Download ECO 154/254

ECO 154/254
Intermediate
Macroeconomics
Prof. Michael B. McElroy
Multimedia by: Mannig J. Simidian
x2
x2a
x2b
x1a x2b x1
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What is Scarcity?
The Production Function
The Production Possibilities Frontier
Opportunity Cost
Dynamics of the PPF: Economic Growth
Choice: Investment or Consumption?
Public vs. Private Spending
Summary & Exercises
What is Scarcity?
Allow me to introduce myself…I am Scarcityman the hero who will never fail to remind you that there’s
no such thing as a free lunch. You can’t get get away from scarcity; it is simply an inherent condition in
nature, that we all must endure. I am sure you have noticed that you can’t just have or produce
everything. Opportunity costs exist and we must constantly make choices. Decisions will always be
about “this or that”, not “this and that” and “now or later” not “now and later.”
No Free
Lunch!
Scarcityman won’t have to remind us to take our bitter pill, scarcity, we will constantly run
into it as we further our study of Macroeconomics. We will come to realize that scarcity exists for
everyone, rich or poor.
For the richer country, scarcity forces people to work instead of play. If
resources were not scarce, the people would pursue more leisure
activities like vacation.
For the poorer country, poverty and appalling
living conditions make scarcity a matter of life
and death.
The Production Function
The production function is a process of transforming inputs (labor (n),
capital (k), institutional structure (inst) ) into outputs (final goods
and services for a certain time period).
The algebraic representation is:
y = F ( n, k, inst)
output
is
some function of
our given inputs
The Production Possibilities Frontier
(The PPF)
• Our goal in working with the PPF is to see the most output that can be produced given a certain amount
of inputs.
• So, first assume that as a nation, our inputs (n,k,inst) are fixed and we produce 2 goods, x1 and x2. In
other words, right now, we only have a certain amount of workers, and capital to work with and a certain
level of institutional efficiency within our society.
• Next, we’d like to determine what combinations of our 2 goods we could produce…so here we go.
Let’s say you decide to
produce this amount of goods x2 and x1.
x2
x2a
Remember that points
that lie outside the PPF,
are unattainable.
x2b
Remember
that points
that lie
inside the
PPF are
attainable,
but not
desirable.
x1a x1b x1
Or you could cut back on x2 and
increase your production of x1.
Opportunity Cost
The downward slope of the PPF depicts that the opportunity cost of producing more of one good is the amount
of the other good that must be sacrificed.
x2
10
units
A
Let’s say you are at point A, producing only good x2.
Suddenly you decide to produce some of good x1 without
reducing the production of good x2.
B
Uh oh…this is outside the
PPF, so you must reduce production of x2.
7
units
Notice that in order to gain 8 units of x1, you had
to give up 3 units (10-7) of good x2.
0 units
8 units
x1
Dynamics of the PPF: Economic Growth
Now, let’s suppose we can increase our inputs (n,k,inst). This
will shift out our PPF, making it possible to produce at a
higher PPF.
x2
PPF
This action is called
PPF
Remember that any points
that lie beyond even the higher PPF...
are still unattainable!!!
x1
9
measured in millions of dollars
Investment
Choice:
Consumption
or Investment?
A nation at point A is choosing “zero-growth”, that is, they
would rather consume right now, than invest and consume
more later.
C
B
6
0
A nation choosing point B shows more willingness to invest.
By investing more, the nation can increase its capital stock
and therefore experience an increase in their PPF in the future.
A
5
Consumption
measured in millions of dollars
8
10
A nation choosing point C is
investing even more and will see an even larger increase in their
PPF.
Consumption or investment?
There is no “better” choice, it just depends on whether one places a higher value on current consumption, than on
growth. Keep in mind that investment implies future consumption, so the decision is really about
when to consume.
measured in millions of dollars
Investment
9
C
A nation choosing point C, is said to have a
Low Rate of Time Preference.
B
6
5
Consumption
measured in millions of dollars
8
A nation choosing point B, is said to have
a High Rate of Time Preference.
Public vs. Private Spending
Public Output
The issue of Public and Private spending must also run into the boundaries set by scarcity. There is an
opportunity cost whereby more government output means less private output.
B
gB
gA
+Dg
Starting at point A, if the government decides
to increase public spending...
It must diminish private spending
and land at point B.
A
-D(c+i)
(c+i)B (c+i)A
Private Output
This is known as
Copyright 1997 Dead Economists Society
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Historical Background
A Glimpse of Adam Smith
Market Clearing
A Visit to The Classical Factory: AS* and AD
Conclusions on the Classical Model
Historical Background
The Classical model of economics relates the standard supply-demand
analysis to the macroeconomy. It holds that wages and prices will be
“flexible” as opposed to “sticky.” Adam Smith’s Wealth of Nations
(1776) suggested that the economy was controlled by the “invisible
hand” whereby the market system, instead of government would be
the best mechanism for a healthy economy.
A Glimpse of
Adam Smith
The central thesis of The Wealth of Nations is that capital is best employed for the production and distribution of wealth
under conditions of governmental noninterference, or laissez-faire, and free trade. In Smith's view, the production and
exchange of goods can be stimulated, and a consequent rise in the general standard of living attained, only through the
efficient operations of private industrial and commercial entrepreneurs acting with a minimum of regulation and control by
governments. To explain this concept of government maintaining a laissez-faire attitude toward commercial endeavors,
Smith proclaimed the principle of the “invisible hand”: Every individual in pursuing his or her own good is led, as if by an
invisible hand, to achieve the best good for all. Therefore any interference with free competition by government is almost
certain to be injurious.
"Smith, Adam," Microsoft® Encarta® 96 Encyclopedia. © 1993-1995 Microsoft Corporation. All rights reserved. © Funk & Wagnalls Corporation. All rights reserved.
Market Clearing
Market clearing is an alignment process whereby decisions between suppliers and demanders reach an equilibrium.
Here’s how it works...
Let’s say you begin with an initial demand and supply curve for CDs.
Remember that the demand curve slopes downward meaning that as you increase the price (by moving along the demand curve), the quantity
demanded decreases. Conversely, the supply curve slopes upward implying that as the price increases (by moving along the supply curve), the
amount supplied will increase.
P
P´
P*
D
D´
S
The center point A is the place where
market decisions reach an equilibrium.
Now, suppose that there is a sudden
increase in the demand for CDs.
Demand will shift from D to D´.
B
A
Q* Q´
Q
The increase in demand places upward pressure
on the price to point B
since the original price,
P* no longer clears the market.
Welcome to...
The place where
Classical Model
mechanics
are made easy!
P
S
P*
D
Q* Q