Keyur D Vasava MBA+Pharmacy Dist :- Narmada

Destiny is not a matter of chance, it is a matter of choice. It is not a thing to be waited for, it is a thing to be achieved.

(EFM)-SEM-I (GTU) Economics for Managers

Module I!!!
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! 1) Ten principles of economics
Economy. . .

. . . The word economy comes from a Greek word for one who manages a household. A household and an economy face many decisions: Who will work? What goods and how many of them should be produced? What resources should be used in production? At what price should the goods be sold?

Society and Scarce Resources: The management of societys resources is important because resources are scarce. Scarcity . . . means that society has limited resources and therefore cannot produce all the goods and services people wish to have. Economics is the study of how society manages its scarce resources. How people make decisions. People face tradeoffs. The cost of something is what you give up to get it. Rational people think at the margin. People respond to incentives.

How people interact with each other.

 Trade can make everyone better off. Markets are usually a good way to organize economic activity. Governments can sometimes improve economic outcomes. The forces and trends that affect how the economy as a whole works. The standard of living depends on a countrys production. Prices rise when the government prints too much money. Society faces a short-run tradeoff between inflation and unemployment. Principle #1: People Face Tradeoffs To get one thing, we usually have to give up another thing. Guns v. butter Food v. clothing Leisure time v. work Efficiency v. equity

Making decisions requires trading off one goal against another. Efficiency v. Equity Efficiency means society gets the most that it can from its scarce resources. Equity means the benefits of those resources are distributed fairly among the members of society. Principle #2: The Cost of Something Is What You Give Up to Get It. Decisions require comparing costs and benefits of alternatives. Whether to go to college or to work? Whether to study or go out on a date? Whether to go to class or sleep in? The opportunity cost of an item is what you give up to obtain that item.

LA Laker basketball star Kobe Bryant chose to skip college and go straight from high school to the pros where he has earned millions of dollars.

Principle #3: Rational People Think at the Margin. Marginal changes are small, incremental adjustments to an existing plan of action. People make decisions by comparing costs and benefits at the margin. Principle #4: People Respond to Incentives. Marginal changes in costs or benefits motivate people to respond. The decision to choose one alternative over another occurs when that alternatives marginal benefits exceed its marginal costs! Principle #5: Trade Can Make Everyone Better Off. People gain from their ability to trade with one another. Competition results in gains from trading. Trade allows people to specialize in what they do best. Principle #6: Markets Are Usually a Good Way to Organize Economic Activity. A market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. Households decide what to buy and who to work for. Firms decide who to hire and what to produce. Adam Smith made the observation that households and firms interacting in markets act as if guided by an invisible hand.

 Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social costs of their actions. As a result, prices guide decision makers to reach outcomes that tend to maximize the welfare of society as a whole. Principle #7: Governments Can Sometimes Improve Market Outcomes. Market failure occurs when the market fails to allocate resources efficiently. When the market fails (breaks down) government can intervene to promote efficiency and equity. Market failure may be caused by An externality, which is the impact of one person or firms actions on the well-being of a bystander. Market power, which is the ability of a single person or firm to unduly influence market prices. Principle #8: The Standard of Living depends on a Countrys Production. Standard of living may be measured in different ways: By comparing personal incomes. By comparing the total market value of a nations production. Almost all variations in living standards are explained by differences in countries productivities. Productivity is the amount of goods and services produced from each hour of a workers time. Standard of living may be measured in different ways: By comparing personal incomes. By comparing the total market value of a nations production. Principle #9: Prices Rise When the Government Prints Too Much Money. Inflation is an increase in the overall level of prices in the economy. One cause of inflation is the growth in the quantity of money. When the government creates large quantities of money, the value of the money falls.

Principle #10: Society Faces a Short run Tradeoff between Inflation and Unemployment. The Phillips Curve illustrates the tradeoff between inflation and unemployment: Decreases Inflation Increases Unemployment Its a short-run tradeoff! Summary When individuals make decisions, they face tradeoffs among alternative goals. The cost of any action is measured in terms of foregone opportunities. Rational people make decisions by comparing marginal costs and marginal benefits. People change their behavior in response to the incentives they face. Trade can be mutually beneficial. Markets are usually a good way of coordinating trade among people. Government can potentially improve market outcomes if there is some market failure or if the market outcome is inequitable. Productivity is the ultimate source of living standards. Money growth is the ultimate source of inflation. Society faces a short-run tradeoff between inflation and unemployment.

2) The market forces of supply and demand

Supply and Demand are the two words that economists use most often. Supply and Demand are the forces that make market economies work! Modern microeconomics is about supply, demand, and market equilibrium. Markets and Competition The terms supply and demand refer to the behavior of people. . . . . . As they interact with one another in markets. Market: any institution, mechanism, or arrangement which facilitates exchange. A market is a group of buyers and sellers of a particular good or service. Buyers determine demand... Sellers determine supply...

Market Type: A Competitive Market A Competitive Market is a market: with many buyers and sellers that is not controlled by any one person in which a narrow range of prices are established that buyers and sellers act upon Market Type: Perfect & Others Perfectly Competitive: Homogeneous Products Buyers and Sellers are Price Takers One Seller, controls price Few Sellers, not aggressive competition Many Sellers, differentiated products

Monopoly: Oligopoly: Monopolistic Competition:

Market Demand -Market demand refers to the sum of all individual demands for a particular good or service. -Graphically, individual demand curves are summed horizontally to obtain the market demand curve. A Shift in Both Supply and Demand

Determinants of Demand -Market price -Consumer income -Prices of related goods -Tastes -Expectations -Products Own Price -Consumer Income -Prices of Related Goods -Tastes -Expectations -Number of Consumers -Demographic changes. Market Supply -Market supply refers to the sum of all individual supplies for all sellers of a particular good or service. -Graphically, individual supply curves are summed horizontally to obtain the market supply curve. Determinants of Supply -Market price -Input prices -Technology -Expectations -Number of producers -Products Own Price -Weather, natural disasters & political disruptions. -Taxes. -Number of sellers.

Three Steps To Analyzing Changes in Equilibrium -Decide whether the event shifts the supply or demand curve (or both). -Decide whether the curve(s) shift(s) to the left or to the right.

-Examine how the shift affects equilibrium price and quantity.

3) Elasticity and its applications

I. The Elasticity of Demand

A.

Definition of elasticity: a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants.

B.

The Price Elasticity of Demand and Its Determinants 9

1.

Definition of price elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price.

