Download Lecture 1: Introduction

Lecture 1
Basics of Economics & Elasticity
Dr. Rajeev Dhawan
Director
Given to the
EMBA 8400 Class
January 4, 2008
Course Objective & Teaching Philosophy
Practical Course to Comprehend the
Economic Environment so that Managers
can make their Decisions
Philosophy is that Micro Sectors Add Up
to a Macro Environment
Optimal Blend of Economics and Real
World Experience/Common Sense
Train You to Critically Evaluate and
Interpret Business Press Writings
Course Layout
First Week (1&2) - Basic Microeconomics
Second Week (3&4) – Basics of
Macroeconomics and Basic Workings of an
Economy with the Help of a “Basic”
Macromodel that can Perform Real-Life
Fiscal And Monetary Experiments
Third Week (5&6) – Wrap up with Model
Training and Group Project Presentations
Field Trip to the Economic Forecasting
Conference on Feb. 27th BONUS)
Background Articles
 My Economics
 Why Journalists Can't Add
 Where Presidents Have No Power
 Their Money Our Strength
 How to Stop Relatives from Bragging About
their Big Profits in Real Estate
 Economic Hypochondria
Grading Policy
50% 2 Quizzes in Class
25% Group Presentations on a
Selected Industry
25% Take Home Final Exam
–Macroeconomic Model Exercise
25% Bonus - Economic
Forecasting Conference
Group Presentations
The objectives of this group project are :
1. To help you bridge the gap between the economic theory and
models discussed in class and the “real world”
2. To confront the problems of trying to find data which are
appropriate for the questions under consideration and to deal
with the problems of incomplete information
3. To showcase your oral and written communication skills
4. To identify how the problems faced and the decisions made by
other firms are similar to your own.
Suggested Industries
1. Wireless Communication
2. Networking & Security Systems
3. Oil Industry
4. Healthcare Industry
5. Hospitality Industry
6. Paper & Pulp Industry
7. Utility & Power Industry
8. Consumer Products
9. Insurance
10. REIT (Real Estate Investment Trust)
Macro Framework
Households: Consume & Work
Firms: Production & Investment
Government: Money Supply,
Taxes, Expenditures
Foreign Sector: Exports,
Imports & Exchange Rate
Macroeconomic Model For Teaching
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Section 1: A Model Simulation Approach to Macroeconomics
Section 2: Classification of Equations
Section 3: Glossary of Variables
Section 4: Listing of Equations in the Integrated Macro Model
Section 5: Flow Diagram of Integrated Macro Model
Section 6: Policy Experiments with Integrated Macro Model
Section 7: Guidelines to Use the Model
GLOSSARY OF VARIABLES
Variable
Meaning
Units
C
Consumption
Billions of $
EX
Exports
Billions of $
EXCH
Exchange Rate
Index
G
Government Purchases
Billions of $
GDP
Gross Domestic Product
Billions of $
GDP@FUL
L
GDP @ Full Employment
Billions of $
GDP@RO
W
GDP in Rest of the World
Billions of $
I
Investment
Billions of $
IM
Imports
Billions of $
M
Money supply
Billions of $
NETEX
Net Exports
Billions of $
P
Price Level
Index
P%
Inflation
Percent
P@ROW
Price Level, Rest of the World
Index
R
Real Interest Rate
Percent
R@ROW
Real Interest Rate, Rest of the World
Percent
T
Tax Revenues
Billions of $
TAX%
Tax Rate
Fraction
YDP
Disposable Income
Billions of $
~Typical Macro-Model~
world
interest
rate
world
price
price
level lag 1
world
GDP
IMPORTS
inflation
lag 1
EXPORTS
EXCHANGE RATE
NET
EXPORTS
money
PRICE
LEVEL
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
CONSUMPTION
tax
rate
capital stock
lag 1
TAX REVENUES
investment
lag 1
DISPOSABLE INCOME
CAPITAL STOCK
EXPECTED
INFLATION
UNEMPLOYMENT
POTENTIAL GDP
labor force
~Typical Macro-Model~
world
interest
rate
world
price
price
level lag 1
world
GDP
IMPORTS
inflation
lag 1
EXPORTS
