Principles of Economics PDF

Principles of Economics Week 1(1): Introduction Three key questions pertaining to “the economy”: What goods should be produced and what services should be made available? How are these goods and services going to be supplied / produced? Who should get access to these goods and...

Principles of Economics Week 1(1): Introduction Three key questions pertaining to “the economy”: What goods should be produced and what services should be made available? How are these goods and services going to be supplied / produced? Who should get access to these goods and services? Everyone? Scarcity is the idea that there are finite resources in comparison to unlimited needs, therefore people have to make trade-offs - Opportunity cost is the cost of missing out on the next best thing by taking a certain action (i.e. missing out on buying an iPad if you buy a laptop) Marginal changes describe incremental changes Individuals are assumed to want to maximise their satisfaction whilst Firms may be assumed to maximise their profits “Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.” (Robbins, 1932) The marginal benefit is the change in benefit and marginal cost is the change in cost The economic system is the way resources are organised and allocated to address the needs of an economy’s citizens Market failure is where scarce resources are not allocated to their most efficient uses by free markets Week 1(2): Demand and Supply Economists are interested in falsifiability (proving their idea is wrong) + cause and effect Endogenous variables are those that a model seeks to explain Exogenous variables are those that are determined outside of a model and so cannot be explained by it, however, these factors can have an impact on the endogenous variables of the model Models have two key components: diagrams and functions General functions describe what effects what, an example could be ‘A=F(B,C)’ which tells us that A is a function of B and C Special functions describe the exact relationship between variables in a model, examples of specific functions could be: A = 20B + 30C Microeconomics studies the behaviour of individuals and firms at a disaggregated level The law of demand is the claim that when the price of a good rises the quantity demanded falls The law of supply is the claim that when the price of a good rises, the quantity supplied rises Demand is a function whilst quantity demanded is a level and same for supply Partial equilibrium analysis is the focused attention on specific market(s) and its outcome Markets are defined in terms of their product and geography and time (demand for beer in Birmingham today) Assumptions of the demand and supply model: many buyers and sellers, each buyer/seller has complete information (qualities, availability etc.) – not realistic, homogenous goods (identical products), sell at a uniform price (single market price which the product is bought and sold for) Demand refers to cumulative demand (everyone who wants to buy added together) Ceteris Paribus is where all other factors are held constant Factors that directly affect demand: number of consumers, income levels, preferences, other goods (substitutes and complements) – these cause a shift in supply Factors that directly affect supply: number of sellers, cost of inputs, level of technology, regulations, the existence and extent of sellers outside options (could use your factory for supplying motorbikes instead of cars if it is more profitable) Equilibrium is known as the Marshallian cross – where demand and supply meet Elasticity Elasticity is a way to measure by how much a variable will change with the change in another variable An elasticity is captured by the percentage change in one variable divided by the percentage change in another Price elasticity of demand = % change in quantity demanded / % change in price A 10% increase in the price of a good causes the quantity demanded to fall by 20% (the value of PED would be -2) PED will always be negative by virtue of the law of demand Price elasticity of supply = % change in quantity supplied / % change in price PES will always be positive by virtue of the law of demand Terms = Elastic (greater than 1 or less than -1), Inelastic (between 1 and -1), Unit Elastic (=1 or =-1) Can be used to determine whether policies/decisions will have an effect (tax on cigarettes effect?) Income Elasticity of Demand = % change in quantity demanded / % change in income If positive (normal good), if negative (inferior good) Cross Price Elasticity of Demand = % change in quantity of good x demanded / % change in the price of good y if positive = substitutes, if negative = compliments Week 2(1): Consumer Choice Consumer Behaviour Assumptions There are 3 elements in the study of consumer behaviour: 1) Consumer preferences 2) Budget Constraints 3) Consumer Choices (Given 1 and 2) Basic assumptions we make regarding consumer preferences: completeness (ranking in order of preference), non-satiation/monotonicity (‘more is better’), and transitivity (consistency – if I prefer a to b, and b to c, then I prefer a to c) - These assumptions ensure that a consumer’s preferences are rational Graph Demonstration Utility Utility is a measure of how satisfied a consumer is – represented as a numerical score A general function form: U = F(X,Y) - ‘Utility is a function of the consumption of goods X and Y’ - In other words: consuming X and Y makes you happy, but we don’t specify how or to what extent A specific functional form: U = 10X + 5 Y - “Utility is equal to 10 times the quantity of X that is consumed plus 5 times the quantity of Y that is consumed” If there is a utility function that is given of U = 2F + C, for the example above in the graph - Then B would give the most utility out of A, B, and D - UA = 20 + 3(30) = 110 , UB = 10 + 3(50) = 160, UD = 40 + 3(20) = 100 Indifference If a different consumer has a utility function: U = 2F + C This second consumer would prefer Basket D: - UA = 2(20) + 30 = 70, UB = 2(10) + 50 = 70, UD = 2(40) + 20 = 100 This hypothetical consumer would be indifferent between consuming Basket A and consuming Basket B, as they both are 70 Indifference Curves have certain characteristics: - They can be drawn - ICs further from the origin represent higher utility. - ICs never intersect. - ICs are broadly convex to the origin. We can measure how a person is willing to trade one good for another by the marginal rate of substitution (MRS) - The MRS quantifies the amount of one good a consumer is willing to give-up to obtaining more of another good - It is measured by the slope of the indifference curve: Diminishing Marginal Utility Marginal utility is the extra utility a consumer receives from consuming one extra unit of something Diminishing marginal utility is the notion that the more of a good you already have, the less you are willing to give up something else in order to get even more of it\ Substitutes and Complements Budget Constraint Suppose there are two goods you could buy, Food and Clothing. - Y = the total income a consumer has to spend. - F = the quantity of Food bought. - C = the quantity of Clothing bought. - PF = the price of Food. - PC = the price of Clothing. The budget constraint in this example can then be written as: Y = PFF + PCC Suppose that a consumer’s income is £80 a week, a unit of Food (F) costs £1, and a unit of Clothing (C) costs £2 - In other words: Y = 80, PF = 1, PC = 2 - In this case, the budget constraint is 80 = 1F + 2C or 80 = F + 2C Week 2(2): Consumer Choice and Maximising Utility Changing Budget Constraints We have drawn a BC line for a fixed level of income and a particular level of prices, but what if these things change, what is the impact on the BC line? Things that could change: The price of one of the goods The level of income The prices of both of the goods If the price of one of the goods changes (assuming ceteris paribus) If increases then budget line pivots inward from the intercept on the other good’s axis and vice versa There is a pivot change in the BC slope because the relative levels of the two prices have changed – for example suppose the price of. Food changes whilst the price of clothing and income are constant If consumer income changes (assuming ceteris paribus) An increase in income causes the budget line to shift outward parallel to the original line and a decrease causing an inward shift parallel to the original line The rate of substitution is not affected as this depends on the prices of goods rather than on income Graphs Price of Goods Consumer Income Prices of Both Goods Change If the prices of both goods change, but the ratio of the two prices is unchanged then the slope will not change, but the budget line will shift parallel to the original line - If increase then line will shift inward - If decrease then line will shift outward This is where both prices change proportionately such as ‘both prices double’ Consumer Choices How do consumers choose what to buy? - Consumers are faced