Economics Textbook PDF: The Ten Principles of Economics

**CHAPTER** **1: The Ten Principles of Economics** \"Economy\" Greek \"*oikonomos*\"=\"one who manages a household\", because, even in a family, one must organize to try to ensure wellbeing for all members. *[Economics is a science that studies how society manages its scarce resources/ studies the...

**CHAPTER** **1: The Ten Principles of Economics** \"Economy\" Greek \"*oikonomos*\"=\"one who manages a household\", because, even in a family, one must organize to try to ensure wellbeing for all members. *[Economics is a science that studies how society manages its scarce resources/ studies the choices of economic agents regarding the management of scarce resources and the rules and/or institutions that can make such choices \"better\".]* The fundamental economic problem is **scarcity**= society has limited resources, insufficient to produce all the goods and services that its members would desire, while guaranteeing each of them the maximum standard of living to which they aspire=\> **Economics deals with the logic of choices of economic subjects.** The **economic subjects** are: \- **Individuals**who try to maximize their *utility* **15 minutes** to produce **1 kg of potatoes**. **Rancher**: **20 minutes** to produce **1 kg of meat**/ **10 minutes** for **1 kg of potatoes**. So we can say that the **rancher** is **more efficient** because he *takes less time to produce the same quantity of output*. **8 hours= Farmer**:**8 kg of meat** (1hr per 1 kg) / **32 kg of potatoes** (1hr per 4 kg - 4 x 8 hours = 32). **Rancher** produces **24 kg of meat** (1hr per 3 kg of meat - 3 x 8 = 24)/ **48 kg of potatoes** (1 hr per 6 kg of potatoes - 6 x 8 = 48). *The **production possibilities frontier**: when we have a table of this kind, we can graphically represent the combinations of meat and potatoes that each individual subject can produce.* If the **farmer** decided to dedicate the ***whole day*** to producing **meat**, he could produce a **maximum of 8 kg of meat**/ **potato 32 kg**. If instead he decided to dedicate **half a day** to **meat**/ **potatoes**, he would produce **4 kg of meat** per day and **16 kg of potatoes.** *Is it possible for the farmer to produce and consume a point outside the frontier? No.* One day the **farmer** (less efficient) proposes to the **rancher**: to **specialize in potato production** and **a change on the rancher\'s frontier point**, that is, not to produce 4 hours a day of meat and 4 hours a day of potatoes but to **specialize in meat for 6 hours a day (3 kg x 6 = 18) and the other 2 hours in potatoes (6 kg x 2 = 12).** In this way, **they move to a higher point on the frontier.** Then the next step is to **exchange**; they **exchange 5 kg of meat for 15 kg of potatoes**. In this case, it is assumed that there is a certain **exchange rate: 1 kg of meat for 3 kg of potatoes.** Situation before and after the exchange: In the ***absence of exchange***, the **farmer** consumed **4 kg of meat**, now **5+1**; he consumed **16 kg of potatoes**, now **17 kg**. The **rancher**, when he did everything alone, consumed **12 kg of meat**/ **24 kg of potatoes**, now **13 kg of meat**/ **27 kg of potatoes**. It would seem that **everyone is better off than before.** - **Opportunity cost = RENUNCIATION / BENEFIT** How many potatoes do I have to give up to have 8 kg of meat?A math equation with black text AI-generated content may be incorrect. It means that **1 kg of meat costs me 4 kg of potatoes**= **opportunity cost**. What is the opportunity cost of 1 kg of potatoes? I have to give up 8 kg of meat to have 32kg of potatoes.  It means **1kg of potato** costs me **0.25 or 1/4 kg of meat**. So, the **opportunity cost** of **1 kg of meat** for the **farmer** is **4 kg of potatoes** and the opportunity cost of **1 kg of potatoes is 1/4 kg of meat**. For the **rancher, 1 kg of meat costs 2 kg of potatoes**. A number and a line AI-generated content may be incorrect. Proportionally, *[1 kg of meat costs more to the farmer and 1 kg of potatoes costs more to the rancher.]* The **rancher** has a **comparative advantage in meat production** because he has a **lower opportunity cost** while the **farmer** has a **comparative advantage in potato production.** - **Comparative advantage**= is the *ability to produce a good at a **lower opportunity cost** than another producer.* - **Absolute advantage**= is the *ability expressed in terms of **technical efficiency***, that is, the *ability to produce a good using a smaller quantity of production factors than another producer.* The **rancher** has an **absolute advantage** in the production of **both goods**, but in terms of **comparative advantage**, the **farmer** has an advantage in **potato** **production** and the **rancher** has an advantage in **meat production.** *Exchange is advantageous because each of the two parties can exchange goods at a lower opportunity cost than doing everything alone*. Each of us consumes goods and services produced by others, from this we can emphasize how *interdependence and exchange are useful as they allow each to specialize in what they do best and at the same time enjoy a greater quantity and variety of goods and services.* There are **two ways to satisfy consumption needs**: - **Autarkic choice (self-sufficiency)**= consuming only what one produces and choice of specialization - **Exchange/ specialization (interdependence)=** consuming what is obtained in exchange for what has been produced. Economic agents in most cases opt for exchange, and in this regard, there are two ways to compare the productive capacity of individuals, companies or nations: comparative/ absolute advantage. The ***benefits*** of **exchange and specialization** *do not* derive from absolute advantage, but from **comparative advantage**; exchage benefits all participants because it allows **specialization** in the production of the good, which enjoys a **comparative advantage**, ensuring that the **total production of the economy and the well-being of individuals grow**. The **principle of comparative advantage applies to nations as well as individuals**. Economists consider the principle of comparative advantage an **argument in support of free trade between nations**. *Is it convenient to establish trade relations with other countries?* Goods **produced abroad**/ **sold in our country**= **imports**; **produced internally**/ **sold abroad**= **exports**. **Chapter 4: The Market Forces of Supply and Demand** **Supply** and **demand** are the forces that make market economies work, determining the quantity sold of each good and its relative selling price i.e. to establish what effect an event/measure, will have on the economy, one must ask how it will affect them. The terms **supply**/ **demand** refer to the *behavior of individuals interacting in a market*, the *set of buyers/sellers of a given good/ service*. Markets can take various forms, *every buyer knows that there are several sellers of the same good, and every seller is aware that his product is similar to that offered by others*. The **price** and **quantity** of goods sold are **not determined by the behavior of a single seller or buyer, but by the interaction of a multitude of buyers and sellers in the market**. Most markets are **competitive**, a market is said to be so if there are **many buyers and sellers**, so that the *decisions of each of them, individually, have an insignificant influence on the market price.* The **seller** ***does not* *control* the *price***, since *other sellers offer a similar product to his*; moreover, he *has little interest in applying a price lower than the current one* and if he applies a *higher price*, *buyers will make their purchases elsewhere*. Not all goods and services, however, are exchanged in competitive markets. - **Oligopoly**= **few sellers** who do not always compete aggressively, and the products offered for sale are **perfectly substitutable** for each other. - **Monopoly** (e.g. computer software market)= **sellers in large quantities** but their products are **not perfectly substitutable,** so each seller enjoys in some way the possibility of **determining his own price**. - **Demand** = the *quantity of the good that buyers want and can buy*. Many elements determine the quantity demanded of a good, but one of these plays a fundamental role: the **price of the good**. The **quantity demanded increases if the price decreases**/ **decreases if the price increases**= **quantity demanded is inversely correlated to the price.** - **Law of demand**= the *principle according to which the quantity demanded of a good decreases as its price increases*. This relationship is easily demonstrable thanks to the **demand schedule (table)** and/or the **demand curve (graph),** both of which collect data illustrating the relationship between the price of a good and the quantity demanded. The demand curve, however, not being necessarily stable over time, shows us how as the price varies, consequently, the total quantity demanded of a good varies. To analyze the functioning of the market, we must determine the **market demand**= *sum of all individual demands for a given good or service.* Since market demand is *determined by the **algebraic sum of individual demands***, the quantity demanded by the market depends on the same factors that determine individual demand**. The market demand schedule is given, therefore, by the *sum (horizontally) of the values relating to individual demand***. From this it follows that the **market demand curve is the geometric locus that describes the variation of the total quantity demanded of a given good as the price varies**. The demand curve, however, does not necessarily remain stable over time: if something happens that changes the total quantity demanded at each given price, the demand curve shifts. The variables that can cause the demand curve to shift are: \- **income** (having less income means being able to spend less): if the demand for a good *increases* as *income increases*= **normal good**; if demand *increases* as *income* *decreases*= **inferior good**. \- **price of related goods**: when the *decrease in the price of one good* causes a *reduction in the demand for another good*, the two goods are said to be **substitutes**; when the *decrease in the price of one good* induces an *increase in the demand for another good*, the two goods are said to be **complementary**. \- **preferences**: economists usually do not explain individuals\' preferences since these often depend on historical, cultural and personal factors that do not fall within the domain of economics. Economists, however, are interested in what happens when preferences change. \- **expectations**: the *expectations that each individual may have about the future can condition the current demand for a good or service* (if one expects to earn more, one is more inclined to spend a part of what is usually reserved for savings). \- **number of buyers**: the *more people are added as consumers*, the *more the quantity demanded in the market increases.* - **Supply**= (focus on the behavior of sellers) *the quantity supplied of a given good or service is the quantity that sellers can and want to sell.* - **Law of supply**= all other conditions being equal, the *quantity supplied of a given good increases as the price increases.* This can be demonstrated through the supply schedule and/or the supply curve, both of which are representations, in the first case through data collection, in the second graphically, of the relationship between the price of a given good and the quantity supplied. **Since an increase in price causes an increase in the quantity supplied of a good, the supply curve has a positive slope.** However, a **change in price** causes a **movement** **along the supply curve**, while a **change in all other variables** generates a **shift of the curve**. The variables that can cause a shift in the supply curve are: \- **price of factors**: when the *price of one or more factors increases*, the *production* of a *good is less profitable*, therefore, the *supply of that good decreases*. Therefore, we state that the **quantity supplied has an inverse correlation with the price of production factors.