ECONOMICS 101

Basic Economics (Rohlf)

Chapter 1

Scarcity --> Requires choices on how to best use your resources.

Opportunity cost, your next best alternative.

The Productions Possibilities Frontier (PPF) -- an illustration of scarcity.  A graph representing all possible combinations of two goods that an economy can produce given its limited resources. 

- Points inside the line are attainable, but economy has unemployed resources (it can do better.)
- Points on the curve are the best the economy can do (full employment).
- Points outside of the line are unattainable given current resources.

When the PPF is linear (straight), there are no specialized resources.  When the PPF is curved, that means resources are specialized, and the Law of Increasing Costs applies (the more you shift your resources toward producing one good, the greater the opportunity cost in terms of the other good becomes).

Chapter 2

Three questions of resource allocation (the Basic Economic Questions):

1. What to produce
2. How to produce it most efficiently
3. For whom to produce.

Economic systems:

1. Capitalism -- economic questions answered by market forces; private ownership of resources.
2. Socialism -- economic systems answered by central planning; public (government) ownership of resources.
3. Mixed economies -- economies in industrialized nations (including U.S.) is generally some mixture of Capitalism and Socialism.
4. Communism -- not same as socialism; idealized state of organized anarchy.

The Market System

1. Profit drives all voluntary exchange. Adam Smith: the "Invisible Hand". All voluntary exchange benefits both parties involved, otherwise exchange would not take place at all.  [Book: Wealth of Nations]

2. Price Mechanism serves 2 purposes: (a) rationing device -- makes sure people who value resource the most are the ones who get it; (b) communication between producer and consumer -- how the consumer tells the producer how much to make.

3. Competition yeilds 2 benefits: (a) lower prices for consumers; (b) innovation -- making the product better than the other guys', and finding more efficient ways to produce in order to lower prices.

Chapter 3 -- Supply & Demand

The First Law of Demand: ceterus paribus (all else constant), if price goes up, quantity demanded goes down, i.e., if bread gets more expensive, you buy less bread. A change in price effects ONLY quantity demanded (cet. par.).

Determinants of Demand: income (make more $$, buy more stuff)... price of substitute goods (price of Coke goes up relative to Pepsi, you buy less Coke (quantity demanded) and your demand for Pepsi goes up)... price of complimentary goods (price of cereal goes up, demand for milk goes down)... number of consumers in market (more people buy more stuff)... taste/consumer preference.

Law of Supply: ceterus paribus, if price goes up, quantity supplied goes up; if the price you can get for Spam goes up, you want to start selling more Spam.

Determinants of Supply: input prices / cost of production (able to produce less at any given price)... price of substitute goods (if McD's can get a better price for chicken sandwiches than for Big Macs, they will shift their resources toward the production of chicken sandwiches)... price of complimentary goods (if the market price of shoes goes up, you make more shoes (Law of Supply), ergo, you need to start making more shoelaces)... number of suppliers in the market (more companies can make more stuff).

Chapter 4 -- Elasticity

Own-price Elasticity of Demand (ed) -- Measure of how responsive quantity demanded (Qd) is to a change in price (P).  Elasticity =  % change Qd / % change P

Formula:   ed = (P1 / Q1) * [(Q1-Q2) / (P1-P2)]

   Always negative (First Law of Demand).   Usually stated in terms of absolute value:  |ed|

   |ed| > 1 -- relatively elastic demand.  % change in Qd large relative to % change in P.

|ed| < 1 -- relatively inelastic demand.  % change in Qd small relative to % change in P.

|ed| = 1 -- unit elastic.  % change in Qd = % change in P.

Determinants of ed: 

1. availability of substitutes -- demand more elastic where substitutes are more readily available.

2. necessity vs. luxury -- demand for necessity tends to be more inelastic.

3. portion of budget -- tend to be more elastic for "big-ticket" purchases.

4. time -- the longer someone has to adjust to a price change, the more elastic demand becomes. 

ed and the Demand curve -- We call a flatter demand curve relatively more elastic.  A steeper demand curve is more inelastic.   [Memory device:   stretch a rubberband -- notice it is flat when you stretch it -- this is elastic.]

    On any downward-sloped Demand curve:   The upper portion of the curve will be relatively elastic, the lower portion will be relatively inelastic.  The midpoint of the curve is unit elastic.

Total Revenue (TR) and ed -- Total Revenue = P * Q

            Marginal Revenue (MR) = change in Total Revenue with the sale of one more unit of the good.

    When demand is relatively elastic, a price increase decreases Total Revenue.  (MR > 0)

    When demand is relatively inelastic, a price increase will increase Total Revenue.  (MR < 0)

    Total Revenue is maximized at unit elastic point (where MR = 0).

Elasticity of Supply (es) -- same formula as above (except will be (+) b/c of Law of Supply)

    Time and es:  (1) In short run, less able to change Qs (example, # of seats in Bi-Lo Center).  (2)  In the long-run, a higher price may lead to the addition of seats at Bi-Lo Center.

Exam 1

Chapter 5 -- Marginal Reasoning and Profit Maximization

Economists assume that people are motivated by self-interest.   Therefore, whenever an individual makes decisions, they base their decision on the costs and the benefits. 

People make decisions "at the margin".  In other words, if I were deciding whether to order a second Big Mac at McDonald's, I would weigh how much additional benefit I would get from eating a second hamburger (Marginal Benefit) with the costs of consuming that second hamburger (Marginal Cost). 

"Marginal" means "per one more unit".  (Example from Ch.4: Marginal Revenue is the change in total revenue from selling one more unit."

Costs of Production:
    Fixed costs --  the same regardless of the level of output.   Commonly called "overhead".  Examples include property tax, rent on building and insurance premiums.  (Fixed costs only occur in the short run -- in the long run, all costs are variable, since in the long run, a firm can sell off its assets or gain new assets.)
    Variable costs -- vary with output.  Variable costs are 0 at 0 output.  They increase as output increases.  Examples are inventory costs, payroll for employees, and fuel and energy costs.
    Total Cost -- Fixed + Variable
    Marginal Cost (MC) -- change in Total Cost from producing one more unit.

Profit maximization:

Profit = Total Revenue - Total Cost

Firms are profit maximizers (b/c they act in own self-interest).  If they aren't making a profit, then they will minimize their loss.

Profit maximizing level of output is where MR = MC.

