Economy Analysis PDF - 1st Year, 1st Semester

Economy Analysis 1º Year, 1º Semester Microeconomics 1.1 Ten principles of economics A household and an economy face many decisions like: o Who will work? o...

Economy Analysis 1º Year, 1º Semester Microeconomics 1.1 Ten principles of economics A household and an economy face many decisions like: o Who will work? o What good and how many of them should be produced? o What resources should be used in production? o At what price should the goods be sold? Main resources of an economy : Price of the resources: o T -> land = space o R -> rents o L -> time = labour o W -> wage o K -> capital o J -> interest rates Society and scare resources: o The management of society´s resources is important because resources are scarce o Scarcity -> society has limited resources and therefore cannot produce all the good and services people wish to have Economics is the study of how societies produce and distribute goods (scare) in an attempt to satisfy the want and needs of their members Principle #1: People Face Trade-offs To get one thing, we usually have to give up another thing Efficiency -> society gets the most it can from its scare resources Equity -> the benefits of those resources are distributed fairly among the members of society Effectiveness -> actually reach a goal Equality -> distribution the same resources to everyone without thinking about their individual needs 1  The market itself work with efficiency and nor with equity → the governments need to intervene Principle #2: The Cost of Something is What you Give up to Get it Decisions require comparing costs and benefits of alternatives. The value of my choice is the opportunity cost. Opportunity cost -> what you give up to obtain a specific item, because resources are scarce When someone makes a choice, should think about implicit and explicit values. ▪ Example: sell your actual smartphone Explicit values: money that you´ll get Implicit values: contacts, photos, files, … Principle #3: Rational People think at the Margin Marginal changes are small, incremental adjustments to an existing plan of action. ➔ People make decisions by comparing costs and benefits at the margin Principle #4: People Respond to Incentives Marginal changes in costs or benefits motivate people to respond. The decision to choose one alternative over another when that alternative´s marginal benefits exceed its marginal costs! If you want to be an economist, take into account that you need 3 steps: 1. Getting information; 2. Treat information; 3. See if the incentive is enough for you. Principle #5: Trade can make Everyone Better off People gain from their ability to trade with one another Competition results in gains from trading Trade allows people to specialize in what they do best 2 Principle #6: Markets are Usually a good way to organize Economic Activity A market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. o Households decide what to buy and who to work for o Firms decide who to hire and what to produce Adam Smith saw that households and firms interacting in markets act as id guided by an "invisible hand” Because households and firms look at prices when deciding what to buy and sell, they unknowingly consider the social costs od their actions. As a result, prices guide decision makers to reach outcome that tend to maximize the welfare of society as a whole. Principle #7: Governments can sometimes Improve Market Outcomes Markets work only if property rights are enforced o Property rights are the ability of an individual to own and exercise control over a scarce resource Market failure occurs when the market fails to allocate resources efficiently and may be caused by: o Externalities -> extern impacts of one person or firm´s actions o Market power -> ability of a single person or firm to unduly influence market prices When the market fails (breaks down), government can intervene to promote efficiency and equity Principle #8: A Country´s Standard of Living depends on its Ability to Produce Goods and Services Standard of living may be measured in different ways: o By comparing personal incomes o By comparing the total market value of nation´s production Almost all variations in living standards are explained by differences in countries´ productivities Productivity is the amount of goods and services from each hour of a worker´s time Principle #9: Prices Rise when the Government Prints too much Money Inflation is an increase in the overall level of prices in the economy o One cause of inflation is the growth in the quantity of money When the government creates large quantities of money, the value of money falls Principle #10: Society Faces a Short-run Trade-off between Inflation and Unemployment The Phillips Curve illustrates the trade-off between inflation and unemployment: and it´s a short-run trade-off! 3  The trade-off plays a key role in the analysis of the business cycle – fluctuations in economic activity, such as employment and production 1.2 Thinking like an Economist Economics trains you to : o Think in terms of alternatives o Evaluate the cost of individual and social choices o Examine and understand how certain events and issues are related The economic way of thinking: o Involves thinking analytically and objectively o Makes use of the scientific method (observation, theory, and more observation) : ▪ Uses abstract models to help explain how a complex, real world operates ▪ Develops theories, collects and analyses data do evaluate the theories The role of Assumptions o Economists make assumptions in order to make the world easier to understand o The art in scientific thinking is deciding which assumptions to make o Economists use different assumptions to answer different questions ECONOMIC MODELS Economists use models to simplify reality in order to improve our understanding of the world: The circular Flow Diagram ✓ Visual model of the economy that shows how dollars flow through markets among households and firms. 4  The production Possibilities Frontier ✓ Graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology Concepts illustrated by the production possibilities frontier: o Efficiency o Trade-offs o Opportunity costs o Economic growth Microeconomics VS Macroeconomics Focuses on the individual parts of the Looks at the economy as a whole economy → How households and firms make → Explain economic changes that affect many decisions and how they interact in specific households, firms, and markets at once -> markets economy-wide phenomena, including inflation, unemployment, and growth The economist as a policy advisor o When economists are trying to explain the world, they are scientists o When they are trying to change the world, they are policy advisors Why economists disagree ? Ten propositions about which most economists agree: o They may disagree about the validity of alternative positive theories about how the world works o They may have different values and, therefore, different normative views about what policy should try to accomplish 5  Positive Analysis VS Normative Analysis Statements that attempt to describe the Statements about how the world should be -> world as it is -> descriptive analysis prescriptive analysis Examples: Examples: - An increase in the minimum wage will - The income gains from a higher minimum cause a decrease in employment among wage are worth more than any slight the least-skilled reductions in employment - higher federal budget deficits will cause - State governments should be allowed to interest rates to increase collect from tobacco companies the costs of treating smoking-related illness among the poor Economists in Washington serve as advisers in the policymaking process of the three branches of government: - Legislative - Executive - Judicial 1.3 Interdependence and the gains from trade How do we satisfy our wants and needs in a global economy? o We can be economically self-sufficient o We can specialize and trade with others, leading to economic dependence Individuals and nations rely on specialized production and exchange to address problems caused by scarcity o Why is interdependence the norm? ▪ Interdependence occurs because people are better off when they specialize and trade with others o What determines the pattern of production and trade? ▪ They are based upon differences in opportunity costs Example: Suppose that in a society only exists a farmer that produces potatoes, and a cattle rancher that produces meat. If they decide not to engage in trade: - each one consumes only what they produce - the production frontier is also the consumption possibilities frontier - economic gains are diminished If they decide to specialize and trade: - both would be better off producing the product they are more suited to produce, and then trade with each other 6 Comparative Advantage Differences in the costs of production determine: o Who should produce what? o How much should be traded for each product How to measure it? o The nº of hours to produce a unit of output (the product) o The opportunity cost of sacrificing one good for another Absolute Advantage The comparison among producers of a good according to their productivity o Describes the productivity of one person, firm, or nation compared to that of another o The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good Opportunity cost and Comparative Advantage o Compares producers of a good according to their opportunity cost, that is, what must be given up to obtain some item o The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good