** \- **technology**: by *reducing business costs*, *technological progress increases the quantity of goods offered.* \- **expectations**: if the *producer expects an increase in the prices of a certain good*, they will *probably increase production to offer it later at a higher price.* \- **number of sellers**: *market supply* also depends on the *number of firms in the sector.* To obtain the ***market supply curve, individual supply curves must be summed horizontally, which means that market supply is the sum of the supply of all sellers.*** **The point of intersection of the demand and supply curves in the Cartesian plane determines the equilibrium.** The **equilibrium price** is the price at which the *quantity demanded is equal to the quantity supplied*; it is sometimes defined as the **market price** as *all active subjects in the market are satisfied*: *buyers purchase everything they want and sellers sell exactly the quantity they want to sell.* There is a **surplus** (**excess supply**) when the **quantity *supplied is greater than the quantity demanded***. On the other hand, there is a **shortage** (**excess demand**) when the ***quantity demanded is greater than that supplied***. In *most free markets*, however, situations of *surplus or shortage are temporary*, because *prices naturally tend towards equilibrium*this phenomenon is widespread: **law of supply and demand**: the *price of every good naturally tends to adjust in order to bring the quantity into equilibrium.* To analyze how a given event affects a market, we use the *supply and demand model* to *examine the consequences on equilibrium price and quantity*, that is, the *quantity supplied and the quantity demanded at the equilibrium price*. To do this, a three-phase procedure is used: \- determine whether the event induces shifts in the demand curve or the supply curve (or both); \- determine in which direction the curves move; \- compare the new equilibrium with the previous one. In a market economy, prices are the reference points against which economic decisions are made and resources are allocated. For *every existing good in the economy, the price ensures the balance of supply and demand*, and the *equilibrium price establishes how much buyers will purchase and how much sellers will produce of that good*. **Demand function** The point E (equilibrium) is on the demand curve and simultaneously on the supply curve, that is, it satisfies all the preferences of consumers and producers. On the supply curve, I read how much producers are willing to offer. - If **P \< Pe**: **price tends to rise** because there is **excess demand (shortage**). - If **P \> Pe**: the **price tends** to **fall**. - If **quantity supplied** \> **quantity demanded** (**Qo\> Qd**) the **price tends to fall**. *[A market alone reaches an equilibrium without the need for the State to increase/ decrease prices because no producer offers more than what the market demands]*. The *economic system*, on its own, **self-adjusts** thanks to the **invisible hand (Keynes)** that ***regulates prices***; the ***price*** is the ***signal that changes the behaviors of consumers and producers and automatically adjusts supply or demand***. *Ex. consumer income increases, the demand curve shifts because this phenomenon influences consumer behavior; the curve moves away from the origin, that is, it shifts to the right. There is excess demand so the price increases and converges to a new point, different from E.* *If instead the supply curve contracts and shifts to the left, excess demand is created, the price increases and the quantity decreases.* **Chapter 5: Elasticity and Its Applications** - **Elasticity** = a *measure of the responsiveness of quantity demanded or quantity supplied to changes in one of its determinants, namely **price**.* The **price elasticity of demand** measures **how the quantity demanded changes as the price changes.** The demand for a good is **elastic** **(v\>1)** when the elasticity value is greater than 1, meaning the ***quantity demanded reacts significantly to price changes***; it is ***inelastic*** **(v\ MC**, an **increase in Q increases profit** and the *firm should increase production.* \- If **MR \< MC**, a **reduction in Q increases profit** and the *firm should decrease production.* \- Therefore, if **MR = MC, profit is maximized** *When talking about firm equilibrium, it means the choice of how much to produce and at what price to sell.* - **Suspending production=** *is the decision not to produce in the short term, during a specific period due to presumably contingent market conditions*. The firm *suspends production if **the revenue it would obtain by staying in business is less than its variable production costs**;* - **Exiting the market**= *is a long-term decision*. *By exiting the market, the firm loses all revenue from selling the product but saves both fixed and variable production costs. For this reason, the firm exits the market if **the revenue it obtains from production is less than the total cost**.* - **Sunk costs=** *costs already incurred that cannot be recovered.* ***In a firm with positive profit, the demand curve, in perfect competition, is a horizontal line: D=P=MR.*** *Without the marginal cost curve and the average total cost curve, we cannot say how much the firm should produce.* To see what is the *optimal quantity to produce* to *maximize profit*, I *apply the marginalist logic and therefore I go to see where the marginal revenue curve meets the marginal cost curve.* If the *marginal revenue is not present on the graph*, I CANNOT say how much the firm should produce to maximize profits. - **Demand curve is below the minimum of the ATC** **firm is at a loss**. - **Demand curve is tangent to the minimum of the ATC curve firm would break even** *(= meaning it **should produce a quantity corresponding to the minimum average cost.)*** - **Market supply curve**= is the *horizontal sum of individual supply curves*. The **short run** is characterized by the **presence of fixed costs**, so economists speak of *market equilibrium to mean a stable situation that persists in that market.* Firms, in the short run, can **break even but also make profits; profits and losses are incentives to enter or exit the market***.* The *market situation ends in **equilibrium** when there are **no more profits or losses***, so when the firm will **find a price equal to the minimum of the long-run average total cost**. At the market level, **if new firms enter attracted by profit, the supply changes, expanding, and the equilibrium price lowers.** Since **firms can enter or exit more easily in the long run** than in the short run, the **long-run market supply curve is usually more elastic than the short-run one.**  **Chapter 14: Monopoly** In **monopoly conditions**, there is **no competition** and therefore the **firm can influence the market price** of the good it produces and sells. The monopolist\'s **price is higher than marginal cost.** So what changes in monopoly compared to competition? If there is only one firm selling, the **producer chooses the price (price maker)**; according to the law of demand, if the *producer chooses a high price, they will sell less quantity and vice versa*. A firm is a monopoly when it is the **only seller of a good for which there are no substitute goods.** A monopolist is the only seller present in the market because **other firms cannot enter and compete with them**. **Entry barriers** (for example patents) are *generated by three types of causes:* 1\. **Resource monopoly**: Example of DeBeers diamonds, a Dutch company that owns 90% of diamond mines. So *if a producer is almost the exclusive owner of resources, the good is sold in monopoly.* 2\. **State monopolies** are divided into those where the *State is the sole producer* or *distributor, and patents or copyright*. 3\. **Production process (or economies of scale)** that *allows a company to produce at lower costs than others. Economies of scale are a reduction in average total cost as the quantity produced increases.* A sector is a **natural monopoly** if a *single firm can supply the good or service to the entire market at lower costs than those incurred by a multiplicity of firms.* Perfect competition: Perfect Competition: Demand Curve - Academistan In perfect competition, the firm\'s demand has **infinite elasticity** because the firm sells *perfectly substitutable products*. Monopoly: There is only one firm and it has the entire market demand (downward sloping curve). Being the only producer, it has a demand curve D that corresponds to the market demand.  Since the *monopolist\'s profit is equal to the difference between total revenue and total cost, to analyze the behavior of the monopolistic firm we need to analyze revenues.* The **marginal revenue curve** is *lower than the demand curve* because it is *always* *lower than the price*; to *sell a higher quantity of the good, the firm must offer it at a lower price*. The marginal revenue thus has a very different trend for the monopolist and for the competitive firm. When the **monopolist increases the quantity sold, it has two effects on total revenue:** \- The **production effect** as the **quantity sold increases**. \- The **price effect** because the **price decreases.** The **competitive firm**, being able to **sell any quantity at the market price**, **does not suffer the price effect**; if *it increases its supply by 1 unit, it collects the market price for that unit as well, so the **marginal revenue equals the price.*** In a **monopoly regime**, however, if the firm *increases production by 1 unit*, **it must** **reduce the price for all units sold**; consequently, the **monopolist\'s marginal revenue is always lower than the price**. **Marginal revenue can also have a negative value.** N.B. In **competitive markets,** **price equals marginal cost while in monopolistic markets, price is greater than marginal revenue.** **For the competitive firm: P = MR = MC; long run: P=MC=min ATC** **For the monopolistic firm: P \> MR = MC** So if the **marginal cost is greater than the marginal revenue**, the **firm can increase profit by reducing production**. Therefore, **the quantity of product that maximizes the monopolist\'s profit is determined by the intersection of the marginal cost and marginal revenue curves.** Since the **monopolist charges a price higher than the marginal cost**, **not all consumers who attribute to the good a value higher than its cost buy it.** For this reason, the **quantity produced and sold under monopoly is lower than the socially efficient one.** *The **deadweight loss** is graphically identified by the area of the triangle between the demand curve and the marginal cost curve.* - **Price discrimination=** *is an economic practice of selling the same good to different consumers at different prices*. In other words, it means charging different prices for the same product, for example, an airline that sells tickets for the same route at different prices. Price segmentation can be done when: \- **Different market segments with different willingness to pay are recognized.** \- The **company must be able to prevent arbitrage**, i.e. *when someone who buys at the lower price then sells the ticket to others.* Note: Discrimination can *[increase market welfare if it \"expands\" the market by reaching consumers who previously would not have purchased the good; so it serves to maximize profits.]* A diagram of a economic profit AI-generated content may be incorrect. **Chapter 15: Monopolistic Competition** - **Monopolistic competition**= *is a market structure in which many sellers are offering similar but not identical products*. *Firms can **enter or exit the market without restrictions**, so the number of firms in the market adjusts to drive **economic profit to zero**. Monopolistic competition is a market structure that falls between the two extreme cases of perfect competition and monopoly.