may lie inside
the PPF (that is—producing less of the required output) is that some resources are
unemployed
...

A market economy is an elaborate mechanism for coordinating people, activities, and
businesses through a system of prices and markets
...

A market is a mechanism through which buyers and sellers interact to determine prices and
exchange goods, services and assets
...
Prices serve as signals to
producers and consumers
...

Prices coordinate the decisions of producers and consumers in a market
...
Lower prices encourage
consumption and discourage production
...


MARKET EQUILIBRIUM
•
•

A market equilibrium represents a balance among all the different buyers and sellers
...
Too high a price would mean a glut of goods with too much output; too low a price
would produce long lines in stores and a deficiency of goods
...


OUTLINE OF MARKET EQUILIBRIUM:
•
•

•

WHAT goods and services will be produced is determined by the dollar votes of consumers in
their daily purchase decisions
...
Best
way for producers to meet price competition and maximize profits: keep costs at a minimum
by adopting the most efficient methods of production
...
Factor markets determine wage
rates, land rents, interest rates and profits
...
e
...

4

PRICES AND MARKETS: CIRCULR FLOW OF MARKET ECONOMY

PRODUCT MARKETS
Demand:
- shoes

- housing
- pizzas

Prices on
Product
Markets

Supply:
- shoes
- housing
- pizzas

WHAT

CONSUMERS

HOW

PRODUCERS

FOR WHOM

FACTOR MARKETS

Supply:
- labor

- land
- capital

Prices on
Factor
Markets
(wages, rents,
interest)

Demand:
- labor
- land
- capital

DISCUSSION:
•
•

•

The diagram provides an overview of how consumers and producers interact to determine
prices and quantities for both inputs and outputs
...
In
the factor markets, consumers sell (supply) factors of production and producers buy (demand)
factors of production
...
Producers base their prices of goods on the costs of labor and
property
...

The distribution of income is determined by the ownership of factors of production (land,
labor and capital) and by factor prices
...

Market failures with invisible hand: (i) monopolies and other forms of imperfect competition;
(ii) spillovers of externalities outside the marketplace (positive externalities such as scientific
discoveries and negative externalities such as pollution); and (iii) income distribution is
politically or ethically unacceptable
...

Modern economies today make extensive use of money which provides the yardstick for
measuring economic values and is the means of payment
...
Capital leverages
human labor into a much more efficient factor of production and allows productivity many
times greater than that possible in an earlier age
...


MONEY: THE LUBRICANT OF EXCHANGE
•
•

Money is the means of payment in the form of currency and checks used to buy things
...

The control of money supply is under the responsibility of the central banks
...

Governments promote equity by using tax and expenditure programs to redistribute income
toward particular groups
...


6

EFFICIENCY
•

Three ways where markets can fall short of efficient perfect competition:
o Imperfect competition such as monopolies
o Externalities such as pollution
o Public goods such as national defense and lighthouses

IMPERFECT COMPETITION
•
•
•
•
•
•

Imperfect competition occurs when a buyer or a seller can affect a good’s price
...

The pattern of too high price and too low output is the hallmark of the inefficiencies associated
with imperfect competition
...
Monopolist is a single supplier who
alone determines the price of a particular good or service
...

Few monopolies can long withstand the attack of competitors unless governments protect
them through tariffs or regulations
...

Externalities or spillover effects occur when firms or people impose costs or benefits on others
outside the marketplace
...


PUBLIC GOODS
•

•

Two key attributes of a public good are: (i) non-rivalry (the cost of extending the service to an
additional person is zero and (ii) non-excludability (it is impossible to exclude individuals from
enjoying it)
...
The government must find the revenues to pay for its public goods and for its income
redistribution programs
...
Taxes are prices paid for
public goods
...


MACROECONOMIC GROWTH AND STABILITY

7

•

•
•
•

Macroeconomic policies for stabilization and economic growth include fiscal policies (of
taxing and spending) along with monetary policies (which affect interest rates and credit
conditions)
...

Monetary policy involves determining the supply of money and interest rates
...


Failure of market
econommy
• Inefficiency
• Monopoly
• Externalities
• Public Goods
• Inequality
• Unacceptable
inequalities of income
and wealth
• Macroeconomic problems
• Business cycles (high
inflation and
unemployment)
• Slow economic growth

Gov ernment intervention

Current examples of
government policy

• Encourage competition
• Intervene in markets
• Encourage beneficial
activities

• Anti-trust laws, deregulation
• Anti-pollution laws, antismoking ordinances
• Provide public education, build
roads

• Redistribute Income

• Progressive taxation of income
and wealth
• Income support or transfer
programs

• Stabilize through
macroeconomic policies
• Stimulate growth

• Monetary policies
• Fiscal policies
• Improve efficiency of tax system
• Raise national savings rate by
reducing budget deficit or
increasing budget surplus
...

Theory of supply and demand: shows how consumer preferences determine consumer
demand for commodities, while business costs are the foundation of the supply of
commodities
...

The changes in supply and demand drive the changes in output and prices
...

Law of downward sloping demand: when the price of a commodity is raised, buyers tend to
buy less of the commodity
...
demanded tends to fall when price increases for two reasons:

8

o
o

Substitution effect: occurs because a good becomes relatively more expensive when
its price rises
...


MARKET DEMAND
•
•

The fundamental building block for demand is individual preferences
...


FORCES BEHIND THE DEMAND CURVE
•
•
•
•
•

Average income of consumers: Key determinant of demand
...

Size of the market
Prices of related goods: Demand for good A tends to be low if the price of substitute product
B is low
...

Special Influences: weather conditions (i
...
, demand for air conditioners is high in a sunny
and warm area)
...


MOVEMENTS ALONG CURVES VS
...

If prices change, there will be a change in QUANTITY DEMANDED and thus, there will be a
movement ALONG the demand curve
...


SUPPLY CURVE
•
•

Upward sloping curve: quantity supplied increases as price of that good increase
...


FORCES BEHIND THE SUPPLY CURVE
•

Cost of production: one major element underlying the supply curve
...


9

o

•
•

•

Prices of inputs: The prices of inputs such as labor, energy or machinery have a very
important influence on the cost of producing a given level of output
...

o Technological Advances: Consist of changes that lower the quantity of inputs needed
to produce the same quantity of output
...

Government policy: Taxes and minimum wage laws can significantly affect input prices
...
Example: when a free-trade
agreement opens up the U
...
market to Mexican footwear, the total supply of footwear in the
U
...
increases
...


EQUILIBRIUM OF SUPPLY AND DEMAND
•
•

Market equilibrium comes at that price and quantity where the forces of supply and demand
are in balance
...


SUPPLY, DEMAND AND IMMIGRATION
•
•

Immigration alone: causes the supply of labor to increase; thus, lowering the wages
...


RATIONING BY PRICES
•
•

•

•

The marketplace, through the interaction of supply and demand, does the rationing
...

WHAT goods are produced? This is answered by the signals of market price
...
Those who have the most dollar votes have the greatest influence
on what goods are produced
...
Those with higher incomes end up with larger houses, fancier cars and
longer vacations
...


PART TWO: MICROECONOMICS (SUPPLY, DEMAND AND PRODUCT MARKETS)
CHAPTER 4: SUPPLY AND DEMAND (ELASTICITY AND APPLICATIONS)
10

PRICE ELASTICITY OF DEMAND
•
•

•
•
•
•

•
•

•

The quantitative relationship between price and quantity purchased is analyzed using the
concept of elasticity
...
It is the percentage change in quantity demanded divided by the percentage change
in price
...

When the price elasticity of a good is low, we say that the good is “inelastic” and its quantity
demanded responds little to price changes
...

The length of the time that people have to respond to price changes also plays a role
...
In the long-run, however, you can
adjust your behaviour to the higher price of gasoline
...

The ability to adjust consumption patterns implies that demand elasticities are generally
higher in the long-run than in the short-run
...
Price elasticities tend to be higher (elastic) when the goods are
luxuries, when substitutes are available and when consumers have more time to adjust their
behaivor
...


CALCULATING

ELASTICITIES
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑡𝑦
...

Demanded, the good has
price-elastic demand (𝑬𝒅 > 1)
...
demanded, the good has price-inelastic demand (𝑬𝒅 < 1)
...
demanded, the good
is a unit-elastic demand
...
demanded is > % change in price)
Ed = 1
Ed < 1 (% change in qty
...

∆𝑸

Q
0
10
20
30

10 = (10-0)
10 =(20-10)
10 = (3020)

P

∆𝑷

𝑸𝟏 + 𝑸𝟐
𝟐

𝑷𝟏 + 𝑷𝟐
𝟐

6
4
2
0

2
2
2

5 =(10+0)/2
15=(20+10)/2
25=(30+20)/2

5
3
1

𝑬𝒅 =

∆𝑸
∆𝑷
÷
(𝑸𝟏+𝑸𝟐)/𝟐
(𝑷𝟏+𝑷𝟐)/𝟐

(10/5)/(2/5)=5 (elastic)
(30/30) = 1 (unit elastic)
1/5 (inelastic)

ELASTICITY AND REVENUE
•
•
•

Ed < 1: When demand is price inelastic, a price decrease reduces total revenue (this is because
qty
...

Ed > 1: When demand is price elastic, a price decrease increases total revenue (this is because
a decrease in price will lead to more qty
...

Price discrimination is the practice of charging different prices for the same service to
different customers (i
...
, airline companies)
...
It is the
percentage change in quantity supplied divided by the percentage change in price
...

𝐸𝑠 =

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑡𝑦
...
cases of supply elasticity):
a) Es = 0
b) Es = 1

c) Es = ∞

(a) = perfectly inelastic supply (quantity supplied will not change due to any changes in price
...

FACTORS INFLUENCING SUPPLY ELASTICITY:
•

•

The major factor influencing supply elasticity is the ease with which production in the industry
can be increased
...
This
would indicate that supply elasticity is relatively large
...

Another important factor in supply elasticities is the time period under consideration
...
For very brief periods after a price increase, firms may be unable to
increase their inputs of labor, materials and capital, so supply may be very price-inelastic
...


APPLICATIONS TO MAJOR ECONOMIC ISSUES:
1
...

Supply also increases due to important advances that include modernization through
tractors, combines, and cotton pickers; fertilization and irrigation; selective breeding
and development of genetically modified crops
...


13

•

What must happen at the new competitive equilibrium? Sharp increases in supply
outpaced modest increases in demand, producing a downward trend in farm prices
relative to other prices in the economy
...


Crop Restrictions
S’

S

E’

B
Price
A

After crop
restrictions
E

Before crop
restrictions

Quantity

•

•

How can reducing production actually help farmers raise their incomes? Because the demand
for food is inelastic, crop restrictions not only raise the price of crops but also tend to raise
farmers’ total revenues
...
They often raise the income of one group at the expense of consumers
...


