Unemployment and Inflation 1/22/09 4:17 PM 1/20/09 Huge economic principle that confronts every society: unlimited wants and limited resources. Every society has an economic system, differences reflect society. Economics—the study of the allocation and distribution of society’s scarce resources in an attempt to meet its unlimited wants. Every Economic Society has 3 questions to answer: What? What goods will be produced by our resources? How? How should we produce the goods? A lot of little labor with variable capital. For Whom? Who gets the goods? The US price mechanism In macroeconomics the correct combination of goods has been predetermined. Goal: make sure you produce greatest volume. In microeconomics you assume the greatest level of production will occur. Must go into inner workings of economy. Study individual components of economy. Resources A) Material—those to which one can claim capital Capital—equipment. Goods used to produce other goods. Land—raw materials on land B) Human—sum total of mental and physics capabilities of a population Three. Labor—provides services for a fee. A laborer. Four. Entrepreneurship: 1) gets new idea 2)undertake all the risk 3)personally directs all “factors of production” 4)if successful-profit. Unsuccessful-loss Payment: Capital-interest Land-rest Labor-wage Entrepreneurship-profit The Deal with theory in economics: attempt to explain reality in simplest way possible so we can predict recurrence of an event. 1/22/09 Fallacy Composition—commit it when you wrongly assume what is true for the individual part is true for the system. Fallacy of Division—commit it when you assume what is true for the entire system is true for the individual part. If you try to spend 10% more to help the economy it will do nothing. Fallacy of False Cause—wrongly assume event A causes event B merely because it precedes it. Scarcity is a relative topic, not always the same as limited. Law of Scarcity–economic resources are scarce because there are never enough goods to produce all of the goods wanted at a point in time. All costs are opportunity costs. The opportunity cost involved in undertaking any taken action is the next best alternative action you could have taken. Money is the most liquid of all assets. Spending money giving up = satisfaction of having money. Capitalism—an economic system where the factors of production are privately owned and operated for personal gain in a fairly competitive atmosphere. Competition guarantees continuing survival of capitalism. Production Possibility Frontier—shows the maximum productive possibilities of your economy at any given point in time. Construction of PPF depends on: 2 goods. Given amount of factors. Technology—application of scientific principles in the production process. Full employment of resources. Not all factors of production are equally efficient. Law of Increasing Costs—as you increase your production of one good by equal increments you must sacrifice greater amounts of alternative. Slope is ∆y/∆x the marginal rate of transformation. MRT. Marketplace—buyers and sellers come together, market is said to exist when supply and demand come together. No defined location. Pw=f(price, price of substitute good, price of complimentary good, income(y), taste, expectations) Law of Demand—certeris paribus. All other things remaining equal. Inverse relationship between quantity of goods demanded and price. A change in quantity demanded is used in the movement for the demand curve. A change in any one of the variables other than the price of the good itself will cause the demand curve to shift. A normal good is where demand of the good moves in the same direction of income. An inferior good is one where demand of the good moves opposite to the direction of the income. Market exists when supply and demand come together. A system is said to be in a state of equilibrium when there is no net change. An increase in the factors of production: if cost production then price supply labor wages supply cost production wage same= 2x supply cost production wage same= supply cost production Stable equilibrium—if you remove external force which moved it, system will return to original position. Unstable equilibrium—even when you remove external force it does not go back. 1/29/09 Elasticity and Utility 4 cases: supply constant, demand decreases. supply constant, demand increases. demand constant, supply increases. demand constant, supply decreases. Elasticity: %∆q / %∆p If |E|>1 the demand is relatively elastic If |E|<1 the demand is relatively inelastic If |E=1 demand is unitary. If |E|=0 the demand is perfectly inelastic If |E|=∞ the demand perfectly elastic Class Notes 1/22/09 4:17 PM The Art and Science of Economic Analysis Economics examines how people use their scarce resources to satisfy their unlimited wants. Resources are the inputs or factors of production used to produce the goods and services people want. Goods and services are scare because resources are scarce. Labor is human effort. Capital includes all human creations used to produce goods and services. Physical capital is: factories, tools, machines, computers, buildings, airports, highways, the taxi, the doctor’s scalpel. Human capital consists of the knowledge and skill people acquire to increase their productivity. Natural Resources are all gifts of nature—oil, water, trees, minerals, etc. Can be divided into 2 categories: Renewable resource—can be drawn on indefinitely if used conservatively. Exhaustible resource—oil, coal, copper ore, does not renew itself and so is available in a limited amount. Entrepreneurial ability is the managerial and organizational skills needed to start a firm, combined with the willingness to take the risk of profit or loss. Entrepreneur is a profit-seeking decision maker who starts with an idea, organizes an enterprise to bring the idea to life, and assumes the risk of the operation. Wages is the payment to resource owners for their labor. Interest is the payment to resource owners for the use of their capital. Rent is the payment to resource owners for the use of their natural resources. Profit is the reward for entrepreneurial ability; sales revenue minus resource cost. Good is a tangible product used to satisfy human wants. Service is an activity, or intangible product, used to satisfy human wants. Scarcity occurs when the amount people desire exceeds amount available at zero price. Goods and services that are truly free are not the subject matter of economics. Without scarcity, there would be no economic problem and no need for prices. Clean air, clean seawater is scarce. There are 4 types of decision makers in the economy: households, firms, governments and the rest of the world. Households play the starring role. As consumers, households demand the good and services produced. Firms, governments, rest of the world demand the resources that households supply and then use these resources to supply the goods and services households demand. Markets are the means by which buyers and sellers carry out exchange at mutually agreeable terms. Product Markets is a market in which a good or service is bought or sold. Resource Market is a market in which a resource is bought and sold. Circular-flow model is a diagram that traces the flow of resources, products, income and revenue among economic decision makers. A key economic assumption is that individual, n making choices, rationally select alternatives they perceive to be in their best interests. Rational self-interest is the individual try to maximize the expected benefit achieved with a given cost or to minimize the expected cost of achieving a given benefit. The lower the personal cost of helping others, the more help we offer. Marginal means incremental, additional, or extra; used to describe a change in an economic variable. A