* Its **demand curve** has a **negative slope**, so to **maximize profit**, a firm in monopolistic competition (like in monopoly) **determines the quantity to produce such that marginal cost equals marginal revenue** and **sets the price based on demand to be consistent with that quantity.** But this **situation cannot last over time**. When firms **make profits**, **new firms are incentivized to enter the market**. The entry of **new firms leads to an increase in the number of products for sale in the sector.** The **increase in supply causes a decrease in the price received by each firm per unit of product**, so **if a firm wants to sell more, it is forced to reduce the price. As demand for existing firms\' products decreases, profits contract.** The process of entry and exit continues **until firms active in the market make a profit or incur a loss.** Once **equilibrium is reached**, **new firms have no incentive to enter the market while existing firms are not incentivized to exit**. The **demand curve** for a firm in **monopolistic competition** in the **long run is tangent to the average total cost curve at a single point.** This is because the **process of firm entry and exit in the market has driven profit to zero, so these two curves touch without ever intersecting.**  In summary, in a monopolistically competitive market: \- As in a *monopolistic market*, **price is greater than marginal cost**; indeed, **profit maximization requires equality of marginal cost and marginal revenue** and, given a downward sloping demand curve, **marginal revenue is always less than price**. \- As in a *competitive market*, **price equals average total cost**; indeed, **free entry and exit from the market drives profit to zero.** **Monopolistic competition vs. perfect competition:** **Excess capacity:** The **quantity produced is less than that which minimizes average total cost**, meaning that in **monopolistic competition**, the firm is positioned on the *decreasing portion of the average total cost curve*. **The quantity that minimizes average total cost is called the efficient scale.** In the **long run**, firms in **perfect competition** produce **quantities corresponding to their efficient scale**, while those in **monopolistic competition** produce **smaller quantities and thus have excess capacity.** In other words, the firm in **monopolistic competition**, unlike the perfectly competitive firm, **could reduce its ATC by increasing production.** **Mark-up over marginal cost:** A second difference between the two market structures is found in the **relationship between price and marginal cost**. For the **perfectly competitive firm**, **price equals marginal cost**, while for the **monopolistically competitive firm, price is greater than marginal cost.** One source of **inefficiency** is the **mark-up of price over marginal cost**; **some consumers value the good above its cost but refrain from purchasing it.** Another possible **inefficiency** of **monopolistic competition** is related to the **number of firms operating in the market**, which could have **different entries or exits**. Thus, in a monopolistically competitive market, the **entry of new firms generates both negative and positive externalities.** - **Branding**= *the means by which a firm creates its identity and emphasizes its uniqueness compared to competitors.* The fundamental characteristic of a **perfectly contestable market** is that **firms are threatened by the entry of new competitors.** - **Entry** **limit pricing**= a *strategy that consists of keeping prices artificially low and thus limiting profit, to discourage potential new entrants.* - **Predatory pricing**= a *strategy that consists of keeping prices below average cost for a certain period to drive competitors out of the market or prevent new firms from entering.* In a **contestable market**, firms can also **erect other artificial barriers to prevent new competitors from entering the sector.** - **Competitive advantage=** *is the set of distinctive and defensible advantages that a firm can acquire over others.* - **Market skimming**= *a business strategy that consists of identifying and exploiting higher value-added market segments*. **Chapter 16:Oligopoly** - **Oligopoly=** *is a market structure in which few sellers are offering similar or identical products, dominating the market*. The market is said to be ***concentrated in the hands of a few firms.*** It is positioned *between monopolistic competition and monopoly.* Main characteristics: \- There are **many buyers**. \- **Few sellers with significant market shares**, i.e. with a *high concentration ratio* (number indicating the sum of market shares of the top firms). \- Goods can be **either perfect or imperfect substitutes**. \- There are **barriers to entry or exit from the market (not absolute).** \- There **may not be perfect information**. *Ex. chocolate (only 3 companies in Italy), air transport, automobiles, telephone and internet services, television, oil, LCD screens, electricity and gas.* What are the main implications? The ***actions of one firm have strong consequences for other firms, so what subject A does has implications for what subject B does.*** We can *no longer apply the marginalist principle for firm choices.* We talk about ***firm strategies** because, in making decisions, **firms also consider what other competitors might do.*** *Ex. of **duopoly**: Giacomo and Giuliana are two owners of two water wells, for them the extraction cost is 0.* There is a **downward-sloping demand** for water from consumers; the ***lower the market price, the higher the quantity sold***. Since the ***marginal cost of water is zero, total revenue corresponds to profit.\--\> MC=0; TR=PROFIT*** One possible outcome is that *Giacomo and Giuliana agree on the **quantity** of water to **produce** and the **price to charge***. - **Collusion**= *an agreement between firms operating in the same market aimed at determining quantities or prices.* - **Cartel=** *is an agreement between a group of firms acting in a coordinated manner (coincides with monopoly equilibrium).* Cartels and collusion are *prohibited* by all *national antitrust laws.* Giacomo and Giuliana *split the market in half* (each produces 30) but what would happen if Giacomo *increased* his *production* to 40? The *equilibrium point changes and we move down because the quantity* will go from 60 to 70 and the price will become 50. So when there is an **agreement**, the ***agreement works if respected by everyone***, but **both have an individual incentive to break the agreement because individually they would gain more.** - **Nash equilibrium=** *is a situation in which economic agents, through mutual interaction, determine their optimal strategy given the strategies chosen by other agents.* It is a situation in ***oligopoly*** where ***each player stays where they are at that moment because they have no incentive to change their strategy if everyone else does not change theirs.*** How the **equilibrium changes** if instead of two competitors there were **three or more**: \- Every time the **firm increases the quantity produced**, it has a **positive effect on total revenues but a negative effect on the market price because it lowers.** \- There is an **incentive to increase production if the quantity effect is greater than the price effect.** \- As the **number of firms increases, the price effect gets smaller and smaller**. \- The **final equilibrium approaches the competitive equilibrium.** So, to summarize, *how does the total quantity offered vary as the number of firms in an oligopoly increases*? As **firms increase, the total quantity exchanged increases and the equilibrium price decreases.** - How much is exchanged in an oligopoly? More or less than in a monopoly? More or less than in competition? In between, *between monopoly and competition*. - How is the price? In between, *between a monopoly price and a competitive price.* - How does the total quantity exchanged change? It *increases as the number of firms in the market increases.* - **Game theory**= *studies the behavior of individuals in strategic situations, i.e. situations where the outcome depends not only on the individual but also on other subjects participating in the game.* - **Payoff**= *is a matrix showing the benefits of each player depending on their own strategy and that of the competitor; both have the same matrix. They can be positive or negative, depending on the action taken by the subjects.* Since the ***number of firms in an oligopolistic market is reduced***, each firm ***must maintain strategic behavior***; each firm knows that ***its profit depends not only on the quantity it produces, but also on the quantity produced by other firms.*** Each **game involves two or more players** (for example firms) **confronting various options or strategies.** The **decision-making process regarding the strategy to undertake determines different results or payoffs.** - **Prisoner\'s dilemma**= *is a particular game between two prisoners that explains why it is difficult to maintain cooperation, even when it would be mutually beneficial.* - ***Dominant strategy**= when one strategy is better than others*, regardless of *what the other subject will do, it is called a dominant strategy, it means a strategy that is always preferable to an alternative given the other\'s strategy.* The ***agreement is more likely to be respected when the game is repeated multiple times and not just once***, it is observed that ***greater profits can be obtained and a final equilibrium closer to the interests of the individual parties could be reached.*** - **Tacit collusion=** *is a situation in which the behavior of firms leads to a market outcome that seems anti-competitive but stems from firms\' awareness of being interdependent.* **MACROECONOMICS** **CHAPTER 17: Measuring a Nation\'s Income** The goal of **macroeconomics** is to *explain economic changes that affect households, businesses, and markets.* - **Microeconomics**=*the study of how individuals and businesses make decisions and interact in the market.* - **Macroeconomics**= *the study of phenomena that concern the economy as a whole, such as inflation, unemployment, and economic growth.* In macroeconomics, we lose sight of the individual market to focus on the system as a whole. **Individual income** and **national income**: the ***circular flow model of income*** assumed **no role for the state**, **no foreign trade**, and **no private savings.** We saw the *equality between **national income*** *(**sum of all economic subjects\' incomes**)* and the ***total expenditure of individuals to purchase final goods and services.*** - **Gross Domestic Product (GDP)**= the ***market value of all final goods and services produced in a country in a given period.*** To determine if an **economic system** is doing *well or poorly*, it\'s natural to consider the ***sum of incomes earned by all members of society*, i.e., the Gross Domestic Product (GDP).** It measures the **total income of society\'s members and the total expenditure on purchasing what is produced and sold in that society**. For an economic system as a whole, **income must equal expenditure**. It\'s a **kind of circular flow between buyers and sellers**, and *GDP can measure it in two ways*: 1. by **summing the total expenditure of individuals** 2. by **summing the total incomes paid by businesses** GDP measurement *sums different types of products into a single measure of economic activity value*. It *must use market prices that reflect the monetary value attributed to these goods.* GDP must be comprehensive, including: - *all goods legally produced and sold in the economy* - *includes the market value of services provided by the economy\'s real estate assets* - *includes the value of housing services enjoyed by homeowners* - *excludes products whose value is difficult to measure (narcotics, products for self-consumption\...)