Chapter 6-8 -- More on Costs of Production and Industry Structure

[Note:  Because of the unusual layout of the next 3 chapters, I've decided to combine them into one in the notes -- hope this isn't too confusing.]

Average Costs:

1. Average Fixed Cost = fixed costs / output

2. Average Variable Cost (AVC) = variable costs / output

3. Average Total Cost (ATC) = total cost / output, or AVC + AFC.  This is the per-unit cost of production.  (This is different from MC -- we will add ATC & AVC to our chart:)

**RULE:  Profit is maximized / loss is minimized when MR = MC.**

Total Revenue = Price * Quantity (output)   --    Profit = TR - TC

    When (& only when) price is fixed (flat Demand curve), MR is the same as Price.

*Example:  In the above table, if the firm charges a fixed price of $200, it will produce an output of 4 units.*

Firms plan for the long run, by observing average costs of production at various levels of output.  For example, you can compare your ATC and MC curves for producing with one plant, vs. the ATC and MC for producing with two plants, vs. three plants, etc.

    If you draw all of these cost curves and connect the break even point of each with a line, that will be the Long Run Average Total Cost (LRATC) or "Planning" Curve.  Typically, the LRATC curve is "U"-shaped.

• Economies of Scale -- the downward-sloped portion of the LRATC curve.   As firm increases its level of production by adding new plant and equipment, ATC decreases (i.e., the bigger your operation, the cheaper per unit it is to produce).   This is a concept borrowed from engineering.  [Example: compare one guy stringing tennis rackets in his basement to a big plant stringing rackets with machines and hundreds of workers -- the big plant will be able to produce the rackets at a lower per unit cost.

• Diseconomies of Scale -- the upward-sloped portion of the LRATC curve.   Once a firm gets "too" big, it starts to become less efficient, therefore, its per-unit cost of production (ATC) begins to creep upward.

                A firm will be inclined to operate at the minimum point on the LRATC curve, taking full advantage of Economies of Scale, without becoming so large as to expect diseconomies of scale. 

Now that we have this foundation, we can look at Industry Structure...

Pure Competition

Assumptions (in this unit, the assumptions are very important -- the model grows out of the assumptions):

1. Very large number of suppliers -- individual firms are price takers, i.e., no one firm is large enough to have any influence on the market price by increasing or decreasing output.  They face a fixed price, represented by a flat (perfectly elastic) demand curve.
2. Products are standardized, that is, one firm's product is identical in every way to every other firm's product.  There is no differentiation [differentiation - where products are perceived by consumer as different].  As a result, every firm's product is a perfect substitiute for all of the others.  This adds to the perfectly elastic demand -- if one guy tries to raise his price, he will lose 100% of his business, because consumers will simply substitute another good for his.
3. Easy entry and exit -- we are assuming firms can start producing in this industry or go out of business at virtually no cost.
4. Perfect information -- consumers know everything about everyones product, so they cannot be deceived into believing that differentiation is there when it is not.

When dealing with models of competitive industries, you have to use two graphs:   The market S&D, and the individual firm's S&D. 

• Market Demand curve (the sum of all the individual firms' demand curves) is downward-sloped.  The market price is determined by the equilibrium -- where market D intersects market S.
• The Firm Demand curve -- the individual firm faces a flat demand curve, because its price is fixed at the market price; they cannot charge a price higher than market price.  The firm's output will be the point where its demand (MR) curve crosses its supply (MC) curve.  Since this is the profit maximizing / loss minimizing level of output, the firm will not charge a price below market price either.  (Homogeneity is kind of an unspoken assumption -- i.e., we assume all firms in the industry have the same cost curves.)

    If firms in a purely competitive industry are making a profit (i.e., P > ATC), then in the long run, enough new competitors will enter the market (easy entry & exit assumption) to shift the market Supply curve outward, lowering the market price until P = ATC for all firms in the industry.  Therefore, in the long run, firms in a perfectly competitive industry operate at zero profit.

    If market price falls below the firms' ATC, so that firms are making a loss, in the long run, enough producers will go out of business until the market Supply curve decreases, raising the market price back to the zero profit level.

One reason why purely competitive industries don't exist in "real life":

        If the industry is an industry that experiences economies of scale, then that firm has an incentive to use whatever profits it may manage to accumulate to get bigger, so that it can bring down its ATC and undercut its competitors.  Once this happens, the firm has become large enough to have some influence on market price, so that a perfectly competitive industry no longer exists.  This has happened in agriculture, where large corporate farms have undercut smaller family-owned farms because of economies of scale. 

Monopoly

Assumptions:

1. Only one producer in the market -- no competitors.  Firm is a price maker; it determines what the market price will be, since it is the entire industry.  A monopolist faces a downward-sloped Demand curve. *(MR doesn't = Price anymore)* 

2. Only one product, so no differentiation.  No close substitutes, so no competition.  (For simplicity, we'll assume the firm only makes one good.)

3. Restricted entry -- either because of prohibitive cost (see "natural monopoly" below) or by legal restriction.

Creation of a Monopoly:

1. Gov't action (example: patents -- designed to allow inventor to own monopoly on the his invention by preventing anyone else from duplicating it.)

2. One firm owns an important resource and keeps other firms from using it.   (example: DeBeers owns the only diamond mines in the world.  They don't let anyone else sell their diamonds.  Therefore, they have a monopoly in the diamond wholesale market.)

3. Economies of scale -- explained in #1 of the following section...

Types of Monopoly:

1. Natural Monopoly -- a monopoly created by economies of scale.   Suppose the electrical industry is a decreasing cost industry (which it is).   Pretend that in the beginning you had several competing electrical companies.   However, like we discussed in the previous chapter, there is an incentive for each of these firms to get bigger, either by expanding their operation or by buying out their competitors.  Suppose Duke Power was able to grow faster than any of the others.   By the time Duke reached the minimum point on its LRATC curve, it was the only power company left.  It is now a natural monopoly.  Any power company attempting to enter the market will not be able to compete with Duke's prices because they will be too small, so Duke's monopoly is protected by prohibitive entry costs. 

2. Local Monopoly -- there is only one seller of a good within a given geographical location.  Example, depending on where you live, Duke Power is the only company you can buy power from.  Northland Cable TV is the only cable provider to which you can subscribe.  If you're sitting in the Carmike 7 movie theater and you get hungry, the only place to buy food is at the concession stand (which is why movie theater concession stands are so expensive).

