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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 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.