EXCHANGE RATE
NET
EXPORTS
money
PRICE
LEVEL
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
CONSUMPTION
tax
rate
capital stock
lag 1
TAX REVENUES
investment
lag 1
DISPOSABLE INCOME
CAPITAL STOCK
EXPECTED
INFLATION
UNEMPLOYMENT
POTENTIAL GDP
labor force
~Typical Macro-Model~
world
interest
rate
world
price
price
level lag 1
world
GDP
IMPORTS
inflation
lag 1
EXPORTS
EXCHANGE RATE
NET
EXPORTS
money
PRICE
LEVEL
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
CONSUMPTION
tax
rate
capital stock
lag 1
TAX REVENUES
investment
lag 1
DISPOSABLE INCOME
CAPITAL STOCK
EXPECTED
INFLATION
UNEMPLOYMENT
POTENTIAL GDP
labor force
~Typical Macro-Model~
world
interest
rate
world
price
price
level lag 1
world
GDP
IMPORTS
inflation
lag 1
EXPORTS
EXCHANGE RATE
NET
EXPORTS
money
PRICE
LEVEL
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
CONSUMPTION
tax
rate
capital stock
lag 1
TAX REVENUES
investment
lag 1
DISPOSABLE INCOME
CAPITAL STOCK
EXPECTED
INFLATION
UNEMPLOYMENT
POTENTIAL GDP
labor force
~”New Economy” Macro-Model~
world
interest
rate
world
price
price
level lag 1
world
GDP
IMPORTS
inflation
lag 1
EXPORTS
EXCHANGE RATE
NET
EXPORTS
money
PRICE
LEVEL
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
Tech/Profit
Opportunities
EXPECTED
INFLATION
STOCK MARKET
CONSUMPTION
tax
rate
capital stock
lag 1
TAX REVENUES
investment
lag 1
DISPOSABLE INCOME
CAPITAL STOCK
UNEMPLOYMENT
POTENTIAL GDP
labor force
~”New Economy” Macro-Model~
world
interest
rate
world
price
price
level lag 1
world
GDP
IMPORTS
inflation
lag 1
EXPORTS
EXCHANGE RATE
NET
EXPORTS
money
PRICE
LEVEL
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
Tech/Profit
Opportunities
EXPECTED
INFLATION
STOCK MARKET
CONSUMPTION
EUPHORIA
tax
rate
capital stock
lag 1
TAX REVENUES
investment
lag 1
DISPOSABLE INCOME
CAPITAL STOCK
UNEMPLOYMENT
POTENTIAL GDP
labor force
~”New Economy” Macro-Model~
world
interest
rate
world
price
price
level lag 1
world
GDP
IMPORTS
inflation
lag 1
EXPORTS
EXCHANGE RATE
NET
EXPORTS
money
PRICE
LEVEL
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
Tech/Profit
Opportunities
EXPECTED
INFLATION
STOCK MARKET
CONSUMPTION
EUPHORIA
EUPHORIA
tax
rate
capital stock
lag 1
TAX REVENUES
investment
lag 1
DISPOSABLE INCOME
CAPITAL STOCK
UNEMPLOYMENT
POTENTIAL GDP
labor force
~”New Economy” Macro-Model~
world
interest
rate
world
price
price
level lag 1
world
GDP
IMPORTS
inflation
lag 1
EXPORTS
EXCHANGE RATE
NET
EXPORTS
money
PRICE
LEVEL
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
Tech/Profit
Opportunities
EXPECTED
INFLATION
STOCK MARKET
CONSUMPTION
EUPHORIA
tax
rate
capital stock
lag 1
TAX REVENUES
investment
lag 1
DISPOSABLE INCOME
CAPITAL STOCK
UNEMPLOYMENT
POTENTIAL GDP
labor force
Field Trip to the Forecasting
Center’s Quarterly Forecast
th
Conference on Feb. 27 !
The Economic Forecasting Center at Georgia
State University collects and analyzes
macroeconomic data and develops procedures
to forecast the national, regional and local
economies.
http://robinson.gsu.edu/efc/index.html
What Products Do We Offer?
The Center offers:
–Forecast Reports
Georgia and Atlanta (Quarterly)
Nation (Quarterly)
Southeast Indicators (Bi-Annual)
–Quarterly Conferences
– Sponsorships
– Custom Consulting Services
Quarterly Conferences
 Consortium of GSU
Experts and
Business Executives
 My Forecast Talk!
 4 Industry Speakers
 Forecast Reports
 Networking
Breakfast,
Refreshments and
Lunch
How to Attend Our Conferences?
It Costs Money!
$150 per Person
 Institutional Discounts Available.
BUT MY STUDENTS ARE IN FOR FREE!
Check Our Website for Latest Program:
www.robinson.gsu.edu/efc
Introduction
The 10 Principles of Economics
What is Economics?
 Economics is the study of how we use our scarce
productive resources for consumption, now or in
future.