Example: Benefits of Trade Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage Applications of comparative advantage: o Imports -> goods produced abroad and sold domestically o Exports -> goods produced domestically and sol abroad 7  2.1 The market forces of supply and demand What is a Market? The market happened when a transaction is made: o It can be a physical market or an online one o A market is a group of buyers and sellers of a particular good or service o The terms supply and demand refer to the behaviour of people, as they interact with one another in markets: ▪ Buyers determine demand ▪ Sellers determine supply Markets and competition Supply and demand are the 2 words that economists use more often -> they´re the forces that make market economies work Modern microeconomics is about supply, demand, and market equilibrium What is Competition? A competitive market is a market in which there are many buyers and sellers so that each has a negligible impact on the market price Competition: Perfect and Otherwise Perfect Competition o Homogeneous products -> Products are the same o Atomicity market -> Numerous buyers and sellers so that each has no influence over price o Perfect Information -> Buyers and sellers are price takers -> they all have the same information Monopoly o One seller, and seller controls price -> one firm, with capacity to control the market -> price makers o (Monopsony -> a market where there is only one consumer) Oligopoly o Few sellers, that have a strategic relation o Not always aggressive competition Monopolistic Competition o Many sellers o Slightly differentiated products -> make people choose where to buy o Each seller may set price for its own product -> the price change because the products of each company have some differences 8 DEMAND Quantity demanded is the amount of a good that buyers are willing and able to purchase Law of demand -> other things equal (ceteris paribus), the quantity demanded of a good falls when the price of the good rises Demand Schedule -> table that shows the relationship between the price of the good and the quantity demanded Demand curve -> graph of the relationship between the price of a good and the quantity demanded o A decrease in price increases quantity of cones demanded Market demand VS Individual demand Market demand refers to the sum of all individual demands for a particular good or service Graphically, individual demand curves are summed horizontally to obtain the market demand curve Shifts in Quantity Demanded Movement along the demand curve Caused by a change in the price of the product Shifts in the Demand Curve Caused by: o Consumer income ▪ As income increases the demand of a normal good will increase and of an inferior good will decrease o Price of related goods ▪ When a fall in the price of one good reduces the demand of another good, the two goods are called substitutes ▪ When a fall in the price of one good increase the demand for another good, the two goods are called complements o Tastes o Expectations o Number of buyers Change in Demand o A shift in the demand curve, either to the left (decrease in demand) or right (increase in demand) o Caused by any change that alters the quantity demanded at every price SUPPLY Quantity supplied is the amount of a good that sellers are willing and able to sell Law of Supply -> other things equal (ceteris paribus), que quantity supplied for a good rises when the price of the goods rises Supply schedule -> table that’s shows the relationship between the price of a good and the quantity supplied Supply curve -> graph of the relationship between the price of a good and the quantity supplied 9 Market Supply VS Individual Supply Market supply refers to the sum of all individual supplies for all sellers of a particular good or service. Graphically, individual supply curves are summed horizontally to obtain the market supply curve Shifts in the Supply curve: Caused by: o Input prices o Technology o Expectations o Number of sellers Change in Quantity supplied o Movement along the supply curve o Caused by a change in anything that alters the quantity supplied at each price Change in Supply o A shift in the supply curve, either to the left (decrease in supply) or right (increase in supply) o Caused by a change in a determinant other than price SUPPLY AND DEMAND TOGETHER Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded Equilibrium price o The price that balances quantity supplied, and quantity demanded o On a graph, is the price at which the supply and demand curves intersect Equilibrium quantity o The quantity supplied and que quantity demanded at que equilibrium price o On a graph, is the quantity at which the supply and demand curves intersect Surplus / excess supply o When price > equilibrium price, quantity supplied > quantity demanded o In this case, suppliers will lower the price to increase sales, moving toward equilibrium Shortage / excess demand o When price < equilibrium price, quantity demanded < quantity supplied o Suppliers will raise the price due to too many buyers chasing too few goods, moving toward equilibrium Law of Supply and Demand o The claim that the price of any good adjusts to bring the quantity supplied and quantity demanded for that good into balance 10  3 steps for analyzing changes in equilibrium 1. Decide whether the event shifts the supply or demand curve (perhaps both) 2. Decide in which direction the curve shifts and what that means 3. Use the supply and demand diagram to see how the shift changes the equilibrium price and quantity Shifts in the Curves VS Movements along Curves o A shift in the supply curve is called a change in supply o A movement along a fixed supply curve is called a change in quantity supplied o A shift in the demand curve is called a change in demand o A movement along a fixed demand curve is called a change in quantity demanded → price is the only factor that can represent a movement along the supply/demand curve. All the others represent just a shift 2.2 ELASTICITY AND ITS APPLICATIONS Elasticity allows us to analyze supply and demand whit greater precision. Is a measure of how much buyers and sellers respond to changes in market conditions. Is always measured in percentage terms The price elasticity of demand The price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. Specifically, the price elasticity of demand is the percentage change in quantity demanded due to a percentage change in the price. Its determinants : o Availability of close substitutes o Necessities VS Luxuries o Definition of the market o Time horizon Demand tends to be more elastic: o The larger the number of close substitutes o If the good is a luxury 11  o The more narrowly defined the market o The longer the time period The variety of Demand Curves Inelastic Demand o Quantity demanded does not respond strongly to price changes o Price elasticity of demand is less than 1 Elastic Demand o Quantity demanded responds strongly to changes in price o Price elasticity of demand is greater than 1 Perfectly Inelastic o Quantity demanded does not respond to price changes. Perfectly Elastic o Quantity demanded changes infinitely with any change in price. Unit Elastic o Quantity demanded changes by the same percentage as the price. Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve. But it is not the same thing as the slope! Total Revenue - TR ✓ Amount paid by buyers and received by sellers of a good. TR = Price x Quantity Example: When the price is $4, consumers will demand 100 units, and spend $400 on this good. 400$ is the total revenue. With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. 12 Income Elasticity of Demand Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. Income Elasticity Types of Goods o Normal Goods o Inferior Goods Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. Goods consumers regard as necessities tend to be income inelastic o Examples include food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic. o Examples include sports cars, furs, and expensive foods Cross-price elasticity of demand A measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good The Price Elasticity of Supply Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good, measured in percentage. Percentage change in quantity supplied Price elasticity of supply = Percentage change in price Its determinants: o Ability of sellers to change the amount of the good they produce. ▪ Beach-front land is inelastic. ▪ Books, cars, or manufactured goods are elastic. o Time period ▪ Supply is more elastic in the long run. 13 Examples: Can goods news for farming be bad news for farmers? Examine whether the supply or demand curve shifts. Determine the direction of the shift of the curve. Use the supply-and-demand diagram to see how the market equilibrium changes. Why Did OPEC Fail to Keep the Price of Oil High? Supply and Demand can behave differently in the short run and the long run o In the short run, both supply and demand for oil are relatively inelastic o But in the long run, both are elastic ▪ Production outside of OPEC ▪ More conservation by consumers Does Drug Interdiction Increase or Decrease Drug-Related Crime? Drug interdiction impacts sellers rather than buyers. o Demand is unchanged. o Equilibrium price rises although quantity falls. Drug education impacts the buyers rather than sellers. o Demand is shifted. o Equilibrium price and quantity are lowered. 