with a constrained optimisation problem: wanting to maximise utility (satisfaction) subject to the budget they have Utility maximisation can be demonstrated on a diagram but the utility-maximising market basket must satisfy two conditions: it must be located on the budget line, and it must give the preferred combination of goods The optimisation problem can also be solved mathematically: - We know that our market basket is the point along the budget line that coincides with the outermost indifference curve, and we also know the slope of IC and BC - Therefore we can identify the tangency, which in this context = where the indifference curve just touches the budget line - Tangency occurs where marginal rate of substitution = ratio of prices When we move from one point to another on an IC, we don’t receive extra utility overall but we do receive extra utility in the consumption of one good (the good we increase) Change in Price Effect on Optimal Choice If a good increases in price, they can afford to buy less, and vice versa As the price of a good decreases, the consumer get a higher level of utility and buy more The Total Effect of a Change in Price Income effect = because purchasing power of a consumers income changes, because one good is cheaper, they can afford to buy more - One good becomes relatively more expensive as they rationally buy the thing that is relatively cheaper = substitution effect ›Total effect: normal goods income and substitution effects Total effect: inferior goods Week 3(1): Costs and Production Firms Face Various Costs Types of Costs Some of these are fixed and some are variable: - Input costs – cost of materials and components - Capital – cost of buying and maintaining equipment - Labour costs - Cost of Utilities - Rent Variable and Fixed Costs Fixed Costs are those that do not vary with quantity of output produced Variable costs are costs that vary directly with quantity of output produced A firm’s total cost is the sum of its total fixed and variable costs Average Cost and Marginal Cost Average cost is the cost of each unit produced - Determined by total cost / quantity - Average fixed cost and Average Variable cost are fixed or variable cost / quantity Marginal cost is the change in total cost / change in quantity Cost Curves and Diagrams The Short Run and Long Run The short run is defined as the period of time in which quantities of one or more factors of production cannot be change - We typically assume that capital is fixed in the SR In the long run, all production inputs become variable - As, fir example, If you have rented piece of machinery, you may not renew its contract Economies of Scale Constant returns to scale is where LRAC stays the same as output changes Economies of scale arise where LRAC is falling as output increases The types of economies of scale are: - Technical - Commercial - Financial - Managerial - Risk-bearing Diseconomies of scale arise where LRAS is rising as output increases - Often arise due to communication and coordination problems that occur with an increase in scale Producer Behaviour Assumptions about producer behaviour: 1. Firm only produces a single good 2. Firm has chosen which good to produce 3. They aim to minimise costs 4. Uses only two generic inputs (capital (k) and labour (l)) 5. More inputs a firm employ, the more output it produces 6. In the short run, labour can be changed but capital is fixed 7. Production exhibits diminishing marginal returns to L and K 8. Firm can buy as much capital and labour as it wants 9. Firm does not have a budget constraint (can get funding from banks) Number 6 implies that in the SR, output can only be increased by increasing labour - In other words, production has only one variable input Production Function General functional form: Q = F(K,L) – “Output is a function of capital and labour” Specific Functional Form: Q = 10K + 5L – “Firm output is 10x amount of capital used and 5x labour used” Average product of labour is productivity of s firms labour in terms of each worker - Average product of labour = output / labour input Marginal product of labour is additional output by increase in one unit - MPL = Change in output / labour input Diminishing Marginal Product As the use of an input increases, with other inputs fixed, the resulting contribution to output will eventually decrease Combination of Capital and Labour Inputs Isoquants indicate the flexibility firms have when making production decisions - As we move along an isoquant, the quantities of labour and capital change but output remains constant The degree of substitution can be quantified by the slope of an isoquant We call the negative of the slope “the marginal rate of technical substitution” The MRTS of labour for capital refers to the amount by which capital can be reduced when one extra unit of labour is used - Can be calculated by change in K / change in L MRTS = Marginal product of labour divided by marginal product of capital MRTS decreases as we move along an isoquant and this can be attributed to the principle of diminishing returns Straighter isoquants represent closer substitutes, and MRTS does not vary much along the curve - If perfect substitutes, then straight diagonal lines (MRTS is constant) - If perfect complements then L shaped lines Returns to Scale Returns to scale is the rate at which output increases as inputs are increased, there are three possibilities: - Constant returns to scale - Increasing RTS - Decreasing RTS Prices of Labour and Capital Labour and capital are not homogenous in the real world, however for the simple model of producer behaviour they are treated as homogenous, as a result: - The price of labour is “the wage” - The price of capital is “the rental rate” The Firm’s Budget L = the quantity of labour employed. K = the quantity of capital employed. w = the price of labour. r = the price of capital. C = the total expenditure of the firm. - And so we can produce something that looks rather like the budget constraints we have seen before: wL+ rK = C Plotting We can plot combinations of inputs that yield the same overall cost to the firm, doing so produces a curve known as an isocost As an example, suppose that the wage given to labour is £10 and the rental rate of capital is £20. For a total cost level of £100, the isocost line would be given by: 10L + 20K = 100. We can plot this (against axes that bear labour and capital): - If the firm only used labour, it could employ 10 units for £100. - If it only used capital, it could employ 5 units for £100. - As a result, the isocost line in this example intercepts the two axes at these points Week 3(2): Competitive Markets Demand and Supply Model Economic welfare is maximised at the equilibrium in the d & s model - Economic welfare is a measure of the wellbeing which is split into two parts: consumer surplus and producer surplus - Consumer surplus = where consumer willing to pay more than they do - Producer surplus = where producer willing to supply at less than market price Total surplus (CS+PS) = Economic wellbeing of all economic agents in a market Consumer Surplus Producer Surplus Economic Efficiency - If there is a shift in d or s, we move to a new equilibrium and some of either cs or ps go to the other - If d and s are more elastic or more inelastic, the relative sizes of cs and ps differ Market Equilibrium and Outcomes 3 Insights that free markets do: - Allocate supply of goods to buyers who value the goods the most - Allocate demand of goods to sellers who can produce them at least cost - Produce quantity that maximises consumer and producer surplus Market structure describes the competitive environment in which firms operate Perfect Competition Assumptions of the model: - There are many buyers and sellers in the market. - Firms sell homogenous goods. - Firms can freely enter or exit the market (no barriers to entry or exit). - Economic agents have complete information - Price taker Profit Maximisation Explicit costs are costs that require a direct outlay of money by the firm Implicit costs are those that do not require an outlay of money Economic profit < accounting profit as accounting profit only deducts explicit Profit maximisation is achieved where MR = MC - If MR > MC, the firm could increase its profit by increasing Q - If MR < MC, the firm could increase its profit by decreasing Q - If MR = MC, the firm’s choice of Q maximises its profit. Perfect Competition Graph Efficiency In addition to maximising consumer and producer surplus, we say that perfect competition is productively and allocatively efficient in the long-run. - Productive efficiency refers to the fact that firms end up producing at the lowest point of the average cost curve. - Allocative efficiency refers to the fact that price equals marginal cost. All these forms of efficiency make it seem like perfect competition is, as its name might suggest, the perfect market structure, however PC is dynamically inefficient. - Dynamic efficiency refers to improvement over time (think: innovation). In order to invest in product improvement, firms need to make supernormal profits in the long run… but PC firms don’t do that Week 4(1): Intro to Macro What is Macroeconomics Macro is the study of the aggregate level, of the economy overall. - Aggregation is the process of summing individual economic variables to obtain economy-wide totals… aggregate means ‘total’ 3 Major issues in macroeconomics are inflation, unemployment, and economic growth Objectives of macro policy: - Low and stable inflation - High employment - High and sustainable econ growth The macroeconomy encompasses not only markets for goods & services, but also financial markets and the involvement of government Circular Flow of Income Firms and households supply things to one another: firms make and provide services, whilst households work and supply capital to firms - Payments for goods/services flows in opposite direction There are also injections and withdrawals from the system, including going to: - Financial Institutions - The government - Persons abroad or overseas Injections - Investment (I) – Spending by firms on capital goods - Government expenditure (G) - Export Expenditure (X) – Households abroad buying domestic g&s Withdrawals - Savings (S) - Net Taxes (T) – Taxes paid to the government whilst payment back (benefits) - Import Expenditure (I) Economic Activity The size of an economy can be captured by what is known as Gross Domestic Product - GDP is the total value of final goods and services produced in a country during a given time An important macroeconomic identity: Y = C + I + G + NX: - Y = GDP/Real National Income - C = household consumption. - I = investment. - G = government spending. - NX = net exports or the ‘trade balance’ GNP is the value of final goods and services produced by domestically-owned factors of production - This is as opposed to GDP, which is about domestically-located production How to Quantify GDP 3 different methods: output, income, expenditure The output method measures GDP by aggregating the value of final goods & services produced in an economy. - I.e. the size of an economy = the value of the things made in it. - Important: to avoid double-counting, we only count the value of final goods and not ‘intermediate goods’ The income method measures GDP by adding up the incomes paid to the factors of production in an economy. The expenditure method measures GDP by adding together the amount spent on final goods and services - I.e. the amount of spending by the final consumers of output A good that is produced (output method) is purchased by someone (expenditure method) & this results in income for someone else (income method) Economic Growth Nominal GDP is the value of production in terms of current prices, i.e. in terms of the prices that prevailed at the time in question. Real GDP is the value of production in terms of constant prices, i.e. the prices of a base period - in the base period nominal GDP will always equal real GDP - If nominal GDP increases, this might be because output has increased or it might be because prices have increased (or it might be both). - If real GDP increases, this can only be due to greater output (because prices are held constant) Economic growth is the rate at which the size of an economy is growing (in other words the percentage change in GDP). - Based on the above, real GDP is the appropriate form of GDP to use when calculating economic growth In the short run, economies fluctuate between periods of positive growth (if high then a boom), and negative growth (known as recession) Actual growth is the % annual increase in output. - This is ‘economic growth’ - the rate of growth in real GDP. Potential growth is the speed at which the economy could grow - This is the rate of growth in ‘potential output’. - Potential output is the level of output that would arise when the economy is operating at ‘normal capacity utilisation’. - Normal capacity utilisation allows for firms having planned a degree of spare capacity to meet unexpected demand – it is not the same as producing at ‘full capacity’ The output gap = the difference between actual and potential output (often measured as a % of potential output). - If actual output > potential output, the output gap is positive and the economy is operating above normal capacity utilisation. - If actual < potential, the output gap is negative and the economy is operating below normal capacity utilisation Business Cycle The business cycle consists of four phases: 1. Upturn or trough: A low point, after which output begins to grow. 2. Expansion: When there is rapid economic growth. A prolonged expansion in economic activity is a boom (a series of positive deviations from trend). 3. Peak / ‘peaking out’: A high point, after which growth slows down. 4. Contraction (a slowdown or recession): When there is little or no growth or even a decline in output. The level of output is highest in phase 3, whilst the rate of growth in output is highest in phase 2 The trend output is a parallel line which goes through the actual output Schools of Thought The main “macro” theory before the 20th C was the quantity theory of money (QT) - That prices in an economy are generally proportional to the quantity of money There was also “cost-of-production theory” - This was the idea that the production of money (the cost of making gold coins) was linked to inflation There was also business cycle theory, with various theories of what caused the cycle. - Real theories: innovation and fluctuations in fixed investment is the cause of business cycles. - Monetary theories: the instability of credit and over-expansion of money supply is the cause of business cycles During 1950s and 1960s, Keynesian economics (intervention) used but less since 70s Week 4(2): Classical Economics Closed Economy Market-Clearing Model A closed economy is one that does not have any flows to / from other economies in the rest of the world - For a closed economy, there is no NX and hence the key identity becomes: Y = C +I+G Flexible versus ‘sticky’ prices. - Flexible: prices adjust quickly to bring D & S into equilibrium. - Sticky: D doesn’t always equal S; variables can be slow to adjust The assumption of flexible prices is analogous with market clearing. - The classical school of thought assumes flexible prices For classical economics, we will assume that economic agents are rational, all markets are perfectly competitive, and agents have complete information Graph Consumption Consumption depends on disposable income, Y-T, so C(Y-T) - But t does not depend on y and c is not impacted by interest rates A specific functional form of the C function could be something like (these are just made-up examples): - C = 500 + 0.75(Y-T) - C = 250 + 0.6(Y-T) - i.e something with a constant (in this cases autonomous consumption/independent from income) and then a parameter (MPC, which varies with income) before the Y-T term - MPC = change in C / change in Y-T Investment Defined as spending on things that are not immediately consumed, but rather used in production or stored for later – function is I(r) with r = real interest rate (I and r inverse) Investment can be divided into three categories: 1. “Business fixed investment”: spending on plants & equipment. (Firms) 2. “Inventory investment”: the accumulation of goods inventories. (Firms) 3. “Residential fixed investment”: spending on housing units (Households) Government Spending Spending on final goods and services by the govt. like schools and the army - For our purposes (throughout the module) we will assume that G is an exogenous policy variable (meaning it don’t depend on anything) - And no g function The Budget Note that the state of the government budget depends on the relative size of G and T: - If G = T, the government has a balanced budget - If G > T, the government has a budget deficit (most common) - If G < T, the government has a budget surplus Therefore G and T are exogenous policy variables, as they are somewhat related - Net taxes effectively constitute income for the government Aggregate Demand AD is defined as the total demand for all of the final goods and services in the economy. - We can derive AD for a closed economy by adding together the functions for consumption, investment and government spending: AD = C(Y-T) + I(r) + G When we plot AD against axes bearing the overall price level (P) and income/output (Y) we produce a downward-sloping line - The reason AD slopes downward is actually to do with the amount of money in the economy Aggregate Supply The level of output in the economy overall is determined by the factors of production: - Capital (K), Labour (L) and the level of technology (i.e. the function that turns K & L into Y), denoted in general form Y=F(K,L) or Y=F(L,K) - We will assume for now that K, L and the level of tech. are fixed… Loanable Funds Market How is R determined Given this special role for r, we are interested in how the level of r is determined. We can explain this with the help