3. Regulated Monopoly -- firm's behavior is control by the gov't.   Example: Duke Power (the perfect example of any type of monopoly) cannot raise its rates unless allowed by the gov't.  All of their production is also closely regulated.

The Monopolist's Demand Curve is the Market Demand curve.  It is downward-sloped.  MR not = Price.  Check it out:

        Q             P             TR                 MR    

        1           1700         1700             1700

        2           1650         3300             1600

        3           1600         4800             1500

    Notice that MR is decreasing faster than Price (which is the Demand curve).  The slope of the MR curve will actually be twice as steep as the slope of the D-curve.  (Again, sorry I can't draw it -- see book.) 

    The Monopolist is a price maker.  They can pick the price they charge.  The output at which they will produce will be... everyone say it together... where MR = MC.  The price they will charge will be the point on the Demand curve directly above where the MR & MC curves intersect.  (see picture in book).  The price charged by monopolies will tend to be higher than that of a competitive firm.  Monopolists do not always necessarily make a profit; remember MR=MC is also the loss-minimizing level of output.  If the monopolist does not make a profit over a long enough period of time, they will go out of business.

Welfare Costs of Monopoly (why monopolies are generally bad):

1. Deadweight Loss -- A monopolist increases his profits by restricting output and raising price.  This results in benefit lost to society lost because those goods were never produced.  This is deadweight loss.  

2. Lost benefits of competition -- Because a monopoly does not face competition, they have less incentive to be efficient.  Whereas a competitive firm will tend to want to keep their costs of operation down so as to undercut their competitors, a monopolist doesn't care if his costs creep up.  This leads to higher prices to consumers, and wasteful uses of resources.  Monopolies may also incur additional costs by using resources to lobby the gov't for laws to protect their monopoly ("rent-seeking").  Monopolies also tend to be less innovative than competitive firms. 

A monopolist does not have free reign, though.  If deadweight losses get too big, or prices creep up too much due to inefficiency, one of two things may happen:

1. Gov't intervention and regulation.
2. Potential competition -- even though there are no close competitors, there is still the potential for competition should the monopolist's prices get too extravagant.  Say Duke Power's electrical rates go through the roof.  It will eventually become less expensive for people to start buying solar panels and installing them on their homes.

Monopolistic Competition

Assumptions:

1. Large number of firms (but less than in pure competition).

2. Differentiated products -- this is the defining factor of monopolistic competition.  Imperfect substitution.  Firms in effect have a "mini-monopoly" in their product (eg., McDonald's is the only place you can get a Big Mac, even though you can get a hamburger in plenty of other places).  Firms engage in non-price competition -- If they can convince their consumers that their product is better than their competitors', then the consumers may be willing to pay more for it. 

3. Easy entry and exit.

4. Imperfect information (which reinforces differentiation -- recall that differentiation is the consumer perception that one firm's product is different from anothers).

As with pure competition, we have to use two graphs:   market S&D, and the firm S&D.

    The market demand curve is downward-sloped.   The market price is at equilibrium (where Supply curve intersects Demand curve).   However, since there are not as large a number of firms as in perfect competition, individual firms are not price takers, so the market price here does not determine the firm price, but rather it is an average of all the individual firms' prices (some will be higher some lower -- we do not assume homogeneity, as we did with perfect competition).  

    The firm also faces a downward-sloped demand curve; however, because there is some substitution between different firms, the firm demand curve will be flatter (more elastic) than the market demand curve.  This is because a price increase in McDonald's hamburgers will cause some consumers to substitute away to Burger King's or Wendy's hamburgers, but, since BK and Wendy's are still in the same industry, it doesn't effect the market Quantity demanded.

        Because the firm is a "mini-monopoly", it is able to set its output at the level where MR=MC.  It will be able to set its price like a monopoly does (although, because of the flatter demand curve, the price won't be as high as in the case of a monopoly).  Consumers desire differentiation and are willing to pay more for it, and since the market S&D are in equilibrium, there is no deadweight loss in a monopolistically competitive industry.  Also, since the industry is competitive, there are none of the other welfare losses associated with monopolies.

--To this point, the monopolistically competitive model is an excellent reflection of what we see the most in "real-life", such as the competition between fast-food joints, supermarkets, drugstore chains, department stores, etc.  Here we see firms, some of which are making substantial profits.  However, when we add the easy entry and exit assumption, it looks a little bit less like "reality". --

    If we assume easy entry and exit, in the long run, monopolistically competitive firms will operate at zero profit.  This is because, so long as there is any profit being made by any of the firms, new competitors will enter, increasing the market supply curve, thus decreasing the market price. 

        Also, each firm's demand curve will decrease, because the extra competition will draw some of the consumers away.   Think about the firms in the industry as dividing up customers like college students dividing up a pizza.  If you get more people around the table, everyone gets less pizza.  In the same way, more competitors lowers the demand faced by each firm in the industry.  Eventually, each firm's demand curve will lower to the point where their price will equal their ATC, and they will operate at zero profit.

Oligopoly

It's hard to say, even harder to model...  Assumptions:

1. Very small number of firms (literally, 2 or 3).

2. There can be standardized or differentiated products.

3. Difficult (costly) entry and exit (less restrictive than in monopoly).

The key feature of oligopoly is the interdependence between firms.   One firm's actions greatly effects those of the other firms.  This leads to strategic behavior of the firms in the industry -- that is, they will act so as to influence the actions of its competitors, or out of reaction to their competitors' actions.  In order to model this, we have to use game theory.

    Two types of games:

1. Dominant strategy game -- where there is one best move regardless of what the other guy does.

2. Sequential game -- move/countermove.  No dominant strategy.   One player waits to see what the other one does; like a chess game.

Collusion and Cartels

    Collusion is when firms within an industry that are supposed to be competing with one another conspire to increase their control over the market.  We will discuss other types of collusion in the next chapter.  For now, we'll concentrate on Cartels and Keiretsu.

        A cartel requires:

1. An oligopolic industry.

2. Standardized products.

3. Barriers to entry (legal, cost, or threat of violence)

    Examples of cartels are OPEC, the Colombian drug cartels, Standard Oil (from next chapter). 

    A cartel is where firms in the industry conspire to restrict output in order to increase the price.  In effect, a cartel behaves exactly like a monopoly, with all the members working together as if one firm.  Cartels come with all of the welfare costs that a monopoly does. 