2
...
Prudent legislators would of course be reluctant to raise gasoline taxes so sharply
without knowing tax incidence
...

S’
S

3
...
8
2
...

The demand curve does not shift because the quantity demanded at each retail price is
unchanged by the gasoline tax increase
...

The reason why supply curve shift upwards by $2 is that producers are only willing to sell a
given quantity only if they will receive the same net price as before
...

Tax incidence: The oil industry only pays a small fraction for it receives $1
...

But the consumer bears most of the burden because supply is price-elastic while demand is
price-inelastic
...
Impact of Subsidies
•

Subsidies are used to encourage production
...
General Rules on Tax Shifting
•
•
•
•

The key issue in determining the incidence of a tax is the relative elasticities of supply and
demand
...
e
...

If supply is inelastic relative to demand (i
...
, land), then most of the tax is shifted to suppliers
...


15

5
...
Minimum Wage Controversy
Effects of a Minimum Wage

Wmin

Wmarket

E

U

S

LF

M

D

Unskilled Labor

•

•

The above figure depicts the market for unskilled workers
...
As the minimum wage rises above the market-clearing
equilibrium at M, the total number of jobs moves up the demand curve to E, so employment
falls (shown as the difference between M and E)
...
Using the supply
and demand, we see that unemployment rises and the number of employed unskilled workers
decreases
...

(Policy question: Is increasing minimum wage an efficient policy action?) The impact on
incomes is yet another reason why people may disagree about the minimum wage
...
Others, who worry more about the
cumulative costs of market interferences or about the impact of higher costs upon prices,
profits or international competitiveness may hold that the inefficiencies are too high a price
...
wage subsidies or direct income transfers
rather than gumming up the wage system
...
Energy Price Controls (Maximum Price Ceiling)

16

•
•

Effect of price ceiling: Suppose the initial price of gasoline is $2 per gallon
...

What will happen if there is price control? The figure below will provide an explanation
...
Without a legal price ceiling, price would
rise to E
...

Some method of formal or informal rationing is needed to allocate the short supply and bring
the actual demand down to supply at RR
...
At the
ceiling price of $2, coupons would sell for $3, and the total price (coupons plus cash) would
be $5
...
Initially, this may be done
through a first-come, first-served basis
...

When rationing is adopted, shortages disappear because demand is limited by the allocation
of the coupons
...
e
...


CHAPTER 5: DEMAND AND CONSUMER BEHAVIOR
Marginal Utility and the Law of Diminishing Marginal Utility

17

•
•
•
•

Utility denotes satisfaction
...

The increment to one’s utility is called marginal utility
...

Law of Diminishing Marginal Utility: States that the amount of extra or marginal utility
declines as a person consumes more and more of a good
...


Equimarginal Principle: The fundamental condition of maximum satisfaction or utility is the
equimarginal principle
...

•

Marginal Utility of Income measures the additional utility that would be gained if the
consumer could enjoy an extra dollar’s worth of consumption
...
Substitution Effect
• When price of a good rises, consumers tend to substitute other goods for the more expensive
good in order to satisfy their desires more inexpensively
...
Income Effect
• When a price rises and money income is fixed, real income falls because the consumer cannot
afford to buy the same quantity of goods as before
...

• Most goods respond positively to higher incomes so the income effect will normally reinforce
the substitution effect in producing a downward sloping demand curve
...

𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 =

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

FROM INDIVIDUAL TO MARKET DEMAND
•

The demand curve for a good for the entire market is obtained by summing up the quantities
demanded by all the consumers
...

18

•
•
•
•
•
•
•
•
•
•

Goods are said to be complements when an increase in the price of good A causes a decrease
in the demand for its complementary good B
...

The income effect is the change in the quantity demanded of a good because the change in
its price has the effect of changing a consumer’s real income
...

Goods are independent if a price change for one has no effect on the demand for the other
...

Low price elasticities exist for those goods which are essential to daily life and which have no
close substitutes
...

Income elasticities are high for luxuries whose consumption grows rapidly relative to income
...


THE ECONOMICS OF ADDICTION
Market for Addictive Substance
S’ (illegal drugs)
A

Pillegal

B
S (legal drugs)

Plegal

C

H

D
O

•

•

F

G

The demand curve is extremely price inelastic for established users of the addictive substance
...
As a result, if
prohibition or heavy taxation shifts supply from S to S’, total spending on drugs will rise from
OHCG to OABF
...

Many drugs appear to be close substitutes rather than complements
...


19

CONSUMER SURPLUS
•

•
•

The gap between the total utility of a good and its total market value is called the consumer
surplus
...
It measures
the extra value that consumers receive above what they pay for a commodity
...


INDIFFERENCE CURVE
•

An alternative and more advanced approach to deriving demand curves
...


LAW OF SUBSTITUTION
•
•

•

•

The scarcer a good, the greater its relative substitution value; its marginal utility rises relative
to the marginal utility of the good that has become plentiful
...

The slope of the IC is the measure of the goods’ relative marginal utilities, or of the
substitution terms on which the consumer would be willing to exchange a little less of one
good in return for a little more of the other
...
As the amount of food you consume
goes up and the quantity of clothing goes down – food must become relatively cheaper in
order for you to be persuaded to take a little extra food in exchange for a little sacrifice of
clothing
...


BUDGET LINE/BUDGET CONSTRAINT
•

Is a straight line that sums up all the possible combinations of the two goods that would just
exhaust the consumer’s income
...
At
this point, the consumer’s substitution ratio is just equal to the slope of the budget line
...


20

𝑝1
𝑝2

𝑀𝑈

•

Equilibrium condition:

•

2 impt
...
)

(ratio of the prices) = (substitution ratio) 𝑀𝑈1
...

To understand why productivity and living standards have risen over time and how firms
manage their internal activities, it is important to understand the fundamentals of production
theory
...
It specifies the maximum output that can be
produced with a given quantity of inputs
...

Three important production concepts: total, average and marginal products
...
The output produced increases as
additional units of labor applied also increases
...

Average product (AP) is total output divided by total units of input
...
The MP of each unit of input will decline as the
amount of that input increases, holding all other inputs constant
...
The land gets more crowded, the machinery is
overworked and the marginal product of labor declines
...
For
Labor
example, living standards in crowded Rwanda or Bangladesh are low because there are so
many workers per acre of land and not because farmers are ignorant or fail to respond to
economic incentives
...

21

RETURNS TO SCALE
•
•

•
•
•

Refers to the effects of scale increases of inputs on the quantity produced
...
k
...

economies of scale) arise when an increase in all inputs leads to a more-than-proportional
increase in the level of output; (iii) decreasing returns to scale (DRS) occur when a balanced
increase of all inputs leads to a less-than-proportional increase in total output
...
Example:
providing clean water to a city shows DRS
...

Firms may divide production into smaller steps, taking advantage of specialization and division
of labor
...
It measures
the ratio of total output to a weighted average of inputs
...

Productivity grows because of:
o Technological advances (process and product innovation)
o Economies of Scale = increases in productivity or decreases in average cost of
production, that arise from increasing all the factors of production in the same
proportion
...
It is like the specialization and division of
labor that increases productivity as economies become larger and more diversified
...

Sometimes called as overhead or sunk costs
...

o Variable Costs (VC) = represents expenses that vary as output changes
...
VC begins at zero when q (output) is zero
...

o Total Costs (TC) = FC + VC
...
TC rises as output rises
...
It denotes the extra or
additional cost of producing 1 extra unit of output
...


THREE NEW MEASURES OF COSTS:
1
...
AC is the total cost divided by the total number of units produced
...
Average Fixed Costs (AFC) = FC/q
...
As a firm sells more output,
it can spread its overhead cost over more and more units
...
Average Variable Costs (AVC) = VC/q
...

THE RELATION BETWEEN AVERGAE COST AND MARGINAL COST
Rule 1: When MC is below AC, it is pulling AC down
Rule 2: When MC is above AC, it is pulling AC up
...
At the bottom of a U-shaped AC, MC=AC=minimum
AC
...
This implies that the new AC (the AC including the last unit) must be
less than the old AC, so AC must be falling
...

THE LINK BETWEEN PRODUCTION AND COSTS
•

What are the factors that determine the cost curves?:
o Factor prices = the prices of inputs like labor and land are important ingredients of
costs
...

o Firm’s production function = if technological improvements allow the firm to produce
the same output with fewer inputs, the firm’s costs will fall
...
In such situation, there are diminishing returns
to the variable factor (labor) because each additional unit of labor has less capital to work
with
...
In other words, diminishing returns to the variable factor will imply an
increasing SR MC
...
A corollary of the least-cost rule is the substitution
rule
...


CHAPTER 8: ANALYSIS OF PERFECTLY COMEPTITIVE MARKETS
•

2 key assumptions for perfectly competitive firm:
o Competitive firm maximizes profits
...

Demand curve is perfectly elastic (horizontal demand curve)
The extra revenue gained from each extra unit sold is therefore the market price
...
The reason underlying this
proposition is that the competitive firm can always make additional profit as long as the price
is greater than the MC of the last unit
...

Shutdown point: losses exactly equal fixed costs
...
For prices below the shutdown point, the firm will
produce nothing at all because by shutting down the firm will only lose its fixed costs
...
When price falls below average variable costs, the firm will
maximize profits (minimize its losses) by shutting down
...


SUPPLY BEHAVIOR IN COMPETITIVE INDUSTRIES
•

Effect of Increase in Demand on Price Under Two Different Time Periods:
a
...
) Long-run equilibrium
P
’
SL

•

•

D’
D’
In the short-run, only variable
inputs or factors (i
...
, labor) can be adjusted orDchanged
...

adjustments (since output changes must
The longer the time for adjustments, the greater the elasticity of supply response and the
smaller the rise in price since there is full adjustment of all factors and there is also free entry
and exit of firms into and from the industry
...

With free entry and exit, and any number of firms able to produce on identical, unchanged
cost curves, the long-run supply curve will be horizontal at each firm’s minimum average cost
or zero-profit price
...
e
...
The long-run supply curve of industries using scarce factors rises because of
diminishing returns
...
But, each dose of labor applied costs the same in
wages, so the MC rises
...


LONG-RUN FOR A COMPETITIVE INDUSTRY
25

•
•
•

•
•

Firms shut down when they can no longer cover their variable costs
...

In the long-run, firms will produce output only when price is at or above the zero-profit
condition where price equals average cost (P=AC)
...