rational decision maker changes the status quo if the expected marginal benefit from the change exceeds the expected marginal cost. A marginal choice can involve a major economic adjustment. Microeconomics is the study of the economic behavior in particular markets, such as that for computers or unskilled labor. It examines individual economic choices and how markets coordinate the choices of various decision makers. Macroeconomics is the study of the economic behavior of entire economies. It puts together all the pieces to the puzzle. Economic Theory is a simplification of economic reality that is used to make predictions about the real world. Variable is a measure such as price or quantity, that can take on different values at different times. Behavioral assumption is an assumption that describes the expected behavior of economic decision makers, what motivates them. Other-things-constant assumption is the assumption, when focusing on the relation among key economic variables, that other variables remain unchanged. Positive economic statement is an assertion about economic reality that can be supported or rejected by reference to the facts. Physics or biology. What is. Normative economic statement reflects an opinion, which cannot be proved or disproved by fact. What should be. Association-is-causation fallacy is the incorrect idea that if two variables are associated in time, one must necessarily cause the other. Fallacy of composition is the incorrect belief that what is true for the individual, or part, must necessarily be true for the group. Secondary effects is the unintended consequences of economic actions that may develop slowly over time as people react to events. Economic Principles: A Contemporary Introduction 1/22/09 4:17 PM Opportunity cost—the value of the best alternative forgone when an item or activity is chosen. It is subjective. Each activity involves an opportunity cost. Sunk cost is a cost that has already been incurred and cannot be recovered, and thus is irrelevant for present and future economic decisions. Economic decision makers should consider only those costs that are affected by the choice. Sunk costs have already been incurred and are not affected by the choice by the choice, so they are irrelevant. Law of comparative advantage states that the individual, firm, region, or country with the lowest opportunity cost of producing a particular good should specialize in that good. Absolute advantage is the ability to make something using fewer resources than other producers use. Comparative advantage is the ability to make something at a lower opportunity cost than other producers face. Absolute advantage focuses on who uses the fewest resources, but comparative advantage focuses on what else those resources could produce—that is, on the opportunity cost of those resources. Resources are allocated most efficiently across the country and around the world when production and trade conform to the law of comparative advantage. Barter is the direct exchange of one good for another without using money. Bartering works in simple economies with little specialization and few traded goods. Money, however, works best in complex economies because it facilities exchange. Division of labor is the breaking down of the production of a good into separate tasks. Each laborer specializes in separate tasks. According to the law of comparative advantage the manager at a restaurant can assign workers different jobs based on their individual skills. Specialization of labor allows focusing work effort on a particular product or a single task. Includes: takes advantage of individual preferences and natural abilities allows workers to develop more experience at a particular task reduces the need to shift between different tasks permits the introduction of labor-saving machinery Production possibilities frontier (PPF) is a curve showing alternative combinations of goods that can be produced when available resources are used efficiently; a boundary line between inefficient and unattainable combinations. Resources are employed efficiently when there is no change that could increase the production of one good without decreasing the production of the other good. Efficiency involves getting the most from available resources. The PPF not only shows efficient combinations of production but also serves as the boundary between inefficient combinations inside the frontier and unattainable combinations outside the frontier. The opportunity cost of making more capital goods increases, because resources in the economy are not all perfectly adaptable to the production of both types of goods. Law of increasing opportunity cost is to produce more of one good, a successively larger amount of the other good must be sacrificed. The PFF derives its bowed-out shape from the law of increasing opportunity cost. As the economy moves down the curve, the curve becomes steeper, reflecting the higher opportunity cost of capital goods in term of forgone consumer goods. The more capital an economy produces during one period, the more output can be produced during the next period. The choice between consumer goods and capital goods is really the choice between the present consumption and future consumption. Economic system is the set of mechanisms and institutions that resolve the what, how and for whom questions. Pure capitalism—an economic system characterized by the private ownership of resources and the use of prices coordinate economic activity in unregulated markets. Private property rights are an owner’s rights to use, rent or sell resources or property. Pure command system is an economic system characterized by the public ownership of resources and centralized planning. Flaws of capitalism: No central authority protects property rights, enforces contracts and otherwise ensures that the rules of the game are followed. People with no resources to sell could starve. Some producers may try to monopolize markets by eliminating the competition. The production or consumption of some goods involves side effects that can harm or benefit people not involved in the market transaction. Private firms have no incentive to produce public goods. Flaws of pure command system: Running an economy is so complicated that some resources are used ineffectively. Each individual has less freedom in making economic choices. Because government is responsible for all production, the variety of products tends to be more limited than in a capitalist economy. Central plans may reflect more the preferences of central planners than those of society. No one has incentive to use resources to their highest-value. Mixed system is an economic system characterized by the private ownership of some resources and the public ownership of other resources; some markets are regulated by government. Economic Tools and Economic Systems 1/22/09 4:17 PM Households play the starring role in a market economy. Their demand for goods and services determines what gets produced. Utility is the satisfaction received from consumption; sense of well-being. Proprietors are people who work for themselves. Transfer payments are cash or in-kind benefits given to individuals as outright grants from the government. Firms—economic units formed by profit-seeking entrepreneurs who employ resources to produce goods and services for sale. Try to maximize profit. Sole proprietorship—a firm with a single owner but who bears unlimited liability for the firm’s losses and debts. Partnership is a firm with multiple owners who share profits and bear unlimited liability for the firm’s losses and debts. Each partner faces unlimited liability for any debts or claims against the partnership. Corporation is a legal entity owned by stockholders whose liability is limited to the value of their stock ownership. A