        A cartel comes with its own self-destruct button, though, because each member constantly has the incentive to cheat on the arrangement.  If Kuwait (a member of OPEC) is assigned to produce 100,000 barrels of oil per day, and they are getting a really high price for it, their natural inclination is to increase production to take advantage of the inflated price (Law of Supply).   Once they do this, the market price drops, and the entire cartel arrangement falls apart. 

Keiretsu is a Japanese form of industry (it is legal in Japan).   There are two types of keiretsu:

1. A number of firms that produce completely different types of goods that are centered around a bank.  Examples of this type are Fuji (film, electronics, other stuff) and Mitsubishi (cars, electronics, Japanese "zero" planes used in WWII, etc.).  Fuji and Mitsubishi are actually the names of Japanese banks.

2. One major firm and its suppliers.  An example is Toyota, which produces cars, and all of the firms that produce its seat covers, engine parts, body panels, etc.

Antitrust Regulation

In the late 1800's, several "trusts" (cartels) arose and exercised monopoly control over several important industries, including the Standard Oil Trust, the Vanderbilt Railroad Trust and others.

Sherman Antitrust Act (1890) -- prohibited contracts and collusion that restricted competition; prohibited conspiring to monopolize any part of the market.

        Rule of Reason -- must prove harm done by anticompetitive acts.

        Per Se Standard -- no need to prove harm done.  Examples of per se violations are price fixing and predatory pricing.

Clayton Act (1914) -- clarification of Sherman.  Specifically outlined prohibited practices.

1. Price discrimination (not strictly enforced except in case of predatory pricing).
2. Interlocking shareholding (where it interferes in competition).
3. Interlocking directorates (in firms within same industry).
4. Tying contracts (done on case-by-case basis).
5. Exclusive Dealings.

Federal Trade Commission (FTC) -- established in 1914 to enforce Sherman and Clayton.  Now primarily concerned with fraudulent advertising cases.

Celler-Kefauver Anti-Merger Act (1950) -- prohibits mergers that reduce competition.  Federal courts review proposed mergers and determine its effect on concentration in the industry.  Enforcement seems rather haphazard.

3 types of Mergers:

1. Horizontal -- between two firms that are on the same level of production in same industry (ex., merger between two banks, drug stores, pharmaceutical companies, long distance companies, etc.)
2. Vertical -- between two firms on different levels of production (ex., merger between a power company and a coal mine, a gasoline wholesaler and a service station, an automobile manufacturer and an engine-parts manufacturer, etc.)
3. Conglomerate -- involving firms in completely different industries.   Example:  ITT (telecommunications) merged with Sheraton (a hotel chain).   Done for the purpose of diversification -- hedging against losses within one industry by spreading assets into other industries.  (Don't confuse with "differentiation".)

Chapter 9 -- Market Failures

A market failure is an area where the market is either unable to produce or is unable to provide for the most efficient allocation of resources.  We discuss three types of market failures:

1. Market power -- when an individual firm gains too much power to control market output and price -- discussed above.

2. Externalities -- cost or benefit imposed on parties not involved in the actual transaction. 
   - Negative externality -- external cost.  Pollution is a classic example of this:   A factory burning coal puts smoke and particulates into the air.  These pollutants cause damage to crops on neighboring farmland, thus imposing a cost on the farmers.
           Markets tend to overproduce goods that generate negative externalities b/c the price of the good does not reflect the true cost to society that the good represents.  To remedy this, the gov't internalizes the cost, that is, it shifts some of the cost imposed on the farmers back onto the factory owner by requiring him to install scrubbers on his smokestacks. 
   
   - Positive externality -- external benefit.  An example of this is a flu shot.   If you get a flu shot and as a result don't get the flu, not only do you benefit, but your classmates will also benefit b/c they won't catch the flu from you. 
           Markets tend to underproduce goods that produce positive externalities b/c the price of the good does not reflect its true value to society.  The gov't may remedy this by subsidizing (either by tax credits or by helping to pay for) flu shots or whatever.

3. Pure Public Goods -- nonexclusive goods.  Nonexclusive means that you cannot prevent someone from consuming the good if they don't pay for it.  As a result, there is no real incentive for someone to pay for a good they can consume for free (free rider problem).  Therefore, the market will generally not produce this type of good, since there is no way to make a profit.  The gov't is able to remedy this problem b/c it has the power of taxation, which allows it to force people to pay to produce this good.
   - The gov't may also produce some goods and services that could be produced in the private sector, but which yield signficant external benefits (see above).  This is why the book makes the distinction "Pure" Public Goods.

Government Failure -- Public Choice Economics

Public Interest Theory operates under the assumption that politicians are motivated by the desire to benefit society.

Public Choice economists generally subscribe to Capture Theory, which states that politicians are motivated by self-interest, just like anybody else.   Since politics is not a market activity, the motivation is not profit, but security, income and power.  Politicians can meet this by seeking to maximize votes.   This may not always lead to the most efficient outcomes as compared to a market system.

Exam 2

Chapter 10 -- Measuring Aggregate Performance

Inflation -- rise in the general price level; money is devalued, i.e., it buys less (ergo is worth less) than before.

The Consumer Price Index (CPI) -- means of measuring prices paid by consumers for goods and services in a given year.  Compiled by the Bureau of Labor Statistics (BLS) monthly.

CPI measures prices against a base year (base year for current CPI is 1982-84).  CPI states prices in each year as a % of the base year's prices.  For example, if the CPI for 1999 is 150, that means that, on average, the prices of everything in 1999 are 150% (or 1-and-a-half times) of what they were in 1982-84.

The inflation rate is the % change in the CPI from one year to the next.

Using the CPI to convert any year's prices to compare them to another year's prices:

new year's price = [new year's CPI / old year's CPI] * old year's price

("old year" is the year whose prices you're converting from -- "new year" is the year that you're converting old year's prices to -- "new year" does not necessarily mean the more recent year.  For example, if you were comparing the price of a car in 1995 to that in 1950, you might convert the 1995 price into 1950 $'s -- here, the 1950 price would be the "new year's price".)

Example:  Real vs. Nominal ("money") Wages -- when the price level increases and nominal wages do not, real wages decrease (eg., if you made $100/week ten years ago, and did not get a raise between then and now, that $100 would not be worth as much now as it was then, therefore, your real wage rate would have decreased, although your nominal rate would be the same.)