2.3 supply, demand and GOVERNMENT POLICIES In a free, unregulated market system, market forces equilibrium prices and exchange quantities. While equilibrium conditions may be efficient, it may be true that not everyone is satisfied. One of the roles of economists is to use their theories to assist in the development of policies. Controls on prices Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created: o Price ceilings -> a legal maximum on the price at which a good can be sold o Price floors -> a legal minimum on the price at which good can be sold How price ceilings affect market outcomes? Two outcomes are possible: o The price ceiling is not binding if set above the equilibrium price -> the price ceiling is ineffective -> doesn´t change anything o The price ceiling is binding if set below the equilibrium price -> the price ceiling is necessary 14 A binding price ceiling creates: -> Shortage because, Qd > Qs Examples: Gasoline shortage of the 1970’s -> Nonprice rationing Examples: long lines, discrimination by sellers CASE STUDY: Rent control in the short run and long run o Rent controls are ceiling placed on the rents that landlords may charge their tenants o The goal of rent control policy is to help the poor by making housing more affordable o A economist called rent control “the best way to destroy a city, other than bombing” o Rent control in the short run -> supply and demand are inelastic o Rent control in the long run -> supply and demand are elastic How price floors affect market outcomes? Two outcomes are possible: o The price floor is not binding if set below the equilibrium price -> the price floor is ineffective -> doesn´t change anything o The price floor in binding if set above the equilibrium price -> the price floor in necessary A binding price floor causes: -> a surplus because Qs > Qd -> nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria Examples: the minimum wage, agricultural price supports Taxes Government levy taxes to raise revenue for public projects How taxes on Buyers (and Sellers) affect market outcomes? o Taxes discourage market activity -> When a good is taxed, the quantity sold is smaller o Buyers and sellers share the tax burden Elasticity and tax incidence : Tax incidence is the way the burden of tax is shared among participants in a market 15  Taxes result in a change in market equilibrium Buyers pay more and sellers receive less, regardless of whom the tax is levied on How is the burden of tax divided? → The burden of a tax falls more heavily on the side of the market that is less elastic 2.4 CONSUMERS, PRODUCERS AND THE EFFICIENCY OF MARKETS Welfare economics ✓ Study of how the allocation of resources affects economic well-being o Buyers and sellers receive benefits from taking part in the market o The equilibrium in a market maximizes the total welfare of buyers and sellers o Equilibrium in the market results in maximum benefits, and therefore maximum total welfare for both the consumers and the producers of the product Consumer Surplus ✓ buyer’s willingness to pay for a good minus the amount of the buyer actually pays for it Willingness to pay is the maximum amount that a buyer will pay for a good; it measures how much the buyer values the good or service → using the demand curve to measure consumer surplus o The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices o The area below the demand curve and above the price measures the consumer surplus in the market 16 → what does consumer surplus measure? o Consumer surplus measures the benefit that buyers receive from a good as the buyers themselves perceive it Producer Surplus ✓ Amount a seller is paid for a good minus the seller’s cost. Measures the benefit to sellers participating in a market → using the supply curve to measure producer surplus o The area below the price and above the supply curve measures the producer surplus in a market ❖ Consumer and producer surplus may be used to address the question: - is the allocation of resources determined by free markets in any way desirable? or The benevolent social planner Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society. In addition to market efficiency, a social planner might also care about equity -> the fairness of the distribution of well-being among the various buyers and sellers 17 Evaluating the Market Equilibrium Three Insights Concerning Market Outcomes Free markets o allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. o allocate the demand for goods to the sellers who can produce them at least cost. o produce the quantity of goods that maximizes the sum of consumer and producer surplus. Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it. This policy of leaving well enough alone goes by the French expression laissez faire Market Power Market power is the ability to influence prices; it can cause markets to be inefficient because it keeps price and quantity from the equilibrium of supply and demand. If a market system is not perfectly competitive, market power may result. Externalities created when a market outcome affects individuals other than buyers and sellers in that market. cause welfare in a market to depend on more than just the value to the buyers and cost to the sellers. -> When buyers and sellers do not take externalities into account when deciding how much to consume and produce, the equilibrium in the market can be inefficient 2.5 THE COST OF TAXATION How do taxes affect the economic well-being of market participants? o A tax places a wedge between the price buyers pay and the price sellers receive o Because of this tax wedge, the quantity sol falls below the level that would be sold without a tax o The size of the market for good shrinks Tax Revenue o T = size of the tax o Q = quantity of the good sold o T x Q = government’s tax revenue 18 Changes in Welfare o A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax ▪ Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade o The change in total welfare includes: ▪ The change in consumer surplus; The change in producer surplus and The change in tax revenue o The losses to buyers and sellers exceed the revenue raised by the government The determinants of the deadweight loss: o The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price o That, in turn, depends on the price elasticities of supply and demand o The greater the elasticities of demand and supply: the larger will be the decline in equilibrium quantity and the greater the deadweight loss of a tax : ▪ Inelastic Supply/ Demand -> deadweight loss of a tax is small ▪ Elastic Supply/ Demand -> deadweight loss of a tax is large The deadweight loss debate : o Some economists argue that labor taxes are highly distorting and believe that labor supply is more elastic o Some examples of workers who may respond more to incentives: ▪ Workers who can adjust the number of hours they work ▪ Families with second earners ▪ Elderly who can choose when to retire ▪ Workers in the underground economy (illegal activity) → With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax ▪ For a small tax, the revenue is small ▪ As the size of the tax rises, tax revenue grows ▪ Tax revenue first rises with the size of the tax, but then, as the tax gets larger, the size of the market is so much reduced that tax revenue starts to fall CASE-STUDY: The Laffer Curve and Supply-side economics o The Laffer curve depicts the relationship between tax rates and tax revenue o Supply-side economics refer to the views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues 2.6 EXTERNALITIES Recall: Adam Smith’s “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society can derive from a market. BUT markets failures can still happen. ✓ An externality refers to uncompensated impact of one person´s actions on the well-being of a bystander. They cause markets to be inefficient, and thus fail to maximize total surplus. 19 Negative Externalities ✓ When the impact on the bystander is adverse Examples: o Automobile exhaust o Cigarette smoking o Barking dogs (loud) o Loud stereos in an apartment building → Lead markets to produce a larger quantity than is socially desirable The intersection of the demand curve and the social-cost curve determines the optimal output level o The socially optimal output level is less than the market equilibrium quantity To achieve the socially optimal output: o The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity Positive Externalities ✓ When the impact on the bystander is beneficial -> the social value of the good exceed the private value Examples: o Immunizations o Restored historic buildings o Research into new technologies → Lead markets to produce a smaller quantity than is socially desirable The intersection of the supply curve and the social-value curve determines the optimal output level o The optimal output level is more than the equilibrium quantity o The market produces a smaller quantity than is socially desirable o The social value of the good exceed their private value Internalizing externalities (involves altering incentives so that people take account of the external effects of their actions) -> works for positive and negative externalities: o Subsidies: ▪ Used as the primary method for attempting to internalize positive externalities o Industrial policy: ▪ Government intervention in the economy that aims to promote technology-enhancing industries -> Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention -> the patent is then said to internalize the externality 20 Example: The market for aluminum : The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus. If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers. For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution. Private