Zero-economic-profit long-run equilibrium condition in competitive industry:
P=MC=minimum long-run AC
...
Profitable industries tend to attract entry of new firms, thereby driving down prices
and reducing profits toward zero
...

SPECIAL CASES OF COMPETITIVE MARKETS
•
•

Demand Rule: the relationship between price and demand of commodity is direct/positive
...


CONSTANT-COST CASE
RETURNS
P

INCREASING

COST

&

DIMINISHING

P

Constant cost
supply curve

Increasing cost
supply

Q

Q

FIXED SUPPLY AND ECONOMIC RENT
•

When the quantity supplied is constant at every price, the payment for the use of factor of
production is called rent or pure economic rent
...
Quantity supplied is
unchanged
...

When a tax is placed upon the fixed commodity, the tax is completely paid by (or shifted back
to) the supplier (say, the landowner)
...
The consumer buys exactly as much of the good or service as before and at no higher
price
...

As improved technology raises real wages, people feel that they want to take part of their
higher earnings in the form of more leisure and early retirement
...
of labor
•

At first, the labor supplied rises as higher wages coax out more labor
...
An increase in
demand raises the price of labor
...


EFFICIENCY AND EQUITY OF COMPETITIVE MARKETS
1
...

• The concept of Pareto efficiency (alternatively called allocative efficiency, Pareto optimality,
or simply efficiency)
...
Under
conditions of allocative efficiency, one person’s satisfaction or utility can be increased only by
lowering someone else’s utility
...
Efficiency of Competitive Equilibrium
• The allocation of resources in a perfectly competitive market is efficient on the assumption
that all markets are perfectly competitive and that there are no externalities like pollution or
imperfect information
...

• Economic surplus = is the welfare or net utility gain from production and consumption of a
good; it is equal to the consumer surplus plus the producer surplus
...
As a
result, every person is gaining P utils of satisfaction from the last unit of food
consumed
...
It is exactly this
condition—that the marginal gain to society from the last unit consumed equals the
marginal cost to society of that last unit produced—which guarantees that a
competitive equilibrium is efficient
...

A perfectly competitive economy is efficient when marginal private cost = marginal social cost
and when both equal marginal utility (MPC=MSC=P=MU)
...


MARGINAL COST AS A BENCHMARK FOR EFFICIENCY
•
•

MC is important in attaining an efficient allocation of resources
...

28

SHORTCOMINGS OF THE PERFECT COMPETITIVE MARKET
1
...
Occurs when a certain firm has market power in a particular market
(say it has monopoly power)
...
Externalities arise when some of the side effects of production or consumption are not
included in market prices
...
Imperfect information
...
A society may choose to alter market outcomes
to improve the equity or fairness of the distribution of income and wealth
...


CHAPTER 9: IMPERFECT COMPETITION AND MONOPOLY
Patterns of Imperfect Competition
•
•
•

•

Prices are higher and outputs are lower
...

Imperfect competition prevails in an industry whenever individual sellers can affect the price
of their output
...

Imperfect competition does not imply that a firm has absolute control over the price of its
product
...
) Firm demand under Perfect Competition
Competition
P

b
...

29

•

The imperfect competitor will find that its demand curve slopes downward as higher price
drives sales down
...

Another way of seeing the difference between perfect and imperfect competition is by
considering the price elasticity of demand
...

The fact that the demand curves of imperfect competitors slope downwards has an important
implication: imperfect competitors are price makers rather than price takers
...

•
•
•

Monopoly
A single seller with complete control over an industry
...

In the long-run, no monopoly is completely secured from attack by competitors
...


2
...

The decision of a single firm to lower price can set off a price war which brings down the prices
charged by all its competitors
...

•
•
•

Monopolistic competition
A large number of sellers produce differentiated products
...

Location is important in product differentiation
...

Product quality is also important feature of product differentiation today
...
Under these conditions, large firms can simply produce
more cheaply and then undersell small firms, which cannot survive
...

1
...
The key is whether there are economies of scale in an
industry
...
Bigger firms will have a cost advantage over smaller firms
...
) Perfect Competition
Monopoly
AC, MC,
P

b
...
)

AC, MC, P
MC

AC

Natural

AC, MC, P
MC
AC
AC
MC

D

Q

D

Q

D

Analysis of Graphs:
a
...
As a result, this industry can support the large number of efficiently
operating firms that are needed for perfect competition
...
) Economies of scale are large relative to the size of the industry
...
The industry
31

Q

demand curve allows only a small number of firms to co-exist at the point of minimum AC
...

c
...
With perpetual increasing
returns to scale, average and marginal costs fall forever
...

2
...
When barriers are high, an
industry may have few firms and limited pressure to compete
...

2
...
Legal restrictions: include patents, entry restrictions and foreign-trade tariffs and quotas
...
Patents are one of the few forms of government-granted
monopolies that are generally approved of by economists
...
Government also impose tariffs; governmentimposed import restrictions have the effect of keeping out foreign competitors
...
2
...
e
...

2
...
Advertising and product differentiation: Advertising can create product awareness and
loyalty to well-known brands (i
...
, pepsi and coca-cola spend hundreds of millions of dollars
every year just for advertising their brands)
...
The demands for
each of the individual differentiated products will be so small that they will not be able to
support a large number of firms operating at the bottom of their U-shaped cost curves
...
Marginal revenue
(MR) can either be positive or negative
...


a
...
) TR

P/q

P/q

Ed = 1

Ed > 1

Ed < 1
32

q

q

ELASTICITY AND MARGINAL REVENUE
• MR is positive when demand is elastic, zero when demand is unit-elastic and negative when
demand is inelastic
...
MR is the change in revenue that is generated by an additional unit of sales
...
P = AR
3
...
For perfect competitors, P = MR = AR
5
...
-profit P* and Q*
...

PERFECT COMPETITION AS A POLAR CASE OF IMPERFECT COMPETITION
1
...
Price and
marginal revenue are identical for perfect competitors
...

2
...
Because a perfect competitor can sell all it wants at
the market price, MR = P = MC at the maximum-profit level of output
...

• Make decisions based on marginal costs and marginal benefits
...

CHAPTER 10: COMPETITION AMONG THE FEW
33

Measures of Market Power
•
•

•
•

•

Market power signifies the degree of control that a single firm or a small number of firms have
over the price and production decisions in an industry
...
The four-firm
concentration ratio measures the fraction of the market or industry accounted for by the four
largest firms
...

An alternative measure of market power, which better captures the role of dominant firms is
the Herfindahl-Hirschman Index (HHI)
...

Perfect competition would have an HHI of near zero because each firm produces only a small
percentage of the total output, while complete monopoly would have an HHI of 10,000
because one firm produces 100% of the output (1002 = 10,000)
...
Costs
...

2
...
When there are large economies of scale or government restrictions
to entry, these will limit the number of competitors in an industry
...
Strategic interaction
...
Occurs when each firm’s business depends upon the behavior of its
rivals
...
Collusive oligopoly
• When only a few firms operate in a market, they see what their rivals are doing and
react
...
Non-cooperative behavior produces price
wars
...

• When firms in an oligopoly actively cooperate with each other, they engage in
collusion
...

• Oligopolists often merged or formed a trust or cartel
...

Collusive Oligopoly Looks Much Like Monopoly
P

MC

AC

34

Profit

D

MR

Q

Downside Risks of Collusion:
1
...
Firms may cheat on the agreement by cutting their price to selected customers, thereby
increasing their market share
...

3
...

Organization of Petroleum Exporting Countries (OPEC)
• One problem of OPEC is that it must negotiate production quotas rather than prices
...

2
...

• Because of product differentiation, seller has some freedom to raise or lower prices
...
) Monopolistic competitors (MC)
profit

b
...
They point to an excessive number
of trivially different products that lead to wasteful duplication and expense

35

3
...

PRICE DISCRIMINATION
•
•
•

When firms have market power, they can sometimes increase their profits through price
discrimination
...

Some examples of price discrimination:
o Identical textbooks are sold at lower prices in Europe than in the United States
...
However,
as an individual, you might well reduce the costs of your books by buying them abroad
through online bookstores
...
They segment the market by pricing
tickets differently for those who travel in peak or off-peak times, for those who are
business or pleasure travellers, and for those who are willing to stand by
...
k
...
nonlinear prices) to recover some of
their overhead costs
...
Since connection is much more price-inelastic than per unit
prices, utility providers are able to lower per-unit prices to increase the quantity sold
...
They will therefore sell at lower prices abroad than at home
...

o Sometimes a company will actually degrade its top-of-the-line product to make a less
capable product, which it will then sell at a discounted price to capture a low-price
market
...


Economic effects of price discrimination:
•

Price discrimination improves economic welfare
...
In doing so, they may capture the market for eager buyers but
lose the market for reluctant buyers
...


GAME THEORY
• Game theory is a world wherein decisions reach the stage of thinking about what your
opponent is thinking, and how you would then react
...

•

Findings of game theorists in the area of imperfect competition:
36

o

•

•

Large number of non-cooperative oligopolists => perfectly competitive industry P* &
Q*
o Colluding firms create market price and quantity that is close to those generated by
monopoly
...

o In many situations, there is no stable equilibrium for an oligopolistic market
...

Game theory analyzes the ways in which two or more players choose strategies that jointly
affect each other
...

Game theory studies the interaction of oligopolists, union-management disputes, countries’
trade policies, international environmental agreements, reputations and a host of other
topics
...

• Example of Pay-off table for a Price war:

Normal Price*

Price War

+

A
$10
C
-$100

EZBooks’ Price
Normal Price*
$10 B
-$10
-$10 D
-$50

Price War
-$100
-$50

* Dominant strategy
+ Dominant equilibrium
•

Four possible outcomes of the two decisions of each duopolists:
o Cell A (light orange shade) = outcome when both firms choose the normal price
o Cell D (light orange shade) = outcome when both choose to conduct a price war
o Cell B (light green shade) = outcome when EZBooks play war price and Amazing’s plays
normal price
...

• The numbers inside the cell are profits (gains and losses) earned by each firm for each of the
four outcomes
...

Dominant strategy

37

•
•

This situation arises when one player has a single best strategy no matter what strategy the
other player follows (i
...
, normal price)
When both players have a dominant strategy, the outcome is a dominant equilibrium
...

• Example:
EZBooks’ Price
High Price
Normal Price*
+
High Price
A
$200 B
$150
$100
-$20
C
-$30 D
$10
Normal Price*
$150
$10
* Nash equilibrium
•

•

Outcomes:
o Cell A = outcome when firms could collude and set the monopoly price
...

o Cell C = EZBooks charge high price and losses $30 of profit whil Amazing’s charge
normal price and gain a profit of $150
o Cell B = Amazing’s gamble on high price and losses $20 of profit while EZBooks charge
normnal price and gain a profit of $150
...
Is sometimes called the non-cooperative equilibrium because each party
choose the strategy which is best for himself – without collusion or cooperation and without
regard for the welfare of society or any other party
...