2.

Determinants of Price Elasticity of Demand

-Availability of Close Substitutes: the more substitutes a good has, the more elastic its demand. -Necessities versus Luxuries: necessities are more price inelastic. -Definition of the market: narrowly defined markets (ice cream) have more elastic demand than broadly defined markets (food). -Time Horizon: goods tend to have more elastic demand over longer time horizons. A. Computing the Price Elasticity of Demand

1.

Formula

Price elasticity of demand =

% change in quantity demanded % change in price

2.

Example: the price of ice cream rises by 10% and quantity demanded falls by 20%.

Price elasticity of demand = (20%)/(10%) = 2

3.

Because there is an inverse relationship between price and quantity demanded (the price of ice cream rose by 10% and the quantity demanded fell by 20%), the price elasticity of demand is sometimes reported as a negative number. We will ignore the minus sign and concentrate on the absolute value of the elasticity.

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B.

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticity 1. Because we use percentage changes in calculating the price elasticity of demand, the elasticity calculated by going from point A to point B on a demand curve will be different than an elasticity calculated by going from point B to point A. a. b. A way around this is called the midpoint method. Using the midpoint method involves calculating the percentage change in either price or quantity demanded by dividing the change in the variable by the midpoint between the initial and final levels rather than by the initial level itself.

c.

Example: the price rises from $4 to $6 and quantity demanded falls from 120 to 80. % change in price = (6 - 4)/5 100% = 40% % change in quantity demanded = (120-80)/100 = 40% Price elasticity of demand = 40/40 = 1

Price elasticity of demand =

(Q2 - Q1) / [(Q1 + Q2) / 2] (P2 - P1) / [(P1 + P2) / 2]

C.

The Variety of Demand Curves

1.

Classification of Elasticity

d.

When the elasticity is greater than one, the demand is considered to be elastic.

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e.

When the elasticity is less than one, the demand is considered to be inelastic.

f.

When the elasticity is equal to one, the demand is said to have unit elasticity.

2.

Slope of demand curve: in general, the flatter the demands curve that passes through a given point, the more elastic the demand.

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II.

The Elasticity of Supply

A.

The Price Elasticity of Supply and Its Determinants

1.

Definition of price elasticity of supply: a measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price.

2.

Determinants of the Price Elasticity of Supply

a.

Flexibility of sellers: goods that are somewhat fixed in supply (beachfront property) have inelastic supplies.

b.

Time horizon: supply is usually more inelastic in the short run than in the long run.

B.

Computing the Price Elasticity of Supply

1.

Formula

Price elasticity of supply =

% change in quantity supplied % change in price

2.

Example: the price of milk increases from $2.85 per gallon to $3.15 per gallon and the quantity supplied rises from 9,000 to 11,000 gallons per month.

% change in price = (3.15 2.85)/3.00 100% = 10% % change in quantity supplied = (11,000 - 9,000)/10,000 100% = 20% Price elasticity of supply = (20%)/(10%) = 2 13

C.

The Variety of Supply Curves

1.

Slope of Supply Curve: in general, the flatter the supply curve that passes through a given point, the more elastic the supply.

2.

Extreme Cases

a.

When the elasticity is equal to zero, the supply is perfectly inelastic and is a vertical line. 14

b.

When the elasticity is infinite, the supply is perfectly elastic and is a horizontal line.

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D. Application of Elasticity -Examine whether the supply or demand curve shifts. -Determine the direction of the shift of the curve. -Use supply and demand diagram to see how the market equilibrium changes. The concept of elasticity has an extraordinarily wide range of applications in economics. In particular, an understanding of elasticity is fundamental in understanding the response of supply and demand in a market. Some common uses of elasticity include:

Effect of changing price on firm revenue. Analysis of incidence of the tax burden and other government policies. Income elasticity of demand can be used as an indicator of industry health, future consumption patterns and as a guide to firms investment decisions. Effect of international trade and terms of trade effects. Analysis of consumption and saving behavior.. Analysis of advertising on consumer demand for particular goods.

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4) The costs and economics of production:

The Costs of Production TOTAL REVENUE, TOTAL COST, AND PROFIT Total Revenue The money a firm receives from the sale of its output. TR = P Q We saw this is chapter 5 Total Cost The market value of all the inputs (resources) a firm uses in production. Explicit and Implicit Costs A firms cost of production includes explicit costs and implicit costs. Explicit costs are costs that require a direct outlay of money by the firms owner(s). Implicit costs are costs that do not require an outlay of money by the firm If some of the resources used in production are provided by the owner(s) of the firm, the firm may not have to pay for them. The market value of such resources is the implicit cost. Implicit costs are included in total cost.

Economic Profit versus Accounting Profit Economists measure a firms economic profit as total revenue minus total cost, which includes both explicit and implicit costs. Accountants measure the accounting profit as the firms total revenue minus only the firms explicit costs. As a result, accounting profit exceeds economic profit

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Economic Profit and Firm Sustainability Non-negative economic profit is essential for the long-run viability of a firm Hungry Helens Cookies earns total revenue of $700 per hour and has total explicit costs of $650 per hour (for labor and raw materials) and Total implicit costs of $110 per hour (in wages Helen could have earned as a computer programmer) Accounting profit = $50 per hour. This indicates short-run financial viability Economic profit = $60 per hour. This indicates a dire long-run future. Dissatisfied with the $50 per hour profit, Helen will eventually shut down the firm and take a programming job

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Measuring the costs of production Costs are defined as those expenses faced by a business in the process of supplying goods and services to consumers. In the short run (where there are fixed and variable factors of production) we make a distinction between fixed and variable costs. Examples of each are given below. VARIABLE COSTS These are costs that vary directly with output since more variable units are required to increase output. Examples are the costs of essential raw materials and components, the wages of part-time staff or employees paid by the hour, the costs of electricity and gas and depreciation of capital inputs due to wear and tear. Total variable cost rises as output increases. Average variable cost (AVC) = Total Variable Costs (TVC) /Output (Q) AVC depends on the cost of employing variable factors compared to the average productivity of these factors (usually labor productivity). If additional units of labor can be hired at a constant cost there will be an inverse relationship between average product and average variable cost. Therefore, when average product is maximized, AVC will be minimized. 19

Average Costs The average cost is also called the per-unit cost. Average costs can be determined by dividing the firms total costs by the quantity of output it produces.

