Macroeconomics Ch01 PDF

R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN MACROECONOMICS ECON 1220 Introductory Macroeconomics Chapter 1: Introduction Dr. Yifei Zhang GLOBAL EDITION © Pearson Education Limited  CHAPTER CHAPTER...

R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN MACROECONOMICS ECON 1220 Introductory Macroeconomics Chapter 1: Introduction Dr. Yifei Zhang GLOBAL EDITION © Pearson Education Limited  CHAPTER CHAPTER 1 Economics: Foundations and Models Chapter Outline and Learning Objectives 1.1 Three Key Economic Ideas 1.2 The Economic Problem That Every Society Must Solve 1.3 Economic Models 1.4 Microeconomics and Macroeconomics 1.5 A Preview of Important Economic Terms APPENDIX: Using Graphs and Formulas © Pearson Education Limited 2 What Is This Class About? People make choices as they try to attain their goals. Choices are necessary because we live in a world of scarcity. Scarcity: A situation in which unlimited wants exceed the limited resources available to fulfill those wants. You want to gain something; you need to sacrifice something (tradeoff). If you spend an hour studying for your economics midterm, you have one hour less to study for your history midterm. Economics is study of the choices consumers, business managers, and government officials make to attain their goals, given their scarce resources. (Maximization subject to constraints) Economists study these choices using economic models, simplified versions of reality used to analyze real-world economic situations. © Pearson Education Limited 3 Typical “Economics” Questions We will learn how to answer questions like these: How are the prices of goods and services determined? How does pollution affect the economy, and how should government policy deal with these effects? Why do firms engage in international trade, and how do government policies affect international trade? Why does government control the prices of some goods and services, and what are the effects of those controls? © Pearson Education Limited 4  Three Key Economic Ideas 1.1 LEARNING OBJECTIVE Explain these three key economic ideas: People are rational; People respond to economic incentives; and Optimal decisions are made at the margin. © Pearson Education Limited 5 1. People Are Rational Economists generally assume that people are rational. Rational: Using all available information to achieve your goals. This assumption does not mean that economists believe everyone knows everything or always makes the “best” decision. Rational consumers and firms weigh the benefits and costs of each action and try to make the best decision possible. Example: Microsoft doesn’t randomly choose the price of its Windows software; it chooses the price(s) that it thinks will be most profitable. © Pearson Education Limited 6 2. People Respond to Economic Incentives As incentives change, so do the actions that people will take. Example: Changes in several factors have resulted in increased obesity in Americans over the last couple of decades, including: Decreases in the price of fast-food relative to healthful food Improved non-active entertainment options (smart phone, etc.) Increased availability of health care and insurance, protecting people against the consequences of their actions © Pearson Education Limited 7 3. Optimal Decisions Are Made at the Margin While some decisions are all-or-nothing, most decisions involve doing a little more or a little less of something. Example: Should you watch an extra hour of TV, or study instead? Economists think about decisions like this in terms of the marginal cost and benefit (MC and MB): the additional cost or benefit associated with a small amount extra of some action. Comparing MC and MB is known as marginal analysis. © Pearson Education Limited 8 3. Optimal Decisions Are Made at the Margin Should you watch an extra hour of TV, or study instead? Hour TV (Benefit) TV (Cost) = Study (Benefit) 1st 10 1 2nd 8 2 3rd 3 3 4th 1 4 … … … © Pearson Education Limited 9  The Economic Problem That Every Society Must Solve 1.2 LEARNING OBJECTIVE Discuss how an economy answers these questions: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced? © Pearson Education Limited 10 1. What Goods and Services Will Be Produced? Individuals, firms, and governments must decide on the goods and services that should be produced. An increase in the production of one good requires the reduction in the production of some other good. This is a trade-off, resulting from the scarcity of productive resources. The highest-valued alternative given up in order to engage in some activity is known as the opportunity cost. Example: the opportunity cost of increased funding for space exploration might be giving up the opportunity to fund cancer research. © Pearson Education Limited 11 2. How Will the Goods Be Produced? A firm might have several different methods for producing its goods and services. Example: A music producer can make a song sound good by Hiring a great singer, and using standard production techniques; or Hiring a mediocre singer and using Auto-Tune to correct the inaccuracies. Example: As the cost of manufacturing labor changes, a firm might respond by Changing its production technique to one that employs more machines and fewer workers. (machine-labor tradeoff) Moving its factory to a location with cheaper labor. © Pearson Education Limited 12 3. Who Will Receive the Goods and Services? The way we are most familiar with in the United States is that people with higher incomes obtain more goods and services. Changes in tax and welfare policies change the distribution of income; though people often disagree about the extent to which this “redistribution” is desirable. © Pearson Education Limited 13 Types of Economies Centrally planned economies result when governments decide what to produce, how to produce it, and who received the goods and services. Market economies result when the decisions of households and firms determine what is produced, how it is produced, and who receives the goods and services. Market: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Mixed economies have features of both of the above. Most economic decisions result from the interaction of buyers and sellers, but governments play a significant role in the allocation of resources. © Pearson Education Limited 14 Efficiency of Economies Market economies tend to be more efficient than centrally-planned economies. Market economies promote: Productive efficiency, where goods or services are produced at the lowest possible cost; and Allocative efficiency, where production is consistent with consumer preferences: the marginal benefit of production is equal to its marginal cost. These efficiencies come about because all transactions result from voluntary exchange: transactions that make both the buyer and seller better off. © Pearson Education Limited 15 Caveats About Market Economies Markets may not result in fully efficient outcomes. For example: People might not immediately do things in the most efficient way. When Blu-ray players were introduced, for example, firms did not instantly achieve productive efficiency. It took several years for firms to discover the lowest-cost method of producing this good. Governments might interfere with market outcomes. Many governments limit the imports of some goods from foreign countries. This limitation reduces efficiency by keeping goods from being produced at the lowest cost. Market outcomes might ignore the desires of people who are not involved in transactions – ex: pollution government intervention can increase efficiency because without such intervention, firms may ignore the costs of environmental damage and thereby fail to produce the goods at the lowest possible cost. Economically efficient outcomes may not be the most desirable. Markets result in high inequality; some people prefer more equity, i.e., fairer distribution of economic benefits. There is often a trade-off between efficiency and equity. © Pearson Education Limited 16  Economic Models 1.3 LEARNING OBJECTIVE Understand the role of models in economic analysis. © Pearson Education Limited 17 Economic Models Economists develop economic models to analyze real-world issues. (Use mathematical language to formulate economic problems.) Building an economic model often follows these steps: 1. Decide on the assumptions to use in developing the model. 2. Formulate a testable hypothesis. 3. Use economic data to test the hypothesis. 4. Revise the model if it fails to explain the economic data well. 5. Retain the revised model to help answer similar economic questions in the future. © Pearson Education Limited 18 Important Features of Economic Models Assumptions and simplifications: every model needs them in order to be useful. Testability: good models generate testable predictions, which can be verified or disproven using data. In an economic model, a hypothesis is a statement that may be either correct or incorrect about an economic variable. Economic variables: something measurable that can have different values, such as the incomes of doctors. © Pearson Education Limited 19 Important Features of Economic Models The process of developing models, testing hypotheses, and revising models occurs not just in economics but also in disciplines such as physics, chemistry, and biology. This process is often referred to as the scientific method. Economics is a social science because it applies the scientific method to the study of the interactions among individuals. © Pearson Education Limited 20 Economics as a Social Science Most prestigious economics departments in the US are facilitated in the social science faculty instead of their business schools. Harvard, MIT, Princeton, Stanford, Chicago, etc. Modern economic research may cover much wider topics than you think of. © Pearson Education Limited 21 The Scientific Nature of Economics Economists try to mimic natural scientists by using the scientific method. But economics is a social science; studying the behavior of people is often tricky. When analyzing human behavior, we can perform: Positive analysis: the study of “what is?”; and/or Normative analysis: the study of “what ought to be?” Economists