Chapter 1: What Is Economics?

Economics the study of human behaviour as a relationship between ends and scarce means which have alternative uses; Primary concern: - human behaviour Secondary concerns: business, money, profit, etc. The Economic Way of Thinking how economists conceptualize human actions 1. People pursue ends and these ends are unlimited (i.e., people are never satisfied) 2. There exists only limited resources Resources Labour physical and mental talents that people contribute to the production of products and/or services Capital produced goods that can be used as input for further production (tools, buildings, etc.) Land natural resources (land, minerals, lakes, deposits) not produced by man Entrepreneurship talent held by some for organizing resources, identifying new opportunities and developing better ways of doing things; risk-taking is very important in this resource Scarcity universal issue wherein there is high demand and low means Scarce good people want more of it than is freely available in nature Free good more is freely available in nature than people want In the face of scarcity, we have to make decisions

Opportunity Cost the highest valued opportunity sacrificed when a choice is made. For example, sleep and tuition are the opportunity cost for a 6am drawing class

Opportunity costs vary from person to person because of different values Ask: What could he/she/I have been doing with that time? Could I have sold this? (If item/service is received for no monetary cost)

When given information, assume that the individual giving the information is only giving you the data that will lead you to the conclusion that he/she wants you to have. Always think for yourself. The opportunity cost that doctors incur for going to medical school is the rational justification for the incredibly high prices that doctors often charge. This is useful for example because understanding opportunity cost would tell us that the Patients Bill of Rights would hurt more people because instead of having affordable insurance that covered some things, they would not be able to afford the premium the insurance company asks for the plan with the newly required services. Whenever the government creates a right for anybody, there will always be a cost.

Minimum wage actually hurts some people because some employers would only be willing to hire certain people if they can pay them less Travel (by frugal bus vs by expensive high-speed plane) can have an opportunity cost that is opposite from its direct monetary cost. For example, for some professionals, taking the bus is actually more expensive because it costs more to miss more days at work. Opportunity cost and other personal values (i.e. enjoying taking a long bus ride through the countryside) are separate Opportunity cost of travel = ticket price + cost of opportunity missed

Positive Economic Analysis the scientific study of what is, among economic relationships; deals with the questions What is the world like?; If we enact a certain policy, what would be the result What can we predictably expect to happen whether we like it or not?; does not answer the question What would we like to happen? The key to positive analysis is consequences. Positive statement a statement which is potentially verifiable or refutable ( i.e. if we can get the right data, we will be able to show that the statement is true). Not necessarily a true statement. A positive statement does not include value judgement

Value judgement a judgement attributing a moral value to something

Normative economic Analysis sees to answer the question What ought to be the case? Is a policy good or bad? Broader. To do a normative analysis, you must first do a positive analysis We will focus on positive economic analysis in this class We will learn that to properly evaluate any situation, we must not only look at the intentions, we should also focus on the probable consequences (positive analysis).

Chapter 2 The Production Possibilities Frontiers (PPF) The PPF a graph of points that shows us the outcome combinations that can be produced given the available resources and technology. Each point on the curve is attainable. All points to the right of the line are unattainable; all points to the left represent positions where the economy is inefficient The difference between guns and butter - Takes everything that is produced in the economy and put them into two classes : civilian production and military production One output combination is 50, 0 Which is to produce 50 guns (maximum resources devoted to military), no butter Finding the optimal point on the PPF is very difficult, involves many factors

Two rules for reaching the frontier 1. The country must have full employment of labour resources (not 0% but as low as possible 2. The country must have efficient employment of resources (a mechanism must be in use that ensures that the majority of the work force is employed in useful areas) When considering the amount of guns, we must consider first the total cost, then the marginal cost Before we do this, we must consider the currency that we will use in defining the cost. Remember that the opportunity cost is the total cost here. It is the amount of butter we are giving up to produce a certain amount of guns. Opportunity cost/ Total Cost = unit of guns (Point B - Point A) compared to loss of units of butter (Point B Point A)