of the Loanable Funds Market, a simple supply- demand model of the financial system in which: - Demand for funds is derived from the desire to invest. - The supply of funds comes from savings. - The ‘price’ of funds is the real interest rate. A key point to remember: because the economy is closed, no money flows in or out Context and Assumptions Context and Assumptions: All borrowers go to the Loanable Funds Market to get loans. All savings are available for lending. There is a single interest rate which is both the return on saving and the cost of borrowing. The market is governed by the forces of supply and demand. Note the simplifications being made. In the real world: Not all savings are repurposed as loans. There are various financial markets and institutions. Savings rates differ from lending rates. Demand and Supply Loanable Funds (Equilibrium is where I = S) Demand for loanable funds: - Comes from investment - Depends (negatively) on r – lower interest rate, means more funds are demanded Supply of Loanable Funds: - Comes from saving (deposits at bank) as well as unspent tax rev. Types of Saving: - Private saving is the amount of households’ disposable income that is not consumed, i.e. (Y – T) - C - Public saving is saving by the government; it is the amount of tax revenue that is not spent, i.e. T - G - National saving is the sum of private and public saving and can be found by adding these together: (Y – T) – C + T – G = Y – C – G Things to Note The standard principles of price adjustment apply: If there is a shortage of funds, the price (interest rate) will increase. If there is a surplus of funds, the price (interest rate) will decrease. Due to the classical assumptions, such price adjustment is quick (effectively instantaneous). Ultimately, r adjusts to ensure simultaneous equilibrium in the LFM and AD-AS. I.e. simultaneous equilibrium in the financial market & the goods market. We can show this with some simple macro accounting, exploiting the things we know about the equilibria (i.e equilibrium in the LFM: S = I and equilibrium in the AD-AS model: Y = C + I + G) What Can We Show With LFM An obvious application is to show the effect of fiscal policy… Fiscal policy involves changing the levels of government spending (G) and net taxes (T) in order to influence the economy. “Expansionary fiscal policy” involves increasing G, decreasing T and/or increasing transfer payments “Contractionary fiscal policy” involves decreasing G, increasing T and/or decreasing transfer payments Week 5(1): Money and Inflation Money In economics, the definition of money is as the stock of assets that is used to carry out transactions - When we talk of money, we are generally referring to fiat money (i.e. Banknotes & coins) - Fiat money has no intrinsic value. - As opposed to commodity money (e.g. gold and silver coins) which was used in the past and had intrinsic value Function of money - It is a medium of exchange – we use it to buy things; without money we would have to rely upon ‘mutual coincidence of wants’ - It is a unit of account – it acts as a yardstick against which we can measure and compare prices and values - It is a store of value – it is a means of transferring purchasing power from the present to the future. The use of money allows us to have standardised prices, and standardised prices allow us to quantify the cost of living Calculating Price Levels In macro, we are interest in the overall price level rather than individual prices, a couples of ways of capturing the overall price level (these are both indices) - The GDP Deflator - The Consumer Price Index (CPI) The GDP deflator is a proxy for the overall price level which is based on production. It is defined as: 100 x (Nominal GDP / Real GDP) - In other words, it is the ratio of nominal GDP to real GDP (in a given time period), multiplied by 100. The CPI is a proxy for the overall price level which is based on consumption. It is defined as: CPI in month t = 100 x (Et / Eb) - Where E stands for expenditure on a particular ‘basket of goods’ (in time t and in the ‘base period’ b). CPI is effectively a measure of the cost of g&s bought by a ‘typical household’ The ‘basket of goods’ is meant to represent the purchases of a typical household - It is fixed: the quantities do not change & so it captures how much it is over time Money Supply The money supply/stock is the total quantity of money circulating in an economy - Different measures of money supply are produced (M0, M1, M2, M3, M4) - M0 and M1 are narrow money (currency and similar easily convertible into other) - M2, M3 and M4 are broad money (including a wider array of assets) As the number M increases the assets included become less liquid - Liquidity refers to the ease in which an asset can be converted into cash Inflation Inflation is an increase in the overall price level of an economy … as opposed to deflation, which is a decrease in the price level. - The rate of inflation is percentage change from one period to another CPI and Deflator as Measures of Inflation Differences between the two measures: - Basket of Goods – Quantities change ever year for deflator but fixed for CPI - Prices of capital goods – Included in deflator but not cpi - Prices of imported cons. goods – Excluded from deflator but in CPI if in basket Expansionary Monetary Policy Graph Economic Theories The quantity theory predicts that changes in the money supply leads to change in the average level of prices - Of importance is the classical dichotomy which is the idea that vars can be divided into two groups, nominal variables and real variables - David Hume suggested that dichotomy is useful for analysing economies as the determinants of the monetary system influence nominal variables but are largely irrelevant when it comes to real variables According to Hume and classical schools of thought: changes in the supply of money have no real effects on the economy (monetary neutrality) - If the money supply doubles, the price level doubles… but wages double… all other values double. - Thus, real variables are unchanged – we have a change in units, but in real terms nothing is different. According to the QT of money, the quantity of money determines the vaue of money and the money growth rate determines the inflation rate The central equation of the QT is quantity equation which is: M x V = P x Y - M = the (nominal) money supply - V = ‘velocity’ of money - P = the overall price level - Y = output Velocity of money = number of times average monetary unit is used to purchase g&s - Suppose in an economy total transaction = $10m, and 1m dollars in circulation meaning each dollar used 10 times - It is reasonable to expect velocity to be constant as relatively stable over time As we assume that velocity is constant and Y is determined by L and K, this means M = P also % change in M = % change in P Costs of Inflation Expected Inflation - Shoe leather costs - the cost and inconvenience of reducing money balances. - Menu costs - costs (to firms) associated with changing prices. - Relative price distortions & the misallocation of resources – firms facing menu costs may change prices infrequently or at different times. - Inflation-induced tax distortions - taxes may be set at the wrong levels - General inconvenience and confusion Unexpected Inflation Many long-term contracts are not indexed but instead based on expected inflation ( e). If actual inflation turns out to be different from expected inflation, one side of a transaction gains at the other’s expense. - We say there are ‘arbitrary redistributions of purchasing power’ High Inflation When inflation is high there is increased uncertainty, meaning the higher it is, the more variable and unpredictable it becomes - Hyperinflation is where inflation exceeds 50% per month When a govt. raises money through printing more money it is said to be a inflation tax which is a tax on people who hold more money Benefits of Inflation Inflation can make the labour market work more efficiently, Consider the following: - Ceteris paribus, an increase in the supply (or decrease in demand) for labour should lead to a fall in wages - However, a fall in nominal wages is rare because in practice workers rarely accept pay cuts! - In the presence of inflation, you can reduce real wages by holding nominal wages constant - Compare (in real terms) a nominal wage cut with zero inflation vs unchanged wages with inflation. Week 5(2): The IS-LM Model What is This Model The IS-LM model is derived from the Keynesian model and the market for real money balances The assumptions we make for this model: - Wages and prices are sticky / rigid - We are dealing with a closed economy Graph Disequilibrium is possible if planned expenditure is < or > in comparison to actual output If greater then there is excess demand and if less than, then it is excess supply Keynes believed firms produce the quantity of goods that are demanded (agents plan to buy) Firms also have inventories of finished but unsold goods which