1
...
e
...
It involves the control of prices, entry
and exit conditions, and standards of service
...
Antitrust policy = laws that prohibit certain kinds of behavior (i
...
, firms joining together to fix
prices) or curb certain market structures (i
...
, pure monopolies and highly concentrated
oligopolies)
...

• Governments override the decisions made in the marketplace in order: (i) to prevent abuses
of market power by monopolies or oligopolies; (ii) to remedy informational failures such as
38

those which occur when consumers have inadequate information; and (iii) to prevent
externalities like pollution
...

• Attacks anti-competitive abuses in 2 different ways: (i) prohibit certain kinds of business
conduct such as price fixing that restrain competitive forces; (ii) restrict some market
structures such as monopolies
...

This is done by buying when goods are abundant and prices are low and selling when goods
are scarce and prices are high
...
It is the purchase of a
good or asset in one market for immediate resale in another market in order to profit from a
price discrepancy
...

SPECULATION AND PRICE BEHAVIOR OVER TIME
• By moving goods over time from periods of abundance to periods of scarcity, the speculator
is buying where the price and marginal utility of the good is low and selling where the price
and marginal utility are high
...

SHEDDING RISKS THROUGH HEDGING
• Hedging consists of reducing the risk involved in owning an asset or commodity by making an
offsetting sale of that asset
...

ECONOMIC IMPACTS OF SPECULATION
• Speculative markets serve to improve the price and allocation patterns across space and time
as well as to help transfer risks
...

RISK AND UNCERTAINTY
• A person is risk-averse when the pain from losing a given amount of income is greater in
magnitude than the pleasure from gaining the same amount of income
...

• Risk-aversion is the same as diminishing marginal utility of income
...

• People are generally risk-averse, preferring a sure thing to uncertain levels of consumption;
people prefer outcomes with less uncertainty and the same average values
...


HEALTH CARE AS A SOCIAL INSURANCE PROGRAM
• 3 Reasons why health care is considered as a social insurance program:
o Many aspects of the health-care system such as the prevention of communicable
diseases and the development of basic science are public goods that the market will
not provide efficiently
...
One
significant reason for this failure is the presence of asymmetric information among
patients, doctors and insurance companies
...
Good health care is also a good social investment
...
Health services or goods are allocated
equitably; hence, rationing of prices is not auctioned to the highest bidders
...

• Nonprice rationing in the medical market:
Price of medical care

Pm
Gov’t
...
of medical care
Q0

•
•

D
Q1

When governments provide free or subsidized access to medical care, some way must be
found to ration out limited services
...
supplied, the
excess demand must be choked off by some mechanism other than price (i
...
nonprice
rationing)
...


INNOVATION AND INFORMATION
• Information is expensive to produce but cheap to reproduce; hence, subject to market
failures
...
Case studies have found that the social return to invention (the value of an
40

•

invention to all consumers and producers) is many times the appropriable private return to
the inventor (the monetary value of the invention to the inventor)
...


INTELLECTUAL PROPERTY RIGHTS (IPR)
• Governments have long recognized that creative activities need special support because the
rewards for producing valuable information are reduced by imitation
...

• If IPRs are too strong, this will lead to high prices and monopoly losses while too weak IPR will
discourage invention and innovation
...
The aggregate of all incomes is called the NATIONAL
INCOME
...
The remainder goes to the different types of property (factor) income: rent,
net interest, corporate profits and proprietors’ income
...

• The key to incomes lies in the marginal products of different factors of production
...

THE NATURE OF FACTOR DEMANDS
• Demand for factors differs from that of consumption goods in 2 important respects: (i) factor
demands are derived demands; and (ii) factor demands are interdependent demands
...
This means that when firms demand an input, they do so because
that input permits them to produce a good which consumers desire now or in the future
...

• It is the interdependence of productivities of land, labor and capital that makes the
distribution of income a complex topic
...
The MRP of input A is the additional revenue produced by an additional unit of
input A
...


41

•

Marginal Revenue Product of Labor: 𝑴𝑹𝑷𝑳 = 𝑴𝑹 𝒙 𝑴𝑷𝑳

•

Marginal Revenue Product of Land: 𝑴𝑹𝑷𝑨 = 𝑴𝑹 𝒙 𝑴𝑷𝑨

•

𝑴𝑷𝒊 𝒙 𝑷 = 𝒇𝒂𝒄𝒕𝒐𝒓 𝒑𝒓𝒊𝒄𝒆 => Least-Cost Rule:

•

To maximize profits: add inputs up to the point where the MRP of the input equals the MC or
P of the input
...
This holds
for both perfect and imperfect competitors in the product markets
...
As the
workforce increases its education and skills, productivity of labor increases also
...

DETERMINANTS OF LABOR SUPPLY
• 3 Key elements for labor supply:
o Hours worked = backward bending supply curve of labor (substitution and income
effect)
o Labor force participation = the entry of women in labor workforce
...
e
...

• Differences in people: labor quality
o Part of the high salaries of professionals should be viewed as a return on their
investment in human capital – a return on the education that makes these highly
trained workers a very special kind of labor
...

o The excess of the wages of these unique individuals above those of the next-best
available occupation are pure economic rent
...
People are all alike – jobs are all alike
No wage differentials
2
...
People differ, but each type of labor is in
unchangeable supply (non-competing
groups)
4
...

General-equilibrium
pattern
of
wage
differentials as determined by general demand
and supply

THE ECONOMICS OF LABOR UNIONS
• The study of unions is an important part of understanding the dynamics of labor markets
...

• Collective bargaining is the process of negotiation between representatives of firms and of
workers for the purpose of establishing mutually agreeable employment conditions
...

EFFECTS ON WAGES AND EMPLOYMENT
• If unions succeed in raising their wages above competitive levels, their gains come at the
expense of the wages of non-union workers
...
The unemployment will not respond to the traditional macroeconomic policy of
increasing aggregate spending but rather will require remedies that will lower real wages
...
Wage differences arose because certain groups were excluded
from the good jobs by their inability to obtain education and training and by the force of
custom, law or collusion
...

• When markets do not capture all the costs and benefits of using natural resources, and
externalities are therefore present, markets give the wrong signals and prices are distorted
...

EFFECT OF TAXING LAND
• A tax on rent will lead to no distortions or economic inefficiencies because a tax on pure
economic rent does not change anyone’s economic behavior
...

• The behavior of suppliers is unaffected because the supply of land is fixed and cannot react
...

A polar case of public externality is a public good which is a commodity that can be provided
to everyone as easily as it can be provided to one person
...

Private goods are ones that can be divided up and provided separately to different individuals
with no external benefits or costs to others
...

• Socially efficient pollution: given that private decisions on pollution control are inefficient,
efficiency requires that the marginal social benefits (MSBs) from abatement should equal the
marginal social costs (MSCs) of abatement
...

• CBA will show that “no risk” or “zero-discharge” policies are generally wasteful
...

• Generally, economic efficiency calls for a compromise, balancing the extra value of the
industry’s output against the extra damage from pollution
...

POLICIES TO CORRECT EXTERNALITIES
1
...
Called as social regulations
b
...

c
...
Also,
standards are inherently a very blunt tool
...
Market solution: emission fees
a
...
This is in effect internalizing the externality by making the firm pay the social
costs of its activities
...
Market solution: tradeable emissions permits
a
...


44

b
...

PRIVATE APPROACHES
1
...

2
...

Chapter 15 – CAPITAL, INTEREST AND PROFITS
THE RATE OF RETURN ON INVESTMENTS
• Also referred to as interest rate
...

• The returns will vary greatly depending upon the maturity, risk, tax status, and other attributes
of the investment
...

•

𝒓𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 =

𝒏𝒆𝒕 𝒂𝒏𝒏𝒖𝒂𝒍 𝒅𝒐𝒍𝒍𝒂𝒓 𝒓𝒆𝒄𝒆𝒊𝒑𝒕𝒔 (𝒓𝒆𝒏𝒕𝒂𝒍𝒔−𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔)
𝒅𝒐𝒍𝒍𝒂𝒓 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒕𝒉𝒆 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒈𝒐𝒐𝒅

PRESENT VALUE OF ASSETS
• Present value is the dollar value today of a stream of future income
...

•
•
•

𝑽=

$𝑵
𝒊

(Present value for perpetuities) where: V = present value of the investment; $N =

perpetual annual receipts ($ per year); and i = interest rate
Future payments are worth less than current payments just as distant objects look smaller
than nearby ones
...

• Example: given a 1-year bond with a $1000 bond returns and an initial interest rate of 5% per
year, the current present value of bond is $1000/1
...
38
...
10 = $909
...

Hence, the price of the asset declined as the interest rate increased
...


45

•

•

Longer-term securities generally command a higher interest rate than do short-term ones
because lenders are willing to sacrifice quick access to their funds only if they can increase
their yield
...


BASIC CAPITAL THEORY
• Roundaboutness: investment in capital goods involves foregoing present consumption to
increase future consumption
...
However, the rate of return on
capital has not fallen markedly over the course of the last 2 centuries even though capital
stocks have grown manyfold
...

DETERMINATION OF INTEREST AND THE RETURN ON CAPITAL
• The quantity of capital and the rate of return on capital are determined by the interaction
between (i) impatience to consume now rather than accumulate more capital goods for future
consumption and (ii) investment opportunities that yield higher or lower returns to such
accumulated capital
...
When capital is very scarce,
the most profitable projects have a very high rate of return
...

DETERMINANTS OF PROFITS
1
...
Much of the reported business profits is primarily the return to the owners of the firm
for the factors of production, including capital and labor provided by the owners
...
Profits as rewards for risk-bearing
a
...
All of
these risks must either be insured against or earn a risk premium in profits
...
Profits as reward for innovation
a
...
These profit earnings are temporary and are soon
competed away by rivals and imitators
...

b
...
Taxes on incomes and goods and services
...
Expenditures on certain goods or services along with transfer payments that provide
resources to individuals
...
Regulations that direct people to perform or refrain from certain economic activities
...
Improving economic efficiency
• Microeconomic side of government policy: assist in the socially desirable allocation of
resources; it concentrates on the “what” and “how” of economic life
...
Reducing economic inequality
• Government perform the role of the “welfare state”
...
Stabilizing the economy through macroeconomic policies
• Government has the responsibility of preventing business depressions through the proper use
of fiscal and monetary policy as well as the regulation of the financial system
...