Marginal Cost = Additional Cost = how much butter is lost when we chose to produce additional units of butter? If you add all marginal costs for a section together you will get the total cost of the section The frontier (and thus living standards) is increased through 1. increased resources (including capital) and our technological advances. 2. Also affected by the institutional rules under which companies and employees must operate (includes legal system, which defines who own property and what the owner of a property can do with it; the rights you have to what youve earned, tec). 3. Free trade laws laws that make it easy for people to trade with individuals in other countries 4. Human capital the stock of knowledge and education that workers have; increased through on-the-job training, educational system 5. Tax rates represents a disincentive 6. Stability of political system can people expect to have the same rules in a few years 7. The willingness of the average person to make sacrifices at the present that will benefit them in future a. Time horizon how far into the future people look when making decisions b. The PPF can also be plotted using current consumption goods and new capital goods (goods that will benefit the country in the future) as the x and y axis. This will affect the current and future standards of living c. Things that increase future capital: current sacrifices, legal systems that protect property rights; lower marginal taxes Three Basic Questions 1. What to produce? a. What point on the frontier do we chose? A true economic PPF would be a figure on a graphical plane that would have thousands of dimensions. b. Question is difficult to answer because there are so many possibilities and so many conflicting perspectives 2. How to produce? 3. Who will we produce for? 4. Who will decide on questions 1-3 for the country?

Thomas Sowell Knowledge and Decisions 1. Grew up in Harlem 2. Was a Marxist at one point 3. Went to U of Chicago

4. Studied under Milton Friedman 5. By the time that he left, he was no longer a socialist 6. According to him An economic system is a system for the production and distribution of goods and services. But what is crucial for understanding the way it function is that it is a system for rationing goods and services that are inadequate to supply all that people want. All economic systems have systematic procedures for preventing people from getting goods and service; denying them access to resources. All economics must use some method of denial. While economic systems can be quite complex, the economic system is quite simple: there just is not enough to go around. Like many simple and important realities, it often gets lost sight of in the midst of complicated reasoning or emotionally powerful rhetoric. 7. Which is to say that an economic system is a rationing scheme that must deny most things to most people Socialism collective decision-making; government decides all three questions; also known as demand economy, planned economy (a misnomer because it infers that other systems are unplanned; in socialism, the plans of the individual are superseded by the plans of the government) Functional Definition of Socialist Economic System 1. Socialism has a system of economic organization where income producing assets are owned and controlled by the state; the government decides how the resources will be used 2. Resource allocation is done through centralized planning; the government makes plans for the entire states production 3. **Government plans are carried out by the use of force

Capitalism prices and markets coordinate the activities and decisions of people and businesses; AKA a laissez faire economy 1. Private ownership of productive resources 2. ***Allocation of goods based on the signals provided by market prices In a market economy, how resources are allocated, what is produced and who gets them are all based on prices (See Ch3) 3. Voluntary exchange of free markets; people are never forced to inter into a decision a. Government acts as rule maker and referee, a neutral party that enforces that rules of the game, but does not instruct players on how to play except for the provision of a framework in which people are free use their resources Functional Definition of Market Economy Companies decide how much to produce based on personal maximum profit, not the good of the entire economy

No one decides collectively the total quantity that should be produced in each industry

Consumer surplus is the difference between the maximum price a consumer is willing to pay and the actual price they do pay.

Chapter 3 : Supply, Demand & The Market Process A look at what happens in an economy like the US, where private individuals get to make their own decisions The Price Mechanism a way of coordinating decisions in an economy that would be done by the government in socialistic states The first good explanation of how the market economy works was provided by a Scottish economists in 1776: Adam Smith, who published An Inquiry into the Nature and Causes of The Wealth of Nations Argued against the prevalent views of the day: mercantilism, which held the view that wealth was gold and that a country could become richer by increasing their supply of gold Believed that true wealth could be measured by the ability of a country to produce what people wanted Mercantilist believed that the economy is like a ship that cant steer itself and could only be improved through the governments help. Smith believed that in order to improve economy, government would have to allow people to engage in unregulated free trade Smith believed that when people are allowed to make profit for themselves, they will unintentionally do what is best for society overall. He believed not in capitalists, but in capitalism This improvement for society in general would be caused by prices A high price tells consumers that other people value a product and that the product should not be purchased unless the consumer values it Tells producers that some consumers value the product significantly and that production should be increased When producers do not give consumers what they want (contribute to the good of society) they are punished through decreased profit

Demand tells us everything we need to know about consumers, but tells us nothing about producers

Supply tells us everything we need to know about producers, but nothing about consumers Demand schedule a schedule showing the quantity of a good that consumers would be willing and able to purchase over time, all things being equal When the price falls, the quantity demanded goes up, ceratis parabis The demand curve is always negative It shows us how consumers change their behaviour when the variable of price changes (CP) If anything changes other than the price, then the curve shifts to the right or to the left

Demand the demand schedule or curve; a relationship between the price of a good and the quantity demanded of that good Quantity Demanded the amount of the good that consumers will want to buy at a particular price

