ECONOMICSFirst EditionCopyright © June 2015 by the Universidad San Ignacio de Loyola, Fondo Editorial

Publisher:Fondo Editorial Universidad San Ignacio de LoyolaAddress: Av. La Fontana 550, La MolinaTelephone: (511) 317-1000, extension 3705

Authors: Kurt Burneo.J Fernando Larios M.Germán Zárate-Hoyos.

ISBN: 978-612-4119-63-7Legal dues deposited at the Biblioteca Nacional del Peru Nº 2015-07117

English Editor: Dr. Mathew Allen mallen@usil.edu.pe

Production Coordinator: María Olivera Canomoliverac@usil.edu.peUniversity Press - Center for Research

Style Editor: Rafael Felices Taboada

Layout and Covert Art: Lisseth Urrutia Heredia

Printer:CECOSAMI Calle Rene Descartes 146 Urb Sta RaquelAte Vitarte, Lima 3 - Perú

Copies printed in Peru

TABLE OF CONTENTS

Prologue............................................................................................................................................11 Acknowledgements...........................................................................................................................13 Acronyms..........................................................................................................................................15 Introduction......................................................................................................................................17

PART I: MICROECONOMIC ISSUES

CHAPTER I: ECONOMICS FUNDAMENTALS. CONCEPTS AND PRINCIPLES

What is economics?.....................................................................................................................21

The production possibility frontier (PPF)......................................................................................22

The principles of economics.........................................................................................................23

Circular flow of income.................................................................................................................24

Exercises......................................................................................................................................26

Real economic cases

- Case 1: Peru.........................................................................................................................29

- Case 2: Ecuador....................................................................................................................31

Activities to develop (Chapter I)...................................................................................................33

CHAPTER II: DEMAND AND SUPPLY

Markets and Prices: Demand and Supply.....................................................................................35

Market Equilibrium.........................................................................................................................41

Exercises.......................................................................................................................................45

Real economic cases

- Case 1: Venezuela.................................................................................................................48

- Case 2: Peru.........................................................................................................................50

- Case 3: Ecuador....................................................................................................................52

Activities to develop (Chapter II)...................................................................................................57

CHAPTER III: ELASTICITY, EFFICIENCY AND EQUITY IN A COMPETITIVE MARKET

Elasticity of demand and supply....................................................................................................59

Exercises on elasticity...................................................................................................................62

Exercises with answers..................................................................................................................66

Efficiency and equity:

- Consumer surplus and producer surplus...............................................................................71

- Market Efficiency....................................................................................................................74

Efficiency and equity Exercises.....................................................................................................75

Proposed efficiency and equity exercises.....................................................................................75

Real economic cases

- Case 1: Brazil.........................................................................................................................76

- Case 2: Peru.........................................................................................................................78

- Case 3: Peru.........................................................................................................................80

Activities to develop (Chapter III)..................................................................................................83

CHAPTER IV: CONSUMER THEORY. CONSUMPTION OPTIMIZATION

Budget Constraint............................................................................................................................85

Utility.............................................................................................................................................87

Indifference curves........................................................................................................................88

The optimal choice of consumption..............................................................................................90

Exercises........................................................................................................................................91

Proposed Exercises.......................................................................................................................93

Real economic cases.....................................................................................................................94

- Case 1: Peru.........................................................................................................................94

- Case 2: Colombia.................................................................................................................96

Activities to develop (Chapter IV)..................................................................................................99

CHAPTER V: THEORY OF THE FIRM. PRODUCTION ORGANIZATION

The firm and its economic problem.............................................................................................101

Firm constraints...........................................................................................................................102

The market and the competitive environment.............................................................................102

Exercises with answers...............................................................................................................103

Proposed Exercises.....................................................................................................................106

Real economic cases

- Case 1: Colombia...............................................................................................................108

- Case 2: Peru.......................................................................................................................111

Activities to develop (Chapter V).................................................................................................113

CHAPTER VI: PRODUCTION, COSTS AND FIRM DECISIONS

The production function..............................................................................................................115

Factors of production...................................................................................................................115

Total product, marginal product and average product of labor...................................................116

Cost curves.................................................................................................................................118

Long-Run Average Cost Curve (LRAC).......................................................................................121

Exercises with answers...............................................................................................................122

Proposed Exercises.....................................................................................................................123

Real economic cases

- Case 1: Colombia................................................................................................................125

- Case 2: Peru.......................................................................................................................127

Activities to develop (Chapter VI).................................................................................................129

CHAPTER VII: PERFECT AND IMPERFECT COMPETITION MARKETS

What is perfect competition?.......................................................................................................131

Maximization of profits.................................................................................................................132

Short and long-run decisions.......................................................................................................132

Profits and losses in the short-run: breakeven point and shutdown point.................................135

Equilibrium in the short-run.........................................................................................................138

Imperfect competition..................................................................................................................141

Monopoly.....................................................................................................................................142