4
...

o Coordinating macroeconomic policies
o Protecting the global environment
PUBLIC CHOICE THEORY
• Branch of economics and political science that studies the way that governments make
decisions
...

• It analyzes government failures, which arise when state actions fail to improve economic
efficiency or when the government redistributes income unfairly
...
Benefit vs
...

• Ability-to-pay principle: states that the amount of taxes people pay should relate to their
income or wealth
...

2
...
vertical equity
• Horizontal equity: states that those who are essentially equal should be taxed equally
...

• Vertical equity: concerns the tax treatment of people with different levels of income
...

3
...
A tax is called proportional, progressive or regressive
depending on whether it takes from high-income people the same fraction of income, a
larger fraction of income, or a smaller fraction of income than it takes from low-income
people
...
Indirect taxes are ones that are levied on goods and services
and thus only “indirectly” on individuals (i
...
, excise and sales tax, cigarette and gasoline
tax, tariffs on imports and property taxes)
...
e
...

Progressive, Proportional and Regressive Taxes
Percent of income paid in taxes
Progressive tax
Proportional tax
Regressive tax
Income
MARGINAL TAX RATE
• A central concept of tax analysis
...

• Under this principle, the major effect of any tax on incentives comes from the marginal tax
rate
...

• It integrates the corporate income tax with the individual income tax
...
Gone are subsidies for medical care,
owner-occupied homes and charitable contributions
...

EFFICIENCY AND FAIRNESS IN THE TAX SYSTEM
• Henry George argued that a tax on land will have little impact on efficiency because the supply
of land is completely inelastic
...
If a commodity is very price-inelastic in supply or demand, a tax on the commodity
will have little impact upon consumption and production
...
EQUALITY: THE BIG TRADE-OFF
HOW TO MEASURE INEQUALITY AMONG INCOME CLASSES
• Lorenz curve = a widely used device for analyzing income and wealth inequality
...
The Gini coefficient is equal to 0 under complete equality and 1 under complete
inequality
...

• The National Academy of Sciences recommended that the definition of poverty be changed
to reflect relative-income status
...

• Important welfare state programs include public pensions, accident and sickness insurance,
unemployment insurance, health insurance, food and housing programs, family allowances,
and income supplements for certain groups of people
...

• The question of how much we are willing to pay in reduced efficiency for greater equity was
addressed by Arthur Okun in his “leaky bucket” experiment
...


49

•

the very poor
...
Then redistribution in the name
of equity has been at the expense of economic efficiency
...
If a country redistributes income by
imposing high tax rates on the wealthiest people, their saving and work effort may be reduced
or misdirected, with a resulting lower total national output
...


MAJOR INEFFICIENCIES INDUCED BY HIGH TAX RATES & BY GENEROUS INCOME-SUPPORT
PROGRAMS
• Administrative costs
• Damage to work and saving incentives
...

• Socio-economic costs
...

Chapter 18 – INTERNATIONAL TRADE
• Trade promotes specialization and specialization increases productivity
...
DOMESTIC TRADE
1
...
Sovereign nations
3
...

• Holds that each country will benefit if it specializes in the production and export of those
goods that it can produce at relatively low cost
...


OUTSOURCING AS ANOTHER KIND OF TRADE
• Refers to locating services or production processes abroad
...

OPENING UP TO TRADE
• Small countries affect world prices the least and therefore can trade at world prices that are
very different from domestic prices
...

TWO IMPORTANT QUALIFICATIONS OF THE THEORY OF COMPARATIVE ADVANTAGE
1
...
Assumes a smoothly working competitive economy
...
Trade might lead to worsening environmental problems if there are local or global
public goods
...
Inefficiencies might arise in the presence of inflexible prices and wages, business
cycles, and involuntary unemployment
...
Income distribution
...
Stolper-Samuelson theorem: reducing trade barriers will tend to reduce the wages of
unskilled domestic workers
...
Trade barriers
a
...
Tariff is a tax levied on imports
...
Prohibitive tariff – tariff that is so high that it chokes off all imports
...
Non-prohibitive tariff – lower tariffs would injure but not kill off trade
...
US puts a
$2 tariff on clothing imports
...

The market price rises from $4 to $6, so the total amount demanded falls
...
Because of these differences, economists generally regard tariffs as the
lesser evil
...
The domestic producers, operating under a price umbrella provided by the tariff, can expand
production
...
Consumers are faced with higher prices and therefore reduce their consumption
...
Government gains tariff revenue
4
...

• The overall social impact of a tariff is a gain to producers of $250, a gain to the government of
$200 and a loss to consumers of $550
...

INTERPRETATION OF THE GRAPH (ECONOMIC INEFFICIENCIES OF TARIFFS):
• Area A = net loss that comes because domestic production is more costly than foreign
production
...
This is the loss in consumer surplus
that cannot be offset by business profits or tariff revenue
...

• Areas A and C represents efficiency losses from inefficiently high domestic production and
inefficiently low consumption, respectively
...
Non-economic goals
...

2
...
Most economists today reject the idea that
raising tariffs to run a trade surplus will improve a country’s economic welfare
...
Tariffs for special interests
...
The few who gain much from specific tariff protection
devote large sums of resources to lobby politicians while individual consumers are only slightly
affected by the tariff on one product; because losses are small and widespread, individuals
52

have little incentive to spend resources expressing an opinion on every tariff case
...

4
...
Free trade exposes domestic workers to competition
from low-wage foreign labor
...
In summary, the cheap-foreign labor argument is flawed because it ignores the
theory of comparative advantage
...
High wages come from high efficiency and not from
tariff protection
...
Retaliatory tariffs
...

6
...
Relief measures include the following actions:
a
...
Injury occurs when the output, employment, and profits in a domestic
industry have fallen while imports have risen
...
Anti-dumping tariffs – levied when foreign countries sell at prices lower than those in
the home/domestic market
...

c
...

POTENTIALLY VALID ARGUMENTS FOR PROTECTION
1
...

2
...

3
...

4
...
Although protection will raise prices to consumers at first, the
mature industry would become so efficient that cost and price would actually fall
...
Tariffs and unemployment
...
As domestic demand increases, firms will hire
more workers and unemployment will fall
...
A more effective way to increase productive employment is through domestic
monetary and fiscal policy
...
General Agreement on Tariffs and Trade (GATT) in which provisions were incorporated in the
World Trade Organization (WTO)
...
e
...

53

2
...
North American Free Trade Agreement (NAFTA)
b
...

PART FIVE – MACROECONOMICS: ECONOMIC GROWTH AND BUSINESS CYCLES
Chapter 19 – OVERVIEW OF MACROECONOMICS
3 Central Questions of Macroeconomics
1
...

Having considered the symptoms, macroeconomists suggest possible remedies, such
as using monetary policy to alter interest rates and credit conditions or using fiscal
instruments such as taxes and spending
...
What are the sources of price inflation, and how can it be kept under control?
• Macroeconomics can suggest the proper role of monetary and fiscal policies, of
exchange rate systems and of an independent central bank in containing inflation
...
How can a nation increase its rate of economic growth?
• This refers to the growth in per capita output of a country
...

• Economic historians found out that the key factors in long-term economic growth
include reliance on well-regulated private markets for most economic activity, stable
macroeconomic policy, high rates of saving and investment, openness to international
trade, and accountable and non-corrupt governing institutions
...

MACROECONOMIC OBJECTIVES
1
...

•

Output
High level and rapid growth of output
Employment
High level of employment with low
involuntary unemployment
4
...
Monetary Policy
• Buying and selling bonds, regulating
financial institutions
2
...
Output (Y)

54

a
...
Nominal GDP = calculated using changing prices
c
...
When the economy is operating at its potential, there are high
levels of utilization of the labor force and the capital stock
...
Y > Y* = inflation rises
ii
...

Depression = severe and protracted downturn
...
High Employment, Low Unemployment
a
...
Unemployment rate
3
...
Consumer Price Index (CPI)
b
...
Fiscal Policy
• Use of taxes and government expenditures
• Impact of taxation: taxes => disposable income => private consumption and saving => Y
• Government expenditure influences the relative size of collective spending and private
consumption
• Fiscal policy is primarily used to affect long-term economic growth through its direct impact
on national saving and investment
• It is also used to stimulate spending in deep or sharp recessions: Y (AD) = C + I + G + X – M
2
...

The central bank affects the economy by determining short-term interest rates
How does central bank affects liquidity? (i) Open market operations (OMOs): To increase
liquidity or the money supply in the economy, the central bank buys short-term government
securities (GS) from the public and therefore, the CB releases money
...
Conversely, to decrease money supply in the economy, the CB sells
GS and the CB gets the money
...


55

•

•

Question: When does the conventional MP or OMO become ineffective? With the
conventional expansionary MP, CB buys short-term government bonds to lower short-term
market interest rates
...
QE may then be
used by monetary authority to further stimulate the economy
...
How does CB implements QE? The CB does QE by purchasing
assets from the commercial banks and other private institutions of longer maturity than shortterm government bonds and thereby, lowering longer-term interest rates
...

2 measures of national product: (i) product approach (flow of spending on final products) and
(ii) earnings/income approach (as the total costs or incomes of inputs)

Integrated Macroeconomic Accounts:

56

57

•

When relative prices of different goods are changing very rapidly, using prices of a fixed year
will give a misleading estimate of real GDP growth
...
Instead of the relative weights on each good being kept fixed, the weights of the
different goods and services change each year to reflect the changes in spending patterns in
the economy
...


COMPONENTS OF GDP
1
...
Durable goods
b
...
Services
2
...
If you want to get a measure of the increase in society’s capital, gross investment is
not a sensible measure because it does not subtract depreciation, which is the amount
of capital that has been used up
...
Components of investment are private domestic investment and net foreign
investment or net exports
3
...
Consumption-type goods (i
...
, food for the military)
b
...
e
...
OMITTED NON-MARKET ACTIVITIES
1
...

2
...
e
...
Value of leisure time = utility-producing leisure activities
4
...
e
...
Estimates of the value of R & D
B
...

Chapter 21 – CONSUMPTION AND INVESTMENT
CONSUMPTION
• Income is the primary determinant of consumption and saving
...
MPC is the slope of the consumption function
...

𝑀𝑃𝑆 = 1 − 𝑀𝑃𝐶
Determinants of consumption: disposable income, permanent income and life cycle model of
consumption, wealth and other influences
...
According to the permanent income
theory, consumption responds primarily to permanent income
...
If a change in income is permanent
(i
...
, being promoted to a secure and high-paying job), people are likely to consume a large
fraction of the increase in income
...
e
...


•
•
•

it is the change in consumption per dollar change in disposable income
...
People tend to save while working so as to build up a nest egg for retirement
and then spend out of their accumulated savings in their twilight years
...