Substitutes Two goods are substitutes for one another if they meet the same need. When the price for a substitute changes the demand for the original item also changes An increase in the price for O increases the demand for S A decreases in the price for O decreases the demand for S An increase in the price for S increases the demand for O A decrease in the price for S decreases the demand for O

Compliments Two things that are often used together An decrease in the price of a compliment will increase the demand of the original item

Income

Increases the demand for normal goods (ex. Houses) so that a larger quantity will be associated with the same price Inferior goods a good with an inverse relationship with income (i.e. income goes up, demand for inferior goods go down); goods of relatively low quality Expected future income Future income increases the demand for normal goods

Chapter 6 Three Main Goals for the Macro Economy 1. Economic Growth Measured by GDP GDP measures how much is produced On average, grows 3-3.5% per year How long will it take to double use the Rule of 72 Take the number 72 and divide by the growth rate to get an approximate amount 2. Full Employment To be on the PPF 3. Price Level Stability low inflation aim in US is currently 1.5% 2%

Unemployment rate the number of unemployed workers divided by the labour force Labour force employed and unemployed workers (registered) Unemployed at least 16 yrs old Not institutionalized Without work and actively looking for work Calculated by Bureau of Labour Statistics BLS Is calculated monthly based on telephone surveys Inaccurate because it does not count discouraged workers There are 6 different monthly unemployment rates published by the BLS

Official rate mentioned above U3 U2 Job losers and people who have completed temporary jobs U6 marginally attached workers (not working, not looking, but available for work and have looked for work within the past 12 months), u3, part-time (by necessity of the economy)

Types of Unemployment 3 types Frictional unemployment Structural unemployment Cyclical Unemployment

Frictional unemployment Different from def in book: temporary unemployment arising from imperfect labour market information. Individuals have marketable skills but are unable to find a suitable employer; voluntary in a sense

Structural unemployment Unemployment due to structural changes in the economy which eliminates some jobs but also creates some new job opening for which the newly unemployed are ill suited; key difference from frictional is that this type of unemployment is more long-term Two things that can lead to structural unemployment o Long-lasting changes in demand o Introduction of new methods of production

Cyclical Unemployment Unemployment due to recessionary conditions and a lack of general demand for labour o Ex, decrease in demand for construction workers o Temporary; only occurs because of recession; consumers are willing but not able to purchase services

The goal is really to have low cyclical unemployment which has to do with recessions. The other two are unavoidable Natural rate of unemployment the lowest sustainable unemployment rate; not the lowest possible; is equivalent to the summation of the frictional rate of unemployment and the structural rate of unemployment;

Being at the natural rate of unemployment (actual rate = natural rate; cyclical unemployment must be 0) is equivalent to being at full employment; means that we are on the production possibilities frontier Going below the natural rate of unemployment causes increased rates of inflation and can only be temporary Factors that Alter the Natural Rate of Unemployment 1. Unemployment insurance system increased benefits leads to increased unemployment 2. Minimum wage increased minimum wage increases unemployment because of worth 3. Demographic composition of the labour force different demographic groups are employed in different areas

Price Level Stability Price level the weighted average of the prices of all goods and services; what is happening to prices in general To measure price level we measure prices on an index, which shows how the average price of a collection of goods changes through time Government must decide: What goods and services to include What year to use as the base (reference/benchmark/comparison) year/ What year to compare all other with

Price Index value for any given year is always a ratio:

Cost of total goods in given year prices (quantity x price for each good in the basket for year z)

____________________________________________________ x 100 Cost of goods in base year prices (quantity x price for each good in the basket for base year )

For any price index, the value of the index in the base year will always be 100

To find the result of percentage change, compare to previous year To find percentage change subtract (given year index - base index) then divide = (difference between given index and base index/ base index) then subtract 100 You cannot assume that any single price can be representative of prices for all goods that year. Therefore, the price index should always be used

Types of Price Indexes CPI Consumer Price Index Attempts to measure changes in the cost of living for the typical American family a fixed weighted index; includes about 300 goods and services Government must consider who is the typical family and what the most commonly purchased goods and services are Problems: Cost of all goods dont change at the same rate and time, so the CBI is inaccurate for people who dont buy typical goods The CBI is a fixed rate index, meaning that the quantities are fixed and that the CBI does not include the law of demand and thus overstates increases in cost of living. If the price of a substitute increases and less expensive alternative is available, the increase will not change your total spending

Chain-Weighted Index chain-weighting - a statistical technique used to adjust for the law of demand - no substitution bias, better measure of inflation GDP Deflator - A chain weighted index that is broader than the CPI; includes over 3200 goods and services, focuses on what the economy produces not what the average person/family consumes PCE Index (PCE = Personal Consumption Expenditures) - Chain-weighted; According to the federal reserve, it is the best index for measuring inflation

Inflation rate the change in the price index that has occurred over time IZ - I Base/previous yr I Base/previous yr
or

Nominal interest - Real Interest What Can We Do With A Price Index?

