Exam 1 - Class @ Northeastern University, professor Martin Konan PDF

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Class @ Northeastern University, professor Martin Konan...

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Exam 1 - Cheat sheet (chapter 1,2,3,8,9) Chapter 1 Economic system (2 extremes) i.e. how command economy will answer the 4 above questions Command economy (central economy) Government answers questions/decide Market economy Individuals and firms decide

Opportunity cost: The value of the next best alternatives/ the value of what is given up when decision is made

Being rational (in sentence) ● Using all available informations to make decision ● Doing best one can (optimize) ● Being efficient to maximize utilities ● People response to economic incentives

Fundamental questions (4) 1. What goods/ services will be produced? 2. How will they be produced? 3. Who will receive the good/ service? 4. Now vs Future? Should society fuels the current generation or the future generation (Invest or consume more?)

Types of efficiency (2) Productive: least costly production techniques are used to produce wanted goods and services Allocative: resources are used for producing the combination of goods and services most wanted by society.

Marginal analysis

MODELS Characteristic of models 1. Model uses variables → things that are measurable 2. Make assumptions and simplifications 3. Testable

2 Types of variables

Formula: Growth rate 1. Approximation

Positive analysis vs Normative analysis 1. Positive analysis: the study of “what is?”; and/or - statements that can be tested with data 2. Normative analysis: the study of “what ought to be?” - based on value judgements, and cannot be tested with data

Scarcity: Situations in which resources are limited to satisfy unlimited wants Tradeoff: Refers to the decision to do one thing is also the decision to not do something else

●

Margin = the effect of a small change in a variables on another variables

Change of TB(total benefit) Change of A (activity ) ●

Marginal cost from activity = additional cost from an addition unit of activity

1.

2.

Endogenous variables: variables that are measured within the model [i.e. supply and demand model] Exogenous variables: variables that are measured outside the model [i.e. input prices, income and taste + preference in supply and demand model]

Change of TC (totalcost ) Change of A (activity ) Limitations of models Each model is particularly designed to answer one question

Δ∈XX XX 2.

Exact

Δ∈XX -1 XX Chapter 2 Tradeoff : producing more of one good requires producing less of another

PPF : curve showing max possible combinations of 2 goods that society can produce given its limited resources and technology, at a given point in time Shows society’s constraints in terms of production due to scarcity

Characteristics of PPF 1. Tradeoff 2. Scarcity 3. Opportunity cost (may be question that required to calculate opportunity cost)

Assumption behind the PPF: Using all resources Society producing 2 goods Producing efficiently Fixed resources (scarcity)

PPF shape PPF bowed out: OC increasing PPF straight: OC constant PPF bowed inwards: OC decreasing (nonexistent)

Opportunity cost of A and B - Moving along the curve Opportunity cost of x (axis) is __ of y (axis) - and vice versa

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Demand pull inflation (definition) Consider point H -> unattainable using current resources and technology - If society attempts to get to point H, it will start an inflationary process -> Demand inflation = inflation caused society’s attempt to consume more goods and services than it is capable of producing - Demand pull inflation example: when government prints more money but limited goods and services -> unit price will be increased

Economic growth I.e. what is the key to economic growth? investment Definition: Persistent increase in a nation’s capacity to produce goods and services 1. Process by which increases in productivity leads in increases in living standard 2. In terms of the PPF, economic growth mean expanding the PPF over time (enlargement by sizes/ area under curve)

Efficiency (on the PPF) “Maximum” = efficiency Law of substitution: getting closer to one objective requires getting away from another objective Points inside PPF inefficient Society is not using resources properly (unemployment) Society is using all resources, but not in best possible manner (underemployment) Points outside PPF not possible Points on the PPF efficient

Calculate opportunity cost of each person/ country // calculate how much 1 unit cost to the other unit What is the good terms of trade? Use opportunity cost table

Trade: Specialisation, interdependence, absolute/comparative advantage

⇒ 1 fruit can be traded for 0.5 or 0.33 timber (or) ⇒ 1 timber can be traded for 2 or 3 fruits

1.