stockholder’s ability to influence corporate policy is limited to voting for a board of directors. Corporate income gets taxed twice, first as corporate profits second as stockholder income. S corporation has limited liability but gets taxed once as income on each shareholder’s tax return. Must have <100 shareholders and no foreigners. Cooperative is an organization consisting of people who pool their resources to buy and sell more efficiently than they could sell individually. Consumer cooperative is a retail business owned and operated by some or all of its customers in order to reduce costs. Credit unions, grocery stores, health plans, student bookstores, etc. Producer cooperative is a co-op in which producers join forces to buy supplies and equipment and to market their output. Each producer’s objective is to reduce costs and increase profits. Not-for-profit organizations are groups that do not pursue profit as a goal; they engage in charitable, educational, humanitarian, cultural, professional, or other activities, often with a social purpose. Households usually perform domestic chores that demand neither expertise nor special machinery. Market failure is a condition that arises when the unregulated operation of markets yields socially undesirable results. Some firms try to avoid competition through collusion, which is an agreement among firms to divide the market and fix the price. Government anti-trust laws try to promote competition. Monopoly is a sole supplier of a product with no close substitute. Natural monopoly is one firm that can supply the entire market at a lower per unit cost than could two or more firms. Private good a good that is both rival in consumption and exclusive, pizza. Public good is a good that once produced is available for all to consume, regardless of who pays and who doesn’t; such a good is nonrival and nonexclusive, such as a safer community. Externality is a cost or a benefit that affects neither the buyer nor the seller, but instead affects people not involved in the market transaction. Governments often use taxes, regulations to discourage negative externalities. Fiscal policy is the use of government purchases, transfer payments, taxes and borrowing to influence economy-wide variables such as inflation, employment and economic growth. Monetary policy is the regulation of the money supply to influence economy-wide variables such as inflation, employment, and economic growth. Ability-to-pay tax principle—those with a greater ability to pay, such as those earning higher incomes or those owning more property, should pay more taxes. Benefits-received tax principle—those who get more benefits from the government should pay more taxes. Tax incidence—the distribution of tax burden among taxpayers; who ultimately pays the tax. Proportional taxation is the tax as a percentage of income remains constant as income increases; also called a flat tax. Progressive taxation is the tax as a percentage of income increases as income increases. Most payroll taxes are regressive, because they impose a flat rate up to a certain level of income, above which the marginal rate drops to zero. Marginal tax rate is the percentage of each additional dollar of income that goes to tax. International trade occurs because the opportunity cost of producing specific goods differs across countries. Foreign exchange is money needed to carry out international transactions. Balance of payments is a record of all economic transactions during a given period between residents of one country and residents of the rest of the world. Merchandise trade balance is the value during a given period of a country’s exported goods minus the value of its imported goods. Economic Decision Makers 1/22/09 4:17 PM Quota is a legal limit on the quantity of a particular product that can be imported or exported. Demand is a relation between the price of a good and the quantity that consumers are willing and able to buy per period, other things constant. Law of Demand—the quantity of a good that consumers are willing and able to buy per period relates inversely to the price, other things constant Substitution effect of a price change—when the price of a good falls, that good becomes cheaper compared to other goods so consumers tend to substitute that good for other goods. The change in the relative price—the price of one good relative to the prices of other goods—that causes the substitution effect. Money income—the number of dollars a person receives per period. Real income—income measured in terms of the goods and services it can buy; real income changes when the price changes. Income effect of a price change—a fall in the price of a good increases consumers’ real income, making consumers more able to purchase goods; for a normal good the quantity demanded increases. Individual demand is a relation between the price of a good and the quantity purchased by an individual consumer per period, other things constant. Marker demand is the relation between the price of a good and the quantity purchased by all consumers in the market during a given period, other things constant; the sum of the individual demands in the market. An increase in demand—that is, the rightward shift of the demand curve—means that consumers are willing and able to buy more goods at each price. Inferior good is a good for which demand decreases as consumer income increases. Normal good is a good for which demand increases as consumer income increases. Movement along a demand curve is a change in quantity demanded resulting from a change in the price of the good, other things constant. Shift of a demand curve is the movement of a demand curve right or left resulting from a change in one of the determinants of demand other than the price of the good. Supply is a relation between the price of a good and the quantity that producers are willing and able to sell per period, other things constant. Law of supply is the amount of a good that producers are willing and able to sell per period is usually directly related to its price, other things constant. As the price increases, other things constant, a producer becomes more willing to supply the good. A higher price makes producers able to increase quantity supplied. A higher price makes producers more willing and more able to increase quantity supplied. Producers are more willing because production becomes more profitable than other uses of the resources involved. Quantity supplied is the amount offered for sale per period at a particular price, as reflected by a point on a given supply curve. Refers to a particular amount offered for sale at a particular price. Individual supply is the relation between the price of a good and the quantity an individual producer is willing and able to sell per period, otc. Market supply is the relation between the price of a good and the quantity all producers are willing and able to sell per period, otc. An increase in supply—that is, a rightward shift of the supply curve—means that producers are willing and able to sell more goods at each price. Relevant sources are resources used to produce the good in question. Alternative goods are other goods that use some or all of the same resources as the good in question. A change in price, otc, causes a movement along a supply curve. Transaction costs are the costs of time and information required to carry out market exchange. Markets reduce transaction costs. Suppliers congregate to attract demanders. Capitalism. Why there are car dealers located next to each other. Surplus—at a given price, the amount by which quantity supplied exceeds quantity demanded; a surplus usually forces the price down. Shortage—at a given price, the amount by which quantity demanded exceeds quantity supplied; a shortage usually forces the price up. A surplus creates