* - *includes both tangible and intangible goods* - *only final goods are included as the value of intermediate goods is incorporated into the final value* In economics, *two types of goods* are distinguished: **final** and **intermediate**. - **Final goods** are *sold directly to consumers or businesses* - **Intermediate goods**= *are bought by some businesses, assembled with other intermediate goods to become a final good, and then sold.* - *includes* *goods and services produced in the current period and not in the past* - *measures the value of production within a country\'s geographical boundaries* - *measures the value of production generated in a specific time interval, i.e., the income and expenditure flows that take place in the period considered.* [State]: spends to purchase public goods and services (hospitals/ highways); it finances itself in financial markets (collects taxes, issuing public debt securities) and also makes transfers to citizens (pensions). [Rest of the world:] demands Italian exports that increase the value of GDP; conversely, our GDP decreases when our spending is on imports (monetary outflow). *Does an [increase] in [exports] increase or decrease GDP? [Increase].* *Does an [increase] in [taxation] increase or decrease GDP? [Decrease] because it reduces household consumption spending, as if an individual has to pay more in taxes, they have less money for consumer spending.* *What effect does a [tax] [reduction] have on [consumption]? It [increases private spending] on consumer goods and therefore, consequently, [increases GDP].* *What effect does an [increase] in [private savings] have on GDP? It [decreases] the income available for consumer goods and therefore if one saves more, they spend less; GDP decreases.* *What effect does an [increase] in [public spending] have on GDP? It [increases] GDP because [GDP = national income].* GDP does not include markets that do not officially appear such as the black market, illegal markets, self-production and self-consumption, and volunteering. - **Gross National Product (GNP)=** *value of final goods and services produced by the economic system in a year from national resources, both domestically and abroad.* - **Net National Product (NNP)=** *take the GNP and subtract depreciation (ammortamenti), i.e., the value/expense of the production of capital goods that have worn out during the year and must be replaced.* - **National Income=** *it is the total income obtained by citizens of a country through the production of goods and services.* - **Disposable Income=** *it is what remains for the consumer to buy consumer goods net of all taxes.* - **Personal Income=** *income received by individuals.* - **GDP per capita=** *indicates the average income of the individual member of the economic system; it is the division of GDP divided by the population of the economic system.* *Each European country detects all forms of expenditure and income to arrive at an estimate of the GDP of its economy.* **GDP (Y)** can be broken down into four elements: **Y = C + I + G + NX** \- **Consumption (C):** *Expenditure for the purchase of consumer goods, i.e., final goods and services.* \- **Investment (I):** *The purchase, by companies, of capital goods, i.e., instrumental goods used to produce other goods.* \- **Public expenditure (G):** *State expenditure to provide public services.* \- **Net exports (NX):** *The* *more they increase, the more they increase GDP; exports minus imports. Imports, on the other hand, reduce the value of GDP.* Consumption: GDP measures the ***total expenditure for the purchase of goods and services in all markets of an economic system***. If ***spending increases from one year to the next***, there can be two reasons: either the **production of goods and services has increased** or **prices have increased (inflation).** - **Nominal GDP=** ***calculates the production of goods and services valued at current prices**.* To obtain a measure of the value of production purged of the effect of price increases, we *calculate real GDP*, i.e., the production of goods and services valued at constant prices. *Nominal GDP uses the current prices of a given year to attribute a value to the goods and services produced by the economy. **Accounts for both changes in production and prices but not for inflation.*** - **Real GDP=** ***values production at constant prices, thus keeping prices fixed**.* The *value of real GDP is **independent of price dynamics**, so its variations reflect **only variations in production not price changes***. Real GDP is a *measure of the production of goods and services.* The goal of calculating GDP is *to evaluate the performance of the economy as a whole*. *Real GDP constitutes a better index of economic well-being than nominal GDP.* - **GDP Deflator=** *reflects the prices of goods and services, but not the quantities produced.*  The **GDP deflator** *measures the current price level in relation to the price level of the base year.* It is *one of the measures that economists use to analyse the trend of the **average price level in the economic system**.* - **Inflation**= *an increase in the general price level in the economic system* - **Inflation rate**= *is the percentage change in the price level between two consecutive periods.* D2= deflatore anno 2/ D1= d. anno1 Regarding *economic well-being*, *GDP says nothing about income distribution and happiness; about leisure time; it does not include the value of all activities and exchanges that take place outside a market and volunteer activities.* **CHAPTER 18: Measuring the Cost of Living** *[Measuring the general price level means measuring the price level of all final goods and services produced by the economic system]*. In common language, this is called ***inflation***, which is *a general increase in prices*; the ***inflation rate***, on the other hand, is *the percentage change*. The *[GDP deflator is a suitable measure to estimate the inflation rate.]* - **Consumer Price Index (CPI)=** *is an indicator of the overall cost of goods and services purchased by the typical consumer; it allows us to determine how the cost of living changes over time.* - **Producer price index***= is an indicator that measures the cost of a basket of goods and services purchased by businesses* The five phases of the calculation process carried out by the **ONS** and **Eurostat** are: **1. Determining the basket** Establish *which prices are important for the typical consumer.* A **basket**= *is a kind of shopping cart in which ISTAT includes a certain number of products that correspond to the average consumption and expenditure of an Italian family* (milk, bread, rent, gasoline etc). *ONS determines these weights by analyzing consumer behavior and defining a basket of goods and services purchased by the average consumer.* **2. Price detection** Record the price at which each good or service in the basket is sold at different periods of time. **3. Calculating the cost of the basket** Use the collected data to calculate the price of the basket of goods and services in each of the three years. The quantities in the cart are multiplied by the average price to find the total cost of the basket. **4. Identifying the base year and calculating the index** Designate a year to be used as a base for calculation, against which comparisons with other years are made.  **5. Calculating the inflation rate** This is the percentage change in the price index between one survey and another, based on the consumer price index. A close up of a text AI-generated content may be incorrect. Problems in measuring the cost of living include: \- **Substitution bias** consumers tend to substitute more expensive goods with those whose price has not increased. Prices do not vary proportionally from one year to another, but the prices of some goods increase more than others. However, the ***cost of living index*** is calculated assuming that the basket is constant, so it does not take into account changes in purchasing. \- **New goods bias** when a new good is introduced to the market, the consumer has more choices (CD player and iPod); the consumer thus needs less money to maintain their standard of living unchanged. \- **Inability to measure quality changes** the quality of a category of goods deteriorates from one year to the next, the value of money decreases even if the price of the good remains unchanged; if the quality of a good increases from one year to the next, the value of money increases. ONS does its best to detect changes in the quality of goods. To *assess the rate at which prices increase*, economists and policymakers consider both the *GDP deflator* and *the consumer price index*. Usually, the two statistics have similar values but can be discrepant for at least two reasons:\ 1. *[GDP deflator reflects the prices of all goods and services produced by the economic system]*, while the *[consumer price index reflects the prices of all goods and services purchased by consumers]*, i.e. those within the basket. 2\. Difference between the *GDP deflator* and the *consumer price index* is more subtle and concerns the weight given to individual prices to arrive at calculating a single value of the general price level. The *[consumer price index is based on a constant basket of goods and services, whose composition is only occasionally modified by ONS]*. The *[GDP deflator compares the price of current production goods and services with what these same goods would have cost in the base year]*, so the *[basket on which it is based automatically changes over time.]* When comparing two monetary values in the presence of inflation, the following formula is used:  *Ex. For example, who earned more between President Hoover (\$75,000 in 1931) and Obama (\$400,000 in 2012)?* *Let\'s take Hoover\'s salary in 1931 and multiply it by the ratio between the two price levels; in 2012 the price level was 229.5 while in 1931 it was 15.2.* A math problem with numbers AI-generated content may be incorrect. *15.1 indicates how many times the cost of the basket increased between 1931 and 2012. In conclusion, we can say that President Hoover in 1931 earned almost triple what Obama earned.* - **Nominal measures**= *are values measured at **current prices** and **do not take into account price changes.*** - **Real measures**= *are measured at **constant prices** and take into account **inflation/price changes**.* *Any nominal value, therefore expressed at today\'s prices, can actually have a different real value when compared to another nominal value because in between there is the change in the general price level.* - **Indexation**= *means changing the value of a variable to adjust it to the consumer price index; therefore, increasing the value if the consumer price index increases. When a monetary value is automatically corrected for inflation, it is said to be indexed.* *Many long-term contracts between companies and unions include full or partial indexation of wages to the consumer price index* expedient is called a **sliding scale** and *automatically varies wages according to the cost of living.* - **Real interest rate=** *is the nominal interest rate adjusted for the effects of inflation. It also establishes how much the purchasing power of a sum deposited in a bank increases over time.* **Real interest rate = nominal interest rate - inflation rate** - **Nominal interest rate=** *measures the absolute change in the amount of money and establishes how much the amount of money deposited in a bank increases over time.* To conclude: *increases in the general price level distort the values of all nominal variables measured at current prices*; therefore, when we evaluate two salaries at two different moments in time, if there has been inflation in between, the comparison is no longer correct. To make comparisons, it is therefore appropriate to *correct nominal values and make them comparable to each other. The CPI or GDP deflator are two ways to try to make these corrections.* **CHAPTER 19: Production and Growth** Data on real GDP per capita show that living standards vary considerably across countries. *Ex. the average individual income in the United States is about 6 times that of China and 14 times that of India*. The *poorest countries* currently have an *average per capita income significantly lower than what was recorded in the world decades ago.