Opportunity cost Fruit

Timber

Figistan

0.5

2

Blah

0.33

3

→ 0.33T < 1F < 0.5T (or) → 2F < 1T < 3F Why government is still important? Protect property right [the book focuses on this] When market failed (externality, public good, market power) When promoting equity

Chapter 3 - Supply and Demand

Circular flow

Sources of economic growth 1. Productivity 2. Investment Economic growths occur over time, it requires: 4. Increases in quantity of resources 5. Increases in the quality of those resources 6. Development and implement of better technologies Physical and human capital are key Limitation of PPF It does not answer all the questions Maximisation of production Amount per person x total labour force

Show how the country/ persons move beyond their ppf Show that the point outside of the curve is achieved Free market Little or no government interaction Market system = price system Adam Smith’s theory on free market

Invisible hand concept How the decisions of households and firms lead to desirable market outcomes Circular flow ● Government $$$ → government spending ● Product market → government (Goods and services) ● Resource market → government (resources)

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Perfect competition Law of demand and supply only apply to perfect competition i.e. Agriculture (closest to perfect competition) Many buyers and sellers Same products No barriers to enter or exit No effective market power Demand - Law of demand Movement along the curve Price ↑ Quantity ↓ What explains the law of demand? Causes of the demand curve to be downward Substitution effect: The change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods that are substitutes Income effect: the change in the quantity demanded of a good that result from the effect of a change in the good’s price on consumers purchasing power Diminishing marginal utility: For each additional unit of a good you consume, you will receive less and less utility i.e. alcohol Shortage A situation in which quantity demanded is greater than quantity supplied

Determinants of demand - what factors influence market demand? 1. Income of consumers Increase in income a. Normal goods: increase demand b. Inferior goods: decrease demand 2. Prices of related goods Increase in price of related good a. Substitutes: increase demand b. Complements: decrease demand 3. Tastes 4. Population and demographics 5. Expected future price a. An expected increase in the price tomorrow increases demand today. b. An expected decrease in the price tomorrow decreases demand today

Supply -

Quantity demand The amount of a good or service that a consumer is willing and able to purchase at a given price (Point on the demand curve)

Market supplied curve Based on market’s supplied habit (aggregate)

Surplus A situation in which quantity supplied > quantity demanded

Equilibrium (Supply = demand) → Q(s) = Q(d)

individual supply curve Only one firm Market supply curve all firms combined Supply curve: Qs= c+dP Determinants of supply 1. Price of inputs 2. Technological change 3. Prices of substitutes in production 4. Number of firms in the market 5. Expected future prices

The law of supply Price ↑ Quantity ↑ Individual supplied curve Based on individual’s supplied habit (of a firm)

Total expenditure → P(e) x Q(e) Elasticities Elasticity Def. Measure of responsiveness of one variable (A) to a change in another (B)

Elasticity of demand Def. Measure of responsiveness of quantity demanded to a change in one factor affecting demand

E A ,B =

Price elasticity demand Def. Measure of responsiveness of quantity demanded to a change in price along a demand

%ΔA = % ΔB

ΔA/ A Δ B/ B

Graphical representation of price elasticity of demand

Determinants of price elasticity of demand 1. Expensive vs inexpensive → elastic vs inelastic 2. Essential vs Inessential // necessities vs luxuries → inelastic vs elastic 3. Availability of substitutes Many substitutes → elastic Few substitutes → inelastic 4. Definition of market Broadly defined (general category i.e. food) → inelastic Narrowly defined (specific category i.e. steak) → elastic 5. Passage of time (time horizon) Long run → elastic Short run → inelastic Income elasticity of demand Def. measures of responsiveness of quantity demanded to a change in income along the

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curve

Highly elastic

Ed = E Q

d ,P

=

ΔQd /Q d Δ P/ P ● ●

● ●

●

%Δ Qd = % ΔP

Q A 2−Q A1 E(C) = 1 / (Q A 2+Q A1 ) 2 Q B 2−Q B1 1 (Q B2 +Q B 1) 2

● ●

Engel’s curve - Engel’s curve: the curve that shows the relationship between quantity demanded and income

