Economics Cram Kit

2013 2014
EDITION
YE AR S
19
DO I NG OU RB EST , SO YO U CA N
ECONOMICS
ECONOMICS Introduction to Economics
DO YO UR S
CRAM KIT
EDITOR ALPACA-IN-CHIEF
Tania Asnes
Daniel Berdichevsky
the World Scholars Cup
E CO N O MI CS
CRAM KIT
HO W T O T HI NK LI KE A N E C ON OMI S T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 C A T E G ORI Z A TI ON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 T HE OR I GI N OF MA R K E T S ( T RA D E ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 I NT ROD U C T I ON T O MA RK ET S . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 D E MA ND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 SUPPLY ................. ..................... ..................... ..................... ...................... ..................... ..................... ..... 7 E LA S T I CI T Y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 E QU I LI BRI U M . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 GO V E RNM E NT P OL I C I ES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 T A RI FFS A ND E XP O R T S . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1 BEH A V I OR OF F I RMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 FA I L U RE S O F P ERFEC T C OM P ET I T I O N . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 3 I NS T I T UT I ON S . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 BA S I C S OF MA C ROE C ONO MI C S . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 6 U NE MP LO Y MENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 GR OS S D OM E S T I C P R OD U C T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 ME A S U RI NG GD P . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 ME A S U RI NG I NF LA T I ON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 MON E Y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 T HE FI N A NC I A L S Y S TE M . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 2 MON E T A RY P OL I C Y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 MOR E ON S A V I NG A ND I NV E S T ME NT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 MON E Y M A R KE T I N T HE L ONG RU N . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 5 MOD E LI N G T HE E C O NO MY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 6 LI V I NG S T A ND A RD S . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 T HE OU T P U T G A P A ND T HE S HOR T RU N . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 A GG RE GA T E D EMA N D . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 A GG RE GA T E S U P P LY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 0 E QU I LI BRI U M . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1 FI S C A L P OLI C Y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2 A ME RI C A N E NT R Y I NT O T HE W A R . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 3 C OS T S OF W A R . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 5 WA R FI NA NC I NG . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 6 E C ON OM I C P E RF OR M A NC E T HR OU GH OU T WWI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 7 E C ON OM I C C ON S EQU ENC ES OF P EA C E . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 8 E C ON OM I C S I N FOU R P A GES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 0 LI S T OF LI S T S . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 4
ECONOMICS CRAM KIT | 2
FUNDAMENTAL ECONOMIC CONCEPTS

How to Think like an Economist
ADMISSION TO THE CLUB
SO YOU WANT TO BE AN ECONOMIST?
THE RATIONAL HOMO ECONOMICUS

RATIONALITY CHECKLIST Perform cost-benefit analysis Maximize utility, or happiness Think on the margin Account for all economic costs MAXIMIZING UTILITY An economic agent maximizes utility when marginal utility equals marginal cost DIMINISHING RETURNS Economists assume that marginal benefit decreases as quantity increases. Eating your 42nd slice will not make you as happy as the first one did.
Marginal utility
Repeat after me
1. There are no free lunches. 2. People have unlimited wants. 3. The cost of doing something includes its full economic cost. 4. Humans behave rationally. 5. Humans benefit from voluntary exchange---otherwise they wouldnt trade. WHY IS THERE SCARCITY? Because wants are unlimited and resources are limited. To cope, we must make choices and face trade-offs MARGINAL ANALYSIS Marginal analysis involves comparing the costs and benefits of doing just a little more of something. The marginal benefit of reading one more page of this Cram Kit is one more question answered correctly at competition. THE COST OF MAKING A CHOICE We have to pay for our choices. What's more, we give up a choice we dont make for every choice we do make.
Marginal benefit
Number of slices
TYPES OF COSTS
Type Opportunity cost (implicit cost) Accounting cost (explicit cost) Economic cost D e f in i t io n Value of the next-best choice What you tangibly pay to get something Opportunity cost + accounting cost Ex a m ple Value of sleep you lose when you choose to cram Cost in dollars of this Cram Kit Sum of the above
THE INVISIBLE HAND STRIKES BACK In 1776, Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations , establishing the field of economics and the idea of the invisible hand (the market regulates itself).
QUICK QUIZ
QUESTIONS 1. The full cost of a decision is its __________. 2. If Jolly Jeremy Joe is in a hot dog competition, the fact that his 100th hot dog gives him far less utility than his first is known as _____________. 3. There are no free lunches in our world because of __________ and _____________. ANSWERS 1. economic cost 2. diminishing returns 3. limited resources, unlimited wants

Categorization
MODELING
ECONOMIC ANALYSIS
`
MICROECONOMICS VS. MACROECONOMICS

THE PYRAMID OF ECONOMICS
Eco n o m i e s
Careful observation Description
Economic Analysis
Measurement of economic theory Theory
Ma rket s
Individuals
Theoretical models capture the basics of economic

interactions while stripping away extra details. Most models look too simplistic. But it is this simplicity that allows us to identify what assumptions and characteristics are important. The true strength of a model is how well it captures and predicts whatever we want to understand.
MICROECONOMICS Microeconomics models individual behavior to analyze markets as a whole. Conclusions about markets are then extended to the economy as a whole. Microeconomics works up the pyramid. MACROECONOMICS Macroeconomics is concerned with the entire economy. It studies big changes and analyzes how societies----and the individuals within them----can and do grow better or worse off. Macroeconomics works down the pyramid.
MODELING PARETO EFFICIENCY

Something is Pareto efficient when no one can have more without someone else ending up with less. If you and your two friends split $100 so that each of you has $33 and $1 is left on the table, the situation is not pareto efficient. You could take one more dollar without hurting your friends. But if you and your two friends split $100 so that you have $100 and each of them has $0, the situation is pareto efficient. They cant get any money without taking away some of yours.
POSITIVE VS. NORMATIVE ECONOMICS POSITIVE

Wh at is ? Falsifiable statements -- now or with future data Conclusions of a model
NORMATIVE
Wh at s hould b e? Subjective statements Judgments
THREE FUNDAMENTAL QUESTIONS Every market must answer three basic questions:
How much should be produced?
1
Who should produce?
2
Who should receive what is produced?
POSITIVE OR NORMATIVE? Academic Decathlon puts the Decathlete through 10 different events (positive) Temperatures next year will cause a 10% decline in crop yields. (positive) Economics is tough, but understanding it is useful for understanding policy (normative) Alpacas are better than llamas (normative)

The Origin of Markets (Trade)
WHY TRADE?
ABSOLUTE VS. COMPARATIVE ADVANTAGE
PRODUCTION POSSIBILITIES FRONTIER (PPF)
Absolute advantage
Comparative advantage
An agent has a comparative advantage for producing a good when he can produce that good at a lower opportunity cost than other agents.
An agent has an absolute advantage for producing a good when he can produce that good more efficiently than other agents.
An agent can be terrible at producing every good and service and have no absolute advantages versus a second agent, but he must have a comparative advantage in at least one good AN EXAMPLE FROM OUTER SPACE 1. Say Laika is very good at producing both dog treats and spacesuits. She can produce 80 dog treats or 20 spacesuits in one month.
A countrys PPF represents all the combinations of

output (in this case, combinations of milk and missiles) that are feasible Any combination of milk and missiles inside or on the curve is possible, but only points o n the curve are efficient Points outside the curve are impossible to produce but may be obtained through the benefits of trade Producing more of one good requires a tradeoff in the form of less production of the other good The curve bows out because of dim inis hing r eturns to sca le: producing more milk increases the opportunity cost in terms of missiles Different slopes (different opportunity costs) imply comparative advantages A curve that is farther out indicates higher production and an absolute advantage
2 . Neil is not very good at producing either good. He can produce 30 dog treats or 10 spacesuits in one month. 3 . Laika has absolute advantages for both goods, while Neil has none. 4. Laika gives up four dog treats for each spacesuit produced, while Neil only gives up three. a. Laika gives up 1/4 of a spacesuit per dog treat, less than Neils 1/3 of an spacesuit b. Neil gives up 3 dog treats per spacesuit, less than Laikas 4 dog treats 5 . This means Laika has a comparative advantage in producing dog treats, while Neil has a comparative advantage in producing spacesuits. 6 . Therefore, Laika should specialize in producing dog treats, and Neil in producing spacesuits. 7. Trade benefits both because they are able to specialize in their comparative advantages.
TRADE QUESTIONS FOR ANSWERS

QUESTIONS
If an agent can produce more of a good than another agent with the same inputs, he has a(n) _____. 2. Comparative advantages arise from lower ___ of production. ANSWERS 1. absolute advantage 2. opportunity costs
1.
MICROECONOMICS
Introduction to Markets
PERFECT COMPETITON MARKET MODEL
ASSUMING MAKES The perfectly competitive market model relies on several key assumptions. These assumptions mark the boundary between perfect competition and other market types:
MARKETS
WE ALL COME TOGETHER Markets occur when producers and consumers exchange a certain good or service voluntarily Markets do not have to be explicitly created by a central body (like a government) Markets are not always highly organized As long as the transactions are voluntary, everyone involved will be better off THE PRICE IS RIGHT A market price conveys the value of a good to producers and consumers In perfect competition, the price represents the opportunity cost of a goods production Price also signals the value of the good to all producers and consumers All buyers and sellers are price takers, not makers AGGREGATION Prices are good indicators of a products value in a competitive market. Adding up prices allows us to compare different goods. This process is called aggregation and allows firms and consumers to make good market decisions.
All agents accept prices as given
No individual has market power No producer can set prices other than the market price
One homogenous product

All producers produce an identical product or service
Diminishing returns
Consuming more of a product eventually offers less utility to consumers Inputs eventually grow less useful as production rises
Entry and exit costs are zero
Entry costs are the costs of starting a certain business Exit costs are costs of shutting down a business
Transaction costs are zero
The process of exchange does not add more costs The market price is the same for all consumers
MARKET MENTALITY
QUESTIONS 1. What does no agent has market power mean in context of a perfectly competitive market? 2. In a competitive market, market price reflects the ______________. 3. Aggregation is the process of ____________. ANSWERS 1. No individual agent can affect the market price. All economic agents must accept the market price as it is determined by the market as a whole. 2. value consumers and producers place on the good 3. comparing different goods using a common measuring stick, such as market price
Perfect information
Consumers are aware of all producers and vice versa Everyone has access to the market price
Rational behavior
Firms maximize profits Consumers maximize utility
MICROECONOMICS
Demand
THEORY OF THE CONSUMER
THE LAW OF DEMAND The quantity demanded of a good by consumers increases when market price decreases and decreases when price increases----price and quantity demanded are negatively correlated.
SHIFTING ALL OVER THE PLACE

CONSUMER INCOME No r m al g o o ds Computers, yachts, calculators Increased income higher demand In f e r io r g o o ds Dollar store goods, used textbooks Increased income l o w e r d e m an d
TERM
DEFINITION
The amount of a good consumers will demand at a given price; a specific value, NOT the general relationship given by demand The overall relationship given by the law of demand, relates price to quantity demanded A table that represents the law of demand, maps values of prices to quantities demanded Curve that represents the law of demand, maps an interval of prices to quantities demanded
PRICES OF RELATED GOODS S u bs t i t u t e s Goods that can replace one another---7-Up and Sprite Increased price of one h i g h e r d e m an d f o r s u b st i tu te NUMBER OF CONSUMERS Increased number of consumers h igher dem an d CONSUMER PREFERENCES AND EXPECTATIONS Good becomes more desirable h igher dem an d Expectation of pay cut lower de m and Sh ift s in a curve are NOT the same as changes in quantity or price Demand increased is a shi ft of the demand curve; quantity demanded has changed at every price A change in quantity demanded or price is a m ov em en t along the curve C o m p leme n ts Goods that combine for consumption---peanut butter and jelly Increased price of one l o w e r d em an d fo r co m pl em en t
Qu an t ity d e m an d e d
D e m an d
D e m an d s c h e du l e
D e m an d cu r v e
[[
THE DEMAND CURVE

Price $25 $20 $15 $10 $5 5 10 15 20 Quantity Demanded
I DEMAND A QUIZ
QUESTIONS 1. The law of demand states that when price increases, quantity demanded ______. 2. A change in quantity demanded for every price implies a _______. 3. An increase in the price of a good will lead to a(n) ______ in the demand for its complement. ANSWERS 1. decreases; 2. shift of the demand curve; 3. decrease
THE DEMAND SCHEDULE P ri ce Qu an t ity $5 20 $10 15 $15 10 $20 5 $25 0
MICROECONOMICS
Supply
THEORY OF THE FIRM
THE LAW OF SUPPLY The quantity of a good supplied by producers increases when market price increases and decreases when price decreases----price and quantity supplied are positively correlated.
SHIFTY SUPPLY
FACTORS AFFECTING SUPPLY Fact o r Increased costs of production factors Technological advances Expectations of lower future prices Increased number of firms Im p act Higher costs Lower costs Higher current prices Hi g he r s u p pl y S u p pl y Lo we r s u p ply
TERM
DEFINITION
The amount of a good firms will supply at a given price; a specific value, NOT the general relationship given by supply The overall relationship given by the law of supply, relates price to quantity supplied A table that represents supply, maps values of prices to quantities supplied Curve that represents supply, maps an interval of prices to quantities supplied
Qu an t ity s u p pli e d
S u p ply
SHIFTS VS. MOVEMENTS
S u p pl y s ch e d u le
S u p pl y cu r ve
THE SUPPLY CURVE