Average Costs

AFC AVC

Fixed cost FC Quantity Q Variable cost VC Quantity Q Total cost TC Quantity Q

ATC

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Marginal Cost Marginal cost (MC) is the increase in total cost (TC) that arises from an extra unit of production. The increase in cost that arises from an extra unit of production is entirely due to the use of additional raw materials and labor Therefore, marginal cost can also be defined as the increase in total variable cost (VC) that arises from an extra unit of production.

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Economies and Diseconomies of Scale

Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases. Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases. Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output increases
Summary

The goal of firms is to maximize profit, which equals total revenue minus total cost. When analyzing a firms behavior, it is important to include all the opportunity costs of production. Some opportunity costs are explicit while other opportunity costs are implicit. A firms costs reflect its production process. A typical firms production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product. A firms total costs are divided between fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output produced; variable costs do change as the firm alters quantity of output produced. Average total cost is total cost divided by the quantity of output. Marginal cost is the amount by which total cost would rise if output were increased by one unit. The marginal cost always rises with the quantity of output. Average cost first falls as output increases and then rises. The average-total-cost curve is U-shaped. The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC. A firms costs often depend on the time horizon being considered. In particular, many costs are fixed in the short run but variable in the long run.
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Module II!!!
1) Firms in competitive markets:
Competitive Market Lots of buyers and sellers dealing in identical goods. Sellers can freely enter or leave.

What Is A Competitive Market? A perfectly competitive market has the following characteristics: 1) There are many buyers and sellers in the market. 2) The goods offered by the various sellers are the same (identical). 3) Firms can freely enter or exit the market. 4) Information is perfect. Buyers and sellers know all prices offered,... As a result of these characteristics, the perfectly competitive market has the following outcomes: The actions of any single buyer or seller in the market have no impact on the market price. 23

Each buyer and seller takes the market price as given. Ex: Gasoline, fish, eggs, pencils, tomatoes, etc.

Buyers and sellers must accept the price determined by the market. No single seller has market power (the power to influence the market price).

The Revenue of a Competitive Firm Total revenue for a firm is the market price times the quantity sold. TR = P Q

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The Revenue of a Competitive Firm Marginal revenue is the change in total revenue when an additional unit is sold. MR =TR / Q 1. Only in a competitive market, marginal revenue equals the price of the good. This is because a firm in a competitive market can sell as much as it wants at the constant market price. 2. If a monopolist or oligopolistic sells more, this causes the price of the good to fall. Ex1: Think of crude oil price and OPEC. Ex2: Consider a downward sloping demand curve. Profit Maximization and the Competitive Firms Supply Curve The goal of a competitive firm is to maximize profit. This means that the firm wants to produce the quantity that maximizes the difference between total revenue and total cost.

Profit maximization occurs at the quantity where marginal revenue equals marginal cost. When MR > MC, profit is increasing, so must produce more. When MR < MC, profit is decreasing, so must produce less. When MR = MC, profit is constant, so this is the point where profit is maximized. 25

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Shutdown vs. Exit A shutdown refers to a short-run decision not to produce anything during a specific period of time. Exit refers to a long-run decision to leave the market. 27

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2) Monopoly

Monopoly means one seller. In perfect competition many sellers were price takers. Any one seller could not influence the price of the product in the market. The competitive firm could only choose what amount to sell.

A monopoly firm will have to determine both how much to sell and at what price. Lets look at these ideas a little more on the following few slides.

Monopoly For a monopoly firm the demand is the same as the market demand we see in competition. The demand downward sloping to the right, what is called less than perfectly elastic. Since the monopolist is the only seller, it is natural they face the market demand curve. The situation of monopoly is often called imperfect competition. Sources of monopoly

1) Exclusive control of an input DeBeers is an example 2) Economies of scale the case of a natural monopoly. The idea here is that AC can be pushed really low by one firm and it then makes sense for only one firm to serve the market. 3) Patents protecting inventions for a time may give monopoly power. 4) Network economies Microsoft Windows is an example of the idea once enough people use a product sometimes using another type of product becomes less functional. 5) Granted by government Maximize profit Since the monopolist is the only seller in the market, the monopolist must decide

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1) What price to charge and 2) How much to sell. When the monopolist sells, she is worried about profit. The goal is to maximize profit. But, in order to maximize profit, the pattern of revenues and costs at various output levels must be understood. The Pattern of cost was the topic of an earlier section. Problems of monopoly The problems of monopoly are higher price and less output than in competition. Moreover, 1) The higher price means those who still buy have less money to spend on other things c and d are surplus areas that consumer used to have for other things but now pays to monopoly. 2) Those who no longer buy must be worse off Because they get less than what they were at their liberty to purchase under competition area e represents the value of lost output to the consumers and is part of the deadweight loss of monopoly.

Monopoly: a firm that is the sole seller of a product without close substitutes. Competitive firm: price taker Monopolist: price maker Why Monopolies Arise? 1. Key resource owned by single firm. 2. Government granted restriction. 3. Increasing returns to scale (natural monopoly).

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Monopoly versus competitive markets

While monopoly and perfect competition mark the extremes of market structures. there is some similarity. The cost functions are the same. Both monopolies and perfectly competitive companies minimize cost and maximize profit. The shutdown decisions are the same. Both are assumed to have perfectly competitive factors markets. There are distinctions, some of the more important of which are as follows:

Marginal revenue and price - In a perfectly competitive market price equals marginal revenue. In a monopolistic market marginal revenue is less than price. Product differentiation: There is zero product differentiation in a perfectly competitive market. Every product is perfectly homogeneous and a perfect substitute for any other. With a monopoly, there is great to absolute product differentiation in the sense that there is no available substitute for a monopolized good. The monopolist is the sole supplier of the good in question.A customer either buys from the monopolizing entity on its terms or does without. Number of competitors: PC markets are populated by an infinite number of buyers and sellers. Monopoly involves a single seller. Barriers to Entry - Barriers to entry are factors and circumstances that prevent entry into market by would-be competitors and limit new companies from operating and expanding within the market. PC markets have free entry and exit. There are no barriers to entry, exit or competition. Monopolies have relatively high barriers to entry. The barriers must be strong enough to prevent or discourage any potential competitor from entering the market. Elasticity of Demand - The price elasticity of demand is the percentage change of demand caused by a one percent change of relative price. A successful monopoly would have a relatively inelastic demand curve. A low coefficient of elasticity is indicative of effective barriers to entry. A PC company has a perfectly elastic demand curve. The coefficient of elasticity for a perfectly competitive demand curve is infinite. Excess Profits- Excess or positive profits are profit more than the normal expected return on investment. A PC company can make excess profits in the short term but excess profits attract competitors which can enter the market freely and decrease prices, eventually reducing excess profits to zero.A

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monopoly can preserve excess profits because barriers to entry prevent competitors from entering the market.