downward pressure on the price, and a shortage creates upward pressure. Equilibrium is the condition that exists in a market when the plans of buyers match those of sellers, so quantity demanded equals quantity supplied and the market clears. Given an upward-sloping supply curve, a rightward shift of the demand curve increases both equilibrium price and quantity and a leftward shift decreases both equilibrium price and quantity. Given a downward-sloping demand curve, a rightward shift of the supply curve decreases price but increases quantity, and a leftward shift increases price but decreases quantity. Disequilibrium is the condition that exists in a market when the plans of buyers do not match those of sellers; a temporary mismatch between quantity supplied and quantity demanded as the market seeks equilibrium. Price floor is a minimum legal price below which a product cannot be sold; to have an impact, a price floor must be set above the equilibrium price. Demand, Supply and Markets 1/22/09 4:17 PM Price ceiling is a maximum legal price which a product cannot be sold; to have an impact, a price ceiling must be set below the equilibrium price. Price elasticity of demand measures how responsive quantity demanded is to a price change; the percentage change in quantity demanded divided by the percentage change in price. PED=percentage change in quantity demanded Percentage change in price Price elasticity formula is the percentage change in quantity demanded divided by the percentage change in price; the average quantity and the average price are used as bases. Elasticity expresses a relationship between two amounts: the percentage change in quantity demanded and the percentage change in price. ED= Δq ÷ Δp (q+q’)/2 (p+p’)/2 Inelastic demand—a change in price has relatively little effect on quantity demanded; the percentage change in quantity demanded is less than the percentage change in price; the resulting price elasticity has an absolute value less than 1. Unit-elastic demand—the percentage change in quantity demanded equals the percentage change in price; the resulting price elasticity has an absolute value of 1. Elastic demand—a change in price has a relatively large effect on quantity demanded the percentage change in price elasticity has an absolute value exceeding 1. Total revenue—price multiplied by the quantity demanded at that price. TR=p*q If the positive effect of a greater quantity demanded more than offsets the negative effect of a lower price, then total revenue rises. If demand is elastic, the percentage increase in quantity demanded exceeds the percentage decrease in price, so total revenue increases. If demand is inelastic, percentage increase in quantity demanded is more than offset by the percentage decrease in price, so total revenue decreases. Linear demand curve is a straight-line demand curve; such a demand curve has a constant slope but usually has a varying price elasticity. If the demand curve is linear, consumers are more responsive to given price change when the initial price is high than when its low. The slope of a demand curve is not the same as the price elasticity of demand. Perfectly elastic demand curve is a horizontal line reflecting a situation in which any price increase would reduce quantity demanded to zero; the elasticity has an absolute value of ∞ For perfectly elastic curve, consumers demand all that is offered for sale at price p but demand nothing at a price above p. Perfectly inelastic demand curve is a vertical line reflecting a situation in which any price change has no effect on the quantity demanded; the elasticity value is zero. Unit-elastic demand curve—everywhere along the demand curve, the percentage change in price causes an equal but offsetting percentage change in quantity demanded, so total revenue remains the same; the elasticity has an absolute value of 1. Constant-elasticity demand curve—the type of demand that exists when price elasticity is the same everywhere along the curve; the elasticity value is unchanged. The greater the availability of substitutes and the more similar these substitutes are to the good in question, the greater that good’s price elasticity of demand The more important the item is as a share of the consumer’s budget, otc, the greater is the income effect of a change in price, so the more price elastic is the demand for the item. The more narrow the definition, the more substitutes, thus the more elastic the demand. Effects of a 10% increase in price: Abs Value of Price Elasticity Type of Demand Quantity Demanded TR ED=0 Perfectly in elastic No change increases by 10% 010% decreases ED=∞ perfectly elastic drops to 0 drops to 0 the longer the period of adjustment, the more responsive the change in quantity demanded is to a given change in price. The price elasticity of demand is greater in the long run because consumers have more time to adjust. Price elasticity of supply is a measure of the responsiveness of quantity supplied to a price change; the percentage change in quantity supplied divided by the percentage change in price. Usually a positive number. ED= Δq ÷ Δp (q+q’)/2 (p+p’)/2 where q is quantity supplied not demanded. If supply elasticity is <1 supply is inelastic, if supply=1 it is unit elastic and if it >1 supply is elastic. Inelastic supply—a change in price has relatively little effect on quantity supplied. Unit-elastic supply—the percentage change in quantity supplied equals the percentage change in price; the price elasticity of supply equals 1. Elastic supply-a change in price has a relatively large effect on quantity supplied; the percentage change in quantity supplied exceeds the percentage change in price; the price elasticity exceeds 1. Perfectly elastic supply curve—a horizontal line reflecting a situation in which any price decrease drops to 0; the elasticity value is ∞. Perfectly inelastic supply curve—a vertical line reflecting a situation in which a price change has no effect on the quantity supplied; the elasticity value is 0. Any good in fixed supply has a perfectly inelastic supply curve. Unit-elastic supply curve—a percentage change in price causes an identical percentage change in quantity supplied; depicted by a straight line through the origin. The elasticity of supply is typically greater the longer the period of adjustment. Income elasticity of demand—the percentage change in demanded divided by the percentage change in consumer income; the value is + for normal goods and – for inferior goods. Elasticity of Demand and Supply 1/22/09 4:17 PM Cross-price elasticity of demand is the percentage change in the demand of one good divided by the percentage change in the price of another good; it’s negative for substitutes, positive for compliments and 0 for nonrelated goods. Total utility—total satisfaction you derive from consumption; this could refer to either your total utility of consuming a particular good or your total utility from all consumption. Marginal utility—the change in your total utility from one-unit change in your consumption of a good. Law of diminishing marginal utility—the more of a good a person consumes per period, the smaller the increase in total utility from consuming more unit, other things constant. Developing numerical values for utility allows us to be more specific about the utility from consumption. Economists assume people consume because it will maximize your total utility. If a good is free, you increase consumption as long as marginal utility is positive. Consumer equilibrium—the condition in which an individual consumer’s budget is spent and the last dollar spent on each good yields the same marginal utility; utility is maximized. MUP=MUV Pp = Pv Marginal valuation is the dollar value of the marginal utility derived from consuming each additional unit of a good. Consumer