* **The growth of real GDP is measured through the percentage change in real GDP**. A *2% annual change* leads to a *doubling of GDP after 35 years*. *Ex. over the past 20 years, China has grown at a rate of 9-10% annually, while Zimbabwe has decreased its per capita income by 38% in the same period. Japan is at the top of the list and is now an economic superpower, with an average per capita income double that of countries like Mexico or Argentina.* How long does it take for real GDP to double, given a certain average annual growth rate?  However, the richest countries in the world have no certainty of remaining rich, and the same applies to the poorest. But how can these changes over time be explained? The *differences in living standards across countries could be explained in one word:* **productivity**, which is *the quantity of goods and services produced with one unit of labor.* - **If productivity increases, well-being also increases**. *Ex. if a person on an island is good at fishing, growing vegetables, and making clothes, they have a relatively comfortable existence. If they are not capable, their standard of living is poor. Therefore, the* **standard of living depends on productivity***.* ***A nation can enjoy a high standard of living only if it can produce large quantities of goods and services.*** Many *factors determine productivity*: **1. Physical capital**workers are more productive if they have tools to work with: the *equipment and structures used for the production of goods and services is called physical capital*. What is used for the production of goods and services is called a factor of production. One of the peculiar aspects *of capital is that it is a factor of production that is itself a product; capital is a factor of production used to produce all kinds of goods, including other capital.* **2. Human capital** the second determinant is the *knowledge and skills accumulated by workers through education*, *training, and experience*. Human capital includes the *knowledge and skills accumulated during school age, at university or in adulthood, and thanks to experience acquired directly on the job.* **3. Natural resources** the third determinant are the factors of production provided by *nature, such as land, rivers or mineral deposits. Natural resources can be renewable and non-renewable*. The *different availability of natural resources is one of the causes of the diversity in standard of living among countries of the world. Natural resources, although important, are not a necessary condition for achieving a high level of productivity.* **4. Technological knowledge** the fourth determinant is the *knowledge of the most effective ways to produce goods and services.* It *can take many forms*: *part of the technology becomes part of the common knowledge base, other forms of technology are defensible from competition and become part of the heritage of the company that developed them, other forms are defensible only for a limited period of time (patents).* - **Production function=** *is a relationship between the quantity of factors used in production and the quantity of products obtained from them.* *For example, suppose that Y = AF(L,K,H,N) where:* *- Y = quantity of product* *- A = variable reflecting the technology available for production* *- F = function illustrating how factors are combined to realize the product* *- L = quantity of labor* *- K = quantity of physical capital* *- H = quantity/quality of human capital* *- N = quantity of natural resources* *[If technology improves, A increases, and the economy reaches a higher production level]. [If we assume constant returns to scale, doubling the quantity of all production factors also doubles production]. Therefore xY = AF(xL, xK, xH, xN) x=2 the right-hand side shows the doubling of production factors while the left-hand side shows the doubling of production. If we assume that x=1/L the equation becomes Y/L = AF(1, K/L, H/L, N/L) Y/L is the quantity produced per employee and represents a measure of productivity.* Given that **capital is a production factor that is itself produced, the amount of available capital can vary over time**. One way to **increase future productivity is to invest a larger share of current resources in capital production**. Since *resources are scarce, dedicating a [larger share to capital production] means dedicating a [smaller share to current consumption production].* Consequently, for **society as a whole, investing more in capital means consuming less and saving more.** **Growth generated through capital accumulation is not without costs**: it requires *sacrificing current consumption of goods and services in favor of higher consumption in the future.* **Encouraging savings and investment** is one of the ways in which the **state** **can stimulate economic growth** and **increase society\'s standard of living in the long term.** Studies examining larger samples of countries have confirmed the *strong correlation* between *investment and growth*. However, the correlation between the two variables *does not allow for certainty in establishing the direction of the cause-and-effect relationship.* *Capital is subject* *to* **diminishing returns**: *as the stock of capital increases, the additional quantity that can be produced thanks to a further unit input of capital decreases*. In other words, *if workers already have a large amount of capital to produce goods and services, providing them with an additional unit only slightly increases their productivity*. Due to diminishing returns, an **increase in the propensity to save only increases growth for a limited period**: although a higher savings rate allows for capital accumulation, the benefits of additional capital units decrease over time, and growth slows down. In the **long run**, a **higher propensity to save leads to higher levels of productivity and income, but not to more sustained growth.** The *diminishing returns of capital have another important implication*: *all else being equal, it is relatively easier for a poor country to achieve high growth rates, this is the* **catch-up effect**. *All other conditions being equal, such as the percentage of GDP dedicated to investment, poor countries tend to grow faster than rich ones.* Citizen investment is only one of the tools a nation has to increase capital accumulation: another investment is **foreign investment**. *Foreign investment takes many forms:* - **Foreign direct investment=** *an investment owned and managed by a foreign entity.* - **Foreign portfolio investment=** *an investment financed with foreign money but managed by residents.* When foreigners invest in a country, they do so in the belief that they can derive economic benefit from it. *Foreign investment does not affect all measures of economic well-being in the same way, but it is one of the tools by which developing countries can acquire advanced technologies used in richer countries.* *[A supranational organization whose goal is to encourage the flow of investment to poor countries is the World Bank.]* For a *nation\'s long-term success*, **education** is at least as important as investment in physical capital. *Investment in **human capital**, like that in physical capital, has an **opportunity cost**.* Some economists argue that the *importance of human capital also stems from the fact that it **generates positive externalities***. An *externality is the effect of an individual\'s behavior on the well-being of uninvolved third parties*. One of the problems that some poor countries face is the so-called **brain drain**, that is, the *emigration of more educated workers to richer countries*, where they *can enjoy a better quality of life.* The **term human capital** also refers to the *resources used to make the population healthier.* *All else being equal, a healthier worker is also more productive.* Making the **right investments in the health of the population is a way to increase productivity and raise the standard of living**. Other tools to promote economic growth are the **protection of property rights**, the **promotion of political stability**, and the **maintenance of good governance**. A *common threat to property rights is political instability.* ***Economic prosperity also depends on political prosperity***: *a country with an efficient judicial system, honest public officials, and a stable legal system enjoys, all else being equal, a better standard of living than a country where the judicial system is inefficient, public officials are corrupt, and the law is uncertain.* Some of the world\'s *poorest countries have attempted to achieve faster economic growth by pursuing **isolationist** **policies***. Most economists today are convinced that *poor countries can only benefit from a more open attitude that integrates them with the economy of the rest of the world*. A *country that eliminated trade barriers could experience the same type of economic growth that usually occurs after significant technological progress.* The volume of trade that a nation conducts with the rest of the world is *determined* *not only by politics but also by geography*. Countries with *access to the sea and natural ports are facilitated compared to countries that only border land.* Countries without access to the sea have greater difficulties in trade and tend to have lower incomes than those with easy access to waterways (**free trade**). One of the most important reasons why the standard of living is now widely better than a century ago is **technological progress**. **Knowledge is a public good**: *once an individual has acquired knowledge, it enters the cultural heritage of society and other people can use it more or less freely.* The ***state must take on the function of encouraging and stimulating research and development of new technologies***. One of the *tools available to the state to incentivize research activity is **patent protection**.* *Population growth interacts with other production factors in less direct and more controversial ways*: \- The **exploitation of natural resources**: Thomas Robert Malthus says that the *continuous growth of the population would have challenged society\'s ability to sustain itself and would have inevitably thrown humanity into abject poverty*. But the predictions are wrong. ***Thanks to economic growth, malnutrition and famine are much less widespread phenomena*** than in Malthus\'s time. \- **Dilution of capital stock**: Some of today\'s economists *emphasize the effects of population on capital accumulation*. ***High population growth would reduce GDP per worker, because as the number of workers increases, the amount of capital employed decreases***. In other words, ***if population growth is rapid, workers have an increasingly reduced endowment of capital, and this decrease in capital per worker leads to a decrease in productivity and GDP per worker***. Some analysts believe that a decrease in population growth in those countries could contribute to raising their standard of living. \- **Promotion of technological progress**: *Rapid population growth can also present benefits.* Some economists have suggested *that the **growth of the world population may have given impetus to technological progress and economic prosperity**.* **CHAPTER 20: Savings, Investment and the Financial System** - **Financial system=** *is a group of institutions that operate in the economy to channel savings from one entity to the investment of another.* By *saving a significant portion of GDP, a country makes **more resources available for investment in capital goods***; the *increase in capital, in turn, increases productivity and standard of living.* The financial system *transfers the economy\'s scarce resources from savers (individuals who spend less than they earn) to borrowers (individuals who spend more than they earn).