Profit Maximization - A PC company maximizes profits by producing such that price equals marginal costs. A monopoly maximizes profits by producing where marginal revenue equals marginal costs. The rules are not equivalent. The demand curve for a PC company is perfectly elastic - flat. The demand curve is identical to the average revenue curve and the price line. Since the average revenue curve is constant the marginal revenue curve is also constant and equals the demand curve, Average revenue is the same as price (AR = TR/Q = P x Q/Q = P). Thus the price line is also identical to the demand curve. In sum, D = AR = MR = P. P-Max quantity, price and profit - If a monopolist obtains control of a formerly perfectly competitive industry, the monopolist would increase prices, reduce production, and realize positive economic profits. Supply Curve - in a perfectly competitive market there is a well defined supply function with a one to one relationship between price and quantity supplied.In a monopolistic market no such supply relationship exists. A monopolist cannot trace a short term supply curve because for a given price there is not a unique quantity supplied. As Pindyck and Rubenfeld note a change in demand "can lead to changes in prices with no change in output, changes in output with no change in price or both." Monopolies produce where marginal revenue equals marginal costs. For a specific demand curve the supply "curve" would be the price/quantity combination at the point where marginal revenue equals marginal cost. If the demand curve shifted the marginal revenue curve would shift as well and a new equilibrium and supply "point" would be established. The locus of these points would not be a supply curve in any conventional sense.

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3) Oligopoly
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists) Because there are few sellers, each oligopolist is likely to be aware of the actions of the others. The decisions of one firm influence, and are influenced by, the decisions of other firms. Strategic planning by oligopolists needs to take into account the likely responses of the other market participants. Characteristics

Profit maximization conditions: An oligopoly maximizes profits by producing where marginal revenue equals marginal costs. Ability to set price: Oligopolies are price setters rather than price takers. Entry and exit: Barriers to entry are high.The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy nascent firms. Additional sources of barriers to entry often result from government regulation favoring existing firms making it difficult for new firms to enter the market.

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Number of firms: "Few" a "handful" of sellers.There are so few firms that the actions of one firm can influence the actions of the other firms. Long run profits: Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms from entering market to capture excess profits. Product differentiation: Product may be homogeneous (steel) or differentiated (automobiles). Perfect knowledge: Assumptions about perfect knowledge vary but the knowledge of various economic actors can be generally described as selective. Oligopolies have perfect knowledge of their own cost and demand functions but their inter-firm information may be incomplete. Buyers have only imperfect knowledge as to price,cost and product quality. Interdependence: The distinctive feature of an oligopoly is interdependence.Oligopolies are typically composed of a few large firms. Each firm is so large that its actions affect market conditions. Therefore the competing firms will be aware of a firm's market actions and will respond appropriately. This means that in contemplating a market action, a firm must take into consideration the possible reactions of all competing firms and the firm's countermoves Strategy

Oligopolists have to make critical strategic decisions, such as:

Whether to compete with rivals, or collude with them. Whether to raise or lower price, or keep price constant. Whether to be the first firm to implement a new strategy, or whether to wait and see what rivals do. The advantages of going first or going second are respectively called 1st and 2nd-mover advantage. Sometimes it pays to go first because a firm can generate head-start profits. 2nd mover advantage occurs when it pays to wait and see what new strategies are launched by rivals, and then try to improve on them or find ways to undermine them.

The advantages of oligopolies However, oligopolies may provide the following benefits: 1. Oligopolies may adopt a highly competitive strategy, in which case they can generate similar benefits to more competitive market structures, such as lower

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prices. Even though there are a few firms, making the market uncompetitive, their behaviour may be highly competitive. 2. Oligopolists may be dynamically efficient in terms of innovation and new product and process development. The super-normal profits they generate may be used to innovate, in which case the consumer may gain. 3. Price stability may bring advantages to consumers and the macro-economy because it helps consumers plan ahead and stabilises their expenditure, which may help stabilise the trade cycle.

4) Monopolistic competition
On one extreme is the Perfect Competition model On the other extreme is the Monopoly Model Monopolistic Competition & Oligopoly are competitive scenarios that lie between these two extremes Therefore, competitive features of Monopolistic Competition and Oligopoly will emulate either Perfect Competition or Monopoly Power to set prices somewhat like a monopoly Face competition like perfect competition

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Large number of firms -- Each firm has relatively small market share -- Each firm must be sensitive to average market price of its -- Collusion is not possible due to the number of firms No barriers to entry or exit

product

Product Differentiation Each firm makes a product that is slightly different from the products of competing firms. -- Close substitutes but no perfect substitutes -- An attempt to increase price will normally results in a lower volume sold Competition on Quality, Price, Marketing -- Quality is design, reliability, service provided to buyer and ease of access to product -- Price downward sloping demand curve -- Marketing firm must market = promotion, distribution, packaging 45

Product Differentiation Product differentiation is crucial to monopolistic competition People value variety, even if it is not material (real) Product differentiation takes place in buyers mind Americans are provided with a wide variety of products and services Variety is valued but costly we pay for it The Typical Monopolistic Competitor

The monopolistic competitor tries to set his or her product apart from the competition The main way of doing this is through advertising When this is done successfully, the demand curve becomes more vertical or inelastic Buyers are willing to pay more for a product or service because they believe it is much better than their other choices Basis for Product Differentiation Physical differences Convenience Ambience Reputations Appeals to vanity Unconscious fears and desires Snob appeal Customized products

The Typical Monopolistic Competitor Tries to set his firm apart from his competition -- New Product Development and Innovation 1. Striving to maintain an economic profit -- Advertising 1. Create consumer perception of product differentiation real or imagined 2. Attempting to keep demand as inelastic as possible Selling costs can be extremely high