Price $25 $20 $15 $10 $5
10
15 20 Quantity Supplied
A HEALTHY SUPPLY OF QUIZZES

THE SUPPLY SCHEDULE P r i ce Qu an t ity $5 0 $10 5 $15 10 $20 15 $25 20 ANSWERS 1. increases; 2. decrease QUESTIONS 1. When price increases, quantity supplied ____. 2. If firms expect prices to rise, supply will ___ now.
MICROECONOMICS
Elasticity
ELASTICITY BASICS
PRICE ELASTICITY OF DEMAND How much is quantity demanded affected by changes in the goods price? PRICE ELASTICITY OF SUPPLY How much is quantity supplied affected by changes in a goods price?
CALCULATING ELASTICITY
THE FORMULA
E=
% changein A (AF - A I ) A I % changeinB (BF - BI ) BI
E is the elasticity of A with respect to B AF is the final value of A, AI is the initial value BF is the final value of B, BI is the initial value
DEFINITIONS E = 0: Perfectly inelastic, vertical line; change in variable B does not affect variable A at all 0 < E < 1: Inelastic; steep line; change in variable B causes a smaller change in variable A E = 1: Unit elastic; convex curve; change in variable B causes an equal change in variable A E > 1: Elastic; shallow line, change in variable B causes a larger change in variable A E = : Perfectly elastic; horizontal line; changing variable B infinitely affects variable A AN EXAMPLE
ELASTICITY AND GOODS DEMAND

E l a s ti c Goods with close substitutes | Example: I n e l a s ti c
baseball caps
Luxury goods that we can do without | Example:
Necessities that people must buy regardless of price | Example: insulin
Porsches
SUPPLY
E l a s ti c In the long run, firms can reallocate resources I n e l a s ti c In the short run, firms cannot reallocate resources Extremely scarce goods
E=
% changein q (qF - qI ) qI % changein p (pF - pI ) pI
E is the price elasticity of demand (elasticity of

demand with respect to price) m is a goods price; pF and pI are final and initial price, respectively q is the quantity demanded; qF and qI are final and initial quantities, respectively
FACTORS THAT AFFECT PRICE ELASTICITY
Degree of substitution (goods with

D e m an d close substitutes have high elasticity of demand) Degree of necessity (necessities are more inelastic) Time frame (in the short run, goods tend to be more inelastic) Scope of the market (a larger market is more inelastic since fewer substitutes are available) means more inelastic supply) Time frame (in the short run, supply is inelastic) Presence of barriers to entry (lower barriers to entry means more elastic supply)
REVENUE | THE ELASTICITY SHORTCUT

Revenue = price of good x quantity
Price elastic good Increase in price decrease in revenue Price inelastic good Increase in price increase in revenue Unit elastic good Increase in price no change in revenue
Scarcity of inputs (scarcity of inputs

S u p ply
MICROECONOMICS
Equilibrium
MEET ME AT THE INTERSECTION
THE INVISIBLE HAND The laws of supply and demand meet at the market equilibrium point, where their forces are equal and opposite.
Price
B
MARKET SURPLUS
Quantity
Triangle A is consu mer surplu s, or the difference

between how much consumers are willing to pay and the market price Triangle B is producer surplu s, or the difference between the price at which firms are willing to sell their product and the market price Market equilibrium maximizes m arke t s urplus, or the sum of producer and consumer surplus; the goal of social planners is to maximize this surplus
SHIFTING SUPPLY AND DEMAND Shift

Supply N/A N/A Demand N/A N/A Price ambiguous ambiguous Quantity ambiguous ambiguous
Result
Producer surplus ambiguous ambiguous ambiguous ambiguous Consumer surplus ambiguous ambiguous ambiguous ambiguous Total surplus ambiguous ambiguous
An - means an increase, not a shift upward. Likewise, means a decrease, not a shift downward.
MICROECONOMICS
Government Policies
PRICE CONTROLS
PRICE CEILINGS Price ceilings set a maximum legal price on a good. If this price is below the equilibrium price, the ceiling is binding and the market price is changed.
TAXATION
ONLY ON THE MARGIN Marginal taxes (taxes per unit) make consumers pay a different price than what producers receive. The government steps in between consumers and producers. Since marginal taxes distort how prices signal value, they lead to inefficiency.
Price
Price
A C
A
Price Ceiling Tax Quantity
Consumer price
C
Producer price
Trapezoid A is the new consumer surplus Triangle B is the new producer surplus Triangle C is the deadweight loss caused by the policy
because the market is not in equilibrium The width of the shaded rectangle is the difference between quantity demanded and quantity supplied, or the s horta ge in the market Note that A + B + C = equilibrium market surplus PRICE FLOOR
Quantity
Triangle A is the new consumer surplus Triangle B is the new producer surplus Triangle C is the deadweight loss caused by taxation
because quantity is contracted (mutually beneficial transactions are not taking place) Rectangle D is tax revenue, which is equal to market quantity times revenue Note that marginal taxation is equivalent to holding quantity at a fixed value (like a quantity ceiling) ELASTICITY AND TAXATION Flatter curves increase the size of the deadweight loss triangle and make the revenue rectangle smaller Therefore, markets with elastic demand and supply curves suffer the most from taxation and provide the least revenue The incidence of taxation determines whether consumers or producers bear the majority of the tax If supply is more inelastic than demand, demand can adjust more easily and firms bear more of the tax Similarly, if demand is more inelastic, consumers will bear the brunt of the taxation
Price Floor
C B
Price
Quantity
Triangle A is the new consumer surplus Trapezoid B is the new producer surplus Triangle C is the policys deadweight loss The width of the shaded rectangle is the difference between quantity supplied and quantity demanded---in other words, the surplus in the market THE LESSON TO BE LEARNED
Applying a price ceiling below equilibrium or a price floor above equilibrium is inefficient and leads to deadweight losses.
MICROECONOMICS
Tariffs and Exports
TRADE IN A SMALL ECONOMY
OVERPOWERED BY THE WORLD We assume the domestic economy is small relative to the world economy and cannot influence the world price. Therefore, the world price is fixed for the domestic market, making international trade equivalent to a price control. The difference is that the world market either buys the surplus or supplies the shortage. DIAGRAM OF AN IMPORTING ECONOMY
C
TRADE TAXATION
TARIFFS, IMPORT DUTIES, AND OTHER NASTIES A tariff is a tax on imports.
Price
C A B C
World Price + Tariff World Price
Quantity Price
A C B D
Triangle A represents the gains from trade with the

World Price
Quantity
The big triangle A is consumer surplus The small triangle B is producer surplus Triangle C represents the gains from trade Rectangle D is the value of the goods imported AN EXPORTING ECONOMY
import tax in place Triangle B is the revenue collected by the government from the tax The two triangles marked by C are the deadweight losses associated with the tax If the tax were removed, the gains from trade would be A + B + C Applying an import tariff increases producer surplus at the expense of consumer surplus and efficiency
TRADE AND TARIFFS TRIVIA

QUESTIONS 1. An export tax benefits domestic _______ at the expense of domestic _______. 2. An import tax benefits international _______ at the expense of international _______. 3. For a small open economy, international trade is equivalent to a binding _______ _______. 4. If voluntary trade is always beneficial, why do some oppose it? ANSWERS 1. consumers; producers 2. consumers; producers 3. price control 4. While the economy as a whole benefits, not everyone does.
A C
World Price
Price
B D
Quantity
The small triangle A is consumer surplus The big triangle B is producer surplus Triangle C represents the gains from trade Rectangle D is the value of the goods exported
MICROECONOMICS
Behavior of Firms
FIRM DECISION-MAKING
TYPES OF COSTS Fix ed c osts: Incurred even when quantity produced is zero, independent of output Variab le c os ts: Change with quantity produced, contribute to marginal cost To ta l co sts: Sum of fixed costs and variable costs MARGINAL COST & MARGINAL REVENUE Marginal cost Cost of producing just one more of a good Revenue from producing just one more of a good. For a perfectly competitive market, fixed at market price
Quantity Produced
COST CURVES
Marginal cost Average total cost
$
AFC Average variable cost Average fixed cost
AVERAGE COST CURVES Average Fixed Cost Average variable cost (AVC) Average total cost (ATC) Fixed costs divided by quantity produced Decreases as quantity increases Variable costs divided by quantity produced Decreases and then increase Sum of average fixed cost and average variable cost ATC =
Total fixed costs + Total variable costs Total number of units produced
Marginal revenue
TYPES OF PROFIT 1. Acco un ting pro fit: Total revenue minus accounting costs; producers attempt to maximize this 2. Eco nom ic prof it: Total revenue minus full economic costs (including opportunity costs) 3. No rm al pro fit: Zero economic profit; means accounting profit equals opportunity cost of production; in a competitive market firms can expect normal profits in the long run THE GOLDEN RULE: MC = MR
DIMINISHING RETURNS TO SCALE Marginal costs first decrease and then increase. This phenomenon is the result of diminishing returns to scale. Firms will spread fixed costs over multiple units of output. Variable costs, however, will drag average cost upward after a certain point. Consider a restaurant kitchen. After a certain point, adding too many cooks will cause inefficiency----they will get in one anothers way, and one may faceplant into the soup.
All firms are assumed to seek to maximize profits.

Profit maximization in any market occurs where marginal revenue equals marginal cost (MC=MR). A ll f i rm s w i l l p ro du ce u p t o t h i s p o in t o f p ro fi t m ax i m iz at i o n . In graphical terms, find where the marginal cost and marginal revenue curves intersect. Then, look at the quantity where that occurs. In a perfectly competitive market, the marginal revenue curve is the same as the demand curve, which is perfectly elastic at the market price. In a perfectly competitive market, therefore, profitmaximization occurs where the demand curve intersects the MC curve.
MULTIPLE INPUTS
Inputs: labor and capital Prices: wage rate and price of capital Increasing the price of an input makes a firm
substitute away from it
MICROECONOMICS
Failures of Perfect Competition
IMPERFECT MARKETS: MONOPOLY
FAILURES OF PERFECT COMPETITION Removing any assumptions of perfect competition creates a new market type. All of these market types are inefficient and create deadweight loss. All firms face downward sloping demand curves. MONOPOLY BASICS Only one firm supplies (example: De Beers diamonds) This firm has full market power to set prices Arise from barriers to entry or economies of scale (after a certain point, producing more of a good will increase costs due to increasing inefficiency) Faces a downward sloping demand curve (for the entire market)
I HAVE THE POWER

MARKET POWER Market power is the ability of an individual to influence market price. Perfect competitors have no market power and must accept the market price. CAUSES OF MARKET POWER
High entry costs
Policies that restrict entry
Economies of scale
Control of natural resources
Rent seeking (see later)
Deliberate scarcity Monopolies can produce less than what is demanded to increase profits This leaves some consumer demand unmet, decreasing general welfare Some consumer surplus becomes producer surplus, but part of it vanishes as deadweight loss Inefficiency Monopolists are sometimes lazy, incompetent, or just lack incentive to raise standards due to no competition This inefficiency can result in wasted resources, higher production costs, and higher prices Positive economic profit A monopoly will set price and quantity supplied where marginal revenue equals marginal cost Unlike a perfectly competitive firm, increasing supply to reach that point increases economic profits
PRICE DISCRIMINATION Price discrimination involves selling the same product to different consumers at different prices----such as airline seats or movie tickets. This practice increases producer surplus at the expense of consumer surplus. Monopolies price discriminate to capture new consumers without losing current ones.
BARRIERS TO ENTRY
Monopolies arise due to barriers that keep competitors from entering the market. Barriers include:
Ownership of a key resource Government-created barriers (patents, copyrights,

and other property protections) Natural monopolies: emerge when it is practical for only one seller to operate in a given market
YOU SHALL NOT MATCH

1. Market power 2. Economies of scale 3. Sherman AntiTrust Act 4. Barriers to entry 5. Only one supplier A. After a certain point, producing more goods increases costs B. Monopoly C. Ability to influence market price D. Legislation that deals with monopolies E. Prevent more firms from entering
DEALING WITH MONOPOLIES

The United States government has devised several methods of dealing with monopolies. Regulation Legislation (Sherman Anti-Trust Act) Public Ownership
Answers: 1. C; 2. A; 3. D; 4. E; 5. B
MICROECONOMICS
Failures of Perfect Competition
IMPERFECT MARKETS CONTINUED
OLIGOPOLY Only a few firms (suppliers) exist Each firm has some degree of market power Goods are either homogenous or differentiated Firms primarily face non-price competition Producers often collude and form cartels Examples: Market for mobile phone service, OPEC
MARKET FAILURES
Market failures occur when competitive markets fail to produce socially desirable outcomes. The two main forms of market failures are linked to externalities and public goods. Externalities are costs or benefits associated with a decision not factored into the decision-making process. They do not affect the decision maker directly.
C ollus ion occurs when firms in an oligopoly cooperate to raise market prices artificially. A group of firms that colludes to control prices is a car te l, which is illegal under U.S. antitrust law. The incentive to cheat in a cartel is strong, so cartels tend to break down even without government intervention.
Negative externalities
Harm others They are the costs of an action that are not passed along to the agent taking that action Since the agent does not face the cost, he will perform more of the action than is optimal
Positive externalities
Benefit others They are the benefits of an action not felt by the agent taking that action Since the agent does not enjoy the benefit, he will perform less of the action than is optimal
THE BOTTOM LINE