solutions to externalities Government action is not always needed to solve the problem of externalities Types of private solutions : o Moral codes and social sanctions o Charitable organizations o Integrating different types of businesses o Contracting between parties The Coase Theorem ✓ Proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. Transaction costs ✓ Costs that parties incur in the process of agreeing to and following through on a bargain → Why private solutions do not always work? Sometimes the private solution approach fails because transactions costs can be so high that private agreement is not possible. Public Policies toward Externalities When externalities are significant and private solution are not found, government may attempt to solve the problem through: Command-and-control policies -> usually take the form of regulations o Forbid certain behaviors o Require certain behaviors 21  o Examples: ▪ Requirements that all students be immunized ▪ Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA) Market-based policies o Policy 1: Corrective Taxes and Subsidies ▪ Government uses taxes and subsidies to align private incentives with social efficiency ▪ Corrective taxes are taxes enacted to correct the effects of a negative externality (also called Pigovian taxes) ▪ Examples of regulation versus corrective tax : -> if the EPA decides it wants to reduce the amount of pollution coming from a specific plant, the EPA could: i) Tell the firm to reduce its pollution by a specific amount (regulation) -> sets the quantity of pollution ii) Levy a tax of a given amount for each unit of pollution the firm emits (corrective tax) -> sets a price of pollution o Policy 2: Tradable Pollution Permits ▪ Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another ▪ A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost 2.7.1 Firms – the costs of production The market forces of supply and demand o Supply and demand are the forces that make market economies work and the two words that economists use more often. o Modern microeconomics is about supply, demand and market equilibrium What are costs? According to the Law of Supply: o Firms are willing to produce and sell a greater quantity of a good when the price of the good if high o This results in a supply curve that slopes upward The firm’s goal: Maximize profit Total Revenue, Total Cost and Profit Total Revenue -> amount a firm receives for the sale of its output Total cost -> market value of the inputs a firm uses in production Profit = Total Revenue - Total Cost --> A firm’s cost of production includes all the opportunity costs of making its output of goods and services. o Explicit Costs -> input costs that require a direct outlay of money by the firm o Implicit Costs -> input costs that do not require an outlay of money by the firm 22 Economic Profit VS Accounting Profit Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs → When total revenue exceeds both explicit and implicit costs, the firm earns economic profit -> economic The production profit function is smaller than accounting profit ✓ Shows the relationship between quantity of input used to make a good and the quantity of output of that good Marginal product ✓ The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases o Example: as more and more workers are hires at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment o The slope of the production function measures the marginal product of an input, such as a worker o When the marginal product declines, the production function becomes flatter From the Production Function to the Total-Cost Curve The relationship between the quantity a firm can produce, and its costs determines pricing decisions The Total-Cost curve shows this relationship graphically The various measures of cost 𝑇𝐹𝐶 TFC = 𝑄 Costs of production: o (Total) Fixed Costs (TFC) -> costs that do not vary with the quantity of output produced o (Total) Variable Costs (TVC) -> costs that vary with the quantity of output produced 𝑇𝑉𝐶 TVC = 𝑄 𝑇𝐶 Total Costs (TC) = TFC + TVC = 𝑄 23  Average Costs ✓ Cost of each typical unit of product. Determined by dividing the firm’s costs by the quantity of output it produces o Average Fixed Costs (AFC) o Average Variable Costs (AVC) o Average Total Costs (ATC) ATC = AFC + AVC Marginal Cost (MC) ✓ Measures the increase in total cost that arises from an extra unit of production. MC helps answer the following question: How much does it cost to produce an additional unit of output? (change in total cost) TC MC = = (change in quantity) Q Cost curves and their Shapes Marginal cost rises with the amount of output produced o This reflects the property of diminishing marginal product The average total-cost curve is U-shaped ; the bottom of the U occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm At very low levels of output average total cost is high because fixed cost is spread over only a few units Average total cost declines as output increases; and starts rising because average variable cost rises substantially → Relationship between Marginal Cost and Average Total Cost o Whenever marginal cost is less than average total cost, average total cost is falling o Whenever marginal cost is greater than average total cost, average total cost is rising o The marginal-cost curve crosses the average-total-cost curve at the efficient scale -> quantity that minimized average total cost Three Important Properties of Cost Curves o Marginal cost eventually rises with the quantity of output o The average-total-cost curve is U-shaped o The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost 24  Costs in the short run and in the long run o For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. ▪ In the short run, some costs are fixed ▪ In long run, all fixed costs became variable Making a firm’s long-run costs curve differ from short-sun cost curve Economies and Diseconomies of Scale Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output increases 2.7.2 Firms in Competitive markets A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker. Buyers and sellers must accept the price determined by the market. Characteristics of a perfectly competitive market: o There are many buyers and sellers in the market o The goods offered by the various sellers are largely the same o Firms can freely enter or exit the market Outcomes of a perfectly competitive market : o The actions of any single buyers or seller in the market have a negligible impact on the market price o Each buyer and seller take the market price as given The revenue of a competitive firm TR = P x Q → Total revenue is proportional to the amount of output Average revenue is total revenue divided by the quantity sold. It tells us how much revenue a firm receives for the typical unit sold In perfect competition, average revenue equals the price of the good 25  Marginal revenue is the change in total △𝑇𝑅 MR = revenue from an additional unit sold △𝑄 For competitive firms, marginal revenue equals the price of the good Profit maximization and the competitive firm’s supply curve o As the goal of a competitive firm is to maximize profit, the firm will want to produce the quantity that maximizes the difference between total revenue and total cost o Profit maximization occurs as the quantity where marginal revenue equals marginal cost ▪ When MR > MC, increase Q ▪ When MR > MC, decrease Q ▪ When MR = MC, profit is maximized △𝑇𝑃  =0 △𝑄 The firm’s short-sun decision to shut down A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions Exit refers to a long-run decision leave the market The firm shuts down if the revenue it gets from producing is less than the variable cost of production o Shut down if TR < VC o Shut down if TR/Q < VC/Q o Shut down if P < AVC The firm considers its sunk costs when deciding to exit, but ignores them when deciding whether to shut down o Sunk costs are costs that have already been committed and cannot be recovered The portion of the marginal-cost curve that lies above average variable cost is the competitive firm’s short-run supply curve The firm´s Long-Run decision to exit or enter a market In the long run, the firm exist if the revenue it would get from producing is less than its total cost : o Exit if TR < TC o Exit if TR/Q < TC/Q o Exit if P < ATC A firm will enter the industry if such an action would be profitable o Enter if TR > TC o Enter if TR/Q > TC/Q o Enter if P > ATC 26 Measuring Profit in Our Graph for the Competitive Firm Profit = = TR – TC 𝑇𝑅 𝑇𝐶 = - xQ 𝑄 𝑄 = (P – ATC) x Q The supply curve in a competitive market Short-Run Supply Curve o The portion of its marginal cost curve that lies above average variable costs Long-Run Supply Curve o The marginal cost curve above the minimum point of its average total cost curve Market supply equals the sum of the quantities supplied by the individual firms in the market The Short Run: Market supply with a fixed number of firms For any given price, each firm supplies a quantity of output so that its marginal cost equals price The market supply curve reflects the individual firm’s marginal cost curves → If the industry has 1000 identical firms, then at each market price, industry output will be 1000 times larger than the representative firm’s output The Long Run: Market supply with entry and exit Firms will enter or exit the market until profit is driven to zero In the long run, price equals the minimum of average total cost The long-run market