Q 2−Q 1 E(I) = 1 (Q1+Q 2) / 2 Y 2−Y 1 1 (Y 1+Y 2) 2

Ed > 1 -> Elastic (quantity demanded is responsive to change) Ed = 1 -> Unit elastic (quantity demanded is just as responsive to change) Ed < 1 -> Inelastic (quantity demanded is unresponsive to change) Ed = 0 -> Perfectly Inelastic (quantity demanded is completely unresponsive to change) Ed = infinite -> Perfectly Elastic (quantity demanded respond by an infinite amount even to tiny price change

Cross Price elasticity of demand Def. measure of responsiveness of quantity demanded for good (A), to a change in the price of good (B)

●

Highly inelastic

● ● ● ● ● ●

Graphical representation of price elasticity of supply Highly elastic

Highly inelastic

E(I) > 0 => Inferior goods E(I) = 0 => Neither goods (rarely) E(I) > 0 => Normal goods 0 < E(I) < 1 => necessity E(I) > 1 => luxury goods E(I) = 1 => customers alway spend the same fraction of the income on that good

Determinants of elasticity of supply Fs = Factors affecting supplies could be: 1. 2. 3.

Price elasticity of supply (price of the good) Technology [Price elasticity of supply (inputs to produce the good)]

E(C) < 0 → goods A and B are complement E(C) > 0 → goods A and B are substitutes E(C) = 0 → goods A and B are unrelated

Elasticity of supply Def. Measures of responsiveness of quantity supplied to a change in one factor affecting supply

Price elasticity of supply ● E(s) > 1 => Supply is elastic ● E(s) < 1 => Supply is inelastic ● E(s) = 1 => Supply is unit elastic 2 extremes

Price elasticity of supply

%Δ Qs = E(S) = % ΔP

ΔQ s /Q s Δ P/ P

● ●

E(s) = 0 -> Supply is perfectly inelastic E(s) = ∞ -> Supply is perfectly elastic

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Q 2−Q 1 1 = (Q2+Q 1) 2 P 2−P 1

/

1 (P2+P 1) 2 Chapter 8 GDP Def. the market value of all final good and services produced domestically during a period

What includes in GDP? Final goods Inventory Rent Stock broking Not included → intermediates goods, imports, old goods...

Production and income 2 ways to measure economic activity 1. Total production 2. Total income

GDP x circular flow GDP measures value of output sold to individuals; but also measures income received by individuals

GDP formula: the expenditure approach GDP = C + I + G + NX 3. Consumption 4. Investment: a. Business fixed investment b. Residential investment c. Inventory investment 5. Government spendings 6. Net export

Old product Sell something that was produced last year = normal calculation - inventory investment

Shortcoming of GDP GDP is not the most accurate measure of economic well being - because it missed a number of factors because it does not take into account: Home production (DIY) - laundry Underground economy (buying and selling of goods and services that unreported, concealed from the government) - avoid taxes or illegal goods and services (black market)

GDP deflator Price index based on prices of goods and services purchased by the 4 sectors of the economy

Government expenditure vs government spendings 1. Government spendings: taxes, transfer payments, government purchases 2. Government expenditure: transfer payment, government purchases [no taxes] Nominal GDP Def. Value of GDP using current prices of that period of time. RGDP =

Σ (Q x P)

Real GDP Def. Value of GDP using constant prices, prices of a base year Increase in GDP, meaning it is an increase in production RGDP =

Σ(Q x Pb )

b = base

year

GDP per capita misses not only home products and underground economy) but also: 1. Quantity changes 2. Leisure Time 3. Pollution and otters negative effect for production 4. Crimes and other social problem 5. Fair distribution of income

GDPD =

NGDP x 100 RGDP

Inflation rate

GDP (2 nd yr )−GDP( prev yr)❑ GDP( prev yr) x 100

Other measures of production and income GNP Def. Market value of all final goods and services produced by a nation’s factors of production, no matter where they happened to be. Apart of GDP (Personal) Disposable income = DI Def. Income received by individuals after taxes have been paid // also income available for

National income = NI (capital consumption) NI = GDP - depreciation

Personal income - PI PI = NI + transfer payment - RE (retained earnings) + interest on government bonds

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consumption and personal savings DI = PI - personal income taxes = Consumption (C) + Saving (S)

Chapter 9 Price level ● Measured by a price index ● Reflects the average of prices of g/s