 Historically, nominal wages have increased when the price level increased, or have even grown faster than inflation -- therefore real wages (in terms of constant purchasing power) have for the most part remained constant or increased over the last century (due largely to increased productivity from advances in technology). 

Compensating for Inflation:

Cost of Living Adjustments (COLAs) -- gov't Social Security, veterans' benefits, etc. tend to be increased each year according to the % inflation in a each year.

Seller beware -- Capital gains taxes are not indexed for inflation.  For example:   If you bought a house in 1980 for $50,000 and sold it in 1999 for $75,000.   Suppose the price level doubled during that time period, so that, in real $'s, you actually sold the house for a loss.  However, you will still have to pay taxes on the $25,000 difference in the buying and selling price.

Interest Rates:

Real interest rate = nominal interest rate - inflation rate

(nominal interest is the rate the bank tells you...  real interest rate is how much your money actually gained in buying power during the time you had it in the bank.)  It is possible to have a negative real interest rate.

Unemployment

Unemployment rate = % of labor force that is not currently working.
                              = (# unemployed / labor force) * 100

Labor force = people working or actively looking for work. 
Currently, adult population of US is ~200 million.  Labor force is ~125 million.

Unemployment rate does not take into account:

1. Discouraged workers -- people who give up looking for a job and drop out of labor force.

2. Underemployed workers -- people who have to support a family on a parttime job, or people who are not fully utilizing their skills (eg., someone with a PhD who is waiting tables).

Natural Rate of Unemployment -- the unemployment rate around which the actual rate fluctuates.  The rate of full employment (remember PPF).  Notice:  this is not 0% unemployment.

Cyclical Unemployment -- the fluctuation of the unemployment rate around the Natural Rate -- resulting from the Business Cycles of recession and prosperity (see below).

Why is full employment not = 0% unemployment?

Frictional unemployment -- "between jobs"; usually people changing carreers, moving to a new city, etc.
Structural unemployment -- outdated skills.  Includes "dislocation" of workers from automation.

GDP

Gross Domestic Product (GDP) -- measure of the value of all goods and services produced in the economy in a given year.  Nominal GDP is stated in current $'s.  Nominal GDP can be influenced by inflation (a rise in the general price level).  Real GDP is discounted for inflation -- gives a more accurate measure of the productivity of an economy across time.  A decrease in Real GDP for 2 quarters (6 months) or longer is called a recession.

GDP = total spending, b/c it represents all goods and services purchased.
GDP= national income (wages, rent, interest and profit), b/c revenue from the sale of goods and services produced is the source of all of these sources of income.

Therefore, total spending = total income.
If total spending > total income, inventories will be depleting and production will have to be increased, thereby increasing total income.
If total spending < total income, inventories will be accumulating and production will have to be cut, thereby decreasing total income.

What counts toward GDP?

1. Final goods and services.  Final means ready for the consumer.  Intermediate would be a good used as an input for another good.   Example -- a house is a final good; the lumber is an intermediate good.

2. Domestic.  It has to be produced within the country.

3. New.  Used cars, previously-owned houses, etc., do not count.  A good only counts once -- when it is first produced and sold.

4. Legal.  Black market stuff doesn't count.

Nominal GDP is the amount of goods & services produced in a year stated in $'s, and it is based on the price level in that particular year.  

Real GDP is a true measure of the actual amount of goods & services produced.  It is normally stated in constant $'s that have been discounted for inflation (more on inflation later).  Real GDP = nominal GDP/price level.  In the table below, real GDP is represented by the # sneakers produced.

Components of Real GDP

C = consumer spending.  Spending by households on goods and services.
I = investment spending.  Spending by businesses on plant and equipment.  Also, spending on new homes.
G = government spending.  Local, state and federal gov't spending on all goods and services.
(X-IM) = Net exports = eXports - IMports.

real GDP = C + I + G + (X-IM) = total spending -- this is equilibrium state -- total spending = total income

For the economy to be in equilibrium (total spending = total income), it must be true that S = I.    This is logical, since we are assuming that all Investment spending is financed by borrowed money, and the source for borrowed money is Savings.  What happens if S is not equal to I?

(Remember the circular flow model...)  Saving is taken out of household income before any spending, so an increase in S is going to mean a decrease in Consumer spending.  This is why we call Saving a leakage, b/c money that is not spent is money that is being drained out of the circular flow, which will result in a decrease in total spending and thus a drop in real GDP.

We consider Investment spending to be an injection, b/c it "injects" the money taken out of the circular flow through Savings back into the circular flow.

The economy is like a bathtub.  As long as you're pouring water into the bathtub at the same rate as the water is draining out, the water level in the tub will remain constant.  If the water is draining out of the tub faster than you are pouring it in, the water level will start dropping.  Likewise, if leakages are greater then injections (S>I), then the level of income in the economy is going to drop.

The Business Cycle -- fluctuations in the GDP.  When GDP is decreasing, this is a recession.  When GDP is increasing, this is expansion (expansion can be divided into "recovery" -- increase in GDP up to the level it was before the recession, and "prosperity" -- growth of GDP beyond where it was before the recession).  This is called a "cycle" because these fluctuations tend to occur in a pattern of recession-recovery-prosperity, recession-recovery-prosperity....  

Chapter 11 & 12 -- Aggregate Demand & Supply

Aggregate Demand (AD) -- demand for domestic product -- i.e., the demand for everything by everybody.

(Graph AD as a downward-sloped line -- real GDP goes on the x-axis, Price Level (PL) goes on y-axis.)
Qad (Quantity of AD) = C + I + G + (X-IM) = Total Spending

Why is AD downward-sloped?

1. Wealth Effect ("Real Balances Effect") -- inflation decreases the value of the money in your pocket.   Therefore, to the extent that you hold your wealth (accumulated income) as cash, inflation will decrease your ability to buy stuff, therefore, as Price Level goes up, Qad goes down.
2. Interest Rate Effect -- when Price Level goes up, it takes more money to buy the same amount of stuff.  Therefore the demand for money goes up, which causes the price of money (interest rates) to increase.  Increase in interest rates means a decrease in Investment Spending (I), therefore Qad goes down.