generally perform positive analysis, which measures the costs and benefits of different courses of action. © Pearson Education Limited 22 Example of Positive and Normative Economics Here's an example of a positive economic statement: "Government-provided healthcare increases public expenditures." This statement is fact-based and has no value judgment attached to it. Its validity can be proven (or disproven) by studying healthcare spending where governments provide healthcare. An example of a normative economic statement is: "The government should provide basic healthcare to all citizens." As you can deduce from this statement, it is value-based, rooted in personal perspective, and satisfies the requirement of what "should" be. © Pearson Education Limited 23  Microeconomics and Macroeconomics 1.4 LEARNING OBJECTIVE Distinguish between microeconomics and macroeconomics. © Pearson Education Limited 24 Microeconomics and Macroeconomics Microeconomics is the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices Macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. © Pearson Education Limited 25 Macroeconomics Macroeconomic issues include explaining why economies experience periods of recession and increasing unemployment and why, over the long run, some economies have grown much faster than others. Macroeconomics also involves policy issues, such as whether government intervention can reduce the severity of recessions. © Pearson Education Limited 26 Micro and Macro The division between microeconomics and macroeconomics is not hard and fast. Many economic situations have both a microeconomic and a macroeconomic aspect. For example, the level of total investment by firms in new machinery and equipment helps to determine how rapidly the economy grows—which is a macroeconomic issue. But to understand how much new machinery and equipment firms decide to purchase, we have to analyze the incentives individual firms face—which is a microeconomic issue. © Pearson Education Limited 27  A Preview of Important Economic Terms 1.5 LEARNING OBJECTIVE Define important economic terms. © Pearson Education Limited 28 Terminology in Economics Firm, company, or business. A firm is an organization that produces a good or service. Most firms produce goods or services to earn profits, but there are also nonprofit firms, such as universities and some hospitals. Economists use the terms firm, company, and business interchangeably. Entrepreneur. An entrepreneur is someone who operates a business. In a market system, entrepreneurs decide what goods and services to produce and how to produce them. An entrepreneur starting a new business puts his or her own funds at risk. If an entrepreneur is wrong about what consumers want or about the best way to produce goods and services, his or her funds can be lost. © Pearson Education Limited 29 Terminology in Economics Innovation. Any significant improvement in a good or in the means of producing a good. Technology. A firm’s technology is the processes it uses to produce goods and services. In the economic sense, a firm’s technology depends on many factors, such as the skill of its managers, the training of its workers, and the speed and efficiency of its machinery and equipment. © Pearson Education Limited 30 Terminology in Economics Goods. Goods are tangible merchandise, such as books, computers, or Blu-ray players. Services. Services are activities done for others, such as providing haircuts or investment advice. Revenue. A firm’s revenue is the total amount received for selling a good or service. We calculate it by multiplying the price per unit by the number of units sold. © Pearson Education Limited 31 Terminology in Economics Profit. A firm’s profit is the difference between its revenue and its costs. Economists distinguish between accounting profit and economic profit. In calculating accounting profit, we exclude the cost of some economic resources that the firm does not pay for explicitly. In calculating economic profit, we include the opportunity cost of all resources used by the firm. When we refer to profit in this course, we mean economic profit. It is important not to confuse profit with revenue. Economic Profit = Total Revenue - (Total Explicit Costs + Total Implicit Costs) © Pearson Education Limited 32 Accounting and Economic Profit Examples Economic profit is based on estimates and assumptions while accounting profit is the figure that companies report for tax purposes and to investors. Accounting profits are easy to determine since we already know that this figure can be found on a company's income statement. As noted above, it is reported as a company's net income. For instance, NVIDIA (NVDA) reported total net income or accounting profit of $9.75 billion for the 2022 fiscal year compared to the $4.33 billion it earned in 2021. "FORM 10-K NVIDIA CORPORATION," Page 31. © Pearson Education Limited 33 Accounting and Economic Profit Examples Unlike accounting profit, you can't get economic profit from a corporate financial or income statement. Suppose a company earns revenue of $10,000 on sales of stuffed