GSIAS – North American Economy Economics 101. 2-2 Lesson Overview Microeconomics...

GSIAS – North American Economy

Economics 101

2-2

Lesson OverviewMicroeconomics

• Supply/Demand/Equilibrium Govt. Policies Effect (Drugs/Min. Wage/Taxes)

• Economic Models Perfect Competition / Monopolies

Macroeconomics

• GDP Circular Flow Model

• Economic Growth and Production

• Interest Rates and Inflation

• Open Economy Macroeconomics

Macro vs. Micro Economics

Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets. Prices and selection of products

Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once. Inflation Unemployment Economic Growth

THE MARKET FORCES OF SUPPLY AND DEMAND 4

Demand

• The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase.

• Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal


$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q

The Market Demand Curve for Lattes

PQd

(Market)

$0.00 24

1.00 21

2.00 18

3.00 15

4.00 12

5.00 9

6.00 6


Demand Curve Shifters• The demand curve shows how price affects

quantity demanded, other things being equal.

• These “other things” are non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price).

• Changes in them shift the D curve…

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30

P

Q


Summary: Variables That Influence Buyers

Variable A change in this variable…

Price …causes a movement along the D curve

# of buyers …shifts the D curve

Income …shifts the D curve

Price ofrelated goods …shifts the D curve

Tastes …shifts the D curve

Expectations …shifts the D curve

A. The price of iPods falls

B. The price of music downloads falls

C. The price of CDs falls

A C T I V E L E A R N I N G A C T I V E L E A R N I N G 11

Demand CurveDemand Curve

8

Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why?


Supply

• The quantity supplied of any good is the amount that sellers are willing and able to sell.

• Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal


$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

The Market Supply CurveP

QS (Market)

$0.00 0

1.00 5

2.00 10

3.00 15

4.00 20

5.00 25

6.00 30


Supply Curve Shifters• The supply curve shows how price affects

quantity supplied, other things being equal.

• These “other things” are non-price determinants of supply.

• Changes in them shift the S curve…

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q


Summary: Variables that Influence Sellers

Variable A change in this variable…

Price …causes a movement along the S curve

Input Prices …shifts the S curve

Technology …shifts the S curve

# of Sellers …shifts the S curve

Expectations …shifts the S curve

A C T I V E L E A R N I N G A C T I V E L E A R N I N G 22

Supply CurveSupply Curve

13

Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios?

A. Retailers cut the price of the software.

B. A technological advance allows the software to be produced at lower cost.

C. Professional tax return preparers raise the price of the services they provide.


$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

Supply and Demand Together

D S Equilibrium: P has reached the level where quantity supplied equals quantity demanded


$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

D S

Surplus (a.k.a. excess supply):when quantity supplied is greater than quantity demanded

SurplusExample: If P = $5,

then QD = 9 lattes

and QS = 25 lattes

resulting in a surplus of 16 lattes


$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

D S


Facing a surplus, sellers try to increase sales by cutting price.

This causes QD to rise

Surplus

…which reduces the surplus.

and QS to fall…


$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

D S


Facing a surplus, sellers try to increase sales by cutting price.

This causes QD to rise and QS to fall.

Surplus

Prices continue to fall until market reaches equilibrium.


STEP 1:

S curve shifts because event affects cost of production.

D curve does not shift, because production technology is not one of the factors that affect demand.

STEP 2:

S shifts rightbecause event reduces cost, makes production more profitable at any given price.

EXAMPLE 2: A Shift in Supply

P

Q

D1

S1

P1

Q1

S2

P2

Q2

EVENT: New technology reduces cost of producing hybrid cars.

STEP 3:

The shift causes price to fall and quantity to rise.


EXAMPLE 3: A Shift in Both Supply and DemandP

Q

D1

S1

P1

Q1

S2

D2

P2

Q2

EVENTS: price of gas rises AND new technology reduces production costs

STEP 1: Both curves shift.

STEP 2: Both shift to the right.

STEP 3: Q rises, but effect on P is ambiguous: If demand increases more than supply, P rises.


EXAMPLE 3: A Shift in Both Supply and Demand

STEP 3, cont.

P

Q

D1

S1

P1

Q1

S2

D2

P2

Q2

EVENTS: price of gas rises AND new technology reduces production costs

But if supply increases more than demand, P falls.

ELASTICITY AND ITS APPLICATION 21

APPLICATION: Does Drug Interdiction Increase or Decrease Drug-Related Crime?

• One side effect of illegal drug use is crime: Users often turn to crime to finance their habit.

• We examine two policies designed to reduce illegal drug use and see what effects they have on drug-related crime.

• For simplicity, we assume the total dollar value of drug-related crime equals total expenditure on drugs.

• Demand for illegal drugs is inelastic, due to addiction issues.


D1

Policy 1: Interdiction

Price of Drugs

Quantity of Drugs

S1

S2

P1

Q1

P2

Q2

Interdiction reduces the supply of drugs.

Since demand for drugs is inelastic, P rises propor-tionally more than Q falls.