* Savers offer money to the financial system, expecting to see it returned with interest at a future date; borrowers demand money from the financial system knowing they will be required to repay it with interest at a future date. **Financial markets are financial institutions through which savers can directly finance borrowers.** The two most important financial markets in our economy are the **bond market** and the **stock market.** - **Bonds=** *debt securities that establish when the loan will be repaid (**maturity** **date**) and the interest rate that will be paid before maturity (**coupon**).* Characteristics: **duration** (time between issuance and maturity of the security), **credit or default risk** (probability that the debtor will not honor commitments), and **tax treatment** (how tax regulations consider interest income generated by bond ownership). - **Stocks=** *are ownership securities of a company and constitute a right to the profits it realizes (**dividends**).* The *sale of stocks* to raise funds is called **equity** **financing**, while the *issuance of bonds* is called **debt financing**. The *prices at which stocks are traded on the market are determined by the interaction of supply and demand*. - **Financial intermediaries=** *financial institutions through which savers can indirectly finance borrowers.* - **Banks** are the financial intermediary with which individuals are most familiar; one of the *primary functions* of a bank is *to collect savings from those who spend less than they earn and use it to make loans to those who need to borrow*. Banks ***pay interest to depositors*** and ***charge borrowers a higher interest on loans***: **active** and **passive** **interest rates**. The *difference between the two interest rates covers the bank\'s costs and ensures a profit for its owners*. The bank also *contributes to the creation of instruments that can be used as means of payment; **stocks** and **bonds** can **constitute deposits of accumulated wealth through savings.*** - **Mutual funds** are *financial institutions that sell participation shares to the public and, with the proceeds, purchase a selection (called a **portfolio**) of stocks and bonds*. One advantage is that mutual funds *facilitate access to diversified portfolios.* **Accounting** establishes how *different values are calculated and added together, and the rules on which national accounting is based include some important identities:* - **GDP** (Y) is divided into **consumption** (C), **investment** (I), **government spending** (G), and **net exports** (NX)= **Y = C + I + G + NX** Assuming a *closed economy* that doesn\'t interact with other economic systems, net exports (NX) are zero= **Y = C + I + G** This equation establishes that GDP is equal to the sum of consumption, investment, and government spending. Subtracting C and G from both sides yields= **Y - C - G = I** *Y - C - G is the **total income** of the **economy** that remains after subtracting consumption and government spending*: this amount corresponds to **national savings**, or **simply savings (S).** **S = (Y - T - C) + (T - G) (private savings + public savings)** - **Private savings** is the *portion of income that remains to individuals after paying for consumption and taxes.* **(Y - T - C)** - **Public savings** is *equal to the difference between tax revenues and government spending.* **(T - G)** If **T is greater than G**, the state collects more money than it spends and has a **budget surplus**, while if **T is less than G,** the state spends more than it collects and has a **budget deficit**. For the *economy as a whole*, **savings must equal investment**. **S = I (national savings = investment)** - **Loanable funds market** is a *market where savers offer funds to those who need to finance their investments.* This market, like any other market, is *governed by supply and demand.* The demand comes from *companies* (and *citizens*) that *need liquidity to finance their investments (or credit consumption)*. The **source of demand for loanable funds is investment.** The *supply comes from households (or companies) that save and are willing to offer liquidity in exchange for an interest rate.* **Savings is the source of the supply of loanable funds.** - **Interest rate is the price of loans**; the *quantity of loanable funds demanded decreases as the interest rate increases*. The *quantity of loanable funds supplied increases as the interest rate increases*; in other words, the **demand curve** for loanable funds has a **negative slope**, while the **supply curve** has a **positive slope.** *When interest rates are high, more people want to save (supply increases) because they can earn more. Fewer people want to borrow (demand decreases) because it\'s expensive. When interest rates are low, fewer people want to save (supply decreases) because they earn less. More people want to borrow (demand increases) because it\'s cheaper.* The *decrease in private investments generated by the **budget deficit*** is called **crowding out**. An *increase in government spending (G) or a decrease in taxation (T)* (\"crowders\") implies *greater recourse by the state to financial markets and greater public debt*; this ***increases the interest rate/less money to invest***, thus ***decreasing private investments (crowded out).*** **If the state reduces national savings through a budget deficit, the interest rate increases and investment decreases.** - **Deficit**= The deficit (or public deficit) is *measured in terms of the difference between revenues and expenditures over a 1-year period*. A **deficit** occurs *when public spending is greater than revenues*, while a **public surplus** occurs *when state revenues are greater*. A form of state revenue is **taxes**, which *are paid both once a year by citizens and with VAT on the purchase of goods or services.* A *series of deficits* implies that the *state must resort to financial markets, thus **accumulating public debt***. - **Public debt** *is the total sum owed by the state to third parties; debt is therefore the **sum of deficits minus any budget surpluses***. Deficit and debt are measured in relation to GDP: **deficit/GDP; debt/GDP**. - **Primary surplus (or deficit)** is the *difference between state revenues and expenditures, net of interest expenses.* *Italy has a **primary surplus/GDP** of about 2.5%; every 1% increase in interest rates costs us about 20 billion euros in annual interest expenses.* But what does a **high debt/GDP** **ratio** entail? Every ***\"large\" debtor when demanding financing from financial markets must pay a higher interest rate***, and the **higher the interest rate it has to pay, the more it will need financing in the future**; at a certain point, **markets no longer lend and a state defaults** (unable to repay creditors, state employees, etc.) - **Spread** = *the* *difference between the 10-year bond rate of country x minus German bond rate.* *Normally, reference is made to Germany, which is a country that manages to issue bonds at a particularly low rate (0.36%).* **CHAPTER 21: Basic Financial Tools** - **Finance** *is the branch of economics that studies individuals\' decisions regarding resource allocation over time and risk management.* *Ex. 100 euros today are different from 100 euros in two years because of the interest rate, meaning the same amount of money has different values over time.* - **Present value** *is the amount of money needed today to have a given sum in the future, given the interest rate*. The present value of 102€ after 1 year at a 2% rate is 100€. - **Future value** *is the amount of money that can be obtained in the future from a current sum, given the current interest rate. If the interest rate were 0, there would be no difference between present and future value.* - **Compound interest** *is the effect of accumulating interest with the capital that produced it, contributing to producing further interest*. *Each year, interest accrues on my capital, which has grown larger thanks to previous years.* Calculating present value and future value: r = annual interest rate PV/VA = present value FV/VF = future value N = number of years Se il tasso di interesse è del 2% al posto di r si dovrebbe scrivere 0,02; se è del 10% 0,10; se è 12,5% 0,125. *Example 1: How much will I have in the bank after 2 years if the interest rate is 10% and I deposit 100€ today?*  *Example 2: How much should I deposit in the bank today to have 200€ in 10 years if the interest rate is 5%?* Quindi vuol dire che mi servono 123€ oggi (VA) per avere 200€ di valore futuro tra 10 anni a un tasso di interesse del 5%. **Risk Management:** - **Risk aversion** *is the manifestation of rejection of uncertainty, as people dislike negative events occurring. This means they detest negative events more than they appreciate equivalent positive events.* Economists have developed a **model of risk aversion** using the concept of **utility**, which is the *subjective measure of individual well-being or satisfaction.* ***This function is characterized by the property of diminishing marginal utility: the greater the wealth, the smaller the increase in utility derived from an additional 1€ of wealth.*** One way to manage risk is to take out an **insurance contract**. The main feature is that an *individual exposed to a risk pays a premium to a specialized company, which in turn accepts the risk. In this way, the risk of a loss is amortized by the insurance company, which distributes the risk of an event that could be extremely burdensome for a single person across many people.* The insurance market suffers from two types of problems: - **adverse selection** a person exposed to a high risk has a greater incentive to take out insurance compared to a person exposed to a lower risk - **moral hazard** after taking out insurance, individuals have fewer incentives to limit their risky behaviors because the costs that could result are almost entirely borne by the insurer. Two principles of finance: 1\. **Diversification of idiosyncratic risk**: *Diversification is the reduction of risk obtained by replacing a single risk with a large number of smaller, uncorrelated risks.* Risk is measured by the **standard deviation (variance)** which *measures the probability* that the *value of the variable will fluctuate over time*. Diversification can eliminate ***idiosyncratic risk*** (of the *individual company*) and ***aggregate risk*** (of the *entire portfolio*). 2\. **The risk-return trade-off**: *any financial activity that promises a higher return is normally riskier.* **Valuation of financial assets:** When purchasing a stock, you are buying an ownership stake in a company, so you must consider both the *value of the assets* and the *price at which the shares are being sold*. - **Fundamental analysis** *refers to the detailed examination of a company\'s financial statements to determine its value*. One way to measure the value of a stock is to *look at the company\'s wealth (**value of assets owned**)* and the ***present value of future cash flows.*** - The **efficient market hypothesis** is a *theory which states that stock prices reflect all publicly available information about the value of the security; markets are efficient because they always establish the right price.* - **Market irrationality**= markets are formed by individuals who are animal spirits and in reality have no idea how to calculate how much a company will earn in the future, they *only aim to sell at a higher price than what they paid*. *When the price of an asset increases beyond what is considered its fundamental value, it is said that a **speculative bubble** has been generated in the market.* **CHAPTER 22: Unemployment** A *more evident measure of a country\'s standard of living is the number of people who are normally **unemployed***: *individuals who want to work but cannot find a job and do not contribute to productivity (and therefore do not contribute to raising GDP).* If there is ***unemployment in an economic system***, it means ***we are not on the production possibilities frontier***; there are ***productive resources that are unused***, and therefore there is ***inefficiency***. Moreover, ***unemployment creates poverty*** and is thus a ***social problem*** for the country. How is unemployment measured? - **Employed person** *is someone who has a job as a paid employee.