An oligopoly will be more efficient and benefit more people than a monopoly, but will be less efficient and benefit fewer people than a perfectly competitive market.
MONOPOLISTIC COMPETITION Goods no longer homogenous Large number of firms, just like perfect competition Firms compete by differentiating their products, often artificially Producers often engage in non-price competition (for example, through advertising) Firms face a downward sloping demand curve Examples: Blue jeans, restaurants, toothbrushes
INTERNALIZE IT! One way to address externalities is to internalize them, by incorporating the cost of the externality into the market. For instance, if companies are taxed for each pound of pollution they emit----and the tax is set to equal the cost of that pollution to society----companies will make choices based on true social cost. THE COASE THEOREM As long as the parties involved in a dispute can negotiate and property rights are clearly defined, the private market can settle any disputes.
The diversif icat ion of products in a monopolistically competitive market gives consumers more choices than in a perfectly competitive market, where all products are homogenous. However, since market price is greater than marginal cost, the markets will experience some social inefficiency.
PLEASE DONT FAIL THIS TRUTH TEST

TRUE/FALSE 1. Oligopolies are more efficient than monopolies 2. Externalities are the only area of market failure ANSWERS 1. True 2. False; public goods are also associated with market failure
THE BOTTOM LINE

You can spot a monopolistically competitive market whenever multiple companies are using ads to convince you that their products are different when they are actually pretty similar.
MICROECONOMICS
Institutions
PROPERTY RIGHTS INSTITUTIONS AND ORGANIZATIONS
In s t itu ti on s Formal or informal rules that structure human interaction Examples: Codes of conduct, social norms, most markets, laws Or g an iza t i on s More formal than institutions Examples: Stock exchanges, organized religions, corporations
ENTREPRENEURS & CREATIVE DESTRUCTION

INNOVATION Entrepreneurs can earn economic profits by taking risks to be the first to sell a product or to provide a new or better service. While innovation can create new barriers to entry in the form of patents and copyrights, it also destroys existing market imperfections and therefore betters society. CREATIVE DESTRUCTION Economist Joseph Schumpeter described the impact of entrepreneurs as creative destruction---- replacing the old and inefficient with the new and improved.
MINE, NOT YOURS Property rights dictate who can and cant use a good. The rival ry of a good is how much one persons use of a good prevents another person from using it. The excl udab ility of a good is the ease of preventing someone from using it. TYPES OF GOODS EXCLUDABLE RIVAL NON-EXCLUDABLE
THE GOVERNMENT
POWERS OF THE GOVERNMENT Ability to tax citizens Legitimate use of force The use of force gives power to the court system, which ensures contracts are upheld. Without the rule of law, market economies cannot function. DEMOCRATIC INEFFICIENCIES Pork barrel politics: The tendency of elected officials to steer money to their home communities to increase their chances of being reelected Logrolling: Vote trading among elected officials, usually to get support for pet projects Rent seeking: Socially unproductive activities that redirect, rather than create, economic benefits (lobbying, for example)
Private Goods
(food, clothes, cars)
Collective goods
(sidewalks, fishing ponds)
Common goods
NONRIVAL (electricity, cable television)
Public Goods
(national defense, air)
INTELLECTUAL PROPERTY C opyright: protection given to the creators of literature, art, or music P atent: rights awarded to inventors so that no one else can copy their inventions for a period of time FINANCIAL INTERMEDIARIES These institutions link savers and borrowers. Banks, stock exchanges, and bond markets are financial intermediaries.
Savings deposited Banks Loans borrowed
AN EFFICIENT LITTLE QUIZ

1. Non-excludable and rival 2. Excludable and rival 3. Non-excludable and nonrival 4. Excludable and non-rival A. B. C. D. Private Public Common Collective
Answers: 1. D; 2. A; 3. B; 4. C
MACROECONOMICS
Basics of Macroeconomics
MACROECONOMICS ISSUES
Macroeconomics is concerned with two main issues: Factors that affect things in the long run (the size of economies, standard of living, and price level) The causes and consequences of short-run economic fluctuations (especially unemployment and inflation)
THE STATE OF THE ECONOMY

THE BUSINESS CYCLE Real output fluctuates cyclically, alternating between periods of growth and decline. Note that even though the economy fluctuates, the general trend is upwards.
Peak
REAL GDP Real Gross Domestic Product (GDP) measures the total quantity of goods and services produced in an economy in a given year, adjusted for the effects of inflation. REAL GDP PER CAPITA Per capita is a Latin phrase meaning per head. GDP per capita is the GDP per person in the economy; it indicates what the average person is able to consume in an economy.
Expansion Real output
Downturn Time
Trough
TERM
If the population were suddenly to double, GDP per capita would be cut in half. (Technically, the same would be true if every person in the economy were to grow a second head.) AVERAGE LABOR PRODUCTIVITY Average labor productivity measures how much the typical worker can produce. Divide the economys total output (GDP) by the total number of workers employed. Economy' s output (GDP) Average labor productivity = Total number of workers Greater levels of production and average labor productivity enable consumption that improves the standard of living. HUMAN HAPPINESS Human happiness depends on more than just material levels of consumption. Other important factors: A long, healthy life Access to education Clean environment Possession of alpacas Depression Expansion
DEFINITION
Increase in real GDP; occurs until a peak Decrease in real GDP; occurs until a trough Downturn that lasts at least two quarters (six months) No official definition; a very steep and prolonged recession
Downturn
Recession
A QUIZ FOR A DEPRESSION

QUESTIONS 1. A period of increase in real GDP is a(n) _______. 2. What were the years of the Great Depression? 3. When was World War II? 4. How do most nations moderate the business cycle? ANSWERS 1. expansion 2. 1929 to 1933 3. 1941 to 1945 4. through countercyclical monetary and fiscal policy
MACROECONOMICS
Unemployment
EMPLOYMENT
THE LABOR FORCE The labor force includes all members of the population who have a job (employed) or are actively seeking employment (unemployed). To be in the labor force, you cannot be:
TYPES OF UNEMPLOYMENT
Structural
Mismatch between skills demanded and skills supplied Spurred by changes in technology or consumer preferences Would be zero if retraining was instant was instant and free Factors into the natural rate of unemployment
Younger than 16 or retired In jail, in the military, or a homemaker A discouraged worker: you must have worked in the past
week or looked for work in the past four weeks
Cyclical
TERM
Employment rate
DEFINITION
Percentage of the labor force that has a job; number of persons employed divided by the labor force; never 100% Percentage of the labor force that lacks a job but is searching for one. The Bureau of Labor Statistics measures unemployment. Percentage of the population in the labor force----about 66% Worked for pay in the past week, or on vacation or sick leave Did not work during the past week but did look for paid work sometime in the past four weeks Did not work in the past week or look for work in the past four weeks
d
Unemployment resulting from movement along the business cycle Increases with recessions and decreases with expansions Does not factor into the natural rate of unemployment
Unemployment rate Participation rate Employed
Frictional
Caused by time-lag between jobs Inevitable Factors into the natural rate of unemployment
QUIZ FOR EMPLOYMENT

QUESTIONS 1. Unemployed workers must be _______, but not have a _______. 2. Unemployment due to a mismatch between skills demanded and skills supplied is _______. 3. No one knows the ____ rate of unemployment. 4. The percentage of the population that is in the labor force is known as the _______.
Unemployed Discouraged worker / out of the labor force
THE NATURAL RATE OF UNEMPLOYMENT Key fact: Full employment is NOT 0% unemployment. There is always unemployment----some people are always between jobs, or just joining the labor force The unemployment rate of an economy at full output is the n atural rate o f un employm en t Ok un s law relates unemployment to GDP; every 1% increase in unemployment above the natural rate results in a 2% drop in real GDP No one knows exactly what the natural rate is in 21 st century America----it might be higher than it used to be
ANSWERS 1. looking for work; job 2. structural unemployment 3. natural 4. labor participation rate
MACROECONOMICS
Gross Domestic Product
THE BIG PART OF MACRO
GROSS DOMESTIC PRODUCT (GDP)
HISTORY OF GDP
Development of GDP
GDP is the market value of all final goods and services produced within a country in a given period of time.
In the mid-17th century, Sir William Petty was assigned by the British government to assess the Irish peoples ability to pay taxes.
the market value
The total value of different goods (add up dollar values)
of all final goods and services
Only final goods are counted Capital goods (made to make other goods) are counted the year they are produced
In 1932, the U.S. Department of Commerce commissioned Simon Kuznets to develop a system to measure national output.
produced within a country"
All goods produced within a countrys borders, even if a foreigner owns the factory
Kuznets presented his findings in 1934 to the U.S. Senate.
in a given period of time
Typically a specific quarter or year
When the U.S. entered World War II (which effectively ended the Great Depression) it continued to refine techniques for measuring output.
WHATS NOT INCLUDED IN GDP In term ediate goo ds: goods used for the production of other goods, value is reflected in its final good Example: bolts Go ods not s ol d on th e open m arket: illegal black market goods, as well as goods produced for personal consumption Example: home-knit sweaters Us ed goo ds: the value of the good was already counted in GDP when the good was sold new Example: a used car Tran s fer pa ym ents: moving money between the government and people Exa m ple: a Social Security check
For his efforts, Kuznets received the Nobel Prize in Economic Science in 1971.
LIMITATIONS OF GDP
HEY, YOU MISSED ME! GDP misses out on a lot of economic activity.
It can be difficult to determine what is a final good GDP excludes goods and services not bought or sold
in official markets (such as work done by stay-athome spouses) GDP usually ignores the fact that certain activities deplete natural resources , pollute, or have other costly externalities
MACROECONOMICS
Measuring GDP
MEASURING GDP, PART A
THREE WAYS TO MEASURE IT
MEASURING GDP, PART B

INCOME APPROACH GDP = production = expenditures = income
Calculating GDP
Production Approach: Measure total value of economic output Expenditures Approach: Count everything spent on consumption Income Approach: Follow the money
REAL VS. NOMINAL REAL

In terms of a base periods price level Can be compared across years
NOMINAL
In terms of the measurement years price level Includes inflation
CONSUMPTION/EXPENDITURES APPROACH GDP = production = expenditures = Y = C + I + G + NX
Real measurements like real GDP are used to

measure economic growth Economists need a way to separate the effects of changes in price from changes in quantity produced (and production equals GDP) Prices do not change consistently----the price of one good may increase while the price of another decreases by a different magnitude
Consumption (C): value of all purchases of final goods designed for consumption by consumers
Consumer durables: long-lived consumer goods Consumer nondurables: used up more quickly than durable goods Services: intangible goods
Investment (I): what firms spend on capital, technologies, and real estate
Business fixed investment: purchase of capital equipment Residential fixed investment: purchase of new homes and apartment buildings Inventories: unsold goods placed in storage for later sale
SURPLUS AND DEFICIT

NX = ne t ex po rt s = expo rts -- im ports Trade surplus: Exports exceed imports; GDP increases Trade deficit: Imports exceed exports; GDP decreases In the long run, imports and exports will move in similar directions, both either decreasing or increasing.
Government spending (G): everything the government pays for labor, goods, and services Net exports (NX): exports minus imports
TRICKY BITS
The value of homes purchased is considered personal

investment, NOT consumption If a good does not sell in the given time period, it enters a firms inventory and is counted as investment A good in inventory sold in a later year does NOT enter that years GDP, as it was already counted as an investment in inventory Government transfer payments, such as Social Security, are not payments for a good or service and thus are not considered government expenditures
CAUTION Dont confuse trade surpluses and deficits with budget surpluses and deficits Budget surpluses and deficits refer to the difference between how much a government takes in (mostly as tax revenue) and how much it spends Trade surpluses and deficits refer to how much an economy exports versus how much it imports
MACROECONOMICS
Measuring Inflation
INFLATION AND THE CONSUMER PRICE INDEX
WHAT IS INFLATION?
GDP DEFLATOR
The GDP deflator also measures inflation.
Inflation is an increase in the aggregate price level or, equivalently, a decrease in the value of money
THE CONSUMER PRICE INDEX (CPI) In the United States, the Bureau of Labor Statistics calculates the CPI each month by comparing the prices of a given basket of goods between the current year and a base year. This basket includes the sorts of goods that an average household would buy regularly (housing is the main component), and varies by income and region. The CPI in the base year is always 100. A CPI of 120 = prices are 20% higher than in the base year. A CPI of 75 = prices went down 25% since the base year. THE FORMULA: CPIYEAR T =
COST OF BASKETYEAR T COST OF BASKETBASE YEAR
The deflator corrects for price increases in nominal GDP. THE FORMULA GDP deflator= VOLATILITY Compared to the CPI, the GDP deflator is much less volatile. It increases less at peaks and declines less at troug nominal GDP x 100 real GDP
DIFFERENCES
The GDP deflator is different from the CPI in two main ways. The GDP deflator reflects only the prices of domestically produced goods. The CPI can include imports like oil. The GDP deflator and CPI place different weights on goods. Since the deflator weights prices by production, it adjusts to changing consumption patterns. DEFLATING THE DEFLATOR: SHORTCOMINGS Unfortunately, the GDP deflator is difficult to calculate accurately and therefore is only published once per year. That means the deflator cannot track inflation very quickly. As a result, it is not very useful for guiding government policy, despite its accuracy. Like the CPI, the GDP deflator fails to take into account changes in product quality.
X 100
ADVANTAGES Used to reflect changes in cost of living (so as to adjust Social Security benefits and other COLA accounts) Captures changes in price for basic consumer goods Makes inflation rate easy to calculate
DISADVANTAGES New goods and services are introduced all of the time. Example: Kenya added mobile phone airtime to its CPI basket in 2010. Does not account for substitution bias (consumers may switch to a good not in the basket if one gets too expensive) Does not account for changes in quality
THE BOSKIN COMMISSION In 1996, economist Michael Boskin was appointed to head a commission to evaluate CPI. His group found that the CPI overstated the rate of price inflation by 1.3% a year.
MACROECONOMICS
Money
ITS A
DEFINITION
THE MONEY SUPPLY