Result: an increase in total spending on drugs, and in drug-related crime

new value of drug-related crime

initial value of drug-related crime


Policy 2: Education

Price of Drugs

Quantity of Drugs

D1

S

P1

Q1

D2

P2

Q2

Education reduces the demand for drugs.

P and Q fall.

Result:A decrease in total spending on drugs, and in drug-related crime.

initial value of drug-related crime

new value of drug-related crime

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 24

Min wage laws do not affect highly skilled workers.

They do affect teen workers.

Studies: A 10% increase in the min wage raises teen unemployment by 1-3%.

The Minimum Wage

W

LD

S

$4

Min. wage

$5

400 550

unemp-loyment


CASE STUDY: Who Pays the Luxury Tax?

• 1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc.

• Goal of the tax: raise revenue from those who could most easily afford to pay – wealthy consumers.

• But who really pays this tax?


CASE STUDY: Who Pays the Luxury Tax?

The market for yachts

P

Q

D

S

Tax

Buyers’ share of tax burden

Sellers’ share of tax burden

PB

PS

Demand is price-elastic. Demand is price-elastic.

In the short run, supply is inelastic. In the short run, supply is inelastic.

Hence, companies that build yachts pay most of the tax.

Hence, companies that build yachts pay most of the tax.

APPLICATION: THE COSTS OF TAXATION 27

Q2 Q1

DWL and the Size of the TaxP

Q

D

S

causes the DWL to more than double.

Doubling the tax

2T T

Initially, the tax is T per unit.

initial DWL

new DWL

APPLICATION: THE COSTS OF TAXATION 28

The Laffer curve shows the relationship between the size of the tax and tax revenue.

Revenue and the Size of the Tax

Tax size

Tax revenue

The Laffer curve

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.

THINKING LIKE AN ECONOMIST 30

The Circular-Flow Diagram

• The Circular-Flow Diagram: a visual model of the economy, shows how dollars flow through markets among households and firms

• Two types of “actors”: households firms

• Two markets: the market for goods and services the market for “factors of production”


FIGURE 1: The Circular-Flow Diagram

Households: Own the factors of production,

sell/rent them to firms for income Buy and consume goods & services

Households: Own the factors of production,

sell/rent them to firms for income Buy and consume goods & services

HouseholdsFirms

Firms: Buy/hire factors of production,

use them to produce goods and services

Sell goods & services

Firms: Buy/hire factors of production,

use them to produce goods and services

Sell goods & services


FIGURE 1: The Circular-Flow Diagram

Markets for Factors of Production

HouseholdsFirms

IncomeWages, rent, profit

Factors of production

Labor, land, capital

Spending

G & S bought

G & S sold

RevenueMarkets for

Goods & Services

THE COMPONENTS OF GDP

GDP (Y) is the sum of the following: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX)

Y = C + I + G + NX

34

Productivity

• Recall one of the Ten Principles from Chap. 1: A country’s standard of living depends on its ability to produce g&s.

• This ability depends on productivity, the average quantity of g&s produced per unit of labor input.

• Based on:-Physical Capital-Human Capital

-Natural Resources-Technical Knowledge

THE MARKET FOR LOANABLE FUNDS

• Financial markets coordinate the economy’s saving and investment in the market for loanable funds.

• The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds.

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

in the market for loanable funds, the real interest rate


• Financial markets work much like other markets in the economy.

• The equilibrium of the supply and demand for loanable funds determines the real interest rate.

Figure 2 An Increase in the Supply of Loanable Funds

Loanable Funds(in billions of dollars)

0

InterestRate

Supply, S1 S2

2. . . . whichreduces the

equilibriuminterest rat e . . .

3. . . . and raises the equilibriumquantity of loanable funds.

Demand

1. Tax incentives forsaving increase thesupply of loanable

fund s . . .

5%

$1,200

4%

$1,600

THE FEDERAL RESERVE SYSTEM

• The Federal Reserve (Fed) serves as the nation’s central bank. Three Primary Functions of the Fed

• Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices.

• 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.

The Federal Open Market Committee

• Open-Market Operations 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.

BANKS AND THE MONEY SUPPLY

• Banks can influence the quantity of demand deposits in the economy and the money supply.

Money Creation with Fractional-Reserve Banking

• 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. Deposits into a bank are recorded as both assets

and liabilities. 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.

Money Creation with Fractional-Reserve Banking

• When one bank loans money, that money is generally deposited into another bank.

• This creates more deposits and more reserves to be lent out.

• When a bank makes a loan from its reserves, the money supply increases.

THE CLASSICAL THEORY OF INFLATION

• Inflation is an increase in the overall level of prices.

• Hyperinflation is an extraordinarily high rate of inflation.

The Level of Prices and the Value of Money

• The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate.

• Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange.

• When the overall price level rises, the value of money falls.

Money Supply, Money Demand, and Monetary Equilibrium

• The money supply is a policy variable that is controlled by the federal govt.

• Through instruments such as open-market operations, the govt. directly controls the quantity of money supplied.