supply curve is horizontal at this price At the end of the process of entry and exit, firms that remain must be making zero economic profit. The process of entry and exit ends only when price and average total cost are driven to equality. Long-run equilibrium must have firms operating at their efficient scale ➔ Why do competitive firms stay in business it they make zero profit? o Profit equals total revenue minus total cost of the firm o Total cost includes all the opportunity costs of the firm o In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going ➔ A shift in demand in the Short Run and Long Run o An increase in demand raises price and quantity in the short run o Firms earn profits because price now exceeds average total cost 27 ➔ Why the Long-Run Supply curve might slope upward o Some resources used in production my be available only in limited quantities o Firms may have different costs o Marginal firm: ▪ The marginal firm is the firm that would exit the market if the price were any lower 2.7.3. monopoly While a competitive firm is a price taker, a monopoly firm is a price maker. A firm is considered a monopoly if: o It is the sole seller of its product o Its product does not have close substitutes Why monopolies arise? The fundamental cause of monopoly is barriers to entry Barriers to entry have 3 sources: o Ownership of a key resource o The government gives a single firm the exclusive right to produce a good in a certain market -> Government-created monopolies ▪ Patent and copyright laws are 2 important examples of how government creates a monopoly to serve the public interest o Costs of production make a single producer more efficient that a large number of producers 28 Monopoly resources: Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason Natural Monopolies A industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost that could two or more firms -> it arises when there are economies of scale over the relevant range of output Monopoly VS Competition - is the sole producer - is sone of many producers - faces a downward-sloping demand curve - faces a horizontal demand curve - is a price maker - is a price taker - reduces price to increase sales - sells as much or as little at same price A monopoly’s revenue o Total revenue (TR) = P x Q 𝑇𝑅 o Average Revenue (AR) = P = 𝑄 △𝑇𝑅 o Marginal Revenue (MR) = △𝑄 A Monopoly’s Marginal Revenue o A monopolist’s marginal revenue is always less than the price of its good ▪ The demand curve is downward sloping ▪ When a monopoly drops the price to sell one more unit, the revenue received from previously sold units also decreases o When a monopoly increases the amount it sells, it has two effects on total revenue : ▪ The output effect — more output is sold, so Q is higher. ▪ The price effect — price falls, so P is lower 29 Profit maximization A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. It then uses the demand curve to find the price that will induce consumers to buy that quantity. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit- maximizing quantity; and then, the demand curve shows the price consistent with this quantity Monopoly VS Competition o For a competitive firm, price equals marginal cost -> P = MR = MC o For a monopoly firm, price exceeds marginal cost -> P > MR = MC → remember, all profit-maximizing firms set MR = MC → The monopolist will receive economic profits as long as price is greater than average total cost → Monopoly charges a price above the marginal cost, which is desirable for the owners but undesirable to the consumers The Deadweight Loss The wedge between the consumer’s willingness to pay and the producer’s cost causes the quantity sold to fall short of the social optimum. The inefficiency of Monopoly o The monopolist produces less than the socially efficient quantity of output The deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit Public policy toward monopolies Government responds to the problem of monopoly in one four ways o Making monopolized industries more competitive o Regulating the behavior of monopolies ▪ Governments may regulate the prices that the monopoly charges -> The allocation of resources will be efficient if price is set to equal marginal cost, if so, the natural monopoly will lose money ▪ In practice, regulator will allow monopolists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from marginal-cost pricing o Turning some private monopolies into public enterprises / public ownership ▪ Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself (ex. in the United States, the government runs the Postal Service) o Doing nothing at all ▪ Government can do nothing at all if the market failure is deemed small compared to the imperfections of public policies Increasing competition with Antitrust Laws 30 ✓ Collection of statutes aimed at curbing monopoly power. They give government various ways to promote competition: o They allow government to prevent mergers o They allow government to break up companies o They prevent companies from performing activities that make markets less competitive 2 important Antitrust Laws o Sherman Antitrust Act (1890) -> reduced the market power of the large and powerful “trusts” of that time period o Clayton Antitrust (1914) -> strengthened the government’s powers and authorized private lawsuits Price discrimination ✓ Business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same o Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power o Perfect price discrimination -> perfect price discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each costumer a different price (has a budget) o 2 important effects of price discrimination : ▪ It can increase the monopolist’s profit ▪ It can reduce deadweight loss Examples of price discrimination : o Movie tickets o Discount coupons o Quantity o Airlice prices o Financial aid discount Conclusion: The prevalence of monopoly → How prevalent are the problems of monopolies? - monopolies are common - firms with substancial Monopoly power are rare - most firms have some control over their prices because of - few goods are truly unique differentiated product 31  Macroeconomics 3.1 Measuring a nation’s incoMe Macroeconomics answers questions like the following: o Why is average income high in some countries and low in others? o Why do prices rise rapidly in some time periods while they are more stable in others? o Why do production and employment expand in some years and contract in others? The economy’s income and expenditure When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning For an economy as a whole, income must equal expenditure because : o Every transaction has a buyer and a seller o Every dollar of spending by some buyer is a dollar of income for some seller The measurement of Gross Domestic Product ✓ Gross Domestic Product (GDP) is a measure of the income and expenditures of an economy. GDP is the total market value of all final goods and services produced within a country in a given period of time. o The output is valued at market prices o Includes all items produced in the economy and legally sold in markets o It records only the value of final goods, not intermediate goods (the value is counted only once) o It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits) o It includes goods and services currently produced, not transactions involving goods produced in the past o It measures the value of production within the geographic confines of a country o It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (3 months) What is not counted in GDP? o Items that are produced and consumed at home and that never enter the marketplace o Items produced and sold illicitly, such as illegal drugs GDP (Y) is the sum of the following: Y = C + I + G + NX o Consumption (C) ▪ The spending by households on goods and services, with the expectation of purchases of new housing o Investment (I) ▪ The spending on capital equipment, inventories and structures, including new housing 32  o Government Purchases (G) ▪ The spending on goods and services by local, state, and federal governments ▪ Does not include transfer payments because they are not made in exchange for currently produced goods and services o Net Exports (NX) ▪ Exports – imports Real GDP VS Nominal GDP Values the production of Values the production of goods and services at goods and services at constant prices current prices An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator The GDP Deflator ✓ Is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. It tells us what portion of the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced. converting nominal GDP to real GDP: GDP is the best single measure of the economic well-being of a society. GDP per person tells us the income and expenditure of the average person in the economy. Higher GDP per person indicates a higher standard of living. However, GDP is not a perfect measure of the happiness or quality of life. Some other things that contribute to well-being: o The value of leisure o The value of a clean environment o The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work 3.2 Production and Growth A country’s standard of living depends on its ability to produce goods and services. Productivity -> amount of goods and services produced from each unit of labor input ; a nation’s standard of living is determined largely by the productivity of its workers o Why productivity is so important? o To understand the large differences in living standards across countries, we must focus on the production 33  