Shifting AD:

1. Income (when people have higher income, they spend more). -- Disposable Income (DI) = after-tax income (GDP - T).  Tax cut increases DI, which increases Consumer spending (C), and therefore increases Qad.
2. Expectations of future income (if people believe they are going to get a big tax cut soon, they may go ahead and increase their spending now).
3. Changes in interest rates..
4. Changes in Gov't Spending (G).
5. Changes in wealth.
6. Changes in national income in foreign countries (if Japan has a major recession, they will buy less from the US, therefore decreasing our eXports which pulls down our AD).

Aggregate Supply (AS) -- supply of domestic product, i.e., supply of everything by all producers.

In the Long-Run -- AS is perfectly inelastic (vertical), since, in the L-R, the productivity of the economy is determined by the availability of resources and technology.  This vertical L-R AS curve represents what the economy can produce given its current resources.  In other words, it represents the nation's productivity at Full Employment -- to avoid confusion, we will just call it Potential GDP. This "natural rate of production" can shift over time due to changes in population, technology and resource availability.   However, for the time being, it is a fixed line that we are going to use as a "yard stick" for measuring the economy's performance.

In the Short-Run -- AS is upward sloped.  This is what we will refer to as the AS curve.  Remember, in the short-run, real GDP can be affected by the price level.

Why is AS upward-sloped?

1. Misperceptions -- we discussed before that people's perceptions can be distorted by inflation.  Only a relative price change affects resource allocation in the long-run, but in the short-run, producers may mistake a rise in the price level for a relative price change and increase their Qas.
2. Sticky Wages (Keynes) -- workers do not react well to wage cuts, therefore employers will be hesitant to cut wages (due to risk of decreased worker morale/productivity).  Therefore, when Price Level falls, the wage rate will not adjust to the new price level right away.  During this lag time, employers will be taking in a lower price while still having to pay their workers the higher wages.  As a result, they will have to cut their output (Qas). 

Shifting AS -- aside from changes in population (labor force), technology and availability of resources, (short-run) AS can be shifted by changes in input prices.  Also can be shifted by expectations of the future (if they're expecting a recession due to a fall in spending, they may go ahead and cut output to prepare).

Equilibrium:  Qad = Qas.  => total spending = total income (output).

Quick digression on Keynes vs. Classical Theory:

Classical Theory -- held by economists from Adam Smith (1776) until Keynes (c.1930).  Economy naturally tends toward Full Employment. 
- Wages and prices are flexible, allowing economy to self-correct from recessions -- no need for gov't activism (laissez-faire).
- Largely dependent on Say's Law, which says "Supply creates its own demand".  In other words, when production in the economy increases, this creates income for workers, who then increase their spending to purchase the goods and services being produced.

Keynes -- wages and prices are "sticky".  It is possible for economy to reach equilibrium below the level of Full Employment.
- Focus on spending (AD).
- Government must take active roll in the economy to regulate Aggregate Demand in order to prevent and correct recessions and inflation.

Neo-Classical -- modern theory that recognizes the contribution of Keynes, but disputes his contention of the need for gov't activism.
- In the short-run -- Keynes was correct that economy can reach equilbrium below or above Full Employment.  Changes in AD and AS can cause short-run fluctuations in real GDP.
- In the long-run -- economy will self-correct as in Classical Theory, because, in the long-run, only changes in availability of resources and technology will affect economy's productivity.
*The models presented below follow the Neo-Classical school of thought.*

Fall in AD -- PL and real GDP both decrease -- recession with deflation ("normal" recession) --
    Recessionary Gap -- equilibrium is to the left of Potential GDP:

1. Gov't can intervene to try to increase AD to get economy back to full employment by increasing Gov't spending or cutting taxes (Expansionary Fiscal Policy).
2. Otherwise, economy will correct itself eventually.  High unemployment will lead to competition between workers for jobs, which will drive down wage rate.  As wage rate falls, AS increases (due to lower input price) -- this brings real GDP back to full employment level and the price level decreases further. -- In Long Run,  only effects on the economy will be on Price Level (deflation).

Rise in AD -- PL and real GDP both increase -- economic growth with inflation --
    Inflationary Gap -- equilibrium to the right of Potential GDP:

1. Gov't may try to get inflation under control by reducing AD by raising taxes or cutting G (Contractionary Fiscal Policy).
2. Otherwise, economy will correct itself eventually.  "Unnaturally" low unemployment will result in "tight" labor market.  Employers will compete with each other to fill jobs or to keep from losing their current workers to higher-paying jobs.   Wage rates rise, which causes AS to decrease.  Real GDP goes down to full employment level, PL goes up further (Stagflation).
3. In Long Run -- only effects on the economy will be on Price Level (inflation).

Fall in AS (such as from rise in oil prices from OPEC) -- results in falling real GDP (recession) with inflation (stagflation).

1. Gov't may "accomodate" the adverse supply shock by increasing AD, but this will cause more inflation.
2. Else, the AS curve will eventually shift back out as wages fall.

Rise in AS -- results in increase in real GDP and drop in PL.

1. Gov't may try to reduce AD.
2. Else, the AS curve will eventually shift back in as wage rates rise.

Chapter 13 -- Determinants of Spending and the Multiplier

Determinants of Consumption (C)

1. Wealth (not the same as income) -- example:  Fred & Barney both work in rock quarry.  Both bring home $20,000 per year in income, but Barney has $1 million in his stock portfolio.  Barney has more wealth than Fred, so Barney's C will be greater than Fred's, all else equal.

2. Expectation of future income -- if you are certain that you are going to win $1 million in the Lottery within the next 6 months, even though your income has not changed yet, your spending will increase. 

3. And of course current Disposable Income determines consumer spending.

4. (To a smaller degree) Interest Rates, which affect the ablility of consumers to purchase on credit.

The Marginal Propensity to Consume (MPC):

Tells how much of each additional $ of DI consumers spend.  Example:  if MPC = .9, this means consumers spend 90% (or 90 cents) of each additional $ of DI; the other 10 cents goes into Savings.

Investment Spending (I) -- more volatile than Consumer Spending.   Determinants are:

1. Expectation of future profits -- tend to only invest if you believe you are likely to profit from it.  Therefore, if recession is anticipated, you are less likely to invest.

2. **Real interest rate (this is the important one) -- if cost of borrowing $ goes up, then investors borrow less money (First Law of Demand).  Since we are assuming that all investment spending is financed by loans, this will lead to less investment.

