PRINCIPLES OF MACROECONOMICS

CHAPTER 1: INTRODUCTION

Dr. Widad Soufi

What is economics?

Economics is the study of choices that economic agents (households, firms, governments) must make as they use scarce resources under the influence of incentives.

Large and complex subject to be understood through ten principles

TEN PRINCIPLES: Trade-off

1. Every choice that people face involves a trade-off.

Definition: Whenever we choose to get more of something or do more of some activity, we have to forgo something else.

Examples: - Consumption vs. Saving- Production vs. Research- Work vs. Education- Efficiency vs. Equity

TEN PRINCIPLES: Trade-off

Efficiency:Noone in society can be made better off without making someone else worse off.

Equity:Everyone in society receives an equal share of what the society produces

TEN PRINCIPLES: Opportunity cost

2. Every trade-off implies an opportunity cost.

Definition:The opportunity cost is whatever needs to be forgone when one gets more of something or does more of some activity.

Examples:What is the opportunity cost of a trip to NYC?What is the opportunity cost of a cup of coffee?What is the opportunity cost of studying?

TEN PRINCIPLES: Marginal analysis

3. When making choices, people think at the margin.

Definition:People evaluate the effect of an incremental increase of something or some activity before making a decision.The benefit from getting more of something or doing more of an activity is called the marginal benefit.The opportunity cost of getting more of something or doing more of an activity is the marginal cost.

Examples:- Studying vs. Playing sports- Producing cheese vs. Producing yogurt

TEN PRINCIPLES: Incentives

4. People respond to incentives.

Definition:When the marginal benefit is higher (lower) than the marginal cost of an additional unit of some item, then we have an incentive to get more (less) of the item.

Examples:- Studying vs. Playing sports- Producing cheese vs. Producing yogurt

TEN PRINCIPLES: Trade

5. Trade increases welfare.

Definition:International trade of goods and services allows countries to specialize, exchange, and buy more at lower prices. So, countries are better off from engaging in trade.

Example:Household/plumber

TEN PRINCIPLES: Markets

6. Economic activity is better organized through the decentralized decisions of many households and firms that interact in markets.

Adam Smith: « invisible hand »

How does the « invisible hand » work? - Rational interest

- Utility maximization- Profit maximization

- Conditions:- Voluntary exchange- Protection of property rights

The invisible hand produces efficiency (although not always), but it does nothing about equity.

TEN PRINCIPLES: Markets

When does the invisible hand not work?

When the government intervenes in the market (e.g. to improve equity), it prevents the price from adjusting in response to a shortage or surplus.

Examples:- Communist system where prices are set- Government policies distording the market price:

- Taxes and subsidies- Quotas- Price floor or ceiling

TEN PRINCIPLES: Market failures

7. Governments can improve market efficiency.

There are situations where resources are not allocated in the best possible way, so the invisible hand does not work and the market fails to achieve an efficient outcome.

Such situations are as follows:- imperfect information- externalities- imperfect competition- public goods- commons

In these cases the government may intervene to improve efficiency.

The government may also intervene to improve equity (see above) because the invisible hand does nothing about welfare distribution. It is only concerned with efficiency.

TEN PRINCIPLES: Productivity

8. A country’s living standard depends on its workers’ productivity.

Definition:The productivity is the amount of goods and services produced by each unit of labor.

Productivity depends on:- Education- Capital - Technology.

TEN PRINCIPLES: Inflation

9. Prices rise when the government supplies more money.

Definition:Inflation is the sustained increase in the average price level.

Inflation is often caused by a rapid money growth. Inflation is usually feared by governments as it imposes costs on society and hence reduces efficiency.

TEN PRINCIPLES: Phillips curve

10. There exists a short run trade-off between inflation and unemployment.

Definition:The Phillips curve describes the negative relationship between inflation and unemployment.

There is a large agreement among economists that this relationship only exists in the short-run.

Why?

TEN PRINCIPLES: Phillips curve

The main reason for the short-run trade-off between unemployment and inflation is the fact that in the short-run prices are sticky (prices adjust slowly to changes in government policies).

Thus, when money growth increases (so inflation rises) and prices are sticky low, people spend more, so firms sell more, so they hire more labor and unemployment falls.

In the long-run, prices are flexible, so the long-run effects of government policies are likely different from their short-run effects.

Quiz (Mankiw, P. 16)

1. What is the opportunity cost of seeing a movie

2. Why should policy makers think about incentives?

3. What does the invisible hand of the market place do?

4. Why is productivity important?

HOMEWORK (Mankiw, P. 16-17)

Solve the following problems: 3, 6, 9, 11, 15

REFERENCES

Mankiw, Gregory. Principles of Macroeconomics. Third edition.