* - **Unemployed person** *is someone who does not have a job but is looking for one, has an active attitude, and desires work.* Finally, there are **individuals not in the labor force**, i.e., *all those who can work* (over 15 years old and not retired) and *are not studying full-time*. **Labor force = employed + unemployed.** *Out of 60 million people in Italy, about 3 million are unemployed; 23 million are employed, and 13 million constitute the non-labor force, i.e., they are inactive.*  *Unemployment rate; Labor force participation rate* - **Natural rate of unemployment** *is the average unemployment rate around which annual observations fluctuate.* So we could say that the natural unemployment rate in Italy is around 9%. - **Cyclical unemployment** *refers to the deviation (difference) between annually observed unemployment and the natural rate.* So when a *system grows rapidly, GDP increases and the unemployment rate decreases*, while when a *system goes into recession and GDP decreases, unemployment increases because there is less income and companies lay off workers.* *n.b. In Italy, the unemployment rate varies greatly by gender, age, and region. Unemployment in the United States is lower than in Italy.* *Some of those classified as unemployed may not be looking for a job with sufficient determination; they may define themselves as unemployed only to access unemployment benefits or because they work in the informal economy* more correct to classify these individuals as *not in the labor force*. *Some individuals who do not participate in the labor force may want to work and may have looked for a job and given up after many failures* **discouraged workers** and *do not appear in unemployment statistics.* If *unemployment* were a *short-term problem*, it would not be serious, since an unemployed person would take only a few weeks to find a new job suitable for their characteristics. However, in the course of their research, economists have highlighted an important, strange, and seemingly contradictory result: ***the duration of unemployment periods is in most cases short, but most of the unemployment observed at any given time is long-term***. This *occurs because most workers who lose their jobs find one very soon; but the problem of unemployment mostly affects a few workers who remain unemployed for a long time, and it is in these cases that the real problem arises (which is long-term).* In most markets, prices adjust to balance supply and demand; in an ***ideal labor market, wages should adjust so that the quantity of labor supplied equals the quantity demanded, which would always ensure full employment***. However, reality is far from this ideal: there are always some unemployed even when the economy is doing well, so the *unemployment rate is never zero*. To understand the *natural rate*, we need to *examine the reasons why the real labor market is different from the ideal one, through four possible explanations for unemployment:* 1)The first is that *workers take time to find a job that meets their expectations*; unemployment caused by the ***time needed for a worker to find a new occupation suitable for their skills and aspirations*** is called **frictional unemployment**, and it is believed to explain short-term unemployment. 2)The other explanation, on the other hand, assumes that the ***quantity of labor supplied (by workers) exceeds the quantity of labor demanded (by employers)***; in practice, there are not enough jobs. This type of unemployment is called **structural unemployment** and *is believed to explain long-term unemployment*. **Frictional unemployment** is often the *result of variations in labor demand between different companies*. If consumers decide to prefer brand X to brand Y, the company producing brand X expands employment and the other lays off its workers. Former employees of company Y must look for a new job, and brand X producers must decide which new workers to hire for the new positions that have opened up. The *result of this transition is a period of unemployment.* *Variations in the composition of labor demand across different sectors* are called **sectoral fluctuations**. Because it *takes time for a worker to find a place in a new sector, such fluctuations cause temporary unemployment*. In addition to these effects, sometimes *workers leave their jobs because they believe their occupation does not meet their expectations, abilities, and desires.* **Economic policy and job search**\ *Frictional unemployment is to some extent inevitable, but its quantity is not predetermined*. Greater *dissemination of information* on *available jobs and job seekers* can *increase* the *speed of the placement process* (internet is one of the best **dissemination systems**). Moreover, **economic policy** can play a **positive role**: some **state programs try to facilitate job search in different ways**, for example through *[employment offices]*, which offer information on vacant positions to help workers find the most suitable job in the shortest possible time, and *[state-funded training programs]*, which aim to facilitate the transition of workers from declining sectors to growing sectors and to help the most disadvantaged social components. *[Start-up contracts]* incentivize companies to hire as part of the worker\'s salary is paid by the state.*[Reduction of the tax wedge]*, which is the difference between the company\'s expense for the worker and what the worker receives net in their paycheck.Companies can temporarily stop work and put some workers on **redundancy pay**, who have a *portion of their salary paid by the state and do not have to go to work*.*[Unemployment benefits]* are a *[state measure designed to offer workers partial protection in case of job loss].* [It is *only paid to those who have been laid off because their skills were no longer needed*]*.* Although it is an excellent social safety net, it *also contributes to increasing the unemployment rate*. In fact, since *finding a job interrupts the provision of the benefit, the unemployed do not devote sufficient energy to the search and are therefore more likely to refuse unattractive offers*. Moreover, since the *subsidy lowers the cost* of *unemployment*, workers have *fewer incentives to put job security at the center of negotiations with potential employers*. **The minimum wage law**\ *Structural unemployment*, as mentioned, is caused by the *insufficiency of available jobs*. The **minimum wage law imposes a minimum remuneration that the company must give to the worker**, therefore, by **imposing a minimum wage level higher than the market equilibrium level, it increases the quantity of labor supplied (by workers) and decreases that demanded (by employers)** compared to the **equilibrium value, creating a labor surplus (i.e., unemployment).** Since there are more workers than jobs, some workers remain unemployed. However, it is important to note that this *law is not a predominant cause of unemployment*: most workers receive wages well above the legal minimum and the law is often binding only for less qualified and less experienced workers; in fact, it is only among these categories that the minimum wage law helps explain the existence of unemployment.*Minimum wages can also result from the presence of **trade** **unions***, *associations of workers that negotiate with employers on wages and working conditions*. Union density measures the proportion of the workforce enrolled in a union, excluding those who, for various reasons, cannot do so (such as members of the armed forces). A union is a *kind of cartel, therefore it represents groups of sellers acting in the hope of exercising joint market power*. The process through which *unions and companies reach an agreement on employment conditions is called **collective bargaining***; if such an agreement is not reached, the *union can take various measures to pressure employers and convince them to come to terms* (for example, a strike).If ***union action raises wages above the equilibrium level***, the *quantity of labor supplied increases and that demanded decreases, producing unemployment*: workers who manage to keep their jobs benefit from it, but those who lose their jobs are harmed. In fact, ***union action*** is often a cause of ***conflict between insiders (workers who are already in the world of work) and outsiders (workers who are outside the world of work)*** because the ***interests of those who are inside the world of work are taken care of and not those who are outside, including the unemployed***. **The efficiency wage theory**\ According to this theory, ***companies operate more efficiently if wages are higher than the equilibrium level***; therefore, it *might be profitable for companies to keep wages high, even in the presence of an excess supply of labor*.Compared to the **minimum wage** and **unionization**, in this case, *[it is the companies themselves that benefit from paying wages higher than equilibrium]*, since they *could increase **labor** **productivity***.There are different interpretations of the efficiency wage theory: - The first emphasizes the *relationship between wages and worker health*: better-paid workers have better *nutrition*, so they are healthier and more productive. A company, therefore, may find it more advantageous to pay high wages and have healthier and more productive workers, and this interpretation *applies to those companies operating in less developed countries, where malnutrition is a widespread problem.* - A second interpretation focuses on the *relationship between wages and worker turnover.* Workers, in fact, leave their jobs for various reasons and the more a company pays its workers, the less frequently they decide to leave their job. Therefore, a company *can reduce turnover by paying higher wages, and this is convenient because turnover is costly*: new hires must be selected and trained and even after that, they are not immediately as productive as more experienced workers. - The third interpretation emphasizes the *relationship between wages and worker effort:* if *wages are higher, workers have a greater incentive to work to the best of their abilities.* - The fourth and final interpretation focuses attention on the *relationship between remuneration and worker quality*. When a *company hires new workers, it cannot perfectly assess the quality of individual candidates. However, by paying a higher wage, it can attract a better pool of more qualified potential employees.* **CHAPTER 23: The Monetary System** The **European Central Bank** *is an institution that controls the quantity of money available to the economic system.* - **Barter** *is the exchange of one good or service for another good or service; unlike money, it requires a coincidence of needs between the seller and the buyer.* Therefore, there is a difference between the concepts of wealth, income, and money. - **Wealth** refers to the *complex of value reserves, both monetary and non-monetary.* - **Money** is *defined as the instrument used for exchanges, in other words, it is the set of values that are regularly used by individuals to purchase goods and services from other individuals.* - **Income** is *what an individual/company/business earns, so it is the monetary flow associated with a work activity and obtained in a specific time.* The functions of money are therefore: **medium of exchange**, what *sellers are willing to accept in exchange for a good or service*; **unit of account**, the *parameter against which prices are determined and debts are valued*; **store of value**, what *individuals can use to transfer purchasing power from the present to the future*, for example if a seller receives money today in exchange for a good, they can spend it immediately or save it to buy other goods in the future. - **Liquidity** *refers to the ease with which an asset can be converted into the medium of exchange of an economy. Money is the most liquid value that exists.