Download lecture3_2007 - Dr. Rajeev Dhawan

Lecture 3: Micro-econ. ~ last topic (Profits)
& Basics of Macroeconomics - I
Dr. Rajeev Dhawan
Director
Given to the
EMBA 8400 Class
South Class Room #600
January 19, 2007
Chapter 13
Costs & Profits
Cost of Production
Cost of production includes all the
opportunity costs of making the output of
goods and services.
– Explicit costs: input costs that require a direct
outlay of money by the firm.
– Implicit costs: input costs that do not require an
outlay of money by the firm.
Profits
 The firm’s objective is to maximize profits
Profit = Total revenue - Total cost
 Economic Profit: total revenue minus total cost,
including both explicit and implicit costs.
 Accounting Profit: total revenue minus only the
firm’s explicit costs.
Profits
How an Economist
Views a Firm
How an Accountant
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
Explicit
costs
Copyright © 2004 South-Western
Article: The Painful Truth About Profits
Business Week; by: Michael Mandel
 Without profits there’s no incentive for innovation or creating new
companies.
 Today the biggest problem is that most companies are shooting for a
return to the highest profit levels of the late 1990s.
 >> HIGH WAGES
– Despite the recession and a year of slow growth, corporate labor
costs are nearly $1 trillion higher now than in 1997.
– Real wages and benefits continue to climb, growing at 2% rate
during the past year
 >> SLOW GLOBAL GROWTH
– Weak economies overseas have kept exports flat at best
– Most major industrial countries are expected to grow more slowly
than the US in the coming year
 >> OVERBUILT
– There’s already an excess of US industrial capacity
– This makes it almost impossible for corporations to raise prices
Article: Economic Profit vs. Accounting Profit
WSJ; by: Robert Bartley
 Profit is any income to a proprietor—Marxist Labor View—which is
fallacious
 The economist is interested in the dynamic forces of production while: The
accountant is interested in proprietorship….cost as a deduction from the
owner’s income
 Economic profit is the unimputable income i.e. “the residium of product
remaining after payment is made at rates established in competition with
all comers for all services of men or things for which competition exists”
 The highest uses depend on economic profit-rate of return on assets-not
on accounting profits.
 The issue of interest on equity has tended to constitute an issue between
accountants and economic theorists
 EPS measures the corporate profit and is called the accounting profit
 Peter Drucker: EPS represents taxable earnings i.e. after all deductions, is
purely arbitrary concept and has nothing to do with business performance
 NET-NET: Takes skill to convert EPS into meaningful economic profit
concept.
Marginal Product
 Marginal Product: for any input, it is the increase in output
that arises from an additional unit of that input.
 Diminishing Marginal Product: the marginal product of an
input declines as the quantity of the input increases.
I
0
Y
0
MP
Y = √I
1.0
1
3.5
1
0.4
2
1.4
2.5
0.3
3
1.7
2
2.2
1
0.5
0.2
5
2
1.5
0.3
4
3
0
0
2
4
6
8
10
Diminishing Marginal Product
Quantity of
Output
(cookies
per hour)
Production function
150
I
0
Y
0
50
140
130
1
120
50
40
110
2
100
90
90
30
80
3
70
120
60
20
50
4
40
140
30
10
20
5
10
0
MP
1
2
3
4
5
Number of Workers Hired
150
Fixed & Variable Costs
 Fixed costs: those costs that do not vary with the quantity
of output produced.
 Variable costs: those costs that do vary with the quantity of
output produced.
TC = TFC + TVC
 Total Costs
–
–
–
–
Total Fixed Costs (TFC)
Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC
Total Cost Curve
Shows the relationship between the quantity
a firm can produce and its costs.
Total Cost Curve
Total
Cost
100
90
80
70
60
50
40
30
20
10
0
0
10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160
Quantity
of Output
(cookies per hour)
Marginal Cost
Marginal Cost (MC): measures the increase
in total cost that arises from an extra unit of
production.