INVESTMENT
• Plays a dual role: (i) affects short-run output through its impact on aggregate demand and (ii)
influence long-run output growth through the impact of capital formation on potential output
and aggregate supply
...

• Investment decisions depend on (Determinants of Investment): (i) the level of output
produced by the new investments; (ii) the interest rates and taxes that influence the costs of
the investment; and (iii) business expectations about the state of the economy
...
It behaves unpredictably because it depends
on such uncertain factors such as the success or failure of new and untried products, changes
in tax rates and interest rates, political attitudes, and approaches to stabilizing the economy,
and similar changeable events of economic life
...

• Interest rate and investment are inversely related
...

Chapter 22 – BUSINESS CYCLES AND AGGREGATE DEMAND
•
•

Keynesian economics emphasizes that changes in aggregate demand can have powerful
impacts on the overall levels of output, employment, and prices in the short-run
...


FEATURES OF THE BUSINESS CYCLE
•

•
•

Business cycles are economy wide fluctuations in total national output, income and
employment usually lasting for a period of 2 to 10 years, marked by widespread expansion or
contraction in most sectors of the economy
...
A
recession that is large in both scale and duration is called a depression
...

CUSTOMARY CHARACTERISTICS OF A RECESSION:
1
...
Consumer purchases often decline sharply as
well
...

2
...

3
...

4
...

5
...
Common stock prices usually fall as investors sniff
the scent of a business downturn
...
As business conditions deteriorate and employment falls, the central bank begins to lower
short-term interest rates to stimulate investment and other interest rates decline as well
...
internal cycles
• Exogenous theories find the sources of the business cycle in the fluctuations of factors outside
the economic system – in wars, revolutions and elections, in oil prices, gold discoveries and
population migrations, in discoveries of new lands and resources, in scientific breakthroughs
and technological innovations, climate change and the weather
• Internal theories look for mechanisms within the economic system itself
...

* In an open economy, monetary policy also affects exchange rate and
net exports
* Increases in government expenditures lead to increase in output
* Tax reductions or increases in transfers raises disposable income and
induce higher onsumption
...

* Technological advances can open up new opportunities for business
investment
...

• The key assumptions underlying the multiplier model are that wages and prices are fixed and
that there are unemployed resources in the economy
...
It can show how changes in investment due to
innovation or pessimism or fluctuations in government spending due to war can lead to sharp
changes in output
...
According to the accelerator principle, rapid output
growth stimulates investment
...
The slower growth in turn reduces investment spending and
this, working through the multiplier, tends to send the economy into a recession
...

• The multiplier model, working together with the dynamics of investment shows how
alternating bouts of investment optimism and pessimism along with other changes in other
exogenous expenditures can lead to the fluctuations called business cycle
...

CB's new interest-rate target and market expectations about
future financial conditions help determine spectrum of short
and long-term interest rates, asset prices and exchange rates
...
The financial system transfers resources (i
...
, through loans, direct foreign investments)
across time, sectors and regions
...
The financial system manages risks for the economy
...

3
...

4
...
This function allows rapid
transfer of funds around the world
...

• It serves as an aid to assess the effect of current economic policies or changes therein, on the
future path of the economy
...

• It also facilitates study of the saving-investment process, by tracing the channels by which
saving reaches borrowing, after passing through various financial institutions and assets
...

❑ Transactors in the FOF are:
63

a
...
) Rest of the World
TWO MAJOR PARTS OF THE FOF:
1
...

2
...
It shows transactions in the following instruments:
a
...
currency and deposits
c
...
loans
e
...
insurance technical reserves (only between insurance
g
...
g
...
other accounts receivables/payables
Broad Money: Standard Components

Broad Money
Standard Components

National Currency

Transferable Deposits
Demand
Deposits
Bank Checks

Other Deposits

Non-transferable
savings deposits
Term Deposits

Traveler’s
Check

64

➢ Components of Monetary & Liquidity Aggregates (Philippine Banking System)

ELEMENTS OF THE MODERN BANKING SYSTEM
1
...

2
...

3
...

EFFICIENT MARKET THEORY (Finance)
• One important hypothesis is that speculative markets tend to be “efficient”
...
When new information arrives, the news is quickly incorporated
into stock prices
...

• The theory of efficient markets holds that market prices contain all available information
...
Returns on stocks will be primarily determined by their riskiness relative to the
market
...
It is the
arrival of new information that affects stock or commodity prices
...

• In summary, efficient-market theory explains why movements in stock prices look so erratic
...
But surprises are unpredictable events that may move in
65

any direction
...

Chapter 24 – MONETARY POLICY AND THE ECONOMY
OPEN MARKET OPERATIONS (OMOs)
• Is central banks’ primary tool for implementing monetary policy
...

• When a CB sells GS => contractionary monetary policy
• When a CB buys GS => expansionary monetary policy
CENTRAL BANK AS LENDER OF LAST RESORT
• Financial intermediaries like banks are inherently unstable because as we have seen, their
liabilities are short-term and subject to rapid withdrawal while their assets are often longterm and even illiquid
...
It complements
OMOs by making reserves available when they are needed on short notice
...

LEGAL RESERVE REQUIREMENTS
• Banks are required to hold a fixed fraction of their checking deposits as reserves
...

• Bank reserves take the form of cash in vault (bank holdings of currency) and deposits by banks
with the central bank
...
These high requirements serve primarily to ensure that the demand for
reserves is relatively predictable so that the central bank can have more precise control over
the interest rate
...


THE MONETARY TRANSMISSION MECHANISM IN DETAIL

66

CB raises interest rate target

CB undertakes OMOs

• The CB may also change the discount rate & the terms of its
lending facilities
...
rates,
asset prices,
exchange rates

Impact on I,
C and X

Effect on AD

Effect on Q
and P

𝑬𝒙𝒑𝒂𝒏𝒔𝒊𝒐𝒏𝒂𝒓𝒚 𝑴𝑷: 𝒓 𝒅𝒆𝒄𝒓𝒆𝒂𝒔𝒆𝒔 => 𝐼, 𝐶, 𝑋 𝑢𝑝 => 𝐴𝐷 𝑢𝑝 => 𝑄 𝑎𝑛𝑑 𝑃 𝑢𝑝
THE CHALLENGE OF A LIQUIDITY TRAP
• When short term interest rates are zero, short-term safe securities are equivalent to money
...
In this
situation, banks have no reason to economize on their reserve holdings; they get essentially
the same interest rates on reserves as on riskless short-term investments
...

MONETARY POLICY IN THE LONG-RUN

67

•

•
•
•

•
•

Stylized fact: Monetary policies to stimulate the economy cannot keep increasing output
beyond its potential for long
...

With low interest rates, speculation may arise and animal spirits may overtake rational
calculations
...

Monetary changes will affect AD and real GDP in the short-run when there are unemployed
resources in the economy and the AS curve is relatively flat
...

As price and wages become more flexible in the long-run, monetary policy changes tend to
have a relatively small impact on output and a relatively large impact on prices
...
As time passes,
however, wages and prices adjust more completely to the higher price and output levels
...
In the end, expansionary MP would produce an
economy with unchanged real output and higher prices
...
e
...
) would be higher while
all real variables would be unchanged
...


VELOCITY OF MONEY & QUANTITY THEORY OF PRICES
• The rate at which money circulates through the economy
...

𝑷𝑸
𝑴
𝑴𝑽
𝑸

•

𝑽=

•

𝑷=

•

If k is constant, the price level would then move proportionally with money supply
...
If the MS grew rapidly, so would prices
...
High interest rates lead to an increase in
money market accounts and interest-bearing checking accounts which are components of
money supply
...
The growth in
output per capita is an important objective of government because it is associated with rising
average real incomes and rising living standards
...

2
...

4
...
e
...
e
...
The Classical Dynamics of Smith and Malthus
• Adam Smith and Thomas Robert Malthus stressed the critical role of land in economic growth
...
Because there is no capital, national output would
exactly double as population doubles
...
Output expands in step with
population, so the real wage rate per worker would be constant over time
...

• Malthus’ Dismal Science: As population growth continues, all the land will be occupied
...
Land becomes scarce and rents rise to
ration it among different uses
...
The
increasing labor-land ratio leads to a declining MPL and hence to declining real wage rates
...
He reasoned that whenever wages were
above the subsistence level, population would expand; below subsistence wages would lead
to high mortality and population decline
...

2
...

• The neoclassical growth model was introduced by Robert Solow
...

• Basic assumptions:
o The neoclassical growth model describes an economy in which a single homogenous
output is produced by capital and labor
...

o The major new ingredients are capital and technological change
...
Capital consists of durable produced goods that are used to
make other goods
...
Capital deepening is
the process by which the quantity of capital per worker increases over time
...

Hence, the competitive wage rate rises along with the MPL
...
In the absence of
technological change, capital deepening will produce a growth of output per worker,
of the MPL, and of real wages; it also will lead to diminishing returns on capital and
therefore a decline in the rate of capital
...
Without technological change, output per worker and the
wage rate stagnate
...
But the long-run equilibrium of the neo-classical growth model
makes it clear that if economic growth consists only of accumulating capital through
replicating factories with existing methods of production, then the standard of living
will eventually stop rising
...
Technological Change: New Growth Theory or Theory of Endogenous Technological Change
• The previous capital-accumulation model cannot explain the tremendous growth in
productivity over time nor does it account for the tremendous differences in per capita
income among countries
...

• Advances in technology like electronics, internet commerce, improved medical
technologies will shift the production function upward
...
As a result of
technological progress, the real interest rate need not fall
...

• The new growth theory seeks to uncover the processes by which private market forces,
public policy decisions and alternative institutions lead to different patterns of
technological change
...

The new growth theory seeks to uncover the processes which generate technological
change
...
Governments increasingly seek to provide strong
intellectual property rights for those who develop new technologies
...


Stock of physical
capital grows
more rapidly
than population
and labor supply
...


Real average
hourly earnings
increased as a
result of capital
deepening and
from
technological
advances

Real interest rates
and profits may
fluctuate but there
is no strong upward
or downward tre
because
technological
change has offset
diminishing returns
to capital
accumulation

Chapter 26 – THE CHANLLENGE OF ECONOMIC DEVELOPMENT
POPULATION GROWTH AND DEVELOPMENT
• Malthus: The population, if unchecked, will grow geometrically while food production will
only grow arithmetically
...

He stressed the positive checks that increase the death rate: pestilence, famine, and war
...

• Population implosion: Most advanced countries face declining population growth rate
...