Identifying Monopolistic Competition 46

 How much is the industry dominated or not dominated by few suppliers -- Geographical scope national, regional, global An industry can be almost perfectly competitive on a national scope, but almost a monopoly locally e.g. Concrete Mixing -- Barriers to entry and exit industries may appear concentrated but few barriers exist to prevent entry: e.g a community with only one restaurant-there is no barrier to other restaurants coming in The four-firm concentration ratio The percentage of the value of total market revenue accounted for by the four largest firms in the industry -- A low concentration ratio indicates a high degree of competition -- A high concentration ratio indicates an absence of competition The Herfindahl-Hirschman Index the square of the percentage market share of each firm summed over the largest 50 firms in the industry (or all of the firms if there is less than 50) -- In perfect competition, the HHI is small -- In monopoly, the HHI is 10,000 (100 squared) -- A popular measure with the Justice Dept in the 1980s HHI < 1000 characterized competitive markets HHI > 1800 would bring Justice Dept challenge To proposed mergers Examples of Monopolistic Competition Banks Sporting Goods Radio Stations Fish and Seafood Clothing Jewelry Computers Health Spas Frozen Foods Apparel Stores Canned Goods Convenience Stores Monopolistic Competition Since the Monopolistic Competitor prices at demand where MR=MC, the firm may have 1. excess production capacity, and is 2. Operating below its efficient scale where ATC is minimum Markup The amount by which price exceeds MC

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Price Discrimination Question Does price discrimination raise or lower profit? Price discrimination selling the same good or service at a number of different prices. Basically an illegal activity under the Clayton Act unless there is a cost justification for the price discrimination Answer Price discrimination is a marketing means to increase economic profit Methods of price discrimination -- Discriminate among groups of buyers Works when different buying groups are willing to pay different prices (on the average) for the same good or service Example: Airline travel prices target business travelers vs leisure time travelers -- Discriminator is advance notice, shorter the notice, the higher the price Methods of discrimination -- Discriminate among units firm charges the same price to all customers but there are volume discounts The key idea is to figure a way to charge those incremental buyers who are willing to pay more a higher price Result Consumer Surplus is converted to Producer Surplus Some Examples of Price Discrimination Doctors often charge rich patients more than poor patients They may have one price for those with insurance and another price for those without insurance Movies in the evening cost more than those in the early afternoon Senior citizen, youth, and student discounts New and used cars Youth fairs on airlines Evening meals in restaurants often cost more than the same meal at lunch

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 Perfect Price discrimination occurs when a firm figures out how to extract the entire consumer surplus Once the firm has the entire consumer surplus, the MR curve becomes the Demand Curve At that point, the firm extracts even more economic profit by increasing production to the point where MR (D) = MC Efficiency When the firm increases output to the point where MC = D, the efficient quantity is produced, but The producer has taken all the consumer surplus, and Since there is ample economic profit, the firm may be induced to spend money (increase costs) to protect its economic profit (rent seeking and is usually political in nature)

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Module III!!!
1) Measuring a nations income
The Economys Income and Expenditure -When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning. -To have this number make sense, it is also best to look at income per person. -For an economy as a whole, income must equal expenditure because: -Every transaction has a buyer and a seller. -Every dollar of spending by some buyer is a dollar of income for some seller. -Says Law-Supply creates its own demand -This process can be seen using a Circular Flow Diagram. Gross Domestic Product -Gross domestic product (GDP) is a measure of the income and expenditures of an economy. -It is the total market value of all final goods and services produced within a country in a given period of time. -How much is the current GDP?

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The Measurement of GDP GDP is: -the market value -of all final goods and services -produced within a country -in a given period of time. What Is Counted and Not Counted in GDP? -GDP includes all items produced in the economy and sold legally in markets. -GDP excludes services that are produced and consumed at home and that never enter the marketplace. -Caring labor, the work that is normally produced by women. -Because GDP does not count it, it diminishes its importance. -GDP also excludes black market items, such as illegal drugs. Other Measures of Income -Gross National Product (GNP) -Net National Product (NNP) -National Income -Personal Income -Disposable Personal Income 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

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Measuring Economic Growth -We use real GDP to calculate the economic growth rate. -The economic growth rate is the percentage change in the quantity of goods and services produced from one year to the next. -We measure economic growth so we can make: -Economic welfare comparisons - International welfare comparisons - Business cycle forecasts Business Cycle Forecasts -Real GDP is used to measure business cycle fluctuations. -These fluctuations are probably accurately timed but the changes in real GDP probably overstate the changes in total production and peoples welfare caused by business cycles. Real versus Nominal GDP -Nominal GDP values the production of goods and services at current prices. -Real GDP values the production of goods and services at constant prices.

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2) Measuring the cost of living

Measuring the Cost of Living; -Inflation refers to a situation in which the economys overall price level is rising. -The inflation rate is the percentage change in the price level from the previous period. The Consumer Price Index -The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. -The Bureau of Labor Statistics reports the CPI each month. -It is used to monitor changes in the cost of living over time. Example of CPI in Action -CPI is also called the Consumer Price Index. -Try and figure how the CPI is biased. Problems in Measuring the Cost of Living The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living. -Substitution bias -Introduction of new goods -Unmeasured quality changes -Because of these problems the CPI tends to overstate the true cost of living for most individuals. The Consumer Price Index -When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living. - Cost of Living for US cities -CPI for Honolulu and USA cities 1940-2002 -Housing Costs 1995-2002

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How the Consumer Price Index Is Calculated -Fix the Basket: Determine what prices are most important to the typical consumer. -The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. -The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services. -Find the Prices: Find the prices of each of the goods and services in the basket for each point in time. -Compute the Baskets Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times. -Choose a Base Year and Compute the Index: -Designate one year as the base year, making it the benchmark against which other years are compared. -Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100. -Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.

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Other Price Indexes -The BLS calculates other prices indexes: -The index for different regions within the country. -The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers. 60

Real and Nominal Interest Rates Interest represents a payment in the future for a transfer of money in the past. -The nominal interest rate is the interest rate not corrected for inflation. u It is the interest rate that a bank pays. -The real interest rate is the nominal interest rate that is corrected for inflation. Real interest rate = (Nominal interest rate Inflation rate) -You borrowed $1,000 for one year. -Nominal interest rate was 15%. -During the year inflation was 10%. Real interest rate = Nominal interest rate Inflation = 15% - 10% = 5% 3) Production and growth, Concepts of GDP, GNP, PPP Production and Growth -A countrys standard of living depends on its ability to produce goods and services. 61

-Within a country there are large changes in the standard of living over time. -In the United States over the past century, average income as measured by real GDP per person has grown by about 2 percent per year. -Productivity refers to the amount of goods and services produced for each hour of a workers time. -A nations standard of living is determined by the productivity of its workers. -A fishing tale-Throw Net fishing, how productive is it? Bring the throw net! Economic Growth around the World -Living standards, as measured by real GDP per person, vary significantly among nations. -The poorest countries have average levels of income that have not been seen in the United States for many decades.