3. Tax Laws -- If capital gains tax rate is increased, this will eat into any profits you may get from your investment, therefore reducing your incentive to invest.

The Multiplier Effect

The concept behind The Multiplier is that one person's spending is anothers income.  If you spend a dollar, the person to whom you give that dollar will then spend part of it (depending on Marginal Propensity to Consume), and the person who gets that person's spending will spend part of it and so on.  Each time that money is spent, it is adding on to GDP, so that in the end, real GDP will increase by more than the initial increase in spending.

The Multiplier = 1 / (1-MPC) -- If MPC = .9, then The Multiplier = 10.

    Say that the gov't increases spending this year by $1 billion.  This initial increase in Gov't Spending (G) will cause real GDP to increase by a total of $10 billion (initial change in spending * The Multiplier, or $1 billion * 10).

        This same "multiplier effect" will apply whether the initial change in spending is Consumer spending, Gov't spending, Investment spending or Net Exports.

Chapter 14 -- Fiscal Policy, Debt & the Deficit

Fiscal Policy is the use of Government spending (G) and taxation to regulate the AD curve.  Increasing G and/or cutting taxes will increase AD (by the multiplier effect).  Cutting G and/or increasing taxes will decrease AD (by the multiplier effect).

A Government Budget Deficit is when the gov't spends more in a given year than it takes in through taxes.  In other words, G > tax revenue.  Deficit spending is financed by the printing and selling of Treasury Bonds (primary market -- discussed in previous chapter).  Tax revenue is a function of national income -- nearly all taxes are related to income, so if we have an unexpected recession, the gov't will not get as much tax revenue as they budgeted for, possibly resulting in a deficit.

The surpluses (tax revenue > G) that the gov't is currently running are the result of unexpectedly rapid growth in our national income -- tax revenue increased faster than they had counted on, allowing it to catch up with and pass gov't spending.  However, an unexpected recession in the next few years could blow the whole deal.

National Debt is the sum of all of the past deficits that have not been paid off yet.  Essentially, national debt consists of all Treasury Bonds outstanding.  These bonds may be held by banks and other businesses, individuals, the Fed, or by foreign individuals and businesses.

Arguements in favor of balancing the budget:

1. Every year that the gov't runs a deficit, national debt is added to.   The gov't must pay interest on the bonds it uses to finance its debt every year, so this money to make the interest payments must be included in each year's budget.  The bigger national debt gets, the more interest that has to be paid.    Eventually, the gov't will have to allocate so much money to pay the interest on the debt, it will not have any left to pay for national defense, education, etc., without a tax increase, and there is still only so much you can increase tax rates.

2. Deficit spending results in higher interest rates.  Crowding out -- Treasury Bonds and Corporate bonds (Corporations finance some of their debt the same as the gov't does) compete with each other.   Since Corp bonds tend to be riskier than Treas. Bonds (because there is a greater chance of a corp. going bankrupt and defaulting on your bond is greater than the chance of the gov't defaulting), they must pay a higher rate.  This makes investment spending (I) by corporations more expensive, so, again, (I) will be lower.  Also, since Treas. Bonds will also draw some potential investors away from corp. bonds, some of the resources that would otherwise be going toward increasing the economy's future ability to produce are going toward financing the gov't's deficit spending.

Chapter 15 -- Money, Banking and Monetary Policy

Money is a commonly accepted  medium of exchange.  

    Common acceptance is what gives money its value.   Any seller knows that if he takes money as payment, he can use that money in turn to purchase whatever good or service he wants.  As such, money acts as a medium of exchange, replacing the barter system (trading good for good or service for service...).  It eliminates the inefficiency of the double coincidence of wants -- the necessity when engaging in barter to not only find someone who is willing to sell what you want to buy, but is also willing to accept what you offer in payment.

Money serves 3 basic functions:

1. Medium of exchange -- requires that what we use as money be transportable.

2. Unit of account (we tend to measure value in $'s for the sake of simplicity) -- requires that what we use as money be easily divisible (so you can have "exact change").

3. Store of value -- requires that what we use as money be durable (non-perishable).

Two types of money:

1. Commodity money -- has some intrinsic value, i.e., it has a valuable use other than as money.  Examples:  gold (jewelry and stuff), buckskins (from frontier days -- used for clothing, blankets and tent-making), salt (paid to Roman soldiers -- used for preserving food). 

2. Fiat money -- has no intrinsic value, i.e., its only valuable use is as money.  Example:  paper money (currency).

How we count money:

    M1 -- ~ $1.1 trillion.  The most narrow measure of the money supply (and the one we will use in this class).  Most liquid (easily spent) forms of money.  Includes

1. Currency and coin.

2. Checkable deposits (incl. travelers' cheques).

    M2 -- ~ $3.7 trillion.  Some economists and gov't policy makers use this measure of the money supply.  Includes less liquid forms of money than M1.  M2 consists of

1. M1

2. Non-checkable savings (regular savings accounts) and time deposits (CD's and IRA's).

3. Money market funds.

The Fractional Reserve Banking System -- before we can discuss how money is created, we have to look at how banks work.

• Banks take in deposits.  They keep a certain % of all their deposits as reserves ("cash on hand").  This is to cover any withdrawls that their depositors may make.  Required reserves (r) is the % they are required to keep by law.  They may also voluntarily hold excess reserves over and above the requirement.

• The balance of the deposits after reserves are taken out is used one of two ways.  Most of it is used to make loans to consumers and businesses for a higher rate of interest than the bank is paying to its depositors.  Some deposits are also used to make financial investments (stocks, bonds).

    Banking regulation -- After the stock market crash in 1929, some banks began failing around the US.  People began to panic, because, since there was not deposit insurance at the time, if their bank failed, they would lose all of the money that they had deposited there.  Depositors began running on their banks demanding all of their money.  Since banks only keep a % of deposits on hand, and the rest had been loaned out, the banks had to foreclose on many mortgages to try to get the depositors' money for them.  This caused many families, especially small farmers, to lose everything when the banks reposessed their property (like the Joads in Grapes of Wrath).  The flood of reposessed property being sold on the real estate market drove down prices, so the banks were not able to get all of the money back that they had put into the loans, and they began to collapse.  This massive decrease in wealth caused a downward shift in the consumption function, which resulted in a multiplier-effect-sized decrease in National Income (real GDP), and resulted in the Great Depression.  To try to prevent this from happening again, the government established the following regulations:

1. Reserve requirements -- so the banks will have enough cash on hand to handle at least small emergencies.

2. Deposit Insurance (FDIC -- Federal Deposit Insurance Corporation) -- if a bank fails, each depositor is insured by the government for up to $100,000. 