– Paul Samuelson
 Resources are scarce:
– Society has limited resources and therefore cannot
produce all the goods and services people wish to have
– Example: clean air & water
– Scarcity is not poverty
Basic Questions
What to produce in what quantity?
How to produce them?
When and where to produce?
For whom?
Who makes economic decisions and by
what process?
Basic Concepts
Opportunity Cost: Things are Scarce
– Next Best Alternative
Ex: Party on Friday night vs. study for exams
– Cost of Time
Ex: 1 hour wait time at the dentist
Basic Concepts
Marginal Concept: At the Margin
Shots of Wild Turk ey
Marginal
Shot
Satisfaction Satisfaction
1
50
20
2
70
10
3
80
5
4
85
1
5
86
0
6
86
Utility: Level of Satisfaction (here, drunkenness)
Basic Concepts
Sunk/Fixed Costs: Expenditures Made that
Cannot be Recovered
– Example:
You bought a computer laptop for $1500
A newer, upgraded model costs $1200
The dealer will accept a trade in + $400
What do you do?
Winnick’s Voyage to the Bottom of the Sea
WSJ; by Andy Kessler
 First Mover, FCC regulated + fixed costs
 Regulated utility
 Price protection
You can’t lose
 Traffic / use was of low economic value or
cashless
 Global Crossing couldn't cut prices without running
the risk of either failing to cover its debt or being
unable to raise more capital
 Accounting Tricks…….
10 Principles of Economics
1. People face tradeoffs :
• “No such thing as free lunch”
• Give up one thing to get another –
Opportunity Cost (OC)
2. Everything has an OC – whatever must be given
up to get that item
3. People make decisions at the margins –
increments matter
4. People respond to incentives – e.g. cigarette
laws, communism
5. Free Trade is good (for everybody)
10 Principles of Economics
6. Markets organize economic activity
- Adam Smith “Invisible Hand”
7. Governments can sometimes improve market
outcome
8. A country’s standard of living depends upon its
production power (productivity)
9. Prices rise when government prints too much
money
10. Phillips curve – short run tradeoff between
inflation and unemployment
Branches of Economics
Micro: The Study of One Entity
(firm, business, people)
Macro: The Study of a Collection of Things
(national, aggregate)
How are Theories Developed?
Decision-Makers
– Firms, governments
Markets
– Place where exchange takes place
Who REALLY Owns that Winery
TIME Magazine; by Terry McCarthy
Consolidation is the Norm
 60% of U.S. wine is produced by the top five
companies
– Consolidation among distributors is squeezing out the
medium-sized producers, who make from 100,000 to 1
million cases a year
 Market is not growing
– Only 10% of adults drink 86% of the wine
 Fixed Costs
– Some wineries do not have enough volume to get a
priority from distributors
Who REALLY Owns that Winery
TIME Magazine; by Terry McCarthy
 Reshuffling to scarce resources
– He can make lots of money just by shifting more of his
production - and more of his customers – from 1.5L jugs
of generic red that sell for less than $5 retail to smaller
bottles of $7 Merlot
 The Future
– The higher end is where the profits and the growth are to
be found
– The Italians have figured it out – how to create tastes
that suit the American palate
Chapter 4
Demand & Supply
Some Basic Definitions
Market: a group of buyers and sellers of a
particular good or service
– E.g. Warren Buffet has been buying up junk
bonds
– E.g. Bars, parties – informal market
Stock market – organized market
Example of Supply & Demand
 Hong Kong chicken flu scare? Price of chicken 
 Mad cow disease in US? Price of beef 
 Oprah bad mouths beef? Price of beef 
– Amarillo farmers sue her.
SARS? (Macro issue…)
Demand
Quantity demanded (Q): the amount of a good that
buyers are willing and able to purchase at a given price
(P).
Demand for Beer
$10.00
$8.00
Price
Pints of Beer
P
QD
$10.00
0
7.00
1
5.00
3
4.00
6
2.00
11
0.00
19
$6.00
$4.00
$2.00
$0.00
0
5
10
15
Quantity (Pints)
20
Market Demand versus
Individual Demand
Market demand refers to the sum of all
individual demands for a particular good or
service.
Graphically, individual demand curves are
summed horizontally to obtain the market
demand curve.
The Market Demand Curve
When
the price
is $5.00,
When the price
is $5.00,
The
market
demand
curve
is the
Catherine will demand Nicholas
3
will demand 4
of
the
individual
demand
curves!
beers.
beers.