Compounding and the Rule of 70 -Annual growth rates that seem small become large when compounded for many years. -Compounding refers to the accumulation of a growth rate over a period of time. According to the rule of 70, if some variable grows at a rate of x percent per year, then that variable doubles in approximately 70/x years. 62

$5,000 invested at 7 percent interest per year, will double in size in 10 years How Productivity is Determined -The inputs used to produce goods and services are called the factors of production. The factors of production directly determine productivity Government Policies That Raise Productivity and Living Standards -Encourage saving and investment. -Encourage investment from abroad -Encourage education and training. -Establish secure property rights and maintain political stability. -Promote free trade. -Control population growth. -Promote research and development. The Importance of Saving and Investment There is definitely a link between investment today and growth in the future.

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-As the stock of capital rises, the extra output produced from an additional unit of capital falls; this property is called diminishing returns. -Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while. -Thus small countries can grow faster than big countries. -The catch-up effect refers to the condition that, other things being equal, it is easier for a country to grow fast if it starts out relatively poor. -Once the country becomes richer, diminishing returns sets in. Investment from Abroad Investment from abroad takes several forms: -Foreign Direct Investment -Capital investment owned and operated by a foreign entity. -Foreign Portfolio Investment -Investments financed with foreign money but operated by domestic residents. Education -For a countrys long-run growth, education is at least as important as investment in physical capital. -Human Capital -In the United States, each year of schooling raises a persons wage on average by about 10 percent. -Thus, one way the government can enhance the standard of living is to provide schools. Property Rights and Political Stability -Property rights refer to the ability of people to exercise authority over the resources they own. -An economy-wide respect for property rights is an important prerequisite for the price system to work. -It is necessary for investors to feel that their investments are secure. -Napster anyone?

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Free Trade -Trade is, in some ways, a type of technology. -A country that eliminates trade restrictions will experience the same kind of economic growth that would occur after a major technological advance. -Remember globalization? Control of Population Growth -Population is a key determinant of a countrys labor force. -Large populations tend to produce greater total GDP. -However, GDP per person is a better measure of economic well-being, and high population growth reduces GDP per person. -Thomas Malthus theory of population growth and economic well-being. Research and Development, Epilogue -The advance of technological knowledge has led to higher standards of living. -Most technological advance comes from private research by firms and individual inventors. -Government can encourage the development of new technologies through research grants, tax breaks, and the patent system. -There are pros and cons to productivity gains though, show Solman DVD video on productivity. Productivity and Bathrooms -This is a tale of the self-cleaning bathroom. -Think about what productivity means in terms of goods and services, jobs and wages. -Journal Question-Can you think other examples where there was a major innovation that has impacted jobs?

4. The monetary system, Money growth and inflation

The History of Money -First, there was barter -Then, there was Commodity money -This money takes the form of a commodity with intrinsic value. -Examples: Gold, silver, cigarettes. -Finally there was Fiat money is used as money because of government decree. 65

-It does not have intrinsic value, it has value because of decree. -Examples: Coins, currency, check deposits. -Money Museum of Richmond Federal Reserve Bank -Money Museum of San Francisco Federal Reserve Bank The Meaning of Money Money is the set of assets in the economy that people regularly use to buy goods and services from other people.

Three Functions of Money -Money has three functions in the economy: -Medium of exchange -Unit of account -Store of value Money in the U.S. Economy -Currency is the paper bills and coins in the hands of the public. -Demand deposits are balances in bank accounts that depositors can access on demand by writing a check.

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Where Is All The Currency? -In 1998 there was about $460 billion of U.S. currency outstanding. -That is $2,240 in currency per adult. -Who is holding all this currency? -Currency held abroad -Currency held by illegal entities The Federal Reserve -The Federal Reserve (Fed) serves as the nations central bank. -It is designed to oversee the banking system. -It regulates the quantity of money in the economy. -It was created in 1914 to restore confidence in the nations banking system. -Online Tour of the Federal Reserve System The Federal Reserve System -The Structure of the Federal Reserve System: -The primary elements in the Federal Reserve System are: 1) The Board of Governors 2) The Regional Federal Reserve Banks 3) The Federal Open Market Committee

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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 bankers bank, making loans to banks and as a lender of last resort. -Conducts monetary policy by controlling the money supply. Feds Tools of Monetary Control -The Fed has three tools in its monetary toolbox: -Open-market operations -Changing the reserve requirement -Changing the discount rate Problems in Controlling the Money Supply -The Feds control of the money supply is not precise. -The Fed must wrestle with two problems that arise due to fractional-reserve banking. -The Fed does not control the amount of money that households choose to hold as deposits in banks. -The Fed does not control the amount of money that bankers choose to lend. Banks and The Money Supply Banks can influence the quantity of demand deposits in the economy and the money supply. -Reserves are deposits that banks have received but have not loaned out. -In a fractional reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest. -When a bank makes a loan from its reserves, the money supply increases Money Creation -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. 68

-Loans become an asset to the bank.

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The Money Multiplier The money multiplier is the reciprocal of the reserve ratio: M = 1/R -With a reserve requirement, R = 20% or 1/5, -The multiplier is 5. -Problem of Bank Runs-its a wonderful life! Federal Deposit Insurance Corporation (FDIC) Inflation Inflation is an increase in the overall level of prices. Historical aspects -Over the past sixty years, prices have risen on average about 5 percent per year. -Deflation, meaning decreasing average prices, occurred in the U.S. in the nineteenth century. -Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s.

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-In the 1970s prices rose by 7 percent per year. -During the 1990s, prices rose at an average rate of 2 percent per year. The Classical Theory of Inflation -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 economys medium of exchange. -When the overall price level rises, the value of money falls.

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The Quantity Theory of Money -How the price level is determined and why it might change over time is called the quantity theory of money. -The quantity of money available in the economy determines the value of money. -The primary cause of inflation is the growth in the quantity of money.

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The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money -The velocity of money is relatively stable over time. -When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P x Y). -Because money is neutral, money does not affect output. -When the Fed alters the money supply and induces parallel changes in the nominal value of output, these changes are also reflected in changes in the price level. -When the Fed increases the money supply rapidly, the result is a high rate of inflation. Hyperinflation -Hyperinflation is inflation that exceeds 50 percent per month. - Hyperinflation occurs in some countries because the government prints too much money to pay for its spending.