surplus—the difference between the most a consumer would pay for a given quantity of a good and what the consumer actually pays The market demand curve is simply the horizontal sum of the individual demand curves for all consumers in the market. The market demand curve shows the quantity demanded per period by all consumers at various prices. At a given price, consumer surplus for the market is the difference between the most consumers would pay for that quantity and the amount they do pay. Consumer Choice and Demand 1/22/09 4:17 PM People are willing to pay a higher price for products that save time. Explicit cost—the opportunity cost of resources employed by a firm that takes the form of cash payments. Wages, rent, interest, taxes. Actually reported by accountant. Implicit cost—a firm’s opportunity cost of using its own resources or those provided by its owners without a corresponding cash payment. Time, use of company funds and capital. Accounting profit—a firm’s total revenue minus its explicit costs. Economic profit—a firm’s total revenue minus its explicit and implicit costs. Any accounting profit in excess of a normal profit is economic profit. Normal profit—the accounting profit earned when all resources earn their opportunity cost. Any accounting profit in excess of a normal profit is economic profit. Variable resource—any resource that can be varied in the short run to increase or decrease production. Fixed resource—any resource that cannot be varied in the short run Long run—a period during which all resources under the firm’s control are variable. All resources have an opportunity cost. Total Product—a firm’s total output. Production function is the relationship between the amount of resources employed and firm’s total product. Marginal product is the change in total product that occurs when the use of a particular resource increases by one unit, all other resources constant. Increasing marginal returns is the marginal product of a variable resource increases as each additional unit of that resource is employed. Law of diminishing marginal returns—as more of a variable resource is added to a given amount of another resource, marginal product eventually declines and could become negative. The LoDMR is the most important feature of production in the short run. Fixed cost—any production cost that is independent of the firm’s rate of output. Variable cost—any production cost that changes as the rate of output changes. Total cost—the sum of fixed cost and variable cost or TC=FC+VC Marginal cost—the change in total cost resulting from a one-unit change in output; the change in total cost divided by the change in output or MC=∆TC/∆q. Changes in marginal cost reflect changes in the marginal productivity of the variable resource. When the firm experiences increasing marginal returns, the marginal cost of output falls; when the firm experiences diminishing marginal returns, the marginal cost of output increases. The slope of the total cost curve at each rate of output equals the marginal cost at that rate of output. Average variable cost—variable cost divided by output, or AVC=VC/q. Average total cost—total cost divided by output, or ATC=TC/q; the sum of average fixed cost and average variable cost, or ATC=AFC+AVC. LoDMR determines the shapes of short-run cost curves. When the marginal product of labor increases, the marginal cost of output falls. Economies of scale—forces that reduce a firm’s average cost as the scale of operation increases in the long run. A larger size often allows for larger, more specialized machines and greater specialization of labor. Diseconomies of scale—forces that may eventually increase a firm’s average cost as the scale of operation increases in the long run. Diseconomies of scale result from a larger firm size, whereas diminishing marginal returns result from using more variable resources in a firm of a given size. Long-run average cost curve—a curve that indicates the lowest average cost of production at each rate of output when the size, or scale, of the firm varies; also called the planning curve. Each point of tangency between a short-run average cost curve and the long-run average cost curve represents the least-cost way of producing that particular rate of output. Constant long-run average cost—a cost that occurs when, over some range of output, long-run average cost neither increases nor decreases with changes in firm size. Minimum efficient scale—the lowest rate of output at which a firm takes full advantage of economies of scale. Only two relationships between resources and output underlie all the curves. In the short run, it’s increasing and diminishing returns from the variable resource. In the long run, it’s economies and diseconomies of scale. Production and Cost in the Firm 1/22/09 4:17 PM in the long run, a firm selects the most efficient size for the desired rate of output. market structure describes the important features of a market, such as the number of suppliers, the product’s degree of uniformity, the ease of entry into the market, and the forms of competition among firms. A firm’s decisions about how much to produce or what price to charge depend on the structure of the market. Perfect Competition is a market structure with many fully informed buyers and sellers of a standardized product and no obstacles to entry or exit of firms in the long run. Commodity is a standardized product that does not differ across producers. A perfectly competitive firm is so small relative to the market that the firm’s supply decision does not affect the market price. Competitive markets include: wheat, corn, livestock. Markets for basic commodities gold, silver, copper. Markets for widely traded stock: goog, ge, citi. The firm maximizes economic profit by finding the quantity at which total revenue exceeds total cost by the greatest amount. Profit is maximized at the rate of output where total revenue exceeds total cost by the greatest amount. Marginal revenue is the firm’s change in total revenue from selling an additional unit; a perfectly competitive firm’s marginal revenue is also the market price. In perfect competition, marginal revenue is the market price. Golden rule of profit maximization—to maximize profit or minimize loss, a firm should produce the quantity at which marginal revenue equals marginal cost; this rule holds for all market structures. Average revenue—total revenue divided by quantity or AR=TR/q; in all market structures, average revenue equals the market price. Market price=marginal revenue=average revenue A firm produces rather than shuts down if total revenue exceeds the variable cost of production. The bottom line is that the firm produces rather than shuts down if there is some rate of output where the price at least covers average variable cost. If the average variable cost exceeds the price at all rates of output, the firm shut down. Fixed cost is sunk cost in the short fun, whether the firm produces or shuts down. Short-run firm supply curve—a curve that shows how much a firm supplies at each price in the short run; in perfect competition, that portion of a firm’s marginal cost curve that intersects and rises above the low point on its average variable cost curve. Short-run industry supply curve—a curve that indicates quantity supplied by the industry at each price in the short run; in perfect competition, the horizontal sum of each firm’s short-run supply curve. A perfectly competitive firm supplies the short-run quantity that maximizes profit or minimizes loss. When confronting a loss, a firm either produces an output that minimizes loss or shuts down temporarily. In the short run, the quantity of variable resources can change, but other resources, which mostly determine firm size, are fixed. Short-run economic profit attracts new entrants