(change in total cost) TC
MC 

(change in quantity)
Q
EMBA 2007 Tavern
(Lemonade Example)
MC 
(change in total cost) TC

(change in quantity)
Q
Tavern’s Total-Cost Curve
Total Cost
$15.00
Total-cost curve
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0
1
2
3
4
5
6
7
8
9
10
Quantity of Output
(pints of beer per hour)
Tavern’s Total-Cost Curve
Total Cost
Total-cost curve
$15.00
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0
1
2
3
4
5
6
7
Quantity
of Output
(glasses of lemonade per hour)
8
9
10
Average Costs
Average costs can be determined by
dividing the firm’s costs by the quantity of
output it produces.
The average cost is the cost of each typical
unit of product.
– ATC
– AFC
– AVC
Tavern’s Various Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50
ATC
1.25
AVC
1.00
0.75
0.50
AFC
0.25
0
1
2
3
4
5
6
7
8
9
10
Quantity of Output
(pints of beer per hour)
Returns/Economies of Scale
 Increasing Returns to Scale/Economies of scale
(IRS): long-run average total cost falls as the
quantity of output increases.
 Decreasing Returns to Scale/Diseconomies of scale
(DRS): long-run average total cost rises as the
quantity of output increases.
 Constant returns to scale (CRS): long-run average
total cost stays the same as the quantity of output
increases
Economies of Scale (P 282)
Average
Total
Cost
ATC in long run
$12,000
10,000
Increasing
returns to
scale
0
Constant
returns to
scale
1,000 1,200
Decreasing
returns to
scale
Quantity of Cars per Day
Chapter 14
Competitive Firms
Total Revenue
Total Revenue: for a firm, is the selling
price times the quantity sold.
TR = (P  Q)
Total revenue is proportional to the amount
of output.
Average Revenue
Average Revenue: how much revenue a
firm receives for the typical unit sold.
Total revenue
Average Revenue =
Quantity
Price  Quantity

Quantity
 Price
Marginal Revenue
Marginal Revenue: the change in total
revenue from an additional unit sold.
MR =TR/ Q
For competitive firms, marginal revenue
equals the price of the good.
Profit Maximization
Firms will produce where TR-TC is greatest
MR=MC
Profit Maximization
Costs
and
Revenue
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
Suppose the market price is P.
MC
If the firm produces
Q2, marginal cost is
MC2.
ATC
MC2
P = MR1 = MR2
P = AR = MR
AVC
If the firm
produces Q1,
marginal cost is
MC1.
MC1
0
Q1
QMAX
Q2
Quantity
Measuring Profits Graphically
Price
MC
ATC
Firm with
Profits
P
ATC
P = AR = MR
0
Quantity
Q
(profit-maximizing quantity)
Decision to Shut Down
Shut Down: a short term decision to stop
production (not to exit the market)
– Fixed/Sunk costs are ignored
Shut down if TR < VC
Shut down if TR/Q < VC/Q
– TR/Q = Average Revenue
– VC/Q = Average Variable Cost
Shut down if P < AVC
In equilibrium
P = MR
Decision to Shut Down
Costs
If P > ATC, the firm
will continue to
produce at a profit.
Firm’s short-run
supply curve
MC
ATC
If P > AVC, firm will
continue to produce
in the short run.
AVC
Firm
shuts
down if
P < AVC
0
Quantity
Decision to Exit
Exit: a long run decision to leave the market
The firm exits if the revenue it would get
from producing is less than its total cost.