You can accurately compare price indexes for different years. If you dont use the price indexes and adjust for inflation, your assessments will be wrong - To compare two salaries in two different years, the salary in one year must be converted so that it uses the price index of the other year o Amount in year A (original) x CPI in year B (comparison/goal) CPI in year A (original)

Money illusion the belief that having more income is equivalent to having more purchasing power caused by an oversimplified way of thinking

Effects of Inflation Average inflation since 92, inflation has been an average of 2.6% The Great Inflation: 1965-1980 high and increasing inflation 1. Unanticipated inflation redistributes wealth (affects the rich most) 2. Prices go up but pp goes down 3. Loans are easier to pay back because the money that is paid back has lower purchasing power o When lenders begin to anticipate an increase in inflation, there will also be an increase in nominal interest rat o Nominal interest rate tells you how many dollars of interest you will have to repay on the loan Equation: Nominal interest rate = real interest rate + expected inflation rate o Real interest rate the inflation adjusted interest rate; interest rate stated in terms of the purchasing power Equation: Real interest rate = nominal interest rate- rate of inflation 4. Makes entering into long-term contracts very risky rates may actually go up or down 5. Real resources are wasted as people use time and money to attempt to protect themselves o Menu cost in restaurant business you would have to use time and money to print out new menus to adjust prices o For individuals, they would not want to hold on to liquid assets (money) because the money can easily and quickly lose value, so time is spent on avoiding this 6. Distorts the tax codes Regan admin indexed the tax code to inflation 7. Causes a misallocation of resources because inflation disrupts the ability of prices to communicate value o Increase in prices may be due to relative price increase or a change in the price level; the consumer will not know if he/she should decrease her spending on the good without looking at other goods

Chapter 7 GDP GDP The total market value of all final goods and services produced annually within a countys borders ;calculated using market values Not included: Sale of used goods Purely financial transactions (buying or selling financial assets, etc) Government transfer payments/Income transfers a payment that is not made in exchange for a good or service that is currently supplied (social security checks, unemployment checks, Leisure

How GDP Is Calculated

Expenditures Approach if you look at all of the goods and services per year how much spending would it take to purchase all of the output produced this year; considers the economy in 4 sectors and tries to figure out how much money is spent on each of the following and adding them together: household (consumption C) - about 2/3rds or 67% of GDP business sector (investment I) 10% government purchases (G) 20% Foreign Exchange (Net exports: NX = exports imports) GDP = C+ I+ G+NX

Income approach gives us the same amount as the expenditures approach, the only differences exist because of measurement errors. Attempts to answer: As all of this output was being produced and sold, how much income was generated in this year? _________________________________________________ Expenditures Approach Consumption durable goods Non-durable goods Services

Business/Investment spending (I) investment in goods and services that are future oriented; Investment = Fixed Investment + Inventory Investment Net Investment Fixed investment 1. Includes spending to purchase newly produced capital goods 2. Spending to purchase newly produced residential housing Inventory investment 3. Any change in business inventories; included in GDP; when inventory is sold it does not show up in GDP for that year; can either be negative or positive; 10% of GDP; ALWAYS refers to physical goods (financial transactions are separate) Net Investment = Gross investment depreciation o Depreciation/capital consumption allowance how much capital wears out Government Spending 20% of economy

Net Exports = Exports Imports When net exports is negative it is called having a foreign trade deficit

GDP (C + I + G + NX) can be greater than 100% if there is a foreign trade deficit (there usually is)

Income Approach [my: NI = EmProRent + ProfInt]

Dispersement of Total Income for National Income 2001 Wages, etc 73% 9% Copyrights, Patents, 2% Property Rentals, Property Ownership Investors 9% Income Received Income 7% Paid Out

Compensation of Employees Proprietors Income Rental Income

Corporate Profits Net Interest

National Income is not equivalent to GDP National income must be adjusted because of business taxes and losses

Indirect business taxes are added to GDP in addition to depreciation, which is given in most questions The income of US workers gaining income in other countries is counted in national income but is not counted in GDP GDP = National Income + IBT (Indirect business tax) + Depreciation + Capital Consumption Allowance + Statistical Discrepancy + Income Earned By the Rest of the World Income Earned From the Rest of the World