DEFINITION
Money is something accepted as payment for goods and for the settlement of debts.
FUNCTIONS OF MONEY M edium of excha nge: Eliminates the need to barter for goods, which requires both parties to want what the other has (double coincidence of wants) Unit o f acco unt: Establishes the value of goods relative to one another Sto re of v alue: Allows individuals to store wealth over a period of time For something to be money, it must satisfy these three functions. TYPES OF MONEY C o mm o d i ty m on ey Money with value outside of just being money, such as gold, or cigarettes in prison
The money supply is the stock of all liquid assets in an economy that can be exchanged for goods.
MONETARY AGGREGATES Monetary aggregates classify money by its liq uidit y: how easily it can be converted into currency. M0 is the most liquid, M1 more liquid, M2 the most liquid.
M0
Cash and coins Most liquid category
M1
M0 Demand/checking deposits Other checkable deposits Nonbank travelers' checks
M2
M1 Savings deposits CDs money market funds
Fia t m oney Money only valuable because the government says it is and we believe it to be so WHAT IS NOT MONEY Credit cards are NOT money. They just provide a convenient way to accumulate debt. The use of credit cards reduces the economys need for money, since credit cards are convenient.
M2 is widely considered the most useful measure of the money supply.
MONEY QUIZ (WITH A WORD BANK)

THE QUANTITY THEORY OF MONEY medium of exchange | unit of account | store of value | liquid | commodity money | fiat money 1. Currency is the most ____ form of money. 2. Moneys role as a ____ allows people to store wealth over time. 3. ____ is money with intrinsic value. 4. Moneys role as a _____ removes the need to barter. 5. Most money today is ____. 6. Moneys role as a ____ provides a way to compare the value of goods.
MV = P Q

M = the money supply V = velocity (how often a dollar is spent in a year) P = the aggregate price level Q = total output V and Q are generally held constant, meaning an increase in M (money supply) will lead to an increase in P (inflation).
Answers 1. liquid; 2. store of value; 3. commodity money; 4. medium of exchange; 5. fiat money; 6. unit of account
MACROECONOMICS
The Financial System
SAVING AND INVESTMENT
DEFINITIONS Sa ving: Difference between what is earned and spent In ves tm ent: Purchase of new capital equipment Fin an cial institut io ns: Coordinate the saving and investment decisions in the economy Fin an cial ma rkets: Institutions in which people with money to save supply their funds to those who wish to borrow for investment
FINANCIAL INTERMEDIARIES
A financial intermediary links two other parties in a financial transaction. Banks and mutual funds are the most common. BANKS Most businesses turn to banks for the funds they need, since most small businesses do not have the resources to sell bonds or stocks. Banks draw their funds from deposits made by people who wish to save money. Banks pay their depositors a rate of interest and charge borrowers an even higher rate of interest for taking loans. MUTUAL FUNDS Mutual funds allow investors to buy into a diverse pool of stocks and bonds in a single investment vehicle.
BONDS AND STOCKS
BONDS
Certificate that specifies how much the borrower owes the bond holder Debt finance The bond purchaser receives both the principal back and interest on the loan Market interest rates can fluctuate The borrower may default by declaring bankruptcy The date of maturity is the date on which the loan will be repaid
STOCKS
Share of ownership in a firm Equity finance Shareholders hope to have their stock increase in value (and may receive dividends) Riskier than bond (bondholders are paid before shareholders) but rewards are greater Often sold to the public on stock exchanges, such as the NASDAQ or New York Stock Exchange
DEFINITION
SELLING
Diversification means mutual funds are less risky

and volatile than individual stocks Mutual funds are managed by experts Even someone with only a small amount of savings can invest in a mutual fund and effectively have a diverse portfolio
PROFITING
INTRODUCING THE FEDERAL RESERVE
RISKS
Federal Reserve
Helps control money supply
Money supply affects economy
OTHER
The Federal Reserve is often called the Fed It serves as the central bank of the United States It is a lender of last resort to other banks, to help
maintain the stability of the banking system Control of the money supply falls to the Federal Open Market Committee (FOMC) The FOMC is made up of the seven governors of the Federal Reserve and five regional bank presidents The amount of money in the economy results from the interaction of the public, commercial banks, and the Federal Reserve system
Sto ck
shares of ownership more risk more potential profit
B o n ds
loans less risk less potential profit
MACROECONOMICS
Monetary Policy
SHOW ME THE MONEY
WHAT IS MONETARY POLICY? The Federal Reserve can use monetary policy to stimulate or slow down the economy.
THE FED IN SLIGHTLY MORE DETAIL

AMERICAS CENTRAL BANK The Federal Reserve is the central banking system of the United States.
Expansionary monetary policy

Increases the money supply Increases aggregate demand in the short run (at the risk of inflation)
Created by the Federal Reserve Act (1913) It contains 12 district banks. It sets monetary policy, manages banks, and serves
as lender of last resort FEDERAL RESERVE BOARD OF GOVERNORS Located in Washington, D.C. Directed by a presidentially-appointed chairman---as of 2012, Ben Bernanke. Members appointed by the President, approved by Senate and serve 14 year terms FEDERAL OPEN MARKET COMMITTEE (FOMC) Manages open market operations Made up of Seven rotating governors of the Fed President of the New York district bank Presidents of four other district banks Day-to-day operations run by New York bank Meets every six weeks in Washington, D.C.
Contractionary monetary policy

Decreases the money supply Lower aggregate demand in the short run
Monetary policy has three goals: price s t ab ility, full em ployment, and eco nom ic g row th. Policy makers cannot achieve all three goals simultaneously
WAYS TO IMPLEMENT MONETARY POLICY

OPEN MARKET OPERATIONS
FOMC trades securities on the open market Buying securities injects money into the economy Open market operations are performed daily Selling securities takes money out of the economy
DISCOUNT RATE AND FEDERAL FUNDS RATE

Discount rate Interest rate the Fed charges banks for loans Changed infrequently and by the board of governors Federal funds rate Overnight rate charged on loans between banks Not directly set by the Fed, but strongly influenced
MONETARY POLICY: PROS AND CONS

THE POSITIVE Monetary policy can be enacted immediately, unlike most fiscal policy, which must be legislated Central banks are relatively free of political interference; thus, they can pursue unpopular but important policies Central banks are staffed by professionals, not politicians THE BAD Monetary policy does not affect the economy quickly Central banks are hard to hold accountable Increasing the money supply may not boost the economy as well as traditional fiscal policy would
Increasing the interest rate decreases the money supply
RESERVE REQUIREMENT
Dictates how much of its deposits a bank must hold in reserve Increasing the reserve requirement decreases the money supply Set by the board of governors Money Multiplier= 1 RR (RR = reserve requirement)
MACROECONOMICS
More on Saving and Investment
SAVING AND INVESTMENT IN AGGREGATE
IDENTITY An identity will always be true, just like the equality of GDP, production, income, and expenditures. CLOSED TO TRADE Assume the economy in question is closed to trade. GDP = Y = C + I + G I = Y -- C -- G = national savings = S By subtracting net taxes (T) from each side: S = (Y -- C -- T) + (T -- G) = I Savings is equal to investment and to the sum of private savings (Y -- C -- T) and government saving (T -- G).
Quantity of Money Savings Demand
COORDINATING SAVING AND INVESTMENT

FINANCIAL MARKETS
Real Interest Rate Supply of Savings
The financial market features the supply of savings and the demand for savings (or investment).
GOVERNMENT SAVINGS
If government savings are positive, the government is running a bu dget s u rplus. If government savings are negative, the government is running a bu dget def icit. This implies that when the government runs a deficit, investment decreases. INTERNATIONAL CAPITAL FLOWS In an open economy, domestic savings do not need to equal domestic investment. There are two kinds of international capital flows.
The supply and demand for savings are equalized

through adjustments of the real interest rate. The real interest rate acts as the price of a loan. It is how much borrowers pay for a loan and how much savers earn for giving up their money so that it can be loaned. E f f e ct o f i nt e re s t r at e S u p pl y of s av i n g s D e m an d for s av i n g s the higher the real interest rate, the more people will save the lower the real interest, the more investing businesses will do R e su l ti ng cu r ve the supply of savings slopes upward the demand for savings slopes downward
Fo reign direct i nvestment: A company or individual

acquires and actively manages assets in a foreign country----such as an airport in Belgium run by the British P ortfo lio inves tm ent: An individual or company purchases stock or bonds issued by a foreign corporation but does not play a direct role in managing it
Net capital output (NCO) equals the purchase of foreign capital or financial assets by domestic residents minus foreign purchase of domestic assets.
In an open economy, NCO = NX Remember: Y = C + I + G + NX, so: Y -- C -- G = S = I + NX Therefore, S = I + NCO In an open economy, savings can differ from investment only as much as the difference is offset by net capital outflow.
BANK RUNS
A bank run occurs when depositors rush to a bank to withdraw their deposits before other depositors. Banks only hold reserves equal to a fraction of their liabilities----so even solvent banks will be unable to pay all of their depositors right away. The FDIC (a government institution) now insures deposits at federal banks for up to $250,000, so, even if a bank collapses in a bank run, accountholders can recover up to $250,000 of their money from the FDIC.
MACROECONOMICS
Money Market in the Long Run
PRICES AND THE LONG RUN
The aggregate price level is the level of prices for the entire economy. It rises and falls over time. If P is the price level, then it also measures the cost of a basket of goods. Therefore, the amount of goods and service that can be bought with $1 is 1/P. 1/P is also the value of money measured in terms of goods and services. PRICES IN THE LONG RUN: MONEY MARKET Just like in any other market, the value of money is determined by the interaction of supply and demand.
BACK TO THE NEUTRALITY OF MONEY

The long-run neutrality of money means that changes in the money supply have no bearing on real quantities in the economy. Recall the quantity theory of money: MV = PY.
M is the money supply V is the velocity of money (how often money

changes hands each year) P is the average current price level Y is real output of goods and services at a given point in time This equation is also called the equation of exchange. Of the variables, P is dependent. Since V and Y are usually fixed for the long run, changes in P depend on changes in M, the money supply. This equation says that the amount of money spent equals the amount of money used. Also note that PY = nominal GDP = MV.
MONEY SUPPLY
Depends on the decisions of the Federal Reserve and the banking system
MONEY DEMAND
Depends on how much wealth people want to hold as money Relates to the volume and prices of the transactions that take place If the real level of economic activity stays the same, doubling prices should double demand for money
Inelastic in the shortrun since it is set by the Federal Reserve
EFFECTS OF INFLATION
While in the long-run, inflation has no effect on the economy, it has powerful short-term effects.
Inflation reduces the value of money, and taxes

those that choose to hold it Inflation distorts prices: not all firms adjust their prices at the same time (so relative prices do not always reflect costs of production) Inflation introduces confusion about the value of goods and services in the future
The long run is the time period it takes for the price level to equate demand for money with the money supply. THE GRAPH Money demand slopes downward. As the price level falls, people need less money to purchase goods. In other words, the value of money increases.
Market for Money

Value of money (1/P) Money Supply
TRUE/FALSE FLASH QUIZ

1. 2. 3. 4. In the quantity equation, Y is nominal output Money supply is inelastic in the short-run 1/price level is the value of money In the quantity equation, M and Y are usually constant 5. Inflation reduces the value of money
Money Demand
ANSWERS 1. False (real output); 2. True; 3. True; 4. False (V and Y are constant); 5. True
Quantity of Money
MACROECONOMICS
Modeling the Economy
THE CIRCULAR FLOW MODEL
GOODS AND SERVICES (CLOCKWISE)
FLOWS
GDP AS FLOW GDP is equal to the flow around the model at any given point The expenditure approach is the sum of consumption and government purchases (since investment and exports are not counted in this model) The income approach uses the flow of income to households Totaling the flow in the money diagram yields nominal GDP Totaling the flow in the goods and services diagram yields real GDP
Land, capital labor
Factor Markets
Factors of production
Transfers
Households
Government Goods and services
Firms
Goods and services
Goods and Services Markets
Goods and services
ENTERING THE CIRCULAR FLOW MODEL MONEY (COUNTER-CLOCKWISE)

Factor Markets
New wealth enters the cycle through households. Households provide the human labor used to work. Even inputs such as land belong to individuals, which in turn belong to households. These land-owning individuals rent their land to businesses.
Income
Wages and rent
Taxes
Households
Government Government purchases
Firms
CIRCULAR FLOW FLASH QUIZ