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The Costs of Inflation -Shoeleather costs -Menu costs -Relative price variability -Tax distortions -Confusion and inconvenience -Arbitrary redistribution of wealth Shoeleather Costs -Shoeleather costs are the resources wasted when inflation encourages people to reduce their money holdings. -Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings. -Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts. -The actual cost of reducing your money holdings is the time and convenience you must sacrifice to keep less money on hand. -Also, extra trips to the bank take time away from productive activities.

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Menu Costs -Menu costs are the costs of adjusting prices. -During inflationary times, it is necessary to update price lists and other posted prices. -This is a resource-consuming process that takes away from other productive activities. Relative-Price Variability -Inflation distorts relative prices. -Consumer decisions are distorted, and markets are less able to allocate resources to their best use. Inflation-Induced Tax Distortion -Inflation exaggerates the size of capital gains and increases the tax burden on this type of income. -With progressive taxation, capital gains are taxed more heavily. -The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. -The after-tax real interest rate falls, making saving less attractive.

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Confusion and Inconvenience -When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account. -Inflation causes dollars at different times to have different real values. -Therefore, with rising prices, it is more difficult to compare real revenues, costs, and profits over time.

Arbitrary Redistribution of Wealth -Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need. -These redistributions occur because many loans in the economy are specified in terms of the unit of account money.

5. Open-economy macroeconomics Basic concepts

Open and Closed Economies -A closed economy is one that does not interact with other economies in the world. -There are no exports, no imports, and no capital flows.

-An open economy is one that interacts freely with other economies around the world. An Open Economy -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 -Exports are domestically produced goods and services that are sold abroad. -Imports are foreign produced goods and services that are sold domestically.

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-Net Exports are exports minus imports. -A trade deficit is a situation in which net exports (NX) are negative. Imports > Exports -A trade surplus is a situation in which net exports (NX) are positive. Exports > Imports -Balanced trade refers to when net exports are zero exports and imports are exactly equal.

The Flow of Capital: Net Foreign Investment -Net foreign investment 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.

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-When a U.S. resident buys stock in Telmex, the Mexican phone company, the purchase raises U.S. net foreign investment. -When a Japanese resident buys a bond issued by the U.S. government, the purchase reduces the U.S. net foreign investment. Variables that Influence Net Foreign Investment -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 Foreign Investment -Net exports (NX) and net foreign investment (NFI) are closely linked. -For an economy as a whole, NX and NFI must balance each other so that: NFI = NX -This holds true because every transaction that affects one side must also affect the other side by the same amount. Nominal Exchange Rates -The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. -The nominal exchange rate is expressed in two ways: -In units of foreign currency per one U.S. dollar. -And in units of U.S. dollars per one unit of the foreign currency. -Assume the exchange rate between the Japanese yen and U.S. dollar is 80 yen to one dollar. -One U.S. dollar trades for eighty yen.

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-One yen trades for 1/80 (=0.0125) of a dollar. -If a dollar buys more foreign currency, there is an appreciation of the dollar. -If it buys less there is a depreciation of the dollar.

Purchasing-Power Parity -The purchasing-power parity theory is the simplest and most widely accepted theory explaining the variation of currency exchange rates. Basic Logic of Purchasing-Power Parity -The theory of purchasing-power parity is based on a principle called the law of one price. -According to the law of one price, a good must sell for the same price in all locations. -If the law of one price were not true, unexploited profit opportunities would exist.

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-The process of taking advantage of differences in prices in different markets is called arbitrage.

Brief Video on German Hyperinflation -This video shows how the DM price of bread increased almost daily during the German hyperinflation of the 1920s.

Module IV!!!
1) Aggregate demand and aggregate supply
What is aggregate demand? -Sum of all possible buyers for all possible new and Finished products -Households 80

-Businesses -Government -Other countries (foreign component) Looks and behaves just like a normal demand curve -Negatively sloped, increase is a shift to the right, decrease is a shift to the left

What about aggregate supply? It is the measure of all levels of output at the Various price levels -Upward sloping -Labeled AS instead of just S for supply -Behaves the same as supply -Increase in AS is a shift to the right -Decrease in AS is a shift to left -Can analyze Aggregate supply in the short run (SRAS) or the long run (LRAS)

Aggregate Demand The sum of all expenditure in the economy over a period of time Macro concept WHOLE economy Formula:

AD = C+I+G+(X-M) C= Consumption Spending I = Investment Spending G = Government Spending (X-M) = difference between spending on imports and receipts from exports (Balance of Payments)

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Aggregate Demand Curve Shows the overall level of spending at different price levels Note Inflation used for the vertical axis follows from new thinking on the derivation of AD curves from the likes of David Romer @ University of California Assumes Central Banks do not target the money supply but short term interest rates Why does it slope down from left to right? Assume Bank of England sets short term interest rates Assume a rise in the price level will be met by a rise in interest rates Any increase in interest rates will raise the cost of borrowing: Consumption spending will fall Investment will fall International competitiveness will decrease exports fall, imports rise Therefore a rise in the price level leads to lower levels of aggregate demand The AD diagram: Inflation on the vertical axis assume an initial target rate of 2.0% (as measured by the HICP or CPI) Real GDP or Real National Income or Real Output on the vertical axis (shown by the initialY)

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Consumption Expenditure Exogenous factors affecting consumption: Tax rates Incomes short term and expected income over lifetime Wage increases Credit Interest rates Wealth Property Shares Savings Bonds

Investment Expenditure Spending on: Machinery Equipment Buildings Infrastructure Influenced by: Expected rates of return Interest rates Expectations of future sales 83

Expectations of future inflation rates

Government Spending Defense Health Social Welfare Education Foreign Aid Regions Industry Law and Order

Import Spending (negative) Goods and services bought from abroad represents an outflow of funds from the UK (reduces AD)

Export Earnings (Positive) Goods and services sold abroad represents a flow of funds into the UK (raises AD)

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OR.