Monopolistic Competition and Oligopoly.....................................................................................143

Traditional models of oligopoly.....................................................................................................145

Exercises......................................................................................................................................150

Proposed exercises......................................................................................................................153

Real economic cases

- Case 1: Argentina................................................................................................................155

Activities to develop (Chapter VII)...............................................................................................159

CHAPTER VIII: INTERNATIONAL TRADE

Comparative (and Absolute) Advantage and International Trade................................................161

The Ricardian model of international trade..................................................................................161

Profits from international trade....................................................................................................162

Consumer and producer surplus.................................................................................................162

International trade restrictions.....................................................................................................164

Exercises.....................................................................................................................................166

Real economic cases

- Case 1: Latin America.........................................................................................................170

- Case 2: Peru.......................................................................................................................174

Activities to develop (Chapter VIII)...............................................................................................177

PART II: MACROECONOMIC ISSUES

CHAPTER IX: MAIN MACROECONOMIC AGGREGATES

Perspective and macroeconomic aspects..................................................................................181Basic Concepts: Gross Domestic Product (GDP), employment, unemployment, inflation, price Level............................................................................................................................................182

Instruments of macroeconomic policy........................................................................................184

Exercises.....................................................................................................................................186

Real economic cases

- Case 1: Peru......................................................................................................................190

- Case 2: Peru-Panama........................................................................................................191

Activities to develop (Chapter IX)...............................................................................................193

CHAPTER X: THE FULL-EMPLOYMENT ECONOMY, LABOUR MARKET AND POTENTIAL GDP

The Classical model...................................................................................................................195

The labor market and potential GDP..........................................................................................196

Labor Market Equilibrium: Unemployment and full employment...............................................200

Minimum wage Family Basket................................................................................................... 201

Exercises.....................................................................................................................................201

Real economic cases

- Case 1: Brazil.....................................................................................................................203

- Case 2: USA.......................................................................................................................204

Activities to develop (Chapter X).................................................................................................207

CHAPTER XI: MONEY, INFLATION AND THE PRICE LEVEL

Money: Types and functions of money........................................................................................209

The money market: Demand and supply of money.....................................................................210

Money market equilibrium...........................................................................................................212

Money Creation and the Money Multiplier...................................................................................212

Money multiplier...........................................................................................................................212

Central Banks..............................................................................................................................213

Monetary Policy and Schools of Economic Thought..................................................................214

Exercises......................................................................................................................................217

Real economic cases

- Case 1: Chile.......................................................................................................................221

- Case 2: Peru.......................................................................................................................223

Activities to develop (Chapter XI)................................................................................................225

CHAPTER XII: AGGREGATE SUPPLY AND DEMAND AND THE MULTIPLIER

Aggregate supply/Aggregate Demand model.............................................................................227

Movement along the AD and AS curves......................................................................................228

Macroeconomic equilibrium: Short and long run........................................................................232

The Keynesian Cross...................................................................................................................234

The Keynesian Multiplier..............................................................................................................237

Exercises.....................................................................................................................................238

Real economic cases

- Case 1: Peru.......................................................................................................................240

- Case 2: Argentina................................................................................................................242

- Case 3: Peru.......................................................................................................................245

Activities to develop (Chapter XII)...............................................................................................247

CHAPTER XIII: FISCAL AND MONETARY POLICY

Fiscal policy.................................................................................................................................249

Objectives and economic environment of fiscal policy...............................................................250

Stabilizing the business cycle: Expansionary and contractionary policies.................................252

Discretionary fiscal policy and automatic stabilizers...................................................................254

Monetary policy...........................................................................................................................255

Objectives and economic environment of monetary policy........................................................255

Decision-making strategies of the Central Bank........................................................................256

Exercises.....................................................................................................................................261

Real economic cases

- Case 1: Peru.......................................................................................................................267

- Case 2: Latin America.........................................................................................................269

Activities to develop (Chapter XIII)..............................................................................................271

CHAPTER XIV: MACROECONOMICS OF OPEN ECONOMIES

Open economy macroeconomics...................................................................................................273 International trade...........................................................................................................................274 Balance of payments......................................................................................................................275 Open economy with flexible exchange rates..................................................................................277 The forex market.............................................................................................................................277 Purchasing power parity: Law of one price....................................................................................278 Effects of exchange rates on the economy....................................................................................279Equilibrium total output (income) in an open economy..................................................................279 The total planned spending and the international sector...............................................................280 Determining the level of imports.....................................................................................................281

Equilibrium solution.........................................................................................................................281 Open economy multiplier................................................................................................................281 Real economic cases

- Case 1: Peru.......................................................................................................................283

- Case 2: Latin America.........................................................................................................285

Activities to develop (Chapter XIV)................................................................................................287