Living standards, as measured by real GDP per a person, vary significantly among nations Compounding refers to the accumulation of a growth rate over a period of time How productivity is determined: o The inputs used to produce goods and services are called the factors of production The factors of production include: o Physical capital -> stock of equipment and structures that are used to produce goods and service per worker ▪ it includes: -> tools used to builds or repair automobiles -> tools used to build furniture -> office buildings, schools, etc ▪ Physical capital is a produced factor of production -> it is an input into the production process that in the past was an output from the production process o Human capital -> economist´s term for the knowledge and skills that a worker acquire through education, training and experience. Includes the resources expended transmitting this understanding to the labor force ▪ Like physical capital, human capital raises a nation’s ability to produce goods and services o Natural resources -> input used in production that are provided by nature, such as land, rivers, and mineral deposits. They can be important but not necessary for an economy to be highly productive in producing goods and services ▪ Renewable resources include trees and forests ▪ Nonrenewable resources include petroleum and coal o Technological knowledge -> includes society’s understanding of the best ways to produce goods and services The production function Economists often use a production function to describe the relationship between the quantity of inputs used in production and the quantity of output from production Y = A F(L, K, H, N) o Y = quantity of output o A = available production technology o L = quantity of labor o K = quantity of physical capital o H = quantity of human capital o N = quantity of natural resources o F( ) is a function that shows how the inputs are combined. A production function has constant returns to scale if, for any positive number x, xY = A F(xL, xK, xH, xN) 34  That is, a doubling of all inputs causes the amount of output to double as well. Production functions with constant returns to scale have an interesting implication. Setting x = 1/L, Y/ L = A F(1, K/L, H/L, N/L) Where: o Y/L = output per worker o K/L = physical capital per worker o H/L = human capital per worker o N/L = natural resources per worker The preceding equation says that productivity (Y/L) depends on: o physical capital per worker (K/L), o human capital per worker (H/L), o and natural resources per worker (N/L), o as well as the state of technology (A). Economic Growth and Public Policy government policies that raise productivity and living standards o Encourage saving and investment. o Encourage investment from abroad. o Encourage education and training. o Establish secure property rights and maintain political stability. o Promote free trade. o Promote research and development. Saving and Investment One way to raise future productivity is to invest more current resources in the production of capital. Diminishing Returns and the Catch-Up Effect As the stock of capital rises, the extra output produced from an additional unit of capital falls; this property is called diminishing returns Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while. In the long run, the higher saving rate leads to a higher level of productivity and income, but not to higher growth in these areas. The catch-up effect refers to the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich 35 Investment from abroad Governments can increase capital accumulation and long-term economic growth by encouraging investment from foreign sources. Investment from abroad takes several forms: o Foreign Direct Investment ▪ Capital investment owned and operated by a foreign entity. o Foreign Portfolio Investment ▪ Investments financed with foreign money but operated by domestic residents. Education For a country’s long-run growth, education is at least as important as investment in physical capital. One way the government can enhance the standard of living is to provide schools and encourage the population to take advantage of them. An educated person might generate new ideas about how best to produce goods and services, which in turn, might enter society’s pool of knowledge and provide an external benefit to others. One problem facing some poor countries is the brain drain — the emigration of many of the most highly educated workers to rich countries Health and Nutrition Healthier workers are more productive. Good investments in the health of the population can lead to increase living standards. Countries can get caught in a vicious cycle : people are poor people cannot afford good nutrition food and health care Property rights and Political stability Property rights refer to the ability of people to exercise authority over the resources they own. An economy-wide respect for property rights is an important prerequisite for the price system to work. It is necessary for investors to feel that their investments are secure Free Trade Trade is, in some ways, a type of technology. A country that eliminates trade restrictions will experience the same kind of economic growth that would occur after a major technological advance Some countries engage in... o... inward-orientated trade policies, avoiding interaction with other countries. o... outward-orientated trade policies, encouraging interaction with other countries. Research and Development The advance of technological knowledge has led to higher standards of living. Most technological advance comes from private research by firms and individual inventors. Government can encourage the development of new technologies through research grants, tax breaks, and the patent system. 36 Population Growth Economists and other social scientists have long debated how population growth affects a society. Population growth interacts with other factors of production: o Stretching natural resources o Diluting the capital stock o Promoting technological progress 3.3 Saving, investment and the financial system The financial systems consists of the group of financial institutions in the economy that help to match one person’s saving with another person’s investment. It moves the economy’s scarce resources from savers to borrowers. Financial Institutions: Financial markets -> institutions through which savers can directly provide funds to borrowers o Stock market -> represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes ▪ The sale of stock to raise money is called equity financing -> compared to bonds, stocks offer both higher risk and potentially higher returns ▪ Most newspaper stock tables provide the following information : -> Price (of a share) -> Volume (numbers of shares hold) -> Dividend (profits paid to stockholders) -> Price-earnings ratio o Bond market -> certificate of indebtedness that specifies obligations of the borrower to the holder of the bond ▪ Characteristics : -> terms: the length of time until the bond matures -> credit risk: the probability that the borrower will fail to pay some of the interest or principal -> tax treatment: the way in which the tax laws treat the interest on the bond (municipal bonds are federal tax exempt) Financial intermediaries -> institutions through which savers can indirectly provide funds to borrowers o Banks ▪ Take deposits from people who wants to save and use the deposits to make loans to people who want to borrow ▪ pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. ▪ Help create a medium of exchange by allowing people to write checks against their deposits. ▪ A medium of exchange is an item that people can easily use to engage in transactions. -> facilitate the purchases of goods and services o Mutual funds -> institution that sells shares to the public and uses the proceeds to buy a portfolio, of various types of stocks, bonds, or both. ▪ Mutual funds allow people with small amounts of money to easily diversify. 37  Other financial institutions o Credit unions o Pension funds o Insurance companies o Loan sharks (not common in Europe) Saving and investment in the national income accounts Assuming a closed economy, where there is no imports or exports: Y=C+I+G.:. Y – C – G = I = saving (S).:. S = I The meaning of saving and Investment National saving -> total income in the economy that remains after paying for consumption and government purchases Private saving -> amount of income that households have left after paying their taxes and saying for their consumption =Y–T–C Public saving -> amount of tax revenue that the government has left after paying for its spending Surplus and Deficit =T–G o If T > G, the government runs a budget surplus because it receives more money than it spends ▪ The surplus of T – G represents public saving o If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue The market for Loanable Funds ✓ Market in which those who want to save supply funds and those who want to borrow to invest demand funds 38 Supply and Demand for Loanable Funds Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption. The supply of loanable funds comes from people who have extra income they want to save and lend out. The demand for loanable funds comes from households and firms that wish to borrow to make investments. Interest rate -> the price of the loan; the amount that borrowers pay for loans and the amount that lenders receive on their saving o in the market for loanable funds, the real interest rate. The equilibrium of the supply and demand for