Aggregate demand curve

a curve that shows the quantity of goods and services that households, firms, and the government want to buy at each price level

Aggregate supply curve

A curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

Aggregate Demand Why does the aggregate demand curve slopes downward? In other words, why does a fall in the price level increases the quantity of goods and services demanded? There are three reasons: 1. The Wealth Effect: Consumers are wealthier, which stimulates the demand for consumption goods

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2. The Interest Rate Effect: Interest rates fall, which stimulates the demand for investment goods 3. The Real Exchange Rate Effect: The exchange rate depreciates which stimulates the demand for net exports Aggregate Supply Why does the aggregate supply curve slope upwards? There are three reasons 1. The Sticky Wage Theory--This theory is at the foundation of New Keynesian economics. The reason for sticky wage is that in labour market, nominal wage is entered into a contract of various lengths, thus firms cannot adjust nominal wages instantaneously. 2. The Sticky Price Theory--This is a derivative from Sticky Wage Theory. As firms cannot adjust wages in the short run, their cost of production remains constant and thus price will remain constant in the short run. 3. The Misperception Theory

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2) The influence of monetary and fiscal policy on aggregate demand

Aggregate Demand

Many factors influence aggregate demand besides monetary and fiscal policy. In particular, desired spending by households and business firms determines the overall demand for goods and services. When desired spending changes, aggregate demand shifts, causing short-run fluctuations in output and employment. Monetary and fiscal policy is sometimes used to offset those shifts and stabilize the economy.

HOW MONETARY POLICY INFLUENCES AGGREGATE DEMAND

The aggregate demand curve slopes downward for three reasons: The wealth effect The interest-rate effect The exchange-rate effect For the U.S. economy, the most important reason for the downward slope of the aggregate-demand curve is the interest-rate effect.

The Theory of Liquidity Preference

Keynes developed the theory of liquidity preference in order to explain what factors determine the economys interest rate. According to the theory, the interest rate adjusts to balance the supply and demand for money. Money Supply The money supply is controlled by the Fed through: Open-market operations Changing the reserve requirements Changing the discount rate 96

Because it is fixed by the Fed, the quantity of money supplied does not depend on the interest rate. The fixed money supply is represented by a vertical supply curve.

Money Demand Money demand is determined by several factors. According to the theory of liquidity preference, one of the most important factors is the interest rate. People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services. The opportunity cost of holding money is the interest that could be earned on interest-earning assets. An increase in the interest rate raises the opportunity cost of holding money. As a result, the quantity of money demanded is reduced.

Equilibrium in the Money Market According to the theory of liquidity preference: The interest rate adjusts to balance the supply and demand for money. There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded equals the quantity of money supplied. Assume the following about the economy: The price level is stuck at some level. For any given price level, the interest rate adjusts to balance the supply and demand for money. The level of output responds to the aggregate demand for goods and services.

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Adjustment to Changes in Ms

I N PAST CHAPTERS, WE LEARNED THAT INDIVIDUALS REBALANCE THEIR PORTFOLIOS BY ADJUSTING THEIR SPENDING. ESM SPEND IT C AD P EDM SPEND LESS C AD P I N LIQUIDITY PREFERENCE THEORY, INDIVIDUALS REBALANCE THEIR PORTFOLIO BY EITHER SPENDING OR LENDING AND WE WILL ASSUME THE PRICE LEVEL CONSTANT. ESM SPEND IT C AD LEND IT R I AND NX AD EDM SPEND LESS C AD LEND LESS R I AND NX AD The Downward Slope of the Aggregate Demand Curve

The price level is one determinant of the quantity of money demanded. A higher price level increases the quantity of money demanded for any given interest rate. Higher money demand leads to a higher interest rate. The quantity of goods and services demanded falls.

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The end result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded.

Changes in the Money Supply

The Fed can shift the aggregate demand curve when it changes monetary policy. An increase in the money supply shifts the money supply curve to the right. Without a change in the money demand curve, the interest rate falls. Falling interest rates increase the quantity of goods and services demanded. When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the right. When the Fed contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded at any given price level, shifting aggregate-demand to the left. 99

HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND

Fiscal policy refers to the governments choices regarding the overall level of government purchases or taxes. Fiscal policy influences saving, investment, and growth in the long run. In the short run, fiscal policy primarily affects the aggregate demand.

Changes in Government Purchases

When policymakers change the money supply or taxes, the effect on aggregate demand is indirectthrough the spending decisions of firms or households. When the government alters its own purchases of goods or services, it shifts the aggregate-demand curve directly. There are two macroeconomic effects from the change in government purchases: The multiplier effect The crowding-out effect

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The Multiplier Effect

Government purchases are said to have a multiplier effect on aggregate demand. Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar. The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

A Formula for the Spending Multiplier The formula for the multiplier is: Multiplier = 1/(1 - MPC) An important number in this formula is the marginal propensity to consume (MPC). It is the fraction of extra income that a household consumes rather than saves. If the MPC is 3/4, then the multiplier will be: Multiplier = 1/(1 - 3/4) = 4 In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.

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The Crowding-Out Effect

Fiscal policy may not affect the economy as strongly as predicted by the multiplier. An increase in government purchases causes the interest rate to rise. A higher interest rate reduces investment spending. This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand. When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.

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3) The short-run trade-off between inflation and Unemployment

Unemployment and Inflation

-The natural rate of unemployment depends on various features of the labor market. -Examples include minimum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search. -The inflation rate depends primarily on growth in the quantity of money, controlled by the Fed. -The misery index, one measure of the health of the economy, adds together the inflation rate and unemployment rate. -Society faces a short-run tradeoff between unemployment and inflation. -If policymakers expand aggregate demand, they can lower unemployment, but only at the cost of higher inflation. -If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment. The Phillips Curve -The Phillips curve illustrates the short-run relationship between inflation and unemployment.

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Aggregate Demand, Aggregate Supply, and the Phillips Curve

-The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve. -The greater the aggregate demand for goods and services, the greater is the economys output, and the higher is the overall price level. -A higher level of output results in a lower level of unemployment.

The Long-Run Phillips Curve

-In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run. -As a result, the long-run Phillips curve is vertical at the natural rate of unemployment. -Monetary policy could be effective in the short run but not in the long run.

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Expectations and the Short-Run Phillips Curve -Expected inflation measures how much people expect the overall price level to change. -In the long run, expected inflation adjusts to changes in actual inflation. -The Feds ability to create unexpected inflation exists only in the short run. -Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be above the anticipated rate.

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Shifts in the Phillips Curve: The Role of Supply Shocks

-Historical events have shown that the short-run Phillips curve can shift due to changes in expectations. -The short-run Phillips curve also shifts because of shocks to aggregate supply. -Major adverse changes in aggregate supply can worsen the short-run tradeoff between unemployment and inflation. -An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

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-A supply shock is an event that directly affects firms costs of production and thus the prices they charge. -It shifts the economys aggregate supply curve... - and as a result, the Phillips curve.

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!The end!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! Keyur D vasava.

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