can show transition to equilibrium Keynesian (demand driven) model If planned expenditure > output - Excess demand - Firms reduce inventories - Output expands If planned expenditure < output - Excess supply - Firms increase inventories - Output contracts Expansionary Fiscal Policy and Multiplier EFP 1. Increase in govt. spending -> increase in planned expenditure 2. Unplanned drop in inventories 3. Firms increase output to restock inventories so output rises Multiplier If G increases, Y will increase, and C depends on Y-T - So, if Y changes, C will as well The extent to which C changes depends on the MPC - We can show multiplier effect is captured by: change in Y / change in G - Which is the same as 1 / 1- MPC Real Money Real money represents supply in our Keynesian money Market In the market for RMB, we assume demand arises from desire to hold money to spend, and we assume this depends on the real interest rate and this is related to opp. Cost - There is an inverse relationship between real interest rate and money demand as if interest rate is higher, more is foregone if money is kept to spend R is not the only thing tjat impacts money demand in. this setting, we also have income (Y) so L (r,Y) - Y and money demand have positive relationship IS-LM Graph This model is a short-run model, and given keynesian assumptions, prices are sticky - IS stands for investment-saving which is derived from the Keynesian cross - LM stands for liquidity money, derived from market for real money balances The IS curve graphs all combinations of the real interest rate and output that results in goods market equilibrium - The equation for this curve is Y = C+I+G The IS curved is negatively sloped, meaning: 1. A fall in interest rates motivates firms to increase investment 2. This increases planned expenditure 3. To restore equilibrium, output must increase to replenish inventories 4. Thus decrease in r is linked to an increase in Y The LM Curve This graphs all combinations of r and Y that result in money market equilibrium. - Again, we plot it against axes with r and Y. The ‘money market’ in question is the Market for Real Money Balances. - Equilibrium is where real money supply = money demand. The equation for the LM curve is: M/P = L(r, Y). The LM curved is positively sloped meaning: 1. Increase in income motivates indivduals to increase money demand 2. This results in a higher real interest rate 3. Thus, ceteris paribus, increase in y is linked to an increase in R The short run IS-LM equilibrium s given by the combination of r and Y that simultaneously satisfies the equilibrium conditions in both the goods and financial markets. What Can We Use IS-LM For? Well, the endogenous variables are obviously the real interest rate (r) and the level of output/income (Y). - As a result, we can show how a change in any exogenous factor affects r and Y in the short run when we make Keynesian assumptions So obvious experiments are changes in fiscal policy (G or T) and in monetary (M) Expansionary Fiscal Policy 1. An increase in G translates to a rise in planned expenditure in the Keynesian Cross. The result is a higher level of output (Y). 2. This corresponds to a rightward shift in the IS curve. The IS-LM model predicts a higher level of real interest rate. 3. This is explained by a rise in money demand – Y is both output and income, so the higher level of Y corresponds to a rightward shift in the money demand line in the Market for RMB. Expansionary Monetary Policy 1. An increase in M translates to an increase in real money supply in the Market for RMB. The result is a lower level of real interest rate. 2. This corresponds to a rightward shift in the LM curve. The IS-LM model predicts a higher level of output. 3. This is explained by a rise in investment – the lower level of r causes investment to increase and we have a rise in planned expenditure in the Keynesian cross Week 7 (1): Intro to Macro Policy Macroeconomic Policy: Fiscal Policy, Monetary Policy, Supply-Side Policy, Exchange Rate Policy, Income Policy Monetary Policy What is Monetary Policy Control of Money Supply is called monetary policy - The central bank can choose to increase or decrease amount of money in circulation, and in doing so influence the economy In 1997, UK govt. delegated monetary policy over to bank of England and the monetary policy committee was established - They have independent control albeit with a broad objective set by the govt. such as a low and stable rate of inflation Commercial Banks Commercial banks differ to central banks in that they are intermediaries who essentially channel funds from depositors to borrowers, their well-functioning is important: - As they assess riskiness and allocate financial resources efficiently - They engage in maturity transformation (borrowers borrow for long time whilst saves want access to their money at short notice) - They direct funds to areas that yield the highest returns Monetary Policy Tools - The policy rate (also known as official rate or central bank base rate) - The use of open market operations - The adjustment of banks reserve requirements The Policy Rate (UK is 4.75%) This is the rate at which commercial banks can borrow from / save with the central bank Why borrow from the central banks? If they urgently need funds, lender of last resort Why save with central bank? Safe in comparison to commercial diverse investments There is more than one policy rate, but for simplicity we think only a single rate The policy rate influences the interest rates that commercia banks offer to their customers and therefore can effect input costs as firms may need to borrow to be able to fund start-up of a new project or carry on with what they are doing (investment?) Open Market Operations This refers to purchase and sale of non-monetary assets from/to banking sector by the central banks (central bank buys/sells stuff to/from commercial banks) - This traditionally refers to bonds, but post 2008 financial crisis they have also bought things like toxic assets and bad debts Reserve Requirements Commercial banks are regulated so that they must hold a particular amount of money reserve to ensure they could cope with a run on the bank - Reserve requirements limit the extent to which banks can give out loans; thus, changing reserve requirements effectively influences the effective money supply. Types of Monetary Policy Expansionary Monetary Policy (Increase in Money Supply) - Decreasing the policy rate. - Creating money and buying bonds (open market operations). - Lowering reserve requirements. Contractionary Monetary Policy (Decrease in Money Supply) - Increasing the policy rate. - Selling bonds (taking money out of circulation). - Raising reserve requirements. Impact of 2008 Financial Crisis on Monetary Policy - They engaged in more extensive open market operations (‘large-scale asset purchases’) funded by quantitative easing (creating new money). - They released statements of intent to influence economic agents’ expectations (“we are going to keep interest rates low for a long time”). - If you talk to monetary policymakers, emphasis is now often placed on nominal GDP targeting rather than inflation targeting. Inflation Targeting Suppose that real GDP (output) is growing at 4% per year, velocity of money is constant (as discussed before), and the central bank has an inflation target of 2%. - Assuming velocity is constant, the quantity theory becomes % change in M = % change in P + % change in Y - % change in M = 2 + 4 = 6 so money supply had to increase by 6% to achieve the inflation target in this example Nominal and Real Interest Rates We can see why a positive target is set for inflation by considering the relationship between nominal and real interest rates? - The relationship between these two is captured by the fisher equation The nominal interest rate (i) is the rate of interest offered by commercial banks - The real interest rate is the nominal interest rate corrected for inflation: r = i - π r can be thought of as a measure of purchasing power: - If i > π, the interest received on deposits (savings) in banks is greater than the rise in the cost of goods and services and the purchasing power of money held rises and vice versa Having a negative real interest rate is useful if demand in an economy is weak, since a negative real interest rate incentivises spending and borrowing rather than saving The Great Depression The Great Depression was a worldwide economic depression spanning from 1929 until the late 1930s. - The GD emanated from the United States where stock prices began to decline in September 1929, culminating in the Wall Street stock market crash on 29/10 - World GDP fell by 15% from 1929 to 1932. But what caused it is something economists debated? - The spending hypothesis (due to exogenous fall in demand) – Keynesian view - The money hypothesis (due to fall in money supply) – Friedman & Schwartz view The Spending Hypothesis The spending hypothesis asserts that the GD was due to an