3. Oversight -- regulators regularly check the financial activities of banks to be sure they are not engaging in excessively risky behavior.  Banks are limited in the amount and type of the financial investments they are allowed to make.

Money Creation:  assume all money is deposited in banks (no one holds cash, so M1 = total deposits), required reserves = 10% of deposits (no excess reserves).  The Federal Reserve prints $100,000.  It goes into the bank as a deposit (the left column).  Total deposits become $100,000, and the bank keeps $10,000.  It will loan $90,000, which will be deposited, so total deposits become $190,000, and so forth, until Total Reserves = $100,000 (the amount of the initial deposit).

Total change in M1 (total deposits)  =  total reserves * 1/r. 
    (r = reserve requirement)
In our example:  $100,000 * 1/.10 = $1,000,000.

The Federal Reserve System (the "Fed") -- the central bank of the United States.  "Bank for banks".  Exercises exclusive control over monetary policy.  While the Fed is a part of the US gov't, it is completely independent of any other part of the gov't.  Made up of 12 districts:

Boston, NY, Philadelphia, Richmond (VA), Cleveland, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, & San Francisco.  [SC is in Richmond's district.]

    The Fed is controled by the Board of Governors.   The board is made up of 7 members, appointed by the president of the US, each of whom serves a 14-year term.  The board is led by the Chairman, who is appointed by the Prez, and confirmed by Congress, to a 4-year term (no term limits).  The current Chairman is Alan Greenspan.  The Chairman of the Board of Governors can only be removed from office by impeachment (if he commits a crime), or when one of his 4-year terms expires, the president can choose not to reappoint him.

    The part of the Fed we hear the most about is the Federal Open Market Committee (FOMC).  This is made up of 12 members -- (7) the Board of Governors, (4) the presidents of four of the Fed district banks (on a rotating basis), and (1) the president of the Federal Reserve of NY.  The Chairman of the Board of Governors presides over this body as well.  The FOMC meets 8 times per year.  We will discuss what they do shortly.

The Fed performs four primary functions:

1. Prints all US currency (paper money) -- coins are minted by the US Treasury, a seperate part of the gov't.

2. Lends money to banks.  The Fed charges these banks interest on the loan, called the discount rate.

3. Holds part of banks' reserves (rather than the banks keeping their entire reserves in their own vault where robbers can get to it).  The Fed does not pay interest on this money.

4. Sets reserve requirements.

- The FOMC -- conducts "open market operations", which consists of buying and selling Treasury (gov't) bonds on the secondary market. 

Quick digression:  Explaining Treasury bonds -- The gov't sells bonds to individuals in order to finance deficit spending; essentially, the gov't is borrowing money from you, and the bond is a note promising you that the gov't will pay you back.  In addition to paying you back the face value of the bond in a certain number of years, the gov't will pay you a % of the face value of the bond per year in interest.   --  When the Treasury sells you a bond, this is the primary market.  However, people also buy and sell Treasury bonds among each other in the Bond Market the same way stocks are traded on the Stock Market -- this is the secondary (as in "second hand") market.

        Now, back to the FOMC:

• If the Fed buys a Treasury bond from you, it is giving you money -- when the Fed gives you money, the ink is still wet, i.e., it is putting new money into circulation, therefore, it is increasing Monetary Base, therefore the Money Supply.  This is Expansionary Monetary Policy. 

• If you buy a Treasury bond from the Fed, you are giving them money -- when you give the Fed money, it is being taken out of circulation, therefore it is decreasing the Money Supply.  This is Contractionary Monetary Policy.

- The FOMC influences interest rates:  The discount rate -- the rate the Fed charges to loan money to banks.  The more they have to pay the Fed in interest, the more they're likely to charge on their loans.  The federal funds rate -- the rate banks charge to loan each other money (set by Fed).  Also influences interest rates charged to banks' customers.  These rates are usually the ones they talk about on the news when they speculate whether the Fed will raise or lower interest rates. 
- The FOMC determines the reserve requirment which affects the rate of money creation.

Money Supply and Demand

The graph for MD and MS has M1 (the quantity of money in circulation) on the x-axis, and real interest rates (the "price of money") on the y-axis.

Money Supply (MS) is set by the Fed.  MS is fixed (vertical, or perfectly inelastic), b/c the Fed can engage in expansionary or contractionary monetary policy to offset any fluctuations.

The Money Demand (MD) curve that is downward-sloped, b/c higher interest rates mean there is a higher opportunity cost of holding cash.  If interest rates are high, then by holding money as cash, you are giving up the interest you could draw on that money if you put it in the bank.  Therefore, at higher interest rates, people are more likely to put their money in the bank -- at lower interest rates, people are more likely to hold it as cash (in their pocket).

The Quantity Theory of Money -- the quantity of money in circulation (M1) determines the price level.

An increase in the MS will cause the value of money to decrease which means that prices will go up.  Notice that a natural consequence of expansionary monetary policy is inflation.   Imagine the Fed decreased the Money Supply to $10.  Since you would have the same amount of goods, services and resources in your economy as before, just less money to buy it with, the prices would have to come down in order to adjust to the new level of M1.   Likewise, whenever the Fed prints a whole lot of new money, the money already out there becomes less valuable and buys less (inflation).  So, for example, if the gov't decided to print enough money to pay off the national debt and get it over with, this would result in major inflation, and the $ would become nearly worthless.

Contractionary Monetary Policy:

When the economy is in an inflationary gap (equilibrium to the right of potential GDP), the Fed may choose to decrease AD by decreasing the MS, which will increase interest rates.  Higher interest rates makes it more expensive to borrow money, therefore, Investment Spending (I) will decrease.  This will cause the AD curve to shift down, lowering the price level.

Expansionary Monetary Policy:

When the economy is in a recessionary gap (equilibrium to the left of potential GDP), the Fed may increase AD by increasing the MS, which lowers interest rates.  This makes it cheaper to borrow money so that (I) increases, which increases AD.  This will also tend to cause inflation, however.

Exam 3