loanable funds determines the real interest rate Government Policies That Affect Saving and Investment Policy 1: Saving incentives o Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save. o A tax decrease increases the incentive for households to save at any given interest rate. ▪ The supply of loanable funds curve shifts right. ▪ The equilibrium interest rate decreases. ▪ The quantity demanded for loanable funds increases. o If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment Policy 2: Investment incentives o An investment tax credit increases the incentive to borrow. o Increases the demand for loanable funds. o Shifts the demand curve to the right. o Results in a higher interest rate and a greater quantity saved. o If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving Policy 3: Government budget deficits and surpluses o When the government spends more than it receives in tax revenues, the short fall is called the budget deficit. o The accumulation of past budget deficits is called the government debt o Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. This fall in investment is referred to as crowding out: The deficit borrowing crowds out private borrowers who are trying to finance investments o A budget deficit decreases the supply of loanable funds, increases the equilibrium interest rate o Shifts the supply curve to the left -> Reduces the equilibrium quantity of loanable funds o When government reduces national saving by running a deficit, the interest rate rises and investment falls. o A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment 39  3.4 Unemployment How is Unemployment measured? Categories of unemployment - Long-run and Short-run problem o The natural rate of unemployment -> unemployment that does not go away on its own even in the long run ▪ It is the amount of unemployment that the economy normally experiences o The cyclical rate of unemployment -> refers to the year-to-year fluctuations in unemployment around its natural rate ▪ It is associated with short-term ups and downs of the business Unemployment is measured by the Bureau of Labor Statistics (BLS) by surveys called the Current Population Survey (inquérito ao emprego) BLS placed each adult (>16) into one of three categories: o Employed -> if the person has spent some of the previous week working at a paid job o Unemployed -> on temporary layoff; is looking for a job; or is waiting for the start date of a new job o Not in the labor force -> full-time students, homemaker, or retiree, … Labor Force = Employed + Unemployed active The labor-force participation rate is the percentage of the adult population that is in the labor force Does the unemployment rate measure what we want it to? It is difficult to distinguish between a person who is unemployed and a person who is not in the labor force. o Discouraged workers, people who would like to work but have given up looking for jobs after an unsuccessful search, don’t show up in unemployment statistics o Other people may claim to be unemployed in order to receive financial assistance, even though they aren’t looking for work How long are the unemployed without work? Most spells of unemployed are short Most of the unemployment is in long-term 40 Why are there always some people unemployed ? In an ideal market, wages would adjust to balance the supply and demand for labor, ensuring that all workers would be fully employed. Frictional Unemployment refers to the unemployment that results from the time that it takes to match workers with jobs – the one that are best suit their tastes and skills Structural unemployment occurs when then quantity of labor supplied exceeds the quantity demanded. Is often though to explain longer spells of unemployment Job Search ✓ Process by which workers find appropriate jobs given their tastes and skills. Results from the fact that it takes time for qualified individuals to be matched with appropriate jobs. This unemployment if different from the other types of unemployment It is not caused by a wage rate higher than equilibrium → it is caused by the time spent searching for the right job Why some frictional unemployment is inevitable? -> because the economy is always changing Changes in the composition of demand among industries or regions are called sectoral shifts Public policies and Job search Government programs can affect the time to find new jobs o Government-run employment agencies ▪ Give out information about job vacancies in order to match workers and jobs more quickly o Public training programs ▪ Aim to ease the transition of workers from declining to growing industries and to help disadvantaged groups escape poverty o Unemployment insurance ▪ Is a government program that partially projects workers incomes when they become unemployed -> offers workers partial protection against job losses -> offers partial payment of former wages for a limited time to those who are laid off ▪ Increases the amount of search unemployment and reduces the search efforts of the unemployed ▪ May improve the chances of workers being matched with the right jobs Why is there Structural Unemployment? Minimum-wage laws -> when the minimum wage is set above the level that balances supply and demand, it creates unemployment Unions and collective bargaining o worker associations that bargains with employers over wages, benefits and working conditions o Collective Bargaining is the process by which unions and firms agree on the terms of employment o A strike will be organized if the union and the firm cannot reach an agreement – a strike makes come workers better off and other workers worse off o Workers in union (insiders) reap the benefits of collection bargaining, while workers not in the union (outsiders) bear some of the costs → Are unions good or bad for the economy ? o Critics argue that unions cause the allocation of labor to be inefficient and inequitable o Wages above the competitive level reduce the quantity of labor demanded and cause unemployment 41  o Some workers benefit at the expense of other workers o Advocates of unions contend that unions are a necessary antidote to the market power of firms that hire workers. o They claim that unions are important for helping firms respond efficiently to workers’ concerns Efficiency wages o Above-equilibrium wages paid by firms in order to increase worker productivity o The theory of efficiency wages states that firms operate more efficiently if wages are above the equilibrium level o A firm may prefer higher than equilibrium wages for the following reasons: ▪ Worker health: Better paid workers eat a better diet and thus are more productive. ▪ Worker turnover: A higher paid worker is less likely to look for another job. ▪ Worker quality: Higher wages attract a better pool of workers to apply for jobs. ▪ Worker effort: Higher wages motivate workers to put forward their best effort. 3.5 The monetary system Money is the set of assets in an economy that people regularly use to buy goods and services from other people The functions of Money o Medium of exchange -> an item that buyers give to sellers when they want to purchase something ; anything that is readily acceptable as payment o Unit of account -> criteria people use to post price and record debts o Store of value -> an item that people can use to transfer purchasing power from the present to the future -> Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange The kinds of money o Commodity money -> takes the form of a commodity with intrinsic value. Ex: gold, silver, cigarettes o Fiat money -> used as money because of government decree; does not have intrinsic money. Ex: coins, currency, check deposits The Federal Reserve System (FED) serves as the nation´s central bank o It is designed to oversee the banking system o It regulates the quantity of money in the economy The Fed’s organization o The Fed is run by a Board of Governors, which has 7 members appointed by the president and confirmed by the Senate. o Among the seven members, the most important is the chairman who directs the fed staff (4 year term) o The Federal Reserve System is made up of the Federal Reserve Board in Washington, D.C., and twelve regional Federal Reserve Banks o Three Primary Functions of the Fed: ▪ Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices. 42  ▪ Acts as a banker’s bank, making loans to banks and as a lender of last resort. ▪ Conducts monetary policy by controlling the money supply. o The Federal Open Market Committee (FOMC) serves as the main policy-making organ of the Fed o Open-market operations: ▪ The primary way in which the Fed changes the money supply is through open-market operations -> The Fed purchases and sells U.S. government bonds. ▪ The money supply is the quantity of money available in the economy -> To increase the money supply, the Fed buys government bonds from the public. -> To decrease the money supply, the Fed sells government bonds to the public The Fed’s 3 tools of monetary control: o Open-Market Operations -> when it buys government bonds from or sells them to the public o Changing the Reserve Requirement -> regulations on the minimum amount of reserves that banks mush hold against deposits; that may not be loaned out o Changing the Discount Rate -> interest rate the Fed charges banks for loans Problems in controlling the money supply o The Fed’s control is not precise o The Fed does not control the amount of money that households choose to hold as deposits in banks. o The Fed does not control the amount of money that bankers choose to lend Banks and the Money Supply Reserves are deposits that banks have received but have not loaned out In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest The reserve ratio is the fraction of deposits that banks hold as reserves When a bank makes a loan from its reserves, the money supply increases. The money supply is affected by the amount deposited in banks and the amount that banks loan. o Deposits into a bank are recorded as both assets and liabilities. o The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio; Loans become an asset to the bank The money multiplier ✓ Amount of money the banking system generates with each dollar of reserves How much money eventually created by the new deposit in this economy? 