exogenous fall in demand for goods and services. - I.e. a downward shift in planned expenditure in the Keynesian cross and a leftward shift in the IS curve. Reasons for the IS shift: - The stock market crash of 1929 caused an exogenous decrease in C. - The 1920s saw “overbuilding”, which was corrected for in the 1930s (drop in i) - There was contractionary fiscal policy – politicians raised tax rates and cut spending (decrease in G) Output and interest rates both fell, which is consistent with a leftward shift in IS. The Money Hypothesis The money hypothesis asserts that the GD was due to a huge fall in money supply. - I.e. a leftward shift in real money supply in the Market for Real Money Balances, and a leftward shift in the LM curve. Evidence? ‘M1’ money fell 25% during 1929-33. However, a couple of problems with the money hypothesis: - P fell even more than M, meaning that M/P (real money supply) actually rose slightly rather than falling. - (Nominal) interest rates fell, whereas we expect a rise in interest rates from a leftward shift in LM. An alternative money hypothesis: the GD was due to huge deflation which followed from the decrease in money supply If P decreases (unexpectedly): - Purchasing power transfers from borrowers to lenders (arbitrarily). - Borrowers spend less, lenders spend more. - If lenders’ marginal propensity to spend is less than borrowers’, aggregate spending falls (C falls). IS shifts to the left, and Y falls Graphs However, we can explicitly derive the familiar AD curve from the IS-LM model. - Since the IS-LM we developed was a closed economy model we will therefore assume that AD = C + I + G, but the inclusion of NX does not significantly change things (NX has no role in IS-LM model) Aggregate Demand is plotted against axes of P & Y… - It essentially shows the quantity (Y) that is demanded, on aggregate, for every possible P. Obviously, Y features prominently in the IS-LM model: - It is on one of the axes of the model. - It also appears in both the K. Cross and the Market for RMB. Where does P feature? - P is one component of the supply of real money balances in the Market for RMB. (which of course determines LM). - Recall that supply of real money balances is given by M/P Week 7 (2): Macro Policy in IS-LM and AD-AS Fiscal and Monetary Policy in Isolation in IS-LM Expansionary fiscal policy (an increase in G or decrease in T): 1. Causes an “upward” shift in planned expenditure in the Keynesian Cross. 2. Which translates to a rightward shift in the IS curve. 3. And we have higher money demand (a movement along the LM curve). Expansionary monetary policy (an increase in M) 1. Causes a rightward shift in real money supply in the Market for RMB 2. Which translates to a rightward shift in the LM curve. 3. And we have higher investment (a movement along the IS curve). These are policy changes in isolation. What if the gov’t is engaging in FP whilst the central bank is engaging in MP? Simultaneous Changes in Policy If the government increases G, we know that IS shifts to the right. If the central bank holds M constant: - There is no change in money supply and therefore no change in LM. - The rightward shift in IS causes Y to increase and r to increase. If the central bank holds r constant: - It will increase M to shift the LM curve to the right. - The result is an even higher increase in Y with no change in r. If the central bank holds Y constant: - It will reduce M to shift the LM curve to the left. - The result is no change in Y but an even higher increase in r. Aggregate Supply In the classical model of AD-AS, the AS curve was vertical. - We said that AS is determined by Y=F(K,L) … in other words, output is a function of capital and labour (and also the level of technology). - However, different schools of thought have different views on the form of AS More generally however we can distinguish between LRAS and SRAS LRAS In the long run, the total quantity of goods & services produced in an economy depend on the economy’s factors of production and the level of production technology. - Therefore, ultimately in the long run (when all factors are variable) a particular level of output will prevail: the natural rate of output (let’s call it Ynr). - This level of output is associated with the ‘natural rate of unemployment’ Anything that alters the natural rate of output will shift LRAS. - In other words, anything that impacts labour, capital or technology will cause LRAS to shift. Labour, examples: - A large influx of migrants that increases the labour force. - A change in employment laws such as minimum wages. Capital, examples: - A change in the physical capital stock such as the number of machines used in production - A change in the human capital stock such as the number of people with university degrees. Technology, examples: - The invention of new technologies - The opening up of international trade (access to new technologies) In addition to these, LRAS can be shifted by a change in natural resources - The discovery of new mineral deposits or oil reserves. - Climate change Supply-Side Policies These are policies designed to increase potential output (i.e. the natural rate of output) - Supply-side policies typically focus on stimulating investment into capital and encouraging increases in labour/capital productivity We can distinguish between ‘market-oriented’ policies and ‘interventionalist’ policies - Where the former are associated with the classical school of thought and the latter are more Keynesian Market-Oriented The classical approach to supply-side policy: provide incentives, reward initiative, ‘free up’ the market - Tax cuts to encourage productivity (income tax) & efficiency (corporation tax). - Tax breaks/relief on investment to encourage R&D - Reducing government spending in the public sector specifically - Reducing the bargaining power of labour (unions lobby for higher wages which increases unemployment of labour) Interventionalist The Keynesian approach to supply-side policy: direct intervention to boost LRAS - Nationalisation to control the use of factors of production - Grants – i.e. sponsoring certain activities - Providing advice or information, for example on how to improve efficiency or how to use new technologies SRAS In large part, the form of SRAS depends on the extent to which you believe prices are flexible or sticky… - Classicists, who believe prices are completely flexible, view SRAS as vertical - Keynesians, who believe in sticky prices, view SRAS as horizontal In the SR, with a Keynesian viewpoint, a change in AD will affect output but not prices Experiments Expansionary fiscal policy: - An increase in G or a decrease in T causes in an increase in planned expenditure in the Keynesian Cross. - …this translates into a rightward shift in IS in the IS-LM, & a higher level of Y. - In terms of AD, higher level of Y for the same P... so AD shifts to the right. Expansionary monetary policy: - An increase in M causes an increase in real money supply in the Market for Real Money Balances. - …this translates into a rightward shift in LM in the IS-LM, & a higher level of Y. - In terms of AD, higher level of Y for the same P... so AD shifts to the right What Causes SRAS to Shift Broadly, we assume that changes in costs of production in the economy will cause SRAS to shift - If costs of production rise, SRAS shifts upwards and subsequently prices higher - If costs of production fall, SRAS shifts down and subsequently prices lower. In reality, we might observe ‘rockets and feathers’ (firms might be quicker to raise their prices than to reduce them), but we are not considering such dynamics here. - Also will vary from market to market Also, any change in a factor of production can cause a shift in both LRAS and SRAS - Such as an increase in the labour force Short-Run Equilibrium and Shocks Economic shocks have an effect in the SR, but not in the LR – in the long run we revert to the vertical AS curve at the natural rate of output. Types of shocks that can occur: - Adverse demand shocks (e.g. a sudden decrease in consumer confidence). - Favourable demand shocks (e.g. a sudden increase in M). - Adverse supply shocks (e.g. the real-world oil shocks of the 1970s). - Favourable supply shocks (e.g. the real-world oil shocks of the 80s) Adverse demand shock: - AD shifts to the left - In the short run, the price level is unchanged and output decreases - In the long run, the price level decreases and output returns to its natural level. Favourable demand shock: - AD shifts to the right - In the SR, P is unchanged and Y increases - In the LR, P increases and Y returns to its natural level Adverse supply shock: - SRAS shifts upwards. - In the SR, P increases and Y decreases. - In the LR, both P and Y return to their original level. Favourable supply shock: - SRAS shifts downwards. - In the SR, P decreases and Y increases. - In the LR, both P and Y return to their original level. Why SRAS Upwards Sloping Sticky Prices One reason we might expect an upward-sloping