Exit if TR < TC
Exit if TR/Q < TC/Q
Exit if P < ATC
Decision to Exit
Costs
Firm’s long-run
supply curve
Firm
enters if
P > ATC
MC = long-run S
ATC
Firm
exits if
P < ATC
0
Quantity
Measuring Profits Graphically
Price
MC
ATC
ATC
P
P = AR = MR
Loss
0
Q
(loss-minimizing quantity)
Quantity
Cost & Profits
Airline Industry
0.00
US Airline Cost Index Report 2nd Quarter 2006
Other
TransRel
Ad &
Promotion
Utils & Office
Supplies
Communication
Insurance
Food &
Beverage
Maintenance
Material
Passenger
Commissions
Landing Fees
Professional
Services
Ownership
Fuel
Labor
UNIT COST BY CATEGORY
Cents per Available Seat Mile
3.50
3.00
2.50
2.00
1.50
1.00
0.50
LABOR COSTS
Wages + Benefits + Payroll Taxes per FTE
$80,000
$75,000
$70,000
$65,000
$60,000
$55,000
$50,000
US Airline Cost Index Report 2nd Quarter 2006
1Q06
1Q05
1Q04
1Q03
1Q02
1Q01
1Q00
1Q99
1Q98
1Q97
1Q96
1Q95
1Q94
1Q93
1Q92
1Q91
1Q90
$45,000
EMPLOYEE PRODUCTIVITY
ASMs (000) per FTE, 4 Quarter Moving Sum
2,500
2,400
2,300
2,200
2,100
2,000
1,900
1,800
1,700
1,600
US Airline Cost Index Report 2nd Quarter 2006
1Q06
1Q05
1Q04
1Q03
1Q02
1Q01
1Q00
1Q99
1Q98
1Q97
1Q96
1Q95
1Q94
1Q93
1Q92
1Q91
1Q90
1,500
Major Costs as Shares of Operating Expenses
%
50
40
30
20
10
0
1975
1980
Labor
Aircraft Ow nership
1985
1990
1995
Fuel
Non-Aircraft Ow nership
US Airline Cost Index Report 2nd Quarter 2006
2000
2005
Major Costs as Shares of Operating Expenses
%
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
1975
1980
Landing Fee
Com m unication
1985
1990
Maintenance
1995
2000
Aircraft Insurance
US Airline Cost Index Report 2nd Quarter 2006
2005
Major Costs as Shares of Operating Expenses
%
12
10
8
6
4
2
0
1975
1980
1985
Passenger com m issions
Utilities and Office Supplies
1990
1995
2000
Advertising and prom otion
Food and Beverages
US Airline Cost Index Report 2nd Quarter 2006
2005
Airline Employment Down by 100,000+
ATA 2004 Economic Report
ATA 2004 Economic Report
ATA 2004 Economic Report
ATA 2004 Economic Report
ATA 2004 Economic Report
Leverage Burden
($ bil.)
70
(%)
12.0
60
10.0
50
40
8.0
30
20
6.0
10
0
1975
1980
Debt Outstanding
1985
1990
1995
2000
Avg. Book Interest Rate (Right)
US Airline Cost Index Report 2nd Quarter 2006
2005
4.0
Total Interest Cost
($ bil.)
4.0
3.0
2.0
1.0
0.0
1975
1980
1985
1990
1995
US Airline Cost Index Report 2nd Quarter 2006
2000
2005
LOAD FACTOR
Including Interest Expense -- 4 Quarter Moving Average
Breakeven
Actual
90%
85%
80%
75%
70%
65%
1Q06
1Q05
1Q04
1Q03
1Q02
1Q01
1Q00
1Q99
1Q98
1Q97
1Q96
1Q95
1Q94
1Q93
1Q92
1Q91
1Q90
60%
WSJ Article 2002
Article: One Airline’s Magic
Time Magazine by: Sally Donnelly
How does Southwest (SW) soar above its money losing
rivals?
 Productivity
Its employees work harder and are smarter, in return, they get
job security and a share of profits
– Pilots fly as many as 83 hours a month, compared with
about 53 hours in a busy month at United Airlines
– Flight attendants work almost twice as many hours as their
counterparts at other airlines
– Mechanics change airplane tires faster (like a NASCAR pit)
and thus get higher wages than their counterparts at other
airlines
 Flexibility
– SW pilots also pitch in to help ground crews move luggage
 In return, SW compensates it workers in ways other than the base pay
– It contributes 15% of its pre-tax income to a profit-sharing plan
– It has assured all its workers and unions that there would be no lay-offs
– SW doesn’t use the word “employee”, and gives them enough room to grow
and learn
– SW has enjoyed big savings by never having the type of defined-benefit
pension plans which has proved so costly for other airlines
 Other advantages of SW:
– Last year, SW selected 6,000 people out of 2 million resumes received on
the basis of attitudes and not necessarily skills
– SW flies point-to-point domestic routes, as opposed to the complex and
expensive hub-and-spoke international networks
– No meals served onboard, no bulky drink carts and no entertainment
– SW uses less expensive, less crowded secondary airports
– Flies only one type of aircraft – Boeing 737 to reduce maintenance costs
– Employees own more than 10% of SW outstanding shares, thus they work
more productively and more creatively to increase their own pay checks
– Lowest cost per seat mile: 7.5 cents
– Highest aircraft hours per day: 10.9 hrs/day
So What is the Solution?
