Ø Income + demand + ; Prices of related goods (Normal good --- price + demand- Strong taste, demand+; Inferior good --- price + demand +) ; Expectation – change income or price of good; No. of buyers – more buyers, higher demand. Ø Input prices (price+ supply -); Technology + productivity+ supply+; Expectations; Number of sellers (more sellers higher supply )-------------------- shift the supply and demand curve (L- R+) Ø Elasticity l l Perfectly elastic -- Quantity demanded changes infinitely with any change in price Elastic demand curve (supply) ---- gentle With elastic demand, Price + Total Revenue – Inelastic demand curve (supply) – steep With inelastic demand, Price + TR+ l Income elasticity of demand = % change in Q demanded / % change in income Luxuries tend to be income elastic; Necessities (fuel, utilities, medical service) are inelastic l Elasticity of supply is the ability of sellers to change the amount of good they produce. Beach-front – inelastic books or cars – elastic In the long-run, supply is more elastic. Ø Theory of consumer choice Income + -- budget constraint shifts right Price - -- budget constraint shifts right -- Moves consumer along an indifference curve to a hypo point B with different the marginal rate of substitution (MRS) -- Moves consumer to a different indifference curve and a new optimum point Income effect and substitution effect - In same direction, consumer buys more - In dif. directions, total effect ambiguous Ø Evaluating the market equilibrium under competitive market and no externality (market efficient) • Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. (Consumer surplus) • Free markets allocate the demand for goods to the sellers who can produce them at least cost. (Producer surplus) • Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus. l A market is efficient when the allocation of resources at the equilibrium outcome maximizes total surplus. Tax on buyers – demand curve shifts to left Tax on sellers – supply curve shifts to left A low domestic price means the country has a comparative advantage in producing the good and that the country will become an exporter. A high domestic price –no comparative advantage-- become an importer. If a country is an exporter of a good, producers of the good are better off and consumers of the good are worse off. Otherwise, consumers are better off and producers are worse off. Diminishing marginal product: the marginal product of an input declines as the quantity of that input increases. Because crowded conditions in a fixed space reduce productivity. A typical firm’s production function gets flatter as the quantity of input increases. Profit ( π ) = Total Rev(TR) – Total Cost(TC) = MR - MC TC= Fixed Cost+ Variable Cost Average Total Cost = AFC+ AVC = FC/Q + VC/Q = TC/Q MC=∆TC/ ∆Q Economies of scale - ATC ↓ as the quantity of output ( TR )↑ . Diseconomies of scale -- ATC ↑ as Q ↑ . The main goal of a competitive firm is to maximize profit( the difference between TR and TC) Profit maximization occurs at the When MR MC, increase Q to increase π When MR MC, decrease Q to increase π When MR = MC=price, π is maximized COMPETITIVE MARKET Ø Shutdown is a short-run decision that a firm does not Total revenue (TR) = P x Q produce anything during a specific period of time because Average revenue (AR) =TR/Q=P of current market condition. Shut down if P minimum AVC Marginal Revenue (MR) =∆TR/ ∆Q Exit is a long-run decision of a firm to leave the market. Exit if P minimum ATC MONOPOLY MARKET l A monopoly firm is the sole seller in its market. Monopolies arise due to barriers to entry, including: government-granted monopolies, the control of a key resource, or economies of scale over the entire range of output. l A monopoly firm faces a downward-sloping demand curve for its product. As a result, it must reduce price to sell a larger quantity, which causes marginal revenue to fall below price. F1 l Monopoly firms maximize profits by producing the quantity where marginal revenue equals marginal cost. But since marginal revenue is less than price, the monopoly price will be greater than marginal cost, leading to a deadweight loss. F2 Monopoly firms (and others with market power) try to raise their profits by charging higher prices to consumers with higher willingness to pay. This practice is called price discrimination. It can increase the monopolist’s profits. And it can reduce deadweight loss Ø In perfect price discrimination, the monopolist produces the efficient quantity and charges each buyer a price which is equal to his WTP. The monopolist captures all consumer surplus, which makes profit increases. There’s no dead weight loss. Ø Governments respond to the problem of monopoly in four different ways: making monopolized industries more competitive (competition laws); regulating the behavior of monopolies (regulating price); turning some private monopolies into public enterprises; doing nothing at all. IMPERFECT MARKET Ø Oligopoly : only a few sellers offer similar or identical products. Monopolistic competition: many firms sell similar but not identical products. Ø Key feature of oligopoly is a tension between cooperation and self-interest. l Collusion: an agreement among firms in a market about quantities to produce or prices to charge. Best off co-operating with each other and acting like a monopoly: produce less quantity and higher price. Cartel: a group of firms acting in unison. Oligopolists can maximize profits if they form a cartel and act like a monopolist. l Yet, each firm has incentive to renege on the agreement and thus self-interest leads each oligopolist to a higher quantity and lower price than under the monopoly outcome. Ø A Nash equilibrium , a non-cooperative equilibrium, is an equilibrium reached by firms when they calculate their own profits separately without co-operating with each other. Applying this, when firms in an oligopoly individually choose production to maximize profit, they may produce a quantity of output greater the monopoly output and less than the competitive level of output. Thus, the price would be between the competitive price and the monopoly price. Ø A “strategy” is a decision or decision-plan chosen by a player, which takes into account the likely reactions of other players. Dominant strategy: a strategy that is “best” for a player in a game regardless of the strategies chosen by the other players. Prisoners’ dilemma: a “game” between two captured criminals that illustrates why cooperation is difficult even when it is mutually beneficial. The prisoners’ dilemma shows that self-interest can prevent people from cooperating, even when cooperation is in their mutual interest. Ø Marginal product of labor MPL= △ Q/ △ L Value of the marginal product VMPL= P x MPL MC = W/MPL =∆TC/ ∆Q = P Ø Changes in the output price (P); Technological change (MPL); The supply of other factors (MPL) --- Shift the Labor Demand Curve Ø The sum of individual labor supply curves; changes in tastes or attitudes regarding the labor–leisure trade-off; opportunities for workers in other labor markets; immigration – shift supply curve Ø GDP is the market value of all final goods and services produced within a country in a given period of time. It measures the total income generated in the production of output and the total expenditure on the economy’s output. ---Expenditure(=output), income and production approaches. l GDP(Y) =Consumption (C)+Investment (I)+Government Purchases (G)+Net Exports (NX=EX-MX) l Nominal GDP is measured using the current prices, not adjusted for inflation. Real GDP is measured using constant prices from the base year, adjusted for inflation. l GDP deflator = 100 x nominal GDP/ real GDP ---measure price level l GNP : the total market value of all final goods and services produced by permanent residents of a nation within a given period of time. GNP=GDP + NFIA Net Factor Income from Abroad) NFIA=Income receipts from rest of world - income payments to rest of world l Limitation of GDP: many things that contribute to economic wellbeing are not included in GDP. (The value of leisure and a clean environment); GDP also does not take into account of the depletion of non-renewable resources, or the destruction of the environment in the process of production. l CPI in any years = 100 x cost of basket in current year / cob in base year Consumer Price Index is a weighted average price of a representative basket of goods and services. n Inflation rate = / CPI last year l Problems with CPI: Introduction of new goods; Substitution bias; unmeasured quality changes. Thus, the CPI overstates increases in the cost of living. n Real interest rate=nominal interest rate –inflation rate. Ø Productivity= Y(real GDP)/ L(quantity of labor employed) l The ability to produce depends on the productivity: the average amount of goods and services per unit of labor input. l The production function describes the relationship between the quantity of inputs and the quantity of output. Y = A F(L, K, H, N). To examine output per unit of labour we could set x = 1/L and we get: Y/L=A F(1,K/L,H/L,N/L). Productivity (Y/L) depends on physical capital per worker (K/L), human capital per worker (H/L) and natural resources per worker (N/L), as well as the state of technology, (A). l in theory , public policy can affect long-run growth in productivity K: boosting productivity by increasing K, which requires increasing investment (I) and redcing consumption goods (C)= increasing saving. But this faster growth is temporary, due to diminishing returns to capital: As K rises, the extra output from an additional unit of K falls. To raise K/L and hence productivity, wages, and living standards, the government can also encourage – foreign direct investment – foreign portfolio investment H: Government increases productivity by promoting education–investment in human capital. Ø Close economy loanable funds market S- national saving D- investment l S = (Y – T- C) +(T- G)= private saving + public saving l If a tax law encourages greater saving --lower real interest rates and greater investment. S shifts R l If a tax law encourages greater investment -- higher real interest rates and greater saving D shifts R l A budget deficit (T-G 0) – shifts the supply curve to the left ; budget surplus (T-G 0) (Right) Ø Natural Unemployment : refers to the amount of unemployment that an economy ‘normally’ experiences. √ Cyclical unemployment: the year-to-year fluctuations that are closely related to the ups and downs of economic activities. l Three types of unemployment: frictional unemployment (people are temporarily unemployed while looking for a new job); structural unemployment (skill mismatch); unemployment due to the persistent lack of jobs (wage rates are set too high). l Unemployment occurs when wage is kept above equilibrium (fig in P4). 