GNP Gross National Product the previous measure of economic growth/status; GNP focuses on citizenship (as opposed to the location focus of GDP) _______________________________________________________________ Nominal GDP - a measure of the value of what was produce if we measure value using current year prices; distorted by inflation Real GDP inflation-adjusted GDP the value of what was produced during the year if we measure value in terms of base year prices Real GDP = Nominal GDP given yr x (Deflator base yr/Deflator given yr) Or Real GDP = Nominal GDP given yr x (100 /Deflator given yr)

GDP Limitations Includes only those things that are produced in markets. Thus, work done for yourself is excluded Does not include wellbeing (ex, increased leisure time) Does not include improved product quality Underground economy is not included (illegal goods and services or goods and services that are not reported to the government); estimated to be between 5-15% of size of visible economy Does not include economic bads which are things that are produced that we dont value or that make us worse off (i.e., pollution Does not take into account destructive acts of nature

1. Destructive events may actually cause GDP to increase The Business Cycle the short run fluctuations we see in the economy as measured by GDP. Depicted, GDP is represented by a linear graph with an intersecting curved line. The straight line represents the long-term trend. Curved line represents real-time fluctuations The Peak a temporary high in GDP The Trough output is at its lowest and will subsequently improve Recession when there are two consecutive quarterly declines in real GDP; the most discussed term mentioned here. Officially defined and determined by NBER (National Bureau of Economic Research private, highly respected group that studies the business cycle). NBER defines recession as a significant decline in economic activity spread across the economy lasting more than a few months, normally visible in and other indicators. Begins when economy is at its peak in activity and ends when the economy has reached its trough 11 recessions since WWII Average recession b4 the current lasted for 10 months Current recession began in Dec 2007; NBER announced in Dec 2008

Expansion from trough to the next peak

Look at Circular Flow Diagram in Chapter 6!!

Chapter 7 Aggregate Supply and Aggregate Demand Very similar to Chapter 3 but looks at economy as a whole (macroeconomy) In Graph: Y axis P instead of representing price of particular good, measures price level X axis Q - instead of representing quantity of particular good, measures national output Real GDP Negative slope is called aggregate demand curve Aggregate demand how much output demanders will want to purchase at various demand prices Equilibrium of demand/output = Total Expenditure = Total output purchased = C+I+G+NX

Negative slope is not directly caused by the law of demand because it shows that everything has become cheaper, not just one good relative to another/others. Three reasons that the slope is negative 1. The real balance effect 2. The interest rate effect 3. The International trade effect See Exhibit 2 Ch7 Price level goes down, purchasing power goes up 1. The Real Balance Effect When price level goes down, the pp of peoples money goes up, pp of their wealth goes up, the ppl spend more, if consumer sector is expending more, total expenditure and total GDP will go up 2. The Interest Effect I Investment spending; i interest rates | Increase in price level will push interest rates up because banks will realize that more people are interested in their $/ need their $. Some consumers will (because of higher prices and interest rates) will cut back on spending on pricier items>>> consumption, investment spending will go down>>>Real GDP goes down. 3. The International Trade Effect Lower local prices will increase exports and decrease imports>>> Net exports increases Only a change in price level can move us along the aggregate demand curve

Shift Factors A change in aggregate demand shifts the curve to the right or left and indicates that people want to buy more than they wanted to before at any price Anything that causes C, I, G, or NX spending to increase will shift the curve to the right One things that will NOT cause the curve to shift is the price level, which simply causes a movement along the curve 1. Wealth 2. Expected future prices (higher expected future prices will increase current expenditures) 3. Expected future Income (higher expected future income will increase current expenditures) 4. Interest rates (decreased interest rates will increase current expenditures) 5. Income taxes (increase in income tax will decrease disposable income and decrease current expenditures)

I Capital budgeting the process of determining which investment project should be chosen When business are optimistic about the future, investment spending drops, aggregate demand decreases NX Foreign real national income consumption in that country/those countries will increase and local net exports will increase, increasing total real GDP Appreciation of the US dollar relative to other currencies will cause a decrease in net exports, causing the aggregate demand curve to shift to the left The money supply theories: Direct transmission mechanism if people have more money, they will spend more money; not controversial, but there is controversy over whether or not this is the primary mechanism Indirect transmission mechanism an increase in money supply will cause interest rates to go down, which is what will increase spending and aggregate demand; controversial

Fed Funds Rate rate of interest that the fed has control overall

Aggregate Supply Curve tells us how much producers will want to sell at given prices