Article: The Airline Industry’s Changing Business
Model
Do the legacy airlines have any comparative advantage that
they can use in competing with their low cost rivals for
domestic travelers?
– The honest answer is NO.
The time has come for some of the airlines to either merge
or liquidate so that excess capacity in the market can be
reduced to profitability manage the new demand frontier.
(permanent downward shift in demand curve esp. domestic
flying)
But will the mergers or liquidations save the big boys?
Maybe…
The only way out is a radical shift in thinking by the big
airlines: outsource to low-cost airlines and allow them to bring
passengers to your legacy hubs! Then fly these travelers to
international destinations on your planes at premium prices
where there is no competition from South-West and upstart
airlines.
Basics of Macroeconomics
Chapter 23
The Economy’s Income &
Expenditure
 For an economy as a whole, income must equal
expenditure because:
– Every transaction has a buyer and a seller.
– Every dollar of spending by some buyer is a dollar of
income for some seller.
 Gross domestic product (GDP) is a measure of the
income and expenditures of an economy.
 It is the total market value of all final goods and
services produced within a country in a given
period of time.
Simple Economy
Circular Flow Diagram
MARKETS
FOR
GOODS AND SERVICES
•Firms sell
Goods
•Households buy
and services
sold
Revenue
Wages, rent,
and profit
Goods and
services
bought
HOUSEHOLDS
•Buy and consume
goods and services
•Own and sell factors
of production
FIRMS
•Produce and sell
goods and services
•Hire and use factors
of production
Factors of
production
Spending
MARKETS
FOR
FACTORS OF PRODUCTION
•Households sell
•Firms buy
Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of dollars
Definition of GDP
GDP is the market value of all final goods
and services produced within a country in a
given period of time.
Definition of GDP
 “GDP is the Market Value . . .”
– Output is valued at market prices.
 “. . . Of All Final . . .”
– It records only the value of final goods, not intermediate
goods (the value is counted only once).
 “. . . Goods and Services . . . “
– It includes both tangible goods (food, clothing, cars) and
intangible services (haircuts, housecleaning, doctor
visits).
Definition of GDP
 “. . . Produced . . .”
– It includes goods and services currently produced, not
transactions involving goods produced in the past.
 “ . . . Within a Country . . .”
– It measures the value of production within the
geographic confines of a country.
–
 “. . . In a Given Period of Time.”
– It measures the value of production that takes place
within a specific interval of time, usually a year or a
quarter (three months).
Definition of GDP
What Is Not Counted in GDP?
– GDP excludes most items that are produced and
consumed at home and that never enter the
marketplace.
– It excludes items produced and sold illicitly,
such as illegal drugs.
GDP and Economic Well-Being
 GDP per person tells us the income and expenditure of the
average person in the economy. Higher GDP per person
indicates a higher standard of living.
 However…GDP is not a perfect measure of the happiness or
quality of life.
 Some things that contribute to well-being are not included in
GDP.
– The value of leisure.
– The value of a clean environment.
– The value of almost all activity that takes place outside of
markets, such as the value of the time parents spend with
their children and the value of volunteer work.
Table 3 GDP and the Quality of Life
NIPA Definition of GDP
Y=C+I+G+NX
Y = GDP
C = Consumption
I = Investment
G = Government Purchases
NX = Net Exports = Exports-Imports
NIPA Definition of GDP
 Consumption (C):
– The spending by households on goods and services,
with the exception of purchases of new housing.
 Investment (I):
– The spending on capital equipment, inventories, and
structures, including new housing.
 Government Purchases (G):
– The spending on goods and services by local, state, and
federal governments.
– Does not include transfer payments because they are
not made in exchange for currently produced goods or
services.
 Net Exports (NX):
– Exports minus imports.
GDP and Its Components
Simple GDP Example
This simple economy has 2 people: Baker and Miller.