SRAS is because some firms set their prices in advance whilst others are able to change prices at short notice. In terms of AS: - If all firms had sticky prices, SRAS would be horizontal. - If all firms had flexible prices, SRAS would be vertical. - With a mix of firms, SRAS is somewhere in between. Naturally, the greater the proportion of ‘sticky price’ firms, the flatter SRAS would be. Sticky Wages Nominal wages are typically slow to adjust due to employment contracts Also, if P turns out to be lower/higher than expected, real labour costs will rise/fall, leading to changes in labour employed and output Imperfect Information Firms know with certainty the price they receive for the thing that they sell, but they do not know the price of every other good in the economy – so what they perceive is vital Week 8 (1): Imperfect Competition Monopolies Assumptions of monopoly: - One firms - Firm sells a unique, differentiated product - High barriers to entry Monopolists are price makers which have market power as ability to set (P>MC) Causes of barriers to entry: ownership of key resource, economies of scale, exclusivity Many of the largest firms have grown through merger/acquisition though competition policy does somewhat restrict this For individual competitive firm (horizontal demand curve), monopolist (downwards) In the case of PC firms, we said P=AR=MR. These things were equal (AR=MR) as a consequence of the horizontal D curve. For a monopolist, AR does not equal MR. - Remember that TR = P*Q, AR = TR/Q = P, and MR = changeTR/changeQ. - A monopolist’s MR is always less than the price of its good: when it sells more, the revenue received from previous units also decreases (the selling price is lower). If a monopolist increases the amount it sells, this has two effects on total revenue (P*Q): More output is sold (Q is higher), The selling price is lower (P is lower). We can also talk about the (in)efficiency of monopoly: - Monopolies may be productively inefficient (not producing at the lowest point of the AC curve - They are allocatively inefficient because P does not equal MC. - Monopoly is better than PC in terms of dynamic efficiency (they may have incentives to innovate). Imperfect Competition Some industries have a large number of small firms, but those firms have power to change their prices (“monopolistic competition”). Other industries have a small number of large and powerful firms that dominate the market (“oligopoly”). Both kinds of market feature product differentiation (i.e. they sell goods that are not homogenous*). - A consequence of differentiation is that setting a price above the price of rivals does not necessarily mean a firm immediately loses all of its sales. - Some consumers prefer Firm A’s product, others prefer Firm B’s product, and for some it might depend on the prices. Strategic interdependence: where the outcome for one party depends not only on their own actions but also the actions of others (& the best course of action may depend on what they expect others to do) Monopolistic Competition Assumptions: A large number of (“small and insignificant”) firms. Product differentiation. Free entry and exit (i.e. no barriers to entry). Complete information. Since each firm’s product is different from those of rivals, the monopolistically competitive firm faces downward-sloping demand - Firms are profit-maximisers and choose to produce where MR=MC At that optimising point, in the short run, the firm: - Could make supernormal profit, if price exceeds average cost (this can be seen on the next slide). - Could make a loss, if price is below average cost. Entry to Market In a monopoly, if a firm makes supernormal profits these persist (protected by high barriers to entry) - However, in monopolistic competition we assume that firms can enter the market. If profits were made in the short run, then in the long run more firms will enter the industry. - Those new firms will have a slightly differentiated product, but at least some consumers will switch their consumption... and the demand curves (AR) of incumbent firms will shift to the left. If losses were made in the short run, then in the long run some firms will exit the industry - The demand curves of remaining firms will shift to the right. Comparing firms in each market type with the same cost curves: - Competitive firms produce at the lowest point on the AC curve, but monopolistically competitive firms produce less, at higher AC. - In each kind of market, firms set P=AC, so consumers have to pay more under monopolistic competition (the price is higher). Does this mean monopolistic competition is worse for consumers? - Not necessarily. Although consumers pay higher prices, they have greater choice due to differentiated products. There is a trade-off between price and variety. - (What do we care about? It is forms of economic efficiency? Is it - consumer surplus? Is it something else?) Monopolistic comp. opens up potential for advertising: - Can attract buyers, and provide info, but can be manipulative Oligopoly A couple of examples: - UK supermarkets. Tesco, Asda, Sainsbury’s and Morrisons hold about 75% of the market. - The global market for carbonated beverages. Coca-Cola and PepsiCo have over 70% of the market. This would effectively be regarded as a duopoly (a subset of oligopoly, with 2 firms). - You can come up with other examples of oligopolies and duopolies Strategic behaviour This is behaviour based on actions of rivals - Like vegetable price wars - We can speculate about this strategizing via kinked demand curve Demand Curve in Oligopoly Curiously, price stability is often a feature of oligopoly. - If Coke increases its price, some customers will prefer Coke enough to pay the higher price but some will switch to Pepsi. Pepsi can gain market share by keeping its current price. Thus Coke’s D curve is relatively flat. - If Coke decreases its price, Pepsi will likely cut price to avoid losing market share. Coke can gain some customers since the D curve is downward-sloping, but quantity is less responsive to price than for a price rise. Thus Coke’s D curve is relatively steep Week 8(2): Market Intervention Market Failure Market failure can, however, cover a range of outcomes: - At one extreme, goods & services might not be provided at all. - At the other, goods may be over-supplied despite harmful effects on individuals, firms or the environment Most goods are private goods, which are excludable & rivalrous. - Excludable: people can’t consume them unless they pay for them. - Rivalrous: one person’s consumption stops another from consuming the good The alternative is public goods, which are non-excludable & non- rival. - Non-excludable: someone who does not pay cannot be prevented from consuming the good. - Non-rival: one person’s consumption does not affect another person’s. The free rider problem: a person who benefits from a good/service without paying for it - Fireworks are a good example Government Intervention in Markets Although the government is sometimes seen as being more concerned with the macroeconomy, it does also aim to change market outcomes Some forms of (micro) intervention: Price controls (price ceilings and price floors). Quantity controls (quotas). Taxes and subsidies. Consider a competitive market in which supply = demand. In it, consumer and producer surplus are maximised – this is efficient. – However, what is efficient isn’t always fair In a given market, suppose that demand and supply are given by the following expressions: QD = 3000 – 60P and QS = 40P. If there was no intervention, we can work out the equilibrium price and quantity by setting demand equal to supply (QD=QS) and solving: - 3000 – 60P = 40P - 3000 = 100P - 30 = P*... The free market equilibrium price is 30. - Q* = 40(30) = 1200... The equilibrium quantity is 1200. We can also calculate the size of PS and CS (area of the triangle). - PS = ½*30*1200 = 18000 - CS = ½*20*1200 = 12000 Total surplus = CS + PS = 30000 That example was for a price ceiling (maximum price). We observed that a binding price ceiling results in: - A Lower price and lower quantity, compared to the free market equilibrium - A decrease in producer surplus. - Deadweight welfare loss. In our example, consumer surplus increased – although this might not necessarily always be the case (depends on the slopes of S/D and the size of DWL created). Quotas Sometimes, the government might wish to restrict the quantity of something that can be bought and sold Suppose that demand and supply in a different market are given by: - QD = 1500 – 50P and QS = 50P. - In this market, P*=15 and Q*=750. If a quota of 500 was introduced, how would that have an impact? A binding quota results in: - Higher price and lower quantity, compared to the free market eq’m. - A decrease in consumer surplus. - Deadweight welfare loss. Externalities We can imagine that a quota might be used in a market where a product is bad for the environment An externality arises where the actions of one