3 reasons: The minimum wage may exceed the equilibrium wage for the least skilled workers, causing unemployment; Unions exert their market power to negotiate higher wages for workers and therefore the typical union worker earns higher wages and gets more benefits than a nonunion worker for the same type of work; the theory of efficiency wages: Firms voluntarily pay above-equilibrium wages to boost worker productivity. l Unemployment rate = Number of unemployed / labor force (15+ exclude not in labor force) x100% l Participation rate = labor force / adult population x 100% Ø Money is the stock of assets in the economy that are used to make transactions, such as buying goods and services. 3 functions : Medium of exchange; Unit of account; Store of value l The primary way in which the Reserve Bank of Australia changes the money supply is through open-market operations, which involves the RBA purchasing or selling Australian government securities. l The quantity theory is a good explanation of the long run behavior of inflation. Prices rise when the government prints too much money. Value of money: 1/P = the value of $1 . Inflation drives up prices and drives down the value of money. l Money Supply- Demand Diagram MS: In real world, money supply is determined by the central bank, the banking system, and consumers. HERE, we assume the central bank can precisely control MS and set it at some fixed amount. MD: It depends on P: An increase in P reduces the value of money, so more money is required to buy goods and services and MD increases, other things (real income, interest rate, availability of ATMs). -- Changes in i do not affect MS, which is fixed by the RBA. A fall in i increases MD. Ø Classical dichotomy -- describe the economy in the long run Nominal variables are measured in monetary units. (measure in $) Real variables are measured in physical units. (measure in output) l A relative price is the price of one good relative to (divided by) another l Real wage = nominal wage / price level = W/P = X units output per hour Ø Monetary neutrality: c lassical economists suggested that monetary developments affect nominal variables but not real variables. If MS increases, all nominal variables, including prices, will increase. All real variables, including relative price, will remain unchanged. --- describe the economy in the long run Ø Velocity of money: V= P.Y / M --- Y is Nominal GDP, quantity of output; M is quantity of money; P.Y is nominal value of output. l Quantity Equation: M.V=P.Y It shows that an increase in M must be reflected in one of the other three variables: P rises or Y rises or V falls. As V is stable and Y is not affected by change in M (money is neutral), P changes by same percentage as M. Ø Inflation Tax: when the government raises revenue by printing money, this is levy an inflation tax. l The Fisher equation: i = r + π Nominal interest rate=Real interest rate+ Inflation rate l Fisher effect : in the long run, an increase in π causes an equal increase in i. l Expectation Inflation ---affects nominal interest rate, wage and price ---does not affect real interest rate and real wage l The costs of inflation: Shoeleather costs, Menu costs, Misallocation of resources from relative-price variability, Confusion inconvenience, Tax distortions and Arbitrary redistributions of wealth l π e = expected inflation rate i – π e = ex ante real interest rate Open Economy Ø Net exports (NX) are the value of exports minus the value of imports. (trade balance) A trade deficit means exportsimports A trade surplus means that exportsimports. Ø NFI measures the imbalance in a country’s trade in assets: When NFI 0, “capital outflow”. Domestic purchases of foreign assets exceed foreign purchases of domestic assets. Ø The current account measures an imbalance between a country’s exports and its imports as well as the flow of income and flow of transfers. CAB = NX + NY + NT Ø The capital account (NFI) measures the imbalance between the amount of foreign assets bought by domestic residents and the mount of domestic assets bought by foreigners. NFI= CAB Ø GNDY: Gross National Disposable Income: an economy’s total income that can be used for consumption and saving. Close Economy: GNDY =GDP=Y S=Y-C-G Open Economy: G NDY=Y+NY+NT S = I + CAB = I + NFI Ø Appreciation (or “strengthening”): an increase in the value of a currency as measured by the amount of foreign currency it can buy. Depreciation (or “weakening”) --- decrease = domestic price level / = P/ P* foreign price level If the real exchange rate appreciates, domestic goods become more expensive relative to foreign goods. Ø Purchasing-power parity (PPP) asserts that a unit of any given currency should be able to buy the same quantity of goods