Baker buys flour for $350. He also uses a worker and pays
$200 in wages. He also pays a rent of $25. He makes a
profit as $25 on the bread he sells for $600.
The miller pays his worker $300, a rent of $25, and his
profit is $25 on a sale of $350.
The GDP of this economy is $600!
Why? 2 sides of a coin, Income=Expenditures
Expenditures=Value of final Goods sold=600
Income=wages+Rent+profits=300+200+25+25+25+25=600
Real vs. Nominal GDP
 Nominal GDP values the production of goods and
services at current prices.
 Real GDP values the production of goods and
services at constant prices.
Real GDP20XX
Nominal GDP20XX

 100
GDP deflator20XX
•GDP Deflator deflates for Inflation!
•Inflation is rate of change of prices.
Macro Framework
Households: Consume & Work
Firms: Production & Investment
Government: Money Supply, Taxes,
Expenditures
Foreign Sector: Exports, Imports &
Exchange Rate
Consumption Pattern
(%)
72
70
68
66
64
62
60
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
GDP and Consumption
(Bil. $)
14000
12000
10000
8000
6000
4000
2000
0
1971
1976
1981
Consumption
1986
GDP
1991
1996
2001
2006
Investment Pattern
(%)
14
13
12
11
10
9
8
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Exports Share
(%)
12
10
8
6
4
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Imports Share
(%)
18
16
14
12
10
8
6
4
2
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Net Exports
(%)
2
0
-2
-4
-6
-8
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Government Share
(%)
24
23
22
21
20
19
18
17
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Federal Budget Deficit
(%)
2
0
-2
-4
-6
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Federal Budget, Trade Deficits and
US dollar trade-weighted exchange rate
(Bil. $)
200
Index 2000 = 100
140
130
0
120
-200
110
-400
100
-600
90
-800
80
-1000
70
1974
1978
1982
Budget Deficit
1986
1990
Trade Deficit
1994
1998
2002
2006
U.S. Dollar Exchange Rate (R)
GDP Components (2005)
Government Purchases
19%
Net Exports
Investment
-6
%
17%
Consumption
70%
Recessions
A recession is a significant decline in
activity lasting more than a few months and
is visible in industrial production,
employment, real income and wholesaleretail sales (NBER definition). NBER uses
monthly data.
Rule of thumb is 2 consecutive quarters of
negative Real GDP growth or GDP decline.
Article: Business Cycles
BUSINESS CYCLE
REFERENCE DATES
Peak
DURATION IN MONTHS
Trough
Quarterly dates
are in parentheses
Contraction
Expansion
Cycle
Peak
to
Trough
Previous
trough
to
this peak
Trough
from
Previous
Trough
Peak from
Previous
Peak
May 1937(II)
February 1945(I)
November 1948(IV)
July 1953(II)
August 1957(III)
June 1938 (II)
October 1945 (IV)
October 1949 (IV)
May 1954 (II)
April 1958 (II)
13
8
11
10
8
50
80
37
45
39
63
88
48
55
47
93
93
45
56
49
April 1960(II)
December 1969(IV)
November 1973(IV)
January 1980(I)
July 1981(III)
February 1961 (I)
November 1970 (IV)
March 1975 (I)
July 1980 (III)
November 1982 (IV)
10
11
16
6
16
24
106
36
58
12
34
117
52
64
28
32
116
47
74
18
July 1990(III)
March 1991(I)
8
92
100
108
March 2001 (I)
November 2001 (IV)
8
120
128
128
NBER Report Cycle Dates 2003
Mar 01’ ~ Nov 01’
9
-0.1%
Forecast of the Nation, 2003
-4.0%
4.2
5.6
Real GDP and Business Cycles
(Bil. 2000$)
12000
10000
8000
6000
4000
2000
1962
1966
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
Real GDP and Business Cycles
(Bil. 2000$)
12000
11000
10000
9000
8000
7000
6000
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Industrial Production and Employment
(Index: 1997=100)
115
(Mil.)
138
136
110
134
105
132
130
100
128
95
126
90
1998
1999
2000
2001
2002
Industrial Production
2003
2004
2005
2006
124
2007
Total Payroll Em ploym ent (Right)
Retail Sales
(Bil.)