Catherine’s Demand
Price of
Beers
+
Nicholas’s Demand
=
Price of
Beers
Price of
Beers
5.00
5.00
5.00
4.00
4.00
3
Quantity of Beers
6
The market demand
horizontal
sum at
$5.00 will be 7 beers.
Market Demand
4.00
4
7
Quantity of Beers
When the price is $4.00, When the price is $4.00,
Catherine will demand 6 Nicholas will demand 7
beers.
beers.
7
13
Quantity of Beers
The market demand at
$4.00, will be 13 beers.
Graph Results
Demand curve/schedule is downward
sloping and shows the relationship between
price of a good and the quantity demanded
Why downward sloping?
– Law of demand: Ceteris Paribus (all other
things being equal) the quantity demanded falls
when price rises
Other Determinants of Demand
Income (I) :
– I  , D   Normal Goods: car, Ferrari
– I  , D   Inferior goods: bus rides, potatoes
Price of related goods
– Substitutes (inversely correlated)
– Compliments (directly correlated)
Other Determinants of Demand
 Tastes – taken as above
– You get old and prefer Lincoln Town cars to sports cars
 Expectations – about future
– Income potential with EMBA degree 
– Loss of jobs, layoffs prospects
 Market Demand
– More players  Increase in demand
– Buy IPO’s in 90’s
Shifts in Demand Curve
Variables that shift the demand curve:
Shifts in the Demand Curve
Price of
Beer
Increase
in demand
Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0
Quantity of
Beer
Supply
Quantity supplied (Q): the amount of a good that sellers
are willing and able to sell at a given price (P).
Supply of Beer - Neighbors
$10.00
$8.00
Price
Pints of Beer
P
QS
$10.00
12
7.00
7
5.00
4
4.00
3
2.00
1
0.00
0
$6.00
$4.00
$2.00
$0.00
0
2
4
6
8
Quantity (Pints)
10
12
Supply
Supply graph for another bar
Supply of Beer - Hand in Hand
Price
Pints of Beer
P
QS
$10.00
8
7.00
5
5.00
4
4.00
3
2.00
1
0.00
0
$10.00
$9.00
$8.00
$7.00
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
2
4
6
8
Quantity (Pints)
10
12
Determinants of Supply
Your own Price
Input Prices
– Cost of bottle of beer: labor, capital, rent
Technology
– Smoking laws  separation of smoking &
drinking
Expectations
– Future outlook
Shifts in The Supply Curve
Variables that shift the supply curve:
Shifts In Supply Curve
Price of
Beer
Supply curve, S3
Decrease
in supply
Supply
curve, S1
Supply
curve, S2
Increase
in supply
0
Quantity of
Beer
Equilibrium
Equilibrium: the price where quantity
supplied is equal to quantity demanded
Market for Beer
$10.00
Price
$8.00
Equilibrium
$6.00
$4.00
$2.00
$0.00
0
5
6
10
Quantity (Pints)
15
20
Markets Not In Equilibrium
Excess Supply
Price of
Beer
Supply
Surplus
$6.50
4.00
Demand
0
2
Quantity
demanded
6
10
Quantity
supplied
Quantity of
Beer
Markets Not In Equilibrium
Excess Demand
Price of
Beer
Supply
$4.00
2.50
Shortage
Demand
0
2
Quantity
supplied
6
10
Quantity
demanded
Quantity of
Beer
Changes in Equilibrium
 Decide whether the event shifts the supply or demand
curve (or both).
 Decide whether the curve(s) shift(s) to the left or to the
right.
 Use the supply-and-demand diagram to see how the shift
affects equilibrium price and quantity.
Changes in Equilibrium
An increase in the
price of hops reduces
the supply of beer
An increase in wealth
increases demand for beer
Price of
Beer
Price of
Beer
Suppl
y
New
equilibrium
$6.50
S2
S1
New
equilibrium
$6.50
4.00
Initial
equilibrium
Initial equilibrium
4.00
D2
Demand
D1
0
6
10 Pints of Beer
0
2
6
Pints of Beer
One bar closes…
New
Equilibrium
Market for Beer
$10.00
S1
S2
Price
$8.00
$6.00
$5.00
$4.00
$2.00
$0.00
0
4 5
10
Quantity (Pints)
15
20
Article: Too Many Cars, WSJ; by: Paul Ingrassia
 Overcapacity is the biggest problem for any automobile
company in the world




GM buys Daewoo Motor, Fiat Auto, Saab
Ford motor owns Mazda, Land Rover
Daimler Chrysler is riding to rescue Mitsubishi
Oldsmobile and Chrysler’s Plymouth, are the first major automobile
companies in 40 years
 Why do ailing automobile companies who decry overcapacity
keep ailing car companies?