• Implication: Because of stable or declining population with increasing life expectancy puts
great stress on the countries’ fiscal conditions because of the need to fund health care and
public pensions
...
Human resources
• It’s hard for poor countries to overcome poverty with very high birth rates
...
One strategy is to take an active role in curbing
population growth like educational campaigns
...
Health care clinics and
provision of safe drinking water are vitally useful social capital
...

o Do not underestimate the importance of human resources
...
Natural resources
• Land ownership patterns are a key to providing farmers with strong incentives to invest
in capital and technologies that will increase their land’s yield
...


3
...

However, poorest countries are already at a near subsistence standard of living
...

4
...

• Entrepreneurship and innovation: poor countries often suffer from pervasive corruption
...
Other elements in poverty are self-reinforcing
...
This syndrome arises
when there are multiple equilibria and one of the equilibria may be particularly pernicious
...
Backwardness hypothesis
• Relative backwardness of a country may aid development as suggested by Harvard
economist Alexander Gerschenkron
...


72

•

Convergence of countries toward the technological frontier is possible
...


2
...
agriculture
• Attempts to accelerate industrialization at the expense of agriculture have led many
analysts to rethink the role of farming
...
Raising productivity on farms may require less
capital while providing productive employment for surplus labor
...
State vs
...

4
...

• Import substitution strategy: developing countries attempt to be self-sufficient to replace
most imports with domestic production
...
A policy of
openness keeps trade barriers as low as practical, relying primarily on tariffs rather than
quotas and other non-tariff barriers
...

THE ASIAN MODELS (“Asian Dragons”)
• Patterns of growth in the East Asian miracle (South Korea, Singapore and Taiwan:
o Investment rates
o Macroeconomic fundamentals: keeping inflation rate low and saving rate high
...

o Outward orientation in trade and technology policies by adopting best practice
techniques of high-income countries
...
Its major components are the current account and financial account
...
If a transaction involves spending foreign currency, it is a debit and
is recorded as a minus item
...

Credits and debits are somewhat complicated in the financial accounts
...

BALANCE OF PAYMENTS ACCOUNTS

CURRENT ACCOUNT
Merchandise trade balance
Services
Investment income
Unilateral transfers

FINANCIAL ACCOUNT
Private borrowing or lending
Government (Official reserve assets and foreign
official assets)
Statistical discrepancy

THE PARADOX OF WEALTHY BORROWERS
• During the recent years, rich countries like the US emerged as net borrower from the Rest of
the World (ROW) or foreign countries
...
In an open financial world, the pattern of trade surpluses
and deficits is largely determined by the balance of saving and investment
...

THE DETERMINATION OF FOREIGN EXCHANGE RATES
• The foreign exchange rate is the price of one currency in terms of another currency
...

𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦

•

𝑒=

•

The price of foreign exchange – the foreign exchange rate (e) – settles at that price where
supply of and demand for currency are in balance
...
This means that the supply of dollars will increase
...

A rise in the price of a currency in terms of another currency is called an appreciation
...


•
•
•
•

MONETARY POLICY AND EXCHANGE RATE
• Monetary policy can affect the exchange rate through the financial account
...


PURCHASING POWER PARITY (PPP) THEORY OF EXCHANGE RATES
• Under this theory, a nation’s exchange rate will tend to equalize the cost of buying traded
goods at home with the cost of buying those goods abroad
...

• The PPP theory only approximates and cannot predict the precise movements in the exchange
rate
...
e
...

INTERNATIONAL MONETARY SYSTEM
• It denotes the institutions under which payments are made for transactions that cross national
boundaries
...


DAVID HUME’S FOUR-PRONGED INTERNATIONAL ADJUSTMENT MECHANISM

US has BOP deficit
US loses gold; Britain gains gold
US MS declines

British MS increases

Prices decline in US

British prices rise

Step 1: US imports of
goods decline

Step 2: US exports
rises

Step 3: British imports
of goods rise

Step 4: British exports
decline

75

•

The result of Hume’s four-pronged gold-flow mechanism is an improvement in the BOP of the
country losing gold and a worsening in that of the country gaining gold
...
This equilibrium is a stable one
and requires no tariffs or other government intervention
...

• If exchange rates are not free to move when the prices or incomes of different countries get
out of the line, then domestic output and prices must adjust to restore equilibrium
...
This will occur when domestic output
falls sufficiently so that the country’s price level will decline relative to world prices
...

• Inescapable fact under a fixed exchange rate regime: Domestic real output and employment
must adjust to ensure that the country’s relative prices are aligned with those of its trading
partners
...

• Strong supply of $ relative to demand for $ in the market causes peso appreciation
...

• Strong demand for $ relative to supply in the market causes peso depreciation
...

Chapter 28: OPEN-ECONOMY MACROECONOMICS
FOREIGN TRADE AND ECONOMIC ACTIVITY
• Open-economy macroeconomics is the study of how economies behave when the trade and
financial linkages among nations are considered
...
The counterpart
of net exports is net foreign investment (a country is lending if its net foreign investment is
positive)
...
Why is it that the rich US borrows abroad? This paradoxical phenomenon
is explained by a relatively low US saving rate, a high foreign saving rate and an attractive
investment climate in the US
...
The
volume and value of imports will be affected by domestic output and the relative prices of
domestic and foreign goods
...
As foreign output rises, or as the exchange rate of the currency
depreciates, the volume and value of exports tend to grow
...
In addition, imports depend upon domestic output and incomes
...
What matters are the reasons for the deficits
...


MARGINAL PROPENSITY TO IMPORT (MPm)
• MPm is the increase in the dollar value of imports for each $1 increase in GDP
...

OPEN ECONOMY MULTIPLIER
1
𝑀𝑃𝑆+𝑀𝑃𝑚

•

𝑂𝑝𝑒𝑛 𝑒𝑐𝑜𝑛𝑜𝑚𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =

•

Because a fraction of any income increases leaks into imports in an open-economy, the open
economy multiplier is smaller than the multiplier for a closed economy
...
e
...

• When financial investments can flow easily among countries and the regulatory barriers to
financial investments are low, countries have high mobility of financial capital
...
Any divergence in the interest
rates between two countries will attract speculators who will sell one currency and buy the
other until the interest rates are equalized
...
Hence, the small country can no longer conduct
independent monetary policy
...
Fiscal policy is, therefore, highly
effective because there is no monetary reaction to changes in government spending or taxes
...
Suppose the CB decides
to reduce interest rates to stimulate the economy
...
The
depreciation of the currency will result to a net export surplus
...
Alternatively, if the CB tightens MP by raising
interest rates, it will attract foreign investors (will increase demand for currency), thereby
causing the currency to appreciate
...

e (exchange rate)
77

e*
depreciation
e**

X*

0

X**

SAVING AND INVESTMENT IN THE OPEN ECONOMY
• 𝑆 = 𝐼
• 𝑆 + (𝑇 − 𝐺) = 𝐼 + 𝑋
• This states that total private saving (S) by households and businesses plus total public saving,
which is given by taxes less government expenditures (T-G) should be EQUAL to total national
investment which consists of investment in domestic capital plus net foreign investment or
net exports
...
This equation
shows that net exports are the difference between domestic saving and domestic investment
...
But the small open economy with mobile financial capital has its
real interest rates determined in world financial markets
...
The difference between national saving and domestic
investment is net exports (net foreign investment)
...

• Examples of the open-economy S-I theory in the small open economy:
o An increase in private saving or lower government spending will increase national
saving
...

o An increase in domestic investment, say, because of an improved business climate or
burst of innovations will lead to a shift in the investment schedule
...
In this case, domestic investment crowds out foreign investment
...
This will lead
to an increase in the difference between S and I, to a depreciation in the forex, and to
an increase in NX and foreign investment
...

o Higher saving at home – whether private or public saving – will lead to higher NX
...

Adjustments in trade accounts require a change in domestic saving or investment
...


MAJOR CONCLUSIONS OF S-I MODEL IN SMALL OPEN ECONOMY
Change in policy or
Change in exchange
Change in Investment
exogenous variable
rate
Increase in G or
exchange rate
decrease in T
Increase in private S
exchange rate
Increase in investment exchange rate
demand
Increase in world exchange rate
interest rates

Change in Net
exports

0

Net exports

0

Net exports

Investment

Net exports

Investment

Net exports

PROMOTING GROWTH IN AN OPEN-ECONOMY
1
...

2
...
Keep tariffs and other trade barriers low so that domestic firms can feel the
spur of competition and that foreign firms are permitted to enter domestic markets
...
Institutions of the market
...

INTERNATIONAL ECONOMIC ISSUES
1
...

• Productivity is measured by the output per unit of input
...
It has no necessary connection with how a nation’s productivity compares
with that of other countries
...

79

•

As the theory of comparative advantage demonstrates, nations are not inherently
uncompetitive
...
The surest route to high productivity and high living standards
is to expose domestic industries to world markets and to encourage vigorous domestic
competition with foreign companies that have adopted the most advanced technologies
...
European Monetary Union (EMU)
• Benefits of EMU:
o Under a common currency, exchange rate volatility will be reduced to zero so trade
and finance will no longer have to contend with the uncertainties about prices
induced by changing exchange rates
...

o Moving to a common currency may allow a more efficient allocation of capital across
countries to the extent that national financial markets are segmented
...

o Removal of one of the major sources of instability – the intra-European exchange rate
movements
...

• Costs of EMU:
o Individual countries will lose the use of both monetary policy and exchange rates as
tools for macroeconomic adjustment
...
An
optimal currency area is one whose regions have high labor mobility or have common
and synchronous AS or AD shocks
...

Europe, for some economists, is not an optimal currency area because of the rigidity
of its wage structures and the low degree of labor mobility among different countries
...

THE FUNDAMENTAL TRILEMMA OF FIXED EXCHANGE RATES
• A country can have only two of the following: (a) fixed but adjustable exchange rate; (b) free
capital and financial movements; and (c) an independent domestic monetary policy
...

• It can fix its exchange rate without weakening its central bank, but only by maintaining
controls on capital flows
...

• It can choose to leave capital free and stabilize the currency, but only by abandoning any
ability to adjust interest rates to fight inflation or recession
...

• In analyzing AS, we will make the central distinction between the long-run and the short-run
...
As a result, higher prices are
associated with higher production of goods and services
...

• The long-run refers to periods associated with economic growth, after most of the elements
of business cycles have damped out
...

Output is determined by potential output and is independent of price level
...

DETERMINANTS OF AGGREGATE SUPPLY
1
...
It is the level of output that would be produced if we remove business-cycle
influences
...

• Over the long-run, AS depends primarily upon potential output
...

• The prime factors determining the growth in potential output are the growth in inputs and
technological progress
...

•
•
•
•

Input or production costs
Businesses have certain costs that are inflexible in the short-run
...