QUESTIONS 1. The three actors in the circular flow model are _______, _______, and _______. 2. The two markets in the circular flow model are the markets for _______ and _______. 3. All factors of production are owned by _______. 4. With regard to the circular flow, nominal GDP is equal to the _______. 5. ______ sits between households and the goods and services market. ANSWERS 1. households; firms; government 2. goods and services; factors of production 3. households 4. flow around the money diagram 5. government
Consumption
Goods and Services Markets
Revenue
THE ACTORS Produce goods and services using the factors of production owned by households Rent the factors of production (land, labor, capital, entrepreneurship) to firms Consume goods produced by firms Ability to tax to earn income Can borrow from financial markets to produce goods for society
FIRMS
HOUSEHOLDS
GOVERNMENT
MACROECONOMICS
Living Standards
AVERAGE LABOR PRODUCTIVITY
Five factors affect average labor productivity.
GDP PER CAPITA
Economy's output depends on the quantity of goods and services a firm can produce
Physical capital
Tools, machinery, even computers and Internet access: the stuff that helps people make stuff Making capital for future poduction requires giving up current consumption
Total quantity of goods and services depends on the quantity of factor inputs households supply and the ability of firms to turn inputs into outputs
All else equal, large economies should produce more than smaller economies.
Human capital
Skills and experienced acquired through education, training, and on-the-job experience By spending time learning and training, we sacrifice current earning and consumption
Real GDP per capita is equal to real GDP per worker multiplied by the fraction of the population employed. GDP GDP N = x POP N POP
POP is the countrys total population N is the labor force

Most differences in GDP per capita can be explained by differences in average labor productivity, since the proportion of the population engaged in production remains remarkably consistent in the long run.
Natural resources
The wealth of many nations depends on their natural resources Example: Saudi Arabia On the other hand, in a global economy, natural resources are not essential for an economy to succeed Example: Singapore
SHORT-RUN FLUCTATIONS
The most important correlates of fluctuations in the economys growth are unemployment and inflation. During recessions, unemployment increases. Businesses increase hiring slowly in the early phases of an expansion. Increased employment lags behind the next stage of economic growth. When the economy expands, inflation accelerates. Recessions are linked to slowing inflation.
Technological knowledge
Transforms inputs into the goods and services households desire Single most important factor in raising average labor productivity Patents help encourage and publicize innovations
A SHORT RUN QUIZ

QUESTIONS 1. What is the most important factor in raising average labor productivity? 2. What is real GDP per capita equal to? ANSWERS 1. Technological knowledge 2. Real GDP per worker multiplied by the fraction of population employed
Political and legal environment

Broken political and legal systems stop many countries from building effective economies Investors and workers alike must feel confident in a country's stability, private property laws, and supply of an educated workforce
MACROECONOMICS
The Output Gap and the Short Run
OUTPUT GAP
TWO PART STRUCTURE Think of the actual level of GDP as having two parts. POTENTIAL OUTPUT Potential output is the quantity of goods and services that the economy could produce when using all its resources at normal rates. Over time, the level of potential output can increase over time as technology improves and the country obtains more resources.
SHORT RUN FLUCTATIONS AGAIN

In the short run, the pace of economic growth is mostly due to the divergence between actual and potential output (that is, the presence of an output gap). In the long run, variations are due to changes in the growth rate of potential output. This, in turn, depends on the growth of the population, the rate at which capital stock increases, and changes in the pace of technological advances.
Y symbolizes actual output Y* symbolizes potential output

OUTPUT GAP The output gap is the difference between actual and potential output. Output gap = Y -- Y* When an output gap exists, the economys resources are not being fully utilized. When the economy is in recession, an output gap exists. Unemployment rises beyond the natural rate of unemployment. During the presence of an output gap, Okuns Law (that for every 1% the unemployment rate differs from the natural rate of unemployment, the output gap deviates by 2%) applies.
Variations in rate of growth of output
LO N G R UN Changes in growth rate of potential output
S H O R T R UN The level of actual output relative to potential output
Growth rate of the population
Rate of increase of capital stock
JOHN MAYNARD KEYNES

British economist John Maynard Keynes (1883-1946) developed the model to explain short-run fluctuations. His theory was first published in the 1936 book, The General Theory of Employment, Interest, and Money . Keynes believed known economic models were inadequate to account for the Great Depression. His view of the business cycleand how to manage it by adjusting taxation and government spendingwould become known as Keynesian economics.
Changes in pace of technological advances

In a world in which prices adjust immediately to balance supply and demand, the economys actual output would never deviate from potential output. However, firms do not constantly adjust prices to respond to changes in market demand----they set prices and sell as much as is demanded. Only after a while will they change prices. Therefore, in the short run, firms respond to variations in demand by changing production rather than prices; short-run output is determined by the level of aggregate demand.
MACROECONOMICS
Aggregate Demand
INTRODUCING THE AD/AS MODEL
WHAT IS AGGREGATE DEMAND? Aggregate demand is the sum of all expenditures in an economy, or the countrys output for a period. Aggregate demand describes how expenditures change in response to changes in the aggregate price level.
AGGREGATE SHIFTS RESULT FROM

CHANGES IN CONSUMPTION Tax cuts, transfer payments from the government Changes in consumer sentiment (such as after 9/11 and the Enron scandal) Changes in wealth due to the stock market Expectations about the price level in the future CHANGES IN INVESTMENT Changes in the interest rate Changed expectations about the future CHANGES IN GOVERNMENT SPENDING Only direct government spending Transfer payments are not included CHANGES IN NET EXPORTS Changes in the income of foreign entities Changes in the exchange rate CAUTION Just as with microeconomics, shifts are NOT changes in output or the price level Changes in the price level lead to move me nt s along the aggregate demand curve Changes in any of the factors above cause s hif t s
AD = Y = C + I + G + NX
C = consumer spending I = investment G = government spending and purchases NX = net exports
THE SHAPE Just like the microeconomic demand curve, the AD curve slopes downward. It slopes downward for different reasons, however. 1. W ealth ef fe ct: Decreases in the price level lead to increases in consumption because consumers real income has increased. 2. In teres t ef fe ct: Decreases in the price level lead to decreases in the interest rate, which increases investment by decreasing its opportunity cost. 3. Fo reign exch an ge e ffect : Decreases in the price level make domestically produced goods cheaper in the international market, increasing net exports. GRAPH IT!
AD QUIZ
QUESTIONS 1. An increase in the price level leads to a decrease in output due to the _______, which denotes that _______. 2. Expectations of a higher future price level shift the AD curve outward because _______. ANSWERS 1. wealth effect; consumers' real wealth has decreased 2. consumers wish to spend now, when prices are lower
Price Level
Real Level of Output
MACROECONOMICS
Aggregate Supply
LOTS OF SUPPLIES
WHAT IS AGGREGATE SUPPLY? Aggregate supply is the potential supply of all the goods and services an economy can produce at different price levels. Aggregate supply behaves very differently in the short term and long term. LONG RUN VS. SHORT RUN Economists define the long run as the period when the market is in equilibrium All prices have adjusted to their equilibrium values and all markets clear The short run is the period in which other effects, such as price stickiness, can prevent long run equilibrium
Level of Output
SHORT RUN AGGREGATE SUPPLY (SRAS)
Short-Run Aggregate Supply

Price Level
LONG RUN AGGREGATE SUPPLY (LRAS)

LRAS Price Level

Level of Output
WHY DOES THE SRAS SLOPE UPWARDS? At the microeconomic level, the supply curve slopes upwards because higher prices attracted resources from the production of other products The aggregate supply curve slopes upward to reflect the relationship between price adjustments and the size of anticipated sales; firms fix prices for a while and only over time do they adjust prices
Long run aggregate supply is a vertical line fixed at the

full employment level of output LRAS is not affected by changes in the price level (monetary neutrality) Output must be the full employment level in the long run YOURE SHIFTING ME! Changes in the expecte d aggregate price level are the most common cause of shifts in the position of SRAS; at the expected level SRAS is equal to Y* Aggregate supply shocks also shift the aggregate supply curve (example: the 1973 OPEC oil embargo) Over time, technological progress can cause LRAS to increase; this increase accounts for the long-run growth of real GDP
SHORT-RUN CRAMMING
QUESTIONS 1. Markets always clear in the _______. 2. What does the position of the SRAS depend on? 3. What is the short run defined as? 4. What accounts for the long-run growth of real GDP? ANSWERS 1. long run 2. The economys long-run potential output (Y*) and expectations for the price level 3. The period when the market is in equilibrium (the economy produces at full, potential output) 4. The steady increase of the LRAS over time due to technological progress
MACROECONOMICS
Equilibrium
BALANCING ACT
EQUILIBRIUM OVER TIME The behavior of the economy in the short run is given by the intersection of SRAS and AD. This point of intersection is called short-run equilibrium. Long-run equilibrium is given by the intersection of LRAS and AD. FLUCTUATIONS Short term departures of the economy from equilibrium can be modeled in terms of short-run equilibriums.
LONG-RUN EQUILIBRIUM
LONG-RUN EQUILIBRIUM
Long-run equilibrium is obtained when SRAS, LRAS, and all intersect at a common point
LRAS Price Level SRAS
In flation ary g ap: Short-run equilibrium output exceeds

long-run output; the economy is overheated Def lation ary g ap: Short-run equilibrium output is less than long-run output; the economy is inefficient and perhaps in a recession
AD Real Level of Output
EFFECTS OF SHIFTS: AN EXAMPLE In the long run, both curves shift to restore long-run equilibrium and changes in either curve only affect the price level.
Y = Y*
An increase in aggregate demand will lead to a higher

price level and output in the short run.
Price Level
SRAS
AD2 LRAS AD1 Real Level of Output
INCREASING LONG-RUN OUTPUT (GROWTH) Increasing long-run output MUST involve an outward shift of the LRAS curve LRAS does NOT shift outward from changes due to monetary policy as money is neutral in the long run Simple government spending does not cause growth as spending only temporarily increases aggregate demand Growth can only result from improvements in labor, capital, natural resources, or productivity
AGGREGATE QUIZ
QUESTIONS 1. An economy is experiencing an inflationary gap when _______ exceeds _______. 2. What adjusts to restore long-run equilibrium when the government stimulates aggregate demand by passing a stimulus? ANSWERS 1. short-run output; long-run output 2. short-run aggregate supply
In the long run, aggregate supply will shift inwards as

people adjust their perceptions and expectations to restore equilibrium.
SRAS Price Level
SRAS1
New equilibrium AD2 LRAS AD1 Real Level of Output
MACROECONOMICS
Fiscal Policy
SPEND, SPEND, SPEND
WHAT IS FISCAL POLICY? Fiscal policy is the use of government spending and taxation to intervene in the economy. Government spending directly and indirectly increases aggregate demand and, consequently, GDP. A government stimulus package---- hiring workers to build dams, reducing taxes on small businesses, and offering more student loans---- is an example of fiscal policy. FLAVORS OF FISCAL POLICY Type Main goal C o n tr a ct i on ar y Decrease aggregate demand to curb inflation Tax increases; government spending cuts Ex p an s ion ar y Increase aggregate demand in a recession Tax cuts; government spending increases
PROBLEMS WITH FISCAL POLICY

CROWDING OUT Fiscal policy usually is needed at the time when the ecoomy generates low tax revenues The government has to finance expansionary fiscal policy by borrowing money or increasing taxes Increasing taxes decreases consumer wealth, directly decreasing consumption Borrowing money drives interest rates up, making investment less desirable Such spending thus crow ds o ut private investment
ASSESSING GOVERNMENT INTERVENTION

FOR Deviations from potential output are costly:
Examples
When resources are not fully employed, the

economy forever loses what it could have produced----even if it recovers on its own later Unemployment imposes hardships on those who lose their jobs Inflation results from overemploying resources AGAINST
The government can employ fiscal policy either directly, by direct spending (or spending less) or indirectly, through changes in taxes and subsidies. ASSESSING FISCAL POLICY Fiscal policy is an important tool to moderate the business cycle.
It is difficult to identify the correct type and degree of intervention.
The economy will not always return quickly to long-run

equilibrium With changes in spending, the government can make up for some of the failings of the free market in the shortterm
GDP estimates can take about three months to

calculate and are imprecise Almost all information about the economy lags, so policy makers must act on incomplete information Effects of policy take time to be felt----businesses will not invest right away When Congress approves spending on new projects, it can take many months until the projects are undertaken The economy may overshoot full employment, resulting in inflation
However, fiscal policy faces two major problems: crowding out and debt creation. DEBTS AND DEFICITS
The governments debt is all the money it owes; it is the
accumulation of all its annual deficits Since the government must pay interest on its debt, more debt means less future spending and less investment The United States has not run a surplus since the Clinton administration
ECONOMIC HISTORY OF WWI

American Entry into the War
BRIEF OVERVIEW
THE COURSE OF WWI WWI was the product of long-term European tensions, caused by rising nationalism and German competition with Great Britain and France for imperial power. The war was sparked off by the assassination of AustriaHungarys Archduke Fra nz Fe rdin an d by a BosnianSerb student on June 28, 1914.
MOBILIZATION IN EUROPE
THE EUROPEAN ECONOMIES The major WWI combatants possessed economies at very different levels of development and readiness for war.
Devoted 40% of GDP to war effort 1913 to 1917: upped steel output 25% M inis t ry of Mun it ion s facilitated M Great Britain munitions production
July 28: Austria-Hungary declares war on Serbia
Russia mobilizes to defend Serbia France August 1: Germany declares war on Russia
Suffered worst damage in the war Government spending increased to 53.5% of GDP by 1918
August 4: England declares war on Germany