animals. Explicit costs amount to $5,000. In addition, the company could have produced a different product; by foregoing that opportunity, it declined $2,000 of income. Using the formula Economic Profit = Total Revenue - (Total Explicit Costs + Total Implicit Costs) The economic profit of producing these toys is $3,000 ($10,000 - $5,000 - $2,000). The $2,000 is included as an implicit cost that is otherwise not recorded on the financial statements. © Pearson Education Limited 34 Terminology in Economics Household. A household consists of all persons occupying a home. Households are suppliers of factors of production—particularly labor—used by firms to make goods and services. Households also demand goods and services produced by firms and governments. © Pearson Education Limited 35 Terminology in Economics Factors of production, economic resources, or inputs. Firms use factors of production to produce goods and services. The main factors of production are labor, capital, natural resources—including land—and entrepreneurial ability. Households earn income by supplying the factors of production to firms. Economists use the terms factors of production, economic resources, and inputs interchageably. © Pearson Education Limited 36 Terminology in Economics Capital. The word capital can refer to financial capital or to physical capital. Financial capital includes stocks and bonds issued by firms, bank accounts, and holdings of money. In economics, though, capital refers to physical capital, which includes manufactured goods that are used to produce other goods and services. Examples of physical capital are computers, factory buildings, machine tools, warehouses, and trucks. The total amount of physical capital available in a country is referred to as the country’s capital stock. © Pearson Education Limited 37 Terminology in Economics Human capital. Human capital refers to the accumulated training and skills that workers possess. For example, college-educated workers generally have more skills and are more productive than workers who have only high school degrees; therefore, college-educated workers have more human capital. © Pearson Education Limited 38  Appendix: Using Graphs and Formulas LEARNING OBJECTIVE Review the use of graphs and formulas. © Pearson Education Limited 39 A Map as a Graphical Model A map is a simplified model of reality, showing essential details only. Economic models, with features like graphs and formulas, can help us understand economic situations just like a map helps us to understand the geographic layout of a city. Street map of New York City. Copyright © 2011 City Maps Inc. © Pearson Education Limited 40 Graphs of One Variable Panel (a) shows a bar graph of market share data for the U.S. automobile industry; market share is represented by the height of the bar. Panel (b) shows a pie chart of the same data; market share is represented by the size of the “slice of the pie”. Figure 1A.1 Bar Graphs and Pie Charts © Pearson Education Limited 41 Time-Series Graphs Both panels present time-series graphs of Ford Motor Company’s worldwide sales during each year from 2001 to 2012. In panel (a), the vertical axis starts at 0 and the distance between each value shown is the same. Figure 1A.2 Time-Series Graphs © Pearson Education Limited 42 Time-Series Graphs In panel (b), the scale on the vertical axis is truncated, which means that although it starts at zero, it jumps to 4.5 million. As a result, the distance on the vertical axis from 0 to 4.5 million is much smaller than the distance from 4.5 million to 5.0 million. In panel (b), the decline in Ford’s sales during 2008 and 2009 appears much larger than in panel (a). Figure 1A.2 Time-Series Graphs © Pearson Education Limited 43 Graphs of Two Variables The figure shows a two- dimensional grid on which we measure the price of pizza along the vertical axis (or y- axis) and the quantity of pizza sold per week along the horizontal axis (or x-axis). Each point on the grid represents one of the price and quantity combinations listed in the table. By connecting the points with a line, we can better illustrate the relationship between the two Figure 1A.3 Plotting Price and variables. Quantity Points in a Graph © Pearson Education Limited 44 Calculating the Slope of a Line We can calculate the slope of a line as the change in the value of the variable on the y- axis divided by the change in the value of the variable on the x- axis. Because the slope of a Figure 1A.4 Calculating the Slope straight line is constant, of a Line we can use any two Change in value on the vertical axis y Rise Slope = = = points in the figure to Change in value on the horizontal axis x Run calculate the slope of the line. © Pearson Education Limited 45 Calculating the Slope of a Line—continued For example, when the price of pizza decreases from $14 to $12, the quantity of pizza demanded increases from 55 per week to Figure 1A.4 Calculating the Slope 65 per week. of a Line So, the slope of Change in value on the vertical axis y Rise Slope = = = this line equals Change in value on the horizontal axis x Run –2 divided