340
320
300
280
260
240
APR AUG DEC APR AUG DEC APR AUG DEC APR AUG DEC APR AUG DEC APR AUG DEC
2001
2002
2003
2004
2005
2006
Real Disposable Income Growth
On a Percent Change from a Year Ago Basis
(%)
8
6
4
2
0
-2
-4
JUL NOV MAR JUL NOV MAR JUL NOV MAR JUL NOV MAR JUL NOV MAR JUL NOV MAR JUL NOV MAR JUL NOV
1999
2000
2001
2002
2003
2004
2005
2006
Real Retail Sales Growth
On a Percent Change from a Year Ago Basis
(%)
8
6
4
2
0
-2
-4
-6
DEC APR AUG DEC APR AUG DEC APR AUG DEC APR AUG DEC APR AUG DEC APR AUG DEC
2000 2001
2002
2003
2004
2005
2006
Article: NBER’s FAQs
Q: The financial press often states the definition of a recession as
two consecutive quarters of decline in real GDP. How does that
relate to the NBER's recession dating procedure?
– Most of the recessions identified by our procedures consist of two
or more quarters of declining real GDP, but not all of them
– We consider the depth as well as the duration of the decline in
economic activity.
– Second, we use a broader array of indicators than just real GDP
– Third, we use monthly indicators to arrive at a monthly chronology
Q: Could you give an example illustrating this point?
– The two-quarter-decline rule of thumb would not have allowed the
declaration of the recession until August 2002
Q: How does the NBER balance the differing behavior of
employment and output?
– There is no fixed rule for how the different indicators are weighted
Article: NBER’s FAQs
Q. You emphasize the payroll survey as a source for data on
economy-wide employment. What about the household survey?
– Although the household survey is a large, well-designed
probability sample of the U.S. population, its estimates of total
employment appear to be noisier than those from the payroll
survey
Q. How do the movements of unemployment claims inform the
Bureau's thinking?
– A bulge in jobless claims would appear to forecast declining
employment, but we do not use forecasts and the claims numbers
have a lot of noise
Q: What about the unemployment rate?
– Unemployment is generally a lagging indicator. Its rise from a very
low level to date is consistent with the employment data
Peak & Trough Announcements
The November 2001 trough was announced July 17, 2003.
The March 2001 peak was announced November 26, 2001.
The March 1991 trough was announced December 22, 1992.
The July 1990 peak was announced April 25, 1991.
The November 1982 trough was announced July 8, 1983.
The July 1981 peak was announced January 6, 1982.
The July 1980 trough was announced July 8, 1981.
The January 1980 peak was announced June 3, 1980.
2001 Recession vs. History
For Details Refer:
http://www.nber.org/
Real GDP and Consumption
FRBSF Economic Letter, June 2003
Investment and Stock Market
FRBSF Economic Letter, June 2003
Chapter 24
Measuring the Cost of Living
Consumer Price Index & Inflation
 Inflation refers to a situation in which the
economy’s overall price level is rising.
 The inflation rate is the percentage change in the
price level from the previous period.
 The Consumer Price Index (CPI) is a measure of
the overall cost of goods and services bought by a
typical consumer (produced by BLS).
 Inflation rate is change in CPI.
Steps to Calculate CPI Index
 Fix the Basket: Determine what prices are most important
to the typical consumer.
– The Bureau of Labor Statistics (BLS) identifies a market basket of
goods and services the typical consumer buys.
– The BLS conducts monthly consumer surveys to set the weights
for the prices of those goods and services.
 Find the Prices: Find the prices of each of the goods and
services in the basket for each point in time.
 Compute the Basket's Cost: Use the data on prices to
calculate the cost of the basket of goods and services at
different times.
 Choose a Base Year and Compute the Index:
Steps to Calculate CPI Index
Choose a Base Year and Compute the
Index:
– Designate one year as the base year, making it
the benchmark against which other years are
compared.
– Compute the index by dividing the price of the
basket in one year by the price in the base year
and multiplying by 100.