An increase in potential output with no change in production costs would shift the AS curve
outward
...

VARIABLE

POTENTIAL OUTPUT
Inputs

IMPACT ON AGGREGATE SUPPLY
Supplies of capital, labor and natural resources
are the important inputs
...
sustainable level
...


81

Technology and efficiency

Innovation, technological improvement, and
increased efficiency increase the level of
potential output and raise AS
...

A decline in foreign prices or an appreciation in
the exchange rate reduces import prices
...

Lower oil prices lower production costs and
thereby raise AS
...

If AD falls because of a monetary tightening or a fall-off in consumer spending, this will lead
to falling output and prices
...

• The long-run approach sometimes called as classical macroeconomics holds that changes in
AD affect prices but have no effect on real output
...
Since the long-run AS curve is vertical, changes in AD have no effect on
output
...
Clearly, there must be unemployed resources in the economy
...
As output rises, labor shortages appear and factories
operate close to capacity
...
A larger fraction of
the response to AD increase comes in the form of price increases and a smaller fraction comes
in output increases
...

a
...
LR AS curve
P

AS

AS

Q
•

Q

The SR AS curve slopes upward because many costs are inflexible in the SR which means that
both output and prices respond to demand shifts
...

A Keynesian economist might desire to stabilize the economy through policies that change AD
while classical economist would concentrate primarily on increasing potential output
...
As a result of this
inflexibility, businesses can profit from higher levels of aggregate demand by producing more
output
...
It is quite rare for
wages to be raised more than once a year or even more uncommon for money wages actually
to be cut
...
In addition, firms often sign
contracts with their suppliers specifying the prices to be paid for materials or components
...
Firms cannot take advantage of fixedmoney wage rates in their labor agreements forever; labor will soon recognize that prices have
risen and insist on compensating increases in wages
...
In the LR, after all
the elements of cost have fully adjusted, firms will face the same ratio of price to costs as they
did before the change in demand
...

The LR AS curve tends to be vertical, which means that output supplied is independent of the
level of prices and costs
...
Unemployment is an
economic problem because it represents waste of a valuable resource
...

• When unemployment rate goes up, the economy is in effect throwing away goods and services
that the unemployed workers could have produced
...
It relates changes in the unemployment rate to the
growth in output
...
Moreover, if you want to bring the
unemployment rate down, actual GDP must be growing faster than potential GDP
...
Frictional unemployment = It arises when people become unemployed voluntarily as they
move from job to job or into and out of labor force
...
Unemployment may be an
efficient outcome in a situation where heterogeneous workers are searching for work or
testing different kinds of jobs
...
Structural unemployment = signifies a mismatch between the supply of and the demand for
workers
...

3
...

• Two examples of disequilibrium unemployment (involuntarily unemployed) are structural and
cyclical unemployment
...

S

Disequilibrium unemployment
w

W**
W*

H

G

<

E
D

•

Labor force

At wage rate above the market clearing wage rate, W**, the number of workers desiring to
work at wage W** is at point G on the supply curve but firms want (demand) to hire only H
workers as shown by the demand curve
...

MICROECONOMIC FOUNDATION OF INFLEXIBLE WAGES
• Most wages in market economies are administered by firms or contracts
...
Wages are inflexible because of the costs involved in administering the
compensation system
...


84

Chapter 30 – INFLATION
ECONOMIC IMPACTS OF INFLATION
1
...
Distortions in the relative prices and outputs of different goods or sometimes in output and
employment for the economy as a whole
...

• The major redistributive impact of inflation comes through its effect on the real value of
people’s wealth
...
If you are a lender and have assets in fixedinterest rate mortgages or long-term bonds, an unexpected rise in prices will leave you poorer
because the amount repaid to you are worth much less than the amount you lent
...

Impacts of inflation on economic efficiency
• Inflation can harm economic efficiency and it can affect total output
...

• Inflation also distorts the use of money
...
If inflation rate rises from 0 to 10% per year, the real interest rate on currency falls from
0 to -10%
...
As a result of the negative real interest
rate on money, people devote real resources to reducing their money holdings during
inflationary times
...
When prices rise, the real value of the taxes paid
rises even though real incomes have not changed
...
When prices are changed, firms must spend real resources adjusting
their prices
...

DEMAND-PULL INFLATION
• Occurs when AD rises more sharply than the economy’s productive potential, pulling prices
up to equilibriate AS and AD
...
It occurs when too much spending chases too few goods
...

• A particularly damaging form of demand-pull inflation occurs when governments engage in
deficit spending and rely on the monetary printing press to finance their deficits
...

• Oil price shocks will lead to cost push inflation
...
This eventually will lead to stagflation
...
Monetary expansion will offset the decline in output but will raise prices further
...

PHILLIPS CURVE
• Major macroeconomic tool used to understand inflation
...

• The basic idea is that when output is high and unemployment is low, wages and prices tend
to rise more rapidly
...


P
r
i
c
e

W
a
g
e

Unemployment rate
•

•
•

The relationship between prices, wages and productivity can be formalized as follows
...

𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑤𝑎𝑔𝑒 𝑔𝑟𝑜𝑤𝑡ℎ − 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑔𝑟𝑜𝑤𝑡ℎ
There is a direct relationship between rate of inflation and rate of wage growth but an inverse
relationship with rate of productivity growth
...
This approach implies
that in the long-run there is minimum unemployment rate that is consistent with steady
inflation
...
At the NAIRU,
upward and downward forces on price and wage inflation are in balance so there is no
tendency for inflation to change
...

• The idea behind the NAIRU is that the state of the economy can be divided into three
situations:
o Excess demand
...

o Excess supply
...
Wage and inflation tend to moderate
...
The upward wage pressures from job vacancies just match the
downward wage pressures from unemployment
...
Here, the economy is at the NAIRU, and inflation neither
rises nor falls
...
It implies that
there is a minimum level of unemployment that an economy can enjoy in the long-run
...

• When the inflation rate is too high, a country can tighten MP, trigger a recession, raise the
unemployment rate above the NAIRU and thereby reduce inflation
...
In the SR, an increase in AD which lowers unemployment rate below the NAIRU will tend to
increase the inflation rate
...
In the
SR, there is a trade-off between inflation and unemployment
...
When inflation is higher or lower than what people expect, inflation expectations adjust
...

3
...
Unemployment above (below) the NAIRU will
tend to lower (increase) the rate of inflation
...
Reducing inflation entails
lower national output and higher unemployment rate
...


87

•

Economists have put forth many proposals for lowering the NAIRU
...


Chapter 31 – FRONTIERS OF MACROECONOMICS
GOVERNMENT BUDGET POLICY
• The government budget serves two major economic functions
...

• The actual budget records the actual expenditures, revenues and deficits in a given period
...

• The cyclical budget is the difference between the actual budget and the structural budget
...

• The distinction between the actual and the structural budgets is important for policymakers
who want to distinguish between long-term or trend budget changes and short-term changes
that are primarily driven by the business cycles
...

• The nation’s S-I balance is primarily affected by the structural budget
...
The confusion arises because fiscal policy operates differently depending
upon the time period:
o In the SR, higher spending and lower tax rates tend to increase AD and thereby to
raise output and lower unemployment
...
This is the growth impact of fiscal policy
...
If taxes are lower, this will decrease public saving and because
private saving is unlikely to rise as much as public saving falls, total national S and I
declines
...

DISPLACEMENT OF PRIVATE CAPITAL
• The most serious consequence of a large public debt is that it displaces private stock of capital
(“crowding out effect”)
...

88

•

•

As the government debt increases, people’s holdings of other assets will be reduced
...
These other assets ultimately represent the stock of private capital (i
...
, stocks,
bonds and mortgages)
...


ADVANCES IN MODERN MACROECONOMICS
1
...

• Say’s Law of Markets:
o Overproduction is impossible by its very nature
...
”
o This law rests on a view that there is no essential difference between a monetary
economy and a barter economy
...

• The classical view is that the economy moves automatically toward its full employment
equilibrium
...
Prices and wages adjust quickly and flexibly to maintain full
employment
...
New Classical Macroeconomics
a
...
This implies that people understand how the economy
works and what the government is doing
...
Real Business Cycles (RBC)
• The major application of modern classical macroeconomics
...

• In this approach, shocks to technology, investment or labor supply change the
potential output of the economy
...

• Standard Keynesian monetary and fiscal policies have no effect on output or
employment in RBC models
...
Ricardian View of Fiscal Policy
• Developed by Robert Barro (Harvard University)
...

This idea is a logical extension of the life-cycle model of consumption
...
Parents care not only about their consumption but also about the well-being of
their children; the children, in turn, care about the well-being of their own children; and
89

•

•

•

so on
...

If the government cuts taxes but leaves expenditures unchanged, this necessarily requires
increased government borrowing
...

In the Ricardian view, consumers have rational expectations about future policies, so
when a tax cut occurs, they know they must plan for a future tax increase
...

The net result in the Ricardian view is that tax changes have no impact on consumption
...
Efficiency Wage Theory
• Developed by Edmund Phelps, Joseph Stiglitz and Janet Yellen
• It explains the rigidity of real wages and the existence of involuntary unemployment in
terms of firms’ attempts to increase productivity by keeping wages above the marketclearing level
...

• As firms raise their wages to increase worker’s productivity, job-seekers may be willing to
stand in line for these high-paying jobs, thereby producing involuntary unemployment
...


5
...

• They argued that Keynesians excessive concern with the business cycle had ignored the
impact of tax rates and incentives on economic growth
...

• Supply-side economist Arthur Laffer suggested that high tax rates might actually lower tax
revenues
...

A NEW SYNTHESIS
• Economists today emphasize the importance of expectations
...


90

•

Adaptive expectations: holds that people form their expectations on the basis of past
information

EFFECTIVENESS OF FISCAL POLICY
• Was seen during the 2007-2009 GFC
...

• While some people worried about the long-term impact of the fiscal stimulus on the
government debt, most macroeconomists believed that fiscal policy was the only feasible way
to reduce the depth and severity of the economic downturn
...

EFFECTIVENESS OF MONETARY POLCIY
• Unlike fiscal policy, monetary policy operates indirectly on the economy
...

• The central bank is much better placed to conduct stabilization policy than are the fiscal policy
makers
...
Because
of their political independence and rapid decision making, central banks are well placed to be
on the front line of defense in stabilizing the economy against business-cycle shocks
...

• When the economy is in or near liquidity trap, fiscal policy must therefore takeover the major
expansionary role
...
Loose fiscal – tight monetary policy
• Increase in government spending increases AD but raises government deficit as well
...
An increase in interest rate will result to lower investment and appreciation
of the currency, which will therefore reduce net exports
...


91



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