The war ended on November 11, 1918, when the Allies signed a ceasefire with Germany. TWO IMPORTANT FIGURES 70 million military personnel fought in WWI 9.4 million soldiers died from battle or disease BREAKING DOWN AMERICAN PARTICIPATION
Italy
Relatively underdeveloped; had fewer resources to mobilize Supreme Committee of Ministers and Under-Secretariat for Arms and Munitions coordinated wartime production
Russia
Considered economically "backward" Unable to organize and mobilize its vast resources
2 million went to France 1.39 million fought on the front lines 114,000 died
1. 2. ECONOMIC WARFARE Each countrys ability to sustain the war effort depended heavily on the strength of its economy. The British established a naval blockade on the Central Powers. This action angered American merchants who wanted to trade with Germany. In return, the Germans imposed a U-boat (submarine) blockade on Great Britain. 3. 4.
QUICK QUIZ
QUESTIONS World War I began when ___ was assassinated. Of the major powers involved, ___ suffered the greatest cost of war. Russia was considered to be economically ___ at the start of war. ___ facilitated British munitions production. ANSWERS 1. 2. 3. 4. Archduke Franz Ferdinand France backward The Ministry of Munitions

American Entry into the War
AMERICAN ENTRY INTO THE WAR
REASONS FOR AMERICAN ENTRY Germanys U-boat blockade caused American indignation at attacks on neutral ships and passengers.
AMERICAN WAR PRODUCTION

GOVERNMENT PLANNING President Wilson established several government bodies to ensure the production and procurement of strategic wartime goods.
RMS Lusitania
Ship torpedoed and sunk on its way from New York to Liverpool 159 American passengers killed
War Industries Board Procured war products for the government and set prices b u l k - l i n e pr i c i n g" Used "b Food Administration Created by the Lev er Fo od and Fu el Act Led by future president Herbert Hoover Relied on voluntary cooperation Railroad Administration Nationalized railroads to deal with railroad congestion Transported 616,000 troops over 800 miles every month Fuel Administration Set the price of coal Worked with Railroad Administration to facilitate coal delivery
Sussex
French ferry mistaken for a mine-laying vessel 25 Americans injured provoked U.S. to threaten to sever relations with Germany Germans promise after the Sussex to leave non-military ships alone Broken in March 1917; Germany sank 5 American merchant ships German effort to entice Mexico to declare war on the United States Immediate cause for American entry into the war
Sussex Pledge
Zimmerman Telegram
MOBILIZATION 4 million men served in the U.S. Army 800,000 men served in the U.S. Navy and other military services 24.2 million men between the ages of 18 and 45 registered under the selective service law; 2.8 million were inducted Men chosen for service trained for 6 months in the United States and another 2 months in Europe DEPLOYMENT American soldiers had to be shipped across the Atlantic to France Great Britain provided half the ships required The American Emergency Fleet Corporation provided another million tons of new ships Germany only sank about 200,000 tons of transAtlantic cargo out of a total of 7.5 million tons
VOLUNTARY COOPERATION
The Food Administration did not directly set prices, but could threaten to revoke food providers distribution licenses if they refused to cooperate.
PRICE-SETTING DURING WAR

BULK-LINE PRICING The P rice F ixing C om m ittee of the War Industry Board set prices on war-related materials The main problem they faced was that suppliers had differing costs of production The Committee used bulk-line pricing It set prices at a level (the bulk-line) just high enough to produce the amount that the government required

Costs of War
CALCULATING THE COST OF WWI
CALCULATING DIRECT COSTS N e t C o s t = G r o ss C o s t - L o a n s
CALCULATING THE COST OF WWI (II)

HUMAN COST OF WAR The enormous number of deaths in WWI represents a further indirect cost. The alliances lost a significant proportion of their total populations:
The gross co st of war is the sum of total

expenditures of all countries involved advan ces) between countries are Loans (or a factored into both countries total expenditures To avoid double-counting, loans must be subtracted from the gross cost to yield the net cost of war
Central Powers: 2.6%
Allied Powers: 0.7%
Total: 1%
AVERAGE NET COSTS PER PERSON C o u n t ry Gre at B r i t ai n Fr a n ce Ge r m any U n i te d S t ate s C o s t ($) 766 613 557 229
The value of lost lives includes their human capital, the

skills and knowledge that they would have used to contribute to the economy Calculating this lost potential earnings provides the capitalized value of war deaths
Total direct net cost of the war: $186 billion

INDIRECT COSTS OF WAR Most of the indirect costs of war were o ppo rtun ity co s ts----what the country could have produced with the resources directed towards the war effort.
Total Direct and Indirect Cost of War: $337.85 billion

PAYING ATTENTION?
QUESTIONS 1. 2. 3. 4. The most immediate cause of American entry into WWI was ___. The United States main obstacle to mobilization not faced by Europeans was ___. The United States shipped ________ tons of cargo to Europe during WWI. The American government created three administrations to coordinate the ___, ____, and ___ industries. The total cost of the war was ___. Of the major powers, ___ had the greatest net cost per person. ANSWERS 1. 2. 3. 4. 5. 6. the Zimmerman Telegram the Atlantic Ocean 7.5 million tons food; fuel; rail $337.85 billion Great Britain
Money spent on bullets, guns, and tanks cannot be spent on food, clothing, or healthcare
Just because spending increases does not necessarily mean that well-being increases. PHYSICAL COSTS OF WAR Property loss Shipping and cargo loss Production loss War relief
5. 6.

War Financing
METHODS OF WAR FINANCING
POCKETBOOK ISSUE(S) Combatant states had three main ways of raising funds:
EUROPEAN WAR FINANCING

GREAT BRITAIN
Debt Financing
Taxation
Borrowing Taxation Printing money

UNITED STATES FINANCING The United States relied mostly on borrowing, or de bt f ina ncin g, to finance the war.
Issued three war loans
Raised about a quarter of total war expenditures
In total, the United States borrowed $19 billion The United States undertook a series of four loans
(called Lib erty Lo an s) with interest rates ranging from 3.5% to 4.25% Most lenders to the United States were individuals who bought Li be rty Bonds from the government Taxation covered nearly a quarter of war expenditures.
Borrowed heavily from the United States
Gradually increased throughout the war Excise taxes on tobacco, tea, alcohol, cars, and musical instruments
Caused debt levels to reach 127.5% of GDP by 1918
The war marked the first widespread use of the

in com e t ax, which had just been added to the Constitution (16th Amendment, 1913) The United States government also created a significant quantity of new money.
*Excise taxes were taxes on specific goods, as opposed to sales taxes, which taxed all goods. FRANCE
Debt Financing
Taxation
The Federal Reserve purchased government bonds

on the open market It paid for the bonds by creating new deposits, effectively increasing the money supply
Raised most of France's war funds
Not used much due to widespread public opposition ineffective 1916 tax on "extraordinary war profits" In fl at ion tax" on "I citizens: rising prices cut purchasing power
TO SUMMARIZE: Amount Taxes Borrowing New money Total $7.6 billion $19.0 billion $4.4 billion $31.0 billion Percent 24.5% 61.4% 14.1% 100%
Debt was already high before the war, at 65% of GDP
After the war, debt rose to 124% of GDP
GERMANY Germany relied more on debt financing than any other country throughout the war, borrowing 81% of its spending.
The money supply rose 500% Prices doubled over the course of the war Post-war hyperinflation helped fuel the Nazis rise

Economic Performance Throughout WWI
THE WARS ECONOMIC IMPACT
MEASURING GDP The economic prosperity of a country is most often measured by calculating GDP, a measure of the total value of production in the country. GDP can be calculated according to either the total expenditures or the total income of a country. ECONOMIC PERFORMANCE DURING THE WAR Only the United States and Great Britain saw economic growth over the course of WWI.
THE WARS ECONOMIC IMPACT (II)

THE PROBLEM WITH GDP Measuring countries economic performance during WWI through GDP alone is problematic for several reasons.
The value of a product is its market price, rather than

its contribution to consumer wellbeing Thus, increased production of guns, munitions, and military aircraft can cause GDP to rise significantly, but This rise does not improve living standards Meawnwhile, other sectors receive fewer resources during wartime
United States
THE UPSHOT:
Increased in GDP does not always mean increased economic prosperity

In a recession before war began Experienced an economic boom when war broke out in Europe Rate of growth slowed significantly after joining the war Majority of economic growth during the war occured while it was neutral Overall GDP increase of 13.2% from 1913 to 1918
NAME THAT COUNTRY!

QUESTIONS Which country 1. 2. 3. 4. 5. 6. 7. 8. Imposed an indirect inflation tax on its citizens? Issued excise taxes on many goods to finance the war? Experienced hyper-inflation during and after the war? Withdrew from the war in 1917? Suffered the largest decline in GDP during the war? Enjoyed the greatest increase in GDP during the war? Had a debt level of 127.5% of GDP in 1918? Experienced an economic boom when the war began? ANSWERS 2. 1. France Great Britain 3. Germany 4. Russia 5. France Great Britain Great Britain United States
Great Britain
Economic contraction in 1914 and 1915 Total production peaked in 1916 Overall, experienced an increase of 14.8% in real GDP throughout the war
Other major powers

6. 7. 8.
Germany: real GDP in 1918 was 81.8% of its 1913 GDP Austria-Hungary: real GDP in 1918 was 73.3% of its 1913 GDP Russia: real GDP fell to 67.7% of 1913 value by 1917, when it withdrew from the war France: real GDP fell to 63.9% of 1913 value by the end of the war

Economic Consequences of Peace
DEMOBILIZATION
HOMECOMING Soldiers began demobilizing after the war ended in November 1918. By mid-1920, 4 million soldiers had returned to the American labor force.
LONG-RUN EFFECTS
GOVERNMENT SPENDING Robert Higgs cited the high levels of government spending during the New Deal as evidence for the ratchet effect. He proposed that increases in government spending during WWI led to permanently higher expenditure even after the war ended. Other scholars disagreed:
Labor-market shock caused by sudden return of soldiers Brief economic downturn while labormarket adjusted itself Economic boom as all aspects of GDP increased (see below)
Soon after the war, the United States experienced a major economic expansion, fueled by several factors:
Lindberg argued government spending was high even

before the war Broadberry and Harrison argued the government had to spend more on its debt s ervice pay ments (repayments of its loans); other government spending only increased along with other types of spending DONT MAKE ME
Government Spending
The government paid transport costs and a $60 bonus for each discharged soldier The United States loaned $2 billion to its allies
The United States became a reluctant world leader after the war.
American entry into the war had broken the stalemate

and allowed the Allies to win American loans to its allies funded their war effort
Business Investment
Businesses spent more on plants and equipment (capital) to make more consumer durable goods, such as cars This, in turn, led to an increase in consumer demand
France: 2.7 bn
Great Britain: 4.0 bn
Italy: 1.6 bn
Russia: 0.2 bn
Others: 0.7 bn
European economies relied on American loans to

recover
Net Exports
As European economies recovered, they demanded more American imports The increase in foreign demand caused net exports to rise
THE TREATY OF VERSAILES

George Clemenceau of France, David Lloyd George of Great Britain, and Woodrow Wilson of the United States drafted the Treaty of Versailles. Germanys new government signed it on June 28, 1919.
MEANWHILE, ACROSS THE ATLANTIC With help from the United States, most European countries slowly recovered after the war. However, Germany continued to experience severe declines.
Germany accepted all of the blame for the war Germany would pay $33 billion in reparations back to
the Allies
It suffered heavy losses in human capital By 1919, its real GDP had fallen between 52 and
72% of its 1913 level War-related industries recovered, but laborintensive industries like agriculture suffered