How the Inflation Rate Is
Calculated
The Inflation Rate
– The inflation rate is calculated as follows:
CPI in Year 2 - CPI in Year 1
Inflation Rate in Year 2 =
 100
CPI in Year 1
Calculating the Consumer Price Index
and the Inflation Rate: An Example
Calculating the Consumer Price Index
and the Inflation Rate: An Example
Another Example of CPI and
Inflation Calculations
 Calculating the Consumer Price Index and the
Inflation Rate:
–
–
–
–
–
Base Year is 2002.
Basket of goods in 2002 costs $1,200.
The same basket in 2003 costs $1,236.
CPI = ($1,236/$1,200)  100 = 103.
Prices increased 3 percent between 2002 and
2003.
FYI: What Is in the CPI’s Basket?
17%
Transportation
15%
Food and
beverages
Education and
communication
42%
Housing
6%
6%
6% 4% 4%
Medical care
Recreation
Apparel
Other goods
and services
The GDP Deflator vs. CPI
The BLS calculates other prices indexes:
– The index for different regions within the
country.
– The producer price index, which measures the
cost of a basket of goods and services bought by
firms rather than consumers.
CPI and GDP Deflator
Percent
per Year
15
CPI
10
5
0
GDP deflator
1965
1970
1975
1980
1985
1990
1995
2000
Japan - GDP Growth and Deflator
(sm oothed)
(%)
10
8
6
4
2
0
-2
-4
1982
1986
Real GDP Growth
1990
1994
1998
Nominal GDP Growth
2002
2006
GDP Deflator
Germany - GDP Growth and Deflator
(sm oothed)
(%)
10
8
6
4
2
0
-2
1992
1994
1996
Real GDP Growth
1998
2000
2002
Nominal GDP Growth
2004
2006
GDP Deflator
Problems in Measuring CPI
Substitution bias
Introduction of new goods
Unmeasured quality changes
Use of Price Indexes
 Price indexes are used to correct for the effects of inflation
when comparing dollar figures from different times.
 Do the following to convert (inflate) Babe Ruth’s wages in
1931 to dollars in 2005:
Do the following to convert (inflate) Babe
Ruth’s wages in 1931 to dollars in 2005:
Salary2005  Salary1931
 $80,000
Price level in 2005
Price level in 1931
195
15.2
 $ 1,026,316
The Most Popular Movies of All
Times, Inflation Adjusted
Article: Haute Con Job (PIMCO)
aka Bill Gross’s Beef With Inflation
Methodology
 Bill Claims that Hedonic Pricing a.k.a. Haute Con
Job is Keeping Inflation Rate Low
 Low Inflation => Higher Productivity (Calculations)
 => FED Can Keep Rates Low, Keep the Consumption
Boom, and Greenspan His Legacy!
 Government Can Keep Social Security Payments Down
 It Hurts Investors, Especially His TIPS Holders
 Bill Says Core Inflation is Not the Real Metric of
Measuring the Cost of Living as We Still Have to
Pay for Food & Energy in Real Life!
Article: Haute Con Job (PIMCO)
Article: Haute Con Job (PIMCO)
Article: Con Job Redux (PIMCO)
by: Bill Gross

Bill claims that CPI inaccurately calculates Americans’ cost of
living.

Example: Say you buy 1 bag of gumdrops for $1 which has 100
of those. Productivity makes it 110 gumdrops but for $1.10.
Hedonic pricing says that CPI hasn’t gone up as per-capita cost
is the same (1 cent). But you have to shelve out $1.10 to get
the bag, which is an increase in cost of 10%. They must fork
out an extra dime even though they’re getting more for their
money.

We can’t buy individual pieces of memory in a computer-we
have to buy the entire package!
Real and Nominal Interest Rates
The nominal interest rate is the interest rate
usually reported and not corrected for
inflation.
– This is the interest rate that a bank pays.
The real interest rate is the nominal interest
rate that is corrected for the effects of
inflation.
Real and Nominal Interest Rates
You borrow $1,000 for one year.
Nominal interest rate is 15%.
During the year inflation is 10%.
Real interest rate = Nominal interest rate – Inflation
= 15% - 10% = 5%
Real and Nominal Interest Rates
Interest Rates
(percent
per year)
15%
Nominal interest rate
10
5
0
Real interest rate
-5
1965
1970
1975
1980
1985
1990
1995
2000
2005