individual (or firm) has unintended consequences on an external third party Private costs/benefits are costs/benefits to the individual (consumer or producer). Social costs/benefits are wider costs/benefits. - For a factory, private costs are costs of running the factory whilst the social costs are things such as the pollution generated by the factory - If a worker takes a year out to study, private venefits are the increased earnings from the qualification, whilst social benefits are gains to the employer from this Externalities arise from failure to take into account social costs/benefits when making economic decisions For the Factory For the Workers Study Solutions to Externalities Private solutions may exist: property rights (right to pollute or to clean air?), producer can pay the locals for the right to pollute – coase theorem - However there may be issues related to bargaining, asymmetric info etc. However taxes and subsidies can be used by the govt. Week 9 (1): The Labour Market As we know, labour is used in the production of goods/services (it is demanded by firms for this purpose) We will assume: - Labour is homogenous (all workers are the same). - There is a single price (a single equilibrium wage) for labour. - Workers have no bargaining power – there are no unions, etc. - There is no limit on the amount of labour that can be supplied The marginal product of labour is the change in output / change in labour input Value of the marginal product labour = Price x marginal product of labour In general, a firm would want to hire an extra worker if that worker adds more to revenue than to cost leading to a downward-sloping demand curve A higher wage means each hour worked will pay for a greater amount of consumption. - therefore, work becomes more attractive and people choose more work and less leisure time. This is a substitution effect: leisure becomes relatively more expensive, so we choose less leisure and more consumption Assuming a single ‘price’ for labour, the cumulative supply and demand for labour determine the prevailing market wage rate The classical view of the labour market is that at equilibrium everyone who wants to work is able to find a job at the prevailing wage rate. In other words, the labour force is fully utilised and there is no unemployment In the labour market, the imposition of minimum wages (a price floor) is common, where the perception is that wages ought to be higher. Wage disparities arise for three main reasons: - Differences in jobs. - Differences in workers. - Discrimination Profit-maximising firms should not be discriminating in this way... in most industries, the characteristics of a worker are not obviously tied to their marginal product Week 9 (3): Unemployment Employed people are those who are working in a paid job. - Unemployed people are those who want to work but are without a job. - We define the labour force as the total number of employed plus the total number of unemployed Some without a job aren’t unemployed: If they don’t seek one, too young/old, disabled or otherwise unable to work – those not looking for jobs are economically inactive Employed: anybody who carries out at least one hour’s paid work in a week, or is only temporarily away from a job (e.g. on holiday) - People who are on government supported training schemes and people who do unpaid work for their family’s business Unemployed: anybody who is without work but is available and seeking work There are two basic ways to measure unemployment: - Labour force survey: ask a series of questions about respondents’ personal circumstances and their activity in the labour market. - The claimant count: measure unemployment by the number of people who are receiving unemployment benefits In general, economists accept that there is unemployment and there are 3 main types: - Frictional unemployment. - Structural unemployment. - Cyclical (‘demand-deficient’) unemployment. Frictional Unemployment Frictional unemployment arises because it takes time for workers to search for, and find, suitable jobs – due to rational thinking and wanting to find the best job Frictional U occurs because: Jobs are different (recall our discussion at the end of last lect). Workers have different abilities and different preferences (for example: part time vs full time, fixed hours vs flexible... also last lect). The geographical mobility of workers varies and is not instantaneous. The flow of information about vacancies & candidates is imperfect. Policies to decrease the natural rate of U by reducing job search: Gov’t employment agencies providing & enhancing the flow of info. Unemployment insurance (i.e. unemployment benefits). Job training programmes (improving skills / abilities) Structural Unemployment Structural unemployment occurs where there is a mismatch between the skills of unemployed people and skills required for vacant jobs - There can also be a geographical mismatch Cyclical Unemployment Cyclical U arises because Aggregate Demand is insufficient to provide employment for everyone that wants to work at the prevailing real wage level The idea is that during periods of prosperity, demand is high and so too is employment... but during recessions, when AD is lower, unemployment rises. - Imagine the AD/LRAS/SRAS diagram. If we have a decrease in AD, in the short run, output would be lower. - We assume that output and employment are linked: lower output is associated with higher unemployment Natural Rate of Unemployment Instead of there being no unemployment, let’s assume that there is a small persistent level of unemployment in the long run (the natural rate of unemployment) - This level of employment coincides with the “natural rate of output”, or the level of output that arises in the long run – where AD meets LRAS Two factors that influence the rate of unemployment: - Job separation: the rate at which employed people lose/leave their jobs. - Job finding: how quickly unemployed workers find new jobs Wage Rigidity Wage rigidity refers to the fact that wages may be slow (or fail) to adjust to a level at which labour S=D - Structural U is obviously bad for those whose skills have become redundant but can be beneficial for those who are in work, who may enjoy an enhanced wage Factors that contribute to wage rigidity: - Minimum wage laws - The power of labour unions, lobbying for higher wages. - The notion of an ‘efficiency wage’ – paying workers more than is required on the assumption that this will make them work harder Is Unemployment Bad It is intuitive that U is bad for the unemployed, but it also impacts government & firms... - Government POV: higher U = loss of tax revenue, higher U benefits. - Firm POV: higher U = lower income meaning less consumer spending. However, it really depends on the type of unemployment. - Cyclical U is bad, as low cyclical U is associated with a prosperous economy. - Structural U means that the composition of the economy is changing... we have new industries, technology, progress... which is good. - Frictional U means people are taking time to search for the right job for them Real GDP and Unemployment We assume an inverse relationship between output and unemployment: as output expands, more labour is employed, and thus employment rises (U falls) - This inverse relationship is captured by Okun’s law, as they suggested in order to keep u rate steady, real gdp needed to grow at close to its potential - To reduce unemployment by 1% per year, real gdp must rise by around 2% more than potential Unemployment and Inflation (Phillips Curve) As unemployment decreases, inflation (specifically wage inflation) increases Wages are negotiated in advance, so expected inflation has a crucial bearing on the wage that is negotiated: - If you expect inflation to be high, then you negotiate a higher wage - Subsequently, if wages are higher, broadly firms demand less labour... and so unemployment is higher In terms of the long-run, the LRPC is regarded as vertical at the natural rate of unemployment. - The suggestion/implication is that there might be a SR trade-off but not a permanent LR trade-off - In LR, U returns to its natural rate and in equilibrium the rate of inflation = the rate of monetary growth (in line with the quantity theory). - Attempts to maintain unemployment below the natural rate will result in an accelerating rate of inflation. - Whilst a trade-off may exist in SR, once economic agents have adjusted their inflationary expectations, the trade-off disappears. To summarise the traditional story of the Phillips curve: 1) Phillips (1958) discovered an inverse relationship between inflation and unemployment for the UK. No one had noted this before. 2) Samuelson and Solow (1960) advocated the idea that policymakers could make a trade-off between unemployment and inflation. 3) Milton Friedman (and others we haven’t mentioned, like Edmund Phelps) then introduced expectations and showed that there was no trade-off in the long run. This was something no one had thought of before