Economic Consequences of Peace
THE TREATY OF VERSAILLES (II)
REPARATIONS TERMS The Treaty of Versailles imposed a heavy payment burden on Germany.
CONCLUSION
UNLIKE ANY THAT CAME BEFORE The First World War was the first war that depended on large-scale industrialized warfare. Many technological advances were introduced in:
Before 1925: $375 million
After 1925: $900 million
Total: $33 billion
Machine guns Tanks Attack aircraft Poison gas Furthermore, it was the first war that depended on large-scale industrialized warfare.
They made their final reparations payment in October 2010, proving that some things do take longer than college loans to pay back. CRITICISM OF THE TREATY John Maynard Keynes, a British economist, criticized the Treaty of Versailles in his 1919 book The Economic Consequences of the Peace.
THE IMPORTANCE OF ECONOMICS Economics determined the result of the war.
Competing blockades were more effective than armies

in draining the enemys resources The Allies ultimately won because they were economically superior They mobilized more effectively and were able to devote more resources to producing weapons and other war goods
It prevented European economic integration It was inconsistent with President Wilsons

proposed Fourteen Points, especially on the subject of reparations Fo u r te e n P o in t s German payment only for damage to invaded territory T r e at y o f V e rs ai l l es
FINAL RECAP
QUESTIONS
Inclusion of losses at sea by submarine, bombardments from sea, and damage from air raids
1. 2. 3. 4. 5.
Its terms were too vague: Germany had to pay for

all damage done to the civilian population of the Allies by land, by sea, and from the air It was guided by political, not economic concerns It did not follow through on its promise that people could determine their own governments Keynes believed that $10 billion would have been a more appropriate sum. WAS KEYNES RIGHT? Other scholars have criticized Keynes arguments:
Why did the United States experience a brief economic downturn at the end of the war? In what type of goods production did American businesses invest after the war? What type of government spending did Broadberry and Harrison argue that the ratchet effect reflected? When was the Versailles Treaty signed? How much did Keynes believe was an appropriate amount for German reparations? ANSWERS Labor market adjustment Consumer durable goods Debt service payments June 28, 1919 $10 billion
They say Germany had the ability to pay; it was

merely unwilling to pay The reparations were less severe than those imposed on France by Germany after the FrancoPrussian War
1. 2. 3. 4. 5.
CRUNCH KIT
Economics in Four Pages (Page 1)
BASICS OF ECONOMICS Human wants are unlimited, but goods are scarce There are no free lunches; you can never get something truly free (due to the cost of time, and other costs) To get one thing, we must give up another Humans behave rationally in economics Economic cost includes opportunity and accounting costs Accounting cost: tangible cost Opportunity cost: value of the next-best alternative RATIONALITY Marginal cost: cost of producing/consuming one more Marginal benefit: benefit of producing/consuming one more Diminishing returns: marginal benefit decreases as quantity increases Rational agents will produce or consume a good until marginal cost = marginal benefit/revenue (MC = MR) Rational consumers maximize their utility, or satisfaction; rational firms maximize their profits POSITIVE VS. NORMATIVE Positive: What is (taxes are 20%) Normative: What should be (taxes should be lower) MICRO VS. MACRO Microeconomics: focuses on individual decision making; works its way up from individuals to markets to economies Macroeconomics: focuses on the economy as a whole; tracks economy wide variables; takes a top-down approach COMPARATIVE ADVANTAGE Comparative advantage: being able to produce a good at a lower opportunity cost than anyone else Absolute advantage: being able to produce a good more efficiently than everyone else An individual can have an absolute advantage in everything, but NOT a comparative advantage in everything Agents should specialize in what they have a comparative advantage for, and then everyone will benefit from trade THE PRODUCTION POSSIBILITIES FRONTIER (PPF) A PPF shows all of the ways an economy can produce goods Each axis features a good; the PPF measure trade-offs between these two goods All points outside the curve are impossible to produce at Points inside the curve are possible but inefficient and do not use all available resources PARETO EFFICIENCY Something is Pareto efficient if it is impossible to improve well-being without hurting someone else Pareto efficiency provides no way to judge the superiority of one distribution versus another THREE FUNDAMENTAL QUESTIONS OF ECONOMICS How much should be produced? Who should produce the good? Who should receive the good? PERFECTLY COMPETITIVE MARKETS The good being sold must be highly standardized Large number of buyers and sellers Everyone is well informed about the market price No barriers to entry exist; firms enter and exit easily Everyone is a price taker The market price represents the opportunity cost of a goods production DEMAND Law of demand: the quantity demanded of a good decreases when the price increases and vice versa Demand: this relationship between prices and quantities for a particular market Quantity demanded: amount demanded at each price Demand can shift due to consumer income, substitutes and complements, the number of consumers, and consumer preferences and expectations SUPPLY Law of supply: the quantity supplied of a good increases when the price increases and vice versa Supply: relationship between prices and quantities for a particular market Quantity supplied: the amount supplied at a given price Supply can shift due to changes in factor costs, technology, expectations of future prices, number of producers, and government regulations Changes in demand or supply cause a shift of the curve; quantity changes at every price Change in quantity demanded or supplied causes a movement along the curve MICROECONOMIC EQUILIBRIUM Equilibrium: intersection of supply and demand Consumer surplus: difference between how much consumers are willing to pay and the market price Producer surplus: difference between the price at which firms are willing to sell and the market price Market equilibrium maximizes consumer and producer surplus ELASTICITY Percent change in quantity over percentage change in price Price elastic demand: goods with close substitutes, luxuries Price inelastic demand: necessities Price elastic supply: long run
CRUNCH KIT
ELASTICITY Price inelastic supply: short run, scarce good Factors affecting demand elasticity: substitutes, necessities, scope of market, time horizon Factors affecting supply elasticity: scarcity of inputs, presence of barriers to entry, time horizon Elasticity= 0: perfectly inelastic 0 < Elasticity < 1: price inelastic Elasticity = 1: unit elastic Elasticity > 1: elastic Elasticity = : perfectly inelastic ECONOMIC AND ACCOUNTING PROFIT Total revenue: amount a firm receives from selling its goods Total cost: costs of a firm supplying its goods Accounting cost: actual monetary cost Accounting profit: straight monetary profit earned Economic cost: both monetary (accounting) cost and the opportunity cost of the resources used Economic profit: monetary profit minus opportunity cost; always equal to zero in the long run FIRMS AND COSTS Fixed costs: costs that a firm must pay regardless of how much it produces (rent, utilities); only fixed in short run Variable costs: costs that change with the amount produced Average cost: the sum of fixed costs and total variable costs, divided by the total number of units produced After a certain point, marginal costs stop decreasing and begin increasing----this is called diminishing returns to scale In the long run, all costs are variable PRICE CONTROLS Price ceilings set a maximum; price floors set a minimum Deadweight loss: lost efficiency due the market not being in equilibrium Binding price controls ALWAYS have deadweight losses Price controls transfer surplus from consumers to producers or vice versa Taxes distort the market, transferring surplus from the market to the government at the expense of efficiency The more inelastic party always bears more of the tax Revenue equals price times quantity MARKET FAILURES A market failure is when competitive markets fail to produce socially desirable outcomes Two types discussed here are externalities and public goods EXTERNALITIES Externalities are costs or benefits that affect a third party uninvolved in the activity or transaction in question EXTERNALITIES Individuals do not factor externalities into their decisions Negative externalities harm third parties; the tendency is to overproduce them Positive externalities benefit third parties; there are not enough of them Coase Theorem: private parties can resolve the inefficiencies created by externalities as long as property rights are clearly defined and all parties can negotiate with each other PUBLIC GOODS A rival good, when it is consumed, can no longer be consumed by anyone else People have limited access to excludable goods Private goods are both rival and excludable Public goods are neither Collective goods are non-rival and excludable Common resources are non-excludable and rival The tragedy of the commons occurs when people overuse a resource because no one owns it MARKET POWER A firm with a downward sloping demand curve has market power; they can choose their price The combinations of price and quantity available to choose from are determined by the market demand MONOPOLY Market with only one firm Produce less than what consumers demand, and sell it at higher than the market price Arise due to the presence of barriers to entry Price discrimination: charging different customers different prices; a monopoly can capture more of the consumer surplus for the firm OLIGOPOLY Market with only a few firms Collusion: when firms cooperate to artificially raise market prices by restricting supply Cartel: group of firms that collude Cartels often break up due to an incentive to cheat MONOPOLISTIC COMPETITION Firms compete through product differentiation, not price competition Few barriers to entry exist INSTITUTIONS, ORGANIZATIONS, AND GOVERNMENT Institutions: formal or informal rules that guide human interactions Organizations are like institutions but more formal Governments can tax their citizens and use force
CRUNCH KIT
INSTITUTIONS, ORGANIZATIONS, AND GOVERNMENT Pork barrel politics: elected officials tend to steer money to their constituents by introducing projects Logrolling: vote trading among elected officials Rent seeking: socially unproductive activities that simply direct economic benefits GROSS DOMESTIC PRODUCT (GDP) Market value of all final goods and services produced within a country in a given period of time; four components GD P = Y = C + I + G + N X Consumption: consumer spending on final goods Investment: value of all money spent on capital or technology Government expenditures xports: exports minus imports Net ex Business cycle: fluctuations in GDP over recessions and expansions Average labor productivity: GDP divided by the total number of workers employed MACROECONOMIC MODELLING Circular flow model: households own factors of production; firms rent factors and produce goods, which households buy; two markets: goods market and factor market Aggregate demand (AD): quantity of goods demanded by an economy at different price levels, slopes downward Aggregate supply (AS): potential supply of goods and services in an economy at different price levels Short run aggregate supply (SRAS): slopes upwards Long run aggregate supply (LRAS); fixed at full employment output; vertical line; independent of price level Short run equilibrium: intersection of SRAS and AD; long run equilibrium is at the intersection of all three curves UNEMPLOYMENT Labor force: all individuals 16 or over, not in prison or armed forces, and actively looking for work or has a job Employment rate: percentage of labor force with a job Participation rate: percentage of population in the labor force Structural unemployment: unemployment due to large shifts in economy; mismatch between skills demanded and skills supplied Cyclical unemployment: caused by the business cycle Frictional unemployment: natural unemployment due to time-lag between jobs Unemployment rate calculated every month by the BLS Natural rate of unemployment: never 100%; structural + frictional unemployment Okuns Law: for every 1% increase in unemployment, GDP drops by 2% MONEY A medium of exchange, unit of account, and store of value Commodity money: money with intrinsic value Fiat money: intrinsically worthless; declared valuable by government Inflation: rise in price level; decrease in purchasing power of money; measured by the CPI and GDP deflator Liquidity: how easily an asset can be converted into currency THE FINANCIAL SYSTEM Savings: income that is not spent Investment: purchase of new capital equipment Bond: a certificate of indebtedness Stock: ownership of a portion of a company Net capital outflow: domestic purchase of foreign capital minus foreign purchase of domestic assets FISCAL POLICY Government spending or taxes to influence AD Contractionary: increasing taxes, decreasing spending Expansionary: decreasing taxes, increasing spending MONETARY POLICY Open market operations: buying or selling securities, done by the FOMC Reserve ratio: fraction of deposits banks must keep in reserve; adjusted by Board of Governors Discount rate: interest rate the Fed charges to member banks; adjusted by Board of Governors Contractionary: selling securities, increasing reserve ratio, increasing discount rate Expansionary: buying securities, decreasing reserve ratio, decreasing discount rate Quantity theory of money: MV = PY ECONOMIC HISTORY OF WWI Great Britain and Germany carried out economic warfare through blockades The Allies used central government planning to coordinate war output Great Britains wealth allowed it to devote a high proportion of its economy to war output France suffered the greatest economic losses as most battles were fought on its territory Italy was economically underdeveloped and Russia economically backward at the start of the war Russia withdrew from WWI in 1917
CRUNCH KIT
AMERICAN ENTRY INTO THE WAR Germanys unrestricted submarine warfare and the Zimmerman telegram prompted American entry into the war The United States contribution tipped the balance to the Allies 4.8 million Americans served in the military during WWI The Emergency Fleet Corporation and the British provided troop transport vessels to ship American soldiers to France Losses to German U-boat attacks after 1917 were small AMERICAN WARTIME PRODUCTION The War Industries Board obtained war products for the government The Boards Price Fixing Committee used bulk-line pricing to set prices for such products Bulk-line pricing involved setting prices at a level that would obtain the corresponding output desired The Food Administration licensed food producers and controlled food production through voluntary cooperation The Railroad Administration was formed after the railroads were nationalized It organized troop transports and worked with the Fuel Administration to ensure coal deliveries COST OF THE WAR WWIs direct net cost was $186 billion Great Britain had the highest per capita spending of $766 per person The United States spent $229 per capita WWI had additional indirect costs, including the opportunity cost of resources diverted to wartime output The combatant states also suffered from the destruction of human and physical capital Peoples deaths represented a loss of their future potential earnings WWIs total cost was $337.85 billion WAR FINANCING IN THE UNITED STATES The United States spent $31 billion on the war effort The United States borrowed $19 billion through public Liberty Bonds to fund the war effort Income taxes were raised during the war and contributed $7.6 billion of the war budget The Federal Reserve also issued $4.4 billion of money WAR FINANCING IN GREAT BRITAIN Great Britain borrowed heavily during WWI, domestically and from the United States Its debt level was 127.5% of GDP Taxes contributed 24.5% of war expenditure Great Britain increased its excise, property, and income taxes over the course of the war WAR FINANCING IN FRANCE France took on long-term debt from 1915 onwards, and had debt amounting to 124% of GDP by 1916 Public opposition limited the governments ability to raise taxes However, inflation caused by a growth in the money supply imposed an implicit tax by reducing consumers purchasing power WAR FINANCING IN GERMANY Germany used debt financing to supply 80% of its war expenditures Its money supply increased fivefold during WWI and prices doubled Germanys heavy debt contributed to hyperinflation after the war ECONOMIC PERFORMANCE DURING THE WAR European demand for American goods pulled the American economy out of recession American entry into the war slowed its growth, but its GDP still grew by 13.2% overall Great Britains economy grew after 1916, with an overall 14.8% increase in GDP Germanys GDP dropped by 19.2%, and AustriaHungarys by 26.7% Frances GDP declined by 34.1% and Russias GDP in 1917 was 67.7% of its 1913 level ECONOMIC IMPACT OF THE WAR Demobilization caused a sudden expansion in the labor force and a brief recession in the United States However, American government spending remained high, fuelling economic growth The United States loaned money to its allies Europe relied on American goods during its reconstruction American businesses invested in plants and equipment to produce consumer durable goods Some scholars believe that WWI permanently increased government spending Others argue that spending only increased to repay debt, or that it had already increased before the war ECONOMIC CONSEQUENCES OF THE PEACE The United States allies owed it a combined $9.2 billion Germany had to pay $33 billion in reparations under the Treaty of Versailles It would have to pay $375 million per year until 1925 and $900 million in yearly interest payments after 1925 British economist Keynes believed this unduly harsh and unrealistic German resentment of the Treaty helped fuel the Nazis rise to power and hence the Second World War.
CRUNCH KIT
List of Lists (1 of 3)
8 ECONOMISTS
Michael Boskin In 1996, assigned to head a committee to review the methods used to calculate CPI Michael Edelstein Constructed the marginal and strong set of standards to gauge the effect of empire on the British economy Stanley Engerman Estimated profitability of the slave trade Milton Friedman Most famous advocate of monetary policy (instead of Kenyesian policy) John Maynard Proposed fiscal policy as a way to smooth Keynes out the business cycle; his theories put to the test in the Great Depression; wrote 1936 book The General Theory of
8 EQUATIONS
Total Fixed Costs + Total Variable Costs Average total ATC = cost Total Number of Units Produced
CPI
CPI =
Basket price in year t 100 Basket price in base year
Elasticity
E=
% quantity % price Nominal GDP 100 Real GDP
GDP deflator GDP deflator =
Employment, Interest, and Money