in the long run and may cause existing firms to expand. Market supply thereby increases driving down the market price until economic profit disappears. A firm in the long run is forced by competition to adjust its scale until average cost is minimized. This long-run adjustment continues until the market supply curve intersects the market demand curve at a price that corresponds to the lowest point on each firm’s long-run average cost curve. Long-run industry supply curve is a curve that shows the relationship between price and quantity supplied by the industry once firms adjust in the long run to any change in market demand. Constant-cost industry—an industry that can expand or contract without affecting the long-run per-unit cost of production; the long-run industry supply curve is horizontal. Increasing-cost industry—an industry that faces higher per-unit production costs as industry output expands in the long run; the long-run industry supply curve slopes upward. New firms enter the industry until the combination of a higher production cost and a lower price squeezes economic profit to zero. Productive efficiency—the condition that exists when production uses the least-cost combination of inputs; minimum average cost in the long run. Allocative efficiency—the condition that exists when firms produce the output most preferred by consumers; marginal benefit equals the marginal cost. the marginal value, or marginal benefit, that consumers attach to the final unit purchased, just equals the opportunity cost of the resources employed to produce that unit. When the marginal benefit that consumers derive from a good equals the marginal cost of producing that good, that market is said to be allocatively efficient. Marginal benefit=marginal cost Producer surplus—a bonus for producers in the short run; the amount by which total revenue from production exceeds variable cost. Social welfare—the overall well-being of people in the economy; maximized when the marginal cost of production equals the marginal benefit to customers. Perfect Competition 1/22/09 4:17 PM Barrier to entry is any impediment that prevents new firms from entering an industry and competing on an equal basis with existing firms. Patent is a legal barrier to entry that grants the holder the exclusive right to sell a product for 20 years from the date the patent application is filed. Innovation is the process of turning an invention into a marketable product. Governments often confer monopoly status by awarding an individual firm the exclusive right to supply a particular good or service. A monopoly that emerges from the nature of costs is called a natural monopoly. A downward sloping LRAC curve for economies of scales often leads to a monopoly. The demand for a monopolists output is also the market demand. The marginal revenue curve is below the demand curve and that total revenue reaches a maximum where marginal revenue is zero. Where demand is elastic, marginal revenue is positive, and total revenue increases as the price falls. Where demand is inelastic, marginal revenue is negative, and total revenue decreases as the price falls. A profit-maximizing monopolist would never expand output to the inelastic range of demand because doing so would reduce total revenue. In perfect competition, each firm’s choice is confined to quantity because the market has already determined the price. The monopolist however, can choose either the price or quantity but choosing one determines the other—they come in pairs. Price maker is a firm with some power to set the price because the demand curve for its output slopes downward; a firm with market power. The monopolist supplies the quantity at which total revenue exceeds total cost by the greatest amount. The profit-maximizing output occurs where marginal revenue equals marginal cost. So the profit-maximizing rate of output is found where the marginal cost curve intersects the marginal revenue curve. The profit-maximizing firm produces where total revenue exceeds total cost by the greatest amount. A monopolist may be able to set the price, but the quantity demanded at that price is determined by consumers. Even the most powerful monopolist is subject to the law of demand. A monopolist is not assured an economic profit. If the price covers average variable cost, the monopolist produces, at least in the short run. If not the monopolist shuts down, at least in the short run. There is no monopolist supply curve. If a monopoly is insulated from competition by high barriers that blow new entry, economic profit can persist into the long run. A monopolist unable to erase a loss will, in the long run, leave the market. The monopolist restricts quantity below what would maximize social welfare. Deadweight loss of monopoly is the net loss to society when a firm with market power restricts output and increases the price. It is a loss to consumers but gain to no one it results from the allocative inefficiency arising from the higher price and reduced output of a monopoly. Society would be better off if output exceeded the monopolist’s profit-maximizing quantity, because the marginal benefit of more output exceeds its marginal cost. If resources must be devoted to securing and maintaining a monopoly position, monopolies may impose a greater welfare loss than simple models suggest. Rent seeking—activities undertaken by individuals or firms to influence public policy in a way that increases their incomes. Price discrimination—increasing profit by charging different groups of consumers different prices for the same product. Perfectly discrimination monopolist is a monopolist who charges a different price for each unit sold; also called the monopolist’s dream. By charging a different price for each unit sold, the perfectly discriminating monopolist is able to convert every dollar of consumer surplus into economic profit. Monopoly 1/22/09 4:17 PM Monopolist competition is a market structure with many firms selling products that are substitutes that are substitutes but different enough that each firm’s demand curve slopes downward; firm entry is relatively easy. Sellers differentiate products in four basic ways: Physical Differences-size, weight, color, taste, texture, etc. Location-number and variety of locations where a product is available. Services-accompanying services. Product image-products differ in the image the producer tries to foster in the buyer’s mind. A firm’s demand curve is more elastic the more substitutes there are and the less differentiated the product is. The profit-maximizing quantity occurs where marginal revenue equals marginal cost; the profit-maximizing price for that quantity is found up on the demand curve. There is no curve that uniquely relates prices and corresponding quantities supplied. Price minus ATC=π*quantity = economic π The monopolistic competitor is not guaranteed an economic profit. So long as price exceeds AVC, the firm in the short run loses less by producing than by shutting down. Because market entry is easy, monopolistically competitive firms earn zero economic profit in the long run. Monopolistic competition is like monopoly in the sense that firms in each industry face demand curves that slope downward. Monopolistic competition is like perfect competition in the sense that easy entry and exit eliminate economic profit or economic loss in the long run. If firms have the same cost curves, the monopolistic competitor produces less and charges more than the perfect competitor does in the long run, though neither earns economic profit. Excess capacity is the difference between a firm’s profit-maximizing quantity and the quantity that minimizes average cost; firms with excess capacity could reduce average cost by increasing quantity. the marginal value of increased output would exceed its