43  The Money multiplier (M) is the reciprocal of the reserve ratio: M = 1/R 3.6 money growth and inflation Inflation is an increase in the overall level of prices. It is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange o When the overall price level rises, the value of money falls Deflation is a decrease in the overall level of prices Hyperinflation is an extraordinarily high rate of inflation (that exceed 50% per moth) Money Supply, Money Demand and Monetary Equilibrium Money Supply is a policy variable that is controlled by the Fed Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied Money Demand has several determinants, including interest rates and the average level of prices in the economy In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply The Quantity Theory of Money ✓ How the price level is determined and why it might change over time o The quantity of money available in the economy determines the value of money o The primary cause of inflation is the growth in the quantity of money The Classical Dichotomy and Monetary Neutrality Nominal Variables are variables measured in monetary units Real variables are variables measured in physical units According to the classical dichotomy, different forces influence real and nominal variables o Changes in the money supply affect nominal variables but not real variables o The irrelevance of monetary changes for real variables is called monetary neutrality 44 Velocity and the Quantity Equation Velocity of money -> the speed at which the typical dollar bill travels around the economy from wallet to wallet. Relatively stable over time. where: P = the price level Y = the quantity of output 𝑃×𝑌 V= M = the quantity of money 𝑀 Rewriting the equation gives the quantity equation: M×V=P×Y The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: o The price level must rise, o the quantity of output must rise, or o the velocity of money must fall. Money and Prices during hyperinflations -> Normally, the price level is above the money supply Inflation The Inflation Tax -> When the governments raises revenue by printing money. Is like a tax on everyone who holds money The fisher effect -> one-to-one adjustment of the nominal interest rate to the inflation rate. o When the rate of inflation rises, the nominal interest rate rises by the same amount. The real interest rate stays the same The costs of inflation → Inflation does not in itself reduce people´s real purchasing power Shoeleather costs -> resources wasted when inflation encourages people to reduce their money holdings Menu costs -> costs of adjusting prices o During inflationary times, it is necessary to update price lists and other posted prices. o This is a resource-consuming process that takes away from other productive activities Relative price variability o Inflation distorts relative prices. o Consumer decisions are distorted, and markets are less able to allocate resources to their best use. Tax distortions o Inflation exaggerates the size of capital gains and increases the tax burden on this type of income. o With progressive taxation, capital gains are taxed more heavily 45  Confusion and inconvenience o Inflation causes dollars at different times to have different real values. Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time. Arbitrary redistribution of wealth o Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need. o These redistributions occur because many loans in the economy are specified in terms of the unit of account—money 3.7 5 debates over macroeconomic policy 1) Should monetary and fiscal policymakers try to stabilize the economy? Pros: The economy is inherently unstable and left on its own will fluctuate. Policy can manage aggregate demand in order to offset this inherent instability and reduce the severity of economic fluctuations. There is no reason for society to suffer through the booms and busts of the business cycle. Monetary and fiscal policy can stabilize aggregate demand and, thereby, production and employment Cons: Monetary policy affects the economy with long and unpredictable lags between the need to act and the time that it takes for these policies to work. Many studies indicate that changes in monetary policy have little effect on aggregate demand until about six months after the change is made Fiscal policy works with a lag because of the long political process that governs changes in spending and taxes. It can take years to propose, pass, and implement a major change in fiscal policy All too often policymakers can inadvertently exacerbate rather than mitigate the magnitude of economic fluctuations. It might be desirable if policy makers could eliminate all economic fluctuations, but this is not a realistic goal. 2) Should monetary policy be made by rule rather than by discretion? Pros: Discretionary monetary policy can suffer from incompetence and abuse of power. To the extent that central bankers ally themselves with politicians, discretionary policy can lead to economic fluctuations that reflect the electoral calendar—the political business cycle There may be a discrepancy between what policymakers say they will do and what they actually do— called time inconsistency of policy. Because policymakers are so often time inconsistent, people are skeptical when central bankers announce their intentions to reduce the rate of inflation. Committing the Fed to a moderate and steady growth of the money supply would limit incompetence, abuse of power, and time inconsistency 46 Cons: An important advantage of discretionary monetary policy is its flexibility. Inflexible policies will limit the ability of policymakers to respond to changing economic circumstances. The alleged problems with discretion and abuse of power are largely hypothetical. Also, the importance of the political business cycle is far from clear 3) Should the central bank aim for zero inflation? Pros: Inflation confers no benefit to society, but it imposes several real costs: o Shoeleather costs o Menu costs o Increased variability of relative prices o Unintended changes in tax liabilities o Confusion and inconvenience o Arbitrary redistribution of wealth Reducing inflation is a policy with temporary costs and permanent benefits. Once the disinflationary recession is over, the benefits of zero inflation would persist Cons: Zero inflation is probably unattainable, and to get there involves output, unemployment, and social costs that are too high. Policymakers can reduce many of the costs of inflation without actually reducing inflation. 4) Should the government balance its budget? Pros: Budget deficits impose an unjustifiable burden on future generations by raising their taxes and lowering their incomes. When the debts and accumulated interest come due, future taxpayers will face a difficult choice: o They can pay higher taxes, enjoy less government spending, or both. By shifting the cost of current government benefits to future generations, there is a bias against future taxpayers. Deficits reduce national saving, leading to a smaller stock of capital, which reduces productivity and growth Cons: The problem with the deficit is often exaggerated. The transfer of debt to the future may be justified because some government purchases produce benefits well into the future. The government debt can continue to rise because population growth and technological progress increase the nation’s ability to pay the interest on the debt 47 5) Should the tax laws be reformed to encourage saving? Pros: A nation’s saving rate is a key determinant of its long-run economic prosperity. A nation’s productive capability is determined largely by how much it saves and invests for the future. When the saving rate is higher, more resources are available for investment in new plant and equipment The consequences of high capital income tax policies are reduced saving, reduced capital accumulation, lower labor productivity, and reduced economic growth An alternative to current tax policies advocated by many economists is a consumption tax. With a consumption tax, a household pays taxes based on what it spends not on what it earns. o Income that is saved is exempt from taxation until the saving is later withdrawn and spent on consumption goods. Cons: Many of the changes in tax laws to stimulate saving would primarily benefit the wealthy. o High-income households save a higher fraction of their income than low-income households. o Any tax change that favors people who save will also tend to favor people with high incomes Reducing the tax burden on the wealthy would lead to a less egalitarian society. This would also force the government to raise the tax burden on the poor. Raising public saving by eliminating the government’s budget deficit would provide a more direct and equitable way to increase national saving 48