Simon Kuznets Commissioned by the U.S. Department of Commerce to develop a system to measure national output Described the impact of entrepreneurs as creative destruction Father of classical economics; wrote the 1776 book An Inquiry into the Nature
Joseph Schumpeter Adam Smith
and Causes of the Wealth of Nations
Y = C + I + G + NX Gross domestic product General profit Marginal revenue = marginal cost maximizing condition 1 Money MM= multiplier RR Quantity MV = PY equation
6 UNEMPLOYMENT TERMS
Frictional unemployment Results from the time lag between workers leaving one job and finding another; exists even in the healthiest and wealthiest of economies Labor force Total number of persons aged 16 and over either working or actively seeking employment (excluding those in prison or in the military) Okuns law Sugests every 1% rise in unemployment above the natural rate of unemployment results in a 2% drop in GDP Participation rate Percentage of the total population eligible for the labor force that is currently in the labor force (employed or actively seeking employment) Structural Results from fundamental changes in the unemployment economy, such as improving technology or shifting consumer preferences---leading to a mismatch of skills offered by labor and skills desired by firms Underemployment When someone is working at a job that does not use the full extent of their education or human capital Cyclical Unemployment that occurs alongside the unemployment business cycle, increasing during contractions and decreasing during expansions
12 FISCAL AND MONETARY POLICY TERMS

Contractionary policy Discount rate Policy meant to fight inflation and decrease aggregate demand Interest rate the Federal Reserve charges for loans to its member banks Expansionary Policy meant to fight recession and policy increase aggregate demand Federal funds rate Interest rates banks charge on loans to each other; based on the discount rate but not set by the Federal Reserve Federal Advisory Advisory body with bankers representing Council each district in the Federal Reserve Federal Reserve The central banking system of the United (the Fed) States; sets monetary policy Federal Open Controls the money supply and conducts Market Committee day-to-day monetary policy Board of Ruling council of the Federal Reserve; Governors consists of seven governors Fiscal policy Government taxation and spending policy choices meant to influence the economy Monetary policy Central bank policies affecting the economy by altering the money supply Open market Trading of securities by the Federal operations Reserve to adjust the the money supply Reserve ratio The amount of each deposit banks must hold in reserve
CRUNCH KIT
12 COMPETITION TERMS
Price elasticity of demand Complements Substitutes Normal good Inferior good Firm Monopoly Natural monopoly A measurement of the sensitivity of quantity demanded to a change in market price Related goods, such that when the price of one good falls, demand for the other rises Related goods, such that when the price of one good falls, demand for the other falls A good the demand for which increases as the income of its consumers increases A good the demand for which decreases as the income of its consumers increases An organization that produces a good or service for sale to the market A market that has only one producer, with high barriers to entry A special monopoly that arises when two or more producers cannot coexist profitably; often regulated or run by the government A market with only a few producers and high barriers to entry; firms in an oligopoly sometimes collude A market with many producers each aiming to differentiate its product, hoping to obtain a small amount of monopoly power A market with many producers and consumers, perfect information, and no barriers
13 FUNDAMENTAL CONCEPTS
Benefit-cost analysis Margin Marginal benefit Marginal cost Utility Marginal utility Total utility Rational decision-making process, weighing pros and cons A small incremental change The benefit of an incremental change The cost of an incremental change Satisfaction gained from doing or consuming something Satisfaction gained from an incremental change The total satisfaction (or dissatisfaction!) Gained from doing or consuming something Act of maximizing total utility An economic system in which market forces allocate goods and services Economic system in which a central authority makes all economic decisions The notion that government should not interfere with the economy When one country is able to produce more of a good than another country When one party has a lower opportunity cost of producing a good than another party
Optimization Free market economy Command economy Laissez-faire Absolute advantage Comparative advantage
Oligopoly
Monopolistic competition Perfect competition
MICROVOCABULARY
Price Quantity supplied Quantity demanded Supply Demand Law of supply Law of demand Demand schedule Supply schedule The amount in exchange for which sellers give buyers a good or service The total of a good or service that, at a given price level, producers will be willing to sell The total of a good or service that, at a given price level, consumers will be willing to buy The relationship between price quantity supplied by producers The relationship between price and quantity demanded by consumers As price increases, producers will supply greater quantities of goods and services As price increases, consumers will demand smaller quantities of goods and services A table showing quantity demanded at various prices A table showing quantity supplied at various prices Economics Microeconomics
MACROVOCABULARY
The study of decision-making Study of economics on the micro-scale: households, firms, specific regions of an economy Study of economics at a broad level: national and international issues Not having the resources to satisfy all wants The value of the next-best alternative to a choice The act of giving something up to get something else Resources used to produce goods and services Factor of production----includes all natural resources Factor of production; includes buildings and equipment Factor of production; includes workers
Macroeconomics Scarcity Opportunity cost Trade-off Factors of production Land Capital Labor
CRUNCH KIT
12 HIGH-PRIORITY FIGURES
13.2% 14.8% 18.2% 32.3% 36.1% 24% 53.5% 1.39 million 9.4 million $375 million $33 billion $186 billion $337.85 billion Total growth in the United States GDP from 1913 to 1918 Total growth in Great Britains GDP from 1913 to 1918 Total decline in Germany's GDP from 1913 to 1918 Total decline in Russias GDP from 1913 to 1917 Total decline in France's GDP from 1913 to 1918 Proportion of Russias economy devoted to war output during WWI Proportion of Frances economy devoted to war spending in 1918 Number of American soldiers serving in the front line during WWI Number of deaths in WWI Yearly reparations to be paid by Germany until 1925 under the Treaty of Versailles Amount of reparations imposed on Germany in the Treaty of Versailles Direct net cost of WWI Total cost of WWI
8 ECONOMIC CONCEPTS
Bulk-line pricing Pricing method used by the American government during WWI for warrelated goods; involved setting a price level that would obtain for it the desired output Method of borrowing money to finance the war effort, relied upon heavily by Germany Payments over a period of time on the principal and interest of a loan, e.g. Allied WWI loans from the United States Products that last at least three years on average, e.g. cars and household appliances Direct taxes on specific products used by Great Britain to fund its war effort A persons skills, knowledge, and experience, all of which contribute to his or her productivity Phenomenon whereby price rises impose an implicit tax on consumer purchasing power
Debt financing
Debt service payments
Durable goods
Excise taxes Human capital
Inflation tax
Ratchet effect
10 WAR AGENCIES
Emergency Fleet Corporation Federal Reserve American body that procured half of the United States' troop transport vessels to ship soldiers to France American central bank; helped to finance the war effort through Liberty Bond issues and issuing money Agency created in August 1917 to oversee food output and license food businesses American agency created in August 1917 to set coal prices and ensure coal deliveries British ministry overseeing key war industries after 1915 American agency established to determine prices of strategically important products; adopted the bulk-line pricing strategy American agency created in 1917 to run the nationalized railroad system and coordinate troop transports Italian government body responsible for economic central planning in WWI Italian agency directly overseeing wartime production decisions in WWI American agency established in July 1917 and restructured in March 1918; procured war products and set prices $229 $557 $613 $766 200,000 616,000
17 MEDIUM-PRIORITY FIGURES
American per capita spending in WWI German per capita spending in WWI French per capita spending in WWI British per capita spending in WWI Deadweight tons of American shipping lost to German attacks Number of troops transported by American railroads monthly after 1917 Number of Americans inducted into the military under selective service Tons of cargo shipped from the United States to Europe during WWI Yearly interest payment on German reparations after 1925 Russian debt to United States in 1918 Italian debt to United States in 1918 French debt to United States in 1918 British debt to United States in 1918 Amount of money issued by the Federal Reserve for WWI spending Amount raised by income tax for the American WWI spending Amount proposed by Keynes for German reparations after WWI Sum raised by American Liberty Bonds
Food Administration Fuel Administration Ministry of Munitions Price Fixing Committee Railroad Administration Supreme Committee of Ministers Under-Secretariat for Arms and Munitions War Industries Board
2.8 million 7.5 million $900 million $0.2 billion $1.6 billion $2.7 billion $4.0 billion $4.4 billion $7.6 billion $10 billion $19 billion
FINAL TIPS AND ABOUT THE AUTHOR

FINAL TIPS ABOUT THE AUTHORS
Catherine Tran is a student of philosophy and religious studies at the University of Texas. When she isnt studying, her next-best alternatives include writing about morality, attending live concerts, and shopping for second-hand clothing. The previous sentence makes her appear a lot hipper than she actually is. Jacqueline Khor (unpictured) was the 2010 Global Round champion in the World Scholars Cup, and lives in an ambiguous land called Singapore where top-scoring students often wear green.
Dont just learn definitions by rote; rephrase

them in ways that make sense to you Repeat after me: shifts in demand are not the same as shifts in quantiy demanded Come prepared to draw out supply and demand diagrams Draw out supply and demand diagrams The marginal utility of eliminating wrong answers before answering is very high When short on time, memorize key facts from Section IV by leader, reform, and year Make a study playlist that gets you pumped for brain workouts
ABOUT THE EDITORS

ROBB DOOLING DANIEL BERDICHEVSKY SOPHY LEE
Robb Dooling first became a DemiDec factor of production in 2009----namely, a beta tester. In addition to beta testers, DemiDec factors of production include writers, editors, and frequentlymisplaced laptops.
Daniel Berdichevsky is conducting a lifelong experiment to determine whether the law of diminishing marginal utility applies to the consumption of tea. He is pictured here speaking at a school in India after drinking four cups.
Sophy Lee rides her bike the way she pursues everything in life, from Academic Decathlon, Harvard, and DemiDec, to her recent appearance on Million Second Quiz: with determination, focus, and a diet of berries, yogurt, and self-appraisal.

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2013 2014

the World Scholars Cup

ECONOMICS CRAM KIT | 2

FUNDAMENTAL ECONOMIC CONCEPTS

THE RATIONAL HOMO ECONOMICUS

ECONOMICS CRAM KIT | 3

FUNDAMENTAL ECONOMIC CONCEPTS

MICROECONOMICS VS. MACROECONOMICS

Theoretical models capture the basics of economic

MODELING PARETO EFFICIENCY

POSITIVE VS. NORMATIVE ECONOMICS POSITIVE

ECONOMICS CRAM KIT | 4

FUNDAMENTAL ECONOMIC CONCEPTS

PRODUCTION POSSIBILITIES FRONTIER (PPF)

A countrys PPF represents all the combinations of

TRADE QUESTIONS FOR ANSWERS

ECONOMICS CRAM KIT | 5

All agents accept prices as given

One homogenous product

Entry and exit costs are zero

Transaction costs are zero

Firms maximize profits Consumers maximize utility

ECONOMICS CRAM KIT | 6

SHIFTING ALL OVER THE PLACE

THE DEMAND CURVE

THE DEMAND SCHEDULE P ri ce Qu an t ity $5 20 $10 15 $15 10 $20 5 $25 0

ECONOMICS CRAM KIT | 7

SHIFTS VS. MOVEMENTS

THE SUPPLY CURVE

A HEALTHY SUPPLY OF QUIZZES

ECONOMICS CRAM KIT | 8

% changein A (AF - A I ) A I % changeinB (BF - BI ) BI

ELASTICITY AND GOODS DEMAND

Necessities that people must buy regardless of price | Example: insulin

% changein q (qF - qI ) qI % changein p (pF - pI ) pI

E is the price elasticity of demand (elasticity of

FACTORS THAT AFFECT PRICE ELASTICITY

Degree of substitution (goods with

REVENUE | THE ELASTICITY SHORTCUT

Scarcity of inputs (scarcity of inputs

ECONOMICS CRAM KIT | 9

Triangle A is consu mer surplu s, or the difference

SHIFTING SUPPLY AND DEMAND Shift

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Triangle A represents the gains from trade with the

TRADE AND TARIFFS TRIVIA

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All firms are assumed to seek to maximize profits.

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I HAVE THE POWER

High entry costs

Policies that restrict entry

Control of natural resources

Rent seeking (see later)

Ownership of a key resource Government-created barriers (patents, copyrights,

YOU SHALL NOT MATCH

DEALING WITH MONOPOLIES

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THE BOTTOM LINE

PLEASE DONT FAIL THIS TRUTH TEST

THE BOTTOM LINE

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ENTREPRENEURS & CREATIVE DESTRUCTION