marginal cost, so greater output would increase social welfare. Oligopoly is a market structure characterized by so few firms that each behaves interdependently. Steel, computers, cigarettes, automobiles, oil, cereals, etc. are oligopolistic. Undifferentiated oligopoly is an oligopoly that sells a commodity, or a product that does not differ across suppliers, such as an ingot of steel or a barrel of oil. Differentiated oligopoly is an oligopoly that sells products that differ across suppliers, such as automobiles or breakfast cereal. Each firm knows that any changes in its product’s quality, price, output or advertising policy may prompt a reaction from its rivals. And each firm may react if another firm alters any of these features. An oligopoly can often be traced to some form of barrier to entry, such as economies of scale, legal restrictions, brand names built up by years of advertising, or control over an essential resource. The most important barrier to entry is economies of scale. Product differentiation expenditures create a barrier to entry. Multiple products from the same brand dominate shelf space and attempt to crowd out new entrants. There is no general theory of oligopoly but rather a set of theories, each based on the diversity of observed behavior in an interdependent market. Collusion is an agreement among firms to increase economic profit by dividing the market and fixing the price. Cartel is a group of firms that agree to coordinate their production and pricing decisions to earn monopoly profit. Colluding firms, compared with competing firms, usually produce less, charge more, block new firms, and earn more profit. Consumers pay higher prices, and potential entrants are denied the opportunity to compete. For cartel profit to be maximized, output must be allocated so that the marginal cost for the final unit produced by each firm is identical. The greater the difference in average costs across firms, the greater the differences in economic profits among them. If average costs differ across firms, the output allocation that maximizes cartel profit yields unequal profit across cartel members. Consensus becomes harder to achieve as the number of firms grow. Establishing and maintaining an effective cartel is more difficult if: The product is differentiated among firms Average costs differ among firms There are many firms in the industry Entry barriers are low Cheating on the cartel agreement becomes widespread Price leader is a firm whose price is matched by other firms in the market as a form of tacit collusion. Typically, a dominant firm sets the market price, and other firms, follow that lead, thereby avoiding price competition. Price leadership faces obstacles: Practice violates US antitrust laws. Firms that fail to follow a price increase take business away from firms that do. The greater the price differentiation among sellers, the less effective price leadership is a means of collusion. Unless there are barriers to entry, a profitable price attracts new entrants, which could destabilize the price-leadership agreement. Game theory is an approach that analyzes oligopolistic behavior as a series of strategic moves and countermoves by rival firms. A general approach that focuses on each player’s incentives to cooperate. Prisoner’s dilemma is a game that shows why players have difficulty even though they would benefit from cooperation. Strategy—in game theory, the operational plan pursued by a player. Payoff matrix—in game theory, a table listing the payoffs that each player can expect from each move based on the actions of the other player. Dominant strategy equilibrium—in game theory, the outcome achieved when each player’s choice does not depend on what the other player does. Duopoly—a market with only two producers; a special type of oligopoly market structure. Nash equilibrium—a situation in which a firm, or a player in game theory, chooses the best strategy given the strategies chosen by others; no participant can improve his or her outcome by changing strategies even after learning of the strategies selected by other participants. Tit-for-tat—in game theory, a strategy in repeated games when a player in one round of the game mimics the other player’s behavior in the previous round; an optimal strategy for getting the other player to cooperate. Coordination game—a type game in which Nash equilibrium occurs when each player chooses the same strategy; neither player can do better than matching the other player’s strategy. If oligopolists engaged in some sort of implicit or explicit collusion, industry would be smaller and the price would be higher than under perfect competition. With barriers to entry, we should expect profit in the long run to be higher under oligopoly than under perfect competition. Monopolistic Competition and Oligopoly 1/22/09 4:17 PM Regardless of the market structure, however, profit maximization prompts firms to produce where marginal revenue equals marginal cost. a producer demands another unit of a resource as long as its marginal revenue exceeds its marginal cost. People supply their resources to the highest-paying alternative, other things constant. Any differences between the profit-maximizing goals of firms and the utility-maximizing goals of households are sorted out through voluntary exchange in markets. Like the demand and supply for final goods and services, the demand and supply for resources depend on the willingness and ability of buyers and sellers to engage in market exchange. Derived demand is demand that arises from the demand for the product the resource produces. the marginal product of labor (MPL) is the chance in total product from employing one more unit of labor. Marginal revenue product—the change in total revenue when an additional unit of a resource is hired, other things constant. Marginal revenue product depends on how much additional output the resource produces and at what price that output is sold. The marginal revenue product curve can be thought if as the firm’s demand curve for that resource. For all types of firms, the marginal revenue product is the change in total revenue resulting from hiring an additional unit of the resource. Marginal resource cost—the change in total cost when an additional unit of a resource is hired, other things constant. the firm hires more labor as long as doing so adds more to revenue than to cost—that is, as long as the marginal revenue product exceeds the marginal resource cost. The firm stops hiring more labor once the two are equal. Hires until Marginal Resource Product=Marginal Resource Cost whether a firm sells in competitive markets or with some market power, the profit-maximizing level of employment occurs where the marginal revenue product of labor equals its marginal resource cost. 2 things can change a resource’s marginal product: change in the amount of other resources employed change in technology resource substitutes—resources that substitute production; an increase in the price of one resource increases the demand for the other. Resource complements—resources that enhance one another’s productivity; an increase in the price of one resource decreases the demand for the other. Resource Markets 1/22/09 4:17 PM economic fluctuations—the rise and fall of economic activity relative to the long-term growth trend of the economy; also called business cycles. Expansion—a period during which the economy’s output increases. Contraction—a period during which the economy’s output decreases. Depression—a sharp reduction in an economy’s total output accompanied by high unemployment lasting more than a year. Recession—a sustained decline in the economy’s total output lasting at least two consecutive quarters; or six months; an economic contraction. Inflation—an increase in the economy’s average price level. Leading