by 10, or –0.2. Price of pizza ($12 − $14) − 2 Slope = = = = −0.2 Quantity of pizza (65 − 55) 10 © Pearson Education Limited 46 Showing Three Variables on a Graph The demand curve for pizza shows the relationship between the price of pizzas and the quantity of pizzas demanded, holding constant other factors that might affect the willingness of consumers to buy pizza. Figure 1A.5 Showing Three Variables on a Graph © Pearson Education Limited 47 Showing Three Variables on a Graph (part B) If the price of pizza is $14 (point A), an increase in the price of hamburgers from $1.50 to $2.00 increases the quantity of pizzas demanded from 55 to 60 per week (point B) and shifts us to Demand curve2. Figure 1A.5 Showing Three Variables on a Graph © Pearson Education Limited 48 Showing Three Variables on a Graph (part C) Or, if we start on Demand curve1 and the price of pizza is $12 (point C), a decrease in the price of hamburgers from $1.50 to $1.00 decreases the quantity of pizza demanded from 65 to 60 per week (point D) and shifts us to Demand curve3. Figure 1A.5 Showing Three Variables on a Graph © Pearson Education Limited 49 Positive and Negative Relationships In a positive relationship between two economic variables, as one variable increases, the other variable also increases. In a negative relationship, as one variable increases, the other decreases. This figure shows the positive relationship between disposable personal income and Figure 1A.6 Graphing the Positive consumption spending. Relationship Between Income and Consumption © Pearson Education Limited 50 Correlation vs. Causation Figure 1A.7 Determining Cause and Effect Using graphs to draw conclusions about cause and effect is dangerous. For example, in panel (a), as the number of fires in fireplaces increases, the number of leaves on trees falls; but the fires don’t cause the leaves to fall. In panel (b), as the number of lawn mowers being used increases, so does the rate at which grass grows. © Pearson Education Limited 51 Are Graphs of Economic Relationships Always Straight Lines? The relationship between two variables is linear when it can be represented by a straight line. Few economic relationships are actually linear. However linear approximations are simpler to use, and are often “good enough” in modeling. © Pearson Education Limited 52 Slopes of Nonlinear Curves A nonlinear curve has different slopes at different points. This curve shows the total cost of production for various quantities of iPhones. We can approximate its slope over a section by measuring the slope as if that section were linear. Between C and D, the slope is greater than between A and B; so we say the curve is steeper Figure 1A.8a The Slope of a between C and D than Nonlinear Curve between A and B. © Pearson Education Limited 53 Slopes of Nonlinear Curves—continued Another way to measure the slope of a nonlinear curve is to measure the slope of a line that is tangent to the point where we want to know the slope. Cost 75 = = 75 Quantity 1 Cost 150 Figure 1A.8b The Slope of a = = 150 Nonlinear Curve Quantity 1 © Pearson Education Limited 54 Formula for a Percentage Change One important formula is the percentage change, which is the change in some economic variable, usually from one period to the next, expressed as a percentage. Value in the second period − Value in the first period Percentage change =  100 Value in the first period © Pearson Education Limited 55 The Area of a Rectangle The area of a rectangle is equal to its base multiplied Area of a rectangle = Base  Height by its height; total revenue is equal to quantity multiplied by price. Here, total revenue is equal to the quantity of 125,000 bottles times the price of $2.00 per bottle, or $250,000. The area of the green- shaded rectangle shows the firm’s total revenue. Figure 1A.9 Showing a Firm’s Total Revenue on a Graph © Pearson Education Limited 56 The Area of a Triangle The area of a 1 triangle is equal to Area of a triangle =  Base  Height ½ multiplied by its 2 base multiplied by its height. The area of the blue-shaded triangle has a base equal to 150,000 – 125,000, or 25,000, and a height equal to $2.00 – $1.50, or $0.50. Therefore, its area Figure 1A.10 The Area of a Triangle equals ½ × 25,000 × $0.50, or $6,250. © Pearson Education Limited 57 Summary of Using Formulas Whenever you must use a formula, you should follow these steps: 1. Make sure you understand the economic concept the formula represents. 2. Make sure you are using the correct formula for the problem you are solving. 3. Make sure the number you calculate using the formula is economically reasonable. For example, if you are using a formula to calculate a firm’s revenue and your answer is a negative number, you know you made a mistake somewhere. © Pearson Education Limited 58 Problem © Pearson Education Limited 59 Answer © Pearson Education Limited 60 Problem © Pearson Education Limited 61 Answer © Pearson Education Limited 62 Exercise © Pearson Education Limited 63 Answer © Pearson Education Limited 64 Problem © Pearson Education Limited 65 Answer © Pearson Education Limited 66