•
•
•
National pride plays a big role
More brands mean more dealerships mean more sales.
But this also means more costs and complexity in business operations.
In reality, overcapacity is not really a problem.
One man’s overcapacity is other’s bargain.
Thus, lower priced leases and generous rebates abound in today’s
car market.
Chapter 5
Elasticity
Elasticity & Its Application
 Evaluating questions like– Banana Republic store manager/headquarters needs to
decide on sale on jeans vs. sale on shirts
– Rain destroys strawberry crop, prices go . Does it
benefit growers ?
– Why don’t you ever see sale or discounts on pure milk
but see it on orange juice ?
 These can be answered with the concept of
elasticity (or responsiveness of buyers & sellers to
changes in market conditions)
Elasticity
Price elasticity of demand: a measure of how
much the quantity demanded of a good responds
to a change in the price of that good
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
Continued..
 Two types of demand:
– Elastic – responds a lot e.g. luxury cars ( luxuries)
– Inelastic – not much change e.g. milk, certain food
items, gasoline ( necessities)
 Preferences: Luxuries vs. Necessities
 Availability of close substitutes: Elastic
– Butter & margarine; cars, booze
 Time horizon:
– Gasoline – necessity in short run
– Substitute long run (electric cars, walk, bike)
Elasticity
Inelastic Demand
– Quantity demanded does not respond strongly
to price changes.
– Price elasticity of demand is < one.
Elastic Demand
– Quantity demanded responds strongly to
changes in price.
– Price elasticity of demand is > one.
Demand Curves
Question: Can I tell from the graphical
shape of the demand curve what kind of
elasticity the curve has?
Answer: Yes, but not all the time.
Perfectly Inelastic Demand
Elasticity = 0
Price
Demand
$5
4
1. An
increase
in price . . .
0
100
Quantity
2. . . . leaves the quantity demanded unchanged.
3. . . . revenue goes from $4 x 100 to $5 x 100
Inelastic Demand
Elasticity < 1
Price
$5
4
1. A 22%
increase
in price . . .
Demand
0
90
100
Quantity
2. . . . leads to an 11% decrease in quantity demanded.
3. . . . revenue goes from $4 x 100 to $5 x 90
Unit Elastic Demand
Elasticity = 1
Price
$5
4
Demand
1. A 22%
increase
in price . . .
0
80
100
2. . . . leads to a 22% decrease in quantity demanded.
3. . . . revenue goes from $4 x 100 to $5 x 80
Quantity
Elastic Demand
Elasticity > 1
Price
$5
Demand
4
1. A 22%
increase
in price . . .
0
50
100
2. . . . leads to a 67% decrease in quantity demanded.
3. . . . revenue goes from $4 x 100 to $5 x 50
Quantity
Perfectly Elastic Demand
Elasticity = Infinity
Price
1. At any price
above $4, quantity
demanded is zero.
$4
Demand
2. At exactly $4,
consumers will
buy any quantity.
0
3. At a price below $4,
quantity demanded is infinite.
Quantity
Relationship Between Total
Revenue (Sales) & Elasticity
Total Revenue = Price x Qty Sold = P x Qty
If demand is elastic, then a price decrease
increases revenue
If demand is inelastic, then a price increase
increases revenue
Example  class to contribute
Box Shows the 50% Drop of New Paying Customers for the May &
August 2004 Conference Caused by the Latest Price Hike
Conference Date
Attendance
New Paying
% of Total
Feb’ 01
72
6
8%
May’ 01
66
10
15%
Aug’ 01
101
31
31%
Nov’ 01
163
49
30%
189
28
15%
May’ 02
160
42
26%
Aug’ 02
195
62
32%
Nov’ 02
169
44
26%
Feb’ 03
260
55
21%
May’ 03
196
37
19%
Aug’ 03
220
43
20%
Nov’ 03
222
40
18%
Feb’ 04
238
48
20%
201
25
12%
211
23
11%
Feb’ 02
May’ 04
Aug’ 04
1st Price Hike
2nd Price Hike
Applications of Supply,
Demand & Elasticity
Can good news for farmers be bad news for
farmers?
Wheat is inelastic: Bumper crop  bad
news
Increase In Supply In Market
For Wheat
Price of
Wheat
2. . . . leads
to a large fall
in price . . .
1. When demand is inelastic,
an increase in supply . . .
S1
S2
$3
2
Demand
0
100
110
Quantity of
Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.