economic indicators—variables that predict, or lead to, a recession in recovery; examples include consumer confidence, stock market prices, business investment, and big-ticket purchases, such as automobiles and homes. Coincident economic indicators—variables that reflect peaks and troughs in economic activity as they occur; examples include employment, personal income, and industrial production. Lagging economic indicators—variables that follow or trail, changes in overall economic activity; examples include the interest rate and average duration of employment. Underground economy—market transactions that go unreported either because they are illegal or because people involved want to evade taxes. GDP therefore includes some economic production that does not involve market exchange. The gross domestic product fails to capture changes in the availability of leisure time and often fails to reflect changes in the quality of products or in the availability of new products. Depreciation—the value of capital stock used up to produce GDP or that becomes obsolete during the year. Net domestic product—gross domestic product minus depreciation. Gross investment is the value of all investment during a year and is used in computing GDP. Net investment equals gross investment minus depreciation. Nominal GDP—GDP based on prices prevailing at the time of production. Base year—the year with which other years are compared when constructing an index; the index equals 100 in the base year. Price index—a number that shows the average price of products; changes in a price index over time show changes in the economy’s average price level. Consumer price index—a measure of inflation based on the cost of a fixed market basket of goods and services. There is a quality bias in the CPI because it assumes that the quality of the market basket remains relatively constant over time. To the extent that the CPI ignores quality improvements, it overstates the true extent of inflation. The CPI calculations, by not allowing households to shift away from goods that have become more costly, overestimates the true extent of inflation experienced by the typical household. The CPI overstates inflation because it includes an item in the market basket only after the product becomes widely used. GDP price index—a comprehensive inflation measure of all goods and services included in the gross domestic product. GDP PI= Nominal GDP x 100 Real GDP Introduction to Macroeconomics 1/22/09 4:17 PM Chain-weighted system—an inflation measure that adjusts the weights from year to year in calculating a price index, thereby reducing the bias caused by a fixed-price weighting system. The gross domestic product measures the market value of all final goods and services produced during a year by resources located in the united states, regardless of who owns the resources. Expenditure approach to GDP—calculating GDP by adding up spending on all final goods and services produced in the nation during the year. Income approach to GDP—calculating GDP by adding up all earnings from resources used to produce output in the nation during the year. Final goods and services—goods and services sold to final, or end, users. Toothbrush, contact lenses, bus rides. Intermediate goods and services—goods and services purchased by firms for further reprocessing and resale. Double counting—the mistake of including both the value of the intermediate products and the value of final products in calculating gross domestic product; counting the same production more than once. GDP only counts the final value. Consumption—household purchases of final goods and services, except for new residences, which count as investment. Haircuts, soap, furniture. Investment—the purchase of new plants, new equipment, and new residences, plus net additions to inventories. Gross private domestic investment. Physical capital—manufactured items used to produce goods and services; includes new plants and new equipment. Residential construction—building new homes or dwelling places. Inventories—producers’ stocks of finished and in-process goods. Government purchases—spending for goods and services by all levels of government; government outlays minus transfer payments. Government consumption and gross investment. Net exports—the value of a country’s exports minus the value of its imports. Aggregate expenditure—total spending on final goods and services in an economy during a given period, usually a year. Investment=I; consumption=C; government purchases=G; net exports=(X—M); C+I+G+(X—M)=Aggregate expenditure=GDP Aggregate income—all earnings of resource suppliers in an economy during a given period, usually a year. Aggregate expenditure=GDP=aggregate income Value added—at each stage of production, the selling price of a product minus the cost of intermediate goods purchased from other firms. The vale added at all stages sums to the market value of the final good and the value added for all final goods sums to GDP based on the income approach. Tracking the U.S. Economy 1/22/09 4:17 PM labor force—those 16 years of age and older who are either working or looking for work. Adult population= civilian noninstitutional adult population. Unemployment rate—the number unemployed as a percentage of the labor force. Discouraged workers—those who drop out of the labor force in frustration because they can’t find work. Labor force participation rate—the labor force as a percentage of the adult population. There are four sources of unemployment: frictional, seasonal, structural, cyclical. Frictional unemployment—unemployment that occurs because job seekers and employers need time to find each other. Seasonal unemployment—unemployment caused by seasonal changes in the demand for certain kinds of labor. Structural unemployment—unemployment because 1) the skills demanded by employers do not match those of the unemployed, or 2)the unemployed do not live where the jobs are. Structural unemployment occurs because changes in tastes, technology, taxes, and competition reduce the demand for certain skills and increase the demand for other skills. Cyclical unemployment—unemployment that fluctuates with the business cycle, increasing during contractions and decreasing during expansions. Full employment—employment level when there is no cyclical unemployment. Unemployment benefits—cash transfers to those who lose their jobs and actively seek employment. Underemployment—workers are overqualified for their jobs or work fewer hours than they would prefer. Hyperinflation—a very high rate of inflation. Deflation—a sustained decrease in the price level. Disinflation—a reduction in the rate of inflation. Demand-pull inflation—a sustained rise in the price level caused by a rightward shift of the aggregate demand curve. Cost-push inflation—a sustained rise in the price level caused by a leftward shift of the aggregate supply curve. Prices increase and real GDP decreases. Inflation erodes confidence in the value of the dollar over the long term. Unanticipated inflation creates more problems than anticipated inflation. The arbitrary gains and losses arising from unanticipated inflation is one reason inflation is so unpopular. Interest—the dollar amount paid by borrowers to lenders. Interest rate—interest per year as a percentage of the amount loaned. Nominal interest rate—the interest rate expressed in dollars of current value (that is, not adjusted for inflation) as a percentage of the amount loaned; the interest rate specified on the loan agreement. Real interest rate—the interest rate expressed in dollars of constant purchasing power as a percentage of the amount loaned; the nominal interest rate minus the inflation rate. COLA—cost-of-living adjustment; an increase in a transfer payment or wage that is tied to the increase in the price level.