in all countries. • This theory is based on the law of one price: the notion that a good should sell for the same price in all markets Ø In loanable funds market, S depends positively on the real interest rate -- r. Because private saving depends on r. Government saving is assumed not to depend on r. I depends negatively on r l When a domestic resident buys imported goods, the quantity of dollars demanded decreases. The increase in imports reduces NX, which we think of as the demand for dollars. So, NX is really the net demand for dollar. l When a foreigner buys a domestic asset, the quantity of dollars supplied falls.The transaction reduces NFI, which we think of as the supply of dollars. Ø Government budget deficits---reduces national saving, which shifts the supply curve for loanable funds to the left, which raises the interest rates. Higher interest rates reduce NFI. A decrease in NFI reduces the supply of dollars. This drives up the real exchange rate and therefore it increases trade deficit. Ø Three Facts: Short-run fluctuations are unpredictable and irregular. Most quantities move together. As output falls, unemployment rises. Ø Classical economic model, real output is determined in the production side, depending on the supplies of production inputs and the available technology. In the long run, monetary changes eventually affect prices and other nominal variables but do not affect real GDP, unemployment, or other real variables. In the short run, changes in nominal variables can affect real variables, and most real and nominal variables are intertwined. Ø AD-AS model l Output of goods and services as measured by real GDP. The aggregate price level, as measured by GDP deflator or CPI level. l AD downward reason: The AD curve shows the quantity of all gs demanded in the economy at any given price level. Suppose P rises, applying the wealth effect, the money balances people hold buy fewer goods and services, so real wealth is lower. People feel poorer and therefore C falls. Applying the interest-rate effect, buying goods services requires more dollars, so people sell bonds or other assets. This drives up interest rates (R). I, which depends negatively on R, falls. Applying the exchange-rate effect, domestic interest rates rise which attracts more foreign investment desire more domestic bonds, and this leads to a reduction in supply of dollars in the foreign exchange market. The real exchange rate appreciates. Exports are more expensive to people abroad and imports are cheaper to domestic residents. Then NX falls. l The natural rate of output (Y1) is the amount of output the economy produces when unemployment is at its natural rate. Why vertical: Y1 determined by the economy’s stocks of labor, capital, and natural resources, and on the level of technology. An increase in P does not affect any of these, so it does not affect Y1. l Consumption; Investment ; government purchases; net exports – shifts the AD curve l Changes in L or natural rate of unemployment (Immigration); Changes in K or H (Past investment in factories and equipment; More people get college degrees); Changes in natural resources (Discovery of new mineral deposits); Changes in technology (Productivity improvements). – Shift LRAS l Everything that shifts LRAS shifts SRAS, too. Also, changes in PE shift SRAS l some type of market imperfection – result: Output deviates from its natural rate when the actual price level deviates from the price level people expected. l Sticky Wage Theory: nominal wages are sticky in the short run, they adjust sluggishly. – Due to labor contracts, social norms. Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail. If P PE, revenue is higher, but labor cost not. Production is more profitable, so firms increase output and employment. Hence, higher P causes higher Y, so the SRAS curve slopes upward. l Sticky Price theory: Many prices are sticky in the short run. – Due to menu costs, the costs of adjusting prices. Firms set prices in advance based on PE. Suppose RBA increases the money supply unexpectedly. In the long run, P will rise. In the short run, firms without menu costs can raise their prices immediately. Meanwhile, their prices are relatively low, which increases demand for their products, so they increase output and employment. Hence, higher P is associated with higher Y, so the SRAS curve slopes upward. l The misperceptions theory: Firms may confuse changes in P with changes in the relative price of the products they sell. If P rises above PE, a firm sees its price rise before realizing all prices are rising. The firm may increase output and employment. So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping. Ø Stock market crash , AD first shifts left , PY lower and unemp. Higher. Over time, PE falls, SRAS shifts right until LRAS eq’m back to A. Y and unemp. return initial levels. Ø Oil prices rise , increases costs which shifts SRAS to left ,P higher Y lower, unemp. higher. From A to D, stagflation, a period of falling output and rising prices. If policemaker does nothing, Pe and wage will decrease and SRAS shifts right back to A. IF fiscal or monetary policy are made, AD shifts right, Y back to Y1 but P higher.