Price indexes 1. GDP deflator (price deflator) 2. CPI 3. PPI 4. PCE (personal consumption expenditure)

Inflation formula

GDP (2 nd yr )−GDP( prev yr)❑ GDP( prev yr) x 100

CPI (2 nd yr )−CPI ( prev yr ) CPI ( prev yr) x 100 CPI Def. price index based on purchases of good and services by typical family of 4

Uses of CPI 1. Measure inflation 2. Keep track of living cost 3. Make cost of living adjustments 4. Adjust prices over time

CPI formula

Cost of basket at (the asked yr) Cost of basket at b (base yr ) x 100 Cost of basket =

Σ

(P x Q

Limitations of CPI CPI tends to overstate cost of living and inflation, because: 1. Substitution bias 2. Quality increase bias 3. New product bias (introduction of new good) 4. Outlet bias Most of these problem associated with the CPI using a fixed basket

Substitution bias CPI ignores that consumers may substitute the purchases away from goods whose prices have increased

Quality increase bias Over time, some goods become more durable and have better quality Price increase can result from: Quality increase Pure inflation increase It’s hard to separate the pure inflation part of a price increase

New product bias CPI ignores the introduction of new goods CPI basket is updated every 10 years Outlet bias CPI does not use prices from discount store in its computation

PPI (Producer Price Index) Price index that represents the average of prices of goods and services received by producers PPI gives early warning of future movement in consumer prices Similar to CPI PPI↑→ CPI↑

PCE (Personal consumption expenditure) Price index measured by federal reserve, based on purchase of good and services by the typical consumer Similar to CPI → Uses basket of typical family

Prices indexes to adjust prices (Equivalent cost in year S in terms of year T) → Formula

Example

Nominal Value vs Real Value Nominal value → current prices Real value → constant prices

Cost in year t = cost in year S x

P( yr T ) P( yr S)

Cost of Tuition Years

Cost of Tuition

Price level

1987

$15,000

40

2017

$50,000

109

Nominal cash flow vs real cash flow Nominal cash flow → not adjusted for inflation Real cash flow → adjusted for inflation

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Cost of 1987 tuition in 2017 dollars 15,000 x

109 40

= 40,875

→ 40,875 < 50,000 => Tuition is more expensive now

Nominal interest rate vs real interest rate Nominal interest rate vs Real interest rate

Notation i→ nominal interest rate r→ real interest rate π → inflation rate

Nominal interest rate 1. 2. 3.

Real interest rate 1.

Not adjusted for inflation Observable Measures growth rate of the dollar value of an investment

2.

3.

Cost of inflation Cost of inflation depend on several factors 1. Balanced or unbalanced a. Balanced: prices are changing at the same rate 2. Indexed or not indexed a. All contrast are adjusted to the rate of inflation 3. Expected or unexpected a. Shoe leather cost of inflation: the cost and inconvenience of reducing money holdings in times of inflation b. Menu cost: cost of updating prices in catalogs and restaurant menus in terms of inflation c. Relative price distortion: With inflation, not all price changes at the same rate

Relative price distortion formula

Equation

Example r = 6% π = 2% Τ = 30%

Exact

Approximation

i = (1+r)(1+π) - 1

i≈r+π

PA PB $4 B →

→ PA =

$8 A

/

$8 ; A

$4 B

=

Adjusted for inflation Not observable, but more important Measures the growth of the purchasing power of an investment

❑

PB =

2B A

Fisher equation Links nominal (i), real (r) interest rate and inflation rate (π) 2 equations: Exact → 1 + i = (1 + r)(1 + π) Approximation → i≈r+π

Tax distortion Notations i→ before tax nominal interest rate r→ before tax real interest rate π→ inflation rate τ→ marginal tax rate -

ia τ → after tax nominal interest rate

General inconvenience Inflation changes the yardstick used to value goods and services and it complicates the long-run planning

-

r a τ → after tax real interest rate (gov taxes nominal incomes)

Tax distortion of inflation (unfair tax treatment) When inflation is higher and nominal income is higher, taxes are higher The government often taxes nominal income rather than real income

-

Exact

Approximation

-

ra τ

→ after tax real interest rate (gov. taxes real incomes) TDI→ tax distort...