• Money demand has several determinants, including interest rates and the average level of prices in the economy.

Money Supply, Money Demand, and Monetary Equilibrium

• People hold money because it is the medium of exchange. The amount of money people choose to

hold depends on the prices of goods and services.

• In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

Figure 2 An Increase in the Money Supply

Quantity ofMoney

Value ofMoney, 1 /P

Price Level, P

Moneydemand

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4

M1

MS1

M2

MS2

2. . . . decreasesthe value ofmone y . . .

3. . . . andincreasesthe pricelevel.

1. An increasein the moneysupply . . .

A

B

Open-Economy Macroeconomics: Basic Concepts

• An open economy interacts with other countries in two ways. It buys and sells goods and services in

world product markets. It buys and sells capital assets in world

financial markets.

The Flow of Goods: Exports, Imports, Net Exports

• Net exports (NX) are the value of a nation’s exports minus the value of its imports.

• Net exports are also called the trade balance.


• Factors That Affect Net Exports The tastes of consumers for domestic and

foreign goods. The prices of goods at home and abroad. The exchange rates at which people can

use domestic currency to buy foreign currencies.


• Factors That Affect Net Exports The incomes of consumers at home and

abroad. The costs of transporting goods from

country to country. The policies of the government toward

international trade.

The Flow of Financial Resources: Net Capital Outflow

• Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.

• A U.S. resident buys stock in the Toyota corporation and a Mexican buys stock in the Ford Motor corporation.


• When a U.S. resident buys stock in Telmex, the Mexican phone company, the purchase raises U.S. net capital outflow.

• When a Japanese residents buys a bond issued by the U.S. government, the purchase reduces the U.S. net capital outflow.


• Variables that Influence Net Capital Outflow The real interest rates being paid on foreign

assets. The real interest rates being paid on domestic

assets. The perceived economic and political risks of

holding assets abroad. The government policies that affect foreign

ownership of domestic assets.

The Equality of Net Exports and Net Capital Outflow

• For an economy as a whole, NX and NCO must balance each other so that:

NCO = NX

• Why?When a nation is running a trade surplus (NX>0), it is selling more goods/services to foreigners than it is buying. What is it doing with the foreign currency received? Must be buying foreign assets. Capital is flowing out of the country (NCO>0).When a nation is running a trade deficit (NX<0), it is buying more goods and services from foreigners than it is selling. How is it financing the purchase? It must be selling assets abroad. Capital is flowing into the country (NCO<0).

Saving, Investment, and Their Relationship to the International Flows

• National saving (S) equals Y – C – G so:

S = I + NX

• orSaving Domestic

InvestmentNet Capital

Outflow= +

S I NCO= +

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL EXCHANGE RATES

• International transactions are influenced by international prices.

• The two most important international prices are the nominal exchange rate and the real exchange rate.

• The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another.

Nominal Exchange Rates

Real Exchange Rates

• The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another.

Figure 1 The Market for Loanable Funds

Quantity ofLoanable Funds

RealInterest

RateSupply of loanable funds

(from national saving)

Demand for loanablefunds (for domesticinvestment and net

capital outflow)

Equilibriumquantity

Equilibriumreal interest

rate

Figure 3 How Net Capital Outflow Depends on the Interest Rate

0 Net CapitalOutflow

Net capital outflowis negative.

Net capital outflowis positive.

RealInterest

Rate

The Market for Foreign-Currency Exchange

Quantity of Dollars Exchangedinto Foreign Currency

RealExchange

RateSupply of dollars

(from net capital outflow)

Demand for dollars(for net exports)

Equilibriumquantity

Equilibriumreal exchange

rate

Why does demand slope downward? Why is the Equil. Qty vertical?

The Effects of Government Budget Deficit

(a) The Market for Loanable Funds (b) Net Capital Outflow

RealInterest

Rate

RealInterest

Rate

(c) The Market for Foreign-Currency Exchange

Quantity ofDollars


Net CapitalOutflow

RealExchange

Rate

Demand

Demand

r2

NCO

SS

S S

r2

B

E1

r rA

1. A budget deficit reducesthe supply of loanable funds . . .

2. . . . which increasesthe real interestrate . . .

4. The decreasein net capitaloutflow reducesthe supply of dollarsto be exchangedinto foreigncurrency . . .

5. . . . which causes thereal exchange rate toappreciate.

3. . . . which inturn reducesnet capitaloutflow.

E2

The Effects of an Import Quota(a) The Market for Loanable Funds (b) Net Capital Outflow

RealInterest

Rate

RealInterest

Rate

(c) The Market for Foreign-Currency Exchange

Quantity ofDollars


Net CapitalOutflow

RealExchange

Rate

r r

Supply

Supply

DemandNCO

D

D

3. Net exports,however, remainthe same.

2. . . . and causes thereal exchange rate to appreciate.

E

E2

1. An importquota increasesthe demand fordollars . . .

GSIAS – North American Economy Economics 101. 2-2 Lesson Overview Microeconomics...

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