Part III: NEW CONCEPTS ABOUT THE ECONOMY - THE ECONOMY IN THE DIGITAL AGE

CHAPTER XV: THE ECONOMICS OF INFORMATION AND COMMUNICATIONS; AND THE GLOBAL ECONOMY

Introduction.....................................................................................................................................291 The knowledge economy................................................................................................................291 Development of the new economy.................................................................................................292 Generation of information in the knowledge economy...................................................................292 Characterization of the Knowledge Economy.................................................................................292 Impact of technology on the economy...........................................................................................292 Policies focused on innovation.......................................................................................................293 Real business cases

- Case 1: Peru................................................................................................................................294

- Case 2: World-International.........................................................................................................296

- Case 3: Peru................................................................................................................................297

CHAPTER XVI: BIODIVERSITY AND ECONOMICS The ecological system of the Earth................................................................................................300 The relationship between economic and ecological systems........................................................301 Economy of services from ecosystems..........................................................................................302Externalities: Total economic value of services from ecosystems.................................................303Comparison between pollution and production.............................................................................305 Real business cases - Case 1: Peru................................................................................................................................309 - Case 2: Colombia.........................................................................................................................311 - Case 3: Peru................................................................................................................................313

CHAPTER XVII: GROWTH AND DEVELOPMENT: CONVERGENT CONCEPTS?

Economic Development.................................................................................................................315 Comparison of the levels of global economic growth....................................................................316 Development...................................................................................................................................318 Development policies......................................................................................................................321 Real business cases - Case 1: Bolivia..............................................................................................................................324 - Case 2: Peru................................................................................................................................326

CHAPTER XVIII: NEW TECHNOLOGICAL DEVELOPMENT AND CHALLENGES FOR THE ECONOMY

New technological development and challenges for the economy................................................328

The revolution of 3D printers..........................................................................................................328

Economic rationality and the map of brain activity.........................................................................329

Drones and the future of logistics...................................................................................................330

Social networking and object relations...........................................................................................330

Despite technological leaps, there is a further way to go..............................................................330

APPENDIX 1: SPECIAL TOPICS ON PERU................................................................................ 332 Insufficient labor productivity in Peru.............................................................................................332 Social capital, sustainable development, biodiversity and genetics..............................................339 APPENDIX 2: ELEMENTARY MATHEMATICS FOR UNDERSTANDING ECONOMICS............341

BIBLIOGRAPHY............................................................................................................................356

ABOUT THE AUTHORS................................................................................................................357

ABOUT THE ENGLISH EDITOR...................................................................................................359

11

PROLOGUEDaily media keeps us informed about news and events from businesses and economy, both national and worldwide. This is useful for decision-making, for taking advantage of opportunities that we face and for evaluating their risks. Undoubtedly, economic issues are present in our everyday conversations but also mean concern and anxiety. Topics such as inflation, unemployment, economic growth, wages, income inequality, taxation, trade balance, and credit, among others, have an effect on us, so we had better anticipate and act efficiently on our consumption, savings or investment decisions, for example.

Lack of knowledge of economic principles can damage families’ well-being and slow down the progress of businesses and the economy as a whole. Here is where the powerful tools of economic analysis come into action to process and interpret this complex flow of information, opinions and projections, and facilitating individual and government actions.

This textbook, written by my colleagues and friends Kurt Burneo and Fernando Larios, importantly contributes to connecting those tools to the world of economic information exposed to us, helping us explain the complex issues of the economy. Thus, in this volume, any student will find real cases from the Peruvian and Latin America economies to which he or she can apply all the analytical tools developed in the fields of microeconomics and macroeconomics. He or she will also find analytical assessments from the economic perspective of factors such as Information and Communication Technologies (ICTs), environment, development as a prioritized objective, plus a section devoted to special topics on Peru, including its insufficient labor productivity, and a useful annex of elementary mathematics to better understand economics.

Economic analysis starts from specific problems such as those people face with their consumption or savings decisions to even more general ones like those linked to fiscal and monetary policies. These problems being so close and important to people, this field of knowledge, and its discussions around it, is exciting and rewarding when it is possible to make decisions or recommendations under solid grounds, that result in successful cases for the economy of households, firms or the nation as a whole.

Effective management of techniques for economic analysis starts by defining variables and by knowing how to measure them, so that we are able to find out whether the economy goes through a bonanza in economic growth or through inflation, just to mention two examples. But analysis must go further to explain why a situation has reached a certain point, with information obtained to make projections of what may happen in a month or a year, and to provide families, businesses and governments with advice on how to avoid risks or to seize opportunities. Also, by knowing these likely future scenarios, it is possible to make adjustments in decisions made either at individual level or at economic policy levels.

Over the last 25 years, the Peruvian economy has been able to reverse the deep economic crisis that originated in the late 70s and which deepened dramatically in the decade of the 80s. The lesson learned from this episode has been that knowing and applying the principles of economics is vital for effective decision making and government policy which favor future generations. For this reason, the initiative of Kurt Burneo and Fernando Larios to prepare this text, Principles of Economics, is remarkable and praise-worthy.

Renzo RossiniGeneral ManagerCentral Bank of Peru