* Money can take **the form of a good with** **intrinsic value**, and in this case, it is called **commodity money**, an example is gold. Money **without intrinsic value** is called **legal money**/ **fiat money**, officially adopted by every economic system (for example, fiat currency, *something that becomes money by state decree*). **Money in the economy** The ***amount of money circulating in an economic system*** is called the **money stock**. - ***Currency** **in circulation*** (the most liquid money of all), that is, banknotes and coins in the hands of the public, *issued by the **European Central Bank***. - ***ATMs, debit cards, checks, and credit cards*** are *means of payment that rely on **bank deposits**/ **demand deposits***, that is, they rely on a ***current account at a bank***; so the *card is the instrument to make the payment while the deposit in the bank is the instrument that constitutes money*. - **Debit cards and checks** draw on a **current account** that contains **money**, so they are **a means of transferring money** - **Credit cards**, on the other hand, are **not really a means of payment** but a **means of deferring payment as the amount spent will be charged at a later date.** - In **term deposits** *within 2 years, the money cannot be used, and banks give interest.* - **Repurchase agreements** are *operations that are short-term contractual commitments, in which a subject gives cash and the bank commits to giving a certain interest rate.* - **Bonds** or **term deposits** that *mature far in the future are forms of near-money and are less liquid.* The European Central Bank distinguishes three **monetary aggregates**: \- **M1** = formed by **currency in circulation + demand deposits**. \- **M2** = **M1** + **savings deposits** + **deposits with maturity up to 2 years** + **deposits redeemable at three months\' notice.** \- **M3** = **M2** + **bonds with maturity up to 2 years, money market funds, repurchase agreements.** At the European level, *M3 is larger than M2, which in turn is larger than M1.* **The banking system** When an economic system adopts a *legal tender monetary system*, there must be an *institution in charge of regulating the system*; this role is normally played by the c**entral bank**, an *institution designed to **oversee the banking system and regulate the quantity of money in the economy***, called the **money supply** (the quantity of money available in the economic system). The ***only objective of the European Central Bank is to keep inflation below 2% in all European countries.*** In an economic system, the **central bank** has the ***power to increase or decrease the quantity of money in the economy***. The ***set of actions taken by the central bank to influence the money supply*** is called **monetary policy**. It *also deals with **open market operations***, i.e., ***buying and selling non-monetary financial assets with the banking sector*** (\"**quantitative easing**\", i.e., ***making money easily available***). The ***central bank also oversees the behavior of individual national ordinary banks and the financial system in general.*** *Ordinary banks are distinguished from the central bank*, for example, Banca Intesa, Banca Popolare di Sondrio, etc. *Ordinary banks are the only clients of the central bank*. - The **European Central Bank** (ECB) is based in *Frankfurt* and was officially established on June 1, *1998*; it is *common to the 19 countries that adhere to the European Economic and Monetary Union (EMU).* - The **Eurosystem** is the *network formed by the ECB and the national central banks of the 19 countries that adhere to the European Economic and Monetary Union.* The first task of the ECB is to ***control the quantity of money and its effects on the price level***; if one *increases the quantity of money supplied within the economic system, it pushes inflation upwards because it allows companies and citizens to buy a little more, increasing demand*. Therefore, the ECB\'s objective is to **control and maintain inflation at a level below but close to 2%.** The ECB also decides the **refinancing rate**, so o*rdinary banks can take liquidity/finance themselves both from citizens and from the European Central Bank*, being their clients; naturally, the ECB in turn **charges an interest rate to ordinary banks, called the refinancing rate.** **Ordinary banks and money creation** **Ordinary banks** are *normal financial intermediaries that collect deposits from savers, i.e. customers, and lend them to other subjects who need liquidity advances*. They can therefore *[create money without taking it from the central bank but by taking it from citizens\' deposits.]* However, they *have a part of the deposits*, the **reserves**, which they *must keep in liquid form and which cannot be lent because it must cope with daily transactions* (ATMs, current accounts, etc.). The ***share of total deposits that the bank retains as reserves** is called the **reserve ratio***. The European Central Bank *establishes the minimum level of reserves that the bank must hold*: the **required reserves** and the **free reserves**, i.e. *reserves in excess of the legal minimum in order to protect themselves more from the risk of not having sufficient liquidity.* Everything that *is not a reserve can be lent*; if lent, *it is used by the bank and the bank obviously makes a profit* on *what it lends because it **lends to third parties at an interest rate and earns on that.*** - **Bank deposit multiplier:** *mechanism through which each additional deposit that arrives at each individual bank allows the bank to create money.* Let\'s suppose that a citizen enters a bank and deposits €100, this money is a liability item and represents a debt of the bank towards the citizen. Let\'s now assume that the central bank authorizes ordinary banks to maintain only a mandatory fraction (reserve ratio of 10%) of deposits and to lend excess liquidity; the bank wants to make profits and therefore lends the €90 which is the excess over the reserve. By doing so, the bank creates more money in the economic system because it allows another consumer to borrow the €90 and then deposit it with a second bank. As before, the bank retains 10% of €90 (i.e. €9) and can lend €81 to a third consumer. And if the third consumer decided to deposit their liquidity with a third bank? The third bank has a liability of €81 towards the consumer, retains €8.10 and can lend the rest. **Money multiplier** The amount of currency in circulation is always €100 but the banks, through ***granting credit to someone, have in fact expanded the money supply and therefore have given the economic system a much greater capacity to purchase goods and services today compared to yesterday***; people have purchasing power today for €190, yesterday they had it for €100. A table with numbers and text AI-generated content may be incorrect. - **Money multiplier** is the *amount of money that a banking system generates from each euro of deposits.* **cause: ΔD**=100 (the initial cause is the change in deposits) **effect: ΔM**=100+90+81+72.9+\...=1000 (effect on the overall change in money) effect ΔM=ΔD+(ΔD(1-r))+(ΔD(1-r)²)+(ΔD(1-r)³)+ \.... = **ΔD x 1/r** *r = required reserve coefficient = 0.10 = 10%* **money multiplier = ΔM/ΔD = 1000/100 = 10 = 1/r** So we can say that the overall change in money is 10 times the initial 100, therefore equal to 1000. The **money multiplier** is that *coefficient that tells me the number of times the money supply increases for 1 euro more of deposit.* Ratio between the monetary base, consisting of bank reserves + currency in circulation; then, larger than the monetary base is the money supply available to the economic system, which instead consists of currency in circulation + demand bank deposits. **The money multiplier is the ratio between the money supply and the monetary base.** **The central bank\'s monetary control instruments** Techniques through which the central bank controls the money supply: \- **open market operations**: when a central bank wishes to increase the money supply, it *creates new currency* electronically. It *uses this newly created money to purchase **government securities*** (such as *bonds*) from *banks or other financial institutions* in the open market. The *banks receive this new money* in exchange for their *government securities*, *increasing their reserves and the overall money supply* in the economy. So these are operations to ***give or remove liquidity from the market***. For example, *if [bond prices rise, interest rates fall, while if prices fall, interest rates rise.]* N.B. if *the bank buys, it means it\'s giving liquidity to the markets; if the bank sells, it means it\'s withdrawing money from the markets.* What should the central bank do if it wants to increase the money supply? Increase and buy. \- **refinancing rate**: the *[central bank sets an interest rate at which it is willing to grant short-term loans to ordinary banks]*. So the *central bank grants a loan and acquires government securities* as **collateral** on the **financing**, subsequently drawing up a list of *safe assets that it is willing to accept*, such as *government securities or bonds issued by large companies*, for which the *risk of default by the issuer is generally negligible*. The ***interest rate applied by the central bank to these loans is called the refinancing rate***. ***[Repurchase agreements]* or \"repos\" are *[contracts by which a bank sells a non-monetary asset to the central bank]*, *[committing to repurchase it at a predetermined price on a specified future date]***. This *[short-term reserve market is called the money market]*, a market in which *[banks lend to each other on short-term maturities]*. So **lowering the refinancing rate means making access to liquidity easier and moving interest rates in the markets downwards.** In this crisis situation, what will the central bank\'s refinancing rate be? Particularly low, 0.25%. \- the **required reserve** is the ***minimum percentage of deposits that banks must hold as a reserve**.* It ***[determines the amount of money that the banking system can create for each euro of deposit;]*** ***[an increase in the required reserve ratio reduces the money multiplier and the money supply.]*** So if the European Central Bank wanted to **increase the money supply and lower rates**, it should: **buy securities in open market operations**; **reduce the refinancing rate** and **lower the required reserve coefficient**. **Quantitative easing** It is a ***monetary easing measure***; ***central banks, during the financial crisis,*** had exhausted the possibility of manipulating the cost of money in the economy and thus moved on to actions aimed at stimulating economic activity through increasing the money supply. In the **quantitative easing process**, the **central bank purchases various types of financial assets**, such as bonds. *What happens if the European Central Bank commits to buying government securities from banks in open market operations?* It will **pay them at prices higher than the value at which the securities were issued** and, by **leaving liquidity to ordinary banks, should stimulate business investments and credit consumption.** The central bank *does not control the amount of money that individuals decide to deposit with banks and this is a problem in controlling the money supply*. 1990-2008: ordinary banks began to expand credit enormously, not caring about the quality of credit, i.e. whether the subjects they were lending to were reliable or not, and thus increasing risk. N.B. **securitizing credits means putting them up for sale.** **CHAPTER 24: Money Growth and Inflation** The *increase in the general price level* is called **inflation**. Inflation may seem natural and inevitable, but *it is not at all inevitable*: in the previous century, there were long periods in some economies during which *